McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc.

Chapter 2

Review of the Accounting Process

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-2

The Accounting Equation

A = L + OE- Owner Withdrawals+ Owner Investments - Expenses+ Revenue

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-3

Accounting Equation for a Corporation

A = L + SE+ Retained Earnings+ Paid-in Capital

- Expenses- Losses

+ Revenues+ Gains

- Dividends

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-4

Account Relationships

Debits and credits affect the Balance Sheet Model as follows:

Debits and credits affect the Balance Sheet Model as follows:

A = L + PIC + RE + R - EAssets

Dr.+

Cr.-

LiabilitiesDr.-

Cr.+

Paid-inCapital

Dr.-

Cr.+

Retained EarningsDr.-

Cr.+

Revenues and GainsDr.-

Cr.+Expenses

and LossesDr.+

Cr.-

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-5

Account Relationships

Debits and credits affect the Balance Sheet Model as follows:

Debits and credits affect the Balance Sheet Model as follows:

A = L + PIC + RE + R - EPermanent accounts represent the basic financial position elements of the

accounting equation.

Temporary accounts keep

track of the changes in the

retained earnings component of shareholders’

equity.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-6

Source documents

Record in Journal

Financial Statements

Transaction Analysis

Post to Ledger

Unadjusted Trial Balance

Record & Post Adjusting

Entries

Adjusted Trial Balance

Close Temporary Accounts

Post-Closing Trial Balance

The Accounting Processing

Cycle

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-7

Accounting Processing Cycle

On January 1, 2004, CWC, Inc. borrows $10,000 from the bank.

Prepare the journal entry.

Two accounts are affected:Cash (an asset) increases by $10,000.Notes Payable (a liability) increases by $10,000.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-8

Accounting Processing Cycle

Two accounts are affected:Cash (an asset) increases by $10,000.Notes Payable (a liability) increases by $10,000.

GENERAL JOURNAL Page 2

Date DescriptionPost. Ref. Debit Credit

Jan. 1 Cash 10,000 Notes Payable 10,000

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-9

Accounting Processing Cycle

GENERAL JOURNAL Page 2

Date DescriptionPost. Ref. Debit Credit

Jan. 1 Cash 10,000 Notes Payable 10,000 Account numbers are

references for posting to the General Ledger.

Two accounts are affected:Cash (an asset) increases by $10,000.Notes Payable (a liability) increases by $10,000.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-10

General Ledger

The “T” account is a shorthand used byaccountants to analyze transactions. Itis not part of the bookkeeping system.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-11

Posting Journal Entries

On July 1, 2003, the owners invest $60,000 in a new business, Dress Right Clothing Corporation.

GENERAL JOURNAL Page 1

Date DescriptionPost. Ref. Debit Credit

July 1 Cash 60,000Common Stock 60,000

Post the debit portion of the entry to the Cash ledger account.Post the debit portion of the entry to the Cash ledger account.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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Posting Journal Entries

1

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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Posting Journal Entries

2 3

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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Posting Journal Entries

4

5

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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6

Posting Journal Entries

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-16

Posting Journal Entries

Post the credit portion of the entry to the Common Stock ledger account.

Post the credit portion of the entry to the Common Stock ledger account.

1

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-17

Posting Journal Entries

23

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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Posting Journal Entries

4

5

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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6

Posting Journal Entries

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-20After recording all entries for the period, Dress

Right’s Trial Balance would be as follows:

After recording all entries for the period, Dress Right’s Trial Balance would be as follows:

Debits = Credits

A Trial Balance is a listing of all

accounts and their

balances at a point in

time.

A Trial Balance is a listing of all

accounts and their

balances at a point in

time.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-21

Additional ConsiderationPerpetual Inventory System

Inventory account is continually updated to

reflect purchases and sales.

Cost of goods sold account is continually updated to

reflect sales.

Periodic Inventory System

Purchases account reflects purchases of

inventory.

Cost of goods sold and inventory are adjusted at

period end.

Discussed in more depth in

Chapters 8 & 9.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-22

Adjusting Entries

At the end of the period, some transactions or

events remain unrecorded.

Because of this, several accounts in the ledger

need adjustments before their balances appear in the financial

statements.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-23

Prepaym ents(Deferrals)

Accruals Estim ates

Adjusting Entries

Transactions where cash is paid or received

before a related expense or revenue is

recognized.

Transactions where cash is paid or received after a related expense

or revenue is recognized.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-24

Asset Expense

UnadjustedBalance

CreditAdjustment

DebitAdjustment

Prepaid Expenses

Today, I will payfor my first

6 months’ rent. Prepaid Expenses

Items paid for in advance of receiving their benefits

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-25

Prepaid Expenses

On December 1, 2004, Scott Company paid $12,000 to cover rent for December 2004 through May 2005. Let’s look at the adjusting journal entry needed on

December 31, 2004.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-26

$12,000 ÷ 6 months = $2,000 per month

Prepaid Expenses

On December 1, 2004, Scott Company paid $12,000 to cover rent for December 2004 through May 2005. Let’s look at the adjusting journal entry needed on

December 31, 2004.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-27

After posting, the accounts look like this:

Prepaid Rent Rent Expense12/1 $12,000 12/31 $2,00012/31 $2,000

Prepaid Expenses

Bal. $10,000

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-28

Depreciation is the process of computing expense by allocating the cost of plant and equipment over their expected useful lives.

Straight-LineDepreciationExpense

= Asset Cost - Salvage Value

Useful Life

Depreciation

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-29

On January 1, 2004, Monroe, Inc. purchased the following oil pumping equipment:

Let’s record depreciation expense for the year ended December 31, 2004.

Depreciation

Asset Cost 62,000$ Salvage Value 2,000 Useful Life 5 yrs.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-30

2000Depreciation

Expense=

$62,000 - $2,000

5= $12,000

On January 1, 2004, Monroe, Inc. purchased the following oil pumping equipment:

Asset Cost 62,000$ Salvage Value 2,000 Useful Life 5 yrs.

Depreciation

Now, prepare the adjusting entry for December 31,

2004.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-31

GENERAL JOURNAL Page 2Date Description PR Debit Credit

Dec. 31 Depreciation Expense 12,000

Accumulated Depr. - Equip. 12,000

To record annual depreciationContra Asset

Depreciation

Let’s see how the accounts would look after posting!

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-32

After posting, the accounts look like this:

Equipment Depreciation Expense

1/1 $62,000 12/31 $12,000

Accumulated Depreciation

12/31 $12,000

Depreciation

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-33

The equipment account is shown on

the balance sheet like

this.

The equipment account is shown on

the balance sheet like

this.

Depreciation

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-34

Liability RevenueUnadjusted

BalanceCredit

AdjustmentDebit

Adjustment

Unearned Revenue

“Go Big Blue”

Buy your season tickets forall home basketball games NOW! Unearned Revenue

Cash received in advance of performing

services

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-35

On December 1, 2004, Ox University sold 1,000 seasons tickets to its 20 home basketball games for

$100 each. OxU makes the following entry:

Unearned Revenue

Liability Account

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Slide2-36

By December 31, OxU has played 8 of its regular home games, winning 6 and losing 2.

Unearned Revenue

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Slide2-37

Unearned Revenue

By December 31, OxU has played 8 of its regular home games, winning 6 and losing 2.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-38

Unearned BasketballRevenue Basketball Revenue

12/1 $100,000 12/31 $40,00012/31 $40,000

After posting, the accounts will look like this . . .

Unearned Revenue

Bal. $60,000

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-39 Alternative Approach to Record

Prepayments

Unearned RevenueRecord initial cash receipts

as follows:

Cash $$$ Revenue $$$

Adjusting EntryRecord the amount for the

unearned liability as follows:

Revenue $$ Unearned revenue $$

Prepaid ExpensesRecord initial cash

payments as follows:

Expense $$$ Cash $$$

Adjusting EntryRecord the amount for the

prepaid expense as follows:

Prepaid expense $$ Expense $$

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-40

Expense LiabilityCredit

AdjustmentDebit

Adjustment

Accrued Liabilities

I won’t pay youuntil the job is done!

Accrued Liabilities

Costs incurred in a period that are both unpaid and

unrecorded

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-41

12/1/04 12/31/04Year end

Last paydate

12/26/04

Next paydate

1/2/05

Record adjustingjournal entry.

Accrued LiabilitiesDenton, Inc.’s weekly salaries are $78,750.

On December 31, 2004, the employees have earned

salaries of $47,250.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-42

Accrued Liabilities

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Slide2-43

Salaries Expense Salaries Payable12/26 $78,750

After posting, the accounts will look like this . . .

12/31 $47,250

Accrued Liabilities

12/31 47,250

Bal. $126,000

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-44

Asset Revenue

CreditAdjustment

DebitAdjustment

Accrued Receivables

Yes, you can pay mein May for your April

15 tax return.Accrued Receivables

Revenues earned in a period that are both

unrecorded and not yet received

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-45

At year-end, Smith & Jones, CPAs, had completed $31,200 of work but had not yet billed the clients. Prepare the adjusting entry for December 31, 2004.

Accrued Receivables

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-46

Accrued Receivables

At year-end, Smith & Jones, CPAs, had completed $31,200 of work but had not yet billed the clients. Prepare the adjusting entry for December 31, 2004.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-47

Accounts Receivable Service Revenue

12/31 $31,20012/31 $31,200

Accrued Receivables

After posting, the accounts involvedwill look like this . . .

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Slide2-48

Estimates

Uncollectible accounts and depreciation of fixed assets are estimated.

An estimated item is a function of future events and developments.

$$

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Slide2-49

EstimatesThe estimate of bad debt expense at the

end of the year is an example of an adjusting entry that requires an estimate.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-50

Let’s look at

financial

statements.

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Slide2-51

The income statement summarizes the results of operating activities of the company.

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Slide2-52

Current assets: Cash 68,500$ Accounts receivable 2,000$ Less: Allowance for uncollectible accounts 500 1,500 Supplies 1,200 Inventory 38,000 Prepaid rent 22,000 Total current assets 131,200 Property and equipment: Furniture and fixtures 12,000 Less: Accumulated depreciation 200 11,800 Total assets 143,000$

Dress Right Clothing CorporationBalance SheetAt July 31, 2003

Assets

The balance sheet presents the financial position of the company on a particular date.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-53

Current liabilities: Accounts payable 35,000$ Salaries payable 5,500 Unearned rent revenue 750 Interest payable 333 Note payable 10,000 Total current liabilities 51,583 Long-term liabilities: Note payable 30,000 Shareholders' equity: Common stock 60,000$ Retained earnings 1,417 Total shareholders' equity 61,417 Total liabilities and shareholders' equity 143,000$

Dress Right Clothing CorporationBalance SheetAt July 31, 2003

Liabilities and Shareholders' Equity

The balance sheet presents the financial position of the company on a particular date.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-54

The statement of cash flows discloses the changes in cash during a period.

Cash flows from operating activities:Cash inflows: From operations 36,500$ From rent 1,000 Cash outflows: For rent (24,000) For supplies (2,000) To suppliers for merchandise (25,000) To employees (5,000) Net cash used by operating activities (18,500)$ Cash flows from investing activities: Purchase of furniture and fixtures (12,000) Cash flows from financing activities: Issue of capital stock 60,000$ Increase in notes payable 40,000 Payment of cash dividend (1,000) Net cash provided by financing activities 99,000 Net increase in cash 68,500$

Dress Right Clothing CorporationStatement of Cash Flows

For the Month of July 2003

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-55

The statement of shareholders’ equity presents the changes in permanent shareholder accounts.

Common Stock

Retained Earnings

Total Shareholders'

EquityBalance at July 1, 2003 -$ -$ -$ Issue of capital stock 60,000 60,000 Net income for July 2000 2,417 2,417 Less: Dividends (1,000) (1,000) Balance at July 31, 2003 60,000$ 1,417$ 61,417$

Dress Right Clothing CorporationStatement of Shareholders' Equity

For the Month of July 2003

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-56

The Closing Process

Resets revenue, expense and dividend account balances to zero at the end of the period.

Helps summarize a period’s revenues and expenses in the Income Summary account.

Identify accounts for closing.

Record and post closing entries.

Prepare post-closing trial balance.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-57

Temporary Accounts

Revenues

Income Summary

Exp

ense

s

Divid

end

s

Permanent Accounts

Assets

Lia

bili

ties

Sh

areho

lders’

Eq

uity

The closing process applies only to temporary accounts.

Temporary and Permanent Accounts

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-58

Close Revenue accounts to Income Summary.

Close Expense accounts to Income Summary.

Close Income Summary account to Retained Earnings.

Let’s prepare the closing entries for

Consulting Inc.!

Closing Entries

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-59

Consulting Inc.Adjusted Trial Balance

December 31, 2004

Cash 7,950$ Accounts receivable 1,800 Supplies 2,670 Prepaid insurance 2,300 Equipment 26,000 Accumulated depreciation-equipment 375$ Accounts payable 1,100 Note payable 5,100 Salaries payable 210 Unearned consulting revenue 2,750 Retained earnings 29,400 Consulting revenue 5,850 Rental revenue 300 Depreciation expense-equipment 375 Salaries expense 1,610 Insurance expense 100 Rent expense 1,000 Supplies expense 1,050 Utilities expense 230 Totals 45,085$ 45,085$

Close Revenue accounts to

Income Summary.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-60

GENERAL JOURNAL Page 34

Date DescriptionPost. Ref. Debit Credit

Dec. 31 Consulting Revenue 5,850

Rental Revenue 300

Income Summary 6,150

Now, let’s look at the ledger accounts after posting this closing entry.

Close Revenue Accounts to Income Summary

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-61

Income Summary5,850

300

6,150

Consulting Revenue5,850 5,850

-

Rental Revenue300 300

-

Close Revenue Accounts to Income Summary

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-62

Close Expense accounts to

Income Summary.

If Consulting Inc. had a Cost of Goods Sold

account, it would be

closed with the expenses.

Consulting Inc.Adjusted Trial Balance

December 31, 2004

Cash 7,950$ Accounts receivable 1,800 Supplies 2,670 Prepaid insurance 2,300 Equipment 26,000 Accumulated depreciation-equipment 375$ Accounts payable 1,100 Note payable 5,100 Salaries payable 210 Unearned consulting revenue 2,750 Retained earnings 29,400 Consulting revenue 5,850 Rental revenue 300 Depreciation expense-equipment 375 Salaries expense 1,610 Insurance expense 100 Rent expense 1,000 Supplies expense 1,050 Utilities expense 230 Totals 45,085$ 45,085$

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-63

GENERAL JOURNAL Page 34

Date DescriptionPost. Ref. Debit Credit

Dec. 31 Income Summary 4,365

Depreciation expense-equipment 375

Salaries expense 1,610

Insurance expense 100

Rent expense 1,000

Supplies expense 1,050

Utilities expense 230

Now, let’s look at the ledger accounts after posting this closing entry.

Close Expense Accounts to Income Summary

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-64

Income Summary375 5,850

1,610 300 100

1,000 1,050

230

1,785 Utilities Expense

230 230 -

Depreciation Expense- Eq.

375 375 -

Salaries Expense1,610 1,610

-

Supplies Expense1,050 1,050

-

Rent Expense1,000 1,000

-

Net Income

Close Expense Accounts to Income Summary

Insurance Expense100 100

-

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-65

Close Income Summary to

Retained Earnings.

Consulting Inc.Adjusted Trial Balance

December 31, 2004

Cash 7,950$ Accounts receivable 1,800 Supplies 2,670 Prepaid insurance 2,300 Equipment 26,000 Accumulated depreciation-equipment 375$ Accounts payable 1,100 Note payable 5,100 Salaries payable 210 Unearned consulting revenue 2,750 Retained earnings 29,400 Consulting revenue 5,850 Rental revenue 300 Depreciation expense-equipment 375 Salaries expense 1,610 Insurance expense 100 Rent expense 1,000 Supplies expense 1,050 Utilities expense 230 Totals 45,085$ 45,085$

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-66

GENERAL JOURNAL Page 34

Date DescriptionPost. Ref. Debit Credit

Dec. 31 Income Summary 1,785

Retained Earnings 1,785

Now, let’s look at the ledger accounts after posting this closing entry.

Close Income Summary to Retained Earnings

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-67

Retained Earnings29,400 1,785

31,185

Income Summary375 5,850

1,610 300 100

1,000 1,050

230 1,785

-

Close Income Summary to Retained Earnings

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-68

Consulting Inc.Post-Closing Trial Balance

December 31, 2004

Cash 7,950$ Accounts receivable 1,800 Supplies 2,670 Prepaid insurance 2,300 Equipment 26,000 Accum. depr.-equip. 375$ Accounts payable 1,100 Note payable 5,100 Salaries payable 210 Unearned revenue 2,750 Retained earnings 31,185 Totals 40,720$ 40,720$

Post-Closing Trial Balance

Lists permanent accounts and their

balances.

Total debits equal total credits.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-69

Conversion From Cash Basis to Accrual Basis

Adjusting entries, for the most part, are conversions from cash to accrual.

Let’s look at an example.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-70

Conversion From Cash Basis to Accrual Basis

Jeter, Inc. paid $20,000 cash for insurance during the current period. On Jan. 1, Prepaid

Insurance was $5,000, and on Dec. 31, the account balance was $3,000.

Determine Insurance Expense for the period.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Slide2-71

Conversion From Cash Basis to Accrual Basis

Prepaid Insurance

Balance, 1/1 5,000$ Plus: cash paid 20,000 Less: insurance expense (22,000) Balance, 12/31 3,000$

Jeter, Inc. paid $20,000 cash for insurance during the current period. On Jan. 1, Prepaid

Insurance was $5,000, and on Dec. 31, the account balance was $3,000.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

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End of Chapter 2