Chapter 1 Review

PRINCIPLES OF ACCOUNTING
LO1: IDENTIFY THE ACTIVITIES AND USERS ASSOCIATED WITH ACCOUNTING

Accounting: The information system that identifies, records, and communicates the
economic events of an organization to interested users.

Two Main Types of Users:

1. Internal Users: Managers who plan, organize, and run a business.

Examples: Marketing managers, production supervisors, finance directors, and company officers.

2. External Users: Includes investors who use accounting information to make

decisions to buy, hold, or sell stock and creditors who use the accounting
information to evaluate the risks of selling on credit or lending money.

Other Examples: Taxing Authorities (Ex: IRS), customers, labor unions, and regulatory
agencies (Ex: Securities and Exchange Commission (SEC)).

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LO2: EXPLAIN THE BULDING BLOCKS OF ACCOUNTING: ETHICS,

PRINCIPLES, AND ASSUMPTIONS
Ethics In Financial Reporting
Sarbanes-Oxley Act (SOX): Passed by congress to reduce unethical corporate behavior and decrease the
likelihood of future corporate scandals. As a result of SOX….
1. Top management must now certify the accuracy of financial information.
2. Penalties for fraudulent financial activity are much more severe.
3. The independence of the outside auditors who review the accuracy of
corporate financial statements and the oversight role of the board of directors
has increased.

Standard-Setting Environment
1. GAAP: (Generally Accepted Accounting Principles) rules and concepts that
govern financial accounting. It attempts to make information RELEVANT, RELIABLE,
and COMPARABLE.

Standard-setting bodies that determine these guidelines:

• SEC (Securities and Exchange Commission): oversees the U.S. financial markets and
accounting standard-setting bodies.
• FASB (Financial Accounting Standards Board): The primary accounting standard-
setting body in the United States.
• IASB (International Accounting Standards Board): The primary accounting
standard-setting body for countries outside the united States that use
International Financial Reporting Standards (IFRS).

2. Characteristics of Financial Information: Financial information needs to be USEFUL to

investors and creditors for making decisions about providing capital. Useful information
possesses two important qualities…
1. RELEVANCE: Has the potential to impact decision making. Information is relevant if it has…
• Predictive Value: helps provide accurate expectations about the future.
• Confirmatory Value: confirms or corrects prior expectations.
• Materiality: when its size makes it likely to influence the decision of an
investor or creditor.

2. FAITHFUL REPRESENTATION: The information accurately reflects an entity’s

economic activity or condition. To provide a faithful representation,
information must be…
• Complete: nothing important has been omitted.
• Neutral: is not biased toward one position or another.
• Free from Error: no errors or omissions in amounts and process
used to report amounts.

3. Accounting Principles: MEASUREMENT PRINCIPALS

• Historical Cost Principle: Accounting information is based on actual cost. Cost is
measured on a cash or equal to cash basis. (Ex: Bob bought equipment for
$15,000 so the equipment should be valued at $15,000). In generally, most
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assets have to be valued using the historical cost principle.

• Fair Value Principle: Indicates that assets and liabilities should be reported at fair
value (the price received to sell an asset or settle a liability). Only in situations
where assets are actively traded, such as investment securities, is the fair value
principle applied.

4. 2 Main Assumptions in the Accounting Process

• MONETARY UNIT ASSUMPTION: stable monetary unit of measure used in
U.S. financial statements such as the U.S. dollar.
• ECONOMIC ENTITY ASSUMPTION: business is accounted for separately from
other business entities, including its owner.

TYPES OF BUSINESS ENTITIES

1. Sole Proprietorship: business owned by ONE PERSON and that person and company are
viewed as ONE entity for tax and liability purposes. For example, if a customer sues Bill
who owns the proprietorship, the court can order Bill to sell his personal belongings
including his house to settle the debt.
• Simple to establish
• Owner controlled
• Tax advantages

2. Partnership: owned by TWO OR MORE PEOPLE who are JOINTLY liable for tax and other
obligations. Like a proprietorship, partnerships are NOT LEGALLY SEPARTE from owners.
Each partner’s share of profits is reported and taxed on that partner’s tax return.
• Simple to establish
• Shared control
• Broader skills and resources
• Tax advantages

3. Corporation: a business legally separate from its owner or owners, meaning it is

responsible for its own acts and its own debts. A corporation is owned by shareholders
who are NOT personally liable for corporate acts and debts. A corporation acts through
its managers.
• Easier to transfer ownership
• Easier to raise funds
• No personal liability
• A major disadvantage is that corporations face double taxation (The corporation
is taxed as a separate entity and the owner’s (stockholders) are taxed on any
earnings distributed to them from the corporation.

Attribute Present Proprietorship Partnership Corporation

One owner allowed YES NO YES
Business taxed NO NO YES
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Limited liability NO* NO* YES

Business entity YES YES YES
Legal entity NO NO YES
Unlimited life NO NO YES

*A proprietorship or partnership that is set up as an LLC (Limited Liability Corporation)

has limited liability. (LLCs are talked about more in business law courses)

LO 3: STATE THE ACCOUNTING EQUATION, AND DEFINE IT COMPONENTS

The two basic elements of a business are what it owns and what it owes. Assets are the
resources a business owns.

Liabilities and stockholders’ equity are the rights or claims against these resources.

The Basic Accounting Equation: Assets = Liabilities + Owners’

Equity
This relationship is the basic accounting equation. Assets must equal the sum of liabilities and
owners’ equity. The equation provides the underlying framework for recording and summarizing
economic events
Assets - resources a business owns. The business uses its assets in carrying out such
activities as production and sales.

Liabilities -claims against assets—existing debts and obligations. Businesses of all sizes
usually borrow money and purchase merchandise on credit. These economic activities
result in payables of various sorts.

Owners’ Equity - The ownership claim on total assets is owner’s equity. It is equal to total assets minus
total liabilities
1. Increase in Owner’s Equity:
• Investment by Owner - are the assets the owner puts into the business. These investments increase
owner’s equity. They are recorded in a category called owner’s capital.
• Revenues - are the gross increase in owner’s equity resulting from business activities entered into
for the purpose of earning income.
2. Decrese in Owner’s Equity:
• Drawings - an owner may withdraw cash or other assets for personal use. Drawings decrease
owner’s equity. They are recorded in a category called owner’s drawings.
• Expenses - are the cost of assets consumed or services used in the process of earning revenue.
They are decreases in owner’s equity that result from operating the business.

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Expanded Accounting Equation:

LO 4: ANALYZE THE EFFECT OF BUSINESS TRANSACTIONS ON THE BASIC

ACCOUNTING EQUATION
THE ACCOUNTING INFORMATION SYSTEM
• Accounting Information System: system of collecting, processing transaction data, and
communicating financial information to decision makers.
o Rely on the accounting process.
1. Analyze business transactions
2. Journalize
3. Post
4. Trial Balance
5. Adjusting Entries
6. Adjusted Trial Balance
7. Financial Statements
8. Closing Entries
9. Post-Closing Trial Balance

• Transactions: economic events that require recording in the financial statements.

o Assets, liabilities, or stockholders’ equity items change as a result of some economic event.
o Dual effect on the accounting equation (Assets = Liabilities + Owners’ Equity)
o Not all activities represent transactions.
o Ex: The payment of rent, purchase of a building, and sale of goods all
represented transactions that need to be recorded.

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ANALYZING TRANSACTIONS

When analyzing transactions keep in mind.

• The accounting equation MUST ALWAYS BALANCE.

• The cause of each change in Owners’ equity must be indicated.
Example Business Transactions (From Softbyte.):
Keep A = L + OE in Balance

TRANSACTION 1. INVESTMENT BY OWNER Ray Neal decides to start a smartphone app

development company which he names Softbyte. On September 1, 2017, he invests $15,000 cash in
the business. This transaction results in an equal increase in assets and owner’s equity.
TRANSACTION 2. PURCHASE OF EQUIPMENT FOR CASH Softbyte Inc. purchases computer
equipment for $7,000 cash.
TRANSACTION 3. PURCHASE OF SUPPLIES ON CREDIT Softbyte Inc. purchases for $1,600 headsets
and other accessories expected to last several months. The supplier allows Softbyte to pay this bill in
October.
TRANSACTION 4. SERVICES PERFORMED FOR CASH Softbyte Inc. receives $1,200 cash from
customers for app development services it has performed.
TRANSACTION 5. PURCHASE OF ADVERTISING ON CREDIT Softbyte Inc. receives a bill for $250
from the Daily News for advertising on its online website but postpones payment until a later date.
TRANSACTION 6. SERVICES PERFORMED FOR CASH AND CREDIT. Softbyte performs $3,500 of
services. The company receives cash of $1,500 from customers, and it bills the balance of $2,000 on
account.
TRANSACTION 7. PAYMENT OF EXPENSES Softbyte Inc. pays the following expenses in cash for
September: office rent $600, salaries and wages of employees $900, and utilities $200.
TRANSACTION 8. PAYMENT OF ACCOUNTS PAYABLE Softbyte Inc. pays its $250 Daily News bill in
cash. The company previously (in Transaction 5) recorded the bill as an increase in Accounts Payable.
TRANSACTION 9. RECEIPT OF CASH ON ACCOUNT Softbyte Inc. receives $600 in cash from
customers who had been billed for services (in Transaction 6).
TRANSACTION 10. WITHDRAWAL OF CASH BY OWNER Ray Neal withdraws $1,300 in cash in cash
from the business for his personal use.
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LO 5: DESCRIBE THE FOUR FINANCIAL STATEMENTS AND HOW THEY

ARE PREPARED
1. Income Statement
2. Owner's Equity Statement
3. Balance Sheet
Income Statement
• Describes a company’s revenues and expenses which result in net income (revenues exceed expenses)
or a net loss (expenses exceed revenues) over a specific period of time due to earnings activities.

Statement of Owner’s Equity

• Explains changes in owner’s equity from net income, net loss, and drawings over a specific period of
time. (Same time period as covered by the income statement)

• Balance Sheet
• Describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a
point in time.

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• Basic Accounting Equation: ASSETS = LIABILITIES + OWNERS’EQUITY

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Summary of Accounts

Category/
Name Financial Quick Definition
Statement
Includes money and any medium of exchange that bank has for deposit (coins,
Cash Asset/Balance Sheet
checks, money orders, checking account balances.)

Held by the SELLER. Promises of future payment to seller from buyer.

Accounts Receivable Asset/Balance Sheet
(RECEIVE money later)

A written promissory note that gives a business the right to receive cash in the
Notes Receivable Asset/Balance Sheet
future. The receipt of cash includes the original amount (principal) and interest.

Inventory Asset/Balance Sheet Goods a company owns and expects to sell in its normal operations.

Assets that represent payments of FUTURE expenses such as Prepaid Insurance

Prepaid Accounts Asset/Balance Sheet
(pay for it ahead of the time you are going to use the insurance.)

Assets such as paper, toner, and pens that become expenses when they are used
Supplies Accounts Asset/Balance Sheet
up.

Incudes land, buildings, and equipment. Equipment and building accounts get
Property, Plant, and
Asset/Balance Sheet expensed by allocating their cost over the periods benefited by them. Land
Equipment Accounts
accounts DO NOT get expensed over their life.

Liability/Balance
Accounts Payable Promise by the BUYER to pay the seller at a later date.
Sheet

Liability/Balance
Notes Payable A formal promise that includes signing a promissory note to pay a future amount.
Sheet

Liability that is going to be settled in the future when a company delivers its
Unearned Revenue Liability/Balance products or services. (Ex: Jim’s neighbor gave him $50 now to mow their lawn
Accounts Sheet while they are on vacation. Jim has an obligation to mow his neighbor’s lawn in
the future.)

Liability/Balance
Accrued Liabilities Amounts owed that are not yet paid.
Sheet

Stockholders’
Common Stock Amount that shareholders (owners) invest in the company.
Equity/Balance Sheet

Stockholders’ Equity Distribution of assets such as cash to the shareholders of the company. It
Dividends
/Retained Earnings REDUCES retained earnings. (NOT AN EXPENSE)

Revenue (Ex: Sales,

Revenue/Income INCREASE retained earnings and are resources generating by a company’s
Professional Service, and
Statement earning activities.
Rent Revenue.)

Expenses (Ex: Advertising,

Expenses/Income DECREASE retained earnings and are the cost of assets or services used to earn
Store Supplies, Rent, and
Statement revenues.
Utilities Expense)

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THE RECORDING PROCESS

LO1: Explain how accounts, debits, and credits are used to record business
transactions.
• Account: an individual accounting record of increases and decreases in a specific asset, liability,
owner’s equity, revenue, or expense item.
o Has 3 Parts: 1) Title of an account 2) A left or debit side 3) A right or credit side
• Accountants use “T accounts” to analyze transactions. A “T account” consists of a vertical line
and a horizontal line that resembles the letter T. “T accounts” are helpful when analyzing
transactions.
• Accounts used in recording transactions have a normal DEBIT or CREDIT balance.

*Debit means Left and Credit means Right

• Normal Balance: The increase side of the account.

* An account with a normal DEBIT balance means that we INCREASE that account with a DEBIT. (and
decrease the account with the opposite…a credit.)
An account with a normal CREDIT balance means that we INCREASE that account with a CREDIT. (and
decrease the account with the opposite…a debit)
• An account balance is the difference between the amounts recorded on the two sides of an
account.

• If Debits are GREATER than Credits, the account will have a DEBIT BALANCE.
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• If Credits are GREATER than Debits, the account will have a CREDIT BALANCE.
• The Cash T-Account above has a debit balance of $83,000.

Extended Accounting Equation

The equation must be in balance after every transaction. Total Debits must equal total Credits.

Double-Entry Accounting
• At least 2 accounts are involved, with at least one debit and one credit.
• DEBITS MUST EQUAL CREDITS.
• The accounting equation must NOT be violated. (Assets = Liabilities + Owner’s Equity)

LO 2: Indicate how a journal is used in the recording process.

The Recording Process

The Journal
• Transactions recorded in chronological order in a journal before they are transferred to the
accounts.
Contributions to the recording process:
1. Discloses the complete effects of a transaction.
2. Provides a chronological record of transactions.
3. Helps to prevent or locate errors because the debit and credit amounts can be easily compared.
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• A complete journal entry consists of

1. The date of a transaction.
2. The accounts and amounts to be debited and credited.
3. A brief explanation of the transaction.

• Example: Entering transaction data into a journal.

Kate Browne engaged in the following activities in establishing her salon, Hair It Is:
1. Opened a bank account in the name of Hair It Is and deposited $20,000 of her own money in this
account as her initial investment.
Cash 20,000
Owner’s Capital 20,000

2. Purchased equipment on account (to be paid in 30 days) for a total cost of $4,800.

Equipment 4,800
Accounts Payable 4,800

3. Interviewed three persons for the position of hair stylist. – No Entry

LO 3: Explain a ledger and posting help in the recording process.

• Ledger: comprised of the entire group of accounts maintained by a company.
• General Ledger: contains all the asset, liability, owner’s equity, revenue, and expense
accounts.

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• Standard form of Accounts:

• Posting: the process of transferring journal entry amounts to ledger accounts. Think about the
ledger accounts as individual “T-accounts” that keep track of the current balance for each account
listed in a company’s chart of accounts.

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• Chart of Accounts:

• Examples:

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LO 4: Prepare a trial balance.

• Trial Balance: list of accounts
and their balances at a given
time.
1. Accounts are listed in
the order in which they
appear in the ledger.
 Assets
 Liabilities
 Owner’s Equity
 Revenues
 Expenses
2. Purpose is to PROVE
DEBITS = CREDITS.
3. Can be used to uncover
errors in journalizing and
posting.
4. Useful in preparation of financial statements.

Limitations of a Trial Balance

The trial balance may balance even when

1. A transaction is not journalized,.

2. A correct journal entry is not posted.
3. A journal entry is posted twice.
4. Incorrect accounts are used in journalizing or posting.
5. Offsetting errors are made in recording the amount of a transaction.

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ACCRUAL ACCOUNTING CONCEPTS

LO 1: Explain the accrual basis of accounting and the reasons for adjusting
entries.
• Periodicity Assumption: Accounting divides the economic life of a business into artificial time
periods (ex: month, quarter, or year)
o Fiscal Year: an accounting time period that is one year long.
• Revenue Recognition Principle: requires that companies recognize revenue in the accounting
period in which the performance obligation is satisfied (when the money is EARNED, not collected.)

Ex: John mowed Danny’s lawn for $40 on May 15. Danny didn’t have the money to pay John until May
26. What are the journal entries for George on May 15 and May 26?

• Expense Recognition (Matching) Principle: requires that companies match expenses with revenues
in the period when the company makes efforts to generate those revenues. (when the expense has
been INCURRED, not paid.)
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ACCRUAL VERSUS CASH BASIS OF ACCOUNTING

Accrual-Basis Accounting

• Transactions recorded in the periods in which the events occur.

• Revenues are recognized when services performed, even if cash was not received.
• Expenses are recognized when incurred, even if cash was not paid.

Cash-Basis Accounting

• Revenues are recognized only when cash is received.

• Expenses are recognized only when cash is paid.
• Not in accordance with generally accepted accounting principles (GAAP).

Ex: Suppose that P Company paints a large office building in 20 YR 1. In 20 YR 1, it incurs and pays total
expenses (salaries and paint costs) of $30,000. It bills the customer $50,000, but does not receive
payment until 20 YR 2.
Accrual Basis Cash Basis
Revenue $ 50,000 Revenue $ -
20 YR 1 Expenses $ 30,000 20 YR 1 Expenses $ 30,000
Net Income $ 20,000 Net Income $ (30,000)

20 YR 2 Revenue $ - 20 YR 2 Revenue $ 50,000

Expenses $ - Expenses $ -
Net Income $ - ADJUSTING Net Income $ 50,000 ENTRIES
• Ensure that the revenue recognition and expense recognition principles are followed.
• Required every time a company prepares financial statements.
• Includes one income statement account and one balance sheet account.

Types of Adjusting Entries

Deferrals:

1. Prepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed.

2. Unearned revenues: Cash received before service are performed.

Accruals:

1. Accrued revenues: Revenues for services performed but not yet received in cash or recorded.

2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.

*ADJUSTING ENTRIES NEVER INVOLVE CASH

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LO 2: Prepare adjusting entries for deferrals.

DEFERRALS
1. PREPAID EXPENSES: Cash payment BEFORE expense is recorded.
• Costs that expire either with the passage of time or through use.
• Adjusting entry results in an increase (a debit) to an expense account and a decrease (a credit)
to an asset account.

Examples of Prepaid Expenses (Assets): Supplies, Prepaid insurance, Prepaid Advertising, Prepaid Rent,
Equipment, and Buildings.
*Adjusted because they have been USED or CONSUMED in the business operations.

Ex (Prepaid Insurance): Jones Co. pays $5,000 for Insurance for 24 months on January 1. What is the
journal entry on January 1 and the adjusting entry at the END of the year when 12 months of the
insurance is USED UP?

INSURANCE EXPENSE
Dec. 31 $2,500

Balance $2,500

PREPAID INSURANCE
Jan. 1 $5,000 Dec. 31 $2,500

Balance $2,500

($5,000/24 months) * 12 months

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Depreciation: the process of allocating the cost of an asset to expense (depreciation) over its useful life.

• Buildings, equipment, and motor vehicles (long-lived assets) are recorded as assets, rather than an
expense, in the year acquired.
• Depreciation does not attempt to report the actual change in the value of an asset.

• “Using Up” of these long-lived fixed assets is debited to depreciation expense and the account that is
credited is the accumulated depreciation account which is a contra-asset
(Normal Balance is a CREDIT….opposite of an asset.)

• For journal entry think of the term DEAD to help you remember.

Ex: Bob’s office equipment depreciated by $300 during the year. The journal entry to record
depreciation on December 31 is

• The difference between the original cost of the office equipment and the balance in the
accumulated depreciation—office equipment account is called the BOOK VALUE OF THE ASSET
(or net book value).

• It is computed as follows:

Book Value of Asset = Cost of the Asset – Accumulated Depreciation of Asset

Ex: Cost of Equipment= $50,000 (on balance sheet)

Accumulated Depreciation-Equipment= $40,000
Book Value = $50,000 - $40,000
Book Value= $10,000

SUMMARY
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2. UNEARNED REVENUES: Cash receipt BEFORE revenue is recorded.

• Adjusting entry is made to record the revenue for services performed during the period and to show
the liability that remains.
• Adjusting entry results in a decrease (a debit) to a liability account and an increase (a credit) to a
revenue account.

Examples of Unearned Revenue (Liability): Unearned Rent, Unearned Ticket Revenue, Unearned
Subscription Revenue, Unearned Service Revenue, and Customer Deposits.
*Adjusted because originally when cash is received services weren’t provided so a liability was recorded.
By the end of the accounting period some services were provided to the customer.

Ex: Tom receives $50 from his neighbor Dave before mowing the lawn on August 25 because Dave is
going on vacation. Tom mows Dave’s lawn on September 5. Prepare the journal entries for Tom for both
days.
Service Revenue
Sept. 5 $50

Balance $50

Unearned Service Revenue

Sept. 5 $50 Aug. 25 $50

Balance $0

SUMMARY
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LO 3: Prepare adjusting entries for accruals.

ACCRUALS
3. ACCRUED REVENUES: Revenue recorded BEFORE cash receipt.
• An adjusting entry serves 2 purposes:
1. Shows the receivable that exists.
2. Records the revenues for services performed.

Examples of Accrued Revenue: Rent Revenue, Interest Revenue, and Service Revenue.
*Adjusted because services have been provided to the customer, but have not been billed or recorded.
Interest has been earned, but has not been received or recorded.

Ex: George shoveled Kim’s driveway for $30 on December 20. Kim didn’t have the money to pay George
until December 28. What are the journal entries for George on December 20 and December 28?

SUMMARY
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4. ACCRUED EXPENSES: Expenses recorded BEFORE cash payment.

• An adjusting entry serves 2 purposes:
1. Records the obligations (payable).
2. Recognizes the expenses.

Examples of Accrued Expenses: Interest, Taxes, Utilities, and Salaries.

*Adjusted because expenses were incurred but have not been paid or recorded.

Ex (Salaries and Wages): Employees of Lincoln Co. are paid $5,000 every 2 weeks. If December 31 occurs
at the end of the 1st week of the pay period what journal entry is made? When the payment for the 2
week pay period actually happens January 7 what is the journal entry?

($5,000/ 2 weeks)

Salaries and Wages Expense- Current Year Salaries and Wages Payable- Current Year
Dec. 31 $2,500 Dec. 31 $2,500

Balance $2,500 Balance $2,500

Labor occurred in the current year

(last week of December)
Labor occurred next year
(first week of January)

Salaries and Wages Expense- Next Year Salaries and Wages Payable- Current Year
Jan. 7 $2,500 Jan. 7 $2,500 Dec. 31 $2,500
Balance $2,500
*Expenses are closed out at YEAR END Balance $0
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Ex (Interest): M Corporation signed a three-month note payable in the amount of $8,000 on

November 1. The note requires M Corporation to pay interest at an annual rate of 10%. What is the
adjusting entry to record the accrual of interest in November?

Face Value of Note × Annual Interest Rate × Time in Terms of One Year = Interest
$8,000 x 10% x (1/12) = 66.67 ≈ $67

SUMMARY

LO 4: Prepare an Adjusted Trial Balance

• Adjusted Trial Balance: Prepared after

all adjusting entries are journalized
and posted to the ledger accounts.
o Purpose is to prove the
EQUALITY of debit
balances and credit
balances in the ledger.
o The primary basis for the
preparation of the financial
statements.

• Order the financial statements are

prepared from the adjusted trial
balance.
1. Income Statement
2. Owner’s Equity Statement
3. Balance Sheet
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Companies can prepare financial statements directly from the adjusted trial balance.
Illustrations below present the interrelationships of data in the adjusted trial balance
and the financial statements.

1. Preparation of the Income Statement and Owner’s Equity statement from the
adjusted trial balance
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2. Preparation of the Balance Sheet from the adjusted trial balance

 Chapter 4 Review

Chpt 4: Completing the Accounting Cycle

LO 1 Prepare a worksheet
Below is a table demonstrating the basic form of a worksheet and the five steps for preparing it. Each
step is performed in sequence – see steps 1 – 5 in graph below. The use of a worksheet is optional.

A worksheet is not a journal, and it cannot be used as a basis for posting to ledger
accounts.
To adjust the accounts, the company must journalize the adjustments and post them to the
ledger.
The adjusting entries are prepared from the adjustments columns of the
worksheet.

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Chpt 4: Completing the Accounting Cycle

LO 2: Prepare closing entries and post close trial balance

CLOSING THE BOOKS

*CLOSE (ZERO OUT) TEMPORARY ACCOUNTS SUCH AS REVENUES, EXPENSES, AND DRAWINGS.

*PERMANENT ACCOUNTS (BALANCE SHEET ACCOUNTS) ARE NOT CLOSED AT THE END OF THE PERIOD
AND ARE CARRIED FORWARD FROM YEAR TO YEAR.

Think “RED” when trying to remember which accounts are temporary which means they get
“Closed Out.”

• Revenue
• Expenses
• Drawings

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Chpt 4: Completing the Accounting Cycle

STEPS TO CLOSING THE BOOKS
STEP 1: Close credit balances in revenue accounts to INCOME SUMMARY. Debit each revenue account
for its balance and credit Income Summary for the total revenue.

STEP 2: Close debit balances in expense accounts to INCOME SUMMARY. Credit each expense account
for its balance and debit Income Summary for the total expenses.

STEP 3: Close Income Summary to OWNER’S CAPITAL

When a company has Net Income: Debit Income Summary for its balance (net income) and credit the
owner’s capital account.

When a company has Net Loss: Credit Income Summary for the amount of its balance and debit the
owner’s capital account for the amount of the net loss.

INCOME SUMMARY

STEP 4: Close drawings account to OWNER’S CAPITAL ACCOUNT. Debit the owner’s capital account
for the balance of the drawings account and credit the drawings account.

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Chpt 4: Completing the Accounting Cycle

***After the closing entries are posted, ALL OF THE TEMPORARY ACCOUNTS HAVE ZERO BALANCES
and they ARE NOT SHOWN ON THE POST-CLOSING TRIAL BALANCE.

• Income Summary: temporary account that is ONLY used during the closing process.

o After the closing entries are posted, ALL OF THE TEMPORARY ACCOUNTS HAVE ZERO
BALANCES.

o During the closing process, revenue and expense accounts are cleared by debiting or
crediting Income Summary for their amounts.

Post-Closing Trial Balance

• Proves the equality of the permanent account balances that the company carries forward into the
next accounting period
• All temporary accounts will have zero balances.

Post-closing trial balance

• Pioneer prepares the post-closing trial balance from the permanent accounts in
the ledger. The example above shows the permanent accounts in Pioneer’s
general ledger.

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Chpt 4: Completing the Accounting Cycle

LO 3: Explain the steps in the accounting cycle and how to prepare correcting
entries.
Summary of the Accounting Cycle

Correcting Entries
Errors that occur in recording transactions should be corrected as soon as they are discovered
by preparing correcting entries. Correcting entries:
a. are unnecessary if the records are free of errors.
b. are journalized and posted whenever an error is discovered.
c. may involve any combination of balance sheet and income statement accounts.

Adjusting entries always affect at least one balance sheet account and one income statement
account. In contrast, correcting entries may involve any combination of accounts
in need of correction.
Correcting entries must be posted before closing entries.
To determine the correcting entry
1. Compare the incorrect entry with the correct entry
2. Then make a correcting entry

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Chpt 4: Completing the Accounting Cycle

Example: On July 4th, Harper Co. journalized and posted a $150 cash collection on
account from a customer as a debit to Cash $150 and a credit to Service Revenue $150
(see below).

The company discovered the error on July 31, when the customer paid the remaining
balance in full.

1. Comparison of entries
Incorrect Entry (July 4) Correct Entry (July 31)

Cash 150 Cash 150

Service Revenue 150 Accounts Receivable 150

Comparison of the incorrect entry with the correct entry reveals that the debit to Cash
$150 is correct.

However, the $150 credit to Service Revenue should have been credited to
Accounts Receivable.

As a result, both Service Revenue and Accounts Receivable are overstated in the ledger.
Harper makes the correcting entry.

2. Correcting Entry Necessary

Correcting entry
July 31 Dr Service Revenue 150
Cr Accounts Receivable 150
(To correct entry of July 4)

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 Chapter 4 Review

Chpt 4: Completing the Accounting Cycle

***Notice that Assets = Liabilities + Owner’ Equity. Everything is balanced.

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 Chapter 4 Review

Chpt 4: Completing the Accounting Cycle

ACCOUNT EXAMPLES DEFINITION

CLASSIFICATION
1. Cash
“Cash and other resources that are expected to be
2. Accounts Receivable
sold, collected, or used WITHIN one year or company’s
3. Inventory
Current Assets 4. Prepaids
operating cycle, whichever is longer.” Companies list
current asset accounts in the order they expect to
5. Supplies
convert them into cash.
6. Investments (short-term).
1. Investments in stocks and bonds of other
corporations that are held for more than one year.
2. Long-term assets such as land or buildings that a “Notes receivable and investments in stocks and bonds
Long-Term company is not currently using in its operating that the company intends to hold onto for MORE THAN
Investments activities. the longer of one year or operating cycle.” Also, they
3. Long-term notes receivable. ARE NOT used in the company’s operating activities.

“Tangible assets that are both long-lived and used in

operating the business.”
1. Equipment
Plant Assets 2. Machinery
All plant assets (EXCLUDING Land) depreciate over their
(Property, 3. Buildings useful lives.
Plant, and 4. Land
• Depreciation: allocating the cost of assets to a
5. Delivery Vehicles
Equipment) 6. Furniture.
number of years.
• Accumulated Depreciation: total amount of
depreciation expensed thus far in the asset’s life.
1. Trademarks
2. Patents
Intangible 3. Copyrights “Long-term resources that lack a physical form (not
Assets 4. Franchises touchable) and benefit business operations.”
5. Goodwill

1. Accounts Payable
2. Salaries and Wages Payable
Current 3. Income Taxes Payable “Obligations due to be paid or settled WITHIN one
Liabilities 4. Interest Payable year or the operating cycle, whichever is longer.”
5. Notes Payable (1 year or less).
6. Current maturities of long-term obligations
1. Bonds Payable
Long-Term 2. Notes Payable (more than 1 year)
“Obligations NOT DUE within one year or the
3. Mortgage Payable.
Liabilities 4. Lease Liabilities
operating cycle, whichever is longer.”
5. Pension Liabilities
1. Common stock
2. Preferred Stock
Equity 3. Paid-in Capital “The owner’s claim on assets.”
4. Retained Earnings ( income retained for use in
the business)

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 Chapter 5 Review

MERCHANDISING OPERATIONS AND THE MULTI-STEP

INCOME STATEMENT
LO 1: Describe merchandising operations and inventory systems.
• Primary source of revenue for merchandisers like Walmart that buy and sell goods is referred to as
sales revenue.
• Cost of goods sold is the total cost of merchandise sold during the period.
o It is an EXPENSE that is directly related to the revenue recognized from the sale of goods.

Ex: Company C, a retailer, bought chairs from a wholesaler for $15 each. Company C then sold the
chairs to their customers for $20 each.

• The $20 represents Company C’s sales revenue for each chair.
• The $15 that Company C spent on each chair represents Company C’s cost of goods sold and
is recognized when each chair is sold to customers.

***Key Formula: Sales Revenue – Cost of Goods Sold = Gross Profit

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FLOW OF COSTS
• Companies use either a perpetual inventory system or a periodic inventory system to account for
inventory.

1. Perpetual: CONTINUOUSLY updates accounting records for merchandising transactions –

SPECIFICALLY reduction of inventory and increasing cost of goods sold.

• Advantages of perpetual inventory system.

1. Traditionally used for merchandise with high unit values.
2. Shows the quantity and cost of the inventory that should be on hand at any time.
3. Provides better control over inventories than a periodic system.

2. Periodic: updates the accounting records for merchandise transactions at the END OF A PERIOD.

• Cost of goods sold determined by count at the end of the accounting period.

***Key Formula… Cost of Goods Sold = Beginning Inventory + Net Purchases – Ending Inventory

Beginning Inventory $ 200,000

Add: Purchases, net $ 900,000
Goods available for sale $ 1,100,000
Less: Ending Inventory $ 400,000
Cost of Goods Sold $ 700,000

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 Chapter 5 Review

LO 2: Record purchases under a perpetual inventory system.

FREIGHT COSTS

Shipping Terms Ownership Transfers when goods passed to Freight cost paid by

1. FOB (Free on Board) 1. BUYER

Shipping Point: GOODS 1. CARRIER
Inventory xxx
ARE BUYERS AS SOON AS
Cash xxx
CARRIER GETS THEM.

2. FOB (Free on Board) 2. SELLER

Destination: GOODS ARE 2. BUYER
SELLERS UNTIL THEY REACH Freight-Out xxx
BUYER. Cash xxx

Del

PURCHASE DISCOUNTS
• Buyer receives a cash discount for prompt payment.
• Saves the buyer money and helps the seller collect money faster.

What does this mean?

*The buyer can deduct 2% of the invoice amount if
payment is made within 10 days of the invoice
date, otherwise full payment is due within a
30-day credit period.
*Simply…The buyer gets a 2% discount if they pay
within 10 days, otherwise the full amount is due in
30 days.

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 Chapter 5 Review

PURCHASE DISCOUNTS (Cont.)

1% discount if paid within first 10 days of next month.

Net amount due within the first 10 days of the next month.

PURCHASE RETURNS AND ALLOWANCES

• Purchase Returns: Return goods for credit if the sale was made on credit, or for a cash refund if the
purchase was for cash.
• Purchase Allowances: May choose to keep the merchandise if the seller will grant a reduction of
the purchase price.

Summary of Purchasing Journal Entries- Perpetual

DEBIT CREDIT
Inventory xxx
1. Purchase inventory ON ACCOUNT.
Accounts Payable xxx

Inventory xxx
2. Purchase inventory for CASH.
B Cash xxx

Inventory xxx
U 3. Paying freight costs on purchases (FOB Shipping Point) Cash xxx

Y Accounts Payable xxx

4. Paying WITHIN discount period. Inventory (For purchase discount) xxx
E Cash xxx

R 5. Paying OUTSIDE discount period.

Accounts Payable
Cash
xxx
xxx

Cash or Accounts Payable xxx

6. Recording Purchase Returns and Allowances. Inventory xxx

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 Chapter 5 Review

Example Journal Entries

Jay Company bought inventory from Z Company on January 1 for $10,000 under the credit terms 3/15,
n/60. On January 10, Jay Company returned goods costing $1,000 to Z Company. Jay Company paid Z
Company for the remaining goods on Jan. 12.

What are the journal entries that need to be recorded in January for Jay Company?

Date Debit Credit

Inventory Jan. 1 10,000
Accounts Payable- Z Company 10,000

Accounts Payable- Z Company Jan. 10 1,000

Inventory 1,000

Accounts Payable- Z Company (10,000 – 1,000) Jan. 12 9,000

Inventory (9,000 × 3% = $270) 270
Cash 8,730

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 Chapter 5 Review

LO 3: Record sales under a perpetual inventory system.

SALES RETURNS AND ALLOWANCES

• Used when the seller either accepts goods back from a purchaser (a return) or grants a reduction in
the purchase price (an allowance) so that the buyer will keep the goods.
• Contra-revenue account on the income statement and has a Debit balance.

SALES DISCOUNTS
• Issued by the seller to obtain their money from the customer faster.
• Contra-revenue account on the income statement and has a Debit balance.

Sales Revenue – Sales Returns and Allowances – Sales Discounts = Net Sales

Net Sales – Cost of Goods Sold = Gross Profit

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Example Journal Entries

• Jay Company sold goods costing $6,000 to X Company for $10,000 on March 1 under the terms
2/10, net 30. On March 5, X Company returned goods to Jay Company with a selling price of $3,000
and a cost of $1,800. On March 10, Jay Company received payment from X Company for the
remainder of the goods.

What are the journal entries that need to be recorded on in March for Jay Company?

Date Debit Credit

Accounts Receivable- X Company Mar. 1 10,000
Sales Revenue 10,000

Cost of Goods Sold Mar. 1 6,000

Inventory 6,000

Sales Returns and Allowances Mar. 5 3,000

Accounts Receivable- X Company 3,000

Inventory Mar. 5 1,800

Cost of Goods Sold 1,800

Cash Mar. 10 6,860

Sales Discounts (7,000 × 2% = $140) 140
Accounts Receivable- X Company (10,000 -3,000) 7,000

LO 5: Apply the steps in the accounting cycle to a merchandising company.

Each of the required steps described in Chapter 4 for service companies applies to
merchandising companies.
Adjusting Entries
A merchandising company generally has the same types of adjusting entries as a service
company. However, a merchandiser using a perpetual system will require one additional
adjustment to make the records agree with the actual inventory on hand. Here’s why: At the end
of each period, for control purposes, a merchandising company that uses a perpetual system will
take a physical count of its goods on hand.
The company’s unadjusted balance in Inventory usually does not agree with the actual amount of
inventory on hand. The perpetual inventory records may be incorrect due to recording errors,
theft, or waste. Thus, the company needs to adjust the perpetual records to make the recorded
inventory amount agree with the inventory on hand.

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• This adjustment impacts Inventory and Cost of Goods Sold.

For example, suppose that PW Audio Supply, Inc. has an unadjusted balance of $40,500 in
Inventory.
Through a physical count, PW Audio Supply determines that its actual merchandise inventory at
December 31 is $40,000. The company would make an adjusting entry as follows.

Dec. 31 Cost of Goods Sold 500

Inventory ($40,500 – $40,000) 500
(To adjust inventory to physical count)

Closing Entries
A merchandising company, like a service company, closes to Income Summary all accounts that
affect net income. In journalizing, the company credits all temporary accounts with debit
balances, and debits all temporary accounts with credit balances. It also closes both Income
Summary and Drawings to Owner's Capital. (Hint – R.E.D – temporary accounts are Revenue,
Expense, and Drawings)

The following are the closing entries for PW Audio Supply using assumed amounts from its
year-end adjusted trial balance.
• Cost of Goods Sold is an expense account with a normal debit balance,
• Sales Returns and Allowances and Sales Discounts are contra revenue accounts with
normal debit balances

The easiest way to prepare the first two closing entries is to identify the temporary
accounts by their balances and then prepare one entry for the credits and one for the
debits.
Dec.31 Sales Revenue 480,000
Income Summary 480,000
(To close income statement accounts with credit
balances)
31 Income Summary 450,000
Sales Returns and Allowances 12,000
Sales Discounts 8,000
Cost of Goods Sold 316,000
Salaries and Wages Expense 64,000
Freight-Out 7,000
Advertising Expense 16,000

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 Chapter 5 Review

Utilities Expense 17,000

Depreciation Expense 8,000
Insurance Expense 2,000
(To close income statement accounts with debit
balances)
31 Income Summary 30,000
Owner's Capital 30,000
(To close net income to Owner's Capital)
31 Owner's Capital 15,000
Owner's Drawing 15,000
(To close dividends to rOwner's Capital)
After PW Audio Supply has posted the closing entries, all temporary accounts have zero
balances. Also, Retained Earnings has a balance that is carried over to the next period

LO 5: Prepare a multi-step income statement

SINGLE-STEP INCOME STATEMENT
• Subtract total expenses from total revenues
• Two reasons for using the single-step format:
1. Company does not realize any type of profit or income until total revenues exceed total
expenses.
2. Form is simple and easy to read.

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 Chapter 5 Review

MULTI-STEP INCOME STATEMENT

• Highlights the components of net income.
• Three important line items:
1. Gross profit
2. Income from Operations
3. Net Income

•
***ALL OF THESE ITEMS ARE PART OF NONOPERATING
ACTIVITIES AND ARE ADDED OR DEDUCTED FROM INCOME
FROM OPERATIONS TO GET INCOME BEFORE TAXES.

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 Chapter 6 Review

REPORTING AND ANALYZING INVENTORY

LO 1: Discuss how to classify and determine inventory.
• Inventory: “Assets a company intends to sell in the normal course of business, has in production for
future sale, or uses currently in the production of goods to be sold.”
1. Inventory--ON BALANCE SHEET: “represents the cost of inventory STILL ON HAND.”
2. Cost of Goods Sold---ON INCOME STATEMENT: “represents the cost of inventory SOLD
DURING THE PERIOD.”

• Merchandising companies have ONE type of inventory: Merchandise Inventory

• Manufacturing companies have THREE types of inventory:
1. Raw Materials
2. Work in Process
3. Finished Goods

DETERMINING INVENTORY QUANTITIES

• Physical inventory is taken for 2 reasons:
o Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost due to wasted raw materials, shoplifting, or
employee theft.

o Periodic System
1. Determine the inventory on hand.
2. Determine the cost of goods sold for the period.

• One challenge in determining inventory quantities is making sure a company owns the inventory.
o Goods in transit: purchased goods not yet received and sold goods not yet delivered.
• FOB (Free on Board) Shipping Point: Ownership of the goods passes to the buyer
when the public carrier accepts the goods from the seller.
• If goods are in transit they are the BUYERS.

• FOB (Free on Board) Destination: Ownership of the goods remains with the seller
until the goods reach the buyer.
• If goods are in transit they are the SELLERS.

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o Consigned Goods: Goods held for other parties to see if they can sell the goods for the
other party. The company holding the goods charges a fee and does not take ownership of
the goods.
• Consignor: goods shipped by the owner.
• Consignee: sell goods for the owner.
**At end of the year GOODS NOT SOLD BELONG AS PART OF CONSIGNOR’S (OWNER’S)
INVENTORY.

Ex: Auto Alex owns a used car lot. Nick has a used car that he wants to sell. He goes to Auto Alex
and the dealer agrees to put Nick’s car on the lot for a fee. Auto Alex does not take ownership of
the car.

Consignor: Nick (Car is INCLUDED in inventory.)

Consignee: Auto Alex (Used car is NOT INCLUDED in inventory.)

LO 2: Apply inventory cost flow methods and discuss their financial effects.
• Inventory is accounted for at cost.
o Cost includes all expenditures necessary to acquire goods and place them in a condition
ready for sale.
o Unit costs are applied to quantities to determine the total cost of the inventory and the cost
of goods sold using the following costing methods:
1. Specific identification
2. First-in, first-out (FIFO)
3. Last-in, first-out (LIFO)
4. Average-cost

o There is NO REQUIREMENT that the cost flow assumption has to be consistent with the
physical movement of goods.

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1. SPECIFIC IDENTIFICATION (PERPETUAL)

• Cost attached to a specific item. (Ex: When selling jewelry.)

Ex: Laker Company ending inventory consists of 200 units, where 180 are from January 24 purchase, 5 are
from January 6 purchase and 15 are from the beginning inventory.

Date Explanation Units Unit Cost Total

Cost
Jan. 1 Beginning Inventory 140 $ 6.00 $ 840.00
Jan.6 Purchase 60 $ 5.00 $ 300.00
Jan. 24 Purchase 180 $ 4.50 $ 810.00
Total 380 $ 1,950

Step 1: Calculate Cost of Goods Sold Step 2: Calculate Ending Inventory

Date Units Unit Cost Total Cost Cost of Goods Available for sale $ 1,950
Beg. Inv. 125 $ 6.00 $ 750 Less: Cost of Goods Sold $ (1,025)
Jan. 6 55 $ 5.00 $ 275 Ending Inventory $ 925.00
Jan. 24 0 $ 4.50 $ 0
Total 180 $ 1,025 OR
Step 2: Calculate Ending Inventory
Date Units Unit Cost Total Cost
Beg. Inv. 15 $ 6.00 $ 90
Jan. 6 5 $ 5.00 25
Jan. 24 180 $ 4.50 $ 810
Total 200 $ 925

2. FIRST-IN, FIRST-OUT (FIFO) (PERPETUAL)

• Assumes OLDEST ITEMS SOLD FIRST (Ex: Grocery stores sell oldest fruit or dairy
products like milk first before newest.)
• Costs of the earliest goods purchased are the first to be recognized in determining
cost of goods sold. (Resembles the actual physical flow of merchandise)
• Example:

[Grab your
reader’s
 Chapter 6 Review

NEWEST UNITS REMAIN IN ENDING INVENTORY.

3. LAST-IN, FIRST-OUT (LIFO) (PERPETUAL)

• Assumes NEWEST ITEMS SOLD FIRST (Ex: When new technology items came out.)
• Costs of the latest goods purchased are the first to be recognized in determining cost
of goods sold.
• Seldom coincides with actual physical flow of merchandise.

• OLDEST UNITS REMAIN IN ENDING INVENTORY.

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4. MOVING AVERAGE (PERPETUAL)

When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold.

INCOME STATEMENT EFFECTS

• In periods of changing prices, the cost flow assumption can have significant impacts both on income
and on evaluations of income, such as the following.

1. In a period of inflation (prices are RISING), FIFO produces a higher net income because lower
unit costs of the first units purchased are matched against revenue.

2. In a period of inflation (prices are RISING), LIFO produces a lower net income because higher
unit costs of the last goods purchased are matched against revenue.

3. If prices are falling, the results from the use of FIFO and LIFO are reversed. FIFO will report the
lowest net income and LIFO the highest.

4. Regardless of whether prices are rising or falling, average-cost produces net income between
FIFO and LIFO.
During Times of Rising Prices:
(Jan. 1 $20, Feb. 1 $30, Mar. 1 $40

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• Each of the three cost flow assumptions are acceptable under GAAP.
• Method should be used consistently, enhances comparability.
• Although consistency is preferred, a company may change its inventory costing method.

LO 3: Indicate the effects of inventory errors on financial statements.

• INCOME STATEMENT EFFECTS

• BALANCE SHEET EFFECTS

Accounting Equation: ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY

LO 4: Explain the statement presentation and analysis of inventory.

• Inventory is classified in the BALANCE SHEET as a CURRENT ASSET immediately below receivables.
• In a multiple-step income statement, cost of goods sold is subtracted from net sales.
• There also should be disclosure of
1. The major inventory classifications
2. The basis of accounting (cost, or lower-of-cost-or-market)
3. The cost method (FIFO, LIFO, or average-cost).

LOWER-OF-COST-OR-MARKET
• Applied to items in inventory after the company has used one of the cost flow methods (
specific identification, FIFO, LIFO, or average-cost) to determine cost.
• Companies can “write down” the inventory to its market value in the period in which the price
decline occurs.

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• Market value = Replacement Cost

• Example of conservatism.
• Inventory is valued at the LOWER of
its COST or MARKET VALUE.

ANALYSIS
1. Inventory Turnover Ratio

• Average Inventory= (Inventory Beginning of Year + Inventory End of Year) ÷ 2

• Used to measure a company’s ability to manage its inventory effectively.
• A company that has an inventory turnover of 4 indicates that it sells and replaces their inventory 4
times per year.

2. Days in Inventory

• Indicates the average number of days’ inventory is held.

• Shorter the number of days’ in inventory, the better, but it depends on industry. For example,
grocery stores will have a much shorter amount of days then jewelry stores.
• A company has 100 days’ in inventory. Therefore, it takes it 100 days to purchase, sell, and replace
their inventory.

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REPORTING AND ACCOUNTS RECEIVABLE

LO 1: Explain how companies recognize accounts receivable.
RECEIVABLES
• “Amounts due from individuals and companies that are expected to be collected in cash.”
1. Accounts Receivable: Amounts customers owe on account that result from the sale of
goods and services. Companies generally expect to collect accounts receivable within 30
to 60 days.

2. Notes Receivable: Written promise (formal instrument) for amount to be received. Also
called trade receivables. They include interest and extend for time periods of 60 to 90
days or longer.

3. Other Receivables: Nontrade receivables such as interest, loans to officers, advances to

employees, and income taxes refundable.

• Service organization records a receivable when it performs service ON ACCOUNT.

• Merchandiser records accounts receivable at the point of sale of merchandise ON ACCOUNT.

***Below are examples of journal entries that would be made with accounts receivables.
Many of these journal entries were explained in Chapter 5.

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Example: Prepare journal entries to record the following transactions entered into by the Castagno
Company: Ignore COGS

Nov. 1 Sold merchandise on account to Mercer, Inc., for $18,000, terms 2/10, n/30.
Nov. 5 Mercer, Inc., returned merchandise worth $1,000.
Nov. 9 Received payment in full from Mercer, Inc.

Date Debit Credit

Accounts Receivable- Mercer, Inc. Nov. 1 18,000
Sales Revenue 18,000

Sales Returns and Allowances Nov. 5 1,000

Accounts Receivable- Mercer, Inc. 1,000

Cash Nov. 9 16,660

Sales Discounts ($17,000 x 0.02) 340
Accounts Receivable- Mercer, Inc. 17,000

***Remember: 2/10, n/30 means that the buyer (Mercer) will get a 2% discount
on the selling price if they pay Castagno within 10 days, otherwise the full
amount is due in 30 days with no discount.

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LO 2: Describe how companies value accounts receivable and record their

disposition.
VALUING ACCOUNTS RECEIVABLE
• Current asset on the balance sheet.
• Valuation (net realizable value). (The amount of accounts receivable that the company actually
expects to collect.)
• Bad Debt Expense: Losses that the seller records as a result from extending credit and not being
able to collect the money.

• Two methods used in accounting for uncollectible accounts are:

1. Direct Write-Off Method
• Records bad debt expense only when an account is determined to be worthless.
• Used by SMALL companies and companies with a FEW receivables.
• No matching.
• Receivable is not stated at net realizable value.
• Not acceptable for financial reporting.
• If an accounts receivable that has been written off is later collected, then 2 journal
entries have to be made. One to reinstate the accounts receivable and the other one
to collect the cash.

2. Allowance Method
• Records bad debt expense by estimating uncollectible accounts at the end of the
accounting period.
• Generally accepted accounting principles (GAAP) require companies with a large
amount of receivables to use the allowance method.
• When an estimation of bad debts is made the account “ALLOWANCE FOR
DOUBTFUL ACCOUNTS” gets credited (Has a normal CREDIT balance after the end
of period adjusting journal entry). It is a contra-asset.
o Allowance for Doubtful accounts has a DEBIT balance when:
the write-offs during the period EXCEED than the beginning balance.
o Allowance for Doubtful accounts has a CREDIT balance when:
write-offs during the period are LESS than the beginning balance.

Cash (Net) Realizable Value of Receivables= Accounts Receivable Balance – Allowance for Doubtful Accounts

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Example: On November 15, it was determined that Mr. Sanders account of $3,000 would be
uncollectible. On December 20, after Mr. Sanders account was written off he paid Company M $3,000 in
full. On December 31, Company M estimated that $10,000 of their remaining credit sales will prove
uncollectible.

a) Prepare the journal entries for November 15, December 20, and December 31 under the direct write-
off method.

Date Debit Credit

Bad Debt Expense Nov. 15 3,000
Accounts Receivable- Mr. Sanders 3,000

Accounts Receivable- Mr. Sanders Dec. 20 3,000

Bad Debt Expense 3,000

Cash Dec. 20 3,000

Accounts Receivable- Mr. Sanders 3,000

NO JOURNAL ENTRY Dec. 31

b) Prepare the journal entries for November 15, December 20, and December 31 under the allowance
method.

Date Debit Credit

Allowance for Doubtful Accounts Nov. 15 3,000
Accounts Receivable- Mr. Sanders 3,000

Accounts Receivable- Mr. Sanders Dec. 20 3,000

Allowance for Doubtful Accounts 3,000

Cash Dec. 20 3,000

Accounts Receivable- Mr. Sanders 3,000

Bad Debt Expense Dec. 31 10,000

Allowance for Doubtful Accounts 10,000

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PRESENTATION OF ACCOUNTS RECIEVABLE ON THE BALANCE SHEET UNDER THE

ALLOWANCE METHOD

• Cash (Net) Realizable Value = Accounts Receivable – Allowance for Doubtful Accounts
• For Hampson Furniture, of the $200,000 in Accounts Receivable, they only expect to collect
$188,000. They do not expect to collect $12,000.

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2 Methods for Estimating Uncollectible Accounts under the Allowance Method

1. Balance Sheet Approach (Percent of Ending Accounts Receivable Method)

Allowance for Doubtful Accounts
% of End Accounts Receivable as Uncollectible as a decimal x End A/R = Y

BEG Balance

*X--- WE NEED TO
JOURNAL ENTRY
FIGURE THE
ADJUSTMENT FROM Bad Debt Expense X
THE BEG TO END
BALANCE
Allowance for Doubtful Accounts X

Y- END BALANCE
RULES
1. IF BEGINNING ALLOWANCE FOR DOUBTFUL ACCOUNTS IS A CREDIT THEN
END BALANCE – BEGINNING BALANCE = X

2. IF BEGINNING ALLOWANCE FOR DOUBTFUL ACCOUNTS IS A DEBIT THEN

END BALANCE + BEGINNING BALANCE = X

Ex: 1 Smith Inc. estimates that 1% of their $100,000 accounts receivable balance as of December
31 will be uncollectible. What Journal entry would be made on December 31 if the beginning
balance for the Allowance for Doubtful Accounts was a $600 CREDIT balance?

Bad Debt Expense 400 $1,000 (END) - $600 (BEG)

Allowance for Doubtful Accounts 400 $1,000 (END) - $600 (BEG)

Allowance for Doubtful Accounts

$600 Beginning Balance
$400 $1,000 (END) - $600 (BEG) = $400

$1,000 0.01 X $100,000 = $1,000

Ending Balance

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Ex: 2 Smith Inc. estimates that 1% of their $100,000 accounts receivable balance as of December
31 will be uncollectible. What Journal entry would be made on December 31 if the beginning
balance for the Allowance for Doubtful Accounts was a $600 DEBIT balance?

Bad Debt Expense 1,600 $1,000 (END) + $600 (BEG)

Allowance for Doubtful Accounts 1,600 $1,000 (END) + $600 (BEG)

Allowance for Doubtful Accounts

BEG: $600 $1,600 $1,000 (END) + $600 (BEG) = $1,600

End: $1,000 0.01 X $100,000 = $1,000

2. Balance Sheet Approach (Aging the Accounts Receivables Method)

Totals Not Yet Due 1-30 days Past Due 31-60 days Past Due 61-90 days Past Due 90 + Days Past Due
John Smith $2,000 $1,000 $1,000
Sue $3,000 $1,000 $1,000 $1,000
Aging of Jim $10,000 $5,000 $2,000 $1,000 $2,000
Recievables Total Recievables $15,000 $6,000 $2,000 $3,000 $2,000 $2,000
Method Percent Uncollectible 2% 5% 10% 25% 40%
ESTIMATED UNCOLLECTIBLE $1,820.00 $120 $100 $300 $500 $800

Ending Balance of Allowance for Doubtful Accounts

*If Allowance for Doubtful Accounts had an unadjusted $500 credit balance then…..

Ending Balance – Beginning Balance = Adjustment

$1,820 - $500 = $1,320

Bad Debt Expense 1,320

Allowance for Doubtful Accounts 1,320

*The amount of the adjusting entry is the amount that will yield an adjusted balance for
Allowance for Doubtful Accounts equal to that estimated by the aging schedule. In this case the
adjusted entry which CREDITS Allowance for Doubtful Accounts by $1,320 leads to the ending
adjusted balance of the Allowance for Doubtful Accounts to have a CREDIT balance of $1,820.

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DISPOSING OF ACCOUNTS RECEIVABLE

Sale of Receivables to a Factor

• A factor is a finance company or bank.

o Buys receivables from businesses and then collects the payments directly from the
customers.
o Typically charges a commission to the company that is selling the receivables.
o Fee ranges from 1% to 3% of the receivables purchased.

Ex: Assume that Hendredon Furniture factors $600,000 of receivables to Federal Factors on Nov. 15.
Federal Factors assesses a service charge of 2% of the amount of receivables sold. The journal entry to
record the sale by Hendredon Furniture is as follows:

Date Debit Credit

Cash Nov. 15 588,000
Service Charge Expense ($600,000 x 2%) 12,000
Accounts Receivable 600,000

National Credit Card Sales (Customers that use Visa, Mastercard, or other credit card)

• A retailer’s acceptance of a national credit card is another form of selling (factoring) the receivables
by the retailer.
o Retailer pays card issuer a fee of 2 to 4% of the invoice price for its services.
o Recorded the same as cash sales.

o Advantages to retailer:
 Issuer does credit investigation of customer.
 Issuer maintains customer accounts.
 Issuer undertakes collection and absorbs losses.
 Receives cash more quickly.

Ex: Chef Louie purchases $2,000 worth of food and ingredients for his restaurant from Frank’s Fresh
Market store, and he charges this amount on his MasterCard. The service fee that MasterCard charges
Frank’s Fresh Market is 4%. Frank’s Fresh Market would record this transaction on March 28 as follows:

Date Debit Credit

Cash Mar. 28 1,920
Service Charge Expense ($2,000 x 4%) 80
Sales Revenue 2,000

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LO 3: Explain how companies recognize, value, and dispose of Notes Receivable.

Promissory Note: “written promise to pay a specified amount of money on demand or at a definite
time.”
• Promissory notes may be used when
1. Individuals and companies lend or borrow money.
2. Amount of transaction and credit period exceed normal limits.
3. In settlement of accounts receivable.
• Used for a credit period of more than 60 days. If it is going to be collected WITHIN ONE YEAR, it is
classified as a current asset on the balance sheet. If it is going to be collected AFTER MORE THAN A
YEAR, then it is classified as a noncurrent asset as an investment on the balance sheet.
• Report short-term notes receivable at their cash (net) realizable value.
• Estimation of cash realizable value and recording bad debt expense and related allowance are
similar to accounts receivable.

EXAMPLE used for terms below: A NOTE DATED JUNE 20, 20XX FOR RON TO PAY CAM $1,000 ON
OCTOBER 20, 20XX WITH AN INTEREST RATE OF 10%.

1. Face Value of a Note (Principal): specified amount of money at a definite future date.
(Ex: $1,000)

2. Maker of the Note: the person who signed the note and promised to pay it at maturity. (Ex: RON)
• The maker of the note recognizes a note payable.

3. Payee of the Note: the person to whom the note is payable. (Ex: CAM)
• The payee of the note recognizes a note receivable.

4. Issuance Date: the date the note is issued. (Ex: JUNE 20, 20XX)

5. Maturity date of the Note: the date the note must be repaid. (Ex: OCTOBER 20, 20XX)
• May be stated on demand, on a stated date, or at the end of a stated period of time.
• Note terms are expressed in months and days.

*When months or years are used, the note matures and is payable in the month of its maturity on the
same day of the month as its original date. For example, a 9-month note dated September 28 would be
payable on June 28.

*If days, then have to count days in the month. DON’T INCLUDE DATE OF NOTE AS PART OF NUMBER OF
DAYS. For example, if note issued March 16 the amount of days note is outstanding in
March is 31 days – 16 = 15 days.

Term of Note 90 days

March (31-16) 15 days
April 30 days
May 31 days 76
June 14
(Maturity Date)

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6. Term of Note: amount of time between the issuance and due dates. (About 122 days—Time
between June 20, 20XX and October 20, 20XX)

7. Interest Computation:

Time in Terms of One Year

Days: # of days ÷ 360
Months: # of months ÷ 12
Years: # of years ÷ 1

Ex: The total interest for a $1,000, 90-day, and 10% note would be computed as follows:
$1,000 X 10% X (90/360) = $25

Current Example: 122 day note between Ron and Cam.

$1,000 x 10% x (122/360) = $33.89 Interest

8. Maturity Value: Amount that must be paid at the due date of the note. It is the sum of the
face amount and interest. In our example Ron has to pay Cam $1,033.89 ($1,000 Face Amount
+ $33.89 Interest) when note is due on October 20, 2017.

Another Note Example

with Terms

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Journal Entries for Notes Receivable

1. Recognizing Notes Receivable (Tropical Breeze-Payee point of view)

Tropical Breeze Inc. received a $2,000, 90-day, 10% promissory note from Paradise Sand to settle their
overdue open account.

2. Recording an Honored Note (Tropical Breeze-Payee point of view)

After 90 days, Tropical Breeze Inc. receives $2,050 from Paradise Sand ($2,000 to repay the note and
$50 in interest.) Interest = (2,000 x 10% x (90/360))= $50

3. Recording a Dishonored Note (Tropical Breeze-Payee point of view)

After 90 days, Paradise Sand is unable and refuses to pay Tropical Breeze Inc. $2,050 ($2,000 to repay
the note and $50 in interest.)

4. Recording End-of-Period Interest Adjustment (Tropical Breeze-Payee point of view)

If Tropical Breeze Inc. receives a $2,000, 90-day, 10% promissory note from Paradise Sand on
December 1, then on December 31 Tropical Breeze Inc. would need to recognize 30 days of interest.

$2,000 X 10% X (30/360) = $16.67

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LO 4: Describe the statement presentation of receivables and the principles of

receivables management.

• Companies need to identify in the balance sheet or in notes to the financial statements each of the
major types of receivables.
• Companies report both the gross amount of receivables and the allowance for doubtful accounts.

MANAGING RECEIVABLES
Managing accounts receivable involves five steps:
1. Determine to whom to extend credit.

2. Establish a payment period.

3. Monitor collections.
• Companies should prepare an accounts receivable aging schedule at least monthly.
• Helps managers estimate the timing of future cash inflows.
• Provides information about the collection experience of the company and
identifies problem accounts.

4. Evaluate the liquidity of receivables.

• Accounts Receivable Turnover: Measure the number of times, on average, a

company collects receivables during the period.

• Average Collection Period: Used to assess the effectiveness of credit and collection
polices. This period SHOULD NOT EXCEED credit term period.

5. Accelerate cash receipts from receivables when necessary.

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Plant Assets, Natural Resources, and Intangible Assets

LO 1: Explain the accounting for Plant Asset Expenditures.
• Plant Assets (Also known as Property, Plant, and Equipment/ Fixed Assets): resources that have
• physical substance (a definite size and shape).
• are used in the operations of a business.
• are not intended for sale to customers.
• are expected to provide service to the company for a number of years.

• Cost of Plant Assets: Historical cost principle requires that companies record plant assets at COST.
• Consists of all expenditures necessary to acquire an asset and make it ready for its
intended use.
• Cost is measured by the cash paid in a cash transaction or the cash equivalent price paid.
• Cash equivalent price is the
• fair value of the asset given up or fair value of the asset received, whichever is
more clearly determinable.

1. Revenue Expenditure: costs incurred to acquire a plant asset that are EXPENSED
IMMEDIATELY.
• Include the cost of ordinary repairs, which are expenditures to maintain operating
efficiency and expected productive life of the unit.
• “Expenditures that produce benefits ONLY IN THE CURRENT PERIOD.” They are
EXPENSED in the current period.
• Ex: Engine tune-up for delivery truck. It allows the truck to continue its productive
activity but DOES NOT INCREASE FUTURE BENEFITS. This is an example of a
maintenance cost.

Ex: Aug. 1: $500 was paid for a tune-up of a delivery truck. The journal entry would be
recorded as
Date Debit Credit
Maintenance and Repairs Expense Aug. 1 500
Cash 500

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2. Capital Expenditure: costs INCLUDED IN A PLANT ASSET ACCOUNT.

• Include the cost of additions and improvements, which are costs incurred
to increase the operating efficiency, productive capacity, or expected useful
life of a plant asset.
• Costs that are CAPITALIZED NOW and expensed later.
• “Expenditures that produce future benefits.” They are recorded as an ASSET
and EXPENSED IN FUTURE PERIODS.
• Ex: Major improvement on a truck that EXTENDS its useful life.
• The accounting varies depending on the nature of the expenditure.

Ex: July 1: The engine of a forklift near the end of its useful life is overhauled (taken apart to be
repaired) at a cost of $5,000 which extends its useful life by 6 years. The journal entry to record this
expenditure is

Date Debit Credit

(1) Forklift July 1 5,000
Cash 5,000

COST OF PLANT ASSETS

1. Land: All necessary costs incurred in making land ready for its intended use increase (debit) the
Land account. Costs typically include:
• Cash purchase price.
• Closing costs such as title and attorney’s fees.
• Real estate brokers’ commissions.
• Accrued property taxes and other liens on the land assumed by the purchaser.

2. Land Improvements: Includes all expenditures necessary to make the improvements ready for
their intended use. They have limited useful lives and they are expensed (depreciated) over their useful
lives. Costs typically include:
• Driveways.
• Parking lots.
• Fences.
• Landscaping.
• Underground sprinklers.

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3. Buildings: Includes all costs related directly to purchase or construction.

Purchase costs typically include:
• Purchase price, closing costs (attorney’s fees, title insurance, etc.) and real estate broker’s
commission.
• Remodeling and replacing or repairing the roof, floors, electrical wiring, and plumbing.
Construction costs typically include:
• Contract price plus payments for architects’ fees, building permits, and excavation costs.
• Interest costs to finance a construction project which are limited to interest costs incurred
during the construction period.

4. Equipment: Include all costs incurred in acquiring the equipment and preparing it for use.
Costs typically include:
• Cash purchase price.
• Sales taxes.
• Freight charges.
• Insurance during transit paid by the purchaser.
• Expenditures required in assembling, installing, and testing the unit.

LO 2: Apply Depreciation Methods to Plant Assets

Depreciation: “Process of allocating to expense the cost of a plant asset over its useful life in a rational
and systematic manner.”

IMPORTANT FACTS ABOUT DEPRECIATION

• Process of cost allocation, not asset valuation.
• Applies to land improvements, buildings, and equipment, NOT LAND.
o LAND DOES NOT DEPRECIATE.
• Depreciable, because the revenue-producing ability of asset will decline over the asset’s useful life.

FACTORS IN COMPUTING DEPRECIATION

1. Cost: All expenditures necessary to acquire the asset and make it ready for intended use.

2. Useful Life: Estimate of the expected productive (service) life of the asset for its owner. It may be
expressed in terms of time, units of activity (such as machine hours), or units of output.

3. Salvage Value (Residual Value): Estimate of the asset’s value at the end of it useful life.
An asset cannot be depreciated past its salvage value.

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DEPRECIATION METHODS
1. STRAIGHT-LINE METHOD: equal amount of depreciation is taken out each year.
*Depreciable Cost (amount that gets depreciated) = Cost – Salvage Value

Depreciation Expense = Cost – Salvage Value

Useful Life in Periods

Ex: Smith Inc. bought a machine for $20,000 to use in his business. The machine’s useful life is 5 years.
What is the depreciation expense per year and what journal entry would be made at the end of the
year?

A) Depreciation Expense = ($20,000 - $0) ÷ 5 years = $4,000 per year

***Another way to compute depreciation expense would be to do depreciable cost × straight-line rate.
Straight-Line Rate= 100% ÷ Useful Life in Years ........ 100% ÷ 5 years = 20%
Depreciable Cost = Cost – Salvage Value………$20,000 - $0 = $20,000
Depreciation Expense = $20,000 x 20% = $4,000 per year

B) End of the year journal entry on December 31 to record depreciation expense.

Date Debit Credit

Depreciation Expense Dec. 31 4,000
Accumulated Depreciation- Machinery 4,000

End Book Value = Cost of Asset – Accumulated Depreciation

OR Beginning Book Value of the Current Year – Depreciation Expense

Beginning Book Value = Cost for the first year AND the End book value from the previous year for all
other years

Accumulated Depreciation: Balance in Accumulated Depreciation from previous year + Current year’s
depreciation expense

• As you can see, after year 5, the machine has fully depreciated and reached its salvage value of $0.

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2. DECLINING BALANCE METHOD: type of an accelerated depreciation method which yields larger
depreciation expenses in the early years of an asset’s life and less depreciation in the later years. It uses
a multiple of the straight-line rate and applies it to the asset’s beginning period book value.

STEP 1: Straight Line Rate = 100% ÷ Useful Life in Years

STEP 2: If Double Declining…Straight-Line Rate x 2
If 1.5 Declining….. Straight-Line Rate x 1.5

Ex: Holiday Company purchased a machine for $600,000. The company expects the service life of the
machine to be five years. The anticipated residual value is $40,000. Holiday Company uses the double
declining method.
100% ÷ 5 years = 20% x 2 =40% Double Declining Rate

STEP 3:
Use table to keep track of depreciation per year.

Depreciation Expense = Beginning Book Value X Depreciation Rate

End Book Value = Cost of Asset – Accumulated Depreciation

OR Beginning Book Value of the Current Year – Depreciation Expense

B) What journal entry would Holiday Company have to record on December 31 of the 1st year the
company had the machine to adjust for depreciation?

Date Debit Credit

Depreciation Expense Dec. 31 240,000
Accumulated Depreciation- Machinery 240,000

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3. UNITS OF ACTIVITY METHOD: charges a varying amount to expense for each period of an asset’s
useful life depending on its USAGE. May also be called the units-of-production method or units-of-
output method. The usage can be in hours, miles driven, or quantity produced.

Depreciation Cost Cost – Salvage Value

STEP 1: =
per Unit Total Units of Activity

STEP 2: Depreciation Expense = Depreciation per unit X Units of Activity for Period

Ex: Clark Company bought an airplane for $500,000 that had a total useful life of 3,000,000 miles. The
salvage value of the plane at the end of its useful life is $50,000. Year 1, the airplane flew 500,000 miles.

A) What is the depreciation expense and journal entry for the end of the 1st year?

Step 1: Depreciation Cost per Unit = ($500,000 - $50,000) ÷ 3,000,000 miles = $0.15 per mile
Step 2: Depreciation Expense = $0.15 per mile X 500,000 miles = $75,000

Date Debit Credit

Depreciation Expense Dec. 31 75,000
Accumulated Depreciation- Airplane 75,000

B) If the airplane flew 800,000 in year 2, 900,000 in year 3, and 400,000 miles in years 4 and 5, what
would the depreciation expense be in each of those years?

***Depreciation Expense = Depreciation Cost per unit X Units of Activity for Period

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PARTIAL YEAR DEPRECIATION

Annual Depreciation X Fraction of the Year that Company Has Fixed Asset
• Assets placed in service during the first half of a month are normally treated as having been
purchased on the FIRST DAY OF THAT MONTH.
• Asset purchases during the second half of a month are treated as having been purchased
on the FIRST DAY OF THE NEXT MONTH.

Ex) Smith Inc. bought a machine for $20,000 on October 1 to use in his business. The machine’s useful
life is 10 years. What is the depreciation expense for the current year and what journal entry would be
made at the end of the year?

STRAIGHT LINE
A) Depreciation Expense = ($20,000 - $0) ÷ 10 years = $2,000 per year X 3/12 months = $500

B) End of the year journal entry on December 31 to record depreciation expense.

Date Debit Credit

Depreciation Expense Dec. 31 500
Accumulated Depreciation- Machinery 500

DECLINING BALANCE METHOD

A) Depreciation Expense for Year 1….
Step 1: Double Declining Rate= 1/10 = 10% x 2 = 20%
Step 2: First-Year Annual Depreciation - $20,000 x 20% = $4,000
Step 3: First-Year Partial Depreciation (For 3 months) = $4,000 x (3/12) = $1,000

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Depreciation Expense for Year 2….

Step 1: Book Value After Year 1 = $20,000 - $1,000 Depreciation= $19,000
Step 2: Second-Year Annual Depreciation - $19,000 x 20% = $3,800

B) End of the year journal entry on December 31 of Year 1 and 2 to record depreciation expense.

Date Debit Credit

Depreciation Expense Dec. 31 1,000
Accumulated Depreciation- Machinery Year 1 1,000

Depreciation Expense Dec. 31 3,800

Accumulated Depreciation- Machinery Year 2 3,800

REVISING PERIODIC DEPRECIATION

• Accounted for in the period of change and future periods (Change in Estimate).
• Not handled retrospectively.
• Not considered error.

Ex) Nanki Corporation purchased equipment on January 1, Year 1 for $650,000. Years 1, 2, and 3 Nanki
depreciated the asset on a straight-line basis with an estimated useful life of eight years and a $10,000
salvage value. In Year 4, due to changes in technology, Nanki revised the useful life to a total of six years
with no salvage value. What depreciation would Nanki record for the Year 4 on this equipment?

1. Find original depreciation expense per year. ($650,000 - $10,000) ÷ 8 years = $80,000 per year

2. Find book value at start of Year 4 (when the change in estimate occurred)
Book Value = Cost – Accumulated Depreciation = $650,000 - $240,000 [$80,000 X 3 years] =
$410,000

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3. Revised Salvage Value = $0

4. Revised Remaining Useful Life= Total Life in Number of Years – Number of Years Used

*If useful life is extended then ADD Number of Years Extended to above formula.
*If useful life is decreased then DEDUCT Number of Years Decreased to above formula.

Revised Useful Life = 6 years – 3 years Used = 3 years remaining

New Depreciation per Year = ($410,000 - $0) ÷ 3 years ≈ $136,667 a year starting in Year 4

Date Debit Credit

Depreciation Expense Dec. 31 136,667
Accumulated Depreciation- Equipment Year 4 136,667

LO 3: Explain how to account for the Disposal of Plant Assets.

DISCARDING (RETIRING) A FIXED ASSET

• No cash is received.
• Decrease (debit) Accumulated Depreciation for the full amount of depreciation taken over the life of
the asset.
• Decrease (credit) the asset account for the original cost of the asset.

Ex: Machinery acquired at a cost of $50,000 is now fully depreciated. On October 31, the machinery is
discarded. The entry to record the discard (retirement) is

Date Debit Credit

Accumulated Depreciation-Machinery Oct. 31 50,000
Machinery 50,000

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Ex: Machinery acquired at a cost of $50,000 is discarded on October 31. However, the Machinery only
had an accumulated depreciation balance of $48,000 on October 31. The entry to record the discard is

Date Debit Credit

Accumulated Depreciation-Machinery Oct. 31 48,000
Loss on Disposal of Machinery 2,000
Machinery 50,000

SELLING AN ASSET

Step 1: Find Book Value = Cost – Accumulated Depreciation

Step 2: Proceeds Received from Sale – Book Value of Asset

If POSITIVE --- Proceeds Received from Sale > Book Value of Asset then there is a GAIN ON SALE.
If NEGATIVE --- Proceeds Received from Sale < Book Value of Asset then there is a LOSS ON SALE.

Ex: Paradise Corporation sold equipment that cost $100,000 and had accumulated depreciation of
$60,000 for $45,000. Compute the gain or loss on sale and record the journal entry for the sale of
equipment.

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Step 1: Find Book Value = $100,000 – $60,000 = $40,000

Step 2: Cash Received from Sale – Book Value of Asset = $45,000 - $40,000 = $5,000 GAIN

LO 4: Describe how to account for Natural Resources and Intangible Assets.

Natural resources: consist of standing timber and underground deposits of oil, gas, and minerals
(see Helpful Hint). These long-lived productive assets have two distinguishing characteristics: (1) they
are physically extracted in operations (such as mining, cutting, or pumping), and (2) they are replaceable
only by an act of nature.

The acquisition cost of a natural resource is the price needed to acquire the resource and prepare it for
its intended use.

Depletion of Natural Resources

The allocation of the cost of natural resources in a rational and systematic manner over the resource’s
useful life is called depletion. Companies generally use the units-of-activity method to compute
depletion. The reason is that depletion generally is a function of the units extracted during the year.
Under the units-of-activity method, companies divide the total cost of the natural resource minus
salvage value by the number of units estimated to be in the resource. The result is a depletion cost per
unit. To compute depletion, the cost per unit is then multiplied by the number of units extracted.
Example: Lane Coal Company invests $5 million in a mine estimated to have 1 million tons of coal and
no salvage value>

Step 1. Computation of Depletion Cost per unit

Total Cost−Salvage Value/ Total Estimated Units Available=Depletion Cost per Unit
($5,000,000−$0)/1,000,000 tons=$5.00 per ton

Step 2: Compute Depletion Extracted

If Lane extracts 250,000 tons in the first year, then the depletion for the year is $1,250,000 (250,000
tons × $5). It records the depletion as follows.

Inventory (coal) 1,250,000

Accumulated Depletion 1,250,000
(To record depletion of coal mine)

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Accumulated Depletion is a contra asset similar to Accumulated Depreciation. Lane credits Inventory
when it sells the inventory and debits Cost of Goods Sold. The amount not sold remains in inventory and
is reported in the current assets section of the balance sheet.

Intangible Assets: are rights, privileges, and competitive advantages that result from ownership of long-
lived assets that do not possess physical substance.

• Limited life or an indefinite life.

• Common types include: patents, copyrights, franchises or licenses, trademarks, trade names,
and goodwill.

ACCOUNTING FOR INTANGIBLES

Limited-Life Intangibles
• Amortize to expense.
• Credit asset account (used more often) or accumulated amortization.
• Amortization: USING up intangible assets. It results from the passage of time or a decline in
usefulness of the intangible asset. (Like depreciation for plant assets.)

Indefinite-Life Intangibles
• No foreseeable limit on time the asset is expected to provide cash flows.
• No amortization.

TYPES OF INTANGIBLE ASSETS

1. Patents: “Exclusive right to manufacture, sell, or otherwise control an invention for a period of 20
years from the date of the grant.”

• Capitalize costs of purchasing a patent and amortize over its 20-year life or its useful
life, whichever is shorter.
• Expense any research and development costs in developing a patent.
• Legal fees incurred successfully defending a patent are capitalized to Patent account.
• Journal entry to record amortization of patents would be…..

2. Research and Development Costs: “Expenditures that may lead to patents, copyrights, new
processes, and new products.”

• NOT intangible costs.

• All research and development costs are expensed when incurred.

3. Copyrights: “Give the owner the exclusive right to reproduce and sell an artistic or published work.”

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• Granted for the life of the creator plus 70 years.

• Capitalize costs of acquiring and defending it.
• Amortized to expense over useful life.

4. Trademarks and Trade Names: “Word, phrase, jingle, or symbol that distinguishes or identifies a
particular enterprise or product.” Examples include Wheaties, Monopoly, Sunkist, Kleenex, Coca-Cola,
Big Mac, and Jeep.

• Legal protection for indefinite number of 20 year renewal periods.

• Capitalize acquisition costs.
• No amortization.

5. Franchises: “Contractual arrangement between a franchisor and a franchisee.” Examples include

Toyota, Shell, Subway, and Marriott.

• When a company incurs costs in connection with the acquisition of the franchise or license,
it should recognize an intangible asset.
• Franchise (or license) with a limited life should be amortized to expense over the life of the
franchise.
• Franchise with an indefinite life should be carried at cost and not amortized.

6. Goodwill: EXCESS of the purchase price that a company pays OVER the fair market value of
another company’s identifiable net assets (assets – liabilities) that it acquires.
• Includes exceptional management, desirable location, good customer relations, skilled
employees, high-quality products, etc.
• Only recorded when an entire business is purchased.
• Internally created goodwill should not be capitalized.

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LO 5: Discuss how Plant Assets, Natural Resources, and Intangible Assets are
Reported and Analyzed.

• Either within the balance sheet or the notes, companies should disclose the balances of the major
classes of assets, such as land, buildings, and equipment, and of accumulated depreciation by major
classes or in total.
• The depreciation and amortization methods used and the amount of depreciation and amortization
expense for the period should also be disclosed.

ANALYSIS
Asset Turnover: indicates how efficiently a company uses its assets to generate sales.

Ex: A asset turnover ratio of 1.4 indicates that a company generated $1.40 of sales from every $1
invested in average total assets.

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Chapter 17 STATEMENT OF CASHFLOWS

LO 1: Discuss the usefulness and format of the statement of cash flows.
USEFULNESS OF THE STATEMENT OF CASH FLOWS
• Statement of Cash Flows: reports the cash receipts and cash payments from operating, investing,
and financing activities during a period.

• Provides information to help assess:

1. Entity’s ability to generate future cash flows.
2. Entity’s ability to pay dividends and meet obligations.
3. Reasons for difference between net income and net cash provided (used) by operating
activities.
4. Cash investing and financing transactions during the period.

CLASSIFICATION OF CASH FLOWS

OIF I can pass accounting…

Operating,
Investing, and
Financing

1. Operating Activities: the cash effects of transactions that create revenues and expenses.
(Income Statement Items)
Cash inflows:

• From sale of goods or services.

• From interest received and dividends received.

Cash outflows:

• To suppliers for inventory.

• To employees for wages.
• To government for taxes.
• To lenders for interest.
• To others for expenses.

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2. Investing Activities: cash transactions that involve…..

a. The purchase or disposal of investments and property, plant, and equipment.
b. Lending money and collecting the loans.
(Long-Term Assets)
Cash inflows:

• From sale of property, plant, and equipment.

• From sale of investments in debt or equity securities of other entities.
• From collection of principal on loans to other entities.

Cash outflows:

• To purchase property, plant, and equipment.

• To purchase investments in debt or equity securities of other entities.
• To make loans to other entities.

3. Financing Activities:
a. Obtaining cash from issuing debt and repaying the amounts borrowed.
b. Obtaining cash from stockholders, repurchasing shares, and paying dividends.
(Long-Term Liabilities and Stockholders’ Equity)
Cash inflows:

• From sale of common stock.

• From issuance of debt (bonds and notes).

Cash outflows:

• To stockholders as dividends.
• To redeem long-term debt or reacquire capital stock (treasury stock).

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SIGNIFICANT NONCASH ACTIVITIES

• Companies report noncash activities in either a
1. Separate schedule (bottom of the statement).
2. Separate note to the financial statements.

• Examples include:
• Direct issuance of common stock to purchase assets.
• Conversion of bonds into common stock.
• Issuance of debt to purchase assets.
• Exchanges of plant assets.

FORMAT OF THE STATEMENT OF CASH FLOWS

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LO 2: Prepare a statement of cash flows using the indirect method.

• Statement of cash flows is prepared differently from the three other basic financial statements.
• Three sources of information:
1. Comparative balance sheets: indicates the amount of changes in asset, liability, and
stockholders; equity accounts from the beginning to the end of the period.
2. Current income statement: helps determine the amount of net cash provided or used
by operating activities during the period.
3. Additional information: Such information includes transaction data that are needed to
determine how much cash was provided or used during the period.

THREE MAJOR STEPS TO PREPARE THE STATEMENT OF CASH FLOWS

Step 1: Determine net cash provided/used by operating activities by converting net income from an
accrual basis to a cash basis.

Step 2: Analyze changes in noncurrent asset and liability accounts and record as investing and financing
activities, or disclose as noncash transactions.

Step 3: Compare the net change in cash on the statement of cash flows with the change in the cash
account reported on the balance sheet to make sure the amounts agree.

STEP 1: OPERATING ACTIVITIES

• TWO METHODS: DIRECT AND INDIRECT. THESE NOTES FOCUS ON INDIRECT.
• Companies favor the INDIRECT METHOD for two reasons:
1. Easier and less costly to prepare.
2. Focuses on differences between net income and net cash flow from operating activities.
• Both methods result in the SAME AMOUNT of cash flow from operating activities. They differ in the
way they report cash flows from operating activities.

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INDIRECT METHOD
*Goal is determine net cash provided/used by operating activities by converting net income from
accrual basis to cash basis.

Steps for the Indirect Method

1. Start with NET INCOME (going to convert accrual net income into cash from operations)
2. ADD (+) noncash expenses such as depreciation, amortization, and depletion.
3. ADD (+ ) losses on sale of long-term assets.
4. DEDUCT (-) gains on sale of long-term assets.
5. Analyze changes to noncash CURRENT ASSET and CURRENT LIABILITY ACCOUNTS.
A. DEDUCT increases in current asset account.
B. ADD decrease in current asset account.

Current Assets INCREASE , then you are going to DECREASE Net Income.

Current Assets DECREASE , then you are going to INCREASE Net Income.

Example: *SINCE ACCOUNTS RECIEVABLE WENT DOWN, WE ARE GOING

YR 2 YR 1
TO INCREASE NET INCOME BY $2,000 BECAUSE WE ARE
Accounts Receivable $1,000 $3,000 COLLECTING CASH THIS PERIOD FOR REVENUE ALREADY
RECOGNIZED IN A PRIOR PERIOD AND IS NOT REFLECTED IN
YR 2 NET INCOME.

C. ADD increases in current liability account.

D. DEDUCT decrease in current liability account.

Example:

Current Liabilities INCREASE , then you are going to INCREASE Net Income.

Current Liabilities DECREASE , then you are going to DECREASE Net Income.

YR 2 YR 1 *ACCOUNTS PAYABLE INCREASED BY $2,000 FROM YR 1 TO YR 2

Ex)
SO WE ARE GOING TO INCREASE NET INCOME BY $2,000 TO GET
Accounts Payable $7,000 $5,000 CASH FROM OPERATIONS.

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INDIRECT METHOD FOR OPERATING ACTIVITIES SECTION (EXAMPLE PROBLEM)

Lake Johnson Company reported net income of $190,000 for the current year. Depreciation recorded on
buildings and equipment amounted to $90,000 for the year. Balances of the current asset and current
liability accounts at the beginning and end of the year are as follows:

End of Year Beginning of Year

Cash $120,000 $100,000
Accounts receivable 70,000 50,000
Inventory 50,000 80,000
Accounts payable 35,000 30,000

Instructions
Prepare the cash flows from the operating activities section of the statement of cash flows using the
indirect method.

Net income ........................................................................................................................ $190,000

Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation expense .............................................................................................. 90,000
Increase in accounts receivable .............................................................................. (20,000)
Decrease in inventory .............................................................................................. 30,000
Increase in accounts payable .................................................................................. 5,000
Net cash provided by operating activities ........................................................ $295,000*
*(Net inc. + dep. exp – inc. in A/R + dec. in inven. + inc. in A/P)

*Notice that the change in cash of $20,000 ($120,000 end of year - $100,000 beginning of year) is not
on the operating activities section. The whole statement of cash flows will explain the $20,000
increase in cash.

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STEP 2: INVESTING ACTIVITIES

*Analyze changes in noncurrent asset and liability accounts and record as investing and financing
activities, or disclose as noncash transactions.

• THINK CHANGES IN NON-CURRENT (LONG-TERM) ASSETS (Property, plant, equipment, investments

in stocks or bonds of other entities, loans to other entities, and collection of a nontrade receivable
(EXCLUDING interest))

DECREASE in cash
Purchase of long-term assets (Ex: buildings, equipment, land)
Purchase of long-term investments
Lending money
(PAYING CASH which means CASH GOES DOWN)

INCREASE in cash
Sale of long-term assets (Ex: buildings, equipment, land)
Sale of long-term investments
Collection of long-term loan
(RECEIVING CASH which means CASH GOES UP)

***BE CAREFUL……Sell Equipment for $2,000 with a $50 GAIN.

• *Equipment sold for $2,000 is shown as an INCREASE in cash in the Investing section and the $50
GAIN is a DECREASE in the Operating section.

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STEP 2 (Cont.): FINANCING ACTIVITIES

• THINK CHANGES IN LONG-TERM LIABILTIES AND SHAREHOLDER’S EQUITY. Money obtained to run a
business from loans (long-term liabilities) or issuing stock (ownership in the company.)

DECREASE in cash
Payback long-term loans
Redemption of bonds payable
Purchase treasury stock (Buying back the company’s own stock.)
Payment of dividends
(PAYING CASH which means CASH GOES DOWN)

INCREASE in cash
Issuance or sale of common or preferred stock
Issuance of bonds payable or long-term notes payable
(RECEIVING CASH which means CASH GOES UP)

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Step 3: Finish Statement of Cash Flows

*Compare the net change in cash on the statement of cash flows with the change in the cash account
reported on the balance sheet to make sure the amounts agree.

• In this situation, Computer Services Company should have a Statement of Cash Flows that explains
how the company went from $33,000 in 2016 to $55,000 in 2017.
• The Operating, Investing, and Financing section of the statement of cash flows should sum to the
$22,000 increase in cash.

***NONCASH INVESTING AND FINANCING ACTIVITIES LIKE BUYING EQUIPMENT BY ISSUING A NOTE
DO NOT INVOLVE CASH, BUT ARE STILL IMPORTANT. THEY ARE SHOWN ON THE BOTTOM OF THE
STATEMENT OF CASHFLOWS OR IN A DISCLOSURE NOTE.

Because such transactions indirectly affect cash flows, they are reported in a separate section that
usually appears at the bottom of the statement of cash flows.

List of Noncash Investing and Financing Activities

• Retirement of debt by issuing equity stock.
• Conversion of preferred stock to common stock.
• Lease of assets in a capital lease transaction.
• Purchase of long-term assets by issuing a note or bond.
• Exchange of noncash assets for other noncash assets.
• Purchase of noncash assets by issuing equity or debt.

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INDIRECT METHOD STATEMENT OF CASH FLOW COMPREHENSIVE TEMPLATE

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INDIRECT METHOD STATEMENT OF CASH FLOW COMPREHENSIVE EXAMPLE

The following information is available for Magic Corporation for the year ended December 31, 20X7:

Collection of principal on long-term loan to a supplier $16,000

Acquisition of equipment for cash 10,000
Proceeds from the sale of long-term investment at book value 22,000
Issuance of common stock for cash 20,000
Depreciation expense 25,000
Redemption of bonds payable at carrying (book) value 34,000
Payment of cash dividends 6,000
Net income 30,000
Purchase of land by issuing bonds payable 40,000

In addition, the following information is available from the comparative balance sheet for Magic at the
end of 20X7 and 20X6:
20X7 20X6
Cash $148,000 $91,000
Accounts receivable (net) 25,000 15,000
Prepaid insurance 19,000 13,000
Total current assets $192,000 $119,000

Accounts payable $ 30,000 $19,000

Salaries and wages payable 6,000 7,000
Total current liabilities $ 36,000 $26,000

Instructions
Prepare Magic’s statement of cash flows for the year ended December 31, 20X7, using the indirect
method.

***Objective of the statement of cash flow will be to explain how cash increased by $57,000 from
$91,000 in 20X6 to $148,000 in 20X7. The next page shows the solution to the problem. Notice that the
cash from operating, investing, and financing activities sum up to that $57,000 difference in cash.
Also, the sum of cash from operating, investing, and financing activities + beginning cash equal the
current year’s cash balance on the balance sheet. This shows how the financial statements are
interrelated.

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MAGIC CORPORATION
Statement of Cash Flows
For the Year Ended December 31, 20X7

Cash flows from operating activities

Net income ........................................................................................... $30,000
Adjustments to reconcile net income to net cash provided by
operating activities
Depreciation .................................................................................. $25,000
Increase in accounts receivable ..................................................... (10,000)
Increase in prepaid insurance ....................................................... (6,000)
Increase in accounts payable ........................................................ 11,000
Decrease in salaries and wages payable ....................................... (1,000) 19,000
Net cash provided by operating activities ................................ 49,000
Cash flows from investing activities
Collection of long-term loan ................................................................... 16,000
Proceeds from the sale of investments ................................................... 22,000
Purchase of equipment ........................................................................... (10,000)
Net cash provided by investing activities ................................. 28,000
Cash flows from financing activities
Issuance of common stock ...................................................................... 20,000
Redemption of bonds .............................................................................. (34,000)
Payment of dividends .............................................................................. (6,000)
Net cash used by financing activities ........................................ (20,000)
Increase in cash .................................................................................... 57,000
Cash at beginning of period .............................................................................. 91,000
Cash at end of period ................................................................................ $148,000

Noncash investing and financing activities

Purchase of land by issuing bonds .......................................................... $40,000

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LO 3: Use the statement of cash flows to evaluate a company.

• Free cash flow: describes the cash remaining from operations after adjustment for capital
expenditures and dividends.

Free Cash Flow Example

Information for two companies in the same industry, Tucker Corporation and Wiggins Corporation, is
presented here.

Tucker Wiggins
Corporation Corporation
Cash provided by operating activities $140,000 $140,000
Net earnings 200,000 200,000
Capital expenditures 60,000 90,000
Dividends paid 5,000 10,000

Instructions
Compute the free cash flow for each company.

Tucker Corporation has a larger amount of cash remaining than Wiggins Corporation after adjustment
for capital expenditures and dividend payments. Therefore, Tucker has a greater cash-generating ability
than Wiggins Corporation.

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Chapter 18: ANALYZING FINANCIAL STATEMENTS

BASICS OF ANALYSIS

Purpose of Analysis
Who analyzes financial statements?
1. Internal users, such as management, internal auditors, and consultants use
financial statement analysis to improve company efficiency and effectiveness in
providing products and services.
2. External users, such as stockbrokers and lenders, to make better and more
informed investing and lending decisions.
3. Others, such as suppliers, to establish credit terms, or analyst services such as
Standard & Poor’s, in making buy-sell ratings on stocks and in setting credit
ratings.

Information for Analysis

External users rely on the financial statements (the income statement, balance sheet,
statement of owner's equity, statement cash flows, and the notes to the financial
statements), for the data needed to perform financial analyses. Internal users
receive special reports not available to those outside the company.

Standards for Comparison

Data derived from financial analysis is not useful unless compared to a benchmark.
Common benchmarks are:
1. Intracompany: Comparing data from the current year to the prior years for the
company analyzed can indicate useful trends in performance.
2. Industry: Comparing financial analysis data from a company to its industry
average lets us know how a company compares to its competitors.
3. Competitor: Comparing a company’s financial data to one of its competitors is
especially useful in making investing decisions.

Analysis Tools
The three most common financial statement analysis tools are:
1. Horizontal analysis
2. Vertical analysis
3. Ratio analysis

Horizontal analysis
Horizontal analysis compares changes in accounts across time. For example, assume
Company A had the following data available:

2019 2018
Net sales $110,000 $100,000
Cost of goods sold 60,000 51,000
Gross profit 50,000 49,000

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A horizontal analysis for this data would be:

Dollar Percent
2019 2018 Change Change
Net sales $110,000 $100,000 $10,000 10.0% (1)
Cost of goods sold 60,000 51,000 9,000 17.6%
Gross profit 50,000 49,000 1,000 2.0%

(1) The percent change is calculated as: Dollar change / older period amount =
Percent change. ($10,000 / $100,000 = 10%.)

What does this tell us? Even though sales increased by 10% from 2018 to 2019, gross
profit only increased by 2%. Why? We don’t know; financial analysis doesn’t give us
answers to questions, but does highlight questions we would direct to management.

A type of horizontal analysis which may also be performed is called trend analysis, or
trend percents. Using 2018 as the base year, the trend percentages for the example above
would be:

2019 2018
Net sales 110% 100%
Cost of goods sold 118% 100%
Gross profit 102% 100%

This analysis tell us that net sales increased by 10%, but gross profit only by 2%.

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Vertical analysis
Vertical analysis expresses each financial statement as a dollar amount and a percentage.
The percentage is calculated on a base amount. For a balance sheet vertical analysis, the
base amount is usually total assets. For an income statement vertical analysis, the base
amount is usually revenues.

Using the above example, a vertical analysis would be:

Common-Size Percents
2019 2018 2019 2018
Net sales $110,000 $100,000 100.0% 100.0%
Cost of goods sold 60,000 51,000 54.5% 51.0%
Gross profit 50,000 49,000 45.5% 49.0%

The common-size percents for cost of goods sold are calculated as follows:

2019: $60,000 / $110,000 =54.5%

2018: $51,000 / $100,000 = 51.0%

What does this tell us? Even though sales increased, gross profit, as a percentage of net
sales decreased. Why? If you were a bank loan officer, and Company A was applying for
a loan, this would be a good question to ask Company A’s chief financial officer.

Ratio Analysis
Several ratios were covered in ACCT 101. This chapter organizes and applies them in a
summary framework.

A ratio is simply a mathematical relationship between two or more items in the financial
statements. Usually, their calculation involves division. The ratio result may be expressed
as a percentage or a number, depending on the ratio.

There is a summary of ratios, and their formulas, may be found in Exhibit 13.16. We will
be working exercises and problems in class to review how these ratios are calculated and
used. These ratios are included in four different areas, which are summarized as follows:

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Name Description Ratios included

Liquidity and Efficiency Liquidity refers to the Current ratio; acid-test
Ratios amount of assets available ratio; Accounts receivable
to meet short-term cash turnover; Inventory
requirements. Efficiency turnover; Days’ sales
ratios measure the uncollected; Days’ sales in
productivity of a company inventory; and Total asset
in using its assets to turnover.
generate revenue or cash
flow.
Solvency Ratios Solvency is the company’s Debt ratio; Equity ratio;
ability to cover long-term Debt-to-equity ratio; and
debt obligations over the Times interest earned.
long run.
Profitability Ratios These ratios measure the Profit margin ratio; Gross
company’s ability to use its margin ratio; Return on
assets to produce profits and total assets; Return on
positive cash flows. common stockholders’
equity; Book value per
common share; and Basic
earnings per share.
Market Prospects Ratios Used primarily by stock Price-earnings ratio and
analysts of publicly-traded Dividend yield.
companies, these ratios are
used to measure investors’
expectations for the
company based on prior
periods’ results of
operations.

We need to understand that ratio computations are worthless unless compared to the
company’s industry average; prior historical results; or directly to a competitor’s ratios.