©2009 The McGraw-Hill Companies, Inc.

Chapter 3

The Financial Reporting Process

©2009 The McGraw-Hill Companies, Inc.

Part A

Accrual-Basis Accounting

3-3

LO1 Revenue and Expense Reporting

Accounting information – necessary for decision making.

To be useful in decision making – accountants must report revenues and expenses in a way that reflects the ability of the company to create value for its owners.

Accrual-basis accounting records revenues when earned (the revenue recognition principle) and expenses with related revenues (the matching principle).

Accounting information – necessary for decision making.

To be useful in decision making – accountants must report revenues and expenses in a way that reflects the ability of the company to create value for its owners.

Accrual-basis accounting records revenues when earned (the revenue recognition principle) and expenses with related revenues (the matching principle).

3-4

Revenue Recognition Principle

Recognize revenue when it is earned

Calvin books a cruise with Carnival Cruise Lines, the world’s largest cruise line. He makes reservations and pays for the cruise in November 2010, but the cruise is not scheduled to sail until April 2011.

When does Carnival report revenue from the ticket sale?

Recognize revenue when it is earned

Calvin books a cruise with Carnival Cruise Lines, the world’s largest cruise line. He makes reservations and pays for the cruise in November 2010, but the cruise is not scheduled to sail until April 2011.

When does Carnival report revenue from the ticket sale?

3-5

Revenue Recognition Principle

In November 2010???

No.

Because it has not substantially fulfilled its obligation to Calvin.

In April 2011???

Yes.

Because it is in April 2011 that the cruise occurs.

In November 2010???

No.

Because it has not substantially fulfilled its obligation to Calvin.

In April 2011???

Yes.

Because it is in April 2011 that the cruise occurs.

3-6

Revenue Recognition Principle

Suppose that, anticipating the cruise, Calvin buys a Jimmy Buffet CD from Best Buy.

Rather than paying cash, Calvin uses his Best Buy card to buy the CD on account.

When does Best Buy recognize revenue?

Suppose that, anticipating the cruise, Calvin buys a Jimmy Buffet CD from Best Buy.

Rather than paying cash, Calvin uses his Best Buy card to buy the CD on account.

When does Best Buy recognize revenue?

3-7

Revenue Recognition Principle

Even though Best Buy doesn’t receive cash immediately from Calvin, it still records the revenue at the time it sells the CD.

Even though Best Buy doesn’t receive cash immediately from Calvin, it still records the revenue at the time it sells the CD.

3-8

Matching Principle

Expenses are reported with the revenues they help to generate

Expenses are reported with the revenues they help to generate

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3-10

LO2 Accrual–Basis Compared with Cash–Basis Accounting

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Accrual–Basis Compared with Cash–Basis Accounting

Recognize Revenue?

Accrual- Cash-

Basis Basis

May Company provides services

to customers on account. Yes No

June Company receives cash from

customers for services provided No Yes

in May.

Recognize Revenue?

Accrual- Cash-

Basis Basis

May Company provides services

to customers on account. Yes No

June Company receives cash from

customers for services provided No Yes

in May.

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Accrual–Basis Compared with Cash–Basis Accounting

Recognize Expense?

Accrual- Cash- BasisBasis

May Company purchases

supplies on account Yes No

and uses them.

June Company pays cash No Yes

for supplies purchased

in May.

Recognize Expense?

Accrual- Cash- BasisBasis

May Company purchases

supplies on account Yes No

and uses them.

June Company pays cash No Yes

for supplies purchased

in May.

©2009 The McGraw-Hill Companies, Inc.

Part B

The Measurement Process

3-14

Closing ProcessClosing Process

LO3 Adjusting Entries

Reporting ProcessReporting Process

3-15

Purpose of Adjusting Entries

To record events that have occurred but which have not been recorded.

To record revenues in the period earned.

To record expenses in the period they are incurred in the generation of those revenues.

To correctly state assets and liabilities in the balance sheet.

To record events that have occurred but which have not been recorded.

To record revenues in the period earned.

To record expenses in the period they are incurred in the generation of those revenues.

To correctly state assets and liabilities in the balance sheet.

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Grouping Adjusting Entries

Prepayments: Prepaid expenses – we paid cash (or had an

obligation to pay cash) for the purchase of an asset before we incurred the expense.

Unearned revenues – we received cash and recorded a liability before we earned the revenue.

Accruals: Accrued expenses – we paid cash after we incurred

the expense and recorded a liability.

Accrued revenues – we received cash after we earned the revenue and recorded an asset.

Prepayments: Prepaid expenses – we paid cash (or had an

obligation to pay cash) for the purchase of an asset before we incurred the expense.

Unearned revenues – we received cash and recorded a liability before we earned the revenue.

Accruals: Accrued expenses – we paid cash after we incurred

the expense and recorded a liability.

Accrued revenues – we received cash after we earned the revenue and recorded an asset.

3-17

Prepaid Expenses

Costs of assets acquired in one period that will be expensed in a future period.

Examples:

Purchase of supplies, payment of rent in advance, payment of insurance in advance.

Adjusting Entry:

Debit expense account

Credit asset account

Costs of assets acquired in one period that will be expensed in a future period.

Examples:

Purchase of supplies, payment of rent in advance, payment of insurance in advance.

Adjusting Entry:

Debit expense account

Credit asset account

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Example: Prepaid Rent

Prepaid rent expires

$500

Adjustingentry

$5,500Remaining

prepaid rentJan. 31

$6,000 Cash paid for prepaid rent

Jan. 1

3-19

Example: Prepaid Rent

3-20

Unearned Revenues

Company receives cash in advance from a customer for products or services to be provided in the future.

Adjusting entry:

Debit liability account

Credit revenue account

Company receives cash in advance from a customer for products or services to be provided in the future.

Adjusting entry:

Debit liability account

Credit revenue account

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Example: Unearned Training Revenue

Adjustingentry

$540Unearned revenue remainsJan. 31

$600Cash

received in advanceJan. 26

Services provided

$60

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Example: Prepaid Rent

3-23

Accrued Expenses

When a company has incurred an expense but hasn’t yet paid cash or recorded an obligation to pay, it still should record the expense.

Examples:

Accrued salaries, accrued interest, accrued utility costs.

Adjusting entry:

Debit expense account

Credit liability account

When a company has incurred an expense but hasn’t yet paid cash or recorded an obligation to pay, it still should record the expense.

Examples:

Accrued salaries, accrued interest, accrued utility costs.

Adjusting entry:

Debit expense account

Credit liability account

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Example: Accrued Utility Costs

At the end of January, Woods receives a utility bill for $960 associated with operations in January.

Woods plans to pay the bill on February 6.

Even though it won’t pay the cash until February, Woods must record the utility costs for January as an expense in January.

At the end of January, Woods receives a utility bill for $960 associated with operations in January.

Woods plans to pay the bill on February 6.

Even though it won’t pay the cash until February, Woods must record the utility costs for January as an expense in January.

3-25

Example: Accrued Utility Costs

Adjustingentry

$960Utilities owed

Jan. 31

$960Cash paid for utilities

Feb. 6

Utilities used$960

Jan. 1

3-26

Example: Accrued Utility Costs

3-27

Accrued Revenues

When a company has earned revenue but hasn’t yet received cash or recorded an amount receivable, it still should record the revenue. This is referred to as an accrued revenue.

Examples:

Interest receivable, accounts receivable

Adjusting entry:

Debit asset account

Credit revenue account

When a company has earned revenue but hasn’t yet received cash or recorded an amount receivable, it still should record the revenue. This is referred to as an accrued revenue.

Examples:

Interest receivable, accounts receivable

Adjusting entry:

Debit asset account

Credit revenue account

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Example: Accounts Receivable

Suppose, Woods provides $200 of golf training to customers from January 28 to January 31.

However, it usually takes Woods one week to mail bills to customers and another week for customers to pay. Therefore, Woods expects to receive cash from these customers during February 8-14.

Irrespective of when cash will be received, the revenue should be recognized in January.

Suppose, Woods provides $200 of golf training to customers from January 28 to January 31.

However, it usually takes Woods one week to mail bills to customers and another week for customers to pay. Therefore, Woods expects to receive cash from these customers during February 8-14.

Irrespective of when cash will be received, the revenue should be recognized in January.

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Example: Accounts Receivable

Adjustingentry

$200Owed from customers

Jan. 31

$200Cash received

from customersFeb. 8-14

Revenues earned$200

Jan. 28

3-30

Example: Accounts Receivable

3-31

LO4 Post Adjusting Entries

Post adjusting entries to the T-accounts in the general ledger to update the account balances.

Prepare an adjusted trial balance.

An adjusted trial balance is a list of all accounts and their balances after we have updated account balances for adjusting entries.

Post adjusting entries to the T-accounts in the general ledger to update the account balances.

Prepare an adjusted trial balance.

An adjusted trial balance is a list of all accounts and their balances after we have updated account balances for adjusting entries.

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Trial Balance and Adjusted Trial Balance of Woods Golf Academy

©2009 The McGraw-Hill Companies, Inc.

Part C

The Reporting Process

3-34

LO5 Financial Statements

3-35

Income Statement

Woods Golf Academy Income Statement

For the month ended January 31

Revenues:Training revenue $6,360

Expenses:Salaries expense $3,100

Rent expense 500

Supplies expense 800

Depreciation expense 400

Interest expense 100

Utilities expense 960

Total expenses 5,860

Net income $ 500

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Statement of Stockholders’ Equity

3-37

Classified Balance Sheet

Woods Golf AcademyClassified Balance Sheet

January 31Assets Liabilities

Current assets: Current liabilities:Cash $ 6,200 Accounts payable $ 2,300Accounts receivable 2,700 Unearned

revenue540

Supplies 1,500 Salaries payable 300Prepaid rent 5,500 Utilities payable 960

Total current assets 15,900 Interest payable 100Total current liabilities 4,200

Long-term assets:Equipment 24,000 Long-term liabilities:Accum. depr., equip.

(400) Notes payable 10,000

Total liabilities $ 14,200Total long-term assets 23,600

Stockholders’ EquityCommon stock 25,000Retained earnings 300

Total stockholders’ equity

$ 25,300

Total liabilities and stockholders’ equity

$ 39,500

Total assets $ 39,500

Total assets equal current plus long-term assets.Total liabilities equal current plus long-term liabilities.Total stockholders’ equity includes common stock and retained earnings from the statement of stockholders’ equity.Total assets must equal total liabilities plus stockholders’ equity.

Total assets equal current plus long-term assets.Total liabilities equal current plus long-term liabilities.Total stockholders’ equity includes common stock and retained earnings from the statement of stockholders’ equity.Total assets must equal total liabilities plus stockholders’ equity.

©2009 The McGraw-Hill Companies, Inc.

Part D

The Closing Process

3-39

LO6 Closing Entries

Transfer the balance of all revenue, expense, and dividend accounts to the balance of retained earnings.

Increase the retained earnings account by the amount of revenues and decrease retained earnings by the amount of expenses and dividends.

The balance of each revenue, expense, and dividend account equals zero after closing entries.

Do not affect the balances of permanent accounts other than retained earnings.

Transfer the balance of all revenue, expense, and dividend accounts to the balance of retained earnings.

Increase the retained earnings account by the amount of revenues and decrease retained earnings by the amount of expenses and dividends.

The balance of each revenue, expense, and dividend account equals zero after closing entries.

Do not affect the balances of permanent accounts other than retained earnings.

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Closing Entries for Woods Golf Academy

3-41

Close to Retained Earnings

3-42

LO7 Post Closing Entries and Prepare Post–Closing Trial Balance

©2009 The McGraw-Hill Companies, Inc.

End of Chapter 3