Exam 1 Material Combined

Review for Exam 1

25 multiple choice questions and 4 problems covering the material in units 1-4 Topic Accrual Accounting What to Know Be able to state a given transaction for cash-basis or accrual-basis accounting. Understand advantages of accrual-basis accounting Be able to adjust from accrual-basis to cash-basis accounting and vice versa. Appendix 3A (Page 195) Most companies use accrual-basis accounting Recognize revenue when it is earned and Expenses in the period incurred Without regard to the time of receipt or payment of cash Under the strict cash-basis, companies Record revenue only when they receive cash, and Record expenses only when they disperse cash Cash basis financial statements are not in conformity with GAAP. Pages 196-201 Adjust from accrual-basis to cash-basis and vice versa Advantages to accrual basis accounting: a) Todays economy is considerably more lubricated by credit than cash b) The accrual basis recognizes all aspects of the credit phenomenon c) Investors, creditors, and other decision makers seek timely information about an enterprises future cash flows Transaction Processing Understand the accounting cycle and its documents and procedures. Record business events in journal entry form. Chapter 3 Accounting Cycle Summarized page 1911

Review for Exam 1

Adjusting Entries

Be able to record the four types of adjusting journal entries and understand their role in the accounting cycle. Chapter 3 (Objective 5) Illustration 3-20 (Page 149) Pages 149-180 Journal Entries & Examples Be able to create Trial Balances: unadjusted, adjusted, and closing. Be able to use Trial Balances to create financial statements. Chapter 3 (Objective 4) Be able to record closing entries & understand their role in the accounting cycle Closing entries are used to reduce the balance of the income statement (revenue and expense) accounts to zero. to transfer net income or net loss to owners equity balance sheet (asset, liability and equity) accounts are not closed dividends are closed directly to retained earnings account

Trial Balances

Closing Entries

Page 187-188 Chapter 3 (Objective 7) Income Statement Be able to prepare in well structured form: Single-step vs. multi-step statements Subtotals of Gross profit, selling expenses, administrative expenses, operating expenses, operating income, income from continuing operations, net income Special items: Discontinued Operations (Page 239-241), Extraordinary Items (Page 242-247), Net of Tax presentation: Be able to allocate tax expense to discontinued operations, extraordinary items and income from continuing operations. Earnings per share Single-step income statement emphasizes total revenues and total2

Review for Exam 1

expenses Multi-step income statement (1) separates operating transactions from non-operating transactions (2) matches costs and expenses with related revenues (3) highlights certain intermediate components of income that analysts use. Intermediate components of the Income Statement: 1. 2. 3. 4. 5. 6. Operating section Non-operating section Income Tax Discontinued operations Extraordinary items Earnings per share

Reporting Irregular Items (when both Discontinued Operations and Extraordinary Items is present): Page 248 Earnings per share = Net Income Preferred Dividends / Weighted average number of shares outstanding Important business indicator Measures the dollars earned by each share of common stock Must be disclosed on the income statement Chapter 4 Single-Step Income Statement (Pages 229) Multi-Step Income Statement (Page 234) Unit 3 Homework and Practice (online) Be able to prepare in well-structured form: Understand where prior period adjustments are placed (Change in Accounting Principle and Correction of Error). Be able to use net of tax presentation of prior period adjustments. Chapter 3 Unit 2 Homework and Practice (online) Be able to prepare in well-structured form: Classified vs. unclassified balance sheets

Statement of Retained Earnings

Balance Sheet

3

Review for Exam 1

Chapter 5 Unit 3 Homework and Practice (online) Purpose and major categories on the statement Chapter 5 Purpose of statement of cash flows: To provide relevant information about the cash receipts and cash payments of an enterprise during a period. The statement provides answers to the following questions: 1) Where did the cash come from? 2) What was the cash used for? 3) What was the change in the cash balance? Three different activities: a) Operating cash inflows and outflows that enter into the determination of net income b) Investing cash inflows and outflows from non-current assets c) Financing cash inflows and outflows from non-current liabilities and equity The statements value is that it helps users evaluate liquidity, solvency and financial flexibility. Illustration 5-18 (Page 338 of Textbook Slides for Exam 1) The accounting institutions: FASB, SEC, AICPA and their components and impact on current GAAP FASB: Financial Accounting Standards Board AICPA: American Institute of Certified Public Accountants SEC: Securities and Exchange Commission GAAP: Generally Accepted Accounting Principles The accounting standard setting process Stakeholders in the accounting standard-setting process.

Statement of Cash Flows

Context of Accounting

4

Review for Exam 1

The role of GAAP in an economy Structure of the FASB Codification System FASB/IFRS state of convergence and some common differences. Chapter 1 The purpose of accounting, the qualitative characteristics of accounting information, the definition of elements of accounting, the principles / assumptions used in recognition and measurement. Chapter 2 Purpose of accounting: to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity.

Conceptual Framework

5

Intermediate Accounting

1-1

Prepared by Coby Harmon University of California, Santa Barbara

1

Financial Accounting and Accounting Standards

Intermediate Accounting 14th Edition

Kieso, Weygandt, and Warfield1-2

Learning Objectives1. 2. 3. 4. 5. 6. 7. 8. 9.1-3

Identify the major financial statements and other means of financial reporting. Explain how accounting assists in the efficient use of scarce resources. Identify the objective of financial reporting. Explain the need for accounting standards. Identify the major policy-setting bodies and their role in the standardsetting process. Explain the meaning of generally accepted accounting principles (GAAP) and the role of the Codification for GAAP. Describe the impact of user groups on the rule-making process. Describe some of the challenges facing financial reporting. Understand issues related to ethics and financial accounting.

Financial Accounting and Accounting Standards

Financial Statements and Financial ReportingAccounting and capital allocation Objectives Need to develop standards

Parties Involved in Standard-Setting

Generally Accepted Accounting PrinciplesFASB Codification

Issues in Financial ReportingPolitical environment Expectations gap Financial reporting challenges International accounting standards Ethics

Securities and Exchange Commission American Institute of CPAs Financial Accounting Standards Board Changing role of the AICPA

1-4

Financial Statements and Financial ReportingEssential characteristics of accounting are:(1) the identification, measurement, and communication of financial information about (2) economic entities to (3) interested parties.

1-5

LO 1 Identify the major financial statements and other means of financial reporting.

Financial Statements and Financial ReportingEconomic EntityFinancial Information Accounting? Identifies and Measures and Communicates

Financial StatementsBalance Sheet Income Statement Statement of Cash Flows Statement of Owners or Stockholders Equity Note Disclosures

Additional InformationPresidents letter Prospectuses Reports filed with governmental agencies News releases Forecasts Environmental impact statements Etc.

GAAP1-6


Financial Statements and Financial ReportingReview QuestionWhat is the purpose of information presented in notes to the financial statements? a. To provide disclosure required by generally accepted accounting principles. To correct improper presentation in the financial statements. To provide recognition of amounts not included in the totals of the financial statements. To present managements responses to auditor comments.

b.

c.

d.1-7


Financial Statements and Financial ReportingAccounting and Capital AllocationResources are limited. Efficient use of resources often determines whether a business thrives.Illustration 1-1 Capital Allocation Process

1-8

LO 2 Explain how accounting assists in the efficient use of scare resources.

Accounting and Capital AllocationReview QuestionAn effective process of capital allocation is critical to a healthy economy, which a. b. c. promotes productivity. encourages innovation. provides an efficient and liquid market for buying and selling securities. All of the above.

d.

1-9

LO 2 Explain how accounting assists in the efficient use of scare resources.

Financial Statements and Financial ReportingObjectives of Financial ReportingProvide financial information about the reporting entity that is useful to

present and potential equity investors, lenders, and other creditors

in making decisions in their capacity as capital providers.

1-10

LO 3 Identify the objectives of financial reporting.

Objective of Financial AccountingGeneral-Purpose Financial Statements

Provide financial reporting information to a wide variety of users. Provide the most useful information possible at the least cost.

Equity Investors and CreditorsInvestors are the primary user group.

1-11

LO 3 Identify the objectives of financial reporting.

Objective of Financial AccountingEntity PerspectiveCompanies viewed as separate and distinct from their owners.

Decision-UsefulnessInvestors are interested in assessing the companys 1. ability to generate net cash inflows and 2. managements ability to protect and enhance the capital providers investments.LO 3 Identify the objectives of financial reporting.

1-12

Need to Develop StandardsVarious users need financial information Financial StatementsBalance Sheet Income Statement Statement of Stockholders Equity Statement of Cash Flows Note Disclosure

The accounting profession has attempted to develop a set of standards that are generally accepted and universally practiced.1-13

Generally Accepted Accounting Principles (GAAP)

LO 4 Explain the need for accounting standards.

Parties Involved in Standard SettingThree organizations:

Securities and Exchange Commission (SEC). American Institute of Certified Public Accountants (AICPA).

Financial Accounting Standards Board (FASB).

1-14

LO 5 Identify the major policy-setting bodies and their role in the standard-setting process.

Parties Involved in Standard SettingSecurities and Exchange Commission (SEC)

Established by federal government. Accounting and reporting for public companies.

Securities Act of 1933 1-15

Securities Act of 1934

http://www.sec.gov/

Encouraged private standard-setting body. SEC requires public companies to adhere to GAAP. SEC Oversight. Enforcement Authority.LO 5 Identify the major policy-setting bodies and their role in the standard-setting process.

Parties Involved in Standard SettingAmerican Institute of CPAs (AICPA)

National professional organization Established the following:http://www.aicpa.org/

Committee on Accounting Procedures

Accounting Principles Board

1939 to 1959 Issued 51 Accounting Research Bulletins (ARBs) Problem-by-problem approach failed

1959 to 1973 Issued 31 Accounting Principle Board Opinions (APBOs) Wheat Committee recommendations adopted in 1973

1-16

LO 5

Parties Involved in Standard SettingFinancial Accounting Standards Board (FASB)Wheat Committees recommendations resulted in creation of FASB. Financial Accounting Foundation Financial Accounting Standards BoardFinancial Accounting Standards Advisory Council1-17

Selects members of the FASB. Funds their activities. Exercises general oversight. Mission to establish and improve standards of financial accounting and reporting.

Consult on major policy issues.LO 5

Financial Accounting Standards BoardMissions is to establish and improve standards of financial accounting and reporting. Differences between FASB and APB include:

Smaller Membership. Full-time, Remunerated Membership. Greater Autonomy. Increased Independence. Broader Representation.http://www.fasb.org/

1-18


Financial Accounting Standards Board ReviewThe first step taken in the establishment of a typical FASB statement is a. The board conducts research and analysis and a discussion memorandum is issued. A public hearing on the proposed standard is held. The board evaluates the research and public response and issues an exposure draft. Topics are identified and placed on the boards agenda.LO 5 Identify the major policy-setting bodies and their role in the standard-setting process.

b. c.

d.1-19

Financial Accounting Standards BoardIllustration 1-3 The Due Process System of the FASB

1-20


Financial Accounting Standards BoardTypes of Pronouncements

Standards, Interpretations, and Staff Positions. Financial Accounting Concepts. Emerging Issues Task Force Statements.

1-21


Types of PronouncementsCA1-14 (Accounting Pronouncements): Standard setting bodies have issued a number of authoritative pronouncements. A list is provided on the left, below, with a description of these pronouncements on the right.

(d) (f) (c) (e) (a) (b)

1-22

LO 5

Parties Involved in Standard SettingChanging Role of AICPAThe AICPA established the Accounting Standards Executive Committee (AcSEC):

Audit and Accounting Guides. Statements of Position (SOP). Practice Bulletins.

AICPA and AcSEC no longer issues authoritative accounting guidance for public companies. PCAOB oversees the development of auditing standards.1-23


Generally Accepted Accounting PrinciplesPrinciples that have substantial authoritative support. Major sources of GAAP:

FASB Standards, Interpretations, and Staff Positions. APB Opinions. AICPA Accounting Research Bulletins.

1-24

LO 6 Explain the meaning of generally accepted accounting principles (GAAP) and the role of the Codification for GAAP.

Generally Accepted Accounting PrinciplesIllustration 1-4 GAAP Documents

1-25


Generally Accepted Accounting Principles ReviewWhich of the following accounting pronouncements is the most authoritative? a. b. c. d. FASB Statement of Financial Accounting Concepts. FASB Technical Bulletins. AICPA Accounting Principles Board Opinion. AICPA Statement of Position.

1-26


Generally Accepted Accounting PrinciplesFASB Codification

Goal in developing the Codification is to provide in one place all the authoritative literature related to a particular topic. Creates one level of GAAP, which is considered authoritative. All other accounting literature is considered non-authoritative.FASB has developed the Financial Accounting Standards Board Codification Research System (CRS). CRS is an online real-time database that provides easy access to the Codification.

1-27

LO 6

Generally Accepted Accounting PrinciplesIllustration 1-5 FASB Codification Framework

1-28

LO 6

Issues in Financial ReportingGAAP in a Political EnvironmentGAAP is as much a product of political action as they are of careful logic or empirical findings.Illustration 1-6 User Groups that Influence the Formulation of Accounting Standards

1-29

LO 7 Describe the impact of user groups on the rule-making process.

Issues in Financial ReportingExpectation GAAPWhat the public thinks accountants should do vs. what accountants think they can do.

Difficult to close in light of accounting scandals. Sarbanes-Oxley Act (2002). Public Company Accounting Oversight Board (PCAOB).

1-30

LO 7 Describe the impact of user groups on the rule-making process.

Issues in Financial ReportingFinancial Reporting Challenges

Non-financial measurements. Forward-looking information. Soft assets. Timeliness

1-31

LO 8 Describe some of the challenges facing financial reporting.

Issues in Financial ReportingInternational Accounting StandardsTwo sets of standards accepted for international use:

U.S. GAAP, issued by the FASB. International Financial Reporting Standards (IFRS), issued by the IASB.

FASB and IASB recognize that global markets will best be served if only one set of GAAP is used.1-32


Issues in Financial ReportingCA1-9 (GAAP Terminology): With accounting and finance, it often helps to be fluent in abbreviations and acronyms. Instructions: Presented below is a list of common accounting acronyms. Identify the term for which each acronym stands, and provide a brief definition of each term. (a) AICPA (b) CAP (c) ARB (d) APB1-33

(e) FAF (f) FASAC (g) SOP (h) GAAP

(i) CPA (j) FASB (k) SEC (l) IASB


Issues in Financial ReportingEthics in the Environment of Financial AccountingIn accounting, we frequently encounter ethical dilemmas.

GAAP does not always provide an answer. Doing the right thing is not always easy or obvious.

1-34

LO 9 Understand issues related to ethics and financial accounting.

RELEVANT FACTS

International standards are referred to as International Financial Reporting Standards (IFRS), developed by the International Accounting Standards Board (IASB). Recent events in the global capital markets have underscored the importance of financial disclosure and transparency not only in the United States but in markets around the world. As a result, many are examining which accounting and financial disclosure rules should be followed. U.S standards, referred to as generally accepted accounting principles (GAAP), are developed by the Financial Accounting Standards Board (FASB). The fact that there are differences between what is in this textbook (which is based on U.S. standards) and IFRS should not be surprising because the FASB and IASB have responded to different user needs.

1-35

RELEVANT FACTS

The internal control standards applicable to Sarbanes-Oxley (SOX) apply only to large public companies listed on U.S. exchanges. There is a continuing debate as to whether non-U.S. companies should have to comply with this extra layer of regulation. Debate about international companies (non-U.S.) adopting SOX-type standards centers on whether the benefits exceed the costs. The concern is that the higher costs of SOX compliance are making the U.S. securities markets less competitive. The textbook mentions a number of ethics violations, such as WorldCom, AIG, and Lehman Brothers. These problems have also occurred internationally, for example, at Satyam Computer Services (India), Parmalat (Italy), and Royal Ahold (the Netherlands).

1-36

RELEVANT FACTS

IFRS tends to be simpler in its accounting and disclosure requirements; some people say more principles-based. GAAP is more detailed; some people say more rules-based. This difference in approach has resulted in a debate about the merits of principlesbased versus rules-based standards. The SEC allows foreign companies that trade shares in U.S. markets to file their IFRS financial statements without reconciliation to GAAP.

1-37

ABOUT THE NUMBERS

Illustration IFRS1-1 Global Companies

1-38

International Standard-Setting Organizations:International Accounting Standards Board (IASB)

Issues International Financial Reporting Standards (IFRS). Standards used on most foreign exchanges. Standards used by foreign companies listing on U.S. securities exchanges. IFRS used in over 115 countries.

1-39

International Organization of Securities Commissions (IOSCO)

Does not set accounting standards. Dedicated to ensuring that global markets can operate in an efficient and effective basis.http://www.iosco.org/

1-40

International Accounting Standards Board (IASB)Composed of four organizations

International Accounting Standards Committee Foundation (IASCF). International Accounting Standards Board (IASB). Standards Advisory Council. International Financial Reporting Interpretations Committee (IFRIC).

http://www.iasb.org

1-41

Illustration IFRS1-2 International Standard-Setting Structure

1-42

Review QuestionIFRS stands for: a. International Federation of Reporting Services. b. Independent Financial Reporting Standards. c. International Financial Reporting Standards. d. Integrated Financial Reporting Services.

1-43

Review QuestionThe major key players on the international side are the: a. IASB and FASB. b. SEC and FASB. c. IOSCO and the SEC. d. IASB and IOSCO.

1-44

Review QuestionWhich body from the U.S. side is similar to the IASB? a. SEC. b. FASB. c. FASC. d. FAF.

1-45

Types of Pronouncements

International Financial Reporting Standards. Framework for financial reporting. International financial reporting interpretations.

1-46

Hierarchy of IFRSCompanies first look to: 1. International Financial Reporting Standards; 2. International Accounting Standards; and 3. Interpretations originated by the International Financial Reporting Interpretations Committee (IFRIC) or the former Standing Interpretations Committee (SIC).

1-47

Review QuestionIFRS is comprised of: a. International Financial Reporting Standards and FASB financial reporting standards. b. International Financial Reporting Standards, International Accounting Standards, and international accounting interpretations. c. International Accounting Standards and international accounting interpretations. d. FASB financial reporting standards and International Accounting Standards.1-48

International ConvergenceThe SEC appears committed to move to IFRS, assuming that certain conditions are met.Illustration IFRS1-3 SEC Roadmap

1-49

International ConvergenceThe SEC will decide, sometime in 2011, whether to mandate the use of IFRS. It is likely that not all companies would be required immediately to change to IFRS, but there would be a transition period in which this would be accomplished.

1-50

CopyrightCopyright 2012 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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2-1


2

Conceptual Framework for Financial Accounting



Learning Objectives1. 2. 3. 4. 5. 6. 7. 8. Describe the usefulness of a conceptual framework. Describe the FASBs efforts to construct a conceptual framework. Understand the objectives of financial reporting. Identify the qualitative characteristics of accounting information. Define the basic elements of financial statements. Describe the basic assumptions of accounting. Explain the application of the basic principles of accounting. Describe the impact that constraints have on reporting accounting information.

2-3

Conceptual Framework For Financial Accounting

Conceptual Framework

First Level: Basic Objectives

Second Level: Fundamental ConceptsQualitative characteristics Basic elements

Third Level: Recognition and MeasurementBasic assumptions Basic principles Constraints Summary of the structure

Need Development Overview

2-4

Conceptual FrameworkThe Need for a Conceptual Framework

To develop a coherent set of standards and rules. To solve new and emerging practical problems.

2-5

LO 1 Describe the usefulness of a conceptual framework.

Conceptual FrameworkReview Question (true or false):A conceptual framework underlying financial accounting is important because it can lead to consistent standards and it prescribes the nature, function, and limits of financial accounting and financial statements.

True

2-6


Conceptual FrameworkReview Question (true or false):A conceptual framework underlying financial accounting is necessary because future accounting practice problems can be solved by reference to the conceptual framework and a formal standard-setting body will not be necessary.

False

2-7


Development of Conceptual FrameworkThe FASB has issued seven Statements of Financial Accounting Concepts (SFAC) for business enterprises.SFAC No.1 - Objectives of Financial Reporting. SFAC No.2 - Qualitative Characteristics of Accounting Information. SFAC No.3 - Elements of Financial Statements. SFAC No.5 - Recognition and Measurement in Financial Statements. SFAC No.6 - Elements of Financial Statements (replaces SFAC No. 3). SFAC No.7 - Using Cash Flow Information and Present Value in Accounting Measurements. SFAC No.8 - The Objective of General Purpose Financial Reporting and Qualitative Characteristics of Useful Financial Information (replaces SFAC No. 1 and No. 2)2-8

LO 2

Conceptual FrameworkOverview of the Conceptual Framework

First Level = Basic Objectives Second Level = Qualitative Characteristics and Elements

Third Level = Recognition, Measurement, and Disclosure Concepts.

2-9

LO 2 Describe the FASBs efforts to construct a conceptual framework.

Illustration 2-7 Conceptual Framework for Financial Reporting

2-10

LO 2

Conceptual FrameworkReviewWhat are the Statements of Financial Accounting Concepts intended to establish? a. Generally accepted accounting principles in financial reporting by business enterprises. The meaning of Present fairly in accordance with generally accepted accounting principles. The objectives and concepts for use in developing standards of financial accounting and reporting. The hierarchy of sources of generally accepted accounting principles.LO 2 Describe the FASBs efforts to construct a conceptual framework.

b.

c.

d.

2-11

First Level: Basic ObjectivesObjective of general-purpose financial reporting is:To provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions about providing resources to the entity.

2-12

LO 3 Understand the objectives of financial reporting.

First Level: Basic ObjectivesReviewAccording to the FASB conceptual framework, the objectives of financial reporting for business enterprises are based on? a. Generally accepted accounting principles b. Reporting on managements stewardship. c. The need for conservatism. d. The needs of the users of the information.

2-13

LO 3 Understand the objectives of financial reporting.

Second Level: Fundamental ConceptsQualitative CharacteristicsThe FASB identified the Qualitative Characteristics of accounting information that distinguish better (more useful) information from inferior (less useful) information for decision-making purposes.

2-14

LO 4 Identify the qualitative characteristics of accounting information.

Second Level: Qualitative Characteristics

Illustration 2-2 Hierarchy of Accounting Qualities

2-15


Relevance


2-16

LO 4

Second Level: Qualitative CharacteristicsFundamental QualityRelevance

To be relevant, accounting information must be capable of making a difference in a decision.

2-17



Financial information has predictive value if it has value as an input to predictive processes used by investors to form their own expectations about the future.2-18



Relevant information also helps users confirm or correct prior expectations.

2-19



Information is material if omitting it or misstating it could influence decisions that users make on the basis of the reported financial information.2-20


Faithful Representation


2-21

LO 4

Second Level: Qualitative CharacteristicsFundamental QualityFaithful Representation

Faithful representation means that the numbers and descriptions match what really existed or happened.

2-22



Completeness means that all the information that is necessary for faithful representation is provided.

2-23



Neutrality means that a company cannot select information to favor one set of interested parties over another.

2-24



An information item that is free from error will be a more accurate (faithful) representation of a financial item.

2-25


Second Level: Qualitative CharacteristicsEnhancing Qualities

Information that is measured and reported in a similar manner for different companies is considered comparable.2-26



Verifiability occurs when independent measurers, using the same methods, obtain similar results.2-27



Timeliness means having information available to decisionmakers before it loses its capacity to influence decisions.2-28



Understandability is the quality of information that lets reasonably informed users see its significance.2-29


Basic Elements


2-30

LO 5

Second Level: Basic ElementsConcepts Statement No. 6 defines ten interrelated elements that relate to measuring the performance and financial status of a business enterprise.Moment in Time

Period of Time

Assets Liabilities Equity

Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains Losses

2-31

LO 5 Define the basic elements of financial statements.

Second Level: Basic ElementsExercise 2-5: Identify the element or elements associated with items below. Elements(a) Arises from peripheral or incidental transactions. (b) Obligation to transfer resources arising from a past transaction. (c) Increases ownership interest. (d) Declares and pays cash dividends to owners. (e) Increases in net assets in a period from nonowner sources. Assets

(b) (c) (d) (e) (c)

Liabilities Equity Investment by owners Distribution to owners Comprehensive income Revenue Expenses

(a) (a)2-32

Gains LossesLO 5

Second Level: Basic ElementsExercise 2-5: Identify the element or elements associated with items below. Elements (f) Assets (f) Items characterized by futureeconomic benefit. (g) Equals increase in net assets during the year, after adding distributions to owners and subtracting investments by owners. (h) Arises from income statement activities that constitute the entitys ongoing major or central operations.2-33

Liabilities Equity Investment by owners Distribution to owners

(g) (h) (h)

Comprehensive income Revenue Expenses Gains LossesLO 5

Second Level: Basic ElementsExercise 2-5: Identify the element or elements associated with items below. Elements(i) Residual interest in the net assets of the enterprise. (j) Increases assets through sale of product. (k) Decreases assets by purchasing the companys own stock. (l) Changes in equity during the period, except those from investments by owners and distributions to owners.2-34

Assets Liabilities

(i) (k) (l) (j)

Equity Investment by owners Distribution to owners Comprehensive income Revenue Expenses Gains LossesLO 5

Second Level: Basic Elements Review:According to the FASB conceptual framework, an entitys revenue may result from a. A decrease in an asset from primary operations. b. An increase in an asset from incidental transactions. c. An increase in a liability from incidental transactions. d. A decrease in a liability from primary operations.

2-35

LO 5 Define the basic elements of financial statements.

Third Level: Recognition and MeasurementThe FASB sets forth most of these concepts in its Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises.


2-36

LO 5

Third Level: Basic AssumptionsEconomic Entity company keeps its activity separate fromits owners and other businesses.

Going Concern - company to last long enough to fulfillobjectives and commitments.

Monetary Unit - money is the common denominator. Periodicity - company can divide its economic activities intotime periods.

2-37

LO 6 Describe the basic assumptions of accounting.

Third Level: AssumptionsBrief Exercise 2-7: Identify which basic assumption of accounting is best described in each item below.(a) The economic activities of KC Corporation are divided into 12-month periods for the purpose of issuing annual reports. (b) Solectron Corporation, Inc. does not adjust amounts in its financial statements for the effects of inflation. (c) Walgreen Co. reports current and noncurrent classifications in its balance sheet. (d) The economic activities of General Electric and its subsidiaries are merged for accounting and reporting purposes.2-38

Periodicity Monetary Unit Going Concern Economic Entity

LO 6 Describe the basic assumptions of accounting.

Third Level: Basic PrinciplesMeasurement Principle The most commonly usedmeasurements are based on historical cost and fair value.

Issues:

Historical cost provides a reliable benchmark for measuring historical trends. Fair value information may be more useful. Recently the FASB has taken the step of giving companies the option to use fair value as the basis for measurement of financial assets and financial liabilities. Reporting of fair value information is increasing.LO 7 Explain the application of the basic principles of accounting.

2-39

Third Level: Basic PrinciplesRevenue Recognition - generally occurs (1) when realizedor realizable and (2) when earned. Exceptions:Illustration 2-5 Timing of Revenue Recognition

2-40

LO 7 Explain the application of the basic principles of accounting.

Third Level: Basic PrinciplesExpense Recognition - Let the expense follow therevenues.Illustration 2-6 Expense Recognition

2-41


Third Level: Basic PrinciplesFull Disclosure providing information that is of sufficientimportance to influence the judgment and decisions of an informed user. Provided through:

Financial Statements Notes to the Financial Statements Supplementary information

2-42


Third Level: Basic PrinciplesBrief Exercise 2-8: Identify which basic principle of accounting is best described in each item below.(a) KC Corporation reports revenue in its income statement when it is earned instead of when the cash is collected. (b) Yahoo, Inc. recognizes depreciation expense for a machine over the 2-year period during which that machine helps the company earn revenue. (c) Oracle Corporation reports information about pending lawsuits in the notes to its financial statements. (d) Eastman Kodak Company reports land on its balance sheet at the amount paid to acquire it, even though the estimated fair market value is greater.2-43

Revenue Recognition Expense Recognition Full Disclosure Measurement


Third Level: ConstraintsCost Constraint cost of providing information must beweighed against the benefits that can be derived from using it.

Industry Practice - the peculiar nature of some industriesand business concerns sometimes requires departure from basic accounting theory.

2-44

LO 8 Describe the impact that constraints have on reporting accounting information.

Third Level: ConstraintsBrief Exercise 2-10: What accounting constraints are illustrated by the items below?(a) KC, Inc. reports agricultural crops on its balance sheet at market value. (b) Rafael Corporation discloses fair value information on its loans because it already gathers this information internally. (c) Willis Company does not disclose any information in the notes to the financial statements unless the value of the information to users exceeds the expense of gathering it. (d) A broker-dealer records all assets and liabilities at fair value.2-45

Industry Practice Cost Constraint Cost Constraint

Industry PracticeLO 8


Summary of the Structure

2-46

RELEVANT FACTS

In 2010, the IASB and FASB completed the first phase of a jointly created conceptual framework. In this first phase, they agreed on the objective of financial reporting and a common set of desired qualitative characteristics. The existing conceptual frameworks underlying GAAP and IFRS are very similar. The converged framework should be a single document, unlike the two conceptual frameworks that presently exist; it is unlikely that the basic structure related to the concepts will change.

2-47

RELEVANT FACTS

Both the IASB and FASB have similar measurement principles, based on historical cost and fair value. Although both GAAP and IFRS are increasing the use of fair value to report assets, at this point IFRS has adopted it more broadly. GAAP has a concept statement to guide estimation of fair values when market-related data is not available (Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present Value in Accounting). The IASB is considering a proposal to provide expanded guidance on estimating fair values. The monetary unit assumption is part of each framework. However, the unit of measure will vary depending on the currency used in the country in which the company is incorporated.

2-48

RELEVANT FACTS

The economic entity assumption is also part of each framework although some cultural differences result in differences in its application. For example, in Japan many companies have formed alliances that are so strong that they act similar to related corporate divisions although they are not actually part of the same company.

2-49

ABOUT THE NUMBERS International Standard-Setting Organizations:While the conceptual framework that underlies IFRS is very similar to that used to develop GAAP, the elements identified and their definitions under IFRS are different. The IASB elements and their definitions are as follows. Assets. A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Liabilities. A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. Liabilities may be legally enforceable via a contract or law, but need not be, i.e., they can arise due to normal business practice or customs.

2-50

ABOUT THE NUMBERS International Standard-Setting Organizations:While the conceptual framework that underlies IFRS is very similar to that used to develop GAAP, the elements identified and their definitions under IFRS are different. The IASB elements and their definitions are as follows. Equity. A residual interest in the assets of the entity after deducting all its liabilities. Income. Increases in economic benefits that result in increases in equity (other than those related to contributions from shareholders). Income includes both revenues (resulting from ordinary activities) and gains. Expenses. Decreases in economic benefits that result in decreases in equity (other than those related to distributions to shareholders). Expenses includes losses that are not the result of ordinary activities.2-51

IFRS SELF-TEST QUESTIONWhich of the following statements about the IASB and FASB conceptual frameworks is not correct? a. The IASB conceptual framework does not identify the element comprehensive income. b. The existing IASB and FASB conceptual frameworks are organized in similar ways. c. The FASB and IASB agree that the objective of financial reporting is to provide useful information to investors and creditors. d. IFRS does not allow use of fair value as a measurement basis.2-52

IFRS SELF-TEST QUESTIONWhich of the following statements is false? a. The monetary unit assumption is used under IFRS. b. Under IFRS, companies may use fair value for property, plant, and equipment. c. The FASB and IASB are working on a joint conceptual framework project. d. Under IFRS, there are the same number of financial statement elements as in GAAP.

2-53

IFRS SELF-TEST QUESTIONThe issues that the FASB and IASB must address in developing a common conceptual framework include all of the following except: a. Should the characteristic of relevance be traded-off in favor of information that is verifiable? b. Should a single measurement method be used? c. Should the common framework lead to standards that are principles-based or rules-based? d. Should the role of financial reporting focus on stewardship as well as providing information to assist users in decisionmaking?2-54


2-55


3-1


3

The Accounting Information System



Learning Objectives1. 2. 3. 4. 5. 6. 7. Understand basic accounting terminology. Explain double-entry rules. Identify steps in the accounting cycle. Record transactions in journals, post to ledger accounts, and prepare a trial balance. Explain the reasons for preparing adjusting entries. Prepare financial statement from the adjusted trial balance. Prepare closing entries.

3-3

The Accounting Information System

Accounting Information SystemBasic terminology Debits and credits Accounting equation Financial statements and ownership structure

The Accounting CycleIdentifying and recording Journalizing Posting Trial balance Adjusting entries Adjusted trial balance Preparing financial statements Closing Post-closing trial balance Reversing entries

Financial Statements for MerchandisersIncome statement Statement of retained earnings Balance sheet Closing entries

3-4

Accounting Information SystemAccounting Information System (AIS)

Collects and processes transaction data. Disseminates the information to interested parties.

3-5

Accounting Information SystemHelps management answer such questions as:

How much and what kind of debt is outstanding? Were sales higher this period than last? What assets do we have? What were our cash inflows and outflows? Did we make a profit last period? Are any of our product lines or divisions operating at a loss? Can we safely increase our dividends to stockholders? Is our rate of return on net assets increasing?

3-6

Accounting Information SystemBasic Terminology

Event Transaction Account Real Account Nominal Account Ledger

Journal Posting Trial Balance Adjusting Entries Financial Statements Closing Entries

3-7

LO 1 Understand basic accounting terminology.

Accounting Information SystemDebits and Credits

An Account shows the effect of transactions on a given asset, liability, equity, revenue, or expense account.

Double-entry accounting system (two-sided effect). Recording done by debiting at least one account and crediting another.

3-8

DEBITS must equal CREDITS.LO 2 Explain double-entry rules.

Debits and CreditsAccount

An arrangement that shows the effect of transactions on an account. Debit = Left Credit = RightAccount NameDebit / Dr. Credit / Cr.

An Account can be illustrated in a T-Account form.

3-9

LO 2 Explain double-entry rules.

Debits and CreditsIf Debit entries are greater than Credit entries, the account will have a debit balance.Account NameDebit / Dr. Credit / Cr.

Transaction #1 Transaction #3

$10,000 8,000

$3,000

Transaction #2

Balance

$15,000

3-10


Debits and CreditsIf Credit entries are greater than Debit entries, the account will have a credit balance.Account NameDebit / Dr. Credit / Cr.

Transaction #1

$10,000

$3,000 8,000

Transaction #2 Transaction #3

Balance

$1,000

3-11


Debits and Credits SummaryLiabilities

Normal Balance DebitAssetsDebit / Dr. Credit / Cr.

Normal Balance CreditEquityDebit / Dr.Chapter 3-24

Debit / Dr.

Credit / Cr.

Normal Balance

Credit / Cr.

Normal Balance Normal BalanceChapter 3-23

ExpenseDebit / Dr. Credit / Cr.

Chapter 3-25

RevenueDebit / Dr. Credit / Cr.

Normal Balance

Normal Balance

Chapter 3-27

Chapter 3-26

3-12


Debits and Credits SummaryBalance Sheet Income Statement

Asset = Liability + Equity Revenue - Expense =

Debit

Credit

3-13


The Accounting EquationRelationship among the assets, liabilities and stockholders equity of a business:Illustration 3-3

The equation must be in balance after every transaction. For every Debit there must be a Credit.3-14


Double-Entry System Illustration1. Owners invest $40,000 in exchange for common stock. Assets = Liabilities +Stockholders Equity

+ 40,000

+ 40,000

3-15


Double-Entry System Illustration2. Disburse $600 cash for secretarial wages.

Assets

=

Liabilities

+

Stockholders Equity

- 600

- 600(expense)

3-16


Double-Entry System Illustration3. Purchase office equipment priced at $5,200, giving a 10 percent promissory note in exchange. Assets = Liabilities +Stockholders Equity

+ 5,200

+ 5,200

3-17


Double-Entry System Illustration4. Received $4,000 cash for services rendered.

Assets

=

Liabilities

+

Stockholders Equity

+ 4,000

+ 4,000(revenue)

3-18


Double-Entry System Illustration5. Pay off a short-term liability of $7,000.

Assets

=

Liabilities

+

Stockholders Equity

- 7,000

- 7,000

3-19


Double-Entry System Illustration6. Declared a cash dividend of $5,000.

Assets

=

Liabilities

+

Stockholders Equity

+ 5,000

- 5,000

3-20


Double-Entry System Illustration7. Convert a long-term liability of $80,000 into common stock. Assets = Liabilities +Stockholders Equity

- 80,000

+ 80,000

3-21


Double-Entry System Illustration8. Pay cash of $16,000 for a delivery van.

Assets

=

Liabilities

+

Stockholders Equity

- 16,000 + 16,000Note that the accounting equation equality is maintained after recording each transaction.3-22


Financial Statements and Ownership StructureOwnership structure dictates the types of accounts that are part of the equity section.Proprietorship or Partnership

Corporation

Capital Account Drawing Account

Common Stock Additional Paid-in Capital Dividends Declared Retained Earnings

3-23


Financial Statements and Ownership StructureBalance Sheet Stockholders Equity Common Stock(Investment by stockholders)Illustration 3-4

Retained Earnings(Net income retained in business)

Net income or Net loss Dividends(Revenues less expenses)

Income Statement Statement of Retained Earnings3-24


The Accounting CycleIllustration 3-6

Transactions 9. Reversing entries 1. Journalization

8. Post-closing trail balance

2. Posting

7. Closing entriesWork Sheet

3. Trial balance

6. Financial Statements

4. Adjustments

5. Adjusted trial balance

3-25

LO 3 Identify steps in the accounting cycle.

Identify and Recording TransactionsWhat to Record? FASB states, transactions and other events and circumstances that affect a business enterprise. Types of Events:

External between a business and its environment. Internal event occurring entirely within a business.

3-26

LO 3 Identify steps in the accounting cycle.

1. JournalizingGeneral Journal a chronological record of transactions. Journal Entries are recorded in the journal.September 1: Stockholders invested $15,000 cash in the corporation in exchange for shares of stock.Illustration 3-7

3-27

LO 4 Record transactions in journals, post to ledger accounts, and prepare a trial balance.

2. PostingPosting the process of transferring amounts from the journal to the ledger accounts.Illustration 3-7

Illustration 3-8

3-28


2. PostingPosting Transferring amounts from journal to ledger.Illustration 3-8

3-29

LO 4

2. PostingExpanded ExampleThe purpose of transaction analysis is (1) to identify the type of account involved, and (2) to determine whether a debit or a credit is required.Keep in mind that every journal entry affects one or more of the following items: assets, liabilities, stockholders equity, revenues, or expense.

3-30


2. Posting1. October 1: Stockholders invest $100,000 cash in an advertising venture to be known as Pioneer Advertising Agency Inc. Oct. 1 Cash Common stockCash Debit 100,000 Credit

100,000 100,000Common Stock Debit Credit 100,000

3-31


2. Posting2. October 1: Pioneer Advertising purchases office equipment costing $50,000 by signing a 3-month, 12%, $50,000 note payable. Oct. 1 Equipment Notes payableEquipment Debit 50,000 Credit Notes Payable Debit Credit 50,000

50,000 50,000

3-32


2. Posting3. October 2: Pioneer Advertising receives a $12,000 cash advance from KC, a client, for advertising services that are expected to be completed by December 31. Oct. 2 Cash Unearned service revenueCash Debit 100,000 12,000 Credit

12,000 12,000

Unearned Service Revenue Debit Credit 12,000

3-33


2. Posting4. October 3: Pioneer Advertising pays $9,000 office rent, in cash, for October. Oct. 3 Rent expense Cash 9,000 9,000

Cash Debit 100,000 12,000 Credit 9,000

Rent Expense Debit 9,000 Credit

3-34


2. Posting5. October 4: Pioneer Advertising pays $6,000 for a one-year insurance policy that will expire next year on September 30. Oct. 4 Prepaid insurance Cash 6,000 6,000

Cash Debit 100,000 12,000 Credit 9,000 6,000

Prepaid Insurance Debit 6,000 Credit

3-35


2. Posting6. October 5: Pioneer Advertising purchases, for $25,000 on account, an estimated 3-month supply of advertising materials from Aero Supply. Oct. 5 Supplies Accounts payableSupplies Debit 25,000 Credit

25,000 25,000Accounts Payable Debit Credit 25,000

3-36


2. Posting7. October 9: Pioneer Advertising signs a contract with a local newspaper for advertising inserts (flyers) to be distributed starting the last Sunday in November. Pioneer will start work on the content of the flyers in November. Payment of $7,000 is due following delivery of the Sunday papers containing the flyers.

LO 43-37

Record transactions in journals, post to ledger accounts, and prepare a trial balance.

2. Posting8. October 20: Pioneer Advertisings board of directors declares and pays a $5,000 cash dividend to stockholders. Oct. 20 Dividends Cash 5,000 5,000

Cash Debit 100,000 12,000 Credit 9,000 6,000 5,000

Dividends Debit 5,000 Credit

3-38


2. Posting9. October 26: Employees are paid every four weeks. The total payroll is $2,000 per day. The pay period ended on Friday, October 26, with salaries of $40,000 being paid. Oct. 26 Salaries expense CashCash Debit 100,000 12,000 Credit 9,000 6,000 5,000 40,0003-39

40,000 40,000Salaries Expense Debit 40,000 Credit


2. Posting10. October 31: Pioneer Advertising receives $28,000 in cash and bills Copa Company $72,000 for advertising services of $100,000 provided in October. Oct. 31 Cash Accounts receivable Service revenueCash Debit 100,000 12,000 28,000 80,0003-40

28,000 72,000 100,000Service Revenue Debit Credit 100,000

Accounts Receivable Credit 9,000 6,000 5,000 40,000 Debit 72,000 Credit

3. Trial BalanceIllustration 3-19

Trial Balance A list of each account and its balance; used to prove equality of debit and credit balances.

3-41

LO 4

4. Adjusting EntriesMakes it possible to:

Report on the statement of financial position the appropriate assets, liabilities, and equity at the statement date. Report on the income statement the proper revenues and expenses for the period.

Revenues are recorded in the period in which they are earned. Expenses are recognized in the period in which they are incurred.

3-42

LO 5 Explain the reasons for preparing adjusting entries.

Types of Adjusting EntriesIllustration 3-20

Prepayments1. Prepaid Expenses. Expenses paid in cash and recorded as assets before they are used or consumed. 2. Unearned Revenues. Revenues received in cash and recorded as liabilities before they are earned.

Accruals3. Accrued Revenues. Revenues earned but not yet received in cash or recorded. 4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded.

3-43


Adjusting Entries for DeferralsDeferrals are either

prepaid expenses or unearned revenues.

Illustration 3-21

3-44


Adjusting Entries for Prepaid ExpensesPayment of cash that is recorded as an asset because service or benefit will be received in the future. Cash PaymentBEFORE

Expense Recorded

Prepayments often occur in regard to:

insurance supplies advertising

rent buildings and equipment

3-45


Adjusting Entries for Prepaid ExpensesSupplies. Pioneer purchased advertising supplies costing $25,000 on October 5. Prepare the journal entry to record the purchase of the supplies. Oct. 5 Supplies CashSupplies Debit 25,000 Credit Debit Cash Credit 25,000

25,000 25,000

3-46


Adjusting Entries for Prepaid ExpensesSupplies. An inventory count at the close of business on October 31 reveals that $10,000 of the advertising supplies are still on hand. Oct. 31 Supplies expense SuppliesSupplies Debit 25,000 10,0003-47

15,000 15,000Supplies Expense Debit 15,000 Credit

Credit 15,000


Adjusting Entries for Prepaid ExpensesStatement Presentation:Supplies identifies that portion of the assets cost that will provide future economic benefit.

Illustration 3-35

3-48

Illustration 3-35

Adjusting Entries for Prepaid ExpensesStatement Presentation:Supplies expense identifies that portion of the assets cost that expired in October.Illustration 3-35

3-49


Adjusting Entries for Prepaid ExpensesInsurance. On Oct. 4th, Pioneer paid $6,000 for a one-year fire insurance policy, beginning October 1. Show the entry to record the purchase of the insurance. Oct. 4 Prepaid insurance CashPrepaid Insurance Debit 6,000 Credit Debit Cash Credit 6,000

6,000 6,000

3-50


Adjusting Entries for Prepaid ExpensesInsurance. An analysis of the policy reveals that $500 ($6,000 / 12) of insurance expires each month. Thus, Pioneer makes the following adjusting entry. Oct. 31 Insurance expense Prepaid insurancePrepaid Insurance Debit 6,000 5,5003-51

500 500Insurance Expense Debit 500 Credit

Credit 500


Adjusting Entries for Prepaid ExpensesStatement Presentation:Prepaid insurance identifies that portion of the assets cost that will provide future economic benefit.

Illustration 3-35

3-52

Illustration 3-35

Adjusting Entries for Prepaid ExpensesStatement Presentation:Insurance expense identifies that portion of the assets cost that expired in October.Illustration 3-35

3-53


Adjusting Entries for Prepaid ExpensesDepreciation. Pioneer Advertising estimates depreciation on its office equipment to be $400 per month. Accordingly, Pioneer recognizes depreciation for October by the following adjusting entry. Oct. 31 Depreciation expense Accumulated depreciationDepreciation Expense Debit 400 Credit

400 400

Accumulated Depreciation Debit Credit 400

3-54


Adjusting Entries for Prepaid ExpensesStatement Presentation:Accumulated Depreciationis a contra asset account.

Illustration 3-35

3-55

Illustration 3-35

Adjusting Entries for Prepaid ExpensesStatement Presentation:Depreciation expense identifies that portion of the assets cost that expired in October.Illustration 3-35

3-56


Adjusting Entries for Unearned RevenuesReceipt of cash that is recorded as a liability because the revenue has not been earned. Cash ReceiptBEFORE

Revenue Recorded

Unearned revenues often occur in regard to:

rent airline tickets school tuition

magazine subscriptions customer deposits

3-57


Adjusting Entries for Unearned RevenuesUnearned Revenue. Pioneer Advertising received $12,000 on October 2 from KC for advertising services expected to be completed by December 31. Show the journal entry to record the receipt on Oct. 2nd. Oct. 2 Cash 12,000 12,000 Unearned advertising revenueCash Debit 12,000 Credit

Unearned Rent Revenue Debit Credit 12,000

3-58


Adjusting Entries for Unearned RevenuesUnearned Revenues. Analysis reveals that Pioneer earned $4,000 of the advertising services in October. Thus, Pioneer makes the following adjusting entry. Oct. 31 Unearned service revenue Service revenueService Revenue Debit Credit 100,000 4,000

4,000 4,000

Unearned Service Revenue Debit 4,000 Credit 12,000 8,000

3-59


Adjusting Entries for Unearned RevenuesStatement Presentation:Unearned service revenue identifies that portion of the liability that has not been earned.

Illustration 3-35

3-60

Illustration 3-35

Adjusting Entries for Unearned RevenuesStatement Presentation:Service Revenue includes the portion of unearned service revenue earned in October.Illustration 3-35

3-61


Adjusting Entries for AccrualsAccruals are either

accrued revenues or accrued expenses.

Illustration 3-27

3-62


Adjusting Entries for Accrued RevenuesRevenues earned but not yet received in cash or recorded. Adjusting entry results in: Revenue RecordedBEFORE

Cash Receipt

Accrued revenues often occur in regard to:

rent interest services performedLO 5 Explain the reasons for preparing adjusting entries.

3-63

Adjusting Entries for Accrued RevenuesAccrued Revenues. In October Pioneer earned $2,000 for advertising services that it did not bill to clients before October 31. Thus, Pioneer makes the following adjusting entry. Oct. 31 Accounts receivable Service revenueAccounts Receivable Debit 72,000 2,000 74,0003-64

2,000 2,000Service Revenue Debit Credit 100,000 4,000 2,000 106,000LO 5

Credit

Adjusting Entries for Accrued RevenuesIllustration 3-35

Illustration 3-35

3-65

LO 5

Adjusting Entries for Accrued ExpensesExpenses incurred but not yet paid in cash or recorded. Adjusting entry results in: Expense RecordedBEFORE

Cash Payment, if any*

Accrued expenses often occur in regard to:

rent interest taxes

salaries bad debts*

3-66


Adjusting Entries for Accrued ExpensesAccrued Interest. Pioneer signed a three-month, 12%, note payable in the amount of $50,000 on October 1. The note requires interest at an annual rate of 12 percent. Three factors determine the amount of the interest accumulation:

1

2

3

Illustration 3-29

3-67


Adjusting Entries for Accrued ExpensesAccrued Interest. Pioneer signed a three-month, 12%, note payable in the amount of $50,000 on October 1. Prepare the adjusting entry on Oct. 31 to record the accrual of interest. Oct. 31 Interest expense Interest payableInterest Expense Debit 500 Credit Interest Payable Debit Credit 500

500 500

3-68


Adjusting Entries for Accrued ExpensesIllustration 3-35

Illustration 3-35

3-69

LO 5

Adjusting Entries for Accrued Expenses

Accrued Salaries. At October 31, the salaries for these days represent an accrued expense and a related liability to Pioneer. The employees receive total salaries of $10,000 for a five-day work week, or $2,000 per day.3-70


Adjusting Entries for Accrued ExpensesAccrued Salaries. Employees receive total salaries of $10,000 for a five-day work week, or $2,000 per day. Prepare the adjusting entry on Oct. 31 to record accrual for salaries. Oct. 31 Salaries expense Salaries payableSalaries Expense Debit 40,000 6,000 46,0003-71

6,000 6,000Salaries Payable Debit Credit 6,000

Credit


Adjusting Entries for Accrued ExpensesAccrued Salaries. On November 23, Pioneer will again pay total salaries of $40,000. Prepare the entry to record the payment of salaries on November 23. Nov. 23 Salaries payable Salaries expense CashSalaries Expense Debit 34,000 Credit

6,000 34,000 40,000Salaries Payable Debit 6,000 Credit 6,000

3-72



Illustration 3-35

3-73

LO 5

Adjusting Entries for Accrued ExpensesBad Debts. Assume Pioneer reasonably estimates a bad debt expense for the month of $1,600. It makes the adjusting entry for bad debts as follows.

Illustration 3-32

3-74



Illustration 3-35

3-75

LO 5

5. Adjusted Trial BalanceShows the balance of all accounts, after adjusting entries, at the end of the accounting period.

3-76

Illustration 3-33

6. Preparing Financial StatementsFinancial Statements are prepared directly from the Adjusted Trial Balance.

Income Statement

Retained Earnings Statement

Balance Sheet

3-77

LO 6 Prepare financial statement from the adjusted trial balance.

6. Preparing Financial Statements

Illustration 3-34 3-78

LO 6

6. Preparing Financial Statements

Illustration 3-35 3-79

LO 6

7. Closing Entries

To reduce the balance of the income statement (revenue and expense) accounts to zero. To transfer net income or net loss to owners equity. Balance sheet (asset, liability, and equity) accounts are not closed. Dividends are closed directly to the Retained Earnings account.

3-80

LO 7 Prepare closing entries.

7. Closing EntriesIllustration 3-33

Closing Journal Entries:Retained earnings Dividends Service revenue Supplies expense Rent expense Insurance expense Interest expense Depreciation expense Bad debt expense Retained earnings 5,000 5,000 106,000 15,000 9,000 500 500 400 1,600 33,000

Salaries & wages expense 46,000

3-81


7. Closing Entries

Illustration 3-37

Illustration 3-37

3-82

8. Post-Closing Trial BalanceIllustration 3-38

3-83

LO 7

9. Reversing Entries

After preparing the financial statements and closing the books, a company may reverse some of the adjusting entries before recording the regular transactions of the next period.

3-84


Accounting Cycle Summarized1. Enter the transactions of the period in appropriate journals. 2. Post from the journals to the ledger (or ledgers). 3. Take an unadjusted trial balance (trial balance). 4. Prepare adjusting journal entries and post to the ledger(s). 5. Take a trial balance after adjusting (adjusted trial balance). 6. Prepare the financial statements from the second trial balance. 7. Prepare closing journal entries and post to the ledger(s). 8. Take a trial balance after closing (post-closing trial balance). 9. Prepare reversing entries (optional) and post to the ledger(s).

3-85


Financial Statements of a Merchandising CompanyIllustration 3-39

3-86

LO 7

Financial Statements of a Merchandising CompanyIllustration 3-40

3-87

LO 7

Financial Statements of a Merchandising Company

Illustration 3-41

3-88

LO 7

APPENDIX

3A

CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING

Most companies use accrual-basis accounting

recognize revenue when it is earned and expenses in the period incurred,

without regard to the time of receipt or payment of cash. Under the strict cash-basis, companies

record revenue only when they receive cash, and record expenses only when they disperse cash.

Cash basis financial statements are not in conformity with GAAP.LO 8 Differentiate the cash basis of accounting from the accrual basis of accounting.

3-89

APPENDIX

3A


Illustration: Quality Contractor signs an agreement to construct a garage for $22,000. In January, Quality begins construction, incurs costs of $18,000 on credit, and by the end of January delivers a finished garage to the buyer. In February, Quality collects $22,000 cash from the customer. In March, Quality pays the $18,000 due the creditors.Illustration 3A-1

3-90

LO 8 Differentiate the cash basis of accounting from the accrual basis of accounting.

APPENDIX

3A


Illustration: Quality Contractor signs an agreement to construct a garage for $22,000. In January, Quality begins construction, incurs costs of $18,000 on credit, and by the end of January delivers a finished garage to the buyer. In February, Quality collects $22,000 cash from the customer. In March, Quality pays the $18,000 due the creditors.Illustration 3A-2

3-91


APPENDIX

3A


Conversion From Cash Basis To Accrual BasisIllustration: Dr. Diane Windsor, like many small business owners, keeps her accounting records on a cash basis. In the year 2010, Dr. Windsor received $300,000 from her patients and paid $170,000 for operating expenses, resulting in an excess of cash receipts over disbursements of $130,000 ($300,000 - $170,000). At January 1 and December 31, 2010, she has accounts receivable, unearned service revenue, accrued liabilities, and prepaid expenses as shown in Illustration 3A-5.Illustration 3A-5

3-92


APPENDIX

3A


Conversion From Cash Basis To Accrual BasisIllustration: Calculate service revenue on an accrual basis.Illustration 3A-8

Illustration 3A-5

3-93


APPENDIX

3A


Conversion From Cash Basis To Accrual BasisIllustration: Calculate operating expenses on an accrual basis.Illustration 3A-11

Illustration 3A-5

3-94


APPENDIX

3A


Conversion From Cash Basis To Accrual BasisIllustration 3A-12

3-95

LO 8

APPENDIX

3A


Theoretical Weaknesses of the Cash BasisTodays economy is considerably more lubricated by credit than by cash. The accrual basis, not the cash basis, recognizes all aspects of the credit phenomenon. Investors, creditors, and other decision makers seek timely information about an enterprises future cash flows.

3-96


APPENDIX

3B

USING REVERSING ENTRIES

Illustration of Reversing EntriesAccrualsIllustration 3B-1

3-97

LO 9 Identifying adjusting entries that may be reversed.

APPENDIX

3B


Illustration of Reversing EntriesDeferralsIllustration 3B-2

3-98


APPENDIX

3B


Summary of Reversing Entries1. All accruals should be reversed. 2. All deferrals for which a company debited or credited the original cash transaction to an expense or revenue account should be reversed. 3. Adjusting entries for depreciation and bad debts are not reversed. Recognize that reversing entries do not have to be used. Therefore, some accountants avoid them entirely.

3-99


APPENDIX

3C

USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED

A company prepares a worksheet either on

columnar paper or within an electronic spreadsheet.

A company uses the worksheet to adjust

account balances and to prepare financial statements.

3-100

LO 10 Prepare a 10-column worksheet.

APPENDIX

3C


Worksheet ColumnsA company prepares a worksheet either on

columnar paper or within an electronic spreadsheet.

3-101


APPENDIX

3C


Illustration 3C-1 Worksheet

3-102

LO 10

APPENDIX

3C


Preparing Financial Statements from a WorksheetThe Worksheet:

provides information needed for preparation of the financial statements. Sorts data into appropriate columns, which facilitates the preparation of the statements.

3-103


APPENDIX

3C

USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITEDIllustration 3-39

3-104

LO 10

APPENDIX

3C

USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITEDIllustration 3-40

3-105

LO 10

APPENDIX

3C


Illustration 3-41

3-106

LO 10

RELEVANT FACTS

International companies use the same set of procedures and records to keep track of transaction data. Thus, the material in Chapter 3 is the same under both GAAP and IFRS. Transaction analysis is the same under IFRS and GAAP but, as you will see in later chapters, different standards sometimes impact how transactions are recorded. Rules for accounting for specific events sometimes differ across countries. For example, European companies rely less on historical cost and more on fair value than U.S. companies. Despite the differences, the double-entry accounting system is the basis of accounting systems worldwide.

3-107

RELEVANT FACTS

Both the IASB and FASB go beyond the basic definitions provided in this textbook for the key elements of financial statements, that is, assets, liabilities, equity, revenues, and expenses. A trial balance under IFRS follows the same format as shown in the textbook. Internal controls are a system of checks and balances designed to prevent and detect fraud and errors. While most companies have these systems in place, many have never completely documented them nor had an independent auditor attest to their effectiveness. Both of these actions are required under SOX. Enhanced internal control standards apply only to large public companies listed on U.S. exchanges.

3-108

IFRS SELF-TEST QUESTIONInformation in a companys first IFRS statements must: a. have a cost that does not exceed the benefits. b. be transparent. c. provide a suitable starting point.

d. All the above.

3-109

IFRS SELF-TEST QUESTIONThe transition date is the date: a. when a company no longer reports under its national standards. b. when the company issues its most recent financial statement under IFRS. c. three years prior to the reporting date.

d. None of the above.

3-110

IFRS SELF-TEST QUESTIONWhen converting to IFRS, a company must: a. recast previously issued financial statements in accordance with IFRS. b. use GAAP in the reporting period but subsequently use IFRS. c. prepare at least three years of comparative statements.

d. use GAAP in the transition year but IFRS in the reporting year.

3-111


3-112


4-1


4

Income Statement and Related Information



Learning Objectives1. 2. 3. 4. 5. 6. 7. 8. Understand the uses and limitations of an income statement. Prepare a single-step income statement. Prepare a multiple-step income statement. Explain how to report irregular items. Explain intraperiod tax allocation. Identify where to report earnings per share information. Prepare a retained earnings statement. Explain how to report other comprehensive income.

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Income Statement and Related Information

Income StatementUsefulness Limitations Quality of Earnings

Format of the Income StatementElements Single-step Multiple-step Condensed income statements

Reporting Irregular ItemsDiscontinued operations Extraordinary items Unusual gains and losses Changes in accounting principles Changes in estimates Corrections of errors

Special Reporting IssuesIntraperiod tax allocation Earnings per share Retained earnings statement Comprehensive income

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Income StatementUsefulness

Evaluate past performance.

Predicting future performance.

Help assess the risk or uncertainty of achieving future cash flows.

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LO 1 Understand the uses and limitations of an income statement.

Income StatementLimitations

Companies omit items that cannot be measured reliably.

Income is affected by the accounting methods employed.

Income measurement involves judgment.

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Income StatementQuality of EarningsCompanies have incentives to manage income to meet or beat Wall Street expectations, so that

market price of stock increases and value of stock options increase.

Quality of earnings is reduced if earnings management results in information that is less useful for predicting future earnings and cash flows.

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Format of the Income StatementElements of the Income StatementRevenues Inflows or other enhancements of assets or settlements of its liabilities that constitute the entitys ongoing major or central operations. Examples of Revenue Accounts

Sales Fee revenue Interest revenue

Dividend revenue Rent revenue

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Format of the Income StatementElements of the Income StatementExpenses Outflows or other using-up of assets or incurrences of liabilities that constitute the entitys ongoing major or central operations. Examples of Expense Accounts

Cost of goods sold Depreciation expense Interest expense

Rent expense Salary expense

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Format of the Income StatementElements of the Income StatementGains Increases in equity (net assets) from peripheral or incidental transactions. Losses - Decreases in equity (net assets) from peripheral or incidental transactions. Gains and losses can result from 4-10

sale of investments or plant assets, settlement of liabilities, write-offs of assets.LO 1 Understand the uses and limitations of an income statement.

Single-Step FormatSingle-Step Income StatementRevenues Expenses Net IncomeNo distinction between Operating and Non-operating categories.Income Statement (in thousands) Revenues: Sales Interest revenue Total revenue Expenses: Cost of goods sold Selling expense Administrative expense Interest expense Income tax expense Total expenses Net income Earnings per share 149,000 10,000 43,000 21,000 24,000 247,000 $ 55,000 $ 0.75 $ 285,000 17,000 302,000

SingleStep

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LO 2 Prepare a single-step income statement.

E4-4: Prepare an income statement from the data below.

Single-Step FormatIncome Statement For the year ended Dec. 31, 2012

Administrative expense: Officers' salaries Depreciation Cost of goods sold Rental revenue Selling expense: Transportation-out Sales commissions Depreciation Sales Income tax expense Interest expense 2,690 7,980 6,480 96,500 7,580 1,860 $ 4,900 3,960 63,570 17,230

Revenues: Sales Rental revenue Total revenues Expenses: Cost of goods sold Selling expense Administrative exense Interest expense Income tax expense Total expenses Net income $ 63,570 17,150 8,860 1,860 7,580 99,020 14,710 $ 96,500 17,230 113,730

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Single-Step Format ReviewThe single-step income statement emphasizes a. the gross profit figure. b. total revenues and total expenses. c. extraordinary items more than it is emphasized in the multiple-step income statement. d. the various components of income from continuing operations.

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Format of the Income StatementMultiple-Step Income Statement

Separates operating transactions from nonoperating transactions.

Matches costs and expenses with related revenues. Highlights certain intermediate components of income that analysts use.

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LO 3 Prepare a multiple-step income statement.

Multiple-Step FormatIntermediate Components of the Income Statement1. Operating section 2. Nonoperating section 3. Income tax 4. Discontinued operations 5. Extraordinary items 6. Earnings per share

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Multiple-Step FormatThe presentation divides information into major sections.1. Operating SectionIncome Statement (in thousands) Sales Cost of goods sold Gross profit Operating expenses: Selling expenses Administrative expenses Total operating expense Income from operations Other revenue (expense): Interest revenue Interest expense Total other Income before taxes Income tax expense Net income $ 285,000 149,000 136,000 10,000 43,000 53,000 83,000 17,000 (21,000) (4,000) 79,000 24,000 55,000

2. Nonoperating Section 3. Income tax4-16

$


Illustration (E4-4): Prepare an income statement from the data below.Administrative expense: Officers' salaries Depreciation Cost of goods sold Rental revenue Selling expense: Transportation-out Sales commissions Depreciation Sales Income tax expense Interest expense 2,690 7,980 6,480 96,500 7,580 1,860 $ 4,900 3,960 63,750 17,230

Multiple-Step FormatIncome Statement For the year ended Dec. 31, 2012 Sales Cost of goods sold Gross profit Operating Expenses: Selling expense Administrative exense Total operating expenses Income from operations Other revenue (expense): Rental revenue Interest expense Total other Income before tax Income tax expense Net income $ 17,230 (1,860) 15,370 22,110 7,580 14,530 17,150 8,860 26,010 6,740 $ 96,500 63,750 32,750

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Multiple-Step Format ReviewA separation of operating and non operating activities of a company exists in a. both a multiple-step and single-step income statement. b. a multiple-step but not a single-step income statement. c. a single-step but not a multiple-step income statement. d. neither a single-step nor a multiple-step income statement.

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Reporting Irregular ItemsCompanies are required to report irregular items in the financial statements so users can determine the long-run earning power of the company. Illustration 4-5Number of Irregular Items Reported in a Recent Year by 500 Large Companies

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LO 4 Explain how to report irregular items.

Reporting Irregular ItemsIrregular items fall into six categories1. Discontinued operations. 2. Extraordinary items. 3. Unusual gains and losses. 4. Changes in accounting principle. 5. Changes in estimates. 6. Corrections of errors.

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Reporting Irregular ItemsDiscontinued OperationsOccurs when,(a) company eliminates the

results of operations and cash flows of a component.

(b) there is no significant continuing involvement in that component. Amount reported net of tax.4-21


Reporting Discontinued OperationsIllustration: KC Corporation had after tax income from continuing op

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