Review of Chapter 2

Name the steps in the accounting cycle discussed so

far.
What is the normal balance for an asset, liability,
equity, revenue and expense?
What causes each of those accounts to increase?
Decrease?
Why is the trial balance prepared?

Review of Chapter 2: Question #1

During the year of the companys business,
expenses exceeded revenues by $42,000.
Dividends in the amount of $20,000 were
declared and common shares issued were
$100,000. If beginning retained earnings was
$500,000, then the closing balance is:
a. $522,000
d. $622,000

b. $438,000

c. $538,000

Accrual Accounting and the

Financial Statements
Chapter 3

Learning Objective 1
Explain how accrual accounting
differs from cash-basis
accounting

The Business Cycle

Collection of
the receivable

1
Entity
has
cash

3
Entity
has a
receivable

Purchase of
inventory

2
Entity
holds
inventory
Sale of inventory on account

Accounting Cycle
1. Transaction occurs
2. Analyze the transaction
3. Record in a journal
4. Transfer to general ledger
5. Trial Balance

Accounting Cycle Continued

6. Adjust the records to make sure all income and
expenses are reported for the period, journalize in
the general journal, post to the individual accounts
7. Take an adjusted trial balance
8. Prepare the financial statements
9. Close the Income Statement accounts

10. Prepare a post closing trial balance

Accrual Basis of Accounting

Revenues are recorded when earned
Expenses are recorded when incurred
regardless of when cash is received or paid

Cash Basis of Accounting

Transactions are only recorded when cash is
received or paid

Accrual Accounting
Records cash transaction + noncash transactions
Examples of noncash transactions:
Purchase of inventory on account
Sales on account
Expenses used but not yet paid
Revenue earned but not yet received
Depreciation expense
Usage of prepaid rent, insurance and supplies

The Time-Period Concept

Businesses need regular progress reports,
so accountants prepare financial statements
for specific periods and at regular intervals.
Monthly
Quarterly
Yearly

Learning Objective 2
Apply the revenue and
expense recognition
principles

Revenue Principle
The revenue principle governs two things:
a) When to record revenue and
b) The amount of revenue to record

Recording Expenses
As revenue is earned, companies incur expenses
a) Identify all expenses incurred during the period
b) Measure the expenses and record

Ethical Issues in
Accrual Accounting
Managing earnings to meet or beat
Bay Street forecasts.
Questionable timing of recognizing
revenues, and expenses; affects
quality of earnings.

Learning Objective 3
Record adjusting
journal entries

Updating the Accounts:

The Adjustment Process
The adjustment process begins
with the trial balance.
The unadjusted trial balance lists the
accounts and their balances after the
periods transactions have been recorded.
Several accounts on the unadjusted trial balance
need to be brought up-to-date. As well,
certain transactions have not been
recorded.

Falk Consulting Inc. One Year Later

Unadjusted Trial Balance Month of May 31/15
Cash
Accounts receivable
Supplies
Prepaid rent
Land
Furniture
Accounts payable
Notes payable
Unearned service revenue
Common shares
Retained earnings
Dividends
Service revenue
Salary expense
Utilities expense

$26,685
3,225
530
3,000
50,000
16,500

Total

$104,050

1,500
2,100
510

500
10,200
3,175
70,000
5,050
15,125

$104,050

Categories of
Accounting Adjustments
Deferrals
Depreciation
Accruals

Adjustments
Deferrals
Expenses paid in advance but not yet incurred
Revenue collected in advance but not yet earned
Depreciation is the allocation of the cost of a property,
plant & equipment to expense over the assets useful
life
Accruals
Expenses incurred but not recorded or paid
Revenues earned but not yet recorded or collected

Example Month of May, 2015

1.
2.
3.
4.
5.
6.

Prepaid rent was for 3 months rent paid on May 1.

An inventory at month end indicated that $350 in office
supplies remain on hand.
During May, $1,325 of unearned revenue has now been
earned.
The furniture was bought on May 1, 2015 and is expected to
last 4 years.
On May 1, the company signed a note payable due in two
years. Interest on the note payable is 10% and is paid yearly
The company performed consulting services but has not yet
billed the customer for $2,300.

Deferrals: Prepaid Rent

On May 1, 2015, Falk Consulting Inc.
paid 3 months rent
Prepaid Rent
3,000

Cash
3,000

Deferrals: Prepaid Rent

What is the adjusting entry on May 31?

May 31

Deferrals: Prepaid Expenses

On May 1, 2015, Falk Consulting Inc.
paid cash of $530 for office supplies.
Supplies
530

Cash
530

Deferrals: Prepaid Expenses

An inventory count at month end indicated
that $350 in supplies remained.
Supplies
May1 530 May 31 180
Bal. 350
Dr
Cr

Supplies Expense
180
Bal. 180

Question #2
The company purchased a one-year insurance policy
on April 2, 2014 for $1,000. The amount of prepaid
insurance reported on the balance sheet and the
amount of insurance expense reported on the
income statement at December 31, 2014 are
respectively:
a. $250;
b. $750;
c. $333;
d. $667;

$750
$250
$667
$333

Deferrals: Unearned Revenue

On May 1, 2015, Falk Consulting Inc.
had received $5,300 for future services
Unearned revenue
5,300

Cash
5,300

Deferrals: Unearned revenue

On May 31, $1,325 of revenue has now been earned
May 31

Depreciation of Property, plant &

equipment
- spreads the cost of a property, plant &
equipment over its useful life
- a company buys buildings, equipment and
furniture for use in the business
- as the company uses these assets, it records
depreciation for their wear and tear and
obsolescence

Depreciation of Property, Plant &

Equipment
On May 1, the business purchased
furniture for $16,500 cash.
The furniture is expected to last 4 years.
Furniture
16,500

Cash
16,500

Depreciation of Property, Plant &

Equipment

Since the furniture for Falk Consulting Inc. is expected to last

four years, the depreciation is:

4. Dr
Cr
On the balance sheet, it is reported at its carrying amount:
Furniture
$16,500
Less: Accumulated depreciation
344
$16,156

Accrued Expenses
The term accrued expense refers to a liability that
arises from an expense that has not yet been paid.
Suppose Falk Consulting signed a note payable on
May 1st due in two years.
Interest on the note is 10% and is
paid yearly.

Accrued Expenses
On May 31, the interest has accrued
for one month but has not yet been paid.

Dr
Cr

Accrued Revenues
An accrued revenue is a revenue that has
been earned but not received in cash.
Falk Consulting has provided consulting
services but has not yet billed the customer
for $2,300

Accrued Revenues
May 31
Dr
Cr
To record revenue earned but not yet billed

Question #3
If a company fails to accrue revenue,
a. Liabilities are overstated and owners equity is
understated
b. Assets are understated and net income is
understated
c. Net income is understated and shareholders
equity is overstated
d. Revenues are understated and net income is
overstated

Falk Consulting Inc. Adjusted Trial

Balance May 31, 2015
Account Title
Cash
Accounts receivable
Supplies
Prepaid rent
Land
Furniture
Accumulated depreciation-furniture
Accounts payable
Notes payable
Unearned service revenue
Interest payable
Common shares
Retained earnings
Dividends
Totals

Adjusted Trial Balance

Debit
Credit
26,685
5,525
350
2,000
50,000
16,500

1,500
102,560

344
500
10,200
1,850
85
70,000
5,050
88,029

Balance
Sheet

Retained
Earnings

Falk Consulting Inc. Adjusted Trial

Balance May 31, 2015
Account Title
Service revenue
Rent expense
Salary expense
Supplies expense
Depreciation expense
Utilities expense
Interest expense
Totals

Adjusted Trial Balance

Debit
Credit
1,000
2,100
180
344
510
85
4,219

18,750
Income
Statement

18,750

Summary of the Adjusting Process

Two purposes of the adjusting process:
Measure income
Update balance sheet
Every adjusting entry affects at least one:
Revenue or expense
Asset or liability
3 - 37

Summary of Adjusting Entries

Type of Account
Category of Adjustment

Debit

Credit

Prepaid expense

Expense

Asset

Depreciation

Expense

Contra asset

Accrued expense

Expense

Liability

Accrued revenue

Asset

Revenue

Unearned revenue

Liability

Revenue

Copyright 2015 Pearson Canada Inc. 3-38

Learning Objective 4
Prepare the financial
statements.

Format for the Income Statement

Single-step: Revenue minus expenses
Multi-step: Revenue
Cost of goods sold
Gross profit
Operating expenses
Operating income
Interest expense
Income before taxes
Income taxes
Net income
3 - 40

Falk Consulting Inc.- Income Statement

For the month ended May 31, 2015
Revenue:
Service revenue
Expenses:
Salary expense
Rent expense
Utilities expense
Supplies expense
Depreciation expense
Interest expense
Net income**
**income taxes are ignored

$18,750
$2,100
1,000
510
180
344
85

4,219
$14,531

Falk Consulting Inc.

Statement of Changes in Equity
For the Month Ended May 31, 2015
Common Shares
Balance, May 1
$70,000
Issued shares
0
Profit
Dividends
______
Balance, May 21
$70,000

Retained Earnings
$5,050
14,531
(1,500)
$18,081

Total
$75,050
0
14,531
(1,500)
$88,081

Format for the Balance Sheet

Assets
Current assets
Non-current assets
Liabilities
Current liabilities
Non-current liabilities
Shareholders Equity
Common shares
Retained earnings
3 - 43

Falk Consulting Inc.

Balance Sheet
May 31, 2015

Assets
Current Assets
Cash
$26,685
Accounts receivable
5,525
Supplies
350
Prepaid rent
2,000
Total current assets
$34,560
Land
50,000
Furniture
$16,500
Less:
Accumulated
depreciation
344 16,156
Total assets

$100,716

Current Liabilities
Accounts payable
$ 500
Note payable
10,200
Unearned revenue
1,850
Interest payable
85
Total current liabilities $12,635
Shareholders Equity
Common shares
Retained earnings
Total equity

$70,000
18,081
$88,081

Total liabilities and

shareholdersequity $100,716

Learning Objective 5
Record closing journal entries

Closing the Accounts

Closing the books means to prepare the accounts
for the next periods transactions
Temporary accounts such as revenue, expenses
and dividends are set to zero at the end of the
accounting period

Closing the Accounts

Permanent accounts (assets, liabilities,

and shareholders equity) are not closed
at the end of the period because their
balances are not used to measure income.
Closing entries transfer the revenue, expense,
and dividends balances to Retained Earnings.

Journalizing the Closing Entries

May 31 Service Revenue
18,750
Retained Earnings
May 31 Retained Earnings
4,219
Rent Expense
Salary Expense
Supplies Expense
Depreciation Expense
Utilities Expense
Interest Expense
May 31 Retained Earnings
1,500
Dividends

18,750
1,000
2,100
180
344
510
85
1,500

Posting the Closing Entries

Salary Expense
2,100 2,100
Rent Expense
1,000
1,000
Utilities Expense
510
510
Supplies Expenses
180
180
Depreciation Expense
344
344
Interest Expense
85
85

Retained Earnings
4,219 5,050
1,500 18,750
18,081

Service Revenue
15,125
1,325
2,300
18,750 18,750

Dividends
1,500 1,500

Learning Objective 6
Analyze and evaluate a
companys debt-paying
ability

Classifying Assets and Liabilities

Liquidity measures how quickly an item can be
converted to cash
A balance sheet lists assets and liabilities in the
order of their relative liquidity:
Current Assets Current Liabilities
Long-term Assets
Long-term

Liabilities

Using Accounting Ratios

- working capital, current ratio and debt ratio
are used by creditors in deciding whether or
not to loan the company money
- they must predict whether or not the loan will
be repaid along with the interest

Financial Ratios
(Net) Working capital is:
Total current assets Total current liabilities
It refers to the ability of the company to use its
current assets to pay off its current liabilities

3 - 53

Financial Ratios
Current ratio = Current assets
Current liabilities
It measures the companys ability to pay short-term debt
Debt ratio = Total liabilities
Total assets
It measures the businesss ability to pay all debt

How Transactions Affect Ratios

Increase revenue and decrease expenses results in an increase in current assets and net
income
Sell shares increases cash and equity
Purchase of assets for cash increases and
decreases assets
Borrow less money decreases liabilities
3 - 55

Question #4
Common shares
$40,000 Sales
Inventory
30,000 Land
Current liabilities
45,000 Cash
Retained earnings
20,000 Building
Bank loan (due in 2 yrs) 30,000 Expenses
Using the above data, the debt ratio is (rounded):
a. 28.8
b. 37.5

c. 22.5
d. 30.6

100,000
60,000
10,000
100,000
60,000

End of Chapter 3