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Boise State University

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1 Boise State University
Financial Accounting A Decision-Making Approach, 2nd Edition King, Lembke, and Smith * Prepared by Dr. Denise English, Boise State University John Wiley & Sons, Inc.

CHAPTER SEVEN After reading Chapter 7, you should be able to: 1. State how the accounting system relates to the accounting process and how it is designed to provide useful information to decision makers. 2. Describe how the accounting equation is useful in understanding and communicating the effects of different transactions and events. 3. Explain how ledger accounts are used to process information about transactions and events to facilitate financial decisions. 4. Discuss the benefits of the double-entry bookkeeping system for financial statement users.

CHAPTER SEVEN After reading Chapter 7, you should be able to: 5. Differentiate between permanent and temporary accounts and explain how the differences in these accounts relate to the types of decisions financial statement users make. 6. Describe the role that each of the accounting cycle steps plays in providing useful information for decision makers. 7. Explain how end-of-period adjustments help ensure that financial statements are fairly presented and describe typical types of adjustments.

4 Accounting Systems Every organization must have an accounting system to generate information needed by decision makers. The size, complexity, and type of entity all influence the kinds of decisions that need to be made and therefore the way in which information is accumulated and reported in the financial statements.

5 The Accounting Equation: The Basis for Useful Information
A = L + OE The Accounting Equation: The Basis for Useful Information Assets = Liabilities + Owners’ Equity Can be expanded by detailing the individual asset, liability, and equity elements. For example, a small store might appear as follows: ASSETS = LIABILITIES O. EQUITY cash + accounts + inventory = accounts other capital + retained receivable payable payables stock earnings

6 Using Ledger Accounts for Accumulation and Analysis
A = L + OE Using Ledger Accounts for Accumulation and Analysis Decision makers are interested in the individual elements of financial statements. Information about individual financial statement elements is accumulated in ledger accounts. The list of all accounts is referred to as the chart of accounts, and each account is assigned both a title and a number.

7 How Ledger Accounts Work
A = L + OE How Ledger Accounts Work Information for an individual asset, liability, or owners’ equity item is accumulated in an account, which can be represented simply as follows: Cash This form of ledger account is known as a T-account and is useful for explanatory purposes. For a given account, all increases are recorded on one side, and all decreases on the other side. The account balance is the difference between total increases and total decreases in the account.

8 T-Accounts and the Accounting Equation
A = L + OE T-Accounts and the Accounting Equation Exhibit 7-2 Each balance sheet element is included in the accounting equation, and a T-account can be used for each one. ASSETS = LIABILITIES + OWNERS’ EQUITY Accounts Payable Common Stock Retained Earnings Cash Inventory + = + + 12,000 28,000 7,000 30,000 3,000

9 Debits & Credits A = L + OE
The accounting profession uses the term debit to mean (1) the left side of an account, (2) an entry or amount on the left side, (3) the act of making an entry to the left side of an account, and the term credit to mean the same for the right side of an account. ANY ACCOUNT DEBIT CREDIT

10 Debits & Credits A = L + OE
Because assets are on the left side of the accounting equation, asset accounts are increased on the left side of the account (with a debit). Liabilities and owners’ equity are on the right side of the equation and are increased on the right side of the account (with a credit). Liabilities and Owners’ Equity Assets = (debit) increase (credit) decrease (debit) decrease (credit) increase

11 Debits & Credits A = L + OE If this is true,
Liabilities and Owners’ Equity Assets = (debit) increase (credit) decrease (debit) decrease (credit) increase then the terms debit and credit reflect the following changes in an account: Debits (dr.) - increase assets Credits (cr.) - decrease assets - decrease liabilities increase liabilities - decrease equities increase equities

12 Double Entry Bookkeeping
Double-entry bookkeeping is based on the accounting equation. The following characteristics must exist: each recorded event must have at least 2 effects debits must always equal the credits for both individual transactions, and the sum of all account balances the equality rule ensures that information is processed accurately and completely $Debits=$Credits

13 The Effects of Transactions in Double-Entry Bookkeeping
Exhibit 7-3 (partial) The Effects of Transactions in Double-Entry Bookkeeping If Then one or More of the Following Must Occur An asset increases - Another asset decreases A liability increases Equity increases An asset decreases - Another asset increases - A liability decreases - Equity decreases

14 The Effects of Transactions in Double-Entry Bookkeeping
Exhibit 7-3 (partial) The Effects of Transactions in Double-Entry Bookkeeping If Then one or More of the Following Must Occur A liability increases - Another liability decreases Equity decreases An asset increases A liability decreases - Another liability increases - Equity increases An asset decreases

15 The Effects of Transactions in Double-Entry Bookkeeping
Exhibit 7-3 (partial) The Effects of Transactions in Double-Entry Bookkeeping If Then one or More of the Following Must Occur An ownership Another ownership claim claim increases decreases - A liability decreases An asset increases An ownership Another ownership claim claim decreases increases - A liability increases An asset decreases

16 Two Types of Accounts Accounting records of all entities contain two major types of accounts: 1) Permanent accounts--are reported in the balance sheet and relate to the financial position of the entity. These account balances carry forward from period to period. 2) Temporary accounts--are reported in the income statement or retained earnings statement and relate to activities during a period. These account balances are carried only for one period.

17 Types of Accounts Exhibit 7-4

18 The Accounting Equation Expanded
A = L + OE The Accounting Equation Expanded Elements of owners’ equity are crucial to understanding a company’s activities. Owners’ equity may be expanded as follows: Assets = Liabilities + Owners’ Equity Assets = Liabilities + Capital Stock + Retained Earnings Assets = Liabilities + Capital Stock + Beginning Retained Earnings + Revenues - Expenses - Dividends The last equation ties together the income statement (revenues, expenses), retained earnings statement (net income, dividends), and balance sheet (retained earnings).

19 Overview of the Accounting Cycle
The accounting cycle is the entire series of steps needed to record, accumulate, process, and report financial information. The eight steps are: 1) Occurrence of a transaction 2) Analysis of transaction 3) Recording of transaction 4) Posting to ledger accounts 5) Preparation of trial balance 6) Adjustment of balances 7) Preparation of financial statements 8) Closing of temporary accounts

20 The Accounting Cycle 1) Occurrence of transactions--Economic events requiring recognition according to the criteria discussed in chapter 4 are evidenced by source documents such as sales receipts and invoices. 2) Analysis of transactions--Based upon the evidence available, the transaction or event is classified and measured in order to know which accounts are affected and by how much.

21 The Accounting Cycle 3) Recording of transactions--Upon analysis, the transaction is recorded in a journal, which provides a chronological record of an entity’s activities. The journal entry includes the date, titles and numbers of accounts affected, and the specific debit or credit dollar amounts. 4) Posting to ledger accounts--Each amount in the journal is transferred to the appropriate ledger account. The entire set of accounts is known as the general ledger.

22 The Accounting Cycle 5) Preparation of trial balance--A list of all accounts and their balances is prepared to ensure the accuracy of the recording and posting processes by making sure the sum of debit balances equals the sum of credit balances. 6) Adjustment of balances--All account balances must be examined prior to preparation of finan-cial statements, and updated as needed through adjusting journal entries posted to the ledger.

23 The Accounting Cycle 7) Preparation of financial statements--The financial statements are prepared from the account balances determined after adjusting entries (the adjusted trial balance). 8) Closing of temporary accounts--All temporary account balances are transferred to retained earnings via closing entries, leaving all temporary account balances at zero. Closing entries must be journalized and posted to the ledger and a post-closing trial balance is prepared.

24 $ The Accounting Cycle Exhibit 7-5 Invoice Sales costs
Closing of temporary accounts Occurrence of transaction Stockholders’ Equity Analysis of transaction Cash Flow Balance Sheet Journal Income Statement Trial Balance Recording of transaction Dr Cr. Preparation of financial statements Posting to ledger account Adjustment of balances Preparation of trial balance

25 Adjustments: The Matching Concept at Work
End-of-period adjustments are needed because recording all events that affect a company when they occur is not cost-effective, such as interest on a bank loan that accrues daily. Accountants make five types of adjusting entries: 1) Accrued income 2) Accrued expense 3) Unearned income 4) Prepaid expenses 5) Depreciation of assets Adjustment of balances

26 Accrued Income Adjustment of balances Income should be reported in the period in which it is earned. Some types of income, such as interest, grow over time rather than occur at a point in time and are therefore said to accrue. Interest earned on a Note Receivable by year-end of $1,225 would be recorded as follows: Dr Cr. Interest Receivable $1,225 Interest Income $1,225 The receivable will appear as a current asset on the balance sheet, and the income on the income statement.

27 Accrued Expenses Adjustment of balances The matching concept requires expenses (expired costs) to be reported in the period in which the related benefits are received, regardless of cash flow. Expenses that grow over time and are paid after the related benefits are received are called accrued expenses. If weekly payroll (paid on Fridays) is $100,000 and year-end is on Tuesday, two days of accrued wages expense and liability must be recognized as follows: Dr Cr. Wages expense $40,000 Wages payable $40,000

28 Unearned Income Adjustment of balances Cash receipts for income before the monies are earned must be recognized as unearned income, a liability. At year-end, the portion of monies received in advance that has been earned must be recognized as income. If our tenant prepaid 12 months of rent for $18,000 on October 1 and we recognized that as Unearned Rent, then on December 31 (year-end), Rental Income must be recognized as follows: Dr Cr. Unearned rental income $ 4,500 Rental income $4,500

29 Prepaid Expenses Adjustment of balances Some types of operating costs are paid in advance of the period(s) in which they provide benefits and are known as prepaid expenses (assets) until expired, when they become expenses. If insurance for $3,600 is purchased for one-year of coverage on September 1, at December 31 (year-end), the following recognition of expired insurance cost is as follows: Dr Cr. Insurance expense $1,200 Prepaid insurance $ 1,200

30 Depreciation of Assets
Adjustment of balances Long-lived operating assets such as equipment are used to generate revenues over a number of periods. A portion of their cost must be recognized as expense in the periods benefitted. Equipment purchased for $80,000 that will benefit the entity for 5 years, would require $16,000 of annual depreciation expense as follows: Dr Cr. Depreciation expense $16,000 Accumulated depreciation $ 16,000 Accumulated depreciation is a contra-asset account that would offset the Equipment account in the balance sheet.

31 Adjustments aren’t corrections . . .
To clarify, adjustments aren’t corrections of errors made, but are cost-effective means of adjusting the accounts to bring them up to date before financial statements are prepared. Note that each adjusting entry affects at least one temporary and at least one permanent account; in other words, each entry updates both the balance sheet and the income statement.

32 Copyright Copyright © 2001 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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