Review of a Company’s

Accounting System

Chapter 3

COPYRIGHT © 2010 South-Western/Cengage Learning

Intermediate AccountingIntermediate Accounting 11th edition 11th edition

Nikolai Bazley JonesNikolai Bazley Jones

An electronic presentationAn electronic presentationBy Norman SundermanBy Norman Sundermanand Kenneth Buchananand Kenneth BuchananAngelo State University

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1. Understand the components of an accounting system.

2. Know the major steps in the accounting cycle.

3. Prepare journal entries in the general journal.

4. Post to the general ledger and prepare a trial balance.

5. Prepare adjusting entries.

6. Prepare financial statements.

Objectives

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Objectives

7. Prepare closing entries.

8. Complete a worksheet (spreadsheet).

9. Prepare reversing entries

10. Use subsidiary ledgers.

11. Understand special journals.

12. Convert cash-basis financial statements to accrual-basis (Appendix).

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Accounting Equation

AssetsAssets = +LiabilitiesLiabilities Stockholder’s Equity

Stockholder’s Equity

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Assets

Accounting Equation

Assets are the corporation’s economic resources and have future value.

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= LiabilitiesDebts

Accounting Equation

Liabilities are obligations or debts. A liability is a present

obligation for a future sacrifice as a result of a past transaction.

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+ Stockholders’ Equity+ Stockholders’ Equity

Net Worth

Accounting Equation

Stockholders’ equity is the

residual interest in assets or net worth,

which is assets minus liabilities.

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Assets = Liabilities + Stockholders’ Equity

Stockholders’ Equity = Contributed Capital + Retained Earnings

Retained Earnings = Beginning Retained Earnings + Net Income – Dividends

Net Income = Revenues – Expenses

Interrelated Accounting Equations

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Revenues

Revenues are charges to customers for goods or services provided.

Revenues are charges to customers for goods or services provided.

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Expenses

Expenses are assets that have expired, been

consumed, or become cost of goods sold and have no

future value.

Expenses are assets that have expired, been

consumed, or become cost of goods sold and have no

future value.

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Title

Account titleAccount title

Accounts

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Title

Debit

“Debit” refers to the left side.

“Debit” refers to the left side.

Accounts

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Title

Debit Credit

Credit refers to the right side.

Credit refers to the right side.

Accounts

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In the double-entry system, for each transaction that a company records, the total dollar amount of the debits entered in all the related accounts must equal the total

dollar amount of the credits.

In the double-entry system, for each transaction that a company records, the total dollar amount of the debits entered in all the related accounts must equal the total

dollar amount of the credits.

Accounts

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Permanent (Real) Accounts

Assets = Liabilities + Stockholders’ Equity

Asset Accounts (debit) (credit) Increase Decrease

Liability Accounts (debit) (credit) Decrease Increase

Capital Stock Accounts (debit) (credit) Decrease Increase

Retained Earnings (debit) (credit) Decrease Increase

Accounts

The debits must equal the creditsThe debits must equal the credits

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Temporary (Nominal) Accounts

Revenue Accounts (debit) (credit) Decrease Increase

Expense Accounts (debit) (credit) Increase Decrease

Retained Earnings (debit) (credit) Decrease Increase

Dividend Accounts (debit) (credit) Increase Decrease

Accounts

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1. Income Statement—Summarizes the results of a company’s income-producing activities for the accounting period.

2. Balance Sheet—Summarizes the amounts of a company’s assets, liabilities, and stockholders’ equity at the end of the accounting period.

3. Statement of Cash Flows—Summarizes a company’s cash receipts and cash payments during the accounting period.

Financial Statements

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1. Record the daily transactions in a journal

2. Post the journal entries to the accounts in the ledger

3. Prepare and post adjusting entries

4. Prepare the financial statements

5. Prepare and post closing entries for revenue, expense, and dividend accounts

The Accounting Cycle

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Comprehensive Comprehensive Illustration for Dapple Illustration for Dapple

CorporationCorporation

Comprehensive Comprehensive Illustration for Dapple Illustration for Dapple

CorporationCorporation

Step 1: Journalizing: Step 1: Journalizing: Recording in the Recording in the General JournalGeneral Journal

Step 1: Journalizing: Step 1: Journalizing: Recording in the Recording in the General JournalGeneral Journal

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GENERAL JOURNAL

On January 1, 2010, various stockholders On January 1, 2010, various stockholders invest in Dapple by purchasing 2,000 invest in Dapple by purchasing 2,000

shares of no-par stock at $10 per share.shares of no-par stock at $10 per share.

On January 1, 2010, various stockholders On January 1, 2010, various stockholders invest in Dapple by purchasing 2,000 invest in Dapple by purchasing 2,000

shares of no-par stock at $10 per share.shares of no-par stock at $10 per share.

Date Account Titles and Explanations Debit Credit2010Jan. 1 Cash 20,000

Capital Stock 20,000Issued 2,000 shares of no-par stock at $10 per share.

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GENERAL JOURNAL Date Account Titles and Explanations Debit Credit

2010Jan. 1 Cash 20,000

Capital Stock 20,000Issued 2,000 shares of no-par stockat $10 per share.

On January 16, Dapple purchases On January 16, Dapple purchases two acres of land as a building two acres of land as a building

site, paying $1,500 an acre.site, paying $1,500 an acre.

On January 16, Dapple purchases On January 16, Dapple purchases two acres of land as a building two acres of land as a building

site, paying $1,500 an acre.site, paying $1,500 an acre.

16 Land 3,000Cash 3,000

Purchased 2 acres of land at $1,500 per acre.

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Comprehensive Comprehensive Illustration for Dapple Illustration for Dapple

CorporationCorporation

Comprehensive Comprehensive Illustration for Dapple Illustration for Dapple

CorporationCorporation

Step 2: Posting to Step 2: Posting to the Ledgerthe Ledger

Step 2: Posting to Step 2: Posting to the Ledgerthe Ledger

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GENERAL JOURNAL Date Account Titles and Explanations Debit Credit

2010Jan. 1 Cash 20,000

Capital Stock 20,000Issued 2,000 shares of no-par stock at $10 per share.

16 Land 3,000Cash 3,000

Purchased 2 acres of land at $1,500 per acre.

Cash 1/1 20,000 Capital Stock

1/1 20,000

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GENERAL JOURNAL Date Account Titles and Explanations Debit Credit

2010Jan. 1 Cash 20,000

Capital Stock 20,000Issued 2,000 shares of no-par stock at $10 per share.

16 Land 3,000Cash 3,000

Purchased 2 acres of land at $1,500 per acre.

Cash 1/1 20,000 1/16 3,000

Land1/16 3,000

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After posting, the general ledger accounts contain the same information as in the general journal, just in a

different format.

After posting, the general ledger accounts contain the same information as in the general journal, just in a

different format.

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Cash1/1 20,000 1/16 3,0004/2 8,000 3/30 10,84012/1 450 3/30 36012/2 2,000 4/8 7,300

7/15 3,30010/1 1,80012/28 42812/29 500

Balance 2,922

Ledger T Account

The balance of each permanent account is

calculated.

Determine the account balance.

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After the journal entries are posted for the accounting period, a trial balance is

often prepared.

After the journal entries are posted for the accounting period, a trial balance is

often prepared.

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The trial balance is used to verify that the total of the

debit balances is equal to the total of the credit balances.

The trial balance is used to verify that the total of the

debit balances is equal to the total of the credit balances.

DebitsDebits

CreditsCredits

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Comprehensive Comprehensive Illustration for Dapple Illustration for Dapple

CorporationCorporation

Comprehensive Comprehensive Illustration for Dapple Illustration for Dapple

CorporationCorporation

Step 3: Preparation Step 3: Preparation of Adjusting Entriesof Adjusting EntriesStep 3: Preparation Step 3: Preparation of Adjusting Entriesof Adjusting Entries

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Adjusting Entries

1. The purpose of adjusting entries is to record revenues and expenses in the correct period

2. Dated the last day of the accounting period

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On March 30, Dapple Corporation purchased a one-On March 30, Dapple Corporation purchased a one-year comprehensive insurance policy.year comprehensive insurance policy.

On March 30, Dapple Corporation purchased a one-On March 30, Dapple Corporation purchased a one-year comprehensive insurance policy.year comprehensive insurance policy.

Prepaid Expense

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GENERAL JOURNAL Date Account Titles and Explanations Debit Credit

2010Jan. 1 Cash 20,000

Capital Stock 20,000Issued 2,000 shares of no-par stock at $10 per share.

Mar. 30 Prepaid Insurance 360Cash 360

Purchased a 1-year comprehensive insurance policy.

On March 30, Dapple Corporation purchased a one-On March 30, Dapple Corporation purchased a one-year comprehensive insurance policy.year comprehensive insurance policy.

On March 30, Dapple Corporation purchased a one-On March 30, Dapple Corporation purchased a one-year comprehensive insurance policy.year comprehensive insurance policy.

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GENERAL JOURNAL Date Account Titles and Explanations Debit Credit

Adjusting EntriesDec. 31 Insurance Expense 270

Prepaid Insurance 270To record expiration of 9 months of insurance coverage purchased on March 30.

By December 31, nine months of the By December 31, nine months of the policy had expired.policy had expired.

By December 31, nine months of the By December 31, nine months of the policy had expired.policy had expired.

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3/30 360

Prepaid Insurance

12/31 Adj. 270

12/31 Adj. 270

Insurance Expense

By December 31, nine months of the By December 31, nine months of the policy had expired.policy had expired.

By December 31, nine months of the By December 31, nine months of the policy had expired.policy had expired.

Balance 90

Adjusting Entries

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On December 1, Dapple Corporation received On December 1, Dapple Corporation received $450 for three months’ rent in advance.$450 for three months’ rent in advance.

On December 1, Dapple Corporation received On December 1, Dapple Corporation received $450 for three months’ rent in advance.$450 for three months’ rent in advance.

Deferred Revenue

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GENERAL JOURNAL Date Account Titles and Explanations Debit Credit

2010Jan. 1 Cash 20,000

Capital Stock 20,000Issued 2,000 shares of no-par stock at $10 per share.

Dec. 1 Cash 450Unearned Rent 450

Received 3 months’ rent in advance at $150 per month. Company owes use of portion of building to Fritz Company for the 3-month period.

On December 1, Dapple Corporation received $450 for three months’ rent in advance.

On December 1, Dapple Corporation received $450 for three months’ rent in advance.

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GENERAL JOURNAL Date Account Titles and Explanations Debit Credit

Adjusting EntriesDec. 31 Insurance Expense 270

Prepaid Insurance 270To record expiration of 9 months of insurance coverage purchased onMarch 30.

31 Unearned Rent 150Rent Revenue 150

To record earning of 1 month of rent revenue from receipt collected in

advance on December 1.

By December 31, one month’s rent ($450 ÷ 3 = $150) has been earned.

By December 31, one month’s rent ($450 ÷ 3 = $150) has been earned.

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12/31 Adj. 150

Unearned Rent

12/1 450

12/31 Adj. 150

Rent Revenue

This entry is posted to the ledger. This entry is posted to the ledger.

Balance 300

Adjusting Entries

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On December 31, Dapple Corporation has accrued salaries of $900.

On December 31, Dapple Corporation has accrued salaries of $900.

Entries must be journalized before they are posted.

Entries must be journalized before they are posted.

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10/1 1,800

Salaries Expense

12/31 Adj. 900

Salaries Payable

Next, the adjusting entry is posted. Next, the adjusting entry is posted.

12/31 Adj. 900

Adjusting Entries

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On September 1, Dapple Corporation accepted a $1,320, 15% note as payment

when it sold an acre of land.

On September 1, Dapple Corporation accepted a $1,320, 15% note as payment

when it sold an acre of land.

Accrual of Interest Revenue

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GENERAL JOURNAL Date Account Titles and Explanations Debit Credit

Adjusting Entries

Sept. 1 Notes Receivable 1,320Loss on Sale of Land 180

Land 1,500Sold 1 acre of land at less than itscost, incurring a loss. Buyer issueda note due in 6 months and bearing15% annual interest.

On September 1, Dapple Corporation accepted a $1,320, 15% note as payment

when it sold an acre of land.

On September 1, Dapple Corporation accepted a $1,320, 15% note as payment

when it sold an acre of land.

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Interest Receivable

12/31 Adj. 66

Interest Revenue

12/31 Adj. 66

By December 31, the company has earned 4 months of interest totaling $66 ($1,320 × 0.15 × 4/12).

By December 31, the company has earned 4 months of interest totaling $66 ($1,320 × 0.15 × 4/12).

Adjusting Entries

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Remaining Adjusting Entries

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GENERAL JOURNAL Date Account Titles and Explanations Debit Credit

2010Jan. 1 Cash 20,000

Capital Stock 20,000Issued 2,000 shares of no-par stockat $10 per share.

Dec. 1 Cash 450Rent Revenue 450

31 Rent Revenue 300Unearned Rent 300

Adjusting entry using alternative method of recording deferred revenue.

Some companies may record the receipt of revenue in advance as revenues instead of

unearned revenues.

Some companies may record the receipt of revenue in advance as revenues instead of

unearned revenues.

At Dec. 31, some of the revenue has still not been earned and an adjusting entry must be made.

At Dec. 31, some of the revenue has still not been earned and an adjusting entry must be made.

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GENERAL JOURNAL Date Account Titles and Explanations Debit Credit

2010Jan. 1 Cash 20,000

Capital Stock 20,000Issued 2,000 shares of no-par stockat $10 per share.

Mar. 30 Insurance Expense 360Cash 360

Purchased a 1-year comprehensiveinsurance policy.

Dec. 31 Prepaid Insurance 90Insurance Expense 90

Prepaid expenses may be recorded as expenses and the unused portion adjusted at year end.

Prepaid expenses may be recorded as expenses and the unused portion adjusted at year end.

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Comprehensive Comprehensive Illustration for Dapple Illustration for Dapple

CorporationCorporation

Comprehensive Comprehensive Illustration for Dapple Illustration for Dapple

CorporationCorporation

Step 4: Preparation Step 4: Preparation of the Financial of the Financial

StatementsStatements

Step 4: Preparation Step 4: Preparation of the Financial of the Financial

StatementsStatements

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1. If necessary, recompute the balance of each account in the ledger.

2. Prepare an adjusted trial balance to verify that debits equal credits.

3. Prepare an income statement.

4. Prepare a statement of retained earnings.

5. Prepare a balance sheet.

Preparation of the Financial Statements

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Income Statement

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Retained Earnings Statement

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Balance Sheet

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Comprehensive Comprehensive Illustration for Dapple Illustration for Dapple

CorporationCorporation

Comprehensive Comprehensive Illustration for Dapple Illustration for Dapple

CorporationCorporation

Step 5: Preparation Step 5: Preparation of Closing Entriesof Closing Entries

Step 5: Preparation Step 5: Preparation of Closing Entriesof Closing Entries

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Closing entries (1) reduce the balance in each

temporary account to zero, and...

Closing entries (1) reduce the balance in each

temporary account to zero, and...

…(2) update the retained earnings and inventory

accounts.

…(2) update the retained earnings and inventory

accounts.

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1. Close temporary accounts with credit balances to Income Summary and record the ending inventory.

2. Close temporary accounts with debit balances to Income Summary and close the beginning inventory.

3. Close Income Summary to Retained Earnings.

4. Close Dividends Distributed to Retained Earnings.

Typical Order of Closing Entries

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The following slide shows how the closing entries “closed” the

temporary accounts.

The following slide shows how the closing entries “closed” the

temporary accounts.

Closing Entries

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Closing Entries

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Sales Returns

Sales Returns and Allowances 500Accounts Receivable

500

OR debit Sales directly

Sales 500Accounts Receivable

500

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Periodic Inventory SystemInventory, January 1, 2010 $ 0

Purchases 12,600

Purchases returns and allowances (300)

Purchases discounts (100)

Cost of goods available for sale $12,200

Less: Inventory, December 31, 2010 (2,140)

Cost of goods sold $10,060

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A worksheet is prepared to facilitate preparing adjusting

entries, closing entries, and the financial statements.

A worksheet is prepared to facilitate preparing adjusting

entries, closing entries, and the financial statements.

Worksheet

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1. Adjusting entries that create accrued revenues or expenses to be collected or paid in the next accounting period

2. Adjusting entries related to prepayments of costs initially recorded as expenses or receipts-in-advance initially recorded as revenues

Reversing entries should be made for any adjusting entry that creates a new balance sheet account as follows:

General Guidelines for Reversing Entries

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1. Adjusting entries related to prepayments of costs initially recorded as assets or receipts-in-advance initially recorded as liabilities

2. Adjusting entries related to estimated items such as depreciation or bad debts

Reversing entries should not be made for:

REVERSING ENTRY

General Guidelines for Reversing Entries

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Reversing Accrued Revenues

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Reversing Accrued Expenses

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Why use a subsidiary ledger?1. To reduce the size of the general ledger

2. To minimize errors

3. To divide the accounting task

4. To keep up-to-date records of its credit customers and suppliers

Subsidiary Ledgers

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Subsidiary Ledgers

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Sales Journal. Used to record all (and only) sales of merchandise on credit.

Purchases Journal. Used to record all (and only) purchases of merchandise on credit.

Cash Receipts Journal. Used to record all cash receipts.

Cash Payments Journal. Used to record all cash payments.

General Journal. Used to record adjusting, closing, and reversing entries and other transactions not recorded in the special journals.

Special Journals

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Cash-basis accounting is used by small retail stores and professionals such as

dentists, doctors, and architects.

Cash-basis accounting is used by small retail stores and professionals such as

dentists, doctors, and architects.

Appendix: Cash-Basis Accounting

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Under cash-basis accounting, a company records revenues when cash

is collected and records expenses when cash is paid.

Under cash-basis accounting, a company records revenues when cash

is collected and records expenses when cash is paid.

Appendix: Cash-Basis Accounting

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Cash Basis

Collections from

customers

+ Ending accounts receivable– Beginning accounts receivable

= Sales revenue

Adjustments Accrual Basis

Payments to suppliers

= Cost of goods sold

+ Beginning inventory– Ending inventory+ Ending accounts payable– Beginning accounts payable

Payments for other

operating costs

= Operating expenses (except

depreciation)

+ Beginning prepaid expenses– Ending prepaid expenses+ Ending accrued expenses– Beginning accrued expenses

Appendix: Cash-Basis Accounting

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Chapter 3

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