1. Copyright © 2015 McGraw-Hill Education. All rights reserved. Chapter 2 Review of the Accounting Process

2. Learning Objectives 1Analyze routine economic events—transactions—and record their effects on a company’s financial position using the accounting equation format. 2Record transactions using the general journal format. 3Post the effects of journal entries to general ledger accounts and prepare an unadjusted trial balance. 4Identify and describe the different types of adjusting journal entries. 5Record adjusting journal entries in general journal format, post entries, and prepare an adjusted trial balance. 6Describe the basic financial statements. 7Explain the closing process. 8Convert from cash basis net income to accrual basis net income. (NOT COVERED!!)

3. The Accounting Cycle Start Analyze transactions Journalize Post Prepare unadjusted trial balance Adjusting Entries Prepare adjusted trial balance Prepare statements Closing Entries Prepare post-closing trial balance C3 3-3 POST

4. Unadjusted Trial Balance LO2- 3

5. The Adjustment Process Accounts are adjusted at the end of a period to record internal transactions and events that are not yet recorded. Two basic principles for recognizing Revenues and Expenses: 1. The revenue recognition principle requires revenue be recorded when earned, not before and not after. 2. The matching principle requires expenses be recorded in the same period as the revenues earned as a result of these expenses.

6. Accrual Basis versus Cash Basis Accrual basis accounting —uses the adjusting process to recognize revenue when earned and to match expenses with revenues. This means the economic effects of revenues and expenses are recorded when earned or incurred, not when cash is received or paid. Accrual basis is consistent with GAAP. Cash basis accounting —revenues are recognized when cash is received and expenses are recognized when cash paid. Cash basis is not consistent with GAAP. Accrual accounting also increases the comparability of financial statements from one period to another.

7. Accounting Accrual Basis vs. Cash Basis Accrual Basis Revenues are recognized when earned and expenses are recognized when incurred. Cash Basis Revenues are recognized when cash is received and expenses recorded when cash is paid. Not GAAP C 1 3-7

8. Accrual Basis vs. Cash Basis On the cash basis the entire $2,400 would be recognized as insurance expense in 2009. No insurance expense from this policy would be recognized in 2010 or 2011, periods covered by the policy. C 1 3-8

9. Accrual Basis vs. Cash Basis On the accrual basis, Insurance expense is recognized as follows: $100 in 2009, $1,200 in 2010, and $1,100 in 2011. The expense is matched with the periods benefited by the insurance coverage. On the accrual basis, Insurance expense is recognized as follows: $100 in 2009, $1,200 in 2010, and $1,100 in 2011. The expense is matched with the periods benefited by the insurance coverage. C 2 3-9

10. Adjusting Accounts An adjusting entry is recorded to bring an asset or liability account balance to its proper amount. The adjusting process is based on ACCRUAL ACCOUNTING of Revenue Recognition and Matching Principle. Adjusting accounts is a 3-step process: (1) Determine the current account balance, (2) Determine what the current account balance should be, and (3) Record adjusting entry to get from step 1 to step 2.

11. Adjustments Adjusting Accounts Paid (or received) cash before expense (or revenue) recognized Paid (or received) cash after expense (or revenue) recognized Prepaid (Deferred) expenses* Unearned (Deferred) revenues Accrued expenses Accrued revenues Framework for Adjustments * including depreciation C2, P1 3-11

12. Prepayments LO2- 4 Occur when the cash flow precedes either expense or revenue recognition Sometimes referred to as deferrals Includes: Prepaid expenses Deferred revenues

13. Prepaid Expenses Example: The unadjusted trial balance of the Dress Right Clothing Corporation lists supplies of $2,000 that were purchased in July. Assume that Dress Right determines that at the end of July, $1,200 of supplies remain. Supplies Expense Beg.bal. 0 800 End.bal. 800 Supplies Beg.bal. 0 2,000800 End.bal. 1,200 Journal Entry – July 31 CreditDebit Supplies expense800 Supplies Cost of assets acquired in one period and expensed in a future period

14. Prepaid Expenses Example: At the beginning of July, Dress Right Clothing Corporation paid $24,000 to its landlord representing one year’s rent paid in advance. LO2- 5 Rent Expense Beg.bal. 0 2,000 End.bal. 2,000 Prepaid Rent Beg.bal. 0 24,0002,000 End.bal. 22,000 Journal Entry – July 31 CreditDebit Rent expense (24000 ÷ 12)2,000 Prepaid rent

15. Prepaid Expenses Example: Furniture and fixtures of $12,000 were purchased during the month of July by Dress Right Clothing Corporation. Assume that the furniture and fixtures have a useful life of five years (60 months) and will be worthless at the end of that period. LO2- 5 Journal Entry – July 31 CreditDebit Depreciation expense200 Accumulated depreciation- furniture and fixtures 12,000 ÷ 60 months Contra asset account

16. Deferred Revenues Cash received from customers in advance of providing a good or service Represent a company’s obligation to provide goods or services in the future Example: Dress Right Clothing Corporation subleased a portion of its building to a jewelry store for $500 per month. On July 16, the jewelry store paid Dress Right $1,000 in advance for the first two months’ rent. Rent Revenue Beg.bal. 0 250 End.bal. 250 Deferred Rent Revenue Beg.bal. 0 1,000250 End.bal. 750 Journal Entry – July 31 CreditDebit Deferred rent revenue250 Rent revenue

17. Accruals Involve cash flows that occur after either expense or revenue recognition Includes: Many accruals involve external transactions that automatically are recorded from a source document Some accruals involve internal transactions and require adjusting entries LO2- 4 Accrued Liabilities Accrued Receivables

18. Accrued Liabilities Example: On July 20, Dress Right Clothing Corporation paid employees $5,000 for salaries for the first half of the month. Assume that salaries for the second half of July are $5,500. Salaries Payable Beg.bal. 0 5,500 End.bal. 5,550 Salaries Expense Beg.bal. 0 5,500 End.bal. 10,500 July 20 5,000 Journal Entry – July 31 CreditDebit Salaries expense5,500 Salaries payable Represent liabilities recorded when an expense has been incurred prior to cash payment

19. Accrued Liabilities Example: The unadjusted trial balance of Dress Right Clothing Corporation reflects a balance in the notes payable account of $40,000. The company borrowed this amount on July 1, 2016, evidenced by two notes, each requiring the payment of 10% interest. LO2- 5 Principal×Interest rate×Time=Interest $40,000×10%× 1 / 12 =$333(rounded) Journal Entry – July 31 CreditDebit Interest expense333 Interest payable

20. Accrued Receivables Example: Assume that Dress Right loaned another corporation $30,000 at the beginning of August, evidenced by a note receivable. Terms of the note call for the payment of principal, $30,000, and interest at 8% in three months. Principal×Interest rate×Time=Interest $30,000×8%× 1 / 12 = $200 Journal Entry – August 31 CreditDebit Interest receivable200 Interest revenue Involve situations when revenue is recognized in a period prior to the cash receipt

21. Estimates Third classification of adjusting entries Example: Depreciation expense requires an estimate of: Expected useful life Expected residual value Bad debt expense requires estimate of: Amount of accounts receivable uncollectible LO2- 5

22. Step 7: Prepare an Adjusted Trial Balance Adjusted trial balance Trial balance after adjusting entries have been recorded LO2- 5 Step 5 Unadjusted Trial Balance Step 6 Adjusting entries Step 7 Adjusted Trial Balance

23. LO2- 5

24. Step 8: Preparation of Financial Statements Financial Statements Primary means of communicating financial information to external parties LO2- 6 Income statement Statement of Comprehensive Income Balance Sheet Statement of Cash Flows Statement of Shareholders’ Equity

25. Income Statement LO2- 6 A change statement that reports the change in shareholders’ equity (retained earnings) that occurred during the period as a result of revenues, expenses, gains, and losses Income Statement

26. Statement of Shareholders’ Equity Discloses the sources of changes in the permanent shareholders’ equity accounts LO2- 6  Investments by owners  Distributions to owners  Net income  Other comprehensive income Statement of Shareholders’ Equity

27. LO2- 6 Balance Sheet

28. Step 9: Closing Process LO2- 7 Serves a dual purpose To measure activity in the upcoming accounting period Revenues and expenses are closed to income summary (1) Temporary accounts are reduced to zero balances To reflect the changes that have occurred Income summary is closed to retained earnings (2) Temporary account balances are closed (transferred) to retained earnings Income summary: A bookkeeping convenience that provides a check that all temporary accounts have been properly closed

29. Closing Revenue Accounts to Income Summary LO2- 7 Journal Entry – July 31 CreditDebit Sales revenue38,500 38,750 Rent revenue Income summary 250

30. Closing Expense Accounts to Income Summary LO2- 7 Journal Entry – July 31 CreditDebit Income summary 35,833 10,500 Cost of goods sold Salaries expense 22,000 Rent expense Interest expense Depreciation expense Supplies expense 800 333 2,000 200

31. Closing Income Summary to Retained Earnings Income Summary Expenses 35,833 Revenues 38,750 Net income 2,917 LO2- 7 Journal Entry – July 31 CreditDebit Income summary2,917 Retained earnings

32. Concept Check √ If expenses exceed revenues for the accounting period, the income summary account: a.Will have a debit balance after closing. b.Will have a debit balance prior to closing. c.Will have a credit balance prior to closing. d.All of these answer choices are incorrect. Revenues are debited to reduce them to zero and the income summary account is credited. Expenses are credited to reduce them to zero and the income summary account is debited. So, a debit balance in income summary results from expenses for the period exceeding revenues.

33. Additional Consideration Closing process for recording a cash dividend Journal Entry CreditDebit Dividends1,000 Cash Journal Entry – July 31 CreditDebit Retained earnings1,000 Dividends

34. Post-Closing Trial Balance (Step 10) LO2- 7

35. End of Chapter 2