Financial accounting : with International Financial Reporting Standards (ch1-9 only) [4th edition.] 9781119504306, 1119504309

Table of contents :
Accounting in action --
The recording process --
Adjusting the accounts --
Completing the accounting cycle --
Accounting for merchandise operations --
Inventories --
Fraud, internal control, and cash --
Accounting for receivables --
Plant assets, natural resources, and intangible assets --
Current liabilities --
Non-Current liabilities --
Corporations: organization, share transactions, and equity --
Investments --
Statements of cash flows --
Financial analysis: the big picture

Citation preview

Financial Accountin with International Financial Reporting Standards

Fourth Edition

JERRY J. WEYGANDT PhD, CPA University of Wisconsin—Madison Madison, Wisconsin

PAUL D. KIMMEL PhD, CPA University of Wisconsin—Milwaukee Milwaukee, Wisconsin

DONALD E. KIESO PhD, CPA Northern Illinois University DeKalb, Illinois

Wiley

DEDICATED TO

Our wives, Enid, Merlynn, and Donna, for their love, support, and encouragement. DIRECTOR ACQUISITIONS EDITOR LEAD PRODUCT DESIGNER PRODUCT DESIGNER EDITORIAL SUPERVISOR EDITORIAL ASSOCIATE EDITORIAL ASSISTANT SENIOR CONTENT MANAGER SENIOR PRODUCTION EDITOR SENIOR DESIGNER SENIOR PHOTO EDITOR COVER IMAGE

Michael McDonald Zoe Craig Ed Brislin Lindsey Myers Terry Ann Tatro Margaret Thompson Alyce Pellegrino Dorothy Sinclair Elena Saccaro Wendy Lai Mary Ann Price ©Teodulo Vida/EyeEm/Getty Images

This book was set in Stix Regular by Aptara®, Inc. Founded in 1807. John Wiley & Sons, Inc. has been a valued source of knowledge and understanding for more than 200 years, helping people around the world meet their needs and fulfill their aspirations. Our company is built on a foundation of principles that include responsibility to the communities we serve and where we live and work. In 2008. we launched a Corporate Citizenship Initiative, a global effort to address the environmental, social, economic, and ethical challenges we face in our business. Among the issues we are addressing are carbon impact, paper specifications and procurement, ethical conduct within our business and among our vendors, and community and charitable support. For more informa­ tion, please visit our website: www.wiley.com/go/citizenship. Copyright © 2019 John Wiley & Sons, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechan­ ical. photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act. without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center. Inc. 222 Rosewood Drive. Danvers. MA 01923. website www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department. John Wiley & Sons. Inc.. 11 I River Street. Hoboken. NJ 07030-5774. (201)748-6011. fax (201)748-6008. website http://www.wiley.com/ go/permissions.

ISBN-13: 978-1-1 19-50340-8

The inside back cover will contain printing identification and country of origin if omitted from this page. In addition, if the ISBN on the back cover differs from the ISBN on this page, the one on the back cover is correct. Printed in Singapore by Markono Print Media Pte Ltd. 10

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7

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Brief Contents 1

Accounting in Action

2

The Recording Process

2-1

3

Adjusting the Accounts

3-1

4

Completing the Accounting Cycle

5

Accounting for Merchandise Operations

6

Inventories

7

Fraud, Internal Control, and Cash

8

Accounting for Receivables

9

Plant Assets, Natural Resources, and Intangible Assets

1-1

4-1

5-1

6-1 7-1

8-1 9-1

10

Current Liabilities

11

Non-Current Liabilities

12

Corporations: Organization, Share Transactions, and Equity

13

Investments

14

Statement of Cash Flows

15

Financial Analysis: The Big Picture

10-1

n-i 12-1

13-1 14-1

15-1

APPENDICES a

Specimen Financial Statements: TSMC, Ltd.

b

Specimen Financial Statements: Nestlé SA

c

Specimen Financial Statements: Delfi Limited

d

Specimen Financial Statements: Apple Inc.

e

Time Value of Money

f

Accounting for Partnerships

g

Subsidiary Ledgers and Special Journals

A-i b-1

c-1 D-1

E-1

COMPANY INDEX / SUBJECT INDEX

F-1 G-1

1-1

iii

From the Authors Dear Student,

WHY THIS TEXT? Your instructor has chosen this text for you because of the authors' trusted reputation. The authors have worked hard to write a text that is engaging, timely, and accurate.

WHY THIS COURSE? Remember your biology course in high school? Did you have one of those “invisible man” HOW TO SUCCEED? We’ve asked many students and many models (or maybe something more high-tech than that) that instructors whether there is a secret for success in this course. gave you the opportunity to look “inside” the human body? The nearly unanimous answer turns out to be not much of a This accounting course offers something similar. To under­ secret: "Do the homework.” This is one stand a business, you have to course where doing is learning. The more understand the financial in­ “Whether you are looking at a large multina­ time you spend on the homework assign­ sides of a business organiza­ tional company like Samsung or adidas or ments — using the various tools that this tion. A financial accounting a single-owner software consulting business text provides — the more likely you are to course will help you under­ or coffee shop, knowing the fundamentals of learn the essential concepts, techniques, stand the essential financial financial accounting will help you understand and methods of accounting. Besides the components of businesses. what is happening.” text itself, the book ’ s companion website Whether you are looking at a also offers various support resources. large multinational company like Samsung or adidas or a single-owner software consult­ Good luck in this course. We hope you enjoy the experience ing business or coffee shop, knowing the fundamentals of and that you put to good use throughout a lifetime of success financial accounting will help you understand what is hap­ the knowledge you obtain in this course. We are sure you will pening. As an employee, a manager, an investor, a business not be disappointed. owner, or a director of your own personal finances—any of which roles you will have at some point in your life—you Jerry J. Weygandt will make better decisions for having taken this course. Paul D. Kimmel

Donald E. Kieso

iv

Author Commitment

Jerry Weygandt

Paul Kimmel

Don

JERRY J. WEYGANDT, PhD, CPA, is Arthur Andersen Alumni Emeritus Professor of Accounting at the University of Wisconsin—Madison. He holds a Ph.D. in accounting from the University of Illinois. Articles by Professor Weygandt have appeared in The Accounting Review, Journal ofAccount­ ing Research, Accounting Horizons, Journal of Accountancy, and other academic and profes­ sional journals. These articles have examined such financial reporting issues as accounting for price-level adjustments, pensions, convertible securities, stock option contracts, and interim reports. Professor Weygandt is author of other accounting and financial reporting books and is a member of the American Accounting Association, the American Institute of Cer­ tified Public Accountants, and the Wiscon­ sin Society of Certified Public Accountants. He has served on numerous committees of the American Accounting Association and as a member of the editorial board of The Accounting Review, he also has served as Pres­ ident and Secretary-Treasurer of the American Accouniing Association. In addition, he has been actively involved with the American Institute of Certified Public Accountants and has been a member of the Accounting Stand­ ards Executive Committee (AcSEC) of that organization. He has served on the FASB task force that examined the reporting issues related to accounting for income taxes and served as a trustee of the Financial Accouniing Foundation. Professor Weygandt has received the Chancellor's Award for Excellence in Teaching and the Beta Gamma Sigma Dean’s Teaching Award. He is on the board of directors of Bascom-Palmer Eye I nstitute—Naples and also on the board of Artis— Naples. He is the recipient of the Wisconsin In­ stitute of CPA's Outstanding Educator’s Award and the Lifetime Achievement Award. In 2001 he received the American Accounting Associa­ tion’s Outstanding Educator Award.

PAUL D. KIMMEL, PhD, CPA. received his bachelor’s degree from the Uni­ versity of Minnesota and his doctorate in ac­ counting from the University of Wisconsin. He teaches at the University of Wisconsin— Milwaukee and Madison, and has public ac­ counting experience with Deloitte & Touche (Minneapolis). He was the recipient of the UWM School of Business Advisory Council Teaching Award, the Reggie Taite Excellence in Teaching Award and a three-time winner of the Outstanding Teaching Assistant Award at the University of Wisconsin. He is also a recipient of the Elijah Walts Sells Award for Honorary Distinction for his results on the CPA exam. He is a member of the American Accounting Association and the Institute of Management Accountants and has published articles in The Accounting Review, Accounting Horizons, Advances in Management Accounting, Managerial Finance, Issues in Accounting Education, Journal of Accounting Education, as well as other journals. His research interests include accounting for financial instruments and innovation in accounting education. He has published papers and given numerous talks on incorporating critical thinking into account­ ing education, and helped prepare a catalog of critical thinking resources for the Federated Schools of Accountancy.

DONALD

Kieso

E. KIESO, PhD, CPA. received his bachelor’s degree from Aurora Uni­ versity and his doctorate in accounting from the University of Illinois. He has served as chairman of the Department of Accountancy and is currently the KPMG Emeritus Professor of Accountancy at Northern Illinois University. Fie has public accounting experience with Price Waterhouse & Co. (San Francisco and Chicago) and Arthur Andersen & Co. (Chicago) and research experi­ ence with the Research Division of the American Institute of Certified Public Accountants (New York). He has done post doctorate work as a Visiting Scholar at the University of California at Berkeley and is a recipient of NIU's Teach­ ing Excellence Award and four Golden Apple Teaching Awards. Professor Kieso is the author of other accounting and business books and is a member of the American Accouniing Associa­ tion, the American Institute of Certified Public Accountants, and the Illinois CPA Society. He has served as a member of the Board of Directors of the Illinois CPA Society, then AACSB’s Accounting Accreditation Commit­ tees. the Stale of Illinois Comptroller’s Commis­ sion, as Secretary-Treasurer of the Federation of Schools of Accountancy, and as SecretaryTreasurer of the American Accounting Associa­ tion. Professor Kieso is currently serving on the Board of Trustees and Executive Committee of Aurora University, as a member of the Board of Directors of Kishwaukee Community Hospital, and as Treasurer and Director of Valley West Community Hospital. From 1989 to 1993 he served as a charter member of the national Ac­ counting Education Change Commission. He is the recipient of the Outstanding Accounting Educator Award from the Illinois CPA Society, the FSA's Joseph A. Silvoso Award of Merit, the NIU Foundation's Humanitarian Award for Service to Higher Education, a Distinguished Service Award from the Illinois CPA Society, and in 2003 an honorary doctorale from Aurora University. v

Hallmark Features Financial Accounting provides a simple and practical introduction to the fundamentals of financial accounting. It explains the concepts you need to know. This edition continues this approach by offering even more explanations, illustrations, and homework problems to help students get a firm understanding of the accounting cycle.

DO IT! Exercises DO IT! Exercises in the body of the text prompt students to stop and review key concepts. They outline the Action Plan necessary to complete the exercise as well as show a detailed solution.

DO IT! 2 I Closing Entries

ACTION PLAN • Close revenue and

Hancock Heating has the following balances in selected accounts of its adjusted trial balance.

expense accounts to Income Summary.

€27.000

Accounts Payable

• Close Income Summary to Retained Earnings.

• Close Dividends to

€ 15,000

Dividends

Service Revenue

98,000

Share Capital—Ordinary

42.000

Rent Expense

22,000

Accounts Receivable

38.1X10

Salaries and Wages Expense

51.000

Supplies Expense

7,000

Prepare the closing entries at December 31.

Retained Earnings.

Solution 98.000

Service Revenue Income Summary

98.000

(To close revenue account to Income Summary)

Income Summary Salaries and Wages Expense

80.000 51,000

Rent Expense

22.000 7.0(H)

Supplies Expense (To close expense accounts to Income Summary)

Review and Practice Each chapter concludes with a Review and Practice section which includes a review of learn­ ing objectives, key terms glossary, practice multiple-choice questions with annotated solu­ tions, practice brief exercises with solutions, practice exercises with solutions, and a practice problem with a solution.

Practice Brief Exercises Prepare the current assets section of a statement offinancial position.

3. (LO 4) The statement of financial position debit column of the worksheet for Soon Cosmetics includes the following accounts (amounts in thousands): Accounts Receivable W25.OOO. Prepaid Insurance W7.000, Cash WS.OOO, Supplies Wl1.000. and Inventory W 14.000. Prepare the current assets section of the statement of financial position, listing the accounts in proper sequence.

Solution 3.

Soon Cosmetics Statement of Financial Position (partial)

Current assets Prepaid insurance Supplies Inventory Accounts receivable Cash

Total current assets

vi

W 7,000 1 1,000 14,000 25.000

8,000 W65.000

Hallmark Features

Infographic Learning Over half of the text is visual, providing students alternative ways of learning about accounting. In addition, a new interior design promotes accessibility.

Title of Account Left or debit side I Right or credit side

f»

ILLUSTRATION 2.1 Basic form of account

j

Real-World Decision-Making Real-world examples that illustrate interesting situations in companies and how accounting information is used are integrated throughout the text, such as in the opening Feature Story as well as the Insight boxes.

People, Planet, and Profit Insight

Nestlé SA

Creating Value

Nutrition: Products meeting or exceeding Nutritional Founda­

tion profiling criteria (as percentage of total sales) and products Appendix B contains the financial state­

ments of Nestlé SA (CHE). Those finan­

with increase in nutritious ingredients or essential nutrients.

cial statements report on the company’s

Water and Environmental Sustainability: Quality of water dis­

In

charged (average mg COD/I) and packaging weight reduction (tonnes).

profitability and

financial

position.

financial statements.

Rural Development: Farmers trained through capacity-build­

Nestlé, like many other companies today,

ing programs and suppliers audited for food safety, quality, and

addition to these

also reports its achievements with regard

processing.

to other, non-financial goals. In Nestlé's

Simon Rawles/Akuny

case, it calls these goals "Creating Shared

To learn more about Nestlé's efforts to create shared value, go to

Value." Nestlé has set objectives to help

the company’s website.

society in areas most directly related to its particular expertise:

nutrition, water and environmental sustainability, and rural

What are some implications of Nestlé’s decision to measure

development. The company evaluates its progress in each area

its results using objective measures and then publicly report

using objective measures. Examples of measures used arc pro­

these results? (Go to the book’s companion website for this

vided below.

answer and additional questions.)

Additional Guidance Throughout the text, marginal notes, such as Helpful Hints, Alternative Terminology, and Ethics Notes, are provided as additional guidance.

Correcting Entries—An Avoidable Step Unfortunately, errors may occur in the recording process. Companies should correct errors, as soon as they discover them, by journalizing and posting correcting entries. If the account­ ing records are free of errors, no correcting entries are needed. You should recognize several differences between correcting entries and adjusting entries. First, adjusting entries are an integral part of the accounting cycle. Correcting entries, on the other hand, are unnecessary if the records are error-free. Second, companies journalize and post adjustments only at the end of an accounting period. In contrast, companies make correcting entries whenever they discover an error (see Ethics Note). Finally, adjusting entries always affect at least one statement of financial position account and one income statement account. In

ETHICS NOTE When companies find errors in previously released income

statements, they restate those

numbers.

vii

C o nte n ts 1 Accounting in Action

Knowing the Numbers 1-1 Accounting Activities and Users 1-3 Three Activities 1-3 Who Uses Accounting Data 1-4 The Building Blocks of Accounting 1-6 Ethics in Financial Reporting 1-6 Accounting Standards 1-7 Measurement Principles 1-8 Assumptions 1-8 The Accounting Equation 1-10 Assets 1-11 Liabilities 1-11 Equity 1-11 Analyzing Business Transactions 1-13 Accounting Transactions 1-13 Transaction Analysis 1-14 Summary of Transactions 1-19 Financial Statements 1-20 Income Statement 1-22 Retained Earnings Statement 1-22 Statement of Financial Position 1-22 Statement of Cash Flows 1-23 Comprehensive Income Statement 1-23 Appendix 1A: Career Opportunities in Accounting Public Accounting 1-25 Private Accounting 1-26 Governmental Accounting 1-26 Forensic Accounting 1-26 A Look at U.S. GAAP 1-46

2 The Recording Process Accidents Happen: Bank of Taiwan 2-1 Accounts, Debits, and Credits 2-2 The Account 2-2 Debits and Credits 2-3 Equity Relationships 2-6 Summary of Debit/Credit Rules 2-6 The Journal 2-7 The Recording Process 2-7 The Journal 2-8 The Ledger and Posting 2-10 The Ledger 2-10 Posting 2-12 Chart of Accounts 2-13 The Recording Process Illustrated 2-13

viii

Summary Illustration of Journalizing and Posting The Trial Balance 2-21 Limitations of a Trial Balance 2-22 Locating Errors 2-22 Currency Signs and Underlining 2-22 A Look at U.S. GAAP 2-46

1-1

2-1

3 Adjusting the Accounts

1-25

2-19

3-1

What Was Your Profit?: Cadbury 3-1 Accrual-Basis Accounting and Adjusting Entries 3-2 Fiscal and Calendar Years 3-3 Accrual- versus Cash-Basis Accounting 3-3 Recognizing Revenues and Expenses 3-3 The Need for Adjusting Entries 3-5 Types of Adjusting Entries 3-5 Adjusting Entries for Deferrals 3-6 Prepaid Expenses 3-6 Unearned Revenues 3-10 Adjusting Entries for Accruals 3-13 Accrued Revenues 3-13 Accrued Expenses 3-14 Summary of Basic Relationships 3-17 Adjusted Trial Balance and Financial Statements 3-20 Preparing the Adjusted Trial Balance 3-21 Preparing Financial Statements 3-21 Appendix 3A: Alternative Treatment of Deferrals 3-24 Prepaid Expenses 3-25 Unearned Revenues 3-26 Summary of Additional Adjustment Relationships 3-27 Appendix 3B: Financial Reporting Concepts 3-28 Qualities of Useful Information 3-28 Assumptions in Financial Reporting 3-28 Principles in Financial Reporting 3-29 Cost Constraint 3-30 A Look at U.S. GAAP 3-56

4 Completing the Accounting Cycle

4-i

Speaking the Same Language: IASB 4-1 The Worksheet 4-3 Steps in Preparing a Worksheet 4-3 Preparing Financial Statements from a Worksheet 4-10 Preparing Adjusting Entries from a Worksheet 4-11 Closing the Books 4-11 Preparing Closing Entries 4-12

Contents

Posting Closing Entries 4-14 Preparing a Post-Closing Trial Balance 4-16 The Accounting Cycle and Correcting Entries 4-19 Summary of the Accounting Cycle 4-19 Reversing Entries—An Optional Step 4-19 Correcting Entries—An Avoidable Step 4-19 Classified Statement of Financial Position 4-23 Intangible Assets 4-24 Property, Plant, and Equipment 4-25 Long-Term Investments 4-25 Current Assets 4-25 Equity 4-26 Non-Current Liabilities 4-27 Current Liabilities 4-27 Appendix 4A: Reversing Entries 4-29 Reversing Entries Example 4-29 A Look at U.S. GAAP 4-57

5 Accounting for Merchandise Operations

5-1

Who Doesn’t Shop?: Carrefour 5-1 Merchandising Operations and Inventory Systems 5-3 Operating Cycles 5-3 Flow of Costs 5-4 Recording Purchases Under a Perpetual System 5-6 Freight Costs 5-8 Purchase Returns and Allowances 5-9 Purchase Discounts 5-9 Summary of Purchasing Transactions 5-10 Recording Sales Under a Perpetual System 5-11 Sales Returns and Allowances 5-12 Sales Discounts 5-13 The Accounting Cycle for a Merchandising Company 5-14 Adjusting Entries 5-15 Closing Entries 5-15 Summary of Merchandising Entries 5-16 Financial Statements for a Merchandiser 5-17 Income Statement 5-17 Classified Statement of Financial Position 5-21 Appendix 5A: Worksheet for a Merchandising Company 5-23 Using a Worksheet 5-23 Appendix 5B: Periodic Inventory System 5-24 Determining Cost of Goods Sold Under a Periodic System 5-25 Recording Merchandise Transactions 5-25 Recording Purchases of Merchandise 5-26 Recording Sales of Merchandise 5-27 Journalizing and Posting Closing Entries 5-27 Using a Worksheet 5-29 A Look at U.S. GAAP 5-54

6 Inventories

6-1

“Where Is That Spare Bulldozer Blade?”: Komatsu 6-1 Classifying and Determining Inventory 6-2 Classifying Inventory 6-2 Determining Inventory Quantities 6-4 Inventory Methods and Financial Effects 6-6 Specific Identification 6-7 Cost Flow Assumptions 6-7 Financial Statement and Tax Effects of Cost Flow Methods 6-11 Using Inventory Cost Flow Methods Consistently 6-12 Effects of Inventory Errors 6-13 Income Statement Effects 6-13 Statement of Financial Position Effects 6-14 Inventory Statement Presentation and Analysis 6-15 Presentation 6-15 Lower-of-Cost-or-Net Realizable Value 6-15 Analysis 6-16 Appendix 6A: Inventory Cost Flow Methods in Perpetual Inventory Systems 6-18 First-In, First-Out (FIFO) 6-18 Average-Cost 6-19 Appendix 6B: Estimating Inventories 6-19 Gross Profit Method 6-20 Retail Inventory Method 6-21 Appendix 6C: LIFO Inventory Method 6-22 A Look at U.S. GAAP 6-44

7 Fraud, Internal Control, and Cash

7-1

Minding the Money at Nick’s: Nick’s Steakhouse and Pizza 7-1 Fraud and Internal Control 7-2 Fraud 7-3 Internal Control 7-3 Principles of Internal Control Activities 7-4 Limitations of Internal Control 7-10 Cash Controls 7-10 Cash Receipts Controls 7-11 Cash Disbursements Controls 7-13 Petty Cash Fund 7-15 Control Features of a Bank Account 7-18 Making Bank Deposits 7-18 Writing Checks 7-19 Electronic Funds Transfer (EFT) System 7-20 Bank Statements 7-20 Reconciling the Bank Account 7-21 Reporting Cash 7-26

ix

X

Contents

Cash Equivalents 7-26 Restricted Cash 7-26 A Look at U.S. GAAP 7-46

8 Accounting for Receivables

10 Current Liabilities

8-i

Are You Going to Pay Me—or Not?: BNP Paribas 8-1 Recognition of Accounts Receivable 8-2 Types of Receivables 8-3 Recognizing Accounts Receivable 8-3 Valuation and Disposition of Accounts Receivable 8-5 Valuing Accounts Receivable 8-5 Disposing of Accounts Receivable 8-11 Notes Receivable 8-13 Determining the Maturity Date 8-14 Computing Interest 8-15 Recognizing Notes Receivable 8-15 Valuing Notes Receivable 8-16 Disposing of Notes Receivable 8-16 Presentation and Analysis 8-18 Presentation 8-19 Analysis 8-19 A Look at U.S. GAAP 8-38

9

Plant Assets, Natural Resources, and Intangible Assets 9-1

How Much for a Ride to the Beach?: Rent-A-Wreck Plant Asset Expenditures 9-2 Determining the Cost of Plant Assets 9-3 Expenditures During Useful Life 9-5 Depreciation Methods 9-7 Factors in Computing Depreciation 9-8 Depreciation Methods 9-8 Component Depreciation 9-13 Depreciation and Income Taxes 9-13 Revaluation of Plant Assets 9-13 Revising Periodic Depreciation 9-14 Plant Asset Disposals 9-15 Retirement of Plant Assets 9-16 Sale of Plant Assets 9-16 Natural Resources and Intangible Assets 9-18 Natural Resources and Depletion 9-18 Intangible Assets 9-20 Statement Presentation and Analysis 9-23 Presentation 9-23 Analysis 9-24 Appendix 9A: Exchange of Plant Assets 9-24 Loss Treatment 9-25 Gain Treatment 9-25 A Look at U.S. GAAP 9-47

9-1

10-1

Financing His Dreams: Wilbert Murdock 10-1 Accounting for Current Liabilities 10-2 What Is a Current Liability? 10-2 Notes Payable 10-3 Value-Added and Sales Taxes Payable 10-4 Unearned Revenues 10-5 Salaries and Wages 10-5 Current Maturities of Long-Term Debt 10-7 Reporting and Analyzing Current Liabilities 10-8 ReportingUncertainty 10-8 Reporting of Current Liabilities 10-9 Analysis of Current Liabilities 10-10 A Look at U.S. GAAP 10-26

11 Non-Current Liabilities

11-1

Are We Living on Borrowed Time? 11-1 Overview of Bonds 11-2 Types of Bonds 11-3 Issuing Procedures 11-3 Bond Trading 11-3 Determining the Market Price of a Bond 11-4 Bond Transactions 11-6 Issuing Bonds at Face Value 11-6 Discount or Premium on Bonds 11-7 Issuing Bonds at a Discount 11-8 Issuing Bonds at a Premium 11-9 Redeeming Bonds 11-10 Accounting for Non-Current Liabilities 11-11 Long-Term Notes Payable 11-11 Lease Liabilities 11-13 Reporting and Analyzing Non-Current Liabilities 11-14 Presentation 11-14 Analysis 11-14 Debt and Equity Financing 11-15 Appendix 11A: Effective-Interest Method of Bond Amortization 11-17 Amortizing Bond Discount 11-17 Amortizing Bond Premium 11-19 Appendix 11B: Straight-Line Amortization 11-20 Amortizing Bond Discount 11-20 Amortizing Bond Premium 11-21 A Look at U.S. GAAP 11-38

12 Corporations: Organization, Share Transactions, and Equity To the Victor Go the Spoils: adidas 12-1 The Corporate Form of Organization 12-2 Characteristics of a Corporation 12-3

12-1

Contents

Forming a Corporation 12-5 Shareholder Rights 12-5 Share Issue Considerations 12-7 Corporate Capital 12-9 Accounting for Share Transactions 12-10 Accounting for Ordinary Shares 12-10 Accounting for Preference Shares 12-12 Accounting for Treasury Shares 12-13 Dividends and Splits 12-16 Accounting for Cash Dividends 12-17 Dividend Preferences 12-18 Accounting for Share Dividends 12-21 Accounting for Share Splits 12-23 Reporting and Analyzing Equity 12-24 Retained Earnings 12-24 Presentation of Statement of Financial Position 12-26 Analysis 12-27 Appendix 12A: Statement of Changes in Equity 12-28 Appendix 12B: Book Value—Another per Share Amount 12-29 Book Value per Share 12-29 Book Value versus Market Price 12-30 A Look at U.S. GAAP 12-55

13 Investments

Significant Non-Cash Activities 14-5 Format of the Statement of Cash Flows 14-5 Preparing the Statement of Cash Flows—Indirect Method 14-7 Indirect and Direct Methods 14-8 Indirect Method—Computer Services International 14-8 Step 1: Operating Activities 14-9 Summary of Conversion to Net Cash Provided by Operating Activities—Indirect Method 14-12 Step 2: Investing and Financing Activities 14-13 Step 3: Net Change in Cash 14-14 Using Cash Flows to Evaluate a Company 14-17 Free Cash Flow 14-17 Appendix 14A: StatementofCash Flows—Direct Method 14-19 Step 1: Operating Activities 14-21 Step 2: Investing and Financing Activities 14-25 Step 3: Net Change in Cash 14-26 Appendix 14B: Statement of Cash Flows—T-Account Approach 14-26 A Look at U.S. GAAP 14-50

15 Financial Analysis: The Big

13-1

Picture

Playing for Fun and Profit: Sony 13-1 Debt Investments 13-2 Why Companies Invest 13-2 Accounting for Debt Investments 13-4 Share Investments 13-6 Holdings of Less than 20% 13-6 Holdings Between 20% and 50% 13-7 Holdings of More than 50% 13-8 Valuing and Reporting Investments 13-10 Categories of Securities 13-10 Statement of Financial Position Presentation 13-16 Presentation of Realized and Unrealized Gain or Loss 13-17 Classified Statement of Financial Position 13-17 Appendix 13A: Preparing Consolidated Financial Statements 13-19 Consolidated Statement of Financial Position 13-19 Consolidated Income Statement 13-23 A Look at U.S. GAAP 13-40

14 Statement of Cash Flows

xi

14-1

What Should We Do with This Cash?: Keyence 14-1 Statement of Cash Flows: Usefulness and Format 14-3 Usefulness of the Statement of Cash Flows 14-3 Classification ofCash Flows 14-3

15-1

Making Money the Old-Fashioned Way: Li Ka-shing Basics of Financial Statement Analysis 15-2 Need for Comparative Analysis 15-3 Tools of Analysis 15-3 Horizontal Analysis 15-3 Vertical Analysis 15-6 Ratio Analysis 15-9 Liquidity Ratios 15-9 Profitability Ratios 15-13 Solvency Ratios 15-16 Summary of Ratios 15-18 Sustainable Income 15-20 Discontinued Operations 15-21 Changes in Accounting Principle 15-22 Comprehensive Income 15-22 A Look at U.S. GAAP 15-48

15-1

Appendix A Specimen Financial Statements: Taiwan Semiconductor Manufacturing Company, Limited a-i

xii

Contents

Appendix F Accounting for Partnerships

Appendix B Specimen Financial Statements: Nestlé SA B-i

Forming a Partnership F-2 Characteristics of Partnerships F-2 Organizations with Partnership Characteristics F-3 Advantages and Disadvantages of Partnerships F-4 The Partnership Agreement F-5 Accounting for a Partnership Formation F-5 Accounting for Net Income or Net Loss F-6 Dividing Net Income or Net Loss F-6 Partnership Financial Statements F-9 Liquidation of a Partnership F-10 No Capital Deficiency F-ll Capital Deficiency F-12 Admissions and Withdrawals of Partners F-15 Admission of a Partner F-15 Withdrawal of a Partner F-18

Appendix C Specimen Financial Statements: Delfi Limited c-i

Appendix D Specimen Financial Statements: Apple Inc. D-i

Appendix E Time Value of Money Interest and Future Values E-l Nature of Interest E-l Future Value of a Single Amount E-3 Future Value of an Annuity E-5 Present Value Concepts E-7 Present Value Variables E-7 Present Value of a Single Amount E-7 Present Value of an Annuity E-9 Time Periods and Discounting E-ll Present Value of a Long-Term Note or Bond E-ll Using Financial Calculators E-14 Present Value of a Single Sum E-14 Present Value of an Annuity E-15 Useful Applications of the Financial Calculator E-16

f-i

e-i

Appendix G Subsidiary Ledgers and Special Journals g-i Subsidiary Ledgers G-l Subsidiary Ledger Example G-2 Advantages of Subsidiary Ledgers G-3 Special Journals G-4 Sales Journal G-4 Cash Receipts Journal G-7 Purchases Journal G-10 Cash Payments Journal G-13 Effects of Special Journals on the General Journal G-15 Cybersecurity: A Final Comment G-16

Company Index 1-1 Subject Index 1-3

Financial Accounting has benefited greatly front the input of those who have sent comments by letter or e-mail, ancillary authors, and proofers. We greatly appreciate the constructive suggestions and innovative ideas of reviewers and the creativity and accuracy of the ancil­ lary authors and checkers.

Michael Barnes Truman State University

Barbara Muller Arizona State University

Ellen Bartley St. Joseph 's College

Yvonne Phang Borough of Manhattan Community College

LuAnn Bean Florida Institute of Technology

Laura Prosser Black Hills State University

Jack Borke University of Wisconsin—Platteville

Alice Sineath Forsyth Technical Community College

Larry Falcetto Emporia State University

Lynn Stallworth Appalachian State University’

Heidi Hansel Kirkwood Community College

Teresa Speck St. Mary's University’

Karen Hern Grossmont College

Lakshmy Sivaratnam Kansas City Kansas Community’ College

Derek Jackson St. Mary’s University

Shelia Viel University of Wisconsin—Milwaukee

Cynthia Lovick Austin Community College

Dick Wasson Southwestern College

Jill Misuraca University of Tampa

Suzanne Wright Pennsylvania State University

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CHAPTER 1

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The Chapter Preview describes the purpose of the chapter and highlights major topics.

Chapter Preview The following Feature Story highlights the importance of having good financial information and knowing how to use it to make effective business decisions. Whatever your pursuits or occupation, the need for financial information is inescapable. You cannot earn a living, spend money, buy on credit, make an investment, or pay taxes without receiving, using, or dispensing financial information. Good decision-making depends on good information. The Feature Story helps you picture how the chapter topic relates to the real world of accounting and business.

Feature Story Knowing the Numbers Many students who take this course do not plan to be accountants. If you are in that group, you might be think­ ing, “If I’m not going to be an accountant, why do I need to know accounting?” In response, consider the quote from Harold Gencen, the former chairman of a major international company: “To be good at your business, you have to know the numbers—cold.”

Success in any business comes back to the numbers. You will rely on them to make decisions, and managers will use them to evaluate your performance. That is true whether your job involves marketing, production, management, or informa­ tion systems. In business, accounting is the means for communicating the numbers. If you don’t know how to read financial state­ ments, you cannot really know your business. Many companies spend significant resources teaching their employees basic accounting so that they can read finan­ cial statements and understand how their actions affect the 1-1

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CHAPTER 1

Accounting in Action

company’s financial results. Employers need managers in all areas of the company to be “financially literate.” Taking this course will go a long way to making you financially literate. In this text, you will learn how to read and prepare financial statements, and how to use basic tools to evaluate financial results. Appendices A, B. and C of this text provide real finan­ cial statements of three companies from different countries that report using International Financial Reporting Standards (IFRS): Taiwan Semiconductor Manufacturing Company (TSMC) Ltd. (TWN), Nestlé SA (CHE), and Delfi Limited (SGP). Throughout this text, we increase your familiarity with

financial reporting by providing numerous references, ques­ tions, and exercises that encourage you to explore these finan­ cial statements. In addition, we encourage you to visit each company’s website where you can view its complete annual report. In examining the financial reports of these three compa­ nies, you will see that the accounting practices of companies in specific countries that follow IFRS sometimes differ with regard to particular details. However, more importantly, you will find that the basic accounting principles are the same. As a result, by learning these basic principles as presented in this text, you will be well equipped to begin understanding the financial results of companies around the world.

The Chapter Outline presents the chapter’s topics and subtopics, as well as practice opportunities.

Chapter Outline LEARNING OBJECTIVES

LOI Identify the activities and

• Three activities

users associated with accounting.

• Who uses accounting data

LO2 Explain the building blocks of accounting: ethics, principles, and assumptions.

• Ethics in financial reporting

DO IT! 1 Basic Concepts

DOIT! 2

Building Blocks of Accounting

DO IT! 3

Equity Effects

• Accounting standards • Measurement principles • Assumptions

LO3 State the accounting

• Assets

equation, and define its components.

• Liabilities

LO4 Analyze the effects of

• Accounting transactions

business transactions on the accounting equation.

• Transaction analysis

LO5 Describe the five financial statements and how they are prepared.

• Income statement

• Equity DO IT! 4 Tabular Analysis

• Summary of transactions

• Retained earnings statement

DO IT! 5 Financial Statement

Items

• Statement of financial position

• Statement of cash flows • Comprehensive income statement Go to the Review and Practice section at the end of the chapter for a review of key concepts and practice applications with solutions.

Accounting Activities and Users

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Accounting Activities and Users LEARNING OBJECTIVE 1

Identify the activities and users associated with accounting.

What consistently ranks as one of the top career opportunities in business? What frequently rates among the most popular majors on campus? Accounting.1 Why clo people choose accounting? They want to acquire the skills needed to understand what is happening finan­ cially inside an organization. Accounting is the financial information system that provides these insights. In short, to understand your organization, you have to know the numbers. Accounting consists of three basic activities—it identifies, records, and communicates the economic events of an organization to interested users. Let’s take a closer look at these three activities.

Three Activities As a starting point to the accounting process, a company identifies the economic events rel­ evant to its business. Examples of economic events are the sale of food and snacks by Uni­ lever (GBR and NLD), the providing of telephone services by Chunghwa Telecom (TWN), and the manufacture of motor vehicles by Tata Motors (IND). Once a company like Unilever identifies economic events, it records those events in or­ der to provide a history of its financial activities. Recording consists of keeping a systematic, chronological diary of events, measured in monetary units. In recording, Unilever also clas­ sifies and summarizes economic events. Finally, Unilever communicates the collected information to interested users by means of accounting reports. The most common of these reports are called financial statements. To make the reported financial information meaningful, Unilever reports the recorded data in a standardized way. It accumulates information resulting from similar transactions. For example, Unilever accumulates all sales transactions over a certain period of time and re­ ports the data as one amount in the company’s financial statements. Such data are said to be reported in the aggregate. By presenting the recorded data in the aggregate, the accounting process simplifies a multitude of transactions and makes a series of activities understandable and meaningful. A vital element in communicating economic events is the accountant’s ability to ana­ lyze and interpret the reported information. Analysis involves use of ratios, percentages, graphs, and charts to highlight significant financial trends and relationships. Interpretation involves explaining the uses, meaning, and limitations of reported data. Appendix A of this text shows the financial statements of Taiwan Semiconductor Manufacturing Company (TSMC) Ltd. (TWN). Appendix B illustrates the financial statements of Nestlé SA (CHE), and Appendix C includes the financial statements of Delfi Limited (SGP). We refer to these statements at various places throughout the text. (In addition, in the A Look at U.S. GAAP section at the end of each chapter, the U.S. company Apple Inc. is analyzed.) At this point, these financial statements probably strike you as complex and con­ fusing. By the end of this course, you’ll be surprised at your ability to understand, analyze, and interpret them.

'The appendix to this chapter describes job opportunities for accounting majors and explains why accounting is such a popular major.

Essential terms are printed in blue when they first appear, and are defined in the end-of-chapter Glossary Review.

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Illustration 1.1 summarizes the activities of the accounting process. ILLUSTRATION 1.1

The activities of the accounting process

You should understand that the accounting process includes the bookkeeping function. Bookkeeping usually involves only the recording of economic events. It is therefore just one part of the accounting process. In total, accounting involves the entire process of identifying, recording, and communicating economic events.2

Who Uses Accounting Data The financial information that users need depends upon the kinds of decisions they make. There are two broad groups of users of financial information: internal users and external users.

Internal Users Internal users of accounting information are managers who plan, organize, and run the busi­ ness. These include marketing managers, production supervisors, finance directors, and com­ pany officers. In running a business, internal users must answer many important questions, as shown in Illustration 1.2.

ILLUSTRATION 1.2

Questions that internal users ask

Questions Asked by Internal Users

Snack chips

Beverages

Finance

Marketing

Human Resources

Management

Is cash sufficient to pay dividends to SAP shareholders?

What price should Nokia charge for a cell phone to maximize the company's net income?

Can Toyota afford to give its employees pay raises this year?

Which PepsiCo product line is the most profitable? Should any product lines be eliminated?

“The origins of accounting are generally attributed to the work of Luca Pacioli. an Italian Renaissance mathemati­ cian. Pacioli was a close friend and tutor to Leonardo da Vinci and a contemporary of Christopher Columbus. In his 1494 text Summa de Aritlimetica, Geometria, Proportione et Proportionalite. Pacioli described a system to ensure that financial information was recorded efficiently and accurately.

Accounting Activities and Users

To answer these and other questions, internal users need detailed information on a timely basis. Managerial accounting provides internal reports to help users make decisions about their companies. Examples are financial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts ofcash needs for the next year.

External Users External users are individuals and organizations outside a company who want financial infor­

mation about the company. The two most common types of external users are investors and creditors. Investors (owners) use accounting information to decide whether to buy. hold, or sell ownership shares of a company. Creditors (such as suppliers and bankers) use accounting information to evaluate the risks of granting credit or lending money. Illustration 1.3 shows some questions that investors and creditors may ask. ILLUSTRATION 1.3

Questions that external users ask

Users

Investors

Creditors

How does Disney compare in size and profitability with Time Warner?

Will Singapore Airlines be able to pay its debts as they come due?

Financial accounting answers these questions. It provides economic and financial in­ formation for investors, creditors, and other external users. The information needs of external users vary considerably. Taxing authorities, such as the State Administration of Taxation in the People’s Republic of China (CHN), want to know whether the company complies with tax laws. Regulatory agencies, such as the Financial Services Authority of Indonesia (IDN), want to know whether the company is operating within prescribed rules. Customers are interested in whether a company like Tesla Motors, Inc. (USA) will continue to honor product warranties and support its product lines. Labor unions, such as the Indian National Trade Union Congress (IND), want to know whether companies have the ability to pay increased wages and benefits to union members.

The DO IT! exercises ask you to put newly acquired knowledge to work. They outline the Action Plan necessary to complete the exercise, and they show a Solution.

DO IT! 1

Basic Concepts

Indicate whether each of the five statements presented below is true or false. If false, indicate how to correct the statement.

1. The three steps in the accounting process are identification, recording, and communication. 2. Bookkeeping encompasses all steps in the accounting process. 3. Accountants prepare, but do not interpret, financial reports. 4. The two most common types of external users are investors and company officers.

5. Managerial accounting activities focus on reports for internal users.

Solution

1. True 2. False. Bookkeeping involves only the recording step. 3. False. Accountants analyze and interpret information in reports as part of the communication step. 4. False. The two most common types of external users are investors and creditors. 5. True. Related exercise material: DO IT! 1.1, El.l, and E1.2.

ACTION PLAN

• Review the basic concepts discussed.

• Develop an understanding of the key terms used.

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The Building Blocks of Accounting LEARNING OBJECTIVE 2

Explain the building blocks of accounting: ethics, principles, and assumptions.

A doctor follows certain protocols in treating a patient’s illness. An architect follows certain structural guidelines in designing a building. Similarly, an accountant follows certain stan­ dards in reporting financial information. These standards are based on specific principles and assumptions. For these standards to work, however, a fundamental business concept must be present—ethical behavior.

Ethics in Financial Reporting People won’t gamble in a casino if they think it is “rigged.” Similarly, people won't invest in the securities market if they think share prices are rigged. In recent years, the financial press has been full of articles about financial scandals at Satyam Computer Services (IND), Toshiba (JPN), Pou Sheng International (HKG), Siwei (CHN), and other companies. As the scandals came to light, mistrust of financial reporting in general grew. One article in the financial press noted that “repeated disclosures about questionable accounting practices have bruised investors' faith in the reliability of earnings reports, which in turn has sent share prices tumbling.” Imagine trying to carry on a business or invest money if you could not depend on the financial statements to be honestly prepared. Information would have no credibility. There is no doubt that a sound, well-functioning economy depends on accurate and dependable financial reporting. The standards of conduct by which actions are judged as right or wrong, honest or dishon­ est, fair or not fair, are ethics. Effective financial reporting depends on sound ethical behavior. To sensitize you to ethical situations in business and to give you practice at solving ethical dilemmas, we address ethics in a number of ways in this text: 1. A number of the Feature Stories and other parts of the text discuss the central importance

of ethical behavior to financial reporting. 2. Ethics Insight boxes and marginal Ethics Notes highlight ethics situations and issues in

actual business settings. 3. Many of the People, Planet, and Profit Insight boxes focus on ethical issues that companies

face in measuring and reporting social and environmental issues. 4. At the end of the chapter, an Ethics Case simulates a business situation and asks you to

put yourself in the position of a decision-maker in that case.

When analyzing these various ethics cases, as well as experiences in your own life, it is useful to apply the three steps outlined in Illustration 1.4, ILLUSTRATION 1.4

Steps in analyzing ethics cases and situations

I. Recognize an ethical situation and the ethical issues involved. Use your personal ethics to identify ethical situations and issues. Some businesses and professional organizations provide written codes of ethics for guidance in some business situations.

2. Identify and analyze the principal elements in the situation. Identify the stakeholders—

3. Identify the alternatives, and weigh the impact of each alternative on various stakeholders.

persons or groups who may be harmed or benefited. Ask the question: What are the responsibilities and obligation of the parties involved?

Select the most ethical alternative, considering all the consequences. Sometimes there will be one right answer. Other situations involve more than one right solution; these situations require an evaluation of each and a selection of the best alternative.

The Building Blocks of Accounting

Insight boxes provide examples of business situations from various perspectives—ethics, investor, international, and company social responsibility. Guideline answers to the critical thinking questions and additional questions are available at the book’s companion website.

Ethics Insight

Dewey & LeBoeuf LLP

I Felt the Pressure— Would You?

• “I intentionally gave the auditors incorrect information in the course of the audit.”

“I felt the pressure.” That's what some of the employees of the now-defunct law firm of Dewey & LeBoeuf LLP indicated when they helped to overstate revenue and use accounting tricks to hide losses and cover up cash shortages. These employees worked for the former finance director and former chief financial officer (CFO) of the firm. Here are some of their comments:

What happened here is that a small group of lowerlevel employees over a period of years carried out the instruc­ tions of their bosses. Their bosses, however, seemed to have no concern as evidenced by various e-mails with one another in which they referred to their financial manipulations as account­ ing tricks, cooking the books, and fake income.

• “I was instructed by the CFO to create invoices, knowing they would not be sent to clients. When I created these invoices. 1 knew that it was inappropriate.”

Why did these employees lie, and what do you believe should be their penalty for these lies? (Go to the book’s companion website for this answer and additional questions.)

Source: Ashby Jones. “Guilty Pleas of Dewey Staff Detail the Alleged Fraud," Wall Street Journal (March 28. 2014).

Accounting Standards In order to ensure high-quality financial reporting, accountants present financial statements in conformity with accounting standards that are issued by standard-setting bodies. Presently, there are two primary accounting standard-setting bodies—the International Accounting Stan­ dards Board (IASB) and the Financial Accounting Standards Board (FASB). More than 130 countries follow standards referred to as International Financial Reporting Standards (IFRS). IFRSs are determined by the IASB. The IASB is headquartered in London, with its 15 board members drawn from around the world. Most companies in the United States follow standards issued by the FASB, referred to as generally accepted accounting principles (GAAP). As markets become more global, it is often desirable to compare the results of companies from different countries that report using different accounting standards. In order to increase comparability, in recent years the two standard-setting bodies made efforts to reduce the dif­ ferences between IFRS and U.S. GAAP. This process is referred to as convergence. Because convergence is such an important issue, we provide at the end of each chapter a section called A Look at U.S. GAAP, to provide a comparison with IFRS.

Global Insight The Korean Discount If you think that accounting standards don’t matter, consider these events in South Korea. For many years, interna­ tional investors complained that the finan­ Toru-Hanai-Pool/ Getty Images. Inc. cial reports of South Korean companies were inadequate and inaccurate. Account­ ing practices there often resulted in huge differences between stated revenues and actual revenues. Because investors did not have faith in the accuracy of the numbers, they were unwilling to pay as much for the shares of these companies relative to shares of comparable companies in different countries. This difference in share price was often referred to as the "Korean discount.” In response. Korean regulators decided that companies would have to comply with international accounting standards. This

change was motivated by a desire to “make the country's busi­ nesses more transparent” in order to build investor confidence and spur economic growth. Many other Asian countries, including China. India. Japan, and Hong Kong, have also decided either to adopt international standards or to create standards that are based on the international standards.

Source: Evan Ramstad, “End to ‘Korea Discount'?" Wall Street Journal (March 16, 2007).

What is meant by the phrase “make the country’s businesses more transparent”? Why would increasing transparency spur economic growth? (Go to the book’s companion website for this answer and additional questions.)

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Measurement Principles HELPFUL HINT

Relevance and faithful rep­ resentation are two primary qualities that make account­ ing information useful for decision-making.

Helpful Hints further clarify concepts being discussed.

IFRS generally uses one of two measurement principles, the historical cost principle or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation (see Helpful Hint). Relevance means that financial information is capable of making a difference in a decision. Faithful representation means that the numbers and descriptions match what really existed or happened—they are factual.

Historical Cost Principle The historical cost principle (or cost principle) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased, but also over the time the asset is held. For example, if Great Wall Manufacturing purchases land for ¥300.000 (amounts in thou­ sands). the company initially reports it in its accounting records at ¥300.000. But what does Great Wall do if. by the end of the next year, the fair value of the land has increased to ¥400,000? Under the historical cost principle, it continues to report the land at ¥300.000.

Fair Value Principle The fair value principle states that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market value information is usually readily available for these types of assets. In determining which measurement principle to use, companies weigh the factual nature of cost figures versus the relevance of fair value. In general, even though IFRS allows companies to revalue property, plant, and equipment and other long-lived assets to fair value, most companies choose to use cost. Only in situations where assets are actively traded, such as investment securities, do companies apply the fair value principle extensively.

Assumptions Assumptions provide a foundation for the accounting process. Two main assumptions are the monetary unit assumption and the economic entity assumption.

Monetary Unit Assumption The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in money terms. This assumption enables account­ ing to quantify (measure) economic events. The monetary unit assumption is vital to applying the historical cost principle. This assumption prevents the inclusion of some relevant information in the accounting records. For example, the health of a company’s owner, the quality of service, and the morale of employees are not included. The reason: Companies cannot quantify this information in money terms. Though this information is important, companies record only events that can be measured in money. Throughout this text, we use a variety of currencies in our examples and end-of-chapter materials, such as the following. Australia, dollar Brazil, real China, yuan renminbi Europe, euro Hong Kong, dollar India, rupee Indonesia, rupia Japan, yen

$ RS ¥ € HK$ ? Rp ¥

Russia, ruble South Africa, rand South Korea, won Switzerland, Swiss franc Taiwan, new dollar Turkey, lira United Kingdom, pound United States, dollar

J₽ R W CHF NTS

£ $

Economic Entity Assumption An economic entity can be any organization or unit in society. It may be a company (such as Maruti Suzuki (IND)), a governmental unit (the Indonesian province of Papua), a munici­ pality (Beijing), or a temple (the Temple of the Six Banyan Trees). The economic entity

The Building Blocks of Accounting

assumption requires that the activities of the entity be kept separate and distinct from the

activities of its owner and all other economic entities. To illustrate. Barb Su, owner of Barb's Bike Shop, must keep her personal living costs separate from the expenses of the business. Similarly. Maxway Cycles Co. (TWN) and Asia Bicycle Trading Company (TWN) are seg­ regated into separate economic entities for accounting purposes (see Ethics Note). Proprietorship. A business owned by one person is generally a proprietorship. The owner is often the manager/operator of the business. Small service-type businesses (plumbing companies, beauty salons, and auto repair shops), farms, and small retail stores (antique shops, clothing stores, and used-book stores) are often proprietorships. Usually, only a relatively small amount of money (capital) is necessary to start in business as a proprietorship. The owner (proprietor) receives any profits, suffers any losses, and is personally liable for all debts of the business. There is no legal distinction between the business as an economic unit

and the owner, but the accounting records of the business activities are kept separate from the personal records and activities of the owner. Partnership. A business owned by two or more persons associated as partners is a part­ nership. In most respects a partnership is like a proprietorship except that more than one

ETHICS NOTE The importance of the eco­ nomic entity assumption is illustrated by scandals in­ volving Adelphia (USA). In this case, senior company employees entered into trans­ actions that blurred the line between the employees’ finan­ cial interests and those of the company. For example, Adel­ phia guaranteed over $2 billion of loans to the founding family.

Ethics Notes help sensitize you to some of the ethical issues in accounting.

owner is involved. Typically, a partnership agreement (written or oral) sets forth such terms as initial investment, duties of each partner, division of net income (or net loss), and settlement to be made upon death or withdrawal of a partner. Each partner generally has unlimited personal liability for the debts of the partnership. Like a proprietorship, for accounting purposes the partnership transactions must be kept separate from the personal activities of the partners. Partnerships are often used to organize retail and service-type businesses, including

professional practices (lawyers, doctors, architects, and accountants). Corporation. A business organized as a separate legal entity under jurisdiction corpora­ tion law and having ownership divided into transferable shares is a corporation. The holders of the shares (shareholders) enjoy limited liability; that is, they are not personally liable for the debts of the corporate entity. Shareholders may transfer all or part of their ownership shares to other investors at any time (i.e., sell their shares). The ease with which ownership can change adds to the attractiveness of investing in a corporation. Because ownership can be transferred without dissolving the corporation, the corporation enjoys an unlimited life. Although the combined number of proprietorships and partnerships in the world significantly exceeds the number of corporations, the revenue produced by corporations is much greater. Most of the largest companies in the world—for example, ING (NLD), Royal Dutch Shell (GBR and NLD), Apple Inc. (USA), Fortis (BEL), and Toyota (JPN)—are corporations.

Accounting Across the Organization Spinning the Career Wheel One question that students frequently ask is, “How will the study of account­ ing help me?” A working knowledge of accounting is desirable for virtually every field of endeavor. Some examples of how accounting is used in other careers include the following. © Josef Volavka/ iStockphoto

General management: Imagine running Volkswagen (DEU), Saudi Telecom (SAU). a Subway (USA) franchise, or a Fuji (JPN) bike shop. All general managers need to understand where the company’s cash comes from and where it goes in order to make wise business decisions.

Marketing people must be sensitive to costs and benefits, which accounting helps them quantify and understand.

Finance: Do you want to be a banker for Shanghai Commer­ cial and Savings Bank (TWN) or a financial analyst for ICBC (CHN)? These fields rely heavily on accounting. In all of them, you will regularly examine and analyze financial statements. In fact, it is difficult to get a good finance job without two or three courses in accounting.

Real estate: Are you interested in being a real estate broker for Hong Kong Property Services (HK.G)? Because a third party— the bank—is almost always involved in financing a real estate transaction, brokers must understand the numbers involved: Can the buyer afford to make the payments to the bank? Does the cash flow from an industrial property justify the purchase price? What are the tax benefits of the purchase?

Marketing: Marketing specialists at a company like Hyundai

Motor (KOR) develop strategies to help the sales force be successful. But making a sale is meaningless unless it is profitable.

How might accounting help you? (Go to the book's companion website for this answer and additional questions.)

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Building Blocks of Accounting

ACTION PLAN

DO IT! 2

• Review the discussion of ethics and financial reporting standards.

Indicate whether each of the five statements presented below is true or false. If false, indicate how to correct the statement.

• Develop an understanding of the key terms used.

1. Convergence refers to efforts to reduce differences between IFRS and U.S. GAAP.

2. The primary accounting standard-setting body headquartered in London is the International Accounting Standards Board (IASB). 3. The historical cost principle dictates that companies record assets at their cost. In later peri­ ods. however, the fair value of the asset must be used if fair value is higher than its cost.

4. Relevance means that financial information matches what really happened: the information is factual. 5. A business owner’s personal expenses must be separated from expenses of the business to comply with accounting's economic entity assumption.

Solution 1. True. 2. True. 3. False. The historical cost principle dictates that companies record assets at their cost. Under the historical cost principle, the company must also use cost in later periods. 4. False. Faithful representation means that financial information matches what really happened; the information is factual. 5. True. Related exercise material: DO IT! 1.2, E1.3, and E1.4.

The Accounting Equation LEARNING OBJECTIVE 3

State the accounting equation, and define its components. The two basic elements of a business are what it owns and what it owes. Assets are the resources a business owns. For example, adidas (DEU) has total assets of approximately €15,176 billion. Liabilities and equity are the rights or claims against these resources. Thus, adidas has €15,176 billion of claims against its €15.176 billion of assets. Claims of those to whom the company owes money (creditors) are called liabilities. Claims of owners are called equity, adidas has liabilities of €8,721 billion and equity of €6.455 billion. We can express the relationship of assets, liabilities, and equity as an equation, as shown in Illustration 1.5.

ILLUSTRATION 1.5

Assets

Liabilities

+

Equity

The basic accounting equation

This relationship is the basic accounting equation. Assets must equal the sum of liabilities and equity. Liabilities appear before equity in the basic accounting equation because they are paid first if a business is liquidated. The accounting equation applies to all economic entities regardless of size, nature of business, or form of business organization. It applies to a small proprietorship such as a cor­ ner grocery store as well as to a giant corporation such as adidas. The equation provides the underlying framework for recording and summarizing economic events. Let's look in more detail at the categories in the basic accounting equation.

The Accounting Equation

1-11

Assets As noted previously, assets are resources a business owns. The business uses its assets in car­ rying out such activities as production and sales. The common characteristic possessed by all assets is the capacity to provide future services or benefits. In a business, that service poten­ tial or future economic benefit eventually results in cash inflows (receipts). For example, con­ sider Taipci Pizza, a local restaurant. It owns a delivery truck that provides economic benefits from delivering pizzas. Other assets of Taipei Pizza are tables, chairs, sound system, cash regis­ ter, oven, tableware, and, of course, cash.

Liabilities Liabilities are claims against assets—that is, existing debts and obligations. Businesses of all sizes usually borrow money and purchase merchandise on credit. These economic activities result in payables of various sorts:

• Taipei Pizza, for instance, purchases cheese, sausage, flour, and beverages on credit from suppliers. These obligations are called accounts payable.

• Taipei Pizza also has a note payable to First Bank for the money borrowed to purchase the delivery truck. • Taipei Pizza may also have salaries and wages payable to employees and sales and real estate taxes payable to the local government. All of these persons or entities to whom Taipei Pizza owes money are its creditors. Creditors may legally force the liquidation of a business that does not pay its debts. In that case, the law requires that creditor claims be paid before ownership claims.

Equity The ownership claim on a company’s total assets is equity. It is equal to total assets minus total liabilities. Here is why: The assets of a business are claimed by either creditors or share­ holders. To find out what belongs to shareholders, we subtract creditors’ claims (the liabili­ ties) from the assets. The remainder is the shareholders' claim on the assets—-equity. It is often referred to as residual equity—that is, the equity “left over” after creditors’ claims are satisfied. Equity generally consists of (1) share capital—ordinary and (2) retained earnings.

Share Capital—Ordinary A company may obtain funds by selling ordinary shares to investors. Share capital— ordinary is the term used to describe the amounts paid in by shareholders for the ordinary shares they purchase.

Retained Earnings Retained earnings is determined by three items: revenues, expenses, and dividends.

Revenues. Revenues are the gross increases in equity resulting from business activi­ ties entered into for the purpose of earning income (see Helpful Hint). Generally, rev­

enues result from selling merchandise, performing services, renting property, and lending money. Revenues usually result in an increase in an asset. They may arise from different sources and are called various names depending on the nature of the business. Taipai Pizza, for in­ stance, has two categories of sales revenues—pizza sales and beverage sales. Other titles for

HELPFUL HINT

The effect of revenues is positive—an increase in equity coupled with an increase in assets or a decrease in liabilities.

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Accounting in Action

ancl sources of revenue common to many businesses are sales, fees, services, commissions, interest, dividends, royalties, and rent.

HELPFUL HINT The effect of expenses is negative—a decrease in equitv coupled with a decrease in assets or an increase in liabilities.

Expenses. Expenses are the cost of assets consumed or services used in the process of earning revenue. They are decreases in equity that result from operating the business (see Helpful Hint). Like revenues, expenses take many forms and are called various names depending on the type of asset consumed or service used. For example. Taipai Pizza recog­ nizes the following types of expenses: cost of ingredients (flour, cheese, tomato paste, meat, mushrooms, etc.), cost of beverages, wages expense, utilities expense (electric, gas. and wa­ ter expense), telephone expense, delivery expense (gasoline, repairs, licenses, etc.), supplies expense (napkins, detergents, aprons, etc.), rent expense, interest expense, and property tax expense.

Dividends. Net income represents an increase in net assets which is then available to dis­ tribute to shareholders. The distribution of cash or other assets to shareholders is called a dividend. Dividends reduce retained earnings. However, dividends are not expenses. A cor­ poration first determines its revenues and expenses and then computes net income or net loss. If it has net income, and decides it has no better use for that income, a corporation may decide to distribute a dividend to its owners (the shareholders). In summary, the principal sources (increases) of equity are investments by shareholders and revenues from business operations. In contrast, reductions (decreases) in equity result from expenses and dividends. These relationships are shown in Illustration 1.6.

Increases and decreases in equity

ILLUSTRATION 1.6

INCREASES

DECREASES

Investments by shareholders

Dividends to shareholders

Equity Expenses

Revenues

ACTION PLAN

• Understand the sources of revenue.

• Understand what causes expenses. • Review the rules for changes in equity: Investments and revenues increase equity. Expenses and dividends decrease equity. • Recognize that dividends are distributions of cash or other assets to shareholders.

DO IT! 3

Equity Effects

Classify the following items as issuance of shares (I), dividends (D). revenues (R). or expenses (E). Then indicate whether each item increases or decreases equity. a. Rent Expense.

c. Dividends.

b. Service Revenue.

d. Salaries and Wages Expense.

Solution a. Rent Expense is an expense (E); it decreases equity, b. Service Revenue is a revenue (R); it increases equity, c. Dividends is a distribution to shareholders (ID); it decreases equity. d. Salaries and Wages Expense is an expense (E); it decreases equity. Related exercise material: BE1.1, BE1.2, BE1.3, BE1.4, BE1.5, BE1.6, DO IT! 1.3, and E1.5.

Analyzing Business Transactions

1-13

Analyzing Business Transactions LEARNING OBJECTIVE 4

Analyze the effects of business transactions on the accounting equation.

►

Analyze business transactions

JOURNALIZE

POST

i

TRIAL

ADJUSTING

BALANCE

ENTRIES

ADJUSTED TRIAL

BALANCE

FINANCIAL

CLOSING

POST-CLOSING

STATEMENTS

ENTRIES

TRIAL BALANCE

The system of collecting and processing transaction data and communicating financial information to decision-makers is known as the accounting information system. Factors that shape an accounting information system include the nature of the company’s business, the types of transactions, the size of the company, the volume of data, and the information demands of management and others. Most businesses use computerized accounting systems—sometimes referred to as elec­ tronic data processing (EDP) systems. These systems handle all the steps involved in the recording process, from initial data entry to preparation of the financial statements. In order to remain competitive, companies continually improve their accounting systems to provide accu­ rate and timely data for decision-making. For example, in a recent annual report, Tootsie Roll (USA) stated. “We also invested in additional processing and data storage hardware during the year. We view information technology as a key strategic tool, and are committed to deploying leading edge technology in this area.” Accounting information systems rely on a process referred to as the accounting cycle. As you can see from the graphic, the accounting cycle begins with the analysis of business transactions and ends with the preparation of a post-closing trial balance. We explain each of the steps, starting in this chapter and continuing in Chapters 2-4. In this text, in order to emphasize the underlying concepts and principles, we focus on a manual accounting system. The accounting concepts and principles do not change whether a system is computerized or manual.

Accounting Transactions Transactions (business transactions) are a business's economic events recorded by ac­ countants. Transactions may be external or internal. External transactions involve economic

events between the company and some outside enterprise. For example, Taipai Pizza’s pur­ chase of cooking equipment from a supplier, payment of monthly rent to the landlord, and sale of pizzas to customers are external transactions. Internal transactions are economic events that occur entirely within one company. The use of cooking and cleaning supplies are internal transactions for Taipai Pizza. Companies carry on many activities that do not represent business transactions. Exam­ ples are hiring employees, responding to e-mails, talking with customers, and placing mer­ chandise orders. Some of these activities may lead to business transactions. Employees will earn wages, and suppliers will deliver ordered merchandise. The company must analyze each event to find out if it affects the components of the accounting equation. If it does, the com­ pany will record the transaction. Illustration 1.7 demonstrates the transaction identification process. Each transaction must have a dual effect on the accounting equation. For example, if an asset is increased, there must be a corresponding:

• Decrease in another asset, or

• Increase in a specific liability, or • Increase in equity.

This accounting cycle graphic illustrates the steps companies follow each period to record transactions and eventually prepare financial statements.

1-14

CHAPTER 1

Accounting in Action

ILLUSTRATION 1.7

Transaction identification process

(CHIP CITY I

Is the financial position (assets, liabilities, or equity) of the company changed?

Yes

No

Yes J

Two or more items could be affected. For example, as one asset is increased €10,000, another asset could decrease €6.000 and a liability could increase €4,000. Any change in a liability or ownership claim is subject to similar analysis.

Transaction Analysis To demonstrate how to analyze transactions in terms of the accounting equation, we will review the business activities ofSoftbyte SA. Aspart of this analysis, we will expand the basic accounting equation. This will allow us to better illustrate the impact of transactions on equity. Recall that equity is comprised of two parts: share capital—ordinary and retained earnings. Share capital— ordinary is affected when the company issues new ordinary shares in exchange for cash. Re­ tained earnings is affected when the company earns revenue, incurs expenses, or pays divi­ dends. Illustration 1.8 shows the expanded accounting equation.

Analyzing Business Transactions

If you are tempted to skip ahead after you've read a few of the following transaction anal­ yses, don't do it. Each has something unique to teach, something you'll need later (see Helpful Hint). (We assure you that we've kept them to the minimum needed!) Transaction (1). Investment by Shareholders.

Ray and Barbara Neal decide to start a smartphone app development company that they incorporate as Softbyte SA. On September 1. 2020. they invest €15,000 cash in the business in exchange for €15.000 of ordinary shares. The ordinary shares indicates the ownership interest that the Neals have in Softbyte SA. This transaction results in an equal increase in both assets and equity.3

Basic Analysis

The asset Cash increases €15,000. and equity identified as Share Capital—Ordinary increases €15.000.

Equation Analysis

(1)

Assets

=

Cash

=

Share Capital

+€15,000

=

+€15,000

Liabilities

Equity

+

Issued Shares

Observe that the equality of the basic equation has been maintained. Note also that the source of the increase in equity (in this case, issued shares) is indicated. Why does this matter? Because investments by shareholders do not represent revenues, and they are excluded in determining net income. Therefore, it is necessary to make clear that the increase is an invest­ ment rather than revenue from operations. Additional investments (i.e., investments made by shareholders after the corporation has been initially formed) have the same effect on equity as the initial investment. Transaction (2). Purchase of Equipment for Cash. Softbyte SA purchases computer

equipment for €7.000 cash. This transaction results in an equal increase and decrease in total assets, though the composition of assets changes.

Basic Analysis

The asset Cash decreases €7,000. and the asset Equipment increases €7.000.

Assets Cash

Equation Analysis

+

=

Equipment

Liabilities

=

€15,000 (2)

Equity

Share Capital €15,000

-7,000 € 8.000

+

+€7,000

+

€7.000

=

€15,000

€15.000

Observe that total assets are still €15.000. Share Capital—Ordinary also remains at €15.000, the amount of the original investment. Transaction (3). Purchase of Supplies on Credit.

Softbyte SA purchases headsets (and other computer accessories expected to last several months) for €1,600 from Mobile Solutions. Mobile Solutions agrees to allow Softbyte to pay this bill in October. This trans­ action is a purchase on account (a credit purchase). Assets increase because of the expected future benefits of using the headsets and computer accessories, and liabilities increase by the amount due Mobile Solutions.

'For the illustrative equations that follow, we use the general account title “Share Capital” instead of “Share Capital—Ordinary” for space considerations.

1-15

HELPFUL HINT You will want to study these transactions until you are sure you understand them. They are not difficult, but un­ derstanding them is impor­ tant to your success in this course. The ability to analyze transactions in terms of the basic accounting equation is essential in accounting.

1-16

CHAPTER 1

Accounting in Action

Basic Analysis

The asset Supplies increases €1.600. and the liability Accounts Payable increases €1.600.

Assets

Cash Equation Analysis

+

Supplies

+

=

Liabilities

+

Equity

=

Accounts Payable

+

Share Capital

Equipment

€8,000

€7.000

€15.000

+€1,600

(3)

€8.000

€1.600 €16^600

+

+€1,600

+

€1,600

=

€7,000

€15,000

+

€16.600

Total assets are now € 16,600. This total is matched by a €1,600 creditor’s claim and a €15,000 ownership claim. Transaction (4). Services Performed for Cash.

Softbyte SA receives €1,200 cash from customers for app development services it has performed. This transaction represents Softbyte’s principal revenue-producing activity. Recall that revenue increases equity. Basic Analysis

The asset Cash increases €1.200, and equity increases €1,200 due to Service Revenue.

Assets

Cash Equation Analysis

= Liabilities

+ Supplies + Equipment =

€8.000

€7.000

€1,600

Accounts Payable

+

Equity Retained Earnings

Share

+

€1.600

Capital +

Rev.

- Exp. - Div.

€15.000

(4) +1,200

Service Revenue

+€1,200

€9.200 +

€1,600

+

€7.000

=

€ 1,600

€17,800

+

€15,000 +

€1,200

€17,800

The two sides of the equation balance at €17,800. Service Revenue is included in determining Softbyte’s net income. Note that we do not have room to give details for each individual revenue and expense account in this illustration. Thus, revenues (and expenses when we get to them) are summa­ rized under one column heading for Revenues and one for Expenses. However, it is important to keep track of the category (account) titles affected (e.g., Service Revenue) as they will be needed when we prepare financial statements later in the chapter. Transaction (5). Purchase of Advertising on Credit.

Softbyte SA receives a bill for €250 from Programming News for advertising on its website but postpones payment until a later date. This transaction results in an increase in liabilities and a decrease in equity. Basic Analysis

The liability Accounts Payable increases €250. and equity decreases €250 due to Advertising Expense.

= Liabilities

Assets Cash Equation Analysis

+ Supplies + Equipment =

€9.200

€1,600

€7,000

Accounts Payable

+

+

Share Capital

+

€15,000

€ 1.600

(5)

Equity Retained Earnings Rev. Exp. - Div.

€ 1,200

+250

€9.200 +

€ 1.600 €17,800

+

€7,000

=

€1.850

-€250

+

€15,000

+

€17,800

€1,200 -

€250

Advertising Expense

Analyzing Business Transactions

The two sides of the equation still balance at €17,800. Retained Earnings decreases when Softbyte incurs the expense. Expenses do not have to be paid in cash at the time they are incurred. When Softbyte pays at a later date, the liability Accounts Payable will decrease and the asset Cash will decrease |see Transaction (8)]. The cost of advertising is an expense (rather than an asset) because Softbyte has used the benefits. Advertising Expense is included in determining net income. Transaction (6). Services Performed for Cash and Credit.

Softbyte SA performs €3.500 of app development services for customers. The company receives cash of €1,500 from customers, and it bills the balance of €2,000 on account. This transaction results in an equal increase in assets and equity.

Basic Analysis

Three specific items are affected: The asset Cash increases €1,500. the asset Accounts Receivable increases €2,000, and equity increases €3,500 due to Service Revenue.

= Liabilities

Assets

+

Equity

Accounts Accounts Share Cash + Receivable + Supplies + Equipment = Payable + Capital + Equation Analysis

€ 9,200

€1,600

(6) +1,500

€7.000

€15.000

€1,850

+€2,000

€10,700 +

Retained Earnings Rev. — Exp. - Div.

€1,200

€250

Service Revenue

+3,500

€2.000 + €1.600 +

€7,000

=

€1.850

+ €15.000 + €4,700 -

€21.300

£9^0

€21,300

Softbyte recognizes €3.500 in revenue when it performs the services. In exchange for these services, it received €1,500 in Cash and Accounts Receivable of €2,000. This Accounts Receivable represents customers’ promise to pay €2,000 to Softbyte in the future. When it later receives collections on account, Softbyte will increase Cash and will decrease Accounts Receivable [see Transaction (9)]. Transaction (7). Payment of Expenses.

Softbyte SA pays the following expenses in cash for September: office rent €600, salaries and wages of employees €900, and utilities €200. These payments result in an equal decrease in assets and equity.

Basic Analysis

The asset Cash decreases €1,700. and equity decreases €1,700 due to the following specific expenses: Rent Expense, Salaries and Wages Expense, and Utilities Expense.

= Liabilities +

Assets Accounts

Cash

+ Receivable + Supplies + Equipment =

€10,700

Equation Analysis

(7)

Accounts

€2,000

€1,600

Payable

€1,850

€7,000

Equity Share

Retained Earnings

+ Capital + Rev. - Exp. - Div. €15,000

€4.700

-1,700

€ 9,000 +

€ 250

-600 -900 -200 €2,000

+ €1.600 +

€19.600

€7.000

=

€1,850

+ €15,000 + €4,700 - € 1,950 €19.600

The two sides of the equation now balance at €19.600. Three lines are required in the analysis to indicate the different types of expenses that have been incurred. Transaction (8). Payment of Accounts Payable. Softbyte SA pays its €250 Pro­ gramming News bill in cash. The company previously [in Transaction (5)] recorded the bill as an increase in Accounts Payable and a decrease in equity.

Rent Exp. SalJWages Exp. Utilities Exp.

1-17

1-18

CHAPTER 1

Basic Analysis

Accounting in Action

This cash payment “on account” decreases the asset Cash by €250 and also decreases the liability Accounts Payable by €250.

Assets Cash

Equation Analysis

4~

+ Supplies

+

€1,600

€2.000

€9.000

(8)

Accounts Receivable

Equipment

=

Liabilities

—

Accounts Payable

+

Share Capital

+

Retained Earnings Rev. - Exp. - Div. €4,700

€15.000

€1.850

€7.000

Equity

+

€1.950

-250

-250 €8.750 +

+

€2,000

€1.600

+

€7,000

=

€1,600

+ €15,000

+ €4,700 - €1,950

€19,350

€19,350

Observe that the payment of a liability related to an expense that has previously been recorded does not affect equity. Softbyte recorded the expense [in Transaction (5)] and should not re­ cord it again. Transaction (9). Receipt of Cash on Account.

Softbyte SA receives €600 in cash from customers who had been billed for services [in Transaction (6)]. Transaction (9) does not change total assets, but it changes the composition of those assets.

Basic Analysis

The asset Cash increases €600, and the asset Accounts Receivable decreases €600.

Cash

Equation Analysis

(9)

+

€8.750

€2,000

+600

-600

€9.350 +

€ 1,400

+

Supplies

+

Equipment =

€1,600

+

€7,000

Accounts Payable

+

=

€1,600

Share Capital

+

€15.000

€1.600

€7,000

€ 1.600

+

Equity

= Liabilities +

Assets Accounts Receivable

+

€15,000

€19.350

Retained Earnings Rev. — Exp. — Div. €4.700

€1,950

+ €4,700 - €1.950

€19,350

Note that the collection of an account receivable for services previously billed and recorded does not affect equity. Softbyte already recorded this revenue [in Transaction (6)1 and should not record it again. Transaction (10). Dividends.

The company pays a dividend of €1.300 in cash to Ray and Barbara Neal, the shareholders of Softbyte SA. This transaction results in an equal decrease in assets and equity.

Basic Analysis

The asset Cash decreases € 1,300, and equity decreases € 1.300 due to dividends.

Cash

Equation Analysis

€9,350 (10)

Equity

= Liabilities +

Assets

Share Accounts Accounts + Receivable + Supplies + Equipment = Payable + Capital €1.400

€ 1,600

€7.000

€1.600

€15,000

Retained Earnings + Rev. - Exp. - Div.

€4,700

€8.050 +

€1.950

—€1,300

-1,300

€ 1,400

+ €1,600 +

€18.050

€7,000

=

€1,600

Dividends

+€15.000 + €4.700-€ 1.950 -€ 1,300

€18.050

Note that the dividend reduces retained earnings, which is part of equity. Dividends are not expenses. Like shareholders’ investments, dividends are excluded in determining net income.

Analyzing Business Transactions

Summary of Transactions Illustration 1.9 summarizes the September transactions of Softbyte SA to show their cumula­

tive effect on the basic accounting equation. It also indicates the transaction number and the specific effects of each transaction. Finally. Illustration 1.9 demonstrates a number of signifi­ cant facts: 1. Each transaction must be analyzed in terms of its effect on:

a. The three components of the basic accounting equation. b. Specific types (kinds) of items within each component. 2. The two sides of the equation must always be equal.

3. The Share Capital—-Ordinary and Retained Earnings columns indicate the causes of each change in the shareholders’ claim on assets.

ILLUSTRATION 1.9

Tabular summary of Softbyte SA transactions Assets

Transaction

Cash

(1) (2) (3) (4) (5) (6) (7)

+€15,000 -7,000

(8) (9) (10)

-250 +600 -1,300

Accounts + Receivable +

= Liabilities + Accounts Supplies + Equipment = Payable +

Equity Share Capital

+

Rev.

Retained Earnings - Exp. - Div.

+ €15.000

Issued Shares

+€7,000

+€1.600

+€1.600

+ 1,200

+€1,200 +250

+ 1.500 -1,700

€ 8.050 +

Service Revenue Adver. Expense Service Revenue Rent Expense Sal/Wages Exp. Utilities Expense

-€250

+€2.000

+3.500

-600 -900 -200 -250

-600 -€ 1.300 Dividends €1.400

+

€1,600 +

€7.000

=

€ 1.600

+ €15.000 +

€18.050

€4,700 -

€ 1,950 - €1,300

€18,050

There! You made it through transaction analysis. If you feel a bit shaky on any of the transactions, it might be a good idea at this point to get up, take a short break, and come back again for a brief (10- to 15-minute) review of the transactions, to make sure you understand them before you go on to the next section.

DO IT! 4

Tabular Analysis

Transactions made by Virmari & Co., a public accounting firm in France, for the month of August are shown below. Prepare a tabular analysis which shows the effects of these transactions on the expanded accounting equation, similar to that shown in Illustration 1.9.

1. The company issued ordinary shares for €25.000 cash. 2. The company purchased €7.000 of office equipment on credit. 3. The company received €8.000 cash in exchange for services performed.

4. The company paid €850 for this month's rent. 5. The company paid a dividend of € 1,000 in cash to shareholders.

ACTION PLAN

• Analyze the effects of each transaction on the accounting equation. • Use appropriate category names (not descriptions). • Keep the accounting equation in balance.

1-19

1-20

CHAPTER 1

Accounting in Action

Transaction

Cash

(1)

+€25.000

Assets

=

Liabilities

+

+

=

Accounts Payable

+

Equipment

(4)

-850

(5)

-1.000 €31.150

Rev.

+

Retained Earnings Exp.

Div.

+€25.000

(2) +8.000

Share Capital

+€7.000

+€7.000

(3)

Equity

Service Revenue

+€8.000

Rent Expense

-€850

-€1.000

+

€7.000

=

€7,000

+

€25.000

€8.000

+

-

€850

-

Dividends

€1.000

€38 J 50

€38.150 Related exercise material: BEI.7, BEI.8, BE1.9. DO IT! 1.4, El.6, El.7, and El.8.

Financial Statements LEARNING OBJECTIVE 5

Describe the five financial statements and how they are prepared.

HELPFUL HINT

The income statement, retained earnings statement, statement of cash flows, and comprehensive income state­ ment are all for a period of time, whereas the statement of financial position is for a point in time.

Companies prepare five financial statements from the summarized accounting data (see Helpful Hint): 1. An income statement presents the revenues and expenses and resulting net income or net

loss for a specific period of time. 2. A retained earnings statement summarizes the changes in retained earnings for a spe­

cific period of time. 3. A statement of financial position (sometimes referred to as a balance sheet} reports the assets, liabilities, and equity of a company at a specific date. 4. A statement ofcash flows summarizes information about the cash inflows (receipts) and outflows (payments) for a specific period of time. 5. A comprehensive income statement presents other comprehensive income items that are not included in the determination of net income. These statements provide relevant financial data for internal and external users. Illustration 1.10 shows the first four financial statements from the above list of Softbyte SA (see Helpful Hints). (Illustration 1.10 assumes Softbyte has no other comprehensive income items.) A comprehensive income statement is presented in Illustration 1.12 for Softbyte. Note that the statements shown in Illustration 1.10 are interrelated: 1. Net income of €2,750 on the income statement is added to the beginning balance of retained earnings in the retained earnings statement.

2. Retained earnings of €1.450 at the end of the reporting period shown in the retained earnings statement is reported on the statement of financial position. 3. Cash of €8.050 on the statement of financial position is reported on the statement of cash flows.

Also, explanatory notes and supporting schedules are an integral part of every set of finan­ cial statements. We illustrate these notes and schedules in later chapters of this text. Be sure to carefully examine the format and content of each statement in Illustration 1.10. We describe the essential features of each in the following sections.

Financial Statements

Softbyte SA

1-21

ILLUSTRATION 1.10

Income Statement For the Month Ended September 30,2020 Revenues Service revenue Expenses Salaries and wages expense Rent expense Advertising expense Utilities expense Total expenses

Financial statements and their interrelationships

€4.700

HELPFUL HINT

The heading of each state­ ment identifies the company, the type of statement, and the specific date or time period covered by the statement.

€900 600 250 200

1.950

Net income

€2,750

Softbyte SA Retained Earnings Statement For the Month Ended September 30,2020 Retained earnings, September 1 Add: Net income

€

0 2,750

HELPFUL HINT

2,750 1,300

Less: Dividends

The arrows in this illustra­ tion show the interrelation­ ships of the four financial statements.

€1,450

Retained earnings, September 30

Softbyte SA Statement of Financial Position September 30,2020 Assets

Equipment Supplies Accounts receivable Cash

€ 7.000 1.600 1,400 8,050

Total assets

€18,050

Equity and Liabilities Equity Share capital—ordinary Retained earnings Liabilities Accounts payable

€15.000 r 1,450 ■ Oct. 3 1

Journal Entry

Depreciation Expense Accumulated Depreciation—Equipment (To record monthly depreciation)

5,000

Oct. 31

Bal. 5,000

40

40

157

Equipment

Oct. 1

711 158

Posting Accumulated Depreciation— Equipment

Depreciation Expense

158

Oct. 31

Adj. 40

Oct. 31

Adj. 40

Oct. 31

Bal. 40

Oct. 3 1

Bal. 40

The balance in the Accumulated Depreciation—Equipment account will increase MO each month, and the balance in Equipment remains 65,000. Statement Presentation. As indicated. Accumulated Depreciation—Equipment is a contra asset account. It is offset against Equipment on the statement of financial position. The normal balance of a contra asset account is a credit. A theoretical alternative to using a contra asset account would be to decrease (credit) the asset account by the amount of depreciation each period. But using the contra account is preferable for a simple reason: It discloses both the original cost of the equipment and the total cost that has been expensed to date. Thus, in the statement of financial position. Yazici deducts Accumulated Depreciation—Equipment from the related asset account, as shown in Illustration 3.8.

71 I

3-9

3-10

CHAPTER 3

Adjusting the Accounts

ILLUSTRATION 3.8

ALTERNATIVE TERMINOLOGY

Book value is also referred to as carrying value.

t-5,000 40

Equipment Less: Accumulated depreciation—equipment

Statement of financial position presentation of accumulated depreciation

t/4,960

Book value is the difference between the cost of any depreciable asset and its related accumulated depreciation (see Alternative Terminology). In Illustration 3.8. the book value of the equipment at the statement of financial position date is M.960. The book value and the fair value of the asset are generally two different values. As noted earlier, the purpose of depreciation is not valuation but a means of cost allocation.

Depreciation expense identifies the portion of an asset’s cost that expired during the period (in this case, in October). The accounting equation shows that without this adjusting entry, total assets, total equity, and net income are overstated by MO and depreciation expense is understated by MO. Illustration 3.9 summarizes the accounting for prepaid expenses. ILLUSTRATION 3.9

Accounting for Prepaid Expenses

Accounting for prepaid expenses Examples

Insurance, supplies. advertising, rent, depreciation

Reason for Adjustment

Accounts Before Adjustment

Adjusting Entry

Prepaid expenses originally recorded in asset accounts have been used.

Assets overstated. Expenses understated.

Dr. Expenses Cr. Assets or Contra Assets

Unearned Revenues Unearned Revenues

Cash is received in advance; liability is recorded

Oct. 3 I Some service has been performed; some revenue is recorded

When companies receive cash before services are performed, they record a liability by increas­ ing (crediting) a liability account called unearned revenues. In other words, a company now has a performance obligation (liability) to transfer a service to one of its customers. Items like rent, magazine subscriptions, and customer deposits for future service may result in unearned revenues. Airlines such as Cathay Pacific (HKG) and Garuda Indonesia (IDN), for instance, treat receipts from the sale of tickets as unearned revenue until the flight service is provided. Unearned revenues are the opposite of prepaid expenses. Indeed, unearned revenue on the books of one company is likely to be a prepaid expense on the books of the company that has made the advance payment. For example, if identical accounting periods are assumed, a landlord will have unearned rent revenue when a tenant has prepaid rent. When a company receives payment for services to be performed in a future accounting period, it increases (credits) an unearned revenue (a liability) account to recognize the liability that exists. The company subsequently recognizes revenues when it performs the service. During the accounting period, it is not practical to make daily entries as the company performs services. Instead, the company delays recognition of revenue until the adjustment process. Then, the company makes an adjusting entry to record the revenue for services per­ formed during the period and to show the liability that remains at the end of the accounting period. Typically, prior to adjustment, liabilities are overstated and revenues are understated. Therefore, the adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account (see Illustration 3.10),

ILLUSTRATION 3.10

Adjusting entries for unearned revenues

Unearned Revenues Liability Debit Adjusting Entry (-)

Unadjusted Balance

Revenue Credit Adjusting Entry (+)

t_____________ f

Adjusting Entries for Deferrals

Yazici Advertising received bl,200 on October 2 from R. Knox for advertising ser­ vices expected to be completed by December 31. Yazici credited the payment to Unearned Service Revenue. This liability account shows a balance of bl,200 in the October 31 trial balance. From an evaluation of the services Yazici performed for Knox during October, the company determines that it should recognize b400 of revenue in October. The liability (Unearned Service Revenue) is therefore decreased, and equity (Service Revenue) is increased. As shown in Illustration 3.11, the liability Unearned Service Revenue now shows a balance of t-800. That amount represents the remaining advertising services Yazici is ob­ ligated to perform in the future. Al the same time, Service Revenue shows total revenue recognized in October of bl 0.400. Without this adjustment, revenues and net income are understated by MOO in the income statement. Moreover, liabilities will be overstated and equity will be understated by MOO on the October 31 statement of financial position.

ILLUSTRATION 3.11

Basic Analysis

Service revenue accounts after adjustment

The liability Unearned Service Revenue is decreased 6400; the revenue Service Revenue is increased MOO. Assets

Equation Analysis

Debit-Credit Analysis

Journal Entry

Liabilities

Equity

Unearned Service Revenue -M00

Service Revenue + M00

“ Debits decrease liabilities: debit Unearned Service Revenue MOO. Credits increase revenues: credit Service Revenue MOO.

-► Oct. 3 1 Unearned Service Revenue Service Revenue (To record revenue for services performed)

Unearned Service Revenue

Posting

Oct. 31

Adj. 400

209 400

209

400

400

Service Revenue

400

10,000

Oct. 2

1,200

Oct. 31 31

Adj.

Oct. 31

Bal. 800

Oct. 3 1

Bal.

400

10,400

Illustration 3.12 summarizes the accounting for unearned revenues.

ILLUSTRATION 3.12

Accounting for unearned revenues

Accounting for Unearned Revenues Examples

Rent, magazine subscriptions, customer deposits for future service

Reason for Adjustment

Accounts Before Adjustment

Adjusting Entry

Unearned revenues recorded in liability accounts arc now recognized as revenue for services performed.

Liabilities overstated. Revenues understated.

Dr. Liabilities Cr. Revenues

3-11

3-12

CHAPTER 3

Adjusting the Accounts

Accounting Across the Organization

Marks & Spencer pic

Turning Gift Cards into Revenue Those of you who are marketing majors (and even most of you who are not) know that gift cards are among the hottest mar­ keting tools in merchandising today. Cus­

tomers at stores such as Marks & Spencer

REUTERS/Toby Melville/NewsCom

pic (GBR) purchase gift cards and give them to someone for later use. Although these programs are popular with marketing executives, they create accounting questions. Should revenue be

ACTION PLAN

• Make adjusting entries at the end of the period for revenues recognized and expenses incurred in the period. • Don’t forget to make adjusting entries for deferrals. Failure to adjust for deferrals leads to overstatement of the asset or liability and understatement of the related expense or revenue.

DO IT! 2

recorded at the time the gift card is sold, or when it is exercised? How should expired gift cards be accounted for?

Suppose that Robert Jones purchases a €100 gift card at Carrefour (FRA) on December 24, 2019, and gives it to his wife, Mary Jones, on December 25, 2019. On January 3, 2020, Mary uses the card to purchase €100 worth of CDs. When do you think Carrefour should recognize revenue and why? (Go to the book’s companion website for this answer and additional questions.)

Adjusting Entries for Deferrals

The ledger of Hammond Deliveries, on March 31. 2020. includes these selected accounts before adjusting entries are prepared. Credit

Debit

Prepaid Insurance Supplies Equipment Accumulated Depreciation—Equipment Unearned Service Revenue

€ 3.600 2,800 25.000

€5.000 9,200

An analysis of the accounts shows the following.

1. Insurance expires at the rate of € 100 per month.

2. Supplies on hand total €800. 3. The equipment depreciates €200 a month. 4. During March, services were performed for €4,000 of the unearned service revenue.

Prepare the adjusting entries for the month of March.

Solution 1. Insurance Expense

100

Prepaid Insurance (To record insurance expired)

2. Supplies Expense (€2.800 - €800)

100

2.000

Supplies (To record supplies used)

3. Depreciation Expense

2.000

200

Accumulated Depreciation—Equipment (To record monthly depreciation)

4. Unearned Service Revenue Service Revenue (To record revenue for services performed)

Related exercise material: BE3.2, BE3.3, BE3.4, BE3.5, BE3.6, and DO IT! 3.2.

200

4.000

4.000

Adjusting Entries for Accruals

3-13

Adjusting Entries for Accruals LEARNING OBJECTIVE 3

Prepare adjusting entries for accruals.

ANALYZE

JOURNALIZE

POST

TRIAL BALANCE

VWÎj

I

ADJUSTED

A

TRIAL

FINANCIAL

CLOSING

POST-CLOSING

W

BALANCE

STATEMENTS

ENTRIES

TRIAL BALANCE

The second category of adjusting entries is accruals. Prior to an accrual adjustment, the revenue account (and the related asset account) or the expense account (and the related liability account) are understated. Thus, the adjusting entry for accruals will increase both a

Accrued Revenues

statement of financial position and an income statement account.

Accrued Revenues Revenues for services performed but not yet recorded at the statement date are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in the case of interest revenue. These are unrecorded because the earning of interest does not involve daily transactions. Companies do not record interest revenue on a daily basis because it is often impractical to do so. Accrued revenues also may result from services that have been performed but not yet billed nor collected, as in the case of commissions and fees. These may be unrecorded because only a portion of the total service has been performed and the clients will not be billed until the service has been completed. An adjusting entry records the receivable that exists at the statement of financial position date and the revenue for the services performed during the period. Prior to adjustment, both assets and revenues are understated. As shown in Illustration 3.13, an adjusting entry for accrued revenues results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account.

ILLUSTRATION 3.13

Adjusting entries for accrued revenues

In October, Yazici Advertising performed services worth 6200 that were not billed to cli­ ents on or before October 31. Because these services were not billed, they were not recorded. The accrual of unrecorded service revenue increases an asset account, Accounts Receivable. It also increases equity by increasing a revenue account, Service Revenue, as shown in Illustration 3.14.

unbilled services

Cash is received; receivable is reduced

3-14

CHAPTER 3

Adjusting the Accounts

ILLUSTRATION 3.14

Adjustment for accrued revenue

The asset Accounts Receivable is increased 6200; the revenue Service Revenue is increased 6200.

Basic Analysis

Assets

Equation Analysis

Debit-Credit Analysis

=

Liabilities

+

Equity

Accounts Receivable

Service Revenue

+ 6200

+6200

Debits increase assets: debit Accounts Receivable 6200. Credits increase revenues: credit Service Revenue 6200.

Accounts Receivable Service Revenue (To record revenue for services performed)

Journal Entry

Accounts Receivable

112 400

200

400

Service Revenue

1 12

10,000 400

Oct. 31

Adj. 200

Oct. 31 31 31

Adj.

Oct. 31

Bal.

Oct. 31

Bal. 10,600

Posting

Equation analyses summarize the effects of transactions on the three elements of the accounting equation, as well as the effect on cash flows.

200

200

200

The asset Accounts Receivable shows that clients owe Yazici 6200 at the statement of financial position date. The balance of 610,600 in Service Revenue represents the total reve­ nue for services performed by Yazici during the month (610,000 + 6400 + 6200). Without the adjusting entry, assets and equity on the statement of financial position and revenues and net income on the income statement are understated.

On November 10, Yazici receives cash of 6200 for the services performed in October and makes the following entry.

+ +200 -200

Nov. 10

Cash Flows +200

The company records the collection of the receivables by a debit (increase) to Cash and a credit (decrease) to Accounts Receivable. Illustration 3.15 summarizes the accounting for accrued revenues.

ILLUSTRATION 3.15

Accounting for Accrued Revenues

Accounting for accrued revenues

Examples

ETHICS NOTE

A report released by Fannie Mae’s (USA) board of direc­ tors stated that improper adjusting entries at the mortgage-finance company resulted in delayed recogni­ tion of expenses caused by interest rate changes. The motivation for such account­ ing apparently was the desire to hit earnings esti­ mates.

Cash Accounts Receivable (To record cash collected on account)

Interest, rent, services

Reason for Adjustment

Accounts Before Adjustment

Adjusting Entry

Services performed but not yet received in cash or recorded.

Assets understated. Revenues understated.

Dr. Assets Cr. Revenues

Accrued Expenses Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses. Interest, taxes, and salaries are common examples of accrued expenses.

Companies make adjustments for accrued expenses to record the obligations that exist at the statement of financial position date and to recognize the expenses that apply to the current accounting period (see Ethics Note). Prior to adjustment, both liabilities and expenses are under­ stated. Therefore, as Illustration 3.16 shows, an adjusting entry for accrued expenses results in an increase (a debit) to an expense account and an increase (a credit) to a liability account.

Adjusting Entries for Accruals

3-15

ILLUSTRATION 3.16

Adjusting entries for accrued expenses

Let’s look in more detail at some specific types of accrued expenses, beginning with accrued interest.

Accrued Interest Yazici Advertising signed a three-month note payable in the amount of 65,000 on October 1. The note requires Yazici to pay interest at an annual rate of 12%. The amount of the interest recorded is determined by three factors: (1) the face value of the note; (2) the interest rate, which is always expressed as an annual rate; and (3) the length of time the note is outstanding. For Yazici, the total interest due on the 65,000 note at its maturity date three months in the future is 6150 (65.000 x 12% X 75), or 650 for one month. Illustration 3.17 shows the formula for computing interest and its application to Yazici for the month of October (see Helpful Hint). Face Value of Note

65.000

X

X

X

12%

X

Terms of One Year 1 12

In computing interest, we express the time period as a fraction of a year. ILLUSTRATION 3.17

Time in

Annual Interest Rate

HELPFUL HINT

=

Interest

=

650

Formula for computing interest

As Illustration 3.18 shows, the accrual of interest at October 31 increases a liability account, Interest Payable. It also decreases equity by increasing an expense account. Interest Expense. ILLUSTRATION 3.18

Adjustment for accrued interest

Basic Analysis

The expense Interest Expense is increased 650; the liability Interest Payable is increased 650.

Assets

Equation Analysis

Debit-Credit Analysis

Equity

Interest Expense

+ t50

— i>50

— Debits increase expenses: debit Interest Expense 650. Credits increase liabilities: credit Interest Payable t50.

Journal Entry

-► Oct. 31

Interest Expense Interest Payable (To record interest on notes payable)

905 230

50 50

Interest Payable

230

Oct. 31

Adj. 50

Oct. 31

Adj. 50

Oct. 31

Bal.

Oct. 3 1

Bal.

Interest Expense

Posting

Liabilities

Interest Payable

50

905

50

3-16

CHAPTER 3

Adjusting the Accounts

Interest Expense shows the interest charges for the month ot October. Interest Payable shows the amount of interest the company owes at the statement date. Yazici will not pay the interest until the note comes due at the end of three months. Companies use the Interest Payable account, instead of crediting Notes Payable, to disclose the two different types of obligations—interest and principal—in the accounts and statements. Without this adjust­ ing entry, liabilities and interest expense are understated, and net income and equity are overstated.

Accrued Salaries and Wages Companies pay for some types of expenses, such as employee salaries and wages, after the ser­ vices have been performed. Yazici Advertising paid salaries and wages on October 26 for its employees’ first two weeks of work. The next payment of salaries will not occur until Novem­ ber 9. As Illustration 3.19 shows, three working days remain in October (October 29-31). ILLUSTRATION 3.19

Calendar showing Yazici’s pay periods

October

S

M

Tu

w

Start of pay period

Adjustment period

F

Th

1 2 4 3 9 10 1 1 7 8 14 IS 16 17 18 21 22 23 24 25 28 29 1” 31

S

6 5 12 13 19 20 26 27

Payday

Payday

At October 31, the salaries and wages for these three days represent an accrued expense and a related liability to Yazici. The employees receive total salaries and wages of 62.000 for a five-day work week, or 6400 per day. Thus, accrued salaries and wages at October 31 are 61,200 (6400 X 3). This accrual increases a liability, Salaries and Wages Payable. It also decreases equity by increasing an expense account, Salaries and Wages Expense, as shown in Illustration 3.20. ILLUSTRATION 3.20

Adjustment for accrued salaries and wages

The expense Salaries and Wages Expense is increased 61,200; the liability Salaries and Wages Payable is increased 61,200.

Basic Analysis

Assets

Equation Analysis

Debit-Credit Analysis

Liabilities

Equity

Salaries and Wages Payable

Salaries and Wages Expense

+ *1,200

- *1,200

Debits increase expenses: debit Salaries and Wages Expense *1,200. Credits increase liabilities: credit Salaries and Wages Payable *1,200.

-► Oct. 31 Salaries and Wages Expense Salaries and Wages Payable (To record accrued salaries and wages)

Journal Entry

Salaries and Wages Expense

Posting

4,000

Oct. 26 31

Adj.

1,200

Oct. 31

Bal.

5,200

726

726 212

1,200 ◄

1,200

Salaries and Wages Payable

212

Oct. 31

Adj. 1,200

Oct. 31

Bal.

1,200

Adjusting Entries for Accruals

3-17

After this adjustment, the balance in Salaries and Wages Expense of =65,200 (13 days x MOO) is the actual salary and wages expense for October. The balance in Salaries and Wages Payable of =61,200 is the amount of the liability for salaries and wages Yazici owes as of October 31. Without the =61,200 adjustment for salaries and wages, Yazici’s expenses are understated tl,200 and its liabilities are understated =61,200. Yazici pays salaries and wages every two weeks. Consequently, the next payday is November 9. when the company will again pay total salaries and wages of =64.000. The payment consists of =61,200 of salaries and wages payable at October 31 plus =62,800 of salaries and wages expense for November (7 working days, as shown in the November calendar x =6400). Therefore, Yazici makes the following entry on November 9. L

Nov. 9

Salaries and Wages Payable Salaries and Wages Expense Cash (To record November 9 payroll)

-1,200

1,200 2.800

-2.800

4.000

^1.000 Cash Flows

-4.000

This entry eliminates the liability for Salaries and Wages Payable that Yazici recorded in the October 31 adjusting entry, and it records the proper amount of Salaries and Wages Expense for the period between November 1 and November 9. Illustration 3.21 summarizes the accounting for accrued expenses.

Accounting for Accrued Expenses Examples Interest, rent, salaries

ILLUSTRATION 3.21

Reason for Adjustment

Accounts Before Adjustment

Adjusting Entry

Expenses have been incurred but not yet paid in cash or recorded.

Expenses understated. Liabilities understated.

Dr. Expenses Cr. Liabilities

Accounting for accrued expenses

People, Planet, and Profit Insight Got Junk?

© Nathan Gleave/ iStockphoto

Do you have an old computer or two that you no longer use? How about an old TV that needs replacing? Many people do. Approximately 163.000 computers and televisions become obsolete each day. Yet. in a recent year, only 11% of computers were recycled. It is estimated that 75% of all computers ever sold are silting in

storage somewhere, waiting to be disposed of. Each of these old TVs and computers is loaded with lead, cadmium, mercury, and other toxic chemicals. If you have one of these electronic gadgets, you have a responsibility, and a probable cost, for disposing of it. Companies have the same problem, but their discarded materials may include lead paint, asbestos, and other toxic chemicals.

What accounting issue might this cause for companies? (Go to the book’s companion website for this answer and additional questions.)

Summary of Basic Relationships Illustration 3.22 summarizes the four basic types of adjusting entries. Take some time to study and analyze the adjusting entries. Be sure to note that each adjusting entry affects one statement of financial position account and one income statement account.

3-18

CHAPTER 3

Adjusting the Accounts

ILLUSTRATION 3.22

Summary of adjusting entries

Type of Adjustment

Accounts Before Adjustment

Adjusting Entry

Prepaid expenses

Assets overstated. Expenses understated.

Dr. Expenses Cr. Assets or Contra Assets

Unearned revenues

Liabilities overstated. Revenues understated.

Dr. Liabilities Cr. Revenues

Accrued revenues

Assets understated. Revenues understated.

Dr. Assets Cr. Revenues

Accrued expenses

Expenses understated. Liabilities understated.

Dr. Expenses Cr. Liabilities

Illustrations 3.23 and 3.24 show the journalizing and posting of adjusting entries for Yazici Advertising on October 31. The ledger identifies all adjustments by the reference J2 because they have been recorded on page 2 of the general journal. The company may insert a center caption “Adjusting Entries” between the last transaction entry and the first adjusting entry in the journal. When you review the general ledger in Illustration 3.24. note that the entries highlighted in red are the adjustments.

ILLUSTRATION 3.23

General journal showing adjusting entries

Date 2020 Oct. 31

(1) Adjusting entries should not involve dehits or credits to Cash. (2) Evaluate whether the adjustment makes sense. For example, an adjustment to recognize supplies used should increase Supplies Expense. (3) Double-check all computations. (4) Each adjusting entry affects one statement of financial position account and one income statement account.

J2

GENERAL JOURNAL

31

31

31

31

31

31

Ref.

Debit

631 126

1.500

Insurance Expense Prepaid Insurance (To record insurance expired)

722 130

50

Depreciation Expense Accumulated Depreciation—Equipment (To record monthly depreciation)

711 158

40

Unearned Service Revenue Service Revenue (To record revenue for services performed)

209 400

400

Accounts Receivable Service Revenue (To record revenue for services performed)

112 400

200

Interest Expense Interest Payable (To record interest on notes payable)

905 230

50

Salaries and Wages Expense Salaries and Wages Payable (To record accrued salaries and wages)

726 212

1,200

Account Titles and Explanation Adjusting Entries Supplies Expense Supplies (To record supplies used)

Credit

1,500

50

40

400

200

50

1,200

ILLUSTRATION 3.24

General ledger after adjustment

GENERAL LEDGER No. 101

Cash

Date 2020 Oct.

Explanation

1 2 3 4 20 26 31

Ref.

Debit

JI JI JI JI JI JI JI

10.000 1.200

Credit

900 600 500 4,000

10.000

Balance 10.000 11.200 10,300 9.700 9.200 5.200 15.200

Interest Payable Date

Explanation

2020 Oct. 31

Adj. entry

Ref.

Debit

No. 230 Credit

Balance

50

50

J2

Share C apital-—Ordina ry

Date 2020 Oct.

Explanation

1

Ref.

Debit

JI

No. 311

Credit

Balance

10.000

10.000

Reta ined E arnings Acco Lints R eceivable

Date

Explanation

2020 Oct. 31

Adj. entry

Ref.

Debit

J2

Credit

200

No. 112

Date

Balance

2020

Explanation

Ref.

Debit

No. 320

Credit

200

Divide nds Supp ies

Date 2020 Oct.

Explanation

5 31

Ref. JI J2

Adj. entry

No. 126

Debit

Credit

Balance

1,500

2.500 1,000

2.500

Pre] laid In surance

Date 2020 Oct.

Explanation 4 31 Adj. entry

Ref.

Debit

JI J2

No. 130

Credit

600

50

Balance 600 550

Explanation

Date 2020 Oct. 20

Ref. JI

No. 332

Debit

Credit

500

Ser vice R evenue Date

Explanation

2020 Oct. 31 31 31

Ref.

Debit

JI J2 .12

Adj. entry Adj. entry

Explanation

2020 Oct.

1

Ref. JI

No. 157

Debit

Credit

5.000

No. 400

Credit

Balance

10,000 400 200

10.000 10,400 10^600

Explanation

2020 Oct. 31

Adj. entry

Ref.

Debit

Credit

J2

40

N otes Pilyable

Date

Explanation

2020 Oct.

1

Ref.

Debit

Credit

JI

2020 Oct.

Explanation 5

Ref.

5.000

Debit

Credit

JI

2020 Oct.

Explanation

Ref.

2,500

Debit

Balance

40

Explanation

Date 2020 Oct. 31

.11 .12

2020 Oct. 31

Explanation Adj. entry

Ref.

1,200 400

J2

Debit

Balance

1,500

1,500

Balance 5.000

Balance 2,500

Ref.

Debit

J2

No. 711

Credit

40

2020 Oct. 31

Adj. entry

Ref.

Debit

40 No. 722

Credit

50

J2

Explanation

2020 Oct. 26 31 Adj. entry

Ref. JI J2

Debit

Balance 50

Salaries and W ages Expe>nse

Date

Balance

Credit

4.000 1,200

No. 726

Balance 4.000 5,200

No. 209

Credit

Salaries and VV ages Paytible

Date

No. 631

Credit

Insu rance Expense

R ent Ex pense

Balance

Explanation

Date

2 31 Adj. entry

Adj. entry

Explanation

Date

No. 201

Unearnt d Sen ice Revei lue Date

J2

Debit

Deprc ciatioii Expense

No. 158

No. 200

Acc ounts Payable

Date

2020 Oct. 31 Adj. entry

Ref.

5.000

A ^cumulated Dep reciati in—Equi pment

Date

Balance

Explanation

Date

Balance 500

Sup plies TExpense squipi nent

Date

Balance

1.200 800

2020 Oct.

JI

3

No. 212

Credit

Balance

1,200

1,200

Ref.

No. 729

Debit

Credit

900

900

Ini erest rExpense

Date 2020 Oct. 31

Explanation Adj. entry

Ref.

J2

Debit 50

Balance

No. 905

Credit

Balance

50 3-19

3-20

CHAPTER 3

Adjusting the Accounts

Adjusting Entries for Accruals

ACTION PLAN

DO IT! 3

• Make adjusting entries at the end of the period to recognize revenues for services performed and for expenses incurred.

Mahindra Computer Services began operations on August 1, 2020. At the end of August 2020, management prepares monthly financial statements. The following information relates to August (amounts in thousands).

• Don’t forget to make adjusting entries for accruals. Adjusting entries for accruals will increase both a statement of financial position and an income statement account.

1. At August 31. the company owed its employees ?800 in salaries and wages that will be paid on September 1. 2. On August 1. the company borrowed ?30.000 from a local bank on a 15-year mortgage. The annual interest rate is 10%. 3. Revenue for services performed but unrecorded for August totaled ? 1.100.

Prepare the adjusting entries needed at August 31. 2020.

Solution 800

1. Salaries and Wages Expense

800

Salaries and Wages Payable (To record accrued salaries)

2. Interest Expense

250 250

Interest Payable (To record accrued interest: T30.000X 10%x^ = ?250) 1.100

3. Accounts Receivable

1,100

Service Revenue (To record revenue for services performed) Related exercise material: BE3.7, DO IT! 3.3, E3.5, E3.6, E3.7, E3.8 and E3.9.

Adjusted Trial Balance and Financial Statements LEARNING OBJECTIVE 4

Describe the nature and purpose of an adjusted trial balance.

ANALYZE

JOURNALIZE

POST

TRIAL

ADJUSTING

BALANCE

ENTRIES

Prepare financial statements J

JOURNALIZE AND

PREPARE A

POST CLOSING

POST-CLOSING

ENTRIES

TRIAL BALANCE

Aller a company has journalized and posted all adjusting entries, it prepares another trial balance from the ledger accounts. This trial balance is called an adjusted trial balance. It shows the balances of all accounts, including those adjusted, at the end of the accounting period. The purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments. Because the accounts contain all data needed for financial statements, the adjusted trial balance is the primary basis for the preparation of financial statements.

Adjusted Trial Balance and Financial Statements

Preparing the Adjusted Trial Balance Illustration 3.25 presents the adjusted trial balance for Yazici Advertising A.S. prepared from the

ledger accounts in Illustration 3.24. The amounts affected by the adjusting entries are highlighted in red. Compare these amounts to those in the unadjusted trial balance in Illustration 3.3. In this comparison, you will see that there are more accounts in the adjusted trial balance as a result of the adjusting entries made at the end of the month.

Yazici Advertising A.§.

ILLUSTRATION 3.25

Adjusted Trial Balance October 31,2020

Adjusted trial balance

Debit Cash Accounts Receivable Supplies Prepaid Insurance Equipment Accumulated Depreciation—Equipment Notes Payable Accounts Payable Interest Payable Unearned Service Revenue Salaries and Wages Payable Share Capital—Ordinary Retained Earnings Dividends Service Revenue Salaries and Wages Expense Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense

Credit

01 5,200 200 1,000 550 5,000

0

40 5,000 2.500 50 800 1,200 10.000 -0-

500

10,600 5,200 1,500 900 50 50 40

030,190

030,190

Preparing Financial Statements Companies can prepare financial statements directly from the adjusted trial balance. Illustrations 3.26 and 3.27 present the interrelationships of data in the adjusted trial balance

and the financial statements. As Illustration 3.26 shows, companies prepare the income statement from the revenue and expense accounts. Next, they use the Retained Earnings and Dividends accounts and the net income (or net loss) from the income statement to prepare the retained earnings statement.

3-21

3-22

CHAPTER 3

Adjusting the Accounts

ILLUSTRATION 3.26

Preparation of the income statement and retained earnings statement

from the adjusted trial balance

Yazici Advertising A.§. Adjusted Trial Balance October 31, 2020 Account

Debit

*15,200 Cash Accounts Receivable 200 1,000 Supplies Prepaid Insurance 550 Equipment 5,000 Accumulated Depreciation— Equipment Notes Payable Accounts Payable Unearned Service Revenue Salaries and Wages Payable Interest Payable Share Capital—Ordinary Retained Earnings Dividends Service Revenue Salaries and Wages Expense Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense

Yazici Advertising A.§. Income Statement For the Month Ended October 31, 2020

Credit

Revenues

Service revenue

*

Expenses Salaries and wages expense Supplies expense Rent expense Insurance expense Interest expense Depreciation expense

40 5,000 2,500 800 1,200 50

*10,600 *5,200 1,500 900 50 50 40

Total expenses Net income

10,000 -0-

7,740 * 2,860

500

10,600 > 5,200 1,500 900 50 50 40

*30,190

► J *30,190

Yazici Advertising A.§. Retained Earnings Statement For the Month Ended October 31, 2020

Retained earnings, October 1 Add: Net income Less: Dividends |“^letained earnings, October 31

* -02,860 2,860 500 *2,360

To statement of financial position

As Illustration 3.27 shows, companies then prepare the statement of financial position from the asset and liability accounts and the ending Retained Earnings balance as reported in the retained earnings statement.

Adjusted Trial Balance and Financial Statements

ILLUSTRATION 3.27

Preparation of the statement of financial position from the adjusted trial balance

Yazici Advertising A.§. Adjusted Trial Balance October 31, 2020

_______ Account__________

Debit

Cash £15,200 Accounts Receivable 200 Supplies 1,000 Prepaid Insurance 550 Equipment 5,000 Accumulated Depreciation— Equipment Notes Payable Accounts Payable Unearned Service Revenue Salaries and Wages Payable Interest Payable Share Capital—Ordinary Retained Earnings Dividends 500 Service Revenue Salaries and Wages Expense 5,200 Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 £30,190

Yazici Advertising A.§. Statement of Financial Position October 31, 2020 Assets

Credit

Equipment Less: Accumulated depreciation—equip. Prepaid insurance Supplies Accounts receivable Cash Total assets

5,000 2,500 800 1,200 50

40

£ 4,960 550 1,000 200 15,200 £21,910

Equity and Liabilities

Equity Share capital—ordinary £10,000 Retained earnings 2,360 X. Liabilities Notes payable 5,000 Accounts payable 2,500 Unearned service revenue 800 Salaries and wages payable 1,200 Interest payable 50 Total equity and liabilities

10,000 -0-

10,600

£12,360

9,550

£21,910

Balance at Oct. 31 from retained earnings statement in illustration 3.26

£30,190

DO IT! 4 1 Trial Balance

✓

ACTION PLAN

Kang Company was organized on April 1, 2020. The company prepares quarterly financial statemcnts. The adjusted trial balance amounts al June 30 are shown below (amounts in millions).

Debit

Cash Accounts Receivable Prepaid Rent Supplies Equipment Dividends Salaries and Wages Expense Rent Expense Depreciation Expense Supplies Expense Utilities Expense Interest Expense

£-5,000

W 6,700 600 900 1.000 15,000 600 9,400 1,500 850 200 510 50

Credit

Accumulated Depreciation— Equipment Notes Payable Accounts Payable Salaries and Wages Payable Interest Payable Unearned Rent Revenue Share Capital—Ordinary Service Revenue Rent Revenue

W37,310

a. Determine the net income for the quarter April 1 to June 30. b. Determine the total assets and total liabilities at June 30, 2020, for Kang Company.

c. Determine the amount of retained earnings at June 30, 2020.

W

850 5.000 1,510 400 50 500 14.000 14.200 800

W37.31O

• In an adjusted trial balance, all asset, liability, revenue, and expense accounts are properly stated.

• To determine the ending balance in Retained Earnings, add net income and subtract dividends.

3-23

3-24

CHAPTER 3

Adjusting the Accounts

a. The net income is determined by adding revenues and subtracting expenses. The net income is computed as follows (in millions). Revenues Service revenue Rent revenue Total revenues

W 14,200 800 W 15,000

Expenses Salaries and wages expense Rent expense Depreciation expense Utilities expense Supplies expense Interest expense Total expenses

9,400 1,500 850 510 200 50

12,510

W 2.490

Net income

Total assets and liabilities are computed as follows (in millions).

Liabilities

Assets

Equipment Less: Accumulated depreciation— equipment Prepaid rent Supplies Accounts receivable Cash

W 15.000

850

W14.150 900 1.000 600 6.700

Total assets

W23.350

Retained earnings. April 1 Add: Net income Less: Dividends

W

Retained earnings, June 30

W 1.890

Notes payable Accounts payable Unearned rent revenue Salaries and wages payable Interest payable

W5.000 1,510

Total liabilities

W7,460

500 400 50

0 2,490 600

ated exercise material: BE3.9, BE3.10, DO IT! 3.4, E3.ll, E3.12, and E3.13.

AppendixsA

Alternative Treatment of Deferrals LEARNING OBJECTIVE *5

Prepare adjusting entries for the alternative treatment of deferrals.

In discussing adjusting entries for prepaid expenses and unearned revenues, we illustrated trans­ actions for which companies made the initial entries to statement of financial position accounts. In the case of prepaid expenses, the company debited the prepayment to an asset account. In the case of unearned revenue, the company credited a liability account to record the cash received. Some companies use an alternative treatment. (1) When a company prepays an expense, it debits that amount to an expense account. (2) When it receives payment for future services, it credits the amount to a revenue account. In this appendix, we describe the circumstances

Appendix ЗА: Alternative Treatment of Deferrals

3-25

that justify such entries and the different adjusting entries that may be required. This alterna­ tive treatment of prepaid expenses and unearned revenues has the same effect on the financial statements as the procedures described in the chapter.

Prepaid Expenses Prepaid expenses become expired costs either through the passage of time (e.g., insurance) or through consumption (e.g., advertising supplies). If at the time of purchase the company expects to consume the supplies before the next financial statement date, it may choose to debit (increase) an expense account rather than an asset account. This alternative treatment is simply more convenient.

Assume that Yazici Advertising expects that it will use before the end of the month all of the supplies purchased on October 5. A debit of 62,500 to Supplies Expense (rather than to the asset account Supplies) on October 5 will eliminate the need for an adjusting entry on October 31. At October 31, the Supplies Expense account will show a balance of 62,500, which is the cost of supplies used between October 5 and October 31. But what if the company does not use all the supplies? For example, what if an inventory of 61.000 of advertising supplies remains on October 31? Obviously, the company would need to make an adjusting entry. Prior to adjustment, the expense account Supplies Expense is overstated 61,000. and the asset account Supplies is understated 61.000. Thus, Yazici makes the following adjusting entry. A

Oct. 31

Supplies Supplies Expense (To record supplies inventory)

1,000

B

L

В

+1.000 Exp

1,000 Cash Flows

no effect

Illustration 3A.1 shows the accounts after the company posts the adjusting entry.

10/31

Adj.

ILLUSTRATION 3A.1

Supplies Expense

Supplies

1,000

10/5

10/31

2,500 Bal.

10/31

Adj.

1,000

1,500

Prepaid expenses accounts after adjustment

After adjustment, the asset account Supplies shows a balance of 61,000, which is equal to the cost of supplies on hand al October 31. In addition. Supplies Expense shows a balance of 61,500. This is equal to the cost of supplies used between October 5 and October 31. Without the adjusting entry, expenses are overstated and net income is understated by 61,000 in the October income statement. Also, both assets and equity are understated by 61.000 on the October 31 statement of financial position. Illustration 3A.2 compares the entries and accounts for advertising supplies in the two adj ustmen t approaches.

Prepayment Initially Debited to Asset Account (per chapter) Oct. 5 Oct. 31

Supplies Accounts Payable

2.500

Supplies Expense Supplies

1.500

ILLUSTRATION 3A.2

Prepayment Initially Debited to Expense Account (per appendix) Oct. 5

Supplies Expense Accounts Payable

2.500

Oct. 31

Supplies Supplies Expense

1.000

2.500 1.500

E

+1.000

Adjustment approaches— a comparison

2,500

1.000

3-26

CHAPTER 3

Adjusting the Accounts

After Yazici posts the entries, the accounts appear as shown in Illustration 3A.3.

ILLUSTRATION 3A.3

(per appendix) Supplies

(per chapter) Supplies

Comparison of accounts 10/5

10/31

2.500

Bal.

10/31

Adj.

1,500

10/31

Adj.

Supplies Expense 10/31

Adj.

1,000

1,000

Supplies Expense

1,500

10/5 10/31

2.500

Bal.

10/31

Adj.

1,000

1,500

Note that the account balances under each alternative are the same at October 31: Supplies £1.000 and Supplies Expense £1.500.

Unearned Revenues

HELPFUL HINT The required adjusted balances here are Service Revenue £400 and Unearned Service Revenue £800.

-800 Rev +800 Cash Flows

Unearned revenues are recognized as revenue al the time services are performed. Similar to the case for prepaid expenses, companies may credit (increase) a revenue account when they receive cash for future services. To illustrate, assume that Yazici Advertising received £1,200 for future services on October 2. Yazici expects to perform the services before October 31.1 In such a case, the company credits Service Revenue. If Yazici in fact performs the service before October 31, no adjustment is needed. However, if at the statement date Yazici has not performed £800 of the services, it would make an adjusting entry (see Helpful Hint). Without the entry, the revenue account Service Revenue is overstated £800, and the liability account Unearned Service Revenue is under­ stated £800. Thus, Yazici makes the following adjusting entry.

Oct. 31

Service Revenue Unearned Service Revenue (To record unearned service revenue)

800

800

no effect

Illustration 3A.4 shows the accounts after Yazici posts the adjusting entry.

ILLUSTRATION ЗА.4

Unearned service revenue accounts after adjustment

Unearned Service Revenue

10/31

Adj.

Service Revenue

800

10/31

Adj.

800

10/2 10/31

1,200 Bal.

400

The liability account Unearned Service Revenue shows a balance of £800. This equals the ser­ vices that will be performed in the future. In addition, the balance in Service Revenue equals the services performed in October. Without the adjusting entry, both revenues and net income are overstated by £800 in the October income statement. Also, liabilities are understated by £800 and equity is overstated by £800 on the October 31 statement of financial position.

'This example focuses only on the alternative treatment of unearned revenues. For simplicity, we have ignored the entries to Service Revenue pertaining to the immediate recognition of revenue (£10,000) and the adjusting entry for accrued revenue (£200).

Appendix 3A: Alternative Treatment of Deferrals

Illustration 3A.5 compares the entries and accounts for initially recording unearned service revenue in (1) a liability account or (2) a revenue account.

Unearned Service Revenue Initially Credited to Liability Account (per chapter) Oct. 2

Oct. 31

Cash Unearned Service Revenue

ILLUSTRATION 3A.5

Unearned Service Revenue Initially Credited to Revenue Account (per appendix)

1 ,200

Oct. 2

Cash Service Revenue

Adjustment approaches— a comparison

1,200 1,200

1,200

Unearned Service Revenue Service Revenue

Oct. 31

400 400

800

Service Revenue Unearned Service Revenue

800

After Yazici posts the entries, the accounts appear as shown in Illustration 3A.6.

10/31

Adj.

400

1,200

10/2

10/31 Bal.

Adj.

10/31

Comparison of accounts 800

800

Service Revenue 10/31 Adj.

ILLUSTRATION 3A.6

(per appendix) Unearned Service Revenue

(per chapter) Unearned Service Revenue

Service Revenue 400

10/31 Adj.

800

10/2

1,200

10/31 Bal.

400

Note that the balances in the accounts are the same under the two alternatives: Unearned Service Revenue 4-800 and Service Revenue 4-400.

Summary of Additional Adjustment Relationships Illustration 3A.7 provides a summary of basic relationships for deferrals.

ILLUSTRATION 3A.7

Type of Adjustment

Summary of basic relationships for deferrals

Reason for Adjustment

1. Prepaid expenses

(a) Prepaid expenses initially recorded in asset accounts have been used. (b) Prepaid expenses initially recorded in expense accounts have not been used.

2. Unearned revenues

(a) Unearned revenues initially recorded in liability accounts are now recognized as revenue. (b) Unearned revenues initially recorded in revenue accounts are still unearned.

Account Balances before Adjustment

Adjusting Entry

Assets overstated. Expenses understated. Assets understated. Expenses overstated.

Dr. Expenses Cr. Assets Dr. Assets Cr. Expenses

Liabilities overstated. Revenues understated. Liabilities understated. Revenues overstated.

Dr. Liabilities Cr. Revenues Dr. Revenues Cr. Liabilities

Alternative adjusting entries do not apply to accrued revenues and accrued expenses because no entries occur before companies make these types of adjusting entries.

3-27

3-28

CHAPTER 3

Adjusting the Accounts

Appendix3b 'zzzzz/OTZ/zxzzzzzzzzzzxe/ZÄ/Zzzznzzzzzzzzid

Financial Reporting Concepts I

®

LEARNING OBJECTIVE *6

Discuss financial reporting concepts.

This appendix provides a summary of the concepts used in this text. In addition, it provides other useful concepts which accountants use as a basis for recording and reporting financial information.

Qualities of Useful Information Recently, the IASB completed the project in which it developed a conceptual framework to serve as the basis for future accounting standards. The framework begins by staling that the primary objective of financial reporting is to provide financial information that is useful to investors and creditors for making decisions about providing capital. Useful information should possess two fundamental qualities, relevance and faithful representation, as shown in Illustration 3B.1. ILLUSTRATION 3B.1

Relevance Accounting information has relevance if it would

Fundamental qualities of useful information

make a difference in a business decision. Information is considered relevant if it provides information that has predictive value, that is, helps provide accurate expectations about the future, and has confirmatory value, that is, confirms or corrects prior expectations. Materiality is a company­ specific aspect of relevance. An item is material when its size makes it likely to influence the decision of an investor or creditor. Faithful Representation Faithful representation means that

information accurately depicts what really happened. To provide a faithful representation, information must be complete (nothing important has been omitted), neutral (is not biased toward one position or another), and free from error.

Enhancing Qualities In addition to the two fundamental qualities, the IASB also describes a number of enhancing qualities of useful information. These include comparability, verifiability, timeliness, and understandability. In accounting, comparability results when different companies use the same accounting principles. Another type of comparability is consistency. Consistency means that a company uses the same accounting principles and methods from year to year. Informa­ tion is verifiable if independent observers, using the same methods, obtain similar results. For accounting information to have relevance, it must be timely. That is, it must be available to decision-makers before it loses its capacity to influence decisions. For example, companies like Tencent Holdings (CHN) or Asia Bicycle Trading Co. (TWN) provide their annual reports to investors within 60 days of their year-end. Information has the quality of understandability if it is presented in a clear and concise fashion, so that reasonably informed users of that infor­ mation can interpret it and comprehend its meaning.

Assumptions in Financial Reporting To develop accounting standards, the IASB relies on some key assumptions, as shown in Illustration 3B.2. These include assumptions about the monetary unit, economic entity, lime period, and going concern.

Appendix 3B: Financial Reporting Concepts

¥¥Y¥Ï Accounting Records

— Salaries Measure of employee satisfaction

|

Total number of employees

Percent of international employees

Monetary Unit Assumption The monetary unit assumption requires that only those things that can be

expressed in money are included in the accounting records. This means that certain important information needed by investors, creditors, and managers, such as customer satisfaction, is not reported in the financial statements. This assumption relies on the monetary unit remaining relatively stable in value. Economic Entity Assumption The economic entity assumption states that every economic entity can be

separately identified and accounted for. In order to assess a company’s performance and financial position accurately, it is important to not blur company transactions with personal transactions (especially those of its managers) ortransactions of other companies. Time Period Assumption Notice that the income statement,

Start of

era era era;

business

q i i .................... |;

Now

End of

business

Future

retained earnings statement, and statement of cash flows all cover periods of one year, and the statement of financial position is prepared at the end of each year. The time period assumption states that the life of a business can be divided into artificial time periods and that useful reports covering those periods can be prepared for the business. Going Concern Assumption The going concern assumption states that the business will remain in operation for the foreseeable future. Of course, many businesses do fail, but in general it is reasonable to assume that the business will continue operating.

Principles in Financial Reporting Measurement Principles IFRS generally uses one of two measurement principles, the historical cost principle or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation.

Historical Cost Principle. The historical cost principle (or cost principle, discussed in Chapter 1) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased but also over the time the asset is held. For example, if land that was purchased for €30,000 increases in value to €40,000. it continues to be reported at €30.000. Fair Value Principle. The fair value principle (discussed in Chapter 1) indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market price information is often readily available for these types of assets. In choos­ ing between cost and fair value, two qualities that make accounting information useful for decision-making are used—relevance and faithful representation. In determining which mea­ surement principle to use, the factual nature of cost figures are weighed versus the relevance of lair value. In general, most assets follow the historical cost principle because fair values may not be representationally faithful. Only in situations where assets are actively traded, such as investment securities, is the fair value principle applied.

ILLUSTRATION 3B.2

Key assumptions in financial reporting

3-29

3-30

CHAPTER 3

Adjusting the Accounts

Revenue Recognition Principle The revenue recognition principle requires that companies recognize revenue in the ac­ counting period in which the performance obligation is satisfied. As discussed earlier in the chapter, in a service company, revenue is recognized at the time the service is performed. In a merchandising company, the performance obligation is generally satisfied when the goods transfer from the seller to the buyer (discussed in Chapter 5). At this point, the sales transac­ tion is complete and the sales price established.

Expense Recognition Principle The expense recognition principle (discussed earlier in the chapter) dictates that companies recognize expense in the period in which they make efforts to generate revenue. Thus, ex­ penses follow revenues.

Full Disclosure Principle The full disclosure principle requires that companies disclose all circumstances and events that would make a difference to financial statement users. If an important item cannot rea­ sonably be reported directly in one of the four types of financial statements, then it should be discussed in notes that accompany the statements.

Cost Constraint Providing information is costly. In deciding whether companies should be required to provide a certain type of information, accounting standard-setters consider the cost constraint. It weighs the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.

Review and Practice Learning Objectives Review

1 Explain the accrual basis of accounting and the reasons for adjusting entries.

The time period assumption assumes that the economic life of a busi­ ness is divided into artificial time periods. Accrual-basis accounting means that companies record events that change a company's finan­ cial statements in the periods in which those events occur, rather than in the periods in which the company receives or pays cash. Companies make adjusting entries at the end of an account­ ing period. Such entries ensure that companies recognize revenues .in the period in which the performance obligation is satisfied and recognize expenses in the period in which they are incurred. The major types of adjusting entries are deferrals (prepaid expenses and unearned revenues) and accruals (accrued revenues and accrued expenses).

2

Prepare adjusting entries for deferrals.

Deferrals are either prepaid expenses or unearned revenues. Compa­ nies make adjusting entries for deferrals to record the portion of the prepayment that represents the expense incurred or the revenue for services performed in the current accounting period.

3

Prepare adjusting entries for accruals.

Accruals are either accrued revenues or accrued expenses. Companies make adjusting entries for accruals to record revenues for services performed and expenses incurred in the current accounting period that have not been recognized through daily entries.

Glossary Review

4 Describe the nature and purpose of an adjusted trial balance.

An adjusted trial balance shows the balances of all accounts, includ­ ing those that have been adjusted, at the end of an accounting period. Its purpose is to prove the equality of the total debit balances and total credit balances in the ledger after all adjustments.

*5 Prepare adjusting entries for the alternative treatment of deferrals.

Companies may initially debit prepayments to an expense account. Likewise, they may initially credit unearned revenues to a revenue ac­ count. At the end of the period, these accounts may be overstated. The adjusting entries for prepaid expenses are a debit to an asset account and a credit to an expense account. Adjusting entries for unearned rev­ enues are a debit to a revenue account and a credit to a liability account.

*6

Discuss financial reporting concepts.

To be judged useful, information should have the primary char­ acteristics of relevance and faithful representation. In addition, it

3-31

should be comparable, consistent, verifiable, timely, and under­ standable. The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in terms of money. The economic entity assumption states that economic events can be identified with a particular unit of accountability. The time period assumption states that the econ­ omic life of a business can be divided into artificial time periods and that meaningful accounting reports can be prepared for each period. The going concern assumption states that the company will con­ tinue in operation long enough to carry out its existing objectives and commitments. The historical cost principle states that companies should record assets at their cost. The fair value principle indicates that assets and liabilities should be reported at fair value. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. The expense recognition principle dictates that efforts (expenses) be matched with results (revenues). The full disclosure principle requires that companies disclose circumstances and events that matter to financial statement users. The cost constraint weighs the cost that companies incur to pro­ vide a type of information against its benefits to financial statement users.

Glossary Review Accrual-basis accounting Accounting basis in which companies record transactions that change a company’s financial statements in the periods in which the events occur, (p. 3-3). Accruals Adjusting entries for either accrued revenues or accrued expenses, (p. 3-5).

Depreciation The process of allocating the cost of an asset to expense over its useful life. (p. 3-9). *Economic entity assumption An assumption that every economic entity can be separately identified and accounted for. (p. 3-29).

Accrued expenses Expenses incurred but not yet paid in cash or recorded, (p. 3-14).

Expense recognition principle (matching principle) The principle that companies recognize expense in the period in which they make efforts (consume assets or incur liabilities) to generate revenue, (pp. 3-4, 3-30).

Accrued revenues Revenues for services performed but not yet received in cash or recorded, (p. 3-13).

*Fair value principle Assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability), (p. 3-29).

Adjusted trial balance A list of accounts and their balances after the company has made all adjustments, (p. 3-20).

:i:Faithful representation Information that accurately depicts what really happened, (p. 3-28).

Adjusting entries Entries made at the end of an accounting period to ensure that companies follow the revenue recognition and expense recog­ nition principles, (p. 3-5).

Book value The difference between the cost of a depreciable asset and its related accumulated depreciation, (p. 3-10). Calendar year An accounting period that extends from January 1 to December 31. (p. 3-3).

Cash-basis accounting Accounting basis in which companies record revenue when they receive cash and an expense when they pay out cash, (p. 3-3). ^Comparability Ability to compare the accounting information of differ­ ent companies because they use the same accounting principles, (p. 3-28).

Fiscal year An accounting period that is one year in length, (p. 3-3).

*Full disclosure principle Accounting principle that dictates that com­ panies disclose circumstances and events that make a difference to finan­ cial statement users, (p. 3-30).

*Going concern assumption The assumption that the company will con­ tinue in operation for the foreseeable future, (p. 3-29). ^Historical cost principle An accounting principle that states that com­ panies should record assets at their cost. (p. 3-29).

Interim periods Monthly or quarterly accounting lime periods, (p. 3-3).

^Materiality A company-specific aspect of relevance. An item is mate­ rial when its size makes it likely to influence the decision of an investor or creditor, (p. 3-28).

^Consistency Use of the same accounting principles and methods from year to year within a company, (p. 3-28).

*Monetary unit assumption An assumption that requires that only those things that can be expressed in money arc included in the accounting records, (p. 3-29).

Contra asset account An account offset against an asset account on the statement of financial position, (p. 3-9).

Prepaid expenses (prepayments) Expenses paid in cash before they are used or consumed, (p. 3-6).

‘Cost constraint Constraint that weighs the cost that companies will incur to provide the information against the benefit that financial state­ ment users will gain from having the information available, (p. 3-30).

*Relevance The quality of information that indicates the information makes a difference in a decision, (p. 3-28).

Deferrals Adjusting entries for either prepaid expenses or unearned revenues, (p. 3-5).

Revenue recognition principle The principle that companies recognize revenue in the accounting period in which the performance obligation is satisfied, (pp. 3-3, 3-30).

3-32

CHAPTER 3

Adjusting the Accounts

*Timely Information that is available to decision-makers before it loses its capacity to influence decisions, (p. 3-28).

Time period assumption An assumption that accountants can divide the economic life of a business into artificial time periods, (pp. 3-3. 3-29).

*Understandability Information presented in a clear and concise fashion

Unearned revenues A liability recorded for cash received before ser­ vices are performed, (p. 3-10).

Useful life The length of service of a long-lived asset, (p. 3-8).

^Verifiable The quality of information that occurs when independent observers, using the same methods, obtain similar results, (p. 3-28).

so that users can interpret it and comprehend its meaning, (p. 3-28).

Practice Multiple-Choice Questions 1. (LOl) The revenue recognition principle states that:

a. revenue should be recognized in the accounting period in which a performance obligation is satisfied. b. expenses should be matched with revenues.

c. the economic life of a business can be divided into artificial time periods. d. the fiscal year should correspond with the calendar year.

2. (LOl) The time period assumption states that: a. companies must wait until the calendar year is completed to prepare financial statements. b. companies use the fiscal year to report financial information.

7. (LO2) The trial balance shows Supplies €1,350 and Supplies Expense €0. If €600 of supplies arc on hand at the end of the period, the adjusting entry is: a. Supplies Supplies Expense

600

b. Supplies Supplies Expense

750

c. Supplies Expense Supplies

750

d. Supplies Expense Supplies

600

600 750 750

600

8. (LO2) Adjustments for prepaid expenses:

c. the economic life of a business can be divided into artificial time periods.

a. decrease assets and increase revenues.

d. companies record information in the time period in which the events occur.

c. decrease assets and increase expenses.

3. (LOl) Which of the following statements about the accrual basis of accounting is false? a. Events that change a company’s financial statements are recorded in the periods in which the events occur.

b. Revenue is recognized in the period in which services are performed. c. This basis is in accordance with International Financial Reporting Standards. d. Revenue is recorded only when cash is received, and expense is recorded only when cash is paid.

4. (LOl) The principle or assumption dictating that efforts (expenses) should be recognized in the period in which a company consumes assets or incurs liabilities to generate revenue is the: a. expense recognition principle.

b. cost assumption. c. time period assumption.

b. decrease expenses and increase assets.

d. decrease revenues and increase assets. 9. (LO2) Accumulated Depreciation is: a. a contra asset account.

c. an equity account.

b. an expense account.

d. a liability account.

10. (LO 2) Rivera Shipping computes depreciation on delivery equipment at ¥1.000 (amounts in thousands) for the month of June. The adjusting entry to record this depreciation is as follows.

a. Depreciation Expense

b. Depreciation Expense

1.000

1.000

Equipment

C. Depreciation Expense

1.000 1.000

Accumulated Depreciation— Equipment

d. Equipment Expense

d. revenue recognition principle.

1,000

Accumulated Depreciation— Rivera Shipping

1.000 1.000

Accumulated Depreciation— Equipment

5. (LOl) Adjusting entries are made to ensure that:

a. expenses are recognized in the period in which they are incurred. b. revenues are recorded in the period in which services are performed.

c. statement of financial position and income statement accounts have correct balances at the end of an accounting period.

d. All the responses above are correct. 6. (LOl) Each of the following is a major type (or category) of ad­ justing entries except:

11. (LO 2) Adjustments for unearned revenues: a. decrease liabilities and increase revenues.

b. have an assets-and-revenues-account relationship. c. increase assets and increase revenues. d. decrease revenues and decrease assets.

12. (LO3) Adjustments for accrued revenues:

a. have a liabilities-and-revenues-account relationship. b. have an assets-and-revenues-account relationship.

a. prepaid expenses.

c. accrued expenses.

c. decrease assets and revenues.

b. accrued revenues.

d. recognized revenues.

d. decrease liabilities and increase revenues.

1.000

Practice Multiple-Choice Questions

3-33

d. The adjusted trial balance is prepared after the adjusting 13. (LO3) Anika Winter earned a salary of €400 for the last week entries have been journalized and posted. of September. She will be paid on October 1. The adjusting entry for Anika’s employer at September 30 is: *15. (LO 5) The trial balance shows Supplies NT$0 and Supplies a. No entry is required. Expense NTS 1.500. If NTS800 of supplies are on hand at the end of the period, the adjusting entry is: b. Salaries and Wages Expense 400 Salaries and Wages Payable

400

C. Salaries and Wages Expense Cash

400

d. Salaries and Wages Payable

400

Cash

a. debit Supplies NTS800 and credit Supplies Expense NTS800.

b. debit Supplies Expense NTS800 and credit Supplies NTS800. 400

c. debit Supplies NTS700 and credit Supplies Expense NTS700. d. debit Supplies Expense NTS700 and credit Supplies NTS700.

400

*16. (LO6) Neutrality is an ingredient of:

14. (LO4) Which of the following statements is incorrect concern­ ing the adjusted trial balance?

a. An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made.

b. The adjusted trial balance provides the primary basis for the preparation of financial statements. c. The adjusted trial balance lists the account balances segre­ gated by assets and liabilities.

Solutions 1. a. Revenue should be recognized in the accounting period in which a performance obligation is satisfied. The other choices are incorrect because (b) defines the expense recognition principle, (c) describes the time period assumption, and (d) a company’s fiscal year does not need to correspond with the calendar year.

2. c. The economic life of a business can be divided into artificial time periods. The other choices are incorrect because (a) companies report their activities on a more frequent basis and not necessarily based on a calendar year; (b) companies report financial information more frequently than annually, such as monthly or quarterly, in order to evaluate results of operations; and (d) describes accrual-basis accounting.

3. d. Under the accrual basis of accounting, revenue is recognized when the performance obligation is satisfied, not when cash is received, and expense is recognized when incurred, not when cash is paid. The other choices are all true statements. 4. a. The expense recognition principle dictates that companies rec­ ognize expense in the period in which they make efforts to generate revenue. The other choices are incorrect because (b) there is no cost assumption, but the historical cost principle states that assets should be recorded at their cost; (c) the time period assumption stales that the economic life of a business can be divided into artificial time periods; and (d) the revenue recognition principle indicates that revenue should be recognized in the accounting period in which a performance obligation is satisfied. 5. d. Adjusting entries are made for the reasons noted in choices (a), (b), and (c). The other choices are true statements, but (d) is the belter answer.

6. d. Unearned revenues, not recognized revenues, is one of the major categories of adjusting entries. The other choices all list one of the major categories of adjusting entries. 7. c. Debiting Supplies Expense for €750 and crediting Supplies for €750 (€1,350 - €600) will decrease Supplies and increase Supplies Expense. The other choices are incorrect because (a) will increase

Faithful Representation

Relevance

a.

Yes

Yes

b.

No

No

c.

Yes

No

d.

No

Yes

*17. (LO6) Which item is a constraint in financial accounting?

a. Comparability.

c. Cost.

b. Materiality.

d. Consistency.

Supplies and decrease Supplies Expense and also for the wrong amounts, (b) will increase Supplies and decrease Supplies Expense, and (d) will cause Supplies to have an incorrect balance of €750 (€1,350 - €600) and Supplies Expense to have an incorrect balance of €600 (€0 +€600).

8. c. Adjustments for prepaid expenses decrease assets and increase expenses. The other choices are incorrect because an adjusting entry for prepaid expenses (a) increases expenses, not revenues; (b) in­ creases. not decreases, expenses and decreases, not increases, assets; and (d) increases expenses, not decreases, revenues and decreases, not increases, assets. 9. a. Accumulated Depreciation is a contra asset account: it is offset against an asset account on the statement of financial position. The other choices are incorrect because Accumulated Depreciation is not (b) an expense account nor located on the income statement, (c) an equity account, or (d) a liability account. 10. c. The adjusting entry is to debit Depreciation Expense and credit Accumulated Depreciation—Equipment. The other choices are incorrect because (a) the contra asset account title includes the asset being depreciated, not the company name; (b) the credit should be to the contra asset account, not directly to the asset; and (d) the debit for this entry should be Depreciation Expense, not Equipment Expense.

11. a. Adjustments for unearned revenues will consist of a debit (decrease) to unearned revenues (a liability) and a credit (increase) to a revenue account. Choices (b). (c), and (d) are incorrect because adjustments for unearned revenues will increase revenues but will have no effect on assets. 12. b. Adjustments for accrued revenues will have an assets-andrevenues-account relationship. Choices (a) and (d) are incorrect because adjustments for accrued revenues have no effect on liabilities. Choice (c) is incorrect because these adjustments will increase, not decrease, both assets and revenues. 13. b. The adjusting entry should be to debit Salaries and Wages Expense for €400 and credit Salaries and Wages Payable for €400.

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The other choices are incorrect because (a) if an adjusting entry is not made, the amount of money owed (liability) that is shown on the state­ ment of financial position will be understated and the amount of salaries and wages expense will also be understated: (c) the credit account is incorrect as adjusting entries never affect cash: and (d) the debit account should be Salaries and Wages Expense and the credit account should be Salaries and Wages Payable. Adjusting entries never affect cash.

NT$700 (NTS1.500 - NTS800). The other choices are incorrect be­ cause (b) will cause the Supplies account to have a credit balance (assets have a normal debit balance) and the Supplies Expense ac­ count to be staled at NTS2.300, which is too high; (c) will result in a NT$700 balance in the Supplies account (NTS 100 too low) and an NTS800 balance in the Supplies Expense account (NTS 100 too high); and (d) will cause the Supplies account to have a credit bal­ ance (assets have a normal debit balance) and the Supplies Expense account to be staled at NT$2,200, which is too high.

14. c. The accounts on the trial balance can be segregated by the balance in the account—either debit or credit—not whether they are assets or liabilities. All accounts in the ledger are included in the ad­ justed trial balance, not just assets and liabilities. The other choices are all true statements.

*16. c. Neutrality is one of the enhancing qualities that makes in­ formation more representationally faithful, not relevant. Therefore, choices (a), (b), and (d) are incorrect.

*15. a. This adjusting entry correctly states the Supplies account at NTS800 (NT$0 + NT$800) and the Supplies Expense account at

*17. c. Cost is a constraint in financial accounting. The other choices are all enhancing qualities of useful information.

Practice Brief Exercises Indicate why adjusting entries are needed.

1. (LO1) The ledger of Dey Company includes the following accounts. Explain why each account may need adjustment. a. Supplies.

c. Salaries and Wages Payable.

b. Unearned Service Revenue.

d. Interest Payable.

Solution 1. a. Supplies: to recognize supplies used during the period. b. Unearned Service Revenue: to record revenue generated for services performed.

c. Salaries and Wages Payable: to recognize salaries and wages accrual to employees at the end of a reporting period.

d. Interest Payable: to recognize interest accrued but unpaid on notes payable. Prepare adjusting entry for depreciation.

2. (LO 2) At the end of its first year, the trial balance of Denton Cleaners shows Equipment of £40.000 and zero balances in Accumulated Depreciation—Equipment and Depreciation Expense. Depreciation for the year is estimated to be £8,000. Prepare the adjusting entry for depreciation at December 31. post the adjustments to T-accounts, and indicate the statement of financial position presentation of the equipment at December 31.

Solution 2. Dec. 31

12/31

Depreciation Expense Accumulated Depreciation—Equipment

Depreciation Expense 8,000 I

8.000

8.000 Accum. Depreciation—Equipment I 12/31 8.000

Statement of financial position: Equipment Less: Accumulated depreciation—equipment

Prepare adjusting entries for accruals.

£40.000 8.000

£32,000

3. (LO3) You are asked to prepare the following accrual adjusting entries at December 31. 1. Services performed but not recorded are €4,200.

2. Utility expenses incurred but not paid are €660.

3. Salaries and wages earned by employees of €3.000 are unpaid. Use the following account titles: Accounts Payable. Accounts Receivable. Service Revenue, Salaries and Wages Expense. Salaries and Wages Payable, and Utility Expense.

Practice Exercises

Solution Dec. 31

Accounts Receivable Service Revenue

31

Utility Expense Accounts Payable

31

Salaries and Wage Expense Salaries and Wages Payable

4.200 4.200 660

660 3.000 3.000

4. (LO 1, 2, 3) The trial balance lor Blair Company includes the following statement of financial

position accounts. Identify the accounts that may require adjustment. For each account that requires adjustment, indicate (a) the type of adjusting entry (prepaid expense, unearned revenue, accrued revenue, or accrued expense) and (b) the related account in the adjusting entry. Accounts Receivable Supplies Prepaid Insurance

Analyze accounts in an unadjusted trial balance.

Interest Payable Unearned Service Revenue

Solution Account

4.

Type of Adjustment

Accounts Receivable Supplies Prepaid Insurance Interest Payable Unearned Service Revenue

Accrued revenue Prepaid expense Prepaid expense Accrued expense Unearned revenue

Related Account

Service Revenue Supplies Expense Insurance Expense Interest Expense Service Revenue

(LO 4) The adjusted trial balance of Harmony Decorating includes the following accounts at December 31. 2020: Cash €12.000. Share Capital—Ordinary €22.000. Dividends €3.000. Service Revenue €41.000. Rent Expense €900. Salaries and Wages Expense €6.000. Supplies Expense €700, and Depreciation Expense €1.800. Prepare an income statement for the year. 5.

Prepare an income statement from an adjusted trial balance.

Solution Harmony Decorating Income Statement For the Year Ended December 31, 2020

5.

Revenues Service revenue Expenses Salaries and wages expense Rent expense Depreciation expense Supplies expense

€41.000

€6.000 900 1.800 700

Total expenses

Net income

9.400

€3 1.600

Practice Exercises 1. (LO2,3) Evan Walls, D.D.S.. opened a dental practice on January 1,2020. During the first month of operations, the following transactions occurred.

1. Watts performed services for patients totaling $2.400. These services have not yet been recorded.

2. Utility expenses incurred but not paid prior to January 31 totaled $400. 3. Purchased dental equipment on January I for $80.000. paying $20.000 in cash and signing a $60.000. 3-year note payable. The equipment depreciates $500 per month. Interest is $600 per month. 4. Purchased a one-year malpractice insurance policy on January 1 for $12.000. 5. Purchased $2.6(X) of dental supplies. On January 31. determined that $900 of supplies were on hand.

Prepare adjusting entries.

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Instructions

Prepare the adjusting entries on January 31. Account titles are Accumulated Depreciation—Equip­ ment. Depreciation Expense. Service Revenue. Accounts Receivable, Insurance Expense. Interest Expense. Interest Payable, Prepaid Insurance, Supplies. Supplies Expense, Utilities Expense, and Utilities Payable.

Solution 2.400

Accounts Receivable Service Revenue

2.400

Utilities Expense Utilities Payable

400

Depreciation Expense

500

400

Accumulated Depreciation—Equipment

500

Interest Expense Interest Payable

600

600

Insurance Expense (SI2.000 Prepaid Insurance

1,000

12)

1.000

Supplies Expense (S2.600 - $900) Supplies

Prepare correct income statement.

1.700

1,700

2. (LO2, 3,4) The income statement of Venden Movers for the month of July shows net income of £4,000 based on Service Revenue £8.700, Salaries and Wages Expense £2,500. Supplies Expense £1,700. and Utilities Expense £500. In reviewing the statement, you discover the following. 1. Insurance expired during July of £700 was omitted. 2. Supplies expense includes £250 of supplies that are still on hand at July 31.

3. Depreciation on equipment of £300 was omitted. 4. Accrued but unpaid wages at July 31 of £400 were not included.

5. Services performed but unrecorded totaled £650. Instructions Prepare a correct income statement for July 2020.

Solution 2

Venden Movers Income Statement For the Month Ended July 31,2020 Revenues Service revenue (£8.700 + £650) Expenses Salaries and wages expense (£2,500 + £400) Supplies expense (£1.700 - £250) Utilities expense Insurance expense Depreciation expense Total expenses

Net income

£9.350

£2.900 1,450 500 700 300 5,850

£3.500

Practice Problem

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Practice Problem (LO 2,3) The Desai Lawn Care began operations on April 1. At April 30. the trial balance shows the following balances for selected accounts (amounts in thousands).

Prepaid Insurance Equipment Noles Payable Unearned Service Revenue Service Revenue

? 3.600 28.000 20.000 4,200 1.800

Analysis reveals the following additional data.

1. Prepaid insurance is the cost of a 2-year insurance policy, effective April 1. 2. Depreciation on the equipment is ?500 per month. 3. The note payable is dated April 1. It is a 6-monlh. 12% note. 4. Seven customers paid for the company's 6-month lawn service package of ?600 beginning in April. The company performed services for these customers in April.

5. Lawn services performed for other customers but not recorded at April 30 totaled ? 1.500.

Instructions Prepare the adjusting entries for the month of April. Show computations.

Solution GENERAL JOURNAL

Account Titles and Explanation

Date

JI

Ref.

Debit

Credit

Adjusting Entries Apr.

30

30

30

30

30

Insurance Expense Prepaid Insurance (To record insurance expired: ^3.600 -? 24 = ? 150 per month)

150

Depreciation Expense Accumulated Depreciation—Equipment (To record monthly depreciation)

500

Interest Expense Interest Payable (To record interest on notes payable: T20.000 x 12% x 1/12 = ?200)

200

Unearned Service Revenue Service Revenue (To record revenue for services performed: ?600 6 = ? 100: ?100 per month X 7 = ?700)

700

Accounts Receivable Service Revenue (To record revenue for services performed)

1.500

150

500

200

700

1.500

Prepare adjusting entries from selected data.

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Note: All asterisked Questions. Exercises, and Problems relate to material in the appendices to the chapter.

Questions 1. a. How does the time period assumption affect an accountant’s analysis of business transactions? b. Explain the terms fiscal year, calendar year, and interim periods.

2. Define two IFRSs that relate to adjusting the accounts. 3. Susan Hardy, a lawyer, accepts a legal engagement in March, performs the work in April, and is paid in May. If Hardy’s law firm prepares monthly financial statements, when should it recognize revenue from this engagement? Why? 4. Why do accrual-basis financial statements provide more useful information than cash-basis statements?

5. In completing the engagement in Question 3. Hardy pays no costs in March, £2,000 in April, and £2.500 in May (incurred in April). How much expense should the firm deduct from revenues in the month when it recognizes the revenue? Why? 6. “Adjusting entries are required by the historical cost principle of accounting.'’ Do you agree? Explain. 7. Why may a trial balance not contain up-to-date and complete finan­ cial information?

8. Distinguish between the two categories of adjusting entries, and identify the types of ad justments applicable to each category. 9. What is the debit/credit effect of a prepaid expense adjusting entry? 10. "Depreciation is a valuation process that results in the reporting of the fair value of the asset.” Do you agree? Explain. 11. Explain the differences between depreciation expense and accu­ mulated depreciation. 12. G. Phillips Company purchased equipment for Rs 18,000. By the current statement of financial position date. Rs6.000 had been depre­ ciated. Indicate the statement of financial position presentation of the data. 13. What is the debit/credit effect of an unearned revenue adjusting entry? 14. Whistler Cabinets performed services for a customer but has not yet recorded payment, nor has it recorded any entry related to the work. Which of the following accounts are involved in the adjusting entry: (a) asset, (b) liability, (c) revenue, or (d) expense? For the accounts se­ lected. indicate whether they would be debited or credited in the entry. 15. A company fails to recognize an expense incurred but not paid. In­ dicate which of the following accounts is debited and which is credited in the adjusting entry: (a) asset, (b) liability, (c) revenue, or (d) expense.

16. A company makes an accrued revenue adjusting entry for NTS27.000 and an accrued expense adjusting entry for NT$21.000. How much was net income understated prior to these entries? Explain.

17. On January 9, a company pays €6,000 for salaries and wages of which €2.000 was reported as Salaries and Wages Payable on December 31. Give the entry to record the payment. 18. For each of the following items before adjustment, indicate the type of adjusting entry (prepaid expense, unearned revenue, accrued revenue, or accrued expense) that i needed to correct the misstatemenl. If an item could result in more than one type of adjusting entry, indicate each of the types.

a. Assets are understated.

d. Expenses are understated.

b. Liabilities are overstated.

c. Assets are overstated.

c. Liabilities are understated.

f. Revenue is understated.

19. One-half of the adjusting entry is given below. Indicate the account title for the other half of the entry.

a. Salaries and Wages Expense is debited. b. Depreciation Expense is debited.

c. Interest Payable is credited. d. Supplies is credited.

e. Accounts Receivable is debited.

f. Unearned Service Revenue is debited.

20. “An adjusting entry may affect more than one statement of financial position or income statement account.” Do you agree? Why or why not? 21. Why is it possible to prepare financial statements directly from an adjusted trial balance? *22. Dashan Company debits Supplies Expense for all purchases of supplies and credits Rent Revenue for all advanced rentals. For each type of adjustment, give the adjusting entry.

*23. a. What is the primary objective of financial reporting? b. Identify the characteristics of useful accounting information. *24. Dan Fineman, the president of King Company, is pleased. King substantially increased its net income in 2020 while keeping its unit in­ ventory relatively the same. Howard Gross, chief accountant, cautions Dan, however. Gross says that since King changed its method of in­ ventory valuation, there is a consistency problem and it is difficult to determine whether King is better off. Is Gross correct? Why or why not? *25. What is the distinction between comparability and consistency? *26. Describe the constraint inherent in the presentation of account­ ing information.

*27. Quinn Becker is president of Better Books. She has no account­ ing background. Becker cannot understand why fair value is not used as the basis for all accounting measurement and reporting. Discuss. *28. What is the economic entity assumption? Give an example of its violation.

Brief Exercises Indicate why adjusting entries are needed.

BE3.1 (LO 1) The ledger of Althukair Company includes the following accounts. Explain why each account may require adjustment. a. Prepaid Insurance.

c. Unearned Service Revenue.

b. Depreciation Expense.

d. Interest Payable.

Brief Exercises

ВЕ3.2 (LO 2, 3) Gee Company accumulates the following adjustment data at December 31. Indicate (a) the type of adjustment (prepaid expense, accrued revenue, and so on), and (b) the status of accounts before adjustment (for example, "assets understated and revenues understated").

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Identify the major types of adjusting entries.

1. Supplies of € 150 are on hand. 2. Services performed but not recorded total €900.

3. Interest of €200 has accumulated on a note payable. 4. Rent collected in advance totaling €850 has been recognized as revenue.

BE3.3 (LO 2) Schramel Advertising’s trial balance at December 31 shows Supplies £6,700 and Sup­ plies Expense £0. On December 31, there are £2,100 of supplies on hand. Prepare the adjusting entry at December 31. and using T-accounts, enter the balances in the accounts, post the adjusting entry, and indicate the adjusted balance in each account.

Prepare adjusting entry for supplies.

BE3.4 (LO 2) At the end of its first year, the trial balance of Wolowitz Company shows Equipment €30.000 and zero balances in Accumulated Depreciation—Equipment and Depreciation Expense. Depreciation for the year is estimated to be €3.750. Prepare the annual adjusting entry for depreciation at December 31, post the adjustments to T-accounts, and indicate the statement of financial position presentation of the equipment at December 31.

Prepare adjusting entry for depreciation.

BE3.5 (LO 2) On July 1. 2020, Major Ltd. pays £15,120 to Orlow Insurance for a 3-year insurance con­ tract. Both companies have fiscal years ending December 31. For Major Ltd., journalize and post the entry on July 1 and the annual adjusting entry on December 31.

Prepare adjusting entry for prepaid expense.

BE3.6 (LO 2) Using the data in ВЕЗ.5. journalize and post the entry on July I and the adjusting entry on December 31 for Orlow Insurance. Orlow uses the accounts Unearned Service Revenue and Service Revenue.

Prepare adjusting entry for unearned revenue.

BE3.7 (LO 3) The bookkeeper for Abduli Marble asks you to prepare the following accrual adjusting entries at December 31.

Prepare adjusting entries for accruals.

1. Interest on notes payable of €400 is accrued.

2. Services performed but not recorded total €2.300. 3. Salaries earned by employees of €900 have not been recorded.

Use the following account titles: Service Revenue. Accounts Receivable. Interest Expense, Interest Payable, Salaries and Wages Expense, and Salaries and Wages Payable.

BE3.8 (LO 1, 2, 3) The trial balance of Beowulf Travel includes the following statement of financial position accounts, which may require adjustment. For each account that requires adjustment, indicate (a) the type of adjusting entry (prepaid expense, unearned revenue, accrued revenue, or accrued expense) and (b) the related account in the adjusting entry. Accounts Receivable Prepaid Insurance Accumulated Depreciation—Equipment

Analyze accounts in an unadjusted trial balance.

Interest Payable Unearned Service Revenue

BE3.9 (LO 4) The adjusted trial balance of Kwun Photos at December 31. 2020. includes the following accounts: Share Capital—Ordinary W 16,400. Dividends W7.000. Service Revenue W39.000, Salaries and Wages Expense W 16.000. Insurance Expense W2.000, Rent Expense W4.000. Supplies Expense W1.500. and Depreciation Expense W1.300. Prepare an income statement for the year (amounts in thousands).

Prepare an income statement from an adjusted trial balance.

ВЕЗЛО (LO 4) Partial adjusted trial balance data for Kwun Photos is presented in ВЕЗ.9. Prepare a retained earnings statement for the year assuming net income is W 14,200 for the year and Retained Earnings is W7.240 on January I (amounts in thousands).

Prepare a retained earnings statement from an adjusted trial balance.

*BE3.11 (LO 5) Eckholm Pet Grooming records all prepayments in income statement accounts. At April 30. the trial balance shows Supplies Expense HK$28,000, Service Revenue HKS92.000. and zero balances

Prepare adjusting entries under alternative treatment of deferrals.

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CHAPTER 3

Adjusting the Accounts

in related statement of financial position accounts. Prepare the adjusting entries al April 30 assuming (a) HK$4,000 of supplies on hand and (b) HK$30.000 of service revenue should be reported as unearned. Identify- characteristics of useful information.

*BE3.12 (LO 6) The accompanying chart shows the qualitative characteristics of useful accounting infor­ mation. Fill in the blanks.

Identify characteristics of useful information.

*BE3.13 (LO 6) Given the characteristics of useful accounting information, complete each of the follow­ ing statements.

a. For information to be_____ . it should have predictive value, confirmatory value, and be material. b. _____ is the quality of information that gives assurance that the information accurately depicts what really happened.

c. _____ means using the same accounting principles and methods from year to year within a company. Identify characteristics of useful information.

*BE3.14 (LO6) Here are some qualitative characteristics of useful accounting information:

1. Predictive value.

3. Verifiable.

2. Neutral.

4. Timely.

Match each qualitative characteristic to one of the following statements.

_________ a. Accounting information should help provide accurate expectations about future events. _________ b. Accounting information cannot be selected, prepared, or presented to favor one set of interested users over another. _________ c. The quality of information that occurs when independent observers, using the same methods, obtain similar results. _________ d. Accounting information must be available to decision-makers before it loses its capacity to influence their decisions. Define full disclosure principle.

*BE3.15 (LO 6) Select the response that completes the following statement correctly. The full disclosure principle dictates that:

a. financial statements should disclose all assets al their cost. b. financial statements should disclose only those events that can be measured in currency.

c. financial statements should disclose all events and circumstances that would matter to users of financial statements.

d. financial statements should not be relied on unless an auditor has expressed an unqualified opinion on them.

DO IT! Exercises

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DO IT! Exercises DO IT! 3.1 (LOI) Below is a list of concepts in the left column, with a description of the concept in the right column. There are more descriptions provided than concepts. Match the description of the concept to the concept.

1. ____ Cash-basis accounting.

a. Monthly and quarterly time periods.

2. ____ Fiscal year.

b. Accountants divide the economic life of a business into artificial time periods.

3. ____ Revenue recognition principle.

Identify timing concepts.

c. Efforts (expenses) should be recognized in the period in which a company uses assets or incurs liabilities to generate ac­ complishments (revenues).

4. ____ Expense recognition principle.

d. Companies record revenues when they re­ ceive cash and record expenses when they pay out cash.

e. An accounting time period that is one year in length.

f. An accounting time period that starts on January 1 and ends on December 31.

g. Companies record transactions in the period in which the events occur. h. Recognize revenue in the accounting period in which a performance obligation is satisfied.

DO IT! 3.2 (LO 2) The ledger of Lafayette Ski School on March 31.2020. includes the following selected accounts before adjusting entries.

Debit

Prepaid Insurance Supplies Equipment Unearned Service Revenue

Prepare adjusting entries for deferrals.

Credit

CHF 2.400 2.500 30.000 CHF9.000

An analysis of the accounts shows the following.

1. Insurance expires at the rate of CHF400 per month.

2. Supplies on hand total CHFI.600. 3. The equipment depreciates CHF480 per month. 4. During March, services were performed for two-fifths of the unearned service revenue. Prepare the adjusting entries for the month of March. DO IT! 3.3 (LO 3) Pegasus Computer Services began operations in July 2020. At the end of the month, the company prepares monthly financial statements. It has the following information for the month.

Prepare adjusting entries for accruals.

1. At July 31. the company owed employees € 1.300 in salaries that the company will pay in August.

2. On July 1. the company borrowed €20.000 from a local bank on a 10-year note. The annual in­ terest rate is 6%. 3. Service revenue unrecorded in July totaled €2.400.

Prepare the adjusting entries needed at July 31.2020. DO IT! 3.4 (LO4) Ming Co. was organized on April 1.2020. The company prepares quarterly finan­ cial statements. The adjusted trial balance amounts at June 30 are as follows.

Calculate amounts from trial balance.

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Credit

Debit Cash Accounts Receivable Prepaid Rent Supplies Equipment Dividends Salaries and Wages Expense Rent Expense Depreciation Expense Supplies Expense Utilities Expense Interest Expense

RS 5.360 580 1,120 920 12.000 500 7,400 1,200 700 160 410 40

Accumulated Depreciation— Equipment Notes Payable Accounts Payable Salaries and Wages Payable Interest Payable Unearned Rent Revenue Share Capital—Ordinary Service Revenue Rent Revenue

R$

700 4.000 790 300 40 400 11.200 11.360 1.600

RS3O.39O

RS30.390

a. Determine the net income for the quarter April 1 to June 30.

b. Determine the total assets and total liabilities al June 30. 2020. for Ming Co. c. Determine the amount that appears for Retained Earnings at June 30. 2020.

Exercises Explain the lime period assumption.

E3.1 (LO 1) Chloe Davis has prepared the following list of statements about the time period assumption. 1. Adjusting entries would not be necessary if a company’s life were not divided into artificial time periods.

2. Taxing authorities require companies to file annual tax returns. 3. Accountants divide the economic life of a business into artificial lime periods, but each transaction affects only one of these periods.

4. Accounting time periods are generally a month, a quarter, or a year. 5. A time period lasting one year is called an interim period. 6. All fiscal years are calendar years, but not all calendar years are fiscal years. Instructions Identify each statement as true or false. If false, indicate how to correct the statement.

Distinguish between cash and accrual basis of accounting.

E3.2 (LO 1) Writing On numerous occasions, proposals have surfaced to pul governments on the accrual basis of accounting. This is no small issue. In many cases, significant unrecorded liabilities and losses would have to be recorded.

Instructions a. What is the difference between accrual-basis accounting and cash-basis accounting?

b. Why would politicians prefer the cash basis over the accrual basis? c. Explain in a letter why governments should adopt the accrual basis of accounting.

Compute cash and accrual accounting income.

E3.3 (LO 1) Carillo Painting collected £108.000 from customers in 2020. Of the amount collected. £25,000 was for services performed in 2019. In addition. Carillo performed services worth £36.000 in 2020. which will not be collected until 2021. Carillo Painting also paid £72.000 for expenses in 2020. Of the amount paid. £30.000 was for expenses incurred on account in 2019. In addition. Carillo incurred £42.000 of expenses in 2020. which will not be paid until 2021.

Exercises

Instructions a. Compute 2020 cash-basis net income. b. Compute 2020 accrual-basis net income.

E3.4 (LO 1,2,3) Yilrnaz A.§. encounters the following situations:

1. Yilrnaz collects 11,300 from a customer in 2020 tor services to be performed in 2021.

Identify1lie type of adjusting entry needed.

2. Yilrnaz incurs utility expense which is not yet paid in cash or recorded. 3. Yilmaz’s employees worked 3 days in 2020 but will not be paid until 2021. 4. Yilrnaz performs services for customers but has not yet received cash or recorded the transaction.

5. Yilrnaz paid £2.800 rent on December 1 for the 4 months starling December I. 6. Yilrnaz received cash for future services and recorded a liability until the service was performed. 7. Yilrnaz performed consulting services for a client in December 2020. On December 31. it had not billed the client for services provided of £1.200. 8. Yilrnaz paid cash lor an expense and recorded an asset until the item was used up.

9. Yilrnaz purchased £900 of supplies in 2020: al year-end. £400 of supplies remain unused. 10. Yilrnaz purchased equipment on January 1.2020: the equipment will be used for 5 years.

11. Yilrnaz borrowed £12.000 on October 1.2020. signing an 8% one-year note payable.

Instructions Identify what type of adjusting entry (prepaid expense, unearned revenue, accrued expense, or accrued revenue) is needed in each situation at December 31, 2020.

E3.5 (LO 2, 3) Hwang Ltd. has the following balances in selected accounts on December 3 1.2020. Accounts Receivable Accumulated Depreciation—Equipment Equipment Interest Payable Notes Payable Prepaid Insurance Salaries and Wages Payable Supplies Unearned Service Revenue

Prepare adjusting entries from selected data.

NTS -0-07.000 -010.000 2.100 -02,450 32.000

All the accounts have normal balances. The information below has been gathered at December 31.2020.

1. Hwang borrowed NTS 10.000 by signing a 9%, one-year note on September 1.2020. 2. A count of supplies on December 31, 2020. indicates that supplies of NTS900 arc on hand. 3. Depreciation on the equipment for 2020 is NTS 1.000. 4. Hwang paid NTS2.100 for 12 months of insurance coverage on June 1.2020.

5. On December 1. 2020. Hwang collected NTS32.000 for consulting services to be performed from December 1,2020. through March 31.2021. 6. Hwang performed consulting services for a client in December 2020. The client will be billed NTS4.200. 7. Hwang pays its employees total salaries of NTS9.000 every Monday for the preceding 5-day week (Monday through Friday). On Monday. December 29. employees were paid for the week ending December 26. All employees worked the last 3 days of 2020.

Instructions Prepare annual adjusting entries for the seven items described above.

E3.6 (LO 2, 3) Orwell Surf Shop accumulates the following adjustment data at December 31.

1. Services performed but unbilled total €3.000. 2. Supplies of €300 have been used.

3. Utility expenses of €552 arc unpaid. 4. Services performed of €260 collected in advance.

5. Salaries of €800 are unpaid. 6. Prepaid insurance totaling €350 has expired.

Identify types of adjustments and account relationships.

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CHAPTER 3

Adjusting the Accounts

Instructions For each of the above items indicate the following. a. The type of adjustment (prepaid expense, unearned revenue, accrued revenue, or accrued expense).

b. The status of accounts before adjustment (overstatement or understatement).

Prepare adjusting entries from selected account data.

E3.7 (LO 2, 3) The ledger of Villa Rental Agency on March 31 of the current year includes the selected accounts, shown below, before adjusting entries have been prepared. Debit

Prepaid Insurance Supplies Equipment Accumulated Depreciation—Equipment Notes Payable Unearned Rent Revenue Rent Revenue Interest Expense Salaries and Wages Expense

Credit

€ 3.600 2,800 25,000

€ 8,400 20.000 10.200 60.000 -014,000

An analysis of the accounts shows the following.

1. The equipment depreciates €400 per month. 2. One-third of the unearned rent revenue was recognized as revenue during the quarter. 3. Interest of €500 is accrued on the notes payable.

4. Supplies on hand total €750. 5. Insurance expires at the rate of €300 per month.

Instructions Prepare the adjusting entries at March 31. assuming that adjusting entries are made quarterly. Addi­ tional accounts are Depreciation Expense. Insurance Expense. Interest Payable, and Supplies Expense.

Prepare adjusting entries.

E3.8 (LO 2,3) Lorena Manzone opened a dental practice on January 1.2020. During the first month of operations, the following transactions occurred.

1. Performed services for patients who had dental plan insurance. At January 31. €785 of such services were performed but not yet recorded.

2. Utility expenses incurred but not paid prior to January 31 totaled €650. 3. Purchased dental equipment on January 1 for €80.000. paying €30.000 in cash and signing a€50.000, 3-year note payable. The equipment depreciates €400 per month. Interest is €500 per month.

4. Purchased a one-year malpractice insurance policy on January 1 for €24.000. 5. Purchased € 1.600 of dental supplies. On January 31. determined that €400 of supplies were on hand.

Instructions Prepare the adjusting entries on January 31. Account titles are Accumulated Depreciation—Equipment. Depreciation Expense. Service Revenue. Accounts Receivable, Insurance Expense, Interest Expense. Interest Payable, Prepaid Insurance, Supplies, Supplies Expense, Utilities Expense, and Utilities Payable. Prepare adjusting entries.

E3.9 (LO 2, 3) The trial balance for Yazici Advertising A.§. is shown in Illustration 3.3. Instead of the adjusting entries shown in the text al October 31. assume the following adjustment data.

1. Supplies on hand at October 31 total £500. 2. Expired insurance for the month is tl 20. 3. Depreciation for the month is ^50. 4. Services related to unearned service revenue in October worth £600 were performed.

5. Services performed but not recorded at October 31 are t360. 6. Interest accrued at October 31 is t-95. 7. Accrued salaries al October 3 I are td .625.

Instructions Prepare the adjusting entries for the items above.

Exercises E3.10 (LO 1, 2, 3, 4) The income statement of Bjorn ASA for the month of July shows net income of €1.400 based on Service Revenue €5.500. Salaries and Wages Expense €2.300. Supplies Expense €1,200. and Utilities Expense €600. In reviewing the statement, you discover the following.

Prepare correct income statement.

1. Insurance expired during July of €500 was omitted.

2. Supplies expense includes €250 of supplies that are still on hand at July 31. 3. Depreciation on equipment of € 150 was omitted.

4. Accrued but unpaid salaries and wages at July 31 of €400 were not included. 5. Services performed but unrecorded totaled €650.

Instructions Prepare a correct income statement for July 2020.

E3.ll (LO 1, 2, 3, 4) A partial adjusted trial balance of Rooney Sports at January 31. 2020. shows the following.

Analyze adjusted data.

Rooney Sports Adjusted Trial Balance January 31, 2020

Debit

Supplies Prepaid Insurance Salaries and Wages Payable Unearned Service Revenue Supplies Expense Insurance Expense Salaries and Wages Expense Service Revenue

Credit

£ 850 2.400

£ 920 750 950 400 2,900

2.000

Instructions Answer the following questions, assuming the year begins January 1.

a. If the amount in Supplies Expense is the January 31 adjusting entry and £1.000 of supplies was purchased in January, what was the balance in Supplies on January 1? b. If the amount in Insurance Expense is the January 31 adjusting entry and the original insurance premium was for one year, what was the total premium and when was the policy purchased?

c. If £3.800 of salaries was paid in January, what was the balance in Salaries and Wages Payable al December 31.2019? E3.12 (LO2, 3) Selected accounts of Al-Kazaz Interiors are shown as follows.

Journalize basic transactions and adjusting entries.

Supplies Expense

7/31

900

Supplies 7/1 Bal. 7/10

1.100 650

7/31

Salaries and Wages Payable 7/3 1

900

Accounts Receivable

7/31

500

Salaries and Wages Expense 7/15 7/31

1.200 1.200

1,200

Unearned Service Revenue

7/31

1.150

7/1 Bal. 7/20

1,500 1.000

Service Revenue 7/14 7/31 7/31

2,200 1,150 500

Instructions After analyzing the accounts, journalize (a) the July transactions and (b) the adjusting entries that were made on July 31. (Hint: July transactions were for cash.)

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3-46

CHAPTER 3

Adjusting the Accounts

Prepare adjusting entries from selected account data.

E3.13 (LO 2,3) The ledger of Yoon Lumber Supply on July 31. 2020. includes the selected accounts below before adjusting entries have been prepared.

Debit

Notes Payable Supplies Prepaid Rent Buildings Accumulated Depreciation—Buildings Unearned Service Revenue

Credit

W 20.000

W 24.000 3.600 250.000

140.000 11.500

An analysis of the company’s accounts shows the following.

1. The notes payable pays interest at a rate of 6% per year. 2. Supplies on hand at the end of the month totaled W18.600.

3. The balance in Prepaid Rent represents 4 months of rent costs. 4. Employees were owed W3.100 related to unpaid salaries and wages. 5. Depreciation on buildings is W6.000 per year. 6. During the month, the company satisfied obligations worth W4.700 related to the Unearned Services Revenue. 7. Unpaid maintenance and repairs costs were W2.300.

Instructions Prepare the adjusting entries at July 31 assuming that adjusting entries are made monthly. Use additional accounts as needed. Determine effect of adjusting entries.

E3.14 (LO 2, 3) On December 31. 2020, Waters Electricians prepared an income statement and state­ ment of financial position, but failed to take into account three adjusting entries. The statement of finan­ cial position showed total assets €150.000. total liabilities €70.000. and equity €80.000. The incorrect income statement showed net income of €70.000. The data for the three adjusting entries were:

1. Salaries and wages amounting to €10.000 for the last 2 days in December were not paid and not recorded. The next payroll will be in January.

2. Rent payments of €8.000 were received for two months in advance on December 1. The entire amount was credited to Unearned Rent Revenue when paid. 3. Depreciation expense for 2020 is €9.000.

Instructions Complete the following table to correct the financial statement amounts shown (indicate deductions with parentheses).

Item Incorrect balances Effects of: Salaries and Wages Rent Revenue Depreciation Correct balances

Prepare and post transaction and adjusting entries for prepayments.

Net Income

Total Assets

Total Liabilities

Equity

€70.000

€150.000

€70.000

€80.000

E3.15 (LO2) Action Quest Games adjusts its accounts annually. The following information is available for the year ended December 31.2020.

1. Purchased a 1-year insurance policy on June 1 for $1,800 cash. 2. Paid $6,500 on August 31 for 5 months’ rent in advance.

3. On September 4, received $3,600 cash in advance from a company to sponsor a game each month for a total of 9 months for the most improved students at a local school. 4. Signed a contract for cleaning services starting December 1 for $ 1,000 per month. Paid for the first 2 months on November 30. (Hint: Use the account Prepaid Cleaning to record prepayments.) 5. On December 5. received $ 1.500 in advance from a gaming club. Determined that on December 31. $475 of these games had not yet been played.

Exercises

Instructions a. For each of the above transactions, prepare the journal entry to record the initial transaction. b. For each of the above transactions, prepare the adjusting journal entry that is required on December 31. (Hint: Use the account Service Revenue for item 3 and Maintenance and Repair Expense for item 4.) c. Post the journal entries in parts (a) and (b) to T-accounts and determine the final balance in each account balance. (Note: Posting to the Cash account is not required.) E3.16(LO3) Greenock Company has the following information available for accruals for the year ended December 31,2020. The company adjusts its accounts annually.

Prepare adjusting and subsequent entries for accruals.

1. The December utility bill for $425 was unrecorded on December 31. Greenock paid the bill on January 11.

2. Greenock is open 7 days a week and employees are paid a total of $3.500 every Monday for a 7-day (Monday-Sunday) workweek. December 31 is a Thursday, so employees will have worked 4 days (Monday. December 28-Thursday, December 31) that they have not been paid for by year-end. Employees will be paid next on January 4. 3. Greenock signed a $48.000. 5% bank loan on November 1. 2020. due in 2 years. No interest pay­ ments were made in 2020. Interest for 2020 was paid on January 1.2021. 4. Greenock receives a fee from Pizza Shop next door for all pizzas sold to customers using Greenock's facility. The amount owed for December is $300, which Pizza Shop will pay on January 4. (Hint: Use the Service Revenue account.)

5. Greenock rented some of its unused warehouse space to a client for $6.000 a month, payable the first day of the following month. It received the rent for the month of December on January 2.

Instructions a. For each situation, prepare the adjusting entry required at December 31. (Round all calculations to the nearest dollar.) b. For each situation, prepare the journal entry to record the subsequent cash transaction in 2021. E3.17 (LO 2, 3, 4) The trial balances before and after adjustment for Matusiak OAO at the end of its fiscal year arc presented below.

Matusiak OAO Trial Balance August 31, 2020 Before Adjustment

Dr. Cash Accounts Receivable Supplies Prepaid Insurance Equipment Accumulated Depreciation—Equipment Accounts Payable Salaries and Wages Payable Unearned Rent Revenue S hare Capi tal—Ordinary Retained Earnings Service Revenue Rent Revenue Salaries and Wages Expense Supplies Expense Rent Expense Insurance Expense Depreciation Expense

Instructions

Dr.

Cr.

€10.400 1 1.200 700 2.500 14.000

€ 3.600 5.800 -01,500 12.600 3,000 34.000 11.000 17,000 -015.000 -0-0€71.500

Prepare the adjusting entries that were made.

Cr.

€10,400 8.800 2,300 4,000 14,000

After Adjustment

€ 4.500 5.800 1.100 400 12.600 3.000 36.400 12,100 18,100 1.600 15.000 1,500 900

€71,500

€75,900

€75,900

Prepare adjusting entries from analysis of trial balances.

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3-48

CHAPTER 3

Adjusting the Accounts

Prepare financial statements from adjusted trial balance.

E3.18 (LO4) The adjusted trial balance for Matusiak OAO is given in E3.I7.

Instructions Prepare the income and retained earnings statements for the year and the statement of financial position at August 31. Record transactions on accrual basis; convert revenue to cash receipts.

E3.19 (LO 2, 3) The following data are taken from the comparative statements of financial position of Newman Billiards Club, which prepares its financial statements using the accrual basis of accounting.

_________ December 31_________

2020

2019

Accounts receivable from members Unearned service revenue

£16.000 17.000

£8.000 25.000

Members are billed based upon their use of the club’s facilities. Unearned service revenues arise from the sale of gift certificates, which members can apply to their future use of club facilities. The 2020 income statement for the club showed that service revenue of £161.000 was recognized during the year.

Instructions {Hint: You will probably find it helpful to use T-accounts to analyze these data.) a. Prepare journal entries for each of the following events that took place during 2020. 1. Accounts receivable from 2019 were all collected.

2. Gift certificates outstanding at the end of 2019 were all redeemed.

3. An additional £38.000 worth of gift certificates were sold during 2020. A portion of these was used by the recipients during the year; the remainder was still outstanding at the end of 2020. 4. Services performed for members for 2020 were billed to members.

5. Accounts receivable for 2020 (i.e., those billed in item [4] above) were partially collected. b. Determine the amount ofcash received by the club, with respect to member services, during 2020.

Journalize adjusting entries.

*E3.20 (LO 5) Vissar Foods has the following balances in selected accounts on December 31.2020. Service Revenue Insurance Expense Supplies Expense

€40.000 2.400 2,450

All the accounts have normal balances. Vissar Foods debits prepayments to expense accounts when paid, and credits unearned revenues to revenue accounts when received. The following information below has been gathered at December 31,2020. 1. Vissar Foods paid €2.400 for 12 months of insurance coverage on June 1. 2020.

2. On December 1. 2020. Vissar collected €40.000 for consulting services to be performed from December 1.2020, through March 31.2021. 3. A count of supplies on December 31,2020, indicates that supplies of €600 are on hand.

Instructions Prepare the annual adjusting entries needed al December 31.2020. Journalize transactions and adjusting entries.

*E3.21 (LO 5) At Moretti Automotive, prepayments are debited to expense when paid, and unearned revenues are credited to revenue when cash is received. During January of the current year, the follow­ ing transactions occurred.

Jan.

2 10 15

Paid € 1.920 for fire insurance protection for the year. Paid €1.700 for supplies. Received €6.100 for services to be performed in the future.

On January 31. it is determined that €2.100 of the services were performed and that there are €650 of supplies on hand.

Instructions a. Journalize and post the January transactions. (Use T-accounts.) b. Journalize and post the adjusting entries al January 31.

c. Determine the ending balance in each of the accounts.

Exercises *E3.22 (LO 6) Presented below are the assumptions and principles discussed in Appendix 3B.

1. Full disclosure principle.

4. Time period assumption.

2. Going concern assumption.

5. Historical cost principle.

3. Monetary unit assumption.

6. Economic entity assumption

3-49

Identify accounting assumptions and principles.

Instructions Identify by number the accounting assumption or principle that is described below. Do not use a number more than once.

_______

a. Is the rationale for why plant assets are not reported at liquidation value. (Note: Do not use the historical cost principle.)

_______

b. Indicates that personal and business recordkeeping should be separately maintained.

_______

c. Assumes that the monetary unit is the "measuring stick” used to report on financial perfor­ mance.

_______

d. Separates financial information into time periods for reporting purposes.

_______

e. Measurement basis used when a reliable estimate of fair value is not available.

_______

f. Dictates that companies should disclose all circumstances and events that make a difference to financial statement users.

*E3.23 (LO 6) Weber Co. had three major business transactions during 2020.

a. Reported at its fair value of $260.000 merchandise inventory with a cost of $208,000.

Identify the assumption or principle that has been violated.

b. The president of Weber Co., Austin Weber, purchased a truck for personal use and charged it to his expense account.

c. Weber Co. wanted to make its 2020 income look better, so it added 2 more weeks to the year (a 54week year). Previous years were 52 weeks.

Instructions In each situation, identify the assumption or principle that has been violated, if any, and discuss what the company should have done. *E3.24 (LO 6) The following characteristics, assumptions, principles, or constraint guide the IASB when it creates accounting standards.

Relevance Faithful representation Comparability Consistency Monetary unit assumption Economic entity assumption

Expense recognition principle Time period assumption Going concern assumption Historical cost principle Full disclosure principle Materiality

Match each item above with a description below. 1. _________ Ability to easily evaluate one company’s results relative to another’s.

2. _________ Assumption that a company will continue to operate for the foreseeable future. 3. _________ The judgment concerning whether an item’s size is large enough to matter to decision­ makers. 4. _________ The reporting of all information that would make a difference to financial statement users.

5. _________ The practice of preparing financial statements at regular intervals. 6. _________ The quality of information that indicates the information makes a difference in a decision. 7. _________ A belief that items should be reported on the statement of financial position at the price that was paid to acquire them.

8. _________ A company’s use of the same accounting principles and methods from year to year. 9. _________ Tracing accounting events to particular companies. 10. _________ The desire to minimize bias in financial statements.

11. _________ Reporting only those things that can be measured in monetary units. 12. _________ Dictates that efforts (expenses) be recognized in the period in which a company gener­ ates results (revenues).

Identity financial accounting concepts and principles.

3-50

CHAPTER 3

Adjusting the Accounts

Comment on the objective and qualitative characteristics of accounting information.

:E3.25 (LO 6) Writing Speyewarc International, headquartered in Vancouver, Canada, specializes in Internet safety and computer security products for both the home and commercial markets. In a recent statement of financial position, it reported a deficit of US$5,678,288. It has reported only net losses since its inception. In spite of these losses. Speyeware’s shares have traded anywhere from a high of $3.70 to a low of $0.32 on the Canadian Venture Exchange. Speyeware’s financial statements have historically been prepared in Canadian dollars. Recently, the company adopted the U.S. dollar as its reporting currency.

Instructions a. What is the objective of financial reporting? How does this objective meet or not meet Speyeware’s investors’ needs? b. Why would investors want to buy Speyeware’s shares if the company has consistently reported losses over the last few years? Include in your answer an assessment of the relevance of the information reported on Speyeware’s financial statements.

c. Comment on how the change in reporting information from Canadian dollars to U.S. dollars likely affected the readers of Speyeware’s financial statements. Include in your answer an assessment of the comparability of the information. Comment on the objective and qualitative characteristics offinancial reporting.

Writing A friend of yours, Mindy Gate, recently completed an undergraduate degree in science and has just started working with a biotechnology company. Mindy tells you that the company is trying to secure new sources of financing in order to proceed with the development of a new healthcare product. Mindy said that her boss told her that the company must put together a report to present to potential investors. Mindy thought that the company should include in this package the detailed scientific findings re­ lated to the Phase I clinical trials for this product. She said. “I know that the biotech industry sometimes has only a 10% success rate with new products, but if we report all the scientific findings, everyone will see what a sure success this is going to be! The president was talking about the importance of following some set of accounting principles. Why do we need to look at some accounting rules? What they need to realize is that we have scientific results that are quite encouraging, some of the most talented employees around, and the start of some really great customer relationships. We haven't made any sales yet. but we will. We just need the funds to get through all the clinical testing and get government approval for our product. Then these investors will be quite happy that they bought in to our company early!” Instructions a. What is accounting information? b. Comment on how Mindy's suggestions for what should be reported to prospective investors conforms to the qualitative characteristics of accounting information. Do you think that the things that Mindy wants to include in the information for investors will conform to financial reporting guidelines?

Problems Prepare adjusting entries, post to ledger accounts, and prepare an adjusted trial balance.

P3.1 (LO 2,3,4) Sadie Cuono started her own consulting firm. Cuono Consulting, on May 1.2020. The trial balance at May 31 is as follows. Cuono Consulting Trial Balance May 31, 2020 Debit

Account Number 101 112 126 130 149 201 209 311 400 726 729

Cash Accounts Receivable Supplies Prepaid Insurance Equipment Accounts Payable Unearned Service Revenue Share Capital—Ordinary Service Revenue Salaries and Wages Expense Rent Expense

Credit

€ 4.500 6.000 1.900 3.600 11.400 € 4.500 2,000 18.700 9.500

6.400 900 €34.700

€34.700

Problems

3-51

In addition to those accounts listed on the trial balance, the chart of accounts for Cuono Consulting also contains the following accounts and account numbers: No. 150 Accumulated Depreciation—Equipment. No. 212 Salaries and Wages Payable, No. 631 Supplies Expense, No. 717 Depreciation Expense. No. 722 Insurance Expense, and No. 732 Utilities Expense. Other data:

1. €900 of supplies have been used during the month.

2. Utilities expense incurred but not paid on May 31.2020. €250.

3. The insurance policy is for 2 years.

4. €400 of the balance in the unearned service revenue account remains unearned at the end of the month.

5. May 31 is a Wednesday, and employees are paid on Fridays. Cuono Consulting has two employees, who are paid €920 each for a 5-day work week.

6. The office furniture has a 5-year life with no residual value. It is being depreciated at €190 per month for 60 months.

7. Invoices representing € 1.700 of services performed during the month have not been recorded as of May 31.

Instructions a. Prepare the adjusting entries for the month of May. Use J4 as the page number for your journal. b. Post the adjusting entries to the ledger accounts. Enter the totals from the trial balance as beginning account balances and place a check mark in the posting reference column. c. Prepare an adjusted trial balance at May 31. 2020.

P3.2 (LO 2,3,4) Lazy River Resort opened for business on May 1,2020. Its trial balance before adjust­ ment on May 31 is as follows.

Lazy River Resort Trial Balance May 31, 2020

Debit

Account Number 101 126 130 140 141 149 201 208 275 311 332 429 610 726 732

Cash Supplies Prepaid Insurance Land Buildings Equipment Accounts Payable Unearned Rent Revenue Mortgage Payable Share Capital—Ordinary Dividends Rent Revenue Advertising Expense Salaries and Wages Expense Utilities Expense

Credit

€ 3,400 2.080 2.400 12.000 60.000 14.000

€ 4,700 3,300 40.000 41.380 1.000 10.300

600 3,300 900 €99,680

€99,680

In addition to those accounts listed on the trial balance, the chart of accounts for Lazy River Resort also contains the following accounts and account numbers: No. 142 Accumulated Depreciation—Buildings. No. 150 Accu­ mulated Depreciation—Equipment. No. 212 Salaries and Wages Payable. No. 230 Interest Payable. No. 619 Depreciation Expense. No. 631 Supplies Expense. No. 718 Interest Expense, and No. 722 Insurance Expense. Other data:

1. Prepaid insurance is a 1-year policy starting May 1.2020.

2. A count of supplies shows €750 of unused supplies on May 31. 3. Annual depreciation is €3.600 on the buildings and €1.500 on equipment. 4. The mortgage interest rate is 6%. (The mortgage was taken out on May 1.) 5. Two-thirds of the unearned rent revenue is recognized as revenue.

6. Salaries of €750 are accrued and unpaid at May 31.

c. Adj. trial balance €37,944 Prepare adjusting entries, post, and prepare adjusted trial balance and Jinancial statements.

3-52

CHAPTER 3

Adjusting the Accounts

Instructions a. Journalize the adjusting entries on May 31. c. Adj. trial balance €101,055

d. Net income €4,795 Ending retained earnings €3,795 Total assets €91,925

Prepare adjusting entries and financial statements.

b. Prepare a ledger using the three-column form of account. Enter the trial balance amounts and post the adjusting entries. (Use J I as the posting reference.)

c. Prepare an adjusted trial balance on May 31.

d. Prepare an income statement and a retained earnings statement for the month of May and a state­ ment of financial position al May 31. P3.3 (LO 2, 3,4) Alena Co. was organized on July 1,2020. Quarterly financial statements are prepared. The unadjusted and adjusted trial balances as of September 30 are shown below.

Alena Co. Trial Balance September 30, 2020 Unadjusted

Dr. Cash Accounts Receivable Supplies Prepaid Rent Equipment Accumulated Depreciation—Equipment Notes Payable Accounts Payable Salaries and Wages Payable Interest Payable Unearned Rent Revenue Share Capital—Ordinary Dividends Service Revenue Rent Revenue Salaries and Wages Expense Rent Expense Depreciation Expense Supplies Expense Utilities Expense Interest Expense

Adjusted

$ 8.700 11.500 650 500 18,000

$

$ -010.000 2,500 -0-01.900 22.000

700 10.000 2,500 725 100 450 22.000

1.600

1.600

17.100 2.860

16.000 1.410 8.725 3,600 700 850 1.510 100

8.000 1.900

1.510

$53,810

Cr.

Dr.

Cr.

$ 8.700 10,400 1.500 2,200 18.000

$53.810

$56.435

$56.435

Instructions b. Net income $4,475 Ending retained earnings $2,875 Total assets $38,650 Prepare adjusting entries.

a. Journalize the adjusting entries that were made. b. Prepare an income statement and a retained earnings statement for the 3 months ending September 30 and a statement of financial position at September 30.

c. If the note bears interest at 12%. how many months has it been outstanding? P3.4 (LO 2, 3) A review of the ledger of Bellingham Accountants at December 31. 2020. produces the following data pertaining to the preparation of annual adjusting entries.

1. Insurance expense €4,840

1. Prepaid Insurance €10,340. The company has separate insurance policies on its buildings and its motor vehicles. Policy B4564 on the building was purchased on April 1, 2019. for €7,920. The policy has a term of 3 years. Policy A2958 on the vehicles was purchased on January 1, 2020, for €4.400. This policy has a term of 2 years.

2. Rent revenue €75,500

2. Unearned Rent Revenue €378.000. The company began subleasing office space in its new building on November I. At December 31. the company had the following rental contracts that are paid in full for the entire term of the lease.

Date

Term (in months)

Monthly Rent

Number of Leases

Nov. I Dec. I

9 6

€5.000 €8.500

5 3

Problems

3. Notes Payable €120.000. This balance consists of a note for 9 months at an annual interest rate of

3-53

3. Interest expense €1,200

6%, dated November 1.

4. Salaries and Wages Payable €0. There are eight salaried employees. Salaries are paid every Friday for the current week. Five employees receive a salary of €700 each per week, and three employees earn €500 each per week. Assume December 31 is a Tuesday. Employees do not work weekends. All employees worked the last 2 days of December.

4. Salaries and wages expense €2,000

Instructions Prepare the adjusting entries at December 31.2020.

P3.5 (LO 2, 3, 4) On November 1. 2020. the account balances of Beck Equipment Repair were as follows.

No.

101 112 126 153

Cash Accounts Receivable Supplies Equipment

Debit

No.

£ 2,400 4,250 1,800 12,000

154 201 209 212 311 320

Journalize transactions and follow through accounting cycle to preparation offinancial statements.

Credit

Accumulated Depreciation—Equipment Accounts Payable Unearned Service Revenue Salaries and Wages Payable Share Capital—Ordinary Retained Earnings

£20.450

£ 2,000 2,600 1,200 700 11.000 2,950 £20,450

During November, the following summary transactions were completed. Nov.

8 10 12 15 17 20 22 25 27 29

Paid £ 1,700 for salaries due employees, of which £700 is for October salaries. Received £3,620 cash from customers on account. Received £3.100 cash for services performed in November. Purchased equipment on account £2.000. Purchased supplies on account £700. Paid creditors on account £2.700. Paid November rent £400. Paid salaries £ 1.700. Performed services on account and billed customers for these services £2,200. Received £600 from customers for future service.

Adjustment data consist of:

1. Supplies on hand £1,400.

2. Accrued salaries payable £350. 3. Depreciation for the month is £200. 4. Services related to unearned service revenue of £1.220 were performed.

Instructions a. Enter the November 1 balances in the ledger accounts.

b. Journalize the November transactions. c. Post to the ledger accounts. Use J1 for the posting reference. Use the following additional accounts: No. 407 Service Revenue. No. 615 Depreciation Expense. No. 631 Supplies Expense, No. 726 Salaries and Wages Expense, and No. 729 Rent Expense.

d. Prepare a trial balance at November 30. e. Journalize and post adjusting entries.

f. Prepare an adjusted trial balance. g. Prepare an income statement and a retained earnings statement for November and a statement of financial position at November 30. *P3.6 (LO 2, 3, 4, 5) Alpha’s Graphics was organized on January 1,2020. by Gabriel Alpha. At the end of the first 6 months of operations, the trial balance contained the following accounts.

d. Trial balance £25,650

f. Adj. trial balance £26,200 g. Net income £1,770; Ending retained earnings £4,720 Total assets £19,250 Prepare adjusting entries, adjusted trial balance, and financial statements using appendix.

3-54

CHAPTER 3

Adjusting the Accounts Credit

Debit Cash Accounts Receivable Equipment Insurance Expense Salaries and Wages Expense Supplies Expense Advertising Expense Rent Expense Utilities Expense

€

8.600 14.000 45,000 2.700 30.000 3.700 1,900 1,500 1.700

Notes Payable Accounts Payable Share Capital—Ordinary Service Revenue

€109.100

€ 20.000 9.000 22.000 58.100

€109.100

Analysis reveals the following additional data. 1. The €3,700 balance in Supplies Expense represents supplies purchased in January. At June 30, € 1,300 of supplies are on hand.

2. The note payable was issued on February 1. It is a 6%, 6-month note. 3. The balance in Insurance Expense is the premium on a one-year policy, dated April 1, 2020. 4. Service revenues are credited to revenue when received. At June 30. services revenue of € 1.300 are unearned. 5. Revenue for services performed but unrecorded at June 30 totals €2.000. 6. Depreciation is €2,250 per year.

b. Adj. trial balance €112,725 c. Net income €19,000 Ending retained earnings €19,000 Total assets €71,800

Instructions a. Journalize the adjusting entries al June 30. (Assume adjustments are recorded every 6 months.)

h. Prepare an adjusted trial balance.

c. Prepare an income statement and retained earnings statement for the 6 months ended June 30 and a statement of financial position at June 30.

Expand Your Critical Thinking Financial Reporting Problem: TSMC, Ltd. (TWN) CT3.1 The financial statements of TSMC are presented in Appendix A. The complete annual report, including the notes to the financial statements, is available at the company’s website.

Instructions a. Using the consolidated financial statements and related information, identify items that may result in adjusting entries for prepayments. b. Using the consolidated financial statements and related information, identify items that may result in adjusting entries for accruals.

Comparative Analysis Problem: Nestlé SA (CHE) vs. Delfi Limited (SGP) CT3.2 Nestle’s financial statements are presented in Appendix B. Financial statements of Delfi Limited are presented in Appendix C.

Instructions Based on information contained in these financial statements, determine the following for each company.

a. Net increase (decrease) in property, plant, and equipment (net) for the most recent fiscal year shown. b. Increase (decrease) in marketing and administration expenses (Nestle) and increase (decrease) in sell­ ing, distribution, and administrative expenses (Delfi) for the most recent fiscal year shown.

c. Increase (decrease) in non-current liabilities for the most recent fiscal year shown.

Expand Your Critical Thinking

d. Increase (decrease) in profit for the most recent fiscal year shown.

e. Increase (decrease) in cash and cash equivalents for the most recent fiscal year shown.

Decision-Making Across the Organization CT3.3 Happy Trails Park was organized on April 1, 2019, by Alicia Henry. Alicia is a good manager but a poor accountant. From the trial balance prepared by a part-time bookkeeper. Alicia prepared the following income statement for the quarter that ended March 31, 2020.

Happy Trails Park Income Statement For the Quarter Ended March 31, 2020 Revenues Rent revenue Operating expenses Advertising Salaries and wages Utilities Depreciation Maintenance and repairs

£88.000 £ 5.200 28.800 750 800 4.000

Total operating expenses

39.550

Net income

£48.450

Alicia thought that something was wrong with the statement because net income had never ex­ ceeded £20.000 in any one quarter. Knowing that you are an experienced accountant, she asks you to review the income statement and other data. You first look at the trial balance. In addition to the account balances reported above in the income statement, the ledger contains the following additional selected balances al March 31, 2020. Supplies Prepaid Insurance Notes Payable

£ 6.200 7,500 12,000

You then make inquiries and discover the following. 1. Rent revenue includes advanced rentals for summer occupancy £14,000.

2. There were £ 1.450 of supplies on hand at March 31. 3. Prepaid insurance resulted from the payment of a 1-year policy on January 1. 2020. 4. The mail on April 1, 2020. brought the following bills: advertising for week of March 24. £130; repairs made March 10. £260; and utilities, £120.

5. There are four employees, who receive wages totaling £300 per day. At March 31,2 days’ salaries and wages have been incurred but not paid. 6. The note payable is a 3-month, 10% note dated January 1.2020.

Instructions With the class divided into groups, answer the following.

a. Prepare a correct income statement for the quarter ended March 31,2020. b. Explain to Alicia the IFRSs that she did not recognize in preparing her income statement and their effect on her results.

Communication Activity CT3.4 In reviewing the accounts of Maribeth Ltd. at the end of the year, you discover that adjusting entries have not been made.

Instructions Write a memo to Maribeth Danon. the owner of Maribeth Ltd., that explains the following: the nature and purpose of adjusting entries, why adjusting entries are needed, and the types of adjusting entries that may be made.

3-55

3-56

CHAPTER 3

Adjusting the Accounts

Ethics Case CT3.5 Watkin Exterminators is a pesticide manufacturer. Its sales declined greatly this year due to the passage of legislation outlawing the sale of several of Watkin's chemical pesticides. In the coming year. Watkin will have environmentally safe and competitive chemicals to replace these discontinued products. Sales in the next year are expected to greatly exceed any prior year's. The decline in sales and profits appears to be a 1-year aberration. But even so, the company's president fears a large dip in the current year’s profits. He believes that such a dip could cause a significant drop in the market price of Watkin's ordinary shares and make the company a takeover target. To avoid this possibility, the company’s president calls in Diane Leno, controller, to discuss this period's year-end adjusting entries. He urges her to accrue every possible revenue and to defer as many expenses as possible. He says to Diane. “We need the revenues this year, and next year can easily absorb expenses deferred from this year. We can’t let our share price be hammered down!'’ Diane didn’t get around to recording the adjusting entries until January 17, but she dated the entries December 31 as if they were recorded then. Diane also made every effort to comply with the president's request.

Instructions a. Who are the stakeholders in this situation? b. What are the ethical considerations of (1) the president’s request and (2) Diane’s dating the adjust­ ing entries December 31 ?

c. Can Diane accrue revenues and defer expenses and still be ethical?

A Look at U.S. GAAP LEARNING OBJECTIVE 7

Compare the procedures for adjusting entries under IFRS and U.S. GAAP. All companies struggle to determine the proper revenues and expenses to use in measuring net income, so timing is everything. Both the IASB and FASB arc working on a project to develop a conceptual framework that will enable companies to better use the same principles to record transactions consis­ tently over time. The objective of the conceptual framework project is to lead to standards that are more principles-based and internally consistent, which will in turn lead to the most useful financial reporting information.

Key Points • As indicated above, both the IASB and FASB are working on a conceptual framework. Some of the major issues that are being addressed are: ♦ What are the qualitative characteristics that make accounting information useful? ♦ What is the primary objective of financial reporting? ♦ What basis should be used to measure and report, that is, should a historical cost or fair value approach be used? ♦ What criteria should be used to determine when revenue should be recognized and when expenses have been incurred? ♦ What guidelines should be established for disclosing financial information?

Similarities

• Like IFRS, companies applying GAAP use accrual-basis accounting to ensure that they record transactions that change a company’s financial statements in the period in which events occur. • Similar to IFRS, cash-basis accounting is not in accordance with GAAP. • GAAP also divides the economic life of companies into artificial time periods. Under both GAAP and IFRS, this is referred to as the time period assumption. GAAP requires that companies pre­ sent a complete set of financial statements, including comparative information annually. • The form and content of financial statements are very similar under GAAP and IFRS. Any sig­ nificant differences will be discussed in those chapters that address specific financial statements.

A Look at U.S. GAAP

3-57

• Revenue recognition fraud is a major issue in U.S. financial reporting. The same situation exists for most other countries as well.

Differences • Prior to the issuance of a new joint revenue recognition standard by the IASB and the FASB. GAAP had more than 100 rules dealing with revenue recognition. Many of these rules were industry-specific. Revenue recognition under IFRS was determined primarily by a single stan­ dard. IAS 18. Despite this large disparity in the detailed guidance devoted to revenue recognition, the general revenue recognition principles required by IFRS were similar to those under GAAP.

• Internal controls are a system of checks and balances designed to detect and prevent fraud and er­ rors. The Sarbanes-Oxley Act requires U.S. companies to enhance their systems of internal control. However, many foreign companies do not have this requirement. • Under IFRS, revaluation to fair value of items such as land and buildings is permitted. This is not permitted under GAAP. • Under IFRS, the term “income" includes both revenues, which arise during the normal course of operating activities, and gains, which arise from activities outside of the normal sales of goods and services. The term income is not used this way under GAAP. Instead, under GAAP income refers to the net difference between revenues and expenses. Expenses under IFRS include both those costs incurred in the normal course of operations, as well as losses that are not part of normal operations. This is in contrast to GAAP, which defines each separately.

Looking to the Future As part of their convergence effort, the IASB and FASB completed a joint project on revenue recogni­ tion. The purpose of this project was to develop comprehensive guidance on when to recognize revenue. This approach focuses on changes in assets and liabilities as the basis for revenue recognition. It is hoped that this approach will lead to more consistent accounting in this area.

GAAP Practice GAAP Self-Test Questions 1. GAAP:

a. provides the same type of guidance as IFRS for revenue recog­ nition.

b. provides only general guidance on revenue recognition, com­ pared to the detailed guidance provided by IFRS. c. allows revenue to be recognized when a customer makes an order. d. requires that revenue not be recognized until cash is received.

2. Which of the following statements is false? a. GAAP employs the time period assumption. b. GAAP employs accrual accounting.

c. GAAP requires that revenues and costs must be capable of being measured reliably.

d. GAAP uses the cash basis of accounting. 3. As a result of the revenue recognition project by the FASB and IASB: a. revenue recognition places more emphasis on when the perfor­ mance obligation is satisfied.

b. revenue recognition places more emphasis on when revenue is realized. c. revenue recognition places more emphasis on when changes occur in related expenses.

d. revenue is no longer recorded unless cash has been received. 4. Which of the following is false? a. Under IFRS, the term income describes both revenues and gains. b. Under IFRS, the term expenses includes losses.

c. Under IFRS, firms do not engage in the closing process.

d. Previously, IFRS had fewer standards than GAAP that ad­ dressed revenue recognition. 5. Accrual-basis accounting: a. is optional under GAAP. b. results in companies recording transactions that change a com­ pany’s financial statements in the period in which events occur.

c. has been eliminated as a result of the IASB/FASB joint project on revenue recognition. d. is not consistent with the GAAP conceptual framework.

3-58

CHAPTER 3

Adjusting the Accounts

GAAP Exercises GAAP3.1 Why might IFRS revalue land and buildings whereas under GAAP this practice is not permissible? GAAP3.2 Under GAAP, do the definitions of revenues and expenses include gains and losses? Explain.

GAAP Financial Reporting Problem: Apple Inc. GAAP3.3 The financial statements of Apple are presented in Appendix D. The complete annual report, including the notes to its financial statements, is available at the company’s website. Instructions

Visit Apple’s company website and answer the following questions from its annual report.

a. Using the financial statements and related information, identify items that may result in adjusting entries for prepayments.

b. Using the financial statements and related information, identify items that may result in adjusting entries for accruals.

Answers to GAAP Self-Test Questions 1. a

2. d

3. a

4. c

5. b

CHAPTER 4

Oliver Burston/Ikon Images/Getty Images. Inc.

Completing the Accounting Cycle Chapter Preview Financial statements help employees understand what is happening in the business. In Chapter 3, we prepared financial statements directly from the adjusted trial balance. However, with so many details involved in the end-of-period accounting procedures, it is easy to make errors. One way to minimize errors in the records and to simplify the end-of-period procedures is to use a worksheet. In this chapter, we will explain the role of the worksheet in accounting. We also will study the remaining steps in the accounting cycle, especially the closing process, again using Yazici Advertising A.§. as an example. Then, we will consider correcting entries and classified state­ ments of financial position.

Feature Story Speaking the Same Language Recent events in the global capital markets underscore the importance of financial disclosure and transparency in mar­ kets around the world. As a result, many countries are ex­ amining their accounting and financial disclosure rules. As indicated in the following graphic, financial regulators in over

120 countries now use the IFRSs issued by the International Accounting Standards Board (IASB). What are the potential benefits of having countries use similar standards to prepare their financial statements? One benefit is that investors can compare the results of compet­ ing companies from different countries. A second benefit is it enhances efforts to finance growth. Companies (par­ ticularly in developing and emerging nations) need to raise funds from outside their borders. Companies that use IFRS 4-1

4-2

CHAPTER 4

Completing the Accounting Cycle

gain credibility in the marketplace, which reduces financing costs. The IASB’s stated objectives are as follows.

Accounting standards may never be absolutely identical around the world. However, financial statement users have already benefitted from the increased comparability that has resulted from efforts to minimize differences in accounting standards.

• To develop a single set of high quality, understandable, enforceable and globally accepted international financial reporting standards (IFRSs) through its standard-setting body, the IASB. • To promote the use and rigorous application of those standards.

• To take account of the financial reporting needs of emerging economies and small- and medium-sized entities (SMEs). • To bring about convergence of national accounting standards and IFRSs to high-quality solutions.

Countries that require or permit IFRS or have fixed dates for adoption Countries seeking conver­ gence with the IASB or pursuing adoption of IFRS

Source: hup^/www.pw’c.coin/us/en/issues/ifrs-reporrmg/coimirx’-adoption/index.jhtnil.

Chapter Outline LEARNING OBJECTIVES

LO 1 Prepare a worksheet.

• Steps in preparing a worksheet

DO IT!

1 Worksheet

DO IT!

2 Closing Entries

DOIT!

3 Correcting Entries

DO IT!

4 Statement of Financial

• Preparing financial statements from a worksheet • Preparing adjusting entries from a worksheet LO2 Prepare closing entries and a

• Preparing closing entries

post-closing trial balance.

• Posting closing entries • Preparing a post-closing trial balance

LO3 Explain the steps in the

• Summary of the accounting cycle

accounting cycle and how to pre­ pare correcting entries.

• Reversing entries

LO4 Identify the sections of a classified statement of financial position.

• Intangible assets

• Correcting entries

• Property, plant, and equipment

Position Classifications

• Long-term investments

• Current assets • Equity • Non-current liabilities • Current liabilities Go to the Review and Practice section at the end of the chapter for a review of key concepts and practice applications with solutions.

The Worksheet

4-3

//..■?iZZZZZZZZZZZ»'-ZZ-—

Aiz/nZTÜtdÆ

Payer

74—102/724

'—Euros

w Blom Bank France 75008 Paris, France Memo_____________________________________________

•:obeu kol,4?i: us? neairoe Remittance |_ Advice J

ul,s

Detach this portion before cashing.

Date

Description

4-16-20 Invoice No. 27662

Gross Amount

1525.00

Discount Net Amount

1525.00

Cray Gourmet, Paris, France

Check with remittance advice

7-20

CHAPTER 7

Fraud, Internal Control, and Cash

Electronic Funds Transfer (EFT) System It is not surprising that companies and banks have developed approaches to transfer funds among parties without the use of paper (deposit tickets, checks, etc.). Such procedures, called electronic funds transfers (EFT), are disbursement systems that use wire, telephone, or computers to transfer cash balances from one location to another. Use of EFT is quite com­ mon. For example, many employees receive no formal payroll checks from their employers. Instead, employers send electronic payroll data to the appropriate banks. Also, companies now frequently make regular payments such as those for utilities, rent, and insurance by EFT. EFT transactions normally result in better internal control since no cash orchecks are handled by company employees. This does not mean that opportunities for fraud are eliminated. In fact, the same basic principles related to internal control apply to EFT transfers. For example, without proper segregation of duties and authorizations, an employee might be able to redirect electronic payments into a personal bank account and conceal the theft with fraudulent accounting entries.

Bank Statements Each month, the company receives from the bank a bank statement showing its bank trans­ actions and balances (see Helpful Hint).4 For example, the statement for Cray Gourmet in Illustration 7.10 shows the following: (1) checks paid and other debits (such as debit card ILLUSTRATION 7.10

Bank statement

Blom Bank France 75008 Paris, France HELPFUL HINT Essentially, the bank state­ ment is a copy of the bank’s records sent to the customer or made available online for review.

ACCOUNT STATEMENT

Cray Gourmet 15 Rue Duphot 75001 Paris, France

Statement Date/Credit Line Closing Date

April 30, 2020 457923 ACCOUNT NUMBER

Balance Last Statement 13,256.90

Deposits and Credits Total Amount

No.

Total Amount

20

34,805.10

26

32,154.55

Amounts Deducted from Account (debits)

Date 4-2 4-3 4-5 4-4 4-3 4-8 4-7 4r-7 4-8 4-11 4-12 4-29 4-29 4-30 4-30 4-30

No. 435 EFT 436 437 438 439 440 EFT 441 442 443 NSF 459 DM DM 461

Checks and Debits

No.

Amount 644.95 1,000.00 2,260.00 1,185.79 776.65 1,781.70 1,487.90 320.00 2,100.00 1,585.60 1,226.00 425.60 1,080.30 120.00 30.00 500.15

Symbols: CM Credit Memo DM Debit Memo

Balance This Statement 15,907.45

Amounts Added to Account (credits)

Daily Balance

Date 4-2 4-3 4-5 4r-7 4-8 4-9 EFT 4-11 4-12 4-13

Amount 4,276.85 2,137.50 1,350.47 982.46 1,320.28 1,035.00 2,720.00 757.41 1,218.56

Date 4-2 4-3 4-4 4-5 4-7 4-8 4-9 4-11 4-12

Amount 16.888.80 18,249.65 17,063.86 15,154.33 14,648.89 11,767.47 12,802.47 13,936.87 13,468.28

4-27 4-29 4-30

1,545.57 2,929.45 2,128.60

4-27 4-29 4-30

13,005.45 14,429.00 15.907.45

EC Error Correction NSF Not Sufficient Funds INT Interest Earned SC Service Charge

EFT Electronic Funds Transfer

4Our presentation assumes that a company makes all adjustments at the end of the month. In practice, a company may also make journal entries during the month as it reviews information from the bank regarding its account.

Control Features of a Bank Account

transactions or electronic funds transfers for bill payments) that reduce the balance in the de­ positor’s account, (2) deposits (by direct deposit, automated teller machine, or electronic funds transfer) and other credits that increase the balance in the depositor’s account, and (3) the ac­ count balance after each day’s transactions. Remember that bank statements are prepared from the bank’s perspective. For ex­ ample. every deposit the bank receives is an increase in the bank’s liabilities (an account payable to the depositor). Therefore, in Illustration 7.10, Blom Bank France credits to Cray Gourmet every deposit it received from Cray. The reverse occurs when the bank “pays” a check issued by Cray Gourmet on its checking account balance: Payment reduces the bank’s liability and is therefore debited to Cray's account with the bank. The bank statement lists in numerical sequence all paid checks along with the date the check was paid and its amount. Upon paying a check, the bank stamps the check “paid”; a paid check is sometimes referred to as a canceled check. In addition, the bank includes with the bank statement memoranda explaining other debits and credits it made to the depositor’s account. A check that is not paid by a bank because of insufficient funds in a bank account is called an NSF check (not sufficient funds). The bank uses a debit memorandum when a previously deposited customer’s check “bounces” because of insufficient funds. In such a case, the cus­ tomer’s bank marks the check NSF (not sufficient funds) and returns it to the depositor’s bank. The bank then debits (decreases) the depositor’s account, as shown by the symbol NSF in Illustration 7.10, and sends the NSF check and debit memorandum to the depositor as notifica­ tion of the charge. The NSF check creates an account receivable for the depositor and reduces cash in the bank account.

Reconciling the Bank Account Because the bank and the company maintain independent records of the company’s checking account, you might assume that the respective balances will always agree. In fact, the two balances are seldom the same at any given time, and both balances differ from the “correct or true” balance. Therefore, it is necessary to make the balance per books and the balance per bank agree with the correct or true amount—a process called reconciling the bank account. The need for reconciliation has two causes: 1. Time lags that prevent one of the parties from recording the transaction in the same

period. 2. Errors by either party in recording transactions.

Time lags occur frequently. For example, several days may elapse between the time a company pays by check and the date the bank pays the check. Similarly, when a company uses the bank’s night depository to make its deposits, there will be a difference of one day between the time the company records the receipts and the time the bank does so. A time lag also oc­ curs whenever the bank mails a debit or credit memorandum to the company. You might think that if a company never writes checks (for example, if a small company uses only a debit card or electronic funds transfers), it does not need to reconcile its account. However, the possibility of errors or fraud still necessitates periodic reconciliation. The incidence of errors or fraud depends on the effectiveness of the internal controls maintained by the company and the bank. Bank errors are infrequent. However, either party could acci­ dentally record a €450 check as €45 or €540. In addition, the bank might mistakenly charge a check drawn by G. Dufour to the account of G. Dupont.

Reconciliation Procedure In reconciling the bank account, it is customary to reconcile the balance per books and balance per bank to their adjusted (correct or true) cash balances. To obtain maximum benefit from a bank reconciliation, an employee who has no other responsibilities related to cash should prepare the reconciliation. When companies do not follow the internal control principle of

independent internal verification in preparing the reconciliation, cash embezzlements may escape unnoticed. For example, in the “Anatomy of a Fraud” box about Chiding Song, a bank reconciliation might have exposed her embezzlement.

7-21

7-22

CHAPTER 7

Fraud, Internal Control, and Cash

Illustration 7.11 shows the reconciliation process. The starting point in preparing the reconciliation is to enter the balance per bank statement and balance per books on a schedule (see Helpful Hint). The following steps should reveal all the reconciling items that cause the difference between the two balances. ILLUSTRATION 7.11

Bank reconciliation adjustments

Per Bank Statement

Per Books X Adjustments to the book balance

z Adjustments to

the bank balance

©

Deposits in transit (+) EFT collections and other deposits (+)

HELPFUL HINT Deposits in transit and out­ standing checks are recon­ ciling items because of time lags.

Pay to the order of

Outstanding checks (-)

Service charges and other payments (-)

>■■. __ ■■■■■■■ —1--- 1 ■■■■■I!

Company errors (+/-)

Reconciling Items per Bank. On the bank side of the reconciliation, the items to reconcile are deposits in transit (amounts added), outstanding checks (amounts deducted), and bank errors (if any). By adjusting the bank balance for these items, a company brings that balance up to date. Step 1.

Deposits in transit (+). Compare the individual deposits on the bank statement with

the deposits in transit from the preceding bank reconciliation and with the deposits per company records or copies of duplicate deposit slips. Deposits recorded by the depositor that have not been recorded by the bank represent deposits in transit. Add these deposits to the balance per bank. Step 2.

Outstanding checks (—). Compare the paid checks shown on the bank statement or

the paid checks returned with the bank statement with (a) checks outstanding from the preceding bank reconciliation, and (b) checks issued by the company recorded as cash payments. Issued checks recorded by the company that have not been paid by the bank represent outstanding checks. Deduct outstanding checks from the balance per bank. Step 3.

Bank errors (+/—). Note any errors made by the bank that were discovered in the previous steps. For example, if the bank processed a deposit of €1,693 as €1,639 in error, the difference of €54 (€ 1,693 — € 1,639) is added to the balance per bank

Control Features of a Bank Account

7-23

on the bank reconciliation. All errors made by the bank are reconciling items in determining the adjusted cash balance per the bank.

Reconciling Items per Books. Reconciling items on the book side relate to amounts not yet recorded on the company’s books and include adjustments from deposits and other amounts added, payments and other amounts deducted, and company errors (if any). Step 1.

Other deposits (+). Compare the other deposits on the bank statement with the com­

pany records. Any unrecorded amounts should be added to the balance per books. For example, if the bank statement shows electronic funds transfers from customers pay­ ing their accounts online, these amounts should be added to the balance per books on the bank reconciliation to update the company’s records unless they had previously been recorded by the company. Step 2.

Other payments (—). Similarly, any unrecorded other payments should be deducted from the balance per books. For example, if the bank statement shows service charges (such as debit and credit card fees and other bank service charges), this amount is deducted from the balance per books on the bank reconciliation to make the company’s records agree with the bank’s records. Normally, the company will already have recorded electronic payments. However, if this has not been the case then these payments must be deducted from the balance per books on the bank reconciliation to make the company’s records agree with the bank’s records.

Step 3.

Book errors (+/—). Note any errors made by the depositor that have been discovered in

the previous steps. For example, say a company wrote check No. 443 to a supplier in the amount of €1,226 on April 12, but the accounting clerk recorded the check amount as € 1,262. The error of €36 (€ 1,262 - € 1,226) is added to the balance per books because the company reduced the balance per books by €36 too much when it recorded the check as €1.262 instead of €1,226. Only errors made by the company, not the bank, are included as reconciling items in determining the adjusted cash balance per books.

Bank Reconciliation Illustrated

HELPFUL HINT

Illustration 7.10 presented the bank statement for Cray Gourmet which the company accessed online (see Helpful Hint). It shows a balance per bank of €15,907.45 on April 30. 2020. On this date the balance ofcash per books is €11,709.45. From the foregoing steps, Cray determines the following reconciling items for the bank. Step 1.

Deposits in transit (+): April 30 deposit (received by bank

on May 1). Step 2.

€2,201.40

Outstanding checks (—): No. 453. €3,000.00; No. 457,

€1.401.30; No. 460. €1,502.70. Step 3.

5,904.00

Bank errors (+/—): None.

Reconciling items per books are as follows: Step 1.

Other deposits (+): Unrecorded electronic receipt from

customer on account on April 9 determined from the bank statement. Step 2.

€1.035.00

Other payments (—): The electronic payments on April 3

and 7 were previously recorded by the company when they were initiated. Unrecorded charges determined from the bank statement are as follows; Returned NSF check on April 29 Debit and credit card fees on April 30 Bank service charges on April 30 Step 3.

Company errors ( + ): Check No. 443 was correctly written by Cray for € 1.226 and was correctly paid by the bank on April 12. However, it was recorded as € 1,262 on Cray's books.

Illustration 7.12 shows Cray's bank reconciliation (see Alternative Terminology).

425.60 120.00 30.00

36.00

Note in the bank statement in Illustration 7.10 that the bank has paid checks No. 459 and 461, but check No. 460 is not listed. Thus, this check is outstanding. If a complete bank statement were pro­ vided, checks No. 453 and 457 also would not be listed. Cray obtains the amounts for these three checks from its cash payments records.

CHAPTER 7

7-24

Fraud, Internal Control, and Cash

ILLUSTRATION 7.12

Cray Gourmet

Bank reconciliation

Bank Reconciliation April 30,2020

€15.907.45 2.201.40

Cash balance per bank statement Add: Deposits in transit

18.108.85

ALTERNATIVE TERMINOLOGY

The terms adjusted cash bal­ ance, true cash balance, and correct cash balance are used interchangeably.

Less: Outstanding checks No. 453 No. 457 No. 460

€3.000.00 1.401.30 1,502.70

5,904.00 €12,204.85

Adjusted cash balance per bank Cash balance per books Add: Electronic funds transfer received Error in recording check No. 443

€11.709.45

€ 1.035.00 36.00

1,071.00

12,780.45 Less: NSF check Debit and credit card fees Bank service charge

425.60 120.00 30.00

575.60

Adjusted cash balance per books

HELPFUL HINT

€12,204.85