ch3 for myself v2 accounting
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1
On July 9, 2010, ABC Company provides legal service toa client, who agrees to pay $200 within one month.On Aug 3, ABC Company receives a check of $200from this client.
When should you record revenue on the book?
Your company opens an electricity account with AmigoEnergy which starts to supply energy on July 1, 2010.On August 4, you receive an electricity bill of $100 forthe period July 1- 31.
Does this expense belong to the month of July or August?
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Accrual Accounting and Income
Chapter 3
2
1. Accrual accounting
Revenue principle
Matching principle
Time period concept
2. Adjusting entries
Deferrals, accruals, depreciation
3. Closing the book
4. Current and long-term assets (liabilities)
5. Current ratio and Debt ratio
6. How to construct a simple Cash Flow
statement using indirect method.
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ACCRUAL ACCOUNTING
Records impact of transactions when they occur
Records:Revenue when earned (e.g., sales on account)
Expenses when incurred (e.g., purchase on account)
No matter whether cash has been received or paid
3
Which method
provides more
information?
In contrast, cash accounting recordstransactions when and only when cashpayment or receipt is involved.
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Some of the transactions recorded in accrual
accounting:
4
Cash transactions Noncash transactions
Collecting payments from
customers
Sales on account
Borrowing money Depreciationexpense
Paying expenses Purchases on account
Paying off loans Usage of prepaid expenses
Issuing stock Accrual of expenses not yet
paid
Accrual accounting is morecomplex but also more
completeand more
informative.
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Time Period Concept
Accounting information is reported at regular intervals--Year, quarter, month
All businesses prepare annual financial statements
The financial year (fiscal year) could be a calendar year or
any other one year period (e.g. April 1 to March 31)
In addition to annual reports, many companies produce
interim financial reportsas well (e.g. quarterly reports)
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Revenue Principle
6
When to record
After revenueis earned:
When good orservice hasbeendelivered tocustomer
Amount to record
Cash valueofgoods orservicestransferred tocustomer
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Matching Principle--
align revenue with expenses
7
Expenses are matched against the revenue that
was earned in a particular period
Expenses incurred to generate revenues should be
recorded in the same period.
When revenues and expenses are properlymatched, we get a reliable measure of net income
(or net loss)
Some expenses are paid in cash
Others are not yet paid for (accruals) Certain other expenses arise from using up assets
(e.g. supplies)
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The Adjusting Process
Adjusting entries are at the heart of accrual accounting.
Accrue- to accumulate a receivable or payable during a givenperiod even though no explicit cash transaction occurs
The receivable or payable grows with time, but nothingchanges with cash.
The goal of adjusting entries is to assure that assets, liabilities,and stockholders equity are properly stated.
Adjusting process is usually made when the financialstatements are about to be prepared.
They are made in the form of adjusting journal entriesthat are posted to the T account.
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Categories of Adjustments
11
Deferrals Depreciation
Accruals
Lets do some necessary adjustments!
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2010 Pearson Prentice Hall. All rightsreserved.
1-12
Prepaid Expenses
Unearned Revenue
Depreciation
Accrued Expenses
Accrued Revenue
Five Types of Adjustments
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Deferrals
Business has paid or received cash in advance
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Prepaid expense
Recorded as an asset when
purchased Expensed when used or
expired
Unearned revenue
Recorded as a liability whenpayment is received
Recorded as revenue whenearned
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How to record these transactions initially?
June 1: pay $12,000 rent for 1 year from this June
to next June.
Aug 3: purchase $3,500 supplies that can last foryears
1-14
JOURNAL
Date Accounts and explanation Debit Credit
June 1 Prepaid rent 12,000
Cash 12,000
Aug 3 Supplies 3,500
Cash 3,500
Do we have the same amount of
prepaid rent and assets by the year
end?
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Use T-accounts to analyze the balances and prepare the
adjusted journal entries:
First: decide what ending balances should appear in the
asset (Prepaid Rent) and expense (Rent Expense)
accounts.
In this example, 7 months expense had been used,therefore $7,000 should be shown in Rent Expense
($1,2000/12 months x 7 months).
Also, at December 31, there are still 5 months remaining
(unused), and $5,000 should be shown in Prepaid
Rent.
2010 Pearson Prentice Hall. All rightsreserved.
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Lets look at the T-accounts
16
Prepaid rent
June 1 $12,000 Dec 31$7,000
$5,000
Rent expense
$7,000Dec 31
Balance
Sheet
Income
Statement
ASSET
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Adjustments made at year end:
Aug 3rd, purchase 3,500 supplies.
On Dec 31th, $600 supplies at hand.
Supplies are expensed when they are used
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JOURNAL
Date Accounts and explanation Debit Credit
Dec 31 Rent expense 7,000
Prepaid rent 7,000
Dec 31 Supplies expense 2,900
Supplies 2,900
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Lets look at the T-accounts
18
SuppliesAug 3 $3,500 Dec 31$2,900
$600
Supplies expense$2,900Dec 31
Amount usedAmount on hand
Balance
Sheet
Income
Statement
ASSET
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Question
On January 1, Bambi Company paid $1,200 rent to cover six
months, the adjusting entry at the end of January should include
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1. A credit to Prepaid
Rent for $1,000
2. A credit to PrepaidRent for $200
3. A debit to Prepaid
Rent for $1,0004. A debit to Prepaid
Rent for $200
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Question
Garcia Company purchased a one-year insurance policy on April 1, Year 1, for $6,000.
After year-end adjustments, the amount of prepaid insurance and the amount of
insurance expense at December 31, Year 1, are, respectively
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1. $1,500, $4,500.
2. $4500, $1,500.
3. $2,000, $4,000.
4. $4,000, $2,000.
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What happens to receipt in advance?
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JOURNAL
Date Accounts and explanation Debit Credit
Sept 1 Cash 12,000
Unearned service revenue 12,000
Receive client payment in advance
No free lunch in the world with
money accepted now you have an
obligationto deliver service in the
future.
Sept 1: you receive $12,000 cash from client for legalservice of next 12 months. $1,000 per month.
A dj t t t th d f th EARNED
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2010 Pearson Prentice Hall. All rightsreserved.
1-22
Use T-accounts to analyze the balances and prepare the
adjusting entry:First: decide what ending balances should appear in
the liability (Unearned Service Revenue) and revenue
(Service Revenue) accounts.
In this example, 4 months revenue had been earned
by 12/31, therefore $4,000 should be shown in Service
Revenue ($12,000/12 months x 4 months).
Also, at December 31, there are still 8 monthsremaining (unearned), and $8,000 should be shown in
Unearned Service Revenue.
Any adjustment at the year end for the EARNEDportion?
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Lets look at the T-accounts
23
Unearned Service Revenue
June 1$12,000Dec 31 $4,000
$8,000
Service Revenue
$4,000 Dec 31
Balance
Sheet
Income
Statement
LIABILITY
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Adjusting Entry at the year end:
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JOURNAL
Date Accounts and explanation Debit CreditSept 1 Cash 12,000
Unearned service revenue 12,000
Receive client payment in advance
Dec 31 Unearned service revenue 4,000
Service revenue 4,000
How do these adjustments
affect balance sheet andincome statement?
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Question
On October 1, River Place Apartment received $5,200 from a tenant
for four months rent. The Receipt was credited to Unearned Rent
Revenue. What adjusting entry is needed on Dec 31th?
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1-25
A. Unearned Rent Revenue 1,300
Rent Revenue 1,300
B. Cash 1,300Rent Revenue 1,300
C. Rent Revenue 1,300
Unearned Rent Revenue 1,300
D. Unearned Rent Revenue 3,900
Rent Revenue 3,900
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Question
Rodenko, Inc., publishes a monthly sports magazine. On July 1, Year 1, the company sold
1,000 two-year subscriptions for $100 each. On December 31, Year 1, the amount
reported as a liability on the balance sheet and the amount reported as revenue on theincome statement are, respectively
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1. $0, $100,000.2. $25,000, $75,000.
3. $50,000, $50,000.
4. $75,000, $25,000.
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Depreciation
How to record a transaction like this?
Jan 1: purchase a machine with $50,000 cash, which is
expected to be used for five years
Do we have the same amount of asset at year end? How
to adjust?
1-27
JOURNALAccounts and explanation Debit Credit
Equipment 50,000
Cash 50,000
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Depreciation
Allocates cost of plant assets to expense over useful lives
Represents wear-and-tear and obsolescence
Examples of plant assets:
Buildings
Equipment
Furniture With depreciation, a new account,
Accumulated Depreciation, is introduced.
Accumulated depreciation - the cumulative sum of all
depreciation recognized over the life of a particular asset.
Straight-Line Depreciation Expense =
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Useful Life
Asset Cost
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Depreciation
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Equipment
Jan 2
$50,000Depreciation Expense
$10,000Dec 31
Both numbers
enter the Balance
Sheet Income
Statement
Accumulated Depreciation
Dec 31$10,000
Depreciation on Dec 31
One year depreciation =
50,000 / 5 = 10,000
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Depreciationinitial and adjusting journal entries
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JOURNAL
Date Accounts and explanation Debit Credit
Jan 2 Equipment 50,000
Cash 50,000
Dec 31 Depreciation expense 10,000
Accumulated depreciation 10,000
A contra asset
account
Q: without the year-end adjustment,
do we get a complete picture aboutthis asset?
M b t A l t d D i ti
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More about Accumulated Depreciation
Sum of all depreciation expenses
Increases over plant assets life Contra-asset: a separate but related account that
offsets or is a deduction from a companion account.
Normal credit balance
Always has a companion account
Appear on Balance Sheet along with certain assets
Book value of plant asset
= Cost of plant asset - accumulated depreciation
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Book value is also
called carrying value.
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Question
What is the effect on the financial statements of recording
depreciation on equipment?
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1-33
1. Net income is not affected, but
assets and stockholders equity
are decreased.
2. Net income and assets are
decreased, but stockholdersequity is not affected.
3. Net income, assets, and
stockholders equity are all
decreased.4. Assets are decreased, but net
income and stockholders
equity are not affected.
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Accruals
Accrued expenses
Record expense
before paying cash Salaries, interest,
and income taxes
Accrued revenues
Record revenue
before collectingcash
Earned and willcollect next period
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No cash has changed hands yet, but youve
owed or earned something:
A d S l i
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Accrued Salaries
35
12-30 12-31 1-31-21-1
$15,000 weekly salaries
$6,000 $9,000
How to present this picture at 12/31?
Costs incurred in a period, that are both unpaid and unrecorded.
Match the expenses to the periods revenues!
Accrued expenses are recorded for amounts that are owedat the end of
an accounting period but have not been paid in that accounting period.In the accrual accounting, a liability(salary payable) is recorded and
increased (Credit).
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Accrued Salaries
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JOURNAL
Date Accounts and explanation Debit Credit
Dec 31 Salaries expense 6,000
Salaries payable 6,000
Later:
JOURNAL
Date Accounts and explanation Debit Credit
Jan 3 Salaries payable 6,000
Salaries expenses 9,000
Cash 15,000
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2010 Pearson Prentice Hall. All rightsreserved.
Interest is much like rent paid for the use of borrowed
money.Interest accumulates (accrues) as time goes on, regardless
of when the interest is actually paid.
Interest = Principal x Interest rate x Fraction of a year
The entry to record the accrual of interest expense is very
similar to the entry to record the accrual of wage expense.
Accrued Interest
JOURNAL
Date Accounts and explanation Debit Credit
Dec 31 Interest expense xxxxInterest payable xxxx
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2010 Pearson Prentice Hall. All rightsreserved. 1-38
Accrued Income Tax
As income is generated, income tax expense is accrued rather
than paid by the company each time a dollar comes in.
The entry to record accrued income taxes is similar to the
accrual of other expenses.
JOURNAL
Date Accounts and explanation Debit Credit
Dec 31 Income Tax Expense xxxxIncome Tax Payable xxxx
Accrued Revenue
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Accrued Revenue Revenue earned but not yet received
The adjusting entries show the recognition of revenues that have been earned,but the entity has not received cash.
Increases receivables and revenue
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JOURNAL
Date Accounts and explanation Debit Credit
Dec 31 Accounts receivable 1,500
Service revenue 1,500
Accrued Revenue
Later:
JOURNAL
Date Accounts and explanation Debit CreditJan 5 Cash 1,500
Accounts receivable 1,500
Collect cash from customer
How accrued revenue is different from
unearned revenue?
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Question
If a real estate company fails to accrue commission revenue,
2010 Pearson Prentice Hall. All rightsreserved. 1-40
1. Revenue are understated
and net income is overstate.
2. Assets are understated and
net income is understated.
3. Net income is understated
and stockholders equity is
overstated.
4. Liabilities are overstated
and owners equity isunderstated.
Prepaids and Accruals a summary
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Prepaids and Accrualsa summary
Deferral CASH FIRST
FIRST LATER
Prepaidexpenses
Prepaid expense (Assets) Expense
Cash Prepaid expense
Unearned
revenues
Cash Unearned revenue
Unearned revenue (Liability) RevenueACCRUALS CASH LATER
FIRST LATER
Accruedexpenses
Expense Accounts Payable
Accounts Payable Cash
Accruedrevenues
Accounts Receivable Cash
Revenue Accounts Receivable
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S f th Adj ti P
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Summary of the Adjusting Process
Two purposes
Measure income
Update balance sheet
Every adjusting entry affects at least one:
Revenue or expense
Asset or liability
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Exercise: Journalize adjusting entries on Dec 31 for each
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Exercise: Journalize adjusting entries on Dec 31 for each
situation
a. The business has interest expense of $9,500 incurred
during 2010 that it must pay early in January 2011.
1-43
b. Interest revenue of $4,500 has been earnedbut notyet received.
JOURNAL
Date Accounts and explanation Debit Credit
(a) Interest expense 9,500
Interest payable 9,500
(b) Interest receivable 4,500
Interest revenue 4,500
Exercise : journal entries of Dec 31
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Exercise : journal entries of Dec 31
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(c) Unearned rent revenue 3,400
Rent revenue 3,400
c. On July 1, when we collected $13,600 rent in advance,
we debited Cash and credited Unearned Rent
Revenue. The tenant was paying us for 2 years rent.
d. Salary expense is $1,800 per dayMonday throughFridayand the business pays employees each Friday.
This year, December 31 falls on a Wednesday.
(d) Salary expense 5,400
Salary payable 5,400
As the Exercise continues:
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As the Exercise continues:
e. The unadjusted balance of the Supplies account is
$3,300. The total cost of supplies on hand is $1,200.
1-45
f. Equipment was purchased at the beginning of this
year at a cost of $100,000. The equipments useful
life is 5 years.
(e) Supplies expense 2,100
Supplies 2,100
(f) Depreciation expense 20,000
Accumulated depreciation 20,000
Exercise:
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Balance SheetDecember 31, 2010
Equipment $100,000
Less: AccumulatedDepreciation
(20,000)
Book value $80,000
Exercise:
The Adjusted Trial Balance
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The Adjusted Trial Balance
Prepared after adjustments are journalized and
posted
Useful step in preparing financial statements
47
ExerciseShineBrite Cash Wash Company
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p y
Preparation of Adjusted Trial Balance
Dec 31th, 2010
2010 Pearson Prentice Hall. All rightsreserved. 1-48
Unadjusted
Debit Credit
Cash 10
Accounts Receivable 12
Supplies 24
Accounts Payable 12
Unearned Revenues 22
Common Stock 6
Retained Earnings 2
Dividends 4
Service Revenues 14
Salaries Expense 6
Supplies Expense 0
56 56
Adjusting JE
Debit Credit
8
6
6
8
Adjusted
Debit Credit
10
12
16
12
16
6
2
4
20
6
8
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ExerciseShineBrite Cash Wash Company
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(a) A physical count made at the end of the period
revealed that there were supplies on hand with a cost of
$16.
AJE:
(b) The unearned revenues account shows $16 had still not
been earned as of year-end.
AJE:
2010 Pearson Prentice Hall. All rightsreserved. 1-49
Preparation of Adjusted Trial Balance
Dec 31th, 2010
(a) Supplies expenses 8
Supplies 8
(b) Unearned Revenue 6
Service Revenue 6
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Closing the books
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Closing the books
Prepared after the financial statements have beenprepared.
Prepares the accounts for next period
Temporary accounts are set to zero and closed intoRetained earnings
Can you guess what are the temporary accounts?
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Temporary accounts
Revenues
expenses
dividends
52
Note: the post-closing Trial Balance consists only of balancesheet accounts.All of the temporary accounts have beenclosed to Retained Earnings, and we are now ready to start
a new year, and accumulate new balances for revenues,expenses, and dividends.
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P3-75A
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P3 75A
Spa View Service, Inc., with fiscal year end March 31, has
following accounts balance:
Service revenue: 95,000
Dividends: 31,200
Advertising expense: 10,900
Depreciation expense: 1,700 Interest expense: 900
Salary expense: 17,800
Supplies expense: 4,400
How to close the accounts? How does retained earnings change?
1-54
P3-75Ajournal entries to close revenue and
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JOURNAL
Date Accounts and explanation Debit Credit
3/31 Sales revenue 95,000
Retained earnings 95,000
jexpenses accounts
3/31 Retained earnings 35,700
Advertising expense 10,900
Depreciation expense 1,700
Interest expense 900Salary expense 17,800
Supplies expense 4,400
P3 75A journal entries to close Dividends
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JOURNAL
Date Accounts and explanation Debit Credit
Retained earnings 31,200
Dividends 31,200
P3-75Ajournal entries to close Dividends
Changes to Retained Earnings
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Changes to Retained Earnings
57
Retained Earnings
$22,000BeginningBalance
$95,000 Revenues$31,200
$35,700
Dividends
Expenses
$50,100EndingBalance
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Question
A major purpose of preparing closing entries is to
2010 Pearson Prentice Hall. All rightsreserved. 1-58
A. Zero out the liability
accounts
B. Close out the supplies
account
C. Adjust the asset accounts
to their correct current
balances
D. Update the RetainedEarnings account.
Question
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Question
Which of the following accounts would notbe included in the closing
entries?
2010 Pearson Prentice Hall. All rightsreserved. 1-59
A. Depreciation Expense
B. Retained Earnings
C. AccumulatedDepreciation
D. Service Revenue
Current or Long-term
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Current or Long term
Current assets:Cash
Short-term investments
Accounts receivable
Merchandise inventory
Prepaid expenses are the current assets
Assets are classified as current or long-term term based on liquidity,or how quickly an item can be converted to cash.
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Can be turned intocash within one year or
one operating cycle.
Current Liabilities
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Current Liabilities
Debts that must be paid within 1 year or within the entitys
operating cycle if longer than a year:
Accounts payable
Notes payable due within 1 year
Salary payable
Unearned revenue
Interest payable
Income tax payable
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Converted to cash, sold or
consumed in the next year
Current
assets
Held for longer than one year
Includes plant assets
Long-termassets
Must be paid within one yearCurrentliabilities
Due date more than one yearfrom balance sheet date
Long-term
liabilities
Classified Balance Sheet
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Categorizes and subtotals assets and liabilities
63
Assets Liabilities
Current assets Current liabilities
Long-term investments Long-term liabilitiesProperty, plant and equipment
Other assets
Financial Statement Formats
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Balance Sheet
Report Format
Assets listed at the top
Liabilities and equity beneath
Account format
Assets on the left Liabilities and equity on the right
Income Statement
Single-Step
All revenues grouped together
All expenses grouped together
Multi-step
Shows subtotals to emphasize
relationships
Includes
Gross profit
Income from operations
64
Use two new ratios to evaluate a business
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Current Ratio Debt Ratio
Enhance users ability to analyze
companys past performance
From the names, how do you think the
ratios should be computed?
And what do they tell you?
Current Ratio
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Current assets
Current liabilities
It measures ability of a business to pay current liabilitieswith its current assets
Whats the implication if this current ratio is less than one?
As a rule of thumb, a strong current ratio is 1.50Most successful businesses operate with current ratiosbetween 1.20 and 1.50
Debt Ratio
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Total assets
Total liabilities
Measuresthe proportion of a businesssassets that are financed with debt.
Measures businesss ability to pay both
current and long-term debt
Low debt ratio is safer than high debt ratio, thoughnot necessarily better.
Question
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Question
UPS earns service revenue of $800,000. How does this transaction
affect UPS ratio?
2010 Pearson Prentice Hall. All rightsreserved. 1-68
A. Improves the currentratio and does not affect
the debt ratio
B. Hurts the current ratio
and improves the debt
ratio
C. Hurts both ratio
D. Improves both ratios
Question
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Question
Suppose Green Mountain Corporation borrows $20 million on a 20
year note payable. How does this transaction affect its ratios?
2010 Pearson Prentice Hall. All rightsreserved. 1-69
A. Hurts both ratio
B. Improves both ratios
C. Improves the current
ratio and hurts thedebt ratio
D. Hurts the current ratio
and improves the debt
ratio
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Statement of Cash FlowsFor the year ended December 31, 2010
Cash flows from operating activities 60
Cash flows from investing activities 20
Cash flows from financing activities (30)
Net cash flows 50
Cash balance, December 31, 2009 10
Cash balance, December 31, 2010 60
How to prepare a cash flow statement
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How to prepare a cash flow statement
Part 1- Cash Flow from Operations*
Net Income
+ Depreciation expense
Increases in accounts receivable
+ Decreases in accounts receivable + Increases in accounts payable
Decreases in accounts payable
= Cash flows from operating activities*The above is a simple version.
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Cash Flow from Operations
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Cash Flow from Operations
Add back Depreciation
Depreciation is a non-cash expense thatreduces net income. Therefore, it is added
back to put net income on a cash basis.
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Cash Flow from Operations
Decrease in accounts receivable
The reverse is true for a decrease in accountsreceivable.
A collection of accounts receivable provides
cash but does not affect net income.
Therefore, the decrease in this current asset is
an addition to put net income on a cash basis.
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Cash Flow from Operations
Increase in accounts payable
Consider accounts payable. An increase inaccounts payable decreases net income
because of the associated expense.
However, since no cash is yet paid, theincrease in this current liability is shown as an
addition to put net income on a cash basis.
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Cash Flow from Operations
Decrease in accounts payable
The reverse is true for a decrease in accountspayable. A payment of accounts payable uses
cash but does not affect net income.
Therefore, the decrease in this currentliability is a subtraction to put net income on a
cash basis.
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Example- Indirect method - Cash FlowsItem Amount
Net Profit $269
Depreciation, Amortization $188
Increase in accounts receivable ($179)
Increase in notes receivable ($84)
Increase in Accounts payable $89
Net Cash provided byoperations
$ 283
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Cash Flow from Investing
Investing activities include cash from buyingand selling noncurrent assets.
It also includes cash generated (lost) from
investments in securities.
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reserved. 1-80
C h l f i i i i i
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Cash Flow from Financing Activities
Financing activities include
borrowing and repaying money,
distributing dividends and
issuing stock.
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reserved. 1-81
SUMMARY
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Compare accrual and cash basis accounting
Apply the revenue and matching principles
Adjust the accounts
Prepare the financial statements
Close the temporary accounts Use ratios to evaluate a business
Understand how to construct a cashflow
statement using the indirect method
SUMMARY
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Compare accrual and cash basis accounting
Apply the revenue and matching principles
Adjust the accounts
Prepare the financial statements
Close the temporary accounts Use ratios to evaluate a business
Cash Flow