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©2009 The McGraw-Hill Companies, Inc.
Chapter 3
The Financial Reporting Process
©2009 The McGraw-Hill Companies, Inc.
Part A
Accrual-Basis Accounting
3-3
LO1 Revenue and Expense Reporting
Accounting information – necessary for decision making.
To be useful in decision making – accountants must report revenues and expenses in a way that reflects the ability of the company to create value for its owners.
Accrual-basis accounting records revenues when earned (the revenue recognition principle) and expenses with related revenues (the matching principle).
Accounting information – necessary for decision making.
To be useful in decision making – accountants must report revenues and expenses in a way that reflects the ability of the company to create value for its owners.
Accrual-basis accounting records revenues when earned (the revenue recognition principle) and expenses with related revenues (the matching principle).
3-4
Revenue Recognition Principle
Recognize revenue when it is earned
Calvin books a cruise with Carnival Cruise Lines, the world’s largest cruise line. He makes reservations and pays for the cruise in November 2010, but the cruise is not scheduled to sail until April 2011.
When does Carnival report revenue from the ticket sale?
Recognize revenue when it is earned
Calvin books a cruise with Carnival Cruise Lines, the world’s largest cruise line. He makes reservations and pays for the cruise in November 2010, but the cruise is not scheduled to sail until April 2011.
When does Carnival report revenue from the ticket sale?
3-5
Revenue Recognition Principle
In November 2010???
No.
Because it has not substantially fulfilled its obligation to Calvin.
In April 2011???
Yes.
Because it is in April 2011 that the cruise occurs.
In November 2010???
No.
Because it has not substantially fulfilled its obligation to Calvin.
In April 2011???
Yes.
Because it is in April 2011 that the cruise occurs.
3-6
Revenue Recognition Principle
Suppose that, anticipating the cruise, Calvin buys a Jimmy Buffet CD from Best Buy.
Rather than paying cash, Calvin uses his Best Buy card to buy the CD on account.
When does Best Buy recognize revenue?
Suppose that, anticipating the cruise, Calvin buys a Jimmy Buffet CD from Best Buy.
Rather than paying cash, Calvin uses his Best Buy card to buy the CD on account.
When does Best Buy recognize revenue?
3-7
Revenue Recognition Principle
Even though Best Buy doesn’t receive cash immediately from Calvin, it still records the revenue at the time it sells the CD.
Even though Best Buy doesn’t receive cash immediately from Calvin, it still records the revenue at the time it sells the CD.
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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
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Accrual–Basis Compared with Cash–Basis Accounting
Recognize Revenue?
Accrual- Cash-
Basis Basis
May Company provides services
to customers on account. Yes No
June Company receives cash from
customers for services provided No Yes
in May.
Recognize Revenue?
Accrual- Cash-
Basis Basis
May Company provides services
to customers on account. Yes No
June Company receives cash from
customers for services provided No Yes
in May.
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Accrual–Basis Compared with Cash–Basis Accounting
Recognize Expense?
Accrual- Cash- BasisBasis
May Company purchases
supplies on account Yes No
and uses them.
June Company pays cash No Yes
for supplies purchased
in May.
Recognize Expense?
Accrual- Cash- BasisBasis
May Company purchases
supplies on account Yes No
and uses them.
June Company pays cash No Yes
for supplies purchased
in May.
©2009 The McGraw-Hill Companies, Inc.
Part B
The Measurement Process
3-14
Closing ProcessClosing Process
LO3 Adjusting Entries
Reporting ProcessReporting Process
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Purpose of Adjusting Entries
To record events that have occurred but which have not been recorded.
To record revenues in the period earned.
To record expenses in the period they are incurred in the generation of those revenues.
To correctly state assets and liabilities in the balance sheet.
To record events that have occurred but which have not been recorded.
To record revenues in the period earned.
To record expenses in the period they are incurred in the generation of those revenues.
To correctly state assets and liabilities in the balance sheet.
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Grouping Adjusting Entries
Prepayments: Prepaid expenses – we paid cash (or had an
obligation to pay cash) for the purchase of an asset before we incurred the expense.
Unearned revenues – we received cash and recorded a liability before we earned the revenue.
Accruals: Accrued expenses – we paid cash after we incurred
the expense and recorded a liability.
Accrued revenues – we received cash after we earned the revenue and recorded an asset.
Prepayments: Prepaid expenses – we paid cash (or had an
obligation to pay cash) for the purchase of an asset before we incurred the expense.
Unearned revenues – we received cash and recorded a liability before we earned the revenue.
Accruals: Accrued expenses – we paid cash after we incurred
the expense and recorded a liability.
Accrued revenues – we received cash after we earned the revenue and recorded an asset.
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Prepaid Expenses
Costs of assets acquired in one period that will be expensed in a future period.
Examples:
Purchase of supplies, payment of rent in advance, payment of insurance in advance.
Adjusting Entry:
Debit expense account
Credit asset account
Costs of assets acquired in one period that will be expensed in a future period.
Examples:
Purchase of supplies, payment of rent in advance, payment of insurance in advance.
Adjusting Entry:
Debit expense account
Credit asset account
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Example: Prepaid Rent
Prepaid rent expires
$500
Adjustingentry
$5,500Remaining
prepaid rentJan. 31
$6,000 Cash paid for prepaid rent
Jan. 1
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Example: Prepaid Rent
3-20
Unearned Revenues
Company receives cash in advance from a customer for products or services to be provided in the future.
Adjusting entry:
Debit liability account
Credit revenue account
Company receives cash in advance from a customer for products or services to be provided in the future.
Adjusting entry:
Debit liability account
Credit revenue account
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Example: Unearned Training Revenue
Adjustingentry
$540Unearned revenue remainsJan. 31
$600Cash
received in advanceJan. 26
Services provided
$60
3-22
Example: Prepaid Rent
3-23
Accrued Expenses
When a company has incurred an expense but hasn’t yet paid cash or recorded an obligation to pay, it still should record the expense.
Examples:
Accrued salaries, accrued interest, accrued utility costs.
Adjusting entry:
Debit expense account
Credit liability account
When a company has incurred an expense but hasn’t yet paid cash or recorded an obligation to pay, it still should record the expense.
Examples:
Accrued salaries, accrued interest, accrued utility costs.
Adjusting entry:
Debit expense account
Credit liability account
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Example: Accrued Utility Costs
At the end of January, Woods receives a utility bill for $960 associated with operations in January.
Woods plans to pay the bill on February 6.
Even though it won’t pay the cash until February, Woods must record the utility costs for January as an expense in January.
At the end of January, Woods receives a utility bill for $960 associated with operations in January.
Woods plans to pay the bill on February 6.
Even though it won’t pay the cash until February, Woods must record the utility costs for January as an expense in January.
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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
3-27
Accrued Revenues
When a company has earned revenue but hasn’t yet received cash or recorded an amount receivable, it still should record the revenue. This is referred to as an accrued revenue.
Examples:
Interest receivable, accounts receivable
Adjusting entry:
Debit asset account
Credit revenue account
When a company has earned revenue but hasn’t yet received cash or recorded an amount receivable, it still should record the revenue. This is referred to as an accrued revenue.
Examples:
Interest receivable, accounts receivable
Adjusting entry:
Debit asset account
Credit revenue account
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Example: Accounts Receivable
Suppose, Woods provides $200 of golf training to customers from January 28 to January 31.
However, it usually takes Woods one week to mail bills to customers and another week for customers to pay. Therefore, Woods expects to receive cash from these customers during February 8-14.
Irrespective of when cash will be received, the revenue should be recognized in January.
Suppose, Woods provides $200 of golf training to customers from January 28 to January 31.
However, it usually takes Woods one week to mail bills to customers and another week for customers to pay. Therefore, Woods expects to receive cash from these customers during February 8-14.
Irrespective of when cash will be received, the revenue should be recognized in January.
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Example: Accounts Receivable
Adjustingentry
$200Owed from customers
Jan. 31
$200Cash received
from customersFeb. 8-14
Revenues earned$200
Jan. 28
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Example: Accounts Receivable
3-31
LO4 Post Adjusting Entries
Post adjusting entries to the T-accounts in the general ledger to update the account balances.
Prepare an adjusted trial balance.
An adjusted trial balance is a list of all accounts and their balances after we have updated account balances for adjusting entries.
Post adjusting entries to the T-accounts in the general ledger to update the account balances.
Prepare an adjusted trial balance.
An adjusted trial balance is a list of all accounts and their balances after we have updated account balances for adjusting entries.
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Trial Balance and Adjusted Trial Balance of Woods Golf Academy
©2009 The McGraw-Hill Companies, Inc.
Part C
The Reporting Process
3-34
LO5 Financial Statements
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Income Statement
Woods Golf Academy Income Statement
For the month ended January 31
Revenues:Training revenue $6,360
Expenses:Salaries expense $3,100
Rent expense 500
Supplies expense 800
Depreciation expense 400
Interest expense 100
Utilities expense 960
Total expenses 5,860
Net income $ 500
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Statement of Stockholders’ Equity
3-37
Classified Balance Sheet
Woods Golf AcademyClassified Balance Sheet
January 31Assets Liabilities
Current assets: Current liabilities:Cash $ 6,200 Accounts payable $ 2,300Accounts receivable 2,700 Unearned
revenue540
Supplies 1,500 Salaries payable 300Prepaid rent 5,500 Utilities payable 960
Total current assets 15,900 Interest payable 100Total current liabilities 4,200
Long-term assets:Equipment 24,000 Long-term liabilities:Accum. depr., equip.
(400) Notes payable 10,000
Total liabilities $ 14,200Total long-term assets 23,600
Stockholders’ EquityCommon stock 25,000Retained earnings 300
Total stockholders’ equity
$ 25,300
Total liabilities and stockholders’ equity
$ 39,500
Total assets $ 39,500
Total assets equal current plus long-term assets.Total liabilities equal current plus long-term liabilities.Total stockholders’ equity includes common stock and retained earnings from the statement of stockholders’ equity.Total assets must equal total liabilities plus stockholders’ equity.
Total assets equal current plus long-term assets.Total liabilities equal current plus long-term liabilities.Total stockholders’ equity includes common stock and retained earnings from the statement of stockholders’ equity.Total assets must equal total liabilities plus stockholders’ equity.
©2009 The McGraw-Hill Companies, Inc.
Part D
The Closing Process
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LO6 Closing Entries
Transfer the balance of all revenue, expense, and dividend accounts to the balance of retained earnings.
Increase the retained earnings account by the amount of revenues and decrease retained earnings by the amount of expenses and dividends.
The balance of each revenue, expense, and dividend account equals zero after closing entries.
Do not affect the balances of permanent accounts other than retained earnings.
Transfer the balance of all revenue, expense, and dividend accounts to the balance of retained earnings.
Increase the retained earnings account by the amount of revenues and decrease retained earnings by the amount of expenses and dividends.
The balance of each revenue, expense, and dividend account equals zero after closing entries.
Do not affect the balances of permanent accounts other than retained earnings.
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Closing Entries for Woods Golf Academy
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Close to Retained Earnings
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LO7 Post Closing Entries and Prepare Post–Closing Trial Balance
©2009 The McGraw-Hill Companies, Inc.
End of Chapter 3