Chapter 03

The Financial Reporting Process

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Part A

Accrual-Basis Accounting

3-2

3-3

LO1 Revenue and Expense Reporting

o Accounting information – necessary for decision making.

o 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.

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

o Accounting information – necessary for decision making.

o 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.

o 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

o Calvin books a cruise with Carnival Cruise Lines, the world’s largest cruise line. He makes reservations and pays for the cruise in November 2012, but the cruise is not scheduled to sail until April 2013.

o When does Carnival report revenue from the ticket sale?

Recognize revenue when it is earned

o Calvin books a cruise with Carnival Cruise Lines, the world’s largest cruise line. He makes reservations and pays for the cruise in November 2012, but the cruise is not scheduled to sail until April 2013.

o When does Carnival report revenue from the ticket sale?

3-5

Revenue Recognition Principle

1. In November 2012???

No.

Because it has not substantially fulfilled its obligation to Calvin.

2. In April 2013???

Yes.

Because it is in April 2013 that the cruise occurs.

1. In November 2012???

No.

Because it has not substantially fulfilled its obligation to Calvin.

2. In April 2013???

Yes.

Because it is in April 2013 that the cruise occurs.

3-63-6

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?

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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.

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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

3-11

Accrual–Basis Compared with Cash–Basis Accounting

Company receives cash fromRuby and Calvin for Hawaiiancruise next April.

Company provides cruiseservices to Ruby and Calvin.

November 2012

April 2013

Recognize Revenue?

No

Yes No

Yes

Accrual-basis Cash-basis

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Accrual–Basis Compared with Cash–Basis Accounting

March 2013 Company pays cash for supplies tobe used next month.

April 2013 Company uses supplies purchasedlast month.Company pays cash for fuel usedduring the cruise this month.Employees earn salaries but willnot be paid until next month.

May 2013 Company pays cash to employeefor salaries earned last month.

No Yes

No

YesYes

Yes

Yes No

Yes

Cash-basis

Recognize Expense?

No

Accrual-basis

Part B

The Measurement Process

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Closing ProcessClosing Process

LO3 Adjusting Entries

Reporting ProcessReporting Process

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Purpose of Adjusting Entries

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

o To record revenues in the period earned.

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

o To correctly state assets and liabilities in the balance sheet.

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

o To record revenues in the period earned.

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

o To correctly state assets and liabilities in the balance sheet.

3-163-16

Grouping Adjusting Entries

Prepayments:

o Prepaid expenses – we paid cash (or had an obligation to pay cash) for the purchase of an asset before we incurred the expense.

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

Accruals:

o Accrued expenses – we paid cash after we incurred the expense and recorded a liability.

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

Prepayments:

o Prepaid expenses – we paid cash (or had an obligation to pay cash) for the purchase of an asset before we incurred the expense.

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

Accruals:

o Accrued expenses – we paid cash after we incurred the expense and recorded a liability.

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

3-173-17

Prepaid Expenses

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

o Examples: Purchase of equipment or supplies, payment of rent in advance, payment of insurance in advance.

Adjusting Entry:

Debit expense account (increase an expense)

Credit asset account (decrease an asset)

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

o Examples: Purchase of equipment or supplies, payment of rent in advance, payment of insurance in advance.

Adjusting Entry:

Debit expense account (increase an expense)

Credit asset account (decrease an asset)

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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

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Example: Prepaid Rent

January 31

Assets = Liabilities +Common

Stock +Retained Earnings Revenues − Expenses =

Net Income

= -500 = -500

Rent Expense (+E, -SE ). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid Rent (-A ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Record prepaid rent due to the passage of time)

Balance Sheet Income StatementStockholders’ Equity

-500 +500

CreditDebit500

500

3-203-20

Unearned Revenues

o Once a company has provided products or services, they can record revenue earned and reduce the obligation to the customer. The adjusting entry for an unearned revenue always includes a debit to a liability account (decrease a liability) and a credit to a revenue account (increase a revenue).

Adjusting entry:

Debit liability account (decrease a liability)

Credit revenue account (increase a revenue)

o Once a company has provided products or services, they can record revenue earned and reduce the obligation to the customer. The adjusting entry for an unearned revenue always includes a debit to a liability account (decrease a liability) and a credit to a revenue account (increase a revenue).

Adjusting entry:

Debit liability account (decrease a liability)

Credit revenue account (increase a revenue)

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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: Unearned Training Revenue

January 31 Debit Credit60

60

Assets = Liabilities +Common

Stock +Retained Earnings Revenues − Expenses =

Net Income

= -60 +60 +60 = +60

Balance Sheet Income StatementStockholders’ Equity

Unearned Revenue (-L ). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Service Revenue (+R, +SE ) . . . . . . . . . . . . . . . . . . . . . . (Provide services to customers who paid in advance )

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Accrued Expenses

o 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.

o Examples: Accrued salaries, accrued interest, accrued utility costs.

Adjusting entry:

Debit expense account (increase an expense)

Credit liability account (increase a liability)

o 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.

o Examples: Accrued salaries, accrued interest, accrued utility costs.

Adjusting entry:

Debit expense account (increase an expense)

Credit liability account (increase a liability)

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Example: Accrued Utility Costs

o At the end of January, Eagle receives a utility bill for $960 associated with operations in January. Eagle plans to pay the bill on February 6.

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

o At the end of January, Eagle receives a utility bill for $960 associated with operations in January. Eagle plans to pay the bill on February 6.

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

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Example: Accrued Utility Costs

Adjustingentry

$960Utilities owed

Jan. 31

$960Cash paid for utilities

Feb. 6

Utilities used$960

Jan. 1

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Example: Accrued Utility Costs

January 31 Debit Credit960

960

Assets = Liabilities +Common

Stock +Retained Earnings Revenues − Expenses =

Net Income

= +960 -960 = -960

Utilities Expense (+E, -SE ). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Utilities Payable(+L ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Owe for utilities costs in the current period )

Balance Sheet Income StatementStockholders’ Equity

+960

3-273-27

Accrued Revenues

o 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.

o Examples: Interest receivable, accounts receivable

Adjusting entry:

Debit asset account (increase an asset)

Credit revenue account (increase a revenue)

o 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.

o Examples: Interest receivable, accounts receivable

Adjusting entry:

Debit asset account (increase an asset)

Credit revenue account (increase a revenue)

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Example: Accounts Receivable

o Suppose, Eagle provides $200 of golf training to customers from January 28 to January 31. However, it usually takes Eagle one week to mail bills to customers and another week for customers to pay. Therefore, Eagle expects to receive cash from these customers during February 8-14.

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

o Suppose, Eagle provides $200 of golf training to customers from January 28 to January 31. However, it usually takes Eagle one week to mail bills to customers and another week for customers to pay. Therefore, Eagle expects to receive cash from these customers during February 8-14.

o 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

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Example: Accounts Receivable

January 31 Debit Credit200

200

Assets = Liabilities +Common

Stock +Retained Earnings Revenues − Expenses =

Net Income

= +200 +200 = +200+200

Balance Sheet Income StatementStockholders’ Equity

Accounts Receivable (+A ). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Service Revenue (+R, +SE ) . . . . . . . . . . . . . . . . . . (Bill customers for services provided during the

current period )

3-313-31

LO4 Post Adjusting Entries

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

o Prepare an adjusted trial balance.

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

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

o Prepare an adjusted trial balance.

o 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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Unadjusted Trial Balance and Adjusted Trial Balance of Eagle Golf Academy

Debit Credit Debit Credit Debit CreditCash $6,200 $6,200 Accounts receivable 2,500 (h) 200 2,700Supplies 2,300 (b) 800 1,500Prepaid rent 6,000 (a) 500 5,500Equipment 24,000 24,000Accum. depr., equip (c) 400 $400 Accounts payable 2,300 2,300Unearned revenue 600 (d) 60 540Salaries payable (e) 300 300Utilities payable (f) 960 960Interest payable (g) 100 100Notes payable 10,000 10,000Common stock 25,000 25,000Retained earnings 0 0Dividends 200 200Service revenue 6,100 6,360Supplies expense (b) 800 800Rent expense (a) 500 500Depreciation expense (c) 400 400Salaries expense 2,800 (e) 300 3,100Utilities expense (f) 960 960Interest expense (g) 100 100

Totals $44,000 $44,000 $45,960 $45,960

AccountsUnadjusted

Trial Balance Adjustments

EAGLE GOLF ACADEMYUnadjusted Trial Balance and Adjusted Trial Balance

January 31

(d and h) 260

AdjustedTrial Balance

Part C

The Reporting Process

3-343-34

LO5 Financial Statements

Accounts Debit CreditCash $6,200 Accounts receivable 2,700Supplies 1,500Prepaid rent 5,500 BALANCE

Equipment 24,000 SHEET

Accumulated Depreciation $400 AssetsAccounts payable 2,300 =

Unearned revenue 540 LiabilitiesSalaries payable 300 +

Interest payable 100 Stockholders’ Equity

Utilities payable 960

Notes Payable 10,000STATEMENT OF Common stock 25,000

STOCKHOLDERS’ Retained earnings 0EQUITY Dividends 200

Common Stock Service revenue 6,360+ Supplies expense 800 INCOME

Retained Earnings Rent expense 500 STATEMENT

(= RE, Jan. 1 + NI – Div) Depreciation expense 400 Revenues

= Salaries expense 3,100 −

Stockholders’ Equity Utilities expense 960 Expenses

Interest expense 100 =

Totals $45,960 $45,960 Net Income

EAGLE GOLF ACADEMYAdjusted Trial Balance

January 31

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Income Statement

Revenues:Service 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 5,860Net income $500

EAGLE GOLF ACADEMYIncome Statement

For the month ended January 31

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Statement of Stockholders’ Equity

TotalCommon Retained Stockholders

’Stock Earnings Equity

Balance at January 1 -0- -0- -0-Issuance of common stock $25,000 $25,000 Add: Net income for January $500 500Less: Dividends (200) (200)Balance at January 31 $25,000 $300 $25,300

EAGLE GOLF ACADEMYStatement of Stockholders’ EquityFor the month ended January 31

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Classified Balance SheetSheetJanuary 31

EAGLE GOLF ACADEMYClassified Balance

Assets Liabilities Current assets: Current liabilities:

Cash

$ 6,20

0

Accounts payable

$ 2,300

Accounts receivable2,70

0 Unearned revenue 540

Supplies1,50

0Salaries payable

300

Prepaid rent5,50

0

Utilities payable

960

Total current assets 15,900

Interest payable 100 Total current liabilities 4,200

Long-term assets:

Equipment24,0

00 Long-term liabilities:

Accum. depr., equip. (400) Notes payable 10,000

Total long-term assets23,6

00 Total liabilities 14,200 Stockholders’ Equity

Common stock 25,000 Retained earnings 300

Total stockholders’ equity $ 25,300

Total liabilities and stockholders’ equity $ 39,500 Total assets

$ 39,5

00

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.

Part D

The Closing Process

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LO6 Closing Entries

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

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

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

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

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

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

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

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

3-403-40

Close to Retained Earnings

0 Beginning balance6,360 Total revenues

Total expenses 5,860 Total dividends 200

300 Ending balance

Retained Earnings

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LO7 Post Closing Entries and Prepare Post–Closing Trial Balance

Accounts Debit CreditCash $6,200 Accounts receivable 2,700 Supplies 1,500 Prepaid rent 5,500 Equipment 24,000 Accumulated Depreciation $400 Accounts payable 2,300 Unearned revenue 540 Salaries Payable 300 Interest Payable 100 Utilities Payable 960 Notes Payable 10,000 Common stock 25,000 Retained earnings 300

Totals $39,900 $39,900

EAGLE GOLF ACADEMYPost-Closing Trial Balance

January 31

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End of Chapter 03