Kieso_et_al_2008_Fundamentals_of_Intermediate_Accounting_Chapter_3

Kieso_et_al_2008_Fundamentals_of_Intermediate_Accounting_Chapter_3

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Unformatted text preview: Chapter The accounting information system N E E D E D : A R E L I A B L E I N F O R M AT I O N S YS T E M Maintaining a set of accounting records is not optional. At a minimum, taxation authorities require that businesses prepare and retain a set of records and documents that can be audited. Public companies must satisfy the reporting requirements of stock exchanges, securities regulators, and the national laws in which the company operates. More importantly, a company that does not keep an accurate record of its business transactions may lose revenue and is more likely to operate inefficiently. Some companies are inefficient partly because of the poor accounting system. Consider a company providing telephone and Internet services. The company may sell hundreds of different services — commercial plans, residential plans, certain free time offers, network connection fees and perhaps even a drink vending machine or parking meter system that can be paid using your telephone. The billing system has to take into account all that. In an increasingly complex environment, the billing system must consider all those hundreds of different services to invoice the customer with the correct amount, as well as provide management with the information needed to manage the business efficiently, and to provide an audit trail to explain how and why the transaction was invoiced in a particular way. One.Tel Ltd was an apparently successful telephone company in Australia during the 1990s. The company successfully marketed mobile telephone services targeted at the student and youth market. Investors funded the company as it grew. Despite growth in revenues the company failed to generate sufficient cash from operations. Worse, the directors apparently did not have adequate information to ascertain the cash position of the company. Accounting and record keeping were chaotic. Bills for telephone ser vices could not be produced on time. When bills were produced, many customer accounts remained unpaid with the company unable to adequately track and pursue unpaid accounts. No doubt encouraged by poor credit controls, customers such as Yogi Bear, Barney Rubble and Astro Boy successfully signed up for telephone services, but never paid their accounts. No one knew what anything cost. Some ser vices were sold for less than the cost of the service. Eventually the company collapsed, losing at least 2 billion dollars Accounting of other people’s money. information system Although such a severe situation is not common in large entities, this example illustrates the point that accurate accounts and detailed records must be kept by every business entity.1 The accounting information system The accounting cycle Using a worksheet PREVIEW As the opening story indicates, a reliable accounting system is a necessity for all business entities. The purpose of this chapter is to explain and illustrate the features of a basic accounting information system. This chapter can be used as a review of the fundamentals of accounting covered in a previous course or as a first introduction to an accounting system. The chapter covers basic bookkeeping, the accounting cycle and the preparation of financial statements. The diagram on these pages shows how this chapter is organised. LEARNING OBJECTIVES v Basic terminology v Debits and credits v Basic equation v Financial statements and ownership structure After studying this chapter, you should be able to: 1 understand basic accounting terminology 2 explain double-entry rules • Identifying and recording transactions and other events • Journals • Posting • Trial balance • Adjusting entries • Adjusted trial balance • Closing • Post-closing trial balance • Reversing entries • The accounting cycle summarised 3 identify steps in the accounting cycle 4 record transactions in journals, post to ledger accounts, and prepare a trial balance 5 explain the reasons for preparing adjusting entries 6 prepare closing entries • Adjustments entered on the worksheet • Worksheet columns • Preparing financial statements from a worksheet • Closing entries • Monthly statements, yearly closing 7 explain how inventory accounts are adjusted at year-end 8 prepare a multicolumn worksheet. ACCOUNTI NG I N FORM ATION SYSTEM The system of collecting and processing transaction data and disseminating financial information to interested parties is known as the accounting information system. Accounting information systems vary widely from one business to another. Factors that shape these systems are the nature of the business and the transactions in which it engages, the size of the firm, the volume of data to be handled, and the information demands that management and others place on the system. A good accounting information system helps management answer such questions as: • How much and what kind of debt is outstanding? • Were our sales higher this period than last? • What assets do we have? • What were our cash inflows and outflows? • Did we make a profit last period? • Are any of our product lines or divisions operating at a loss? • Can we safely increase our dividends to shareholders? • Is our rate of return on net assets increasing? Many other questions can be answered when there is an efficient accounting system to provide the data. A well-devised accounting information system is beneficial for every business entity. ,%!2.).' /"*%#4)6% 1 Understand basic accounting terminology. Basic terminology Financial accounting rests on a set of concepts (discussed in chapters 1 and 2) for identifying, recording, classifying and interpreting transactions and other events relating to business entities. It is important to understand the basic terminology used in connection with accounting data. Basic terminology Event. A happening of consequence. An event generally is the source or cause of changes in assets, liabilities and equity. Events may be external or internal. Transaction. An external event involving a transfer or exchange between two or more entities. Account. A systematic arrangement that shows the effect of transactions and other events on a specific asset or equity. A separate account is kept for each asset, liability, revenue and expense, and for capital (owners’ equity). Real and nominal accounts. Real (permanent) accounts are asset, liability and equity accounts; they appear on the balance sheet. Nominal (temporary) accounts are revenue, expense and dividend accounts; except for dividends, they appear on the income statement. Nominal accounts are periodically closed; real accounts are not. Ledger. The records (or computer file) containing the accounts. Each account usually has a separate page. A general ledger is a collection of all the asset, liability, owners’ equity, revenue and expense accounts. A subsidiary ledger contains the details relating to a given general ledger account. Journal. The book of original entry where transactions and selected other events are initially recorded. Various amounts are transferred to the ledger from the book of original entry, the journal. Posting. The process of transferring the essential facts and figures from the book of original entry to the ledger accounts. Trial balance. A list of all open accounts in the ledger and their balances. A trial balance taken immediately after all adjustments have been posted is called an adjusted trial balance. A trial balance taken immediately after closing entries have been posted is designated a post-closing trial balance. A trial balance may be prepared at any time. Adjusting entries. Entries made at the end of an accounting period to bring all accounts up to date on an accrual accounting basis so that correct financial statements can be prepared. 72 Fundamentals of intermediate accounting Financial statements. Statements that reflect the collection, tabulation and final summarisation of the accounting data. Four main statements are involved: (1) the balance sheet, which shows the financial condition of the entity at the end of a period; (2) the income statement, which measures the results of operations during the period; (3) the statement of changes in equity, which show the changes in equity for the period; and (4) the cash flow statement, which reports the cash used in operating, investing and financing activities during the period. Closing entries. The formal process by which all nominal accounts are reduced to zero and the profit or loss is determined and transferred to an owners’ equity account; also known as ‘closing the ledger’, ‘closing the books’, or just ‘closing’. Debits and credits The terms debit and credit mean left and right, respectively. They are commonly abbreviated as Dr for debit and Cr for credit. These terms do not mean increase or decrease. The terms are used repeatedly in the recording process to describe where entries are made. For example, the act of entering an amount on the left-hand side of an account is called debiting the account, and making an entry on the right-hand side is called crediting the account. When the totals of the two sides are compared, an account will have a debit balance if the total of the debit amounts exceeds the credits. An account will have a credit balance if the total credit amounts exceed the debits. The procedure of having debits on the left and credits on the right is an accounting custom or rule. We could function just as well if debits and credits were reversed. However, the custom of having debits on the left-hand side and credits on the righthand side has been adopted. This rule applies to all accounts. The equality of debits and credits provides the basis for the double-entry system of recording transactions (sometimes referred to as double-entry bookkeeping). Under the universally used double-entry accounting system, the dual (two-sided) effect of each transaction is recorded in appropriate accounts. This system provides a logical method for recording transactions. It also offers a way of proving the accuracy of the recorded amounts. If every transaction is recorded with equal debits and credits, then the sum of all the debits to the accounts must equal the sum of all the credits. All asset and expense accounts are increased on the left (or debit side) and decreased on the right (or credit side). Conversely, all liability and revenue accounts are increased on the right (or credit side) and decreased on the left (or debit side). Equity accounts such as Share Capital and Retained Earnings are increased on the credit side, whereas Dividends is increased on the debit side. The basic guidelines for an accounting system are presented in figure 3.1. Normal balance — debit Asset accounts Debit + (increase) Credit – (decrease) Expense accounts Debit + (increase) Credit – (decrease) ,%!2.).' /"*%#4)6% 2 Explain double-entry rules. Normal balance — credit Liability accounts Debit – (decrease) Credit + (increase) Equity accounts Debit – (decrease) Credit + (increase) Revenue accounts Debit – (decrease) Credit + (increase) FIGURE 3.1 Double-entry (debit and credit) accounting system Basic equation In a double-entry system, for every debit there must be a credit, and vice versa. This leads us, then, to the basic equation in accounting (figure 3.2, p. 74). C H A P T E R 3 The accounting information system 73 FIGURE 3.2 The basic accounting equation Liabilities Assets Equity Figure 3.3 expands this equation to show the accounts that constitute equity. In addition, the debit/credit rules and the effects on each type of account are illustrated. Study this diagram carefully. It will help you understand the fundamentals of the double-entry system. Like the basic equation, the expanded basic equation must be in balance (total debits equal total credits). Basic equation Assets Liabilities Expanded basic equation Assets Liabilities Dr Cr Dr Cr Equity Share Capital Dr Cr Retained Earnings Dr Cr Dividends Revenues Expenses Dr Cr Dr Cr Dr Cr Debit/credit rules FIGURE 3.3 Expanded basic equation and debit/credit rules and effects Every time a transaction occurs, the elements of the equation change, but the basic equality remains. To illustrate, here are eight different transactions for Perry Ltd. 1. Owners invest $40 000 in exchange for ordinary shares. Assets 40 000 Liabilities Equity 40 000 Liabilities Equity 600 (expense) 2. Pay $600 cash for secretarial wages. Assets 600 3. Buy office equipment priced at $5200, giving a 10% promissory note in exchange. Assets 5200 Liabilities 5200 Equity 4. Receive $4000 cash for services rendered. Assets 4000 Liabilities Equity 4000 (revenue) 5. Pay off a short-term liability of $7000. Assets 7000 Liabilities 7000 Equity Liabilities 5000 Equity 5000 6. Declare a cash dividend of $5000. Assets 7. Convert a long-term liability of $80 000 into ordinary shares. Assets Liabilities 80 000 Equity 80 000 8. Pay cash of $16 000 for a delivery van. Assets 16 000 16 000 74 Fundamentals of intermediate accounting Liabilities Equity Financial statements and ownership structure Share capital and retained earnings are reported in the equity section of the balance sheet. Dividends paid in cash are reported in the cash flow statement as a financing activity and in the statement of changes in equity. Revenues and expenses are reported on the income statement. Dividends, revenues and expenses are eventually transferred to retained earnings at the end of the period. As a result, a change in any one of these three items affects equity. The relationships relating to equity are shown in figure 3.4. Balance sheet Equity Share capital (investments by shareholders) Retained earnings (profit retained in business) Dividends Profit or loss (revenues less expenses) Income statement FIGURE 3.4 Financial statements and ownership structure Statement of changes in equity The type of ownership structure used by a business entity dictates the types of accounts that are part of or affect the equity section. In a corporation, Share Capital, Dividends and Retained Earnings are accounts commonly used. In a proprietorship or partnership, a Capital account is used to indicate the owner’s or owners’ investment in the company. A Drawings account is used to indicate withdrawals by the owner(s). Figure 3.5 summarises and relates the transactions affecting equity to the nominal (temporary) and real (permanent) accounts and to the types of business ownership. FIGURE 3.5 Effects of transactions on equity accounts Ownership structure Proprietorships and partnerships Transactions affecting equity Impact on equity Investment by owner(s) Increase Revenues earned Expenses incurred Withdrawal by owner(s) Increase Decrease Decrease Nominal (temporary) accounts Real (permanent) accounts Corporations Nominal (temporary) accounts Capital Revenue º Expense » Drawings ¼ Capital Real (permanent) accounts Share Capital and related accounts Revenue º Expense » Dividends ¼ Retained Earnings ,%!2.).' /"*%#4)6% 3 TH E ACCOUNTI NG CYCLE Figure 3.6 shows the steps in the accounting cycle. These are the accounting procedures normally used by entities to record transactions and prepare financial statements. Identify steps in the accounting cycle. C H A P T E R 3 The accounting information system 75 Identification and measurement of transactions and other events Journals General journal Cash receipts journal Cash payments journal Purchases journal Sales journal Other special journals Reversing entries (optional) Post-closing trial balance (optional) THE ACCOUNTING CYCLE Closing (nominal accounts) Statement preparation Income statement Statement of changes in equity Balance sheet Cash flow statement Posting General ledger (usually monthly) Subsidiary ledgers (usually daily) Trial balance preparation Worksheet (optional) Adjustments Accruals Prepayments Estimated items Adjusted trial balance FIGURE 3.6 The accounting cycle When the steps have been completed, the sequence starts over again in the next accounting period. Identifying and recording transactions and other events 5NDERLYING CONCEPTS Assets are resources controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity. Do human resources of an entity meet this definition? 76 The first step in the accounting cycle is analysis of transactions and selected other events. The problem is to determine what to record. No simple rules exist that state whether an event should be recorded. Most agree that changes in personnel, changes in managerial policies, and the value of human resources, though important, should not be recorded in the accounts. On the other hand, when the company makes a cash sale or purchase — no matter how small — it should be recorded. The treatment relates to the accounting concepts presented in chapter 2. An item should be recognised in the financial statements if it is an element and is measurable. The IASB Framework for the Preparation and Presentation of Financial Statements (paragraph 83) indicates that an item should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity (b) the item has a cost or value that can be measured with reliability. Consider human resources. Entities have experimented with intellectual capital reports. Should we value employees for balance sheet and income statement purposes? Certainly skilled employees are an important asset, but the problems of determining their Fundamentals of intermediate accounting value and measuring it reliably have not yet been solved. Consequently, human resources are not recorded. Perhaps when measurement techniques become more sophisticated and accepted, such information will be presented, if only in supplementary form. Transactions and other events give rise to changes in an entity’s assets, liabilities and equity. Events are of two types: • External events involve interaction between an entity and its environment, such as a transaction with another entity, a change in the price of a good or service that an entity buys or sells, a flood or earthquake, or an improvement in technology by a competitor. • Internal events occur within an entity, such as using buildings and machinery in operations or transferring or consuming raw materials in production processes. Many events have both external and internal elements. For example, acquiring the services of employees or others involves exchange transactions, which are external events. Using those services (labour), often simultaneously with their acquisition, is part of production, which is internal. Events may be initiated and controlled by an entity, such as the purchase of merchandise or the use of a machine. Or they may be beyond its control, such as an interest rate change, a theft or vandalism, or the imposition of taxes. A transaction, as a particular kind of external event, may be an exchange in which each entity both receives and sacrifices value, such as purchases and sales of goods or services. Or transactions may be transfers in one direction in which an entity incurs a liability or transfers an asset to another entity without directly receiving (or giving) value in exchange. Examples include investments by owners, distributions to owners, payment of taxes, gifts, charitable contributions and thefts. In short, as many events as possible that affect the financial position of the entity are recorded. Some events are omitted because of tradition and others because the problems of measuring them are too complex. The accounting profession in recent years has shown signs of breaking with age-old traditions and is more receptive than ever to accepting the challenge of measuring and reporting events and phenomena previously viewed as too complex and immeasurable. Journals Effects on the basic business elements (assets, liabilities and equities) are categorised and collected in accounts. The general ledger is a collection of all the asset, liability, equity, revenue and expense accounts. A T-account (as shown in figure 3.8, p. 79) is a convenient method of illustrating the effect of transactions on particular asset, liability, equity, revenue and expense items. In practice, transactions and selected other events are not recorded originally in a ledger because a transaction affects two or more accounts, each of which is on a different page in the ledger. To circumvent this deficiency and to have a complete record of each transaction or other event in one place, a journal (also called ‘the book of original entry’) is used. The simplest journal form is a chronological listing of transactions and other events expressed in terms of debits and credits to particular accounts. This is called a general journal. It is illustrated in figure 3.7 for the following transactions for Day Ltd. Nov. Nov 1 3 4 16 ,%!2.).' /"*%#4)6% 4 Record transactions in journals, post to ledger accounts, and prepare a trial balance. Bought a new delivery truck on account from Auto Sales, $22 400. Received an invoice from the Evening Graphic for advertising, $280. Returned merchandise to Northern Supply for credit, $175. Received a $95 debit memo from Southern & Co., indicating that freight on a purchase from Southern & Co. was prepaid but is Day Ltd’s obligation. Each general journal entry consists of four parts: (1) the accounts and amounts to be debited (Dr), (2) the accounts and amounts to be credited (Cr), (3) a date, and (4) an explanation (also known as a narration). Debits are entered first, followed by the credits, which are slightly indented. The explanation is placed on the line below the last account to be credited and may take one or more lines. The ‘Ref.’ column is completed at the time the accounts are posted. C H A P T E R 3 The accounting information system 77 In some cases, businesses use subsidiary journals in addition to the general journal. Subsidiary journals summarise transactions that have a common characteristic (e.g. cash receipts, sales, purchases, cash payments), thereby reducing the time necessary to do the various bookkeeping tasks and allowing thousands of similar transactions to be recorded in detail in the subsidiary ledger, but as a single summary entry in the general ledger. Posting The items entered in a general journal must be transferred to the general ledger. This procedure, posting, is part of the summarising and classifying process. For example, the 1 November entry in the general journal in figure 3.7 shows a debit to Delivery Equipment of $22 400 and a credit to Accounts Payable of $22 400. The amount in the debit column is posted from the journal to the debit side of the ledger account (Delivery Equipment). The amount in the credit column is posted from the journal to the credit side of the ledger account (Accounts Payable). FIGURE 3.7 General journal with sample entries GENERAL JOURNAL Date 2007 Nov. 1 Nov. 3 Nov. 4 Nov. 16 Account title and explanation Page 12 Ref. Amount Debit Credit Delivery Equipment Accounts Payable (Purchased delivery truck on account from Auto Sales) 8 34 22 400 Advertising Expense Accounts Payable (Received invoice for advertising from Evening Graphic) 65 34 280 Accounts Payable Purchase Returns (Returned merchandise for credit to Northern Supply) 34 53 175 Freight Inwards Accounts Payable (Received debit memo for freight on merchandise purchased from Southern & Co.) 55 34 95 22 400 280 175 95 The numbers in the ‘Ref.’ column of the general journal refer to the accounts in the ledger to which the respective items are posted. For example, the ‘34’ placed in the column to the right of ‘Accounts Payable’ indicates that this $22 400 item was posted to account no. 34 in the ledger. The posting of the general journal is completed when all of the posting reference numbers have been recorded opposite the account titles in the journal. Thus the number in the posting reference column serves two purposes: (1) it indicates the ledger account number of the account involved, and (2) it indicates that the posting has been completed for the particular item. Each business entity selects its own numbering system for its ledger accounts. One practice is to begin numbering with asset accounts and to follow with liabilities, equity, revenue and expense accounts, in that order. The various ledger accounts in figure 3.8 show the accounts after the posting process is completed. The source of the data transferred to the ledger account is indicated by the reference GJ12 (general journal, page 12). Trial balance A trial balance is a list of accounts and their balances at a given time. Customarily, a trial balance is prepared at the end of an accounting period. The accounts are listed in the order in which they appear in the ledger, with debit balances listed in the left-hand column and credit balances in the right-hand column. The totals of the two columns must agree. The main purpose of a trial balance is to prove the mathematical equality of debits and credits after posting. Under the double-entry system, this equality will occur when 78 Fundamentals of intermediate accounting Delivery Equipment Nov. 1 GJ12 Nov. 4 GJ12 No. 8 22 400 Accounts Payable 175 Nov. 1 Nov. 3 Nov. 16 No. 34 22 400 280 95 GJ12 GJ12 GJ12 Purchase Returns Nov. 4 No. 53 GJ12 175 Freight Inwards Nov. 16 GJ12 Nov. 3 GJ12 FIGURE 3.8 Ledger accounts, in T-account format No. 55 95 Advertising Expense No. 65 280 the sum of the debit account balances equals the sum of the credit account balances. A trial balance also uncovers errors in preparing and posting journals. In addition, it is useful in the preparation of financial statements. The procedures for preparing a trial balance consist of: 1. listing the account titles and their balances 2. totalling the debit and credit columns 3. proving the equality of the two columns. The trial balance prepared from the ledger of Pioneer Advertising Agency is presented in figure 3.9. Note that the total debits of $287 000 equal the total credits of $287 000. Account numbers to the left of the account titles in the trial balance are also often shown. FIGURE 3.9 Trial balance (unadjusted) PIONEER ADVERTISING AGENCY Trial Balance as at 31 October 2007 Cash Accounts Receivable Advertising Supplies Prepaid Insurance Office Equipment Notes Payable Accounts Payable Unearned Service Revenue Share Capital Dividends Service Revenue Salaries Expense Rent Expense Debit $ 80 000 72 000 25 000 6 000 50 000 Credit $ 50 000 25 000 12 000 100 000 5 000 100 000 40 000 9 000 $ 287 000 $ 287 000 A trial balance does not prove that all transactions have been recorded or that the ledger is correct. Numerous errors may exist even though the trial balance columns agree. For example, the trial balance may balance even when (1) a transaction is not recorded in the journal, (2) a correct journal entry is not posted, (3) a journal entry is posted twice, (4) incorrect accounts are used in preparing or posting journals, or (5) offsetting errors are made in recording the amount of a transaction. In other words, as long as equal debits and credits are posted, even to the wrong account or in the wrong amount, the total debits will equal the total credits. Review of the trial balance can, however, help the bookkeeper identify some of the five problems noted and identify the adjusting entries required. C H A P T E R 3 The accounting information system 79 ,%!2.).' /"*%#4)6% 5 Explain the reasons for preparing adjusting entries. Adjusting entries In order for revenues to be recorded in the period in which they are earned, and for expenses to be recognised in the period in which they are incurred, adjusting entries are made at the end of the accounting period. In short, adjustments are needed to ensure that the revenue recognition and matching principles are followed. The use of adjusting entries makes it possible to report on the balance sheet the appropriate assets, liabilities and equity at the statement date and to report on the income statement the proper profit (or loss) for the period. However, the trial balance — the first pulling together of the transaction data — may not contain up-to-date and complete data for the following reasons: • Some events are not recorded in the journals daily because it is not expedient. Examples are the consumption of supplies and the earning of wages by employees. • Some costs are not recorded in the journals during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions. Examples of such costs are building and equipment deterioration and rent and insurance. • Some items may be unrecorded. An example is an electricity bill that will not be received until the next accounting period. Adjusting entries are required every time financial statements are prepared. An essential starting point is an analysis of each account in the trial balance to determine whether it is complete and up-to-date for financial statement purposes. The analysis requires a thorough understanding of the company’s operations and the interrelationship of accounts. The preparation of adjusting entries is often an involved process that requires the services of a skilled professional. In accumulating the adjustment data, the company may need to make inventory counts of supplies and repair parts. Also it may be desirable to prepare supporting schedules of insurance policies, rental agreements, and other contractual commitments. Adjustments are often prepared after the balance sheet date. However, the entries are dated as at the balance sheet date. Types of adjusting entries Adjusting entries can be classified as either prepayments or accruals. Each of these classes has two subcategories as shown below. Prepayments Accruals 1. Prepaid expenses. Expenses paid in cash and recorded as assets before they are used or consumed. 3. Accrued revenues. Revenues earned but not yet received in cash or recorded. 2. Unearned revenues. Revenues received in cash and recorded as liabilities before they are earned. 4. Accrued expenses. Expenses incurred but not yet paid in cash or recorded. Specific examples and explanations of each type of adjustment are given in subsequent sections. Each example is based on the 31 October trial balance of Pioneer Advertising Agency (figure 3.9, p. 79). We assume that Pioneer Advertising uses an accounting period of 1 month. Thus, monthly adjusting entries will be made. The entries will be dated 31 October. Adjusting entries for prepayments As indicated earlier, prepayments are either prepaid expenses or unearned revenues. Adjusting entries for prepayments are required at the statement date to record the portion of the prepayment that represents the expense incurred or the revenue earned in the current accounting period. Assuming an adjustment is needed for both types of prepayments, the asset and liability are overstated and the related expense and revenue are understated. For example, in the trial balance, the balance in the asset account Supplies shows only supplies purchased. This balance is overstated; the related expense account, 80 Fundamentals of intermediate accounting Supplies Expense, is understated because the cost of supplies used has not been recognised. Thus the adjusting entry for prepayments will decrease a balance sheet account and increase an income statement account. The effects of adjusting entries for prepayments are shown graphically in figure 3.10. ADJUSTING ENTRIES Prepaid expenses Asset Expense Unadjusted Credit balance adjusting entry ( ) Debit adjusting entry ( ) Unearned revenues Liability Debit adjusting entry ( ) Unadjusted balance Revenue Credit adjusting entry ( ) FIGURE 3.10 Adjusting entries for prepayments Prepaid expenses Expenses paid in cash and recorded as assets before they are used or consumed are identified as prepaid expenses. When a cost is incurred, an asset account is debited to show the service or benefit that will be received in the future. Prepayments often occur in regard to insurance, supplies, advertising and rent. In addition, prepayments are made when buildings and equipment are purchased. Prepaid expenses expire either with the passage of time (e.g. rent and insurance) or through use and consumption (e.g. supplies). The expiration of these costs does not require daily recurring entries, which would be unnecessary and impractical. It is customary to postpone the recognition of such cost expirations until financial statements are prepared. At each statement date, adjusting entries are made to record the expenses that apply to the current accounting period and to show the unexpired costs in the asset accounts. Before adjustment, assets are overstated and expenses are understated. Thus, the prepaid expense adjusting entry results in a debit to an expense account and a credit to an asset account. Supplies. Several different types of supplies are used in a business entity. For example, an accounting firm will have office supplies such as stationery, envelopes and accounting paper. An advertising firm will have advertising supplies such as graph paper, video film and poster paper. Supplies are generally debited to an asset account when they are acquired. During the course of operations, supplies are depleted or entirely consumed. However, recognition of supplies used is deferred until the adjustment process, when a physical inventory count of supplies is taken. The difference between the balance in the Supplies (asset) account and the cost of supplies on hand represents the supplies used (expense) for the period. C H A P T E R 3 The accounting information system 81 Pioneer Advertising Agency (see figure 3.9, p. 79) purchased advertising supplies costing $25 000 on 5 October. The debit was made to the asset Advertising Supplies. This account shows a balance of $25 000 in the 31 October trial balance. An inventory count at the close of business on 31 October reveals that $10 000 of supplies are still on hand. Thus, the cost of supplies used is $15 000 ($25 000 − $10 000), and the following adjusting entry is made: Oct. 31 A = –15 000 L + E –15 000 Advertising Supplies Expense Advertising Supplies (To record supplies used) 15 000 15 000 After the adjusting entry is posted, the two supplies accounts in T-account form are as shown in figure 3.11. FIGURE 3.11 Supplies accounts after adjustment Advertising Supplies 5/10 31/10 Bal. 25 000 10 000 31/10 Adj. Advertising Supplies Expense 15 000 31/10 Adj. 15 000 The asset account Advertising Supplies now shows a balance of $10 000, which is equal to the cost of supplies on hand at the statement date. In addition, Advertising Supplies Expense shows a balance of $15 000, which equals the cost of supplies used in October. If the adjusting entry is not made, October expenses will be understated and profit will be overstated by $15 000. Moreover, both assets and equity will be overstated by $15 000 on the 31 October balance sheet. Insurance. Most entities have fire and theft insurance on merchandise and equipment, personal liability insurance for accidents suffered by customers, and motor vehicle insurance on company cars and trucks. The cost of insurance protection is determined by the payment of insurance premiums. The term and coverage are specified in the insurance policy. The minimum term is usually 1 year, but 3- to 5-year terms are available and offer lower annual premiums. Insurance premiums normally are charged to the asset account Prepaid Insurance when paid. At the financial statement date it is necessary to debit Insurance Expense and credit Prepaid Insurance for the cost that has expired during the period. On 4 October, Pioneer Advertising Agency paid $6000 for a 1-year fire insurance policy. The effective date of coverage was from 1 October. The premium was charged to Prepaid Insurance when it was paid, and this account shows a balance of $6000 in the 31 October trial balance. An analysis of the policy reveals that $500 ($6000 ÷ 12) of insurance expires each month. Thus, the following adjusting entry is made. Oct. 31 A = –500 L + E –500 Insurance Expense Prepaid Insurance (To record insurance expired) 500 500 After the adjusting entry is posted, the accounts are as shown in figure 3.12. FIGURE 3.12 Insurance accounts after adjustment Prepaid Insurance 4/10 31/10 Bal. 6 000 5 500 31/10 Insurance Expense Adj. 500 31/10 Adj. 500 The asset Prepaid Insurance shows a balance of $5500, which represents the unexpired cost applicable to the remaining 11 months of coverage. At the same time, the balance in Insurance Expense is equal to the insurance cost that has expired in October. If this adjustment is not made, October expenses will be understated by $500 and profit will be overstated by $500. Moreover, both assets and equity also will be overstated by $500 on the 31 October balance sheet. Depreciation. A business entity typically owns a variety of productive facilities such as buildings, equipment and motor vehicles. These assets provide a service for a number of 82 Fundamentals of intermediate accounting years. The term of service is commonly referred to as the useful life of the asset. Because an asset such as a building is expected to provide service for many years, it is recorded as an asset, rather than an expense, in the year it is acquired. Such assets are recorded at cost, as required by the cost principle. Because long-lived (non-current) assets deteriorate with use and time, a portion of the cost of a long-lived asset should be reported as an expense during each period of the asset’s useful life. Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner. This process allows better matching of the cost of using non-current assets to the periods in which revenue is earned. From an accounting viewpoint, the acquisition of productive facilities is seen essentially as a long-term prepayment for services. The need for making periodic adjusting entries for depreciation is, therefore, the same as described before for other prepaid expenses — that is, to recognise the cost that has expired (expense) during the period and to report the unexpired cost (asset) at the end of the period. In determining the useful life of a productive facility, the main causes of depreciation are actual use, deterioration because of the elements, and obsolescence. At the time an asset is acquired, the effects of these factors cannot be known with certainty, so they must be estimated. Thus, you can see that depreciation is an estimate rather than a factual measurement of the cost that has expired. A common way to calculate depreciation expense is to divide the cost of the asset by its useful life. For example, if cost is $10 000 and useful life is expected to be 10 years, annual depreciation is $1000. For Pioneer Advertising Agency, depreciation on the office equipment is estimated to be $4800 a year (cost $50 000 less residual value $2000 divided by useful life of 10 years), or $400 per month. Accordingly, depreciation for October is recognised by the following adjusting entry: Oct. 31 Depreciation Expense Accumulated Depreciation – Office Equipment (To record monthly depreciation) 400 400 A = –400 L + E –400 After the adjusting entry is posted, the accounts are as shown in figure 3.13. FIGURE 3.13 Accounts after adjustment for depreciation Office Equipment 1/10 50 000 Accumulated Depreciation – Office Equipment 31/10 Adj. Depreciation Expense 400 31/10 Adj. 400 The balance in the accumulated depreciation account will increase $400 each month. Therefore, after preparing and posting the adjusting journal entry at 30 November, the balance will be $800. Notice that depreciation expense does not directly involve any cash outflow. Cash may have been exchanged at the time the office equipment was purchased, but there is no effect on cash from the recording of the monthly depreciation. Accumulated Depreciation – Office Equipment is a contra asset account. A contra asset account is an account that is offset against an asset account on the balance sheet. In terms of statement presentation, this means that the accumulated depreciation account is offset against Office Equipment on the balance sheet and that its normal balance is a credit. This account is used instead of crediting Office Equipment in order to permit disclosure of both the original cost of the equipment and the total cost that has expired to date. In the balance sheet, Accumulated Depreciation – Office Equipment is deducted from the related asset account as shown in figure 3.14. Office equipment Less: Accumulated depreciation – office equipment $50 000 400 $49 600 FIGURE 3.14 Balance sheet presentation of accumulated depreciation C H A P T E R 3 The accounting information system 83 The difference between the cost of any depreciable asset and its related accumulated depreciation is referred to as the carrying amount of that asset. In figure 3.14, the carrying amount of the equipment at the balance sheet date is $49 600. It is important to realise that the carrying amount and the market value of the asset are generally two different amounts, because depreciation is not a matter of valuation but rather a means of cost allocation. Note also that depreciation expense identifies that part of the asset’s cost that has expired in October. As in the case of other prepaid adjustments, the omission of this adjusting entry would cause total assets, total equity and profit to be overstated and depreciation expense to be understated. If additional equipment is involved, such as delivery or store equipment, or if the company has buildings, depreciation expense is recorded on each of these items. Related accumulated depreciation accounts also are established. These accumulated depreciation accounts are described in the ledger as follows: Accumulated Depreciation – Delivery Equipment, Accumulated Depreciation – Store Equipment, and Accumulated Depreciation – Buildings. Unearned revenues Revenues received in cash and recorded as liabilities before they are earned are called unearned revenues. Such items as rent, magazine subscriptions and customer deposits for further service may result in unearned revenues. Airlines, such as Qantas, Virgin Blue and Thai Airways, treat receipts from the sale of tickets as unearned revenue until the flight service is provided. Unearned revenues are the opposite of prepaid expenses. Indeed, unearned revenue in the records of one entity is likely to be a prepayment in the records of the entity that has made the advance payment. For example, if identical accounting periods are assumed, a landlord will have unearned rent revenue when a tenant has prepaid rent. When the payment is received for services to be provided in a future accounting period, an unearned revenue (a liability) account should be credited to recognise the obligation that exists. Unearned revenues are subsequently earned through rendering service to a customer. During the accounting period it may not be practical to make daily recurring entries as the revenue is earned. In such cases, the recognition of earned revenue is delayed until the adjustment process. Then an adjusting entry is made to record the revenue that has been earned and to show the liability that remains. Typically, liabilities are overstated and revenues are understated before adjustment. Thus, the adjusting entry for unearned revenues results in a debit (decrease) to a liability account and a credit (increase) to a revenue account. Pioneer Advertising Agency received $12 000 on 2 October from Knox Pty Ltd for advertising services expected to be completed by 31 December. The payment was credited to Unearned Service Revenue, and this account shows a balance of $12 000 in the 31 October trial balance. When analysis reveals that $4000 of these services have been earned in October, the following adjusting entry is made: Oct. 31 Unearned Service Revenue Service Revenue (To record revenue for services provided) 4 000 4 000 After the adjusting entry is posted, the accounts are as shown in figure 3.15. FIGURE 3.15 Service revenue accounts after prepayments adjustments Unearned Service Revenue 31/10 Adj. 4 000 2/10 31/10 Bal. Service Revenue 12 000 8 000 31/10 31/10 Bal. Adj. 100 000 4 000 The liability Unearned Service Revenue now shows a balance of $8000, which represents the remaining advertising services expected to be performed in the future. At the same time, Service Revenue shows total revenue earned in October of $104 000. If 84 Fundamentals of intermediate accounting this adjustment is not made, revenues and profit will be understated by $4000 in the income statement. Moreover, liabilities will be overstated and equity will be understated by $4000 on the 31 October balance sheet. Adjusting entries for accruals The second category of adjusting entries is accruals. Adjusting entries for accruals are required to record revenues earned and expenses incurred in the current accounting period that have not been recognised through daily entries. If an accrual adjustment is needed, the revenue account (and the related asset account) and/or the expense account (and the related liability account) are understated. Thus, the adjusting entry for accruals will increase both a balance sheet and an income statement account. Adjusting entries for accruals are shown graphically in figure 3.16. ADJUSTING ENTRIES Accrued revenues Asset Revenue Debit adjusting entry ( ) Credit adjusting entry ( ) Accrued expenses Expense Liability Debit adjusting entry ( ) Credit adjusting entry ( ) FIGURE 3.16 Adjusting entries for accruals Accrued revenues Revenues earned but not yet received in cash or recorded at the statement date are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in the case of interest revenue and rent revenue. Or they may result from services that have been performed but neither invoiced nor collected, as in the case of commissions and fees. Interest and rent revenue are unrecorded because the earning of interest and rent does not involve daily transactions. Commissions and fees may be unrecorded because only a portion of the total service has been provided. An adjusting entry is required to show the receivable that exists at the balance sheet date and to record the revenue that has been earned during the period. Before adjustment, both assets and revenues are understated. Accordingly, an adjusting entry for accrued revenues results in a debit (increase) to an asset account and a credit (increase) to a revenue account. In October, Pioneer Advertising Agency earned $2000 for advertising services that were not invoiced to clients before 31 October. Because these services have not been invoiced, they have not been recorded. Thus, the following adjusting entry is made: Oct 31 Accounts Receivable Service Revenue (To record revenue for services provided) 2 000 2 000 C H A P T E R 3 The accounting information system 85 After the adjusting entry is posted, the accounts are as shown in figure 3.17. Accounts Receivable FIGURE 3.17 Receivable and revenue accounts after accrual adjustment 31/10 31/10 Service Revenue 72 000 2 000 Adj. 31/10 31/10 31/10 31/10 Adj. Bal. 100 000 4 000 2 000 106 000 The asset Accounts Receivable shows that $74 000 is owed by clients at the balance sheet date. The balance of $106 000 in Service Revenue represents the total revenue earned during the month ($100 000 + $4000 + $2000). If the adjusting entry is not made, assets and equity on the balance sheet, and revenues and profit on the income statement, will all be understated. Accrued expenses Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses. Interest, rent, taxes and salaries can be accrued expenses. Accrued expenses result from the same causes as accrued revenues. In fact, an accrued expense in the records of one entity is an accrued revenue to another entity. For example, the $2000 accrual of service revenue by Pioneer Advertising Agency is an accrued expense to the client that received the service. Adjustments for accrued expenses are necessary to record the obligations that exist at the balance sheet date and to recognise the expenses that apply to the current accounting period. Before adjustment, both liabilities and expenses are understated. Therefore, the adjusting entry for accrued expenses results in a debit (increase) to an expense account and a credit (increase) to a liability account. Accrued interest. Pioneer Advertising Agency signed a 3-month note payable in the amount of $50 000 on 1 October. The note requires interest at an annual rate of 12%. The amount of the interest accumulation is determined by three factors: (1) the face value of the note, (2) the interest rate, which is always expressed as an annual rate, and (3) the length of time the note is outstanding. The total interest due on Pioneer’s $50 000 note at its due date 3 months hence is $1500 ($50 000 × 12% × 3/12), or $500 for 1 month. The formula for calculating interest and its application to Pioneer Advertising Agency for October are shown in figure 3.18. Face value of note Annual interest rate s Time in terms of 1 year Interest $50 000 FIGURE 3.18 Formula for calculating interest s s 12% s 1/12 $500 Note that the time period is expressed as a fraction of a year. The accrued expense adjusting entry at 31 October is as follows: Oct. 31 A = L +500 + E –500 Interest Expense Interest Payable (To record interest on notes payable) 500 500 After this adjusting entry is posted, the accounts are as shown in figure 3.19. FIGURE 3.19 Interest accounts after adjustment Interest Expense 31/10 500 Interest Payable 31/10 500 Interest Expense shows the interest charges applicable to the month of October. The amount of interest owed at the statement date is shown in Interest Payable. It will not be 86 Fundamentals of intermediate accounting paid until the note comes due at the end of 3 months. The Interest Payable account is used instead of crediting Notes Payable to disclose the two types of obligations (interest and principal) in the accounts and statements. If this adjusting entry is not made, liabilities and interest expense will be understated, and profit and equity will be overstated. Accrued salaries. Some types of expenses, such as employee salaries and commissions, are paid for after the services have been performed. At Pioneer Advertising, salaries were last paid on 26 October; the next payment of salaries will not occur until 9 November. As shown in the calendar below, 3 working days remain in October (29–31 October). October S Start of pay period M 1 7 8 14 15 21 22 28 29 Tu 2 9 16 23 30 W 3 10 17 24 31 Adjustment period November Th 4 11 18 25 F S 5 6 12 13 19 20 26 27 Payday S M Tu W Th 1 4 5 6 7 8 11 12 13 14 15 18 19 20 21 22 25 26 27 28 29 F S 2 3 9 10 16 17 23 24 30 Payday At 31 October, the salaries for these days represent an accrued expense and a related liability to Pioneer Advertising. The employees receive total salaries of $10 000 for a 5-day working week, or $2000 per day. Thus, accrued salaries at 31 October are $6000 ($2000 × 3), and the adjusting entry is as follows: Oct. 31 Salaries Expense Salaries Payable (To record accrued salaries) 6 000 A 6 000 = L + E +6 000 –6 000 After this adjusting entry is posted, the accounts are as shown in figure 3.20. Salaries Expense 26/10 31/10 31/10 Adj. Bal. 40 000 6 000 46 000 Salaries Payable 31/10 Adj. 6 000 FIGURE 3.20 Salary accounts after adjustment After this adjustment, the balance in Salaries Expense of $46 000 (23 days × $2000) is the actual salary expense for October. The balance in Salaries Payable of $6000 is the amount of the liability for salaries owed as at 31 October. If the $6000 adjustment for salaries is not recorded, Pioneer’s expenses will be understated by $6000, and its liabilities will be understated by $6000. At Pioneer Advertising, salaries are payable every 2 weeks. Consequently, the next payday is 9 November, when total salaries of $20 000 will again be paid. The payment consists of $6000 of salaries payable at 31 October plus $14 000 of salaries expense for November (7 working days as shown in the November calendar × $2000). Therefore, the following entry is made on 9 November: Salaries Payable 6 000 Salaries Expense Cash (To record 9 November payroll) 14 000 20 000 A = L + E –20 000 6 000 –14 000 This entry eliminates the liability for Salaries Payable that was recorded in the 31 October adjusting entry and records the proper amount of Salaries Expense for the period between 1 November and 9 November. Bad debts. The proper valuation of the receivables balance requires recognition of uncollectable, worthless receivables on the balance sheet. Proper matching of revenues and expenses dictates recording bad debts as an expense of the period in which revenue is earned instead of the later period in which the accounts or notes are subsequently written off as uncollectable. Proper valuation requires an adjusting entry. C H A P T E R 3 The accounting information system 87 At the end of each period, an estimate is made of the amount of current period revenue on account that will later prove to be uncollectable. The estimate is based on the amount of bad debts experienced in past years, general economic conditions, how long the receivables are past due, and other factors that indicate the element of uncollectability. Usually it is expressed as a percentage of the revenue on account for the period. Or it may be calculated by adjusting the Allowance for Doubtful Debts account to a certain percentage of the trade accounts receivable and trade notes receivable at the end of the period. To illustrate, assume that experience indicates a reasonable estimate for bad debt expense for the month is $1600. The adjusting entry for bad debts is: Oct. 31 Bad Debts Expense Allowance for Doubtful Debts (To record monthly bad debts expense) 1 600 1 600 After the adjusting entry is posted, the accounts are as shown in figure 3.21. FIGURE 3.21 Accounts after adjustment for bad debt expense Accounts Receivable 1/10 31/10 Adj. 72 000 2 000 Bad Debt Expense Allowance for Doubtful Accounts 31/10 Adj. 1 600 31/10 Adj. 1 600 Adjusted trial balance After all adjusting entries have been recorded in the journals and posted to the general ledger accounts, another trial balance is prepared summarising the account totals from the ledger accounts. This trial balance is called an adjusted trial balance. It shows the balance of all accounts, including those that have been adjusted, at the end of the accounting period (figure 3.22). The purpose of an adjusted trial balance is to show the effects of all financial events that have occurred during the accounting period. FIGURE 3.22 Adjusted trial balance PIONEER ADVERTISING AGENCY Adjusted Trial Balance 31 October 2007 Cash Accounts Receivable Allowance for Doubtful Debts Advertising Supplies Prepaid Insurance Office Equipment Accumulated Depreciation – Office Equipment Notes Payable Accounts Payable Interest Payable Unearned Service Revenue Salaries Payable Share Capital Dividends Service Revenue Salaries Expense Advertising Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense Bad Debt Expense 88 Fundamentals of intermediate accounting Debit $ 80 000 74 000 Credit $ 1 600 10 000 5 500 50 000 400 50 000 25 000 500 8 000 6 000 100 000 5 000 106 000 46 000 15 000 9 000 500 500 400 1 600 $ 297 500 $ 297 500 ,%!2.).' /"*%#4)6% 6 Closing Basic process The procedure generally followed to reduce the balance of nominal (temporary) accounts to zero in order to prepare the accounts for the next period’s transactions is known as the closing process. In the closing process, all the revenue and expense account balances (income statement items) are transferred to a clearing or suspense account called Income Summary (or Profit and Loss Summary), which is used only at the end of each accounting period (yearly). Revenues and expenses are matched in the Income Summary account. The net result of this matching, which represents the profit or loss for the period, is then transferred to an equity account (retained earnings for a corporation, and capital accounts normally for proprietorships and partnerships). All such closing entries are posted to the appropriate general ledger accounts. For example, assume that revenue accounts of the Apparel Shop have the following balances, after adjustments, at the end of the year: Sales Revenue Rental Revenue Interest Revenue Prepare closing entries. $280 000 27 000 5 000 These revenue accounts would be closed and the balances transferred by the following closing journal entry: Sales Revenue Rental Revenue Interest Revenue Income Summary (To close revenue accounts to Income Summary) 280 000 27 000 5 000 312 000 Assume that the expense accounts, including Cost of Sales, have the following balances, after adjustments, at the end of the year: Cost of Sales Selling Expenses General and Admin. Expenses Interest Expense Income Tax Expense $206 000 25 000 40 600 4 400 13 000 These expense accounts would be closed and the balances transferred through the following closing journal entry: Income Summary Cost of Sales Selling Expenses General and Admin. Expenses Interest Expense Income Tax Expense (To close expense accounts to Income Summary) 289 000 206 000 25 000 40 600 4 400 13 000 The Income Summary account now has a credit balance of $23 000, which is profit after income tax. The profit is transferred to equity by closing the Income Summary account to Retained Earnings as follows: Income Summary Retained Earnings (To close Income Summary to Retained Earnings) 23 000 23 000 A = L + E –23 000 +23 000 A = L + E –7 000 +7 000 Assuming that dividends of $7000 were declared and distributed during the year, the Dividends account is closed directly to Retained Earnings as follows: Retained Earnings Dividends (To close Dividends to Retained Earnings) 7 000 7 000 When the closing process is completed, each income statement (i.e. nominal) account is balanced out to zero and is ready for use in the next accounting period. C H A P T E R 3 The accounting information system 89 Figure 3.23 shows the closing process in T-account form. Cost of Sales End. bal. 206 000 Closing Sales Revenue 206 000 Closing 280 000 End. bal. 280 000 Rental Revenue Closing Selling Expenses End. bal. 25 000 Closing 27 000 End. bal. 27 000 25 000 Interest Revenue Closing 5 000 End. bal. 5 000 General and Admin. Expenses End. bal. 40 600 Closing 40 600 Income Summary Expenses 289 000 Revenues 312 000 Closing 23 000 312 000 312 000 Interest Expense End. bal. 4 400 Closing Retained Earnings 4 400 Div. Income Tax Expense FIGURE 3.23 The closing process ,%!2.).' /"*%#4)6% 7 Explain how inventory accounts are adjusted at year-end. 90 End. bal. 13 000 Closing 7 000 Beg. bal. Net inc. 93 500 23 000 Dividends 13 000 End. bal. 7 000 Closing 7 000 Inventory and cost of sales The closing procedures illustrated above assumed the use of the perpetual inventory system. With a perpetual inventory system, purchases and sales are recorded directly in the Inventory account as the purchases and sales occur. Therefore, the balance in the Inventory account should represent the ending inventory amount, and no adjusting entries are needed. To ensure this accuracy, a physical count of the items in the inventory is generally made annually. No Purchases account is used because the purchases are debited directly to the Inventory account. However, a Cost of Sales account is used to accumulate the issues from inventory. That is, when inventory items are sold, the cost of the sold goods is credited to Inventory and debited to Cost of Sales. With a periodic inventory system, a Purchases account is used, and the Inventory account is unchanged during the period. The Inventory account represents the beginning inventory amount throughout the period. At the end of the accounting period, the Inventory account must be adjusted by closing out the beginning inventory amount and recording the ending inventory amount. The ending inventory is determined by physically counting the items on hand and valuing them at cost or at the lower of cost and market. Under the periodic inventory system, cost of sales is, therefore, determined by adding the beginning inventory and net purchases and deducting the ending inventory. To illustrate how cost of sales is calculated with a periodic inventory system, assume that the Apparel Shop has a beginning inventory of $30 000, Purchases $200 000, Freight Inwards $6000, Purchase Returns and Allowances $1000, Purchase Discounts $3000, and ending inventory $26 000. The calculation of cost of sales is as shown in figure 3.24. Fundamentals of intermediate accounting Beginning inventory Purchases Less: Purchase returns and allowances Less: Purchase discounts Net purchases Plus: Freight Inwards Cost of goods purchased Cost of goods available for sale Less: Ending inventory Cost of sales $ 30 000 $200 000 $1 000 3 000 FIGURE 3.24 Calculation of cost of sales under the periodic inventory system 4 000 196 000 6000 202 000 232 000 26 000 $206 000 Cost of sales will be the same whether the perpetual or periodic method is used. Post-closing trial balance We already mentioned that a trial balance is taken after the regular transactions of the period have been entered and that a second trial balance (the adjusted trial balance) is taken after the adjusting entries have been posted. A third trial balance may be taken after posting the closing entries. The trial balance after closing, called the post-closing trial balance, shows that equal debits and credits have been posted to the Income Summary account. The post-closing trial balance consists only of asset, liability and equity (the real) accounts. Reversing entries After the financial statements have been prepared and the books have been closed, it is often helpful to reverse some of the adjusting entries before recording the regular transactions of the next period. Such entries are called reversing entries. A reversing entry is made at the beginning of the next accounting period and is the exact opposite of the related adjusting entry made in the previous period. For example, at the end of the month an estimate for gas or electricity used in production, but not yet paid, is accrued based on an estimate of the use. By recording this transaction in a journal with a special code for reversing entries, a computerised accounting system can easily generate an offsetting journal entry that reverses this accrual at the start of the following month. The recording of reversing entries is an optional step in the accounting cycle that may be performed at the beginning of the next accounting period. Consider a clerk receiving an invoice for payment that relates to last month’s expenses. If all adjustments at the end of last month have been reversed then the invoice is recorded in full against the expense account for that type of cost. If the end-of-month adjustments have not been reversed, then the invoice must first be identified as a cost that was accrued in the previous month’s expenses; then the cost previously accrued is debited to the liability account used for the accrual (a payable account or the accrued expenses account) and the remaining cost, which results from the difference between the estimated accrual and the actual expense, is debited to the expense account for that type of cost. Appendix 3A discusses reversing entries in more detail. Understanding the nature and accuracy of the adjusting and reversing journal entries is very important to assessing the accuracy of the financial statements being prepared. These journal entries need to be supported by calculations and documentation that confirm the nature and accuracy of the adjustments being made. The adjusting journal entries help to measure the revenue and expenses for the period that describe the financial performance of the entity. The adjusting journal entries should not be calculated backwards so as to achieve a desired profit level — that is not accounting, that is fraud. C H A P T E R 3 The accounting information system 91 The accounting cycle summarised A summary of the steps in the accounting cycle shows a logical sequence of the accounting procedures used during a financial accounting period: 1. Enter the transactions of the period in appropriate journals. 2. Post from the journals to the ledger (or ledgers). 3. Prepare an unadjusted trial balance (trial balance). 4. Prepare adjusting journal entries and post to the ledger(s). 5. Prepare a trial balance after adjusting (adjusted trial balance). 6. Prepare the financial statements from the second trial balance. 7. Prepare closing journal entries and post to the ledger(s). 8. Prepare a trial balance after closing (post-closing trial balance). 9. Prepare reversing entries (optional) and post to the ledger(s). This list of procedures constitutes a complete accounting cycle that is normally performed in every accounting period. ,%!2.).' /"*%#4)6% 8 Prepare a multicolumn worksheet. USI NG A WORKSH E ET To facilitate the end-of-period accounting and reporting process (monthly, quarterly, half-yearly or yearly), a worksheet is often used. Traditionally, a worksheet contains several columns used to adjust the account balances and prepare the financial statements. Worksheets are now typically prepared using computerised spreadsheets. Use of a worksheet helps the accountant prepare the financial statements. Worksheets can also be used when auditing accounts, to understand the process used to compile the financial statements. The 10-column worksheet illustrated in this chapter (figure 3.25) provides columns for the first trial balance, adjustments, adjusted trial balance, income statement and balance sheet. The worksheet does not replace the financial statements. It is an informal device for accumulating and sorting information for the financial statements. Completing the worksheet provides considerable assurance that all the details relating to the end-ofperiod accounting and statement preparation have been properly brought together. Adjustments entered on the worksheet Items (a) to (f) below serve as the basis for the adjusting entries made in the worksheet shown in figure 3.25. (a) Furniture and equipment is depreciated at the rate of 10% per year based on original cost of $67 000. (b) Estimated bad debts, one-quarter of 1% of sales ($400 000). (c) Insurance expired during the year, $360. (d) Interest accrued on notes receivable as at 30 June, $800. (e) The Rent Expense account contains $500 rent paid in advance, which is applicable to next year. (f) Rates accrued at 30 June, $2000. The adjusting entries shown on the 30 June 2007 worksheet are as follows. (a) Depreciation Expense – Furniture and Equipment Accumulated Depreciation – Furniture and Equipment 6 700 (b) Bad Debt Expense Allowance for Doubtful Debts 1 000 6 700 1 000 (c) Insurance Expense Prepaid Insurance 360 (d) Interest Receivable Interest Revenue 800 (e) Prepaid Rent Expense Rent Expense 500 (f) Rates Expense Rates Payable 92 Fundamentals of intermediate accounting 360 800 500 2 000 2 000 These adjusting entries are transferred to the Adjustments columns of the worksheet, and each may be designated by letter. The accounts that are set up as a result of the adjusting entries and that are not already in the trial balance are listed below the totals of the trial balance. The Adjustments columns are then totalled and balanced. FIGURE 3.25 Use of a worksheet UPTOWN CABINET LTD Ten-column Worksheet for the year ended 30 June 2007 Trial balance Accounts Cash Notes receivable Accounts receivable Allowance for doubtful debts Merchandise inventory Prepaid insurance Furniture and equipment Accumulated depreciation – furniture and equipment Notes payable Accounts payable Bonds payable Share capital Retained earnings, 1 Jan. 2007 Sales Cost of sales Sales salaries expense Advertising expense Travelling expense Salaries, office and general Telephone and Internet expense Rent expense Rates expense Interest expense Totals Depreciation expense – furniture and equipment Bad debt expense Insurance expense Interest receivable Interest revenue Prepaid rent expense Rates payable Totals Profit before income tax Totals Profit before income tax Income tax expense Income tax payable Profit for the period Totals Adjustments Adjusted trial balance Dr Dr Dr Cr Cr 1 200 16 000 41 000 Cr Income statement Dr Cr 1 200 16 000 41 000 2 000 (b) 1 000 40 000 900 67 000 (c) (a) 12 000 20 000 13 500 30 000 50 000 14 200 400 000 316 000 20 000 2 200 8 000 19 000 600 4 800 3 300 (f) 1 700 541 700 541 700 360 (d) 500 (f) 11 360 Cr 3 000 40 000 540 67 000 18 700 20 000 13 500 30 000 50 000 14 200 400 000 18 700 20 000 13 500 30 000 50 000 14 200 400 000 316 000 20 000 2 200 8 000 19 000 600 500 4 300 5 300 1 700 316 000 20 000 2 200 8 000 19 000 600 4 300 5 300 1 700 6 700 1 000 360 (a) 6 700 (b) 1 000 (c) 360 (d) 800 (e) 3 000 6 700 1 000 360 800 (e) Dr 1 200 16 000 41 000 40 000 540 67 000 6 700 2 000 Balance sheet 800 800 800 800 500 2 000 2 000 11 360 552 200 552 200 385 160 400 800 15 640 400 800 400 800 500 2 000 15 640 (g) 4 692 4 692 (g) 4 692 10 948 15 640 4 692 10 948 15 640 167 040 167 040 Worksheet columns Trial balance columns Data for the trial balance are obtained from the ledger balances of Uptown Cabinet Ltd at 30 June. The amount for Merchandise Inventory, $40 000, is the year-end inventory amount, which results from the application of a perpetual inventory system. C H A P T E R 3 The accounting information system 93 Adjustments columns After all adjustment data are entered on the worksheet, the equality of the adjustment columns is established. The balances in all accounts are then extended to the adjusted trial balance columns. Adjusted trial balance The adjusted trial balance shows the balance of all accounts after adjustment at the end of the accounting period. For example, the $2000 shown opposite Allowance for Doubtful Debts in the Trial Balance Cr column is added to the $1000 in the Adjustments Cr column. The $3000 total is then extended to the Adjusted Trial Balance Cr column. Similarly, the $900 debit opposite Prepaid Insurance is reduced by the $360 credit in the Adjustments column. The result, $540, is shown in the Adjusted Trial Balance Dr column. Income statement and balance sheet columns All the debit items in the Adjusted Trial Balance columns are extended into the Income Statement or Balance Sheet columns to the right. All the credit items are similarly extended. The next step is to total the Income Statement columns; the figure necessary to balance the debit and credit columns is the pretax profit or loss for the period. The profit before income tax of $15 640 is shown in the Income Statement Dr column because revenues exceeded expenses by that amount. Income tax and profit The company tax expense and related tax liability are estimated next. The company tax rate of 30% is applied to arrive at $4692. Because the Adjustments columns have been balanced, this adjustment is entered in the Income Statement Dr column as Income Tax Expense and in the Balance Sheet Cr column as Income Tax Payable. The following adjusting journal entry is recorded on 30 June 2007, and posted to the general ledger as well as entered on the worksheet: A = L + E +4 692 –4 692 (g) Income Tax Expense Income Tax Payable 4 692 4 692 Next, the Income Statement columns are balanced with the income tax included. The $10 948 difference between the debit and credit columns in this illustration represents profit after income tax. The profit of $10 948 is entered in the Income Statement Dr column to achieve equality and in the Balance Sheet Cr column as the increase in retained earnings. Preparing financial statements from a worksheet The worksheet provides the information needed for preparation of the financial statements without reference to the ledger or other records. In addition, the data have been sorted into appropriate columns, which facilitates the preparation of the statements. The financial statements prepared from the 10-column worksheet illustrated are as follows: 1. income statement for the year ended 30 June 2007 (figure 3.26) 2. statement of changes in equity for the year ended 30 June 2007 (figure 3.27, p. 96) 3. balance sheet as at 30 June 2007 (figure 3.28, p. 96). These illustrations are shown on the following pages. Income statement The income statement presented is that of a trading or merchandising concern. If a manufacturing concern was illustrated, three inventory accounts would be involved — Raw Materials, Work in Process, and Finished Goods. When these accounts are used, a supplementary statement called the cost of goods manufactured statement, must be prepared. 94 Fundamentals of intermediate accounting FIGURE 3.26 Income statement for Uptown Cabinet Ltd UPTOWN CABINET LTD Income Statement for the year ended 30 June 2007 Net sales Cost of sales Gross profit on sales Selling expenses Sales salaries expense Advertising expense Travelling expense Total selling expenses Administrative expenses Salaries, office and general Telephone and Internet expense Rent expense Rates expense Depreciation expense – furniture and equipment Bad debt expense Insurance expense Total administrative expenses Total selling and administrative expenses Income from operations Finance costs Interest revenue Interest expense Profit before income tax Income tax expense Profit for the period Earnings per share $400 000 316 000 84 000 $20 000 2 200 8 000 30 200 $19 000 600 4 300 5 300 6 700 1 000 360 37 260 67 460 16 540 800 1 700 900 15 640 4 692 $ 10 948 $ 1.10 Statement of changes in equity The statement of changes in equity and the associated disclosures in notes to the statement provide a reconciliation of the carrying amount of each class of equity, each reserve and retained earnings between the beginning and end of the period. That is, the statement of changes in equity provides a summary of the changes in share capital, reserves and retained earnings for the period. The changes in share capital include the issue and buyback of shares, as well as the exercise of options resulting in the issue of shares, or other transactions changing the carrying amount reported for shares outstanding. The residual equity of shareholders in the company increases with profits and decreases with distributions to the shareholders. These changes are included as changes in retained earnings. Not all changes in the value of assets and liabilities are, however, included in profits and therefore a statement is needed to explain the change in equity from the beginning to the end of the accounting period. Such changes arise from the revaluation of assets, changes in foreign exchange translation rates, accounting for financial hedges, and other items. Many of these items are discussed in later chapters. In figure 3.27 (p. 96), the profit for the period is added to the balance of retained earnings as at the start of the year, thereby increasing the balance of retained earnings to $25 148 at 30 June 2007. In this simple example the profit for the period is retained in the business and is not distributed to shareholders by payment of dividends; there were no other changes to equity. Balance sheet The balance sheet (figure 3.28, p. 96) prepared from the 10-column worksheet contains new items resulting from year-end adjusting entries. Interest receivable, unexpired insurance, and prepaid rent expense are included as current assets. These assets are considered current because they will be converted into cash or consumed in the ordinary routine of the business within a relatively short period of time. The amount of Allowance C H A P T E R 3 The accounting information system 95 FIGURE 3.27 Statement of changes in equity for Uptown Cabinet Ltd UPTOWN CABINET LTD Statement of Changes in Equity for the year ended 30 June 2007 Share capital — ordinary shares Balance as at 30 June 2006 Issue of share capital Balance as at 30 June 2007 $50 000 — $50 000 Retained earnings Balance as at 30 June 2006 Profit for the period Balance as at 30 June 2007 $14 200 10 948 $ 25 148 for Doubtful Debts is deducted from the total of accounts, notes and interest receivable because it is estimated that only $54 800 of $57 800 will be collected in cash. In the non-current section, the accumulated depreciation is deducted from the cost of the furniture and equipment. The difference represents the carrying value of the furniture and equipment. Rates payable is shown as a current liability because it is an obligation that is payable within a year. Other short-term accrued liabilities are also shown as current liabilities. The bonds payable, due in 2012, are long-term liabilities and are shown in a separate section. (Interest on the bonds was paid on 30 June.) FIGURE 3.28 The balance sheet for Uptown Cabinet Ltd UPTOWN CABINET LTD Balance Sheet as at 30 June 2007 Assets Current assets Cash Notes receivable Accounts receivable Interest receivable Less: Allowance for doubtful debts Merchandise inventory Prepaid insurance Prepaid rent Total current assets Non-current assets Furniture and equipment Less: Accumulated depreciation Total non-current assets Total assets Liabilities and equity Current liabilities Notes payable Accounts payable Rates payable Income tax payable Total current liabilities Non-current liabilities Bonds payable, due 31 December 2012 Total liabilities Equity Share capital (10 000 shares) Retained earnings Total equity Total liabilities and equity 96 Fundamentals of intermediate accounting $ $16 000 41 000 800 $57 800 3 000 1 200 54 800 40 000 540 500 97 040 67 000 18 700 48 300 $ 145 340 $ 20 000 13 500 2 000 3 440 38 940 30 000 68 940 $50 000 26 400 76 400 $ 145 340 Because Uptown Cabinet Ltd is a company, the capital section of the balance sheet, called the ‘Equity’ section in the figure, is somewhat different from the capital section for a proprietorship. Total equity consists of share capital, which is the original investment by shareholders, and the earnings retained in the business. Closing entries The entries for the closing process are as follows: General Journal 30 June 2007 Interest Revenue Sales Cost of Sales Sales Salaries Expense Advertising Expense Travel Expense Salaries, Office and General Telephone and Internet Expense Rent Expense Rates Expense Depreciation Expense – Furniture and Equipment Bad Debt Expense Insurance Expense Interest Expense Income Tax Expense Income Summary (To close revenues and expenses to Income Summary) 800 400 000 Income Summary Retained Earnings (To close Income Summary to Retained Earnings) 10 948 316 000 20 000 2 200 8 000 19 000 600 4 300 5 300 6 700 1 000 360 1 700 4 692 10 948 10 948 Monthly statements, yearly closing The use of a worksheet at the end of each month or quarter permits the preparation of interim financial statements even though the books are closed only at the end of each year. For example, assume that a business closes its books on 30 June but that monthly financial statements are desired. At the end of July, a worksheet similar to the one illustrated in this chapter can be prepared to supply the information needed for statements for July. At the end of August, a worksheet can be used again. Note that because the accounts were not closed at the end of July, the income statement taken from the worksheet on 31 August will present the profit for 2 months. If an income statement for only the month of August is wanted, it can be obtained by subtracting the items in the July income statement from the corresponding items in the income statement for the 2 months of July and August. A statement of changes in equity for August only also may be obtained by subtracting the July items. The balance sheet prepared from the August worksheet, however, shows assets, liabilities and equity as at 31 August, the specific date for which a balance sheet is desired. The September worksheet would show the revenues and expenses for 3 months. The subtraction of the revenues and expenses for the first 2 months could be made to supply the amounts needed for an income statement for the month of September only, and so on throughout the year. C H A P T E R 3 The accounting information system 97 Summary of learning objectives 1. Understand basic accounting terminology. It is important to understand the following eleven terms: (1) event, (2) transaction, (3) account, (4) real and nominal accounts, (5) ledger, (6) journal, (7) posting, (8) trial balance, (9) adjusting entries, (10) financial statements, (11) closing entries. 2. Explain double-entry rules. The left-hand side of any account is the debit side, and the right-hand side is the credit side. All asset and expense accounts are increased on the left or debit side and decreased on the right or credit side. Conversely, all liability and revenue accounts are increased on the right or credit side and decreased on the left or debit side. Equity accounts Share Capital and Retained Earnings are increased on the credit side. Dividends is increased on the debit side. 3. Identify steps in the accounting cycle. The basic steps in the accounting cycle are (1) identifiying and measuring of transactions and other events, (2) journalising, (3) posting, (4) unadjusted trial balance, (5) adjustments, (6) adjusted trial balance, (7) statement preparation, and (8) closing. 4. Record transactions in journals, post to ledger accounts, and prepare a trial balance. The simplest journal form is a chronological listing of transactions and events expressed in terms of debits and credits to particular accounts. The items entered in a general journal must be transferred (posted) to the general ledger. An unadjusted trial balance should be prepared at the end of a given period after the entries have been recorded in the journal and posted to the ledger. 5. Explain the reasons for preparing adjusting entries. Adjustments are necessary to achieve a proper matching of revenues and expenses so as to determine profit for the current period and to achieve an accurate statement of end-of-the-period balances in assets, liabilities and equity accounts. 6. Prepare closing entries. In the closing process, all the revenue and expense account balances (income statement items) are transferred to a clearing account called Income Summary, which is used only at the end of the financial year. Revenues and expenses are matched in the Income Summary account. The net result of this matching represents the profit or loss for the period. It is then transferred to an equity account (retained earnings for a corporation and capital accounts for proprietorships and partnerships). 7. Explain how inventory accounts are adjusted at year-end. Under a perpetual inventory system the balance in the Inventory account should represent the ending inventory amount. When the inventory records are maintained in a periodic inventory system, a Purchases account is used; the Inventory account is unchanged during the period. The Inventory account represents the beginning inventory amount throughout the period. At the end of the accounting period, the inventory account must be adjusted by closing out the beginning inventory amount and recording the ending inventory amount. 8. Prepare a multicolumn worksheet. The multicolumn worksheet provides columns for the first trial balance, adjustments, adjusted trial balance, income statement and balance sheet. The worksheet does not replace the financial statements. Instead, it is the accountant’s informal device for accumulating and sorting information needed for the financial statements. Key terms account 77 accounting cycle 75 accounting information system 72 accrued expenses 86 98 Fundamentals of intermediate accounting accrued revenues 85 adjusted trial balance 88 adjusting entry 80 balance sheet 73 periodic inventory system 90 perpetual inventory system 90 post-closing trial balance 91 posting 78 prepaid expenses 81 real (permanent) accounts 72 reversing entries 91 statement of changes in equity 73 subsidiary journal 78 T-account 77 transaction 77 trial balance 78 unearned revenues 84 useful life 83 worksheet 92 carrying amount 84 cash flow statement 73 closing entries 89 closing process 89 contra asset account 83 credit 73 debit 73 depreciation 83 double-entry accounting 73 event 77 general journal 77 general ledger 77 income statement 73 journal 77 ledger 77 nominal (temporary) accounts 72 Review exercise Presented below are both the adjusted and unadjusted trial balances as at 30 June 2007 for Nalezny Advertising Agency. NALEZNY ADVERTISING AGENCY Trial Balance as at 30 June 2007 Unadjusted Dr $ 11 000 20 000 8 400 60 000 Cash Accounts Receivable Art Supplies Printing Equipment Accumulated Depreciation Accounts Payable Unearned Advertising Revenue Salaries Payable Share Capital Retained Earnings Advertising Revenue Salaries Expense Depreciation Expense Art Supplies Expense Rent Expense Adjusted Cr Dr $ 11 000 21 500 5 000 60 000 $ 28 000 5 000 7 000 — 10 000 4 800 58 600 10 000 4 000 $ 113 400 $ 113 400 Cr $ 35 000 5 000 5 600 1 300 10 000 4 800 61 500 11 300 7 000 3 400 4 000 $ 123 200 $ 123 200 Required (a) Journalise the annual adjusting entries that were made. (b) Prepare an income statement for the year ending 30 June 2007, and a balance sheet as at 30 June 2007. (c) Describe the remaining steps in the accounting cycle to be completed by Nalezny for 2007. Solution to review exercise (a) June 30 Accounts Receivable 1 500 Advertising Revenue Unearned Advertising Revenue Advertising Revenue 1 500 1 400 1 400 C H A P T E R 3 The accounting information system 99 Art Supplies Expense Art Supplies 3 400 Depreciation Expense Advertising Revenue 7 000 Salaries Expense Salaries Payable 1 300 (b) 3 400 7 000 1 300 NALEZNY ADVERTISING AGENCY Income Statement for the year ended 30 June 2007 Revenues Advertising revenue Expenses Salaries expense Depreciation expense Rent expense Art supplies expense Total expenses Profit $61 500 $ 11 300 7 000 4 000 3 400 25 700 $35 800 NALEZNY ADVERTISING AGENCY Balance Sheet as at 30 June 2007 Assets Cash Accounts receivable Art supplies Printing equipment Less: Accumulated depreciation – printing equipment Total assets $11 000 21 500 5 000 $60 000 35 000 Liabilities and equity Liabilities Accounts payable Unearned advertising revenue Salaries payable Total liabilities Equity Share capital Retained earnings Total liabilities and equity *Retained earnings, 31 July 2006 * Add: Profit *Retained earnings, 30 June 2007 25 000 $62 500 $ 5 000 5 600 1 300 11 900 $10 000 40 600* 50 600 $62 500 $ 4 800 35 800 $40 600 (c) Following preparation of financial statements (see figure 3.6, p. 76), Nalezny would prepare closing entries to reduce the temporary accounts to zero. Some entities prepare a post-closing trial balance and reversing entries. 100 Fundamentals of intermediate accounting Behind the numbers & Appendix 3A USI NG REVE RSI NG E NTRI ES ,%!2.).' /"*%#4)6% 9 Identify adjusting entries that may be reversed. The purpose of reversing entries is to simplify the recording of transactions in the next accounting period. The use of reversing entries does not change the amounts reported in the financial statements for the previous period. After studying appendix 3A, you should be able to: Identify adjusting entries that may be reversed. Illustration of reversing entries — accruals Reversing entries are most often used to reverse two types of adjusting entries — accrued revenues and accrued expenses. To illustrate the optional use of reversing entries for accrued expenses, we use the following transaction and adjustment data: 1. 24 April (initial salary entry): $4000 of salaries incurred between 1 April and 24 April are paid. 2. 30 April (adjusting entry): Salaries incurred between 25 April and 30 April are $1200. These will be paid in the 8 May payroll. 3. 8 May (subsequent salary entry): Salaries paid are $2500. Of this amount, $1200 applied to accrued wages payable at 30 April and $1300 was incurred between 1 May and 8 May. The comparative entries are shown in figure 3A.1. Reversing entries not used FIGURE 3A.1 Comparison of entries for accruals, with and without reversing entries Reversing entries used Initial salary entry Apr. 24 Salaries Expense Cash 4 000 Apr. 24 4 000 Salaries Expense Cash 4 000 Salaries Expense Salaries Payable 1 200 Income Summary Salaries Expense 5 200 Salaries Payable Salaries Expense 1 200 Salaries Expense Cash 2 500 4 000 Adjusting entry Apr. 30 Salaries Expense Salaries Payable 1 200 Apr. 30 1 200 1 200 Closing entry Apr. 30 Income Summary Salaries Expense 5 200 Apr. 30 5 200 5 200 Reversing entry May 1 No entry is made. May 1 1 200 Subsequent salary entry May 8 Salaries Payable Salaries Expense Cash 1 200 1 300 May 8 2 500 2 500 The comparative entries show that the first three entries are the same whether or not reversing entries are used. The last two entries are different. The 1 May reversing entry eliminates the $1200 balance in Salaries Payable that was created by the 30 April adjusting entry. The reversing entry also creates a $1200 credit balance in the Salaries Expense account. It is unusual for an expense account to have a credit balance; however, the balance is correct in this instance because the entire amount of the first salary payment in the new accounting period will be debited to Salaries Expense. This debit will eliminate the credit balance, and the resulting debit balance in the expense account will equal the salaries expense incurred in the new accounting period ($1300 in this example). When reversing entries are made, all cash payments of expenses can be debited to the expense account. This means that on 8 May (and every payday) Salaries Expense can be debited for the amount paid without regard to the existence of any accrued salaries payable. Being able to make the same entry each time simplifies the recording process in an accounting system. C H A P T E R 3 The accounting information system 101 Illustration of reversing entries — prepayments Up to this point, we have assumed that all prepayments are recorded as prepaid expense or unearned revenue. In some cases, prepayments are recorded directly in expense or revenue accounts. When this occurs, prepayments may also be reversed. To illustrate reversing entries for prepaid expenses, we use the following transaction and adjustment data: 1. 10 June (initial entry): $20 000 of office supplies are purchased with cash. 2. 30 June (adjusting entry): $5000 of office supplies on hand. The comparative entries are shown in figure 3A.2. FIGURE 3A.2 Comparison of entries for prepayments, with and without reversing entries Reversing entries not used Reversing entries used Initial purchase of supplies entry June 10 Office supplies Cash 20 000 20 000 June 10 Office Supplies Expense Cash 20 000 20 000 Adjusting entry June 30 Office Supplies Expense Office Supplies 5 000 15 000 June 30 Office Supplies Office Supplies Expense 15 000 15 000 June 30 Income Summary Office Supplies Expense 15 000 5 000 Closing entry June 30 Income Summary Office Supplies Expense 15 000 15 000 Reversing entry July 1 No entry July 1 Office Supplies Expense Office Supplies 5 000 5 000 After the adjusting entry on 30 June (regardless of whether reversing entries are used) the asset account Office Supplies shows a balance of $5000 and Office Supplies Expense shows a balance of $15 000. If Office Supplies Expense initially was debited when the supplies were purchased, a reversing entry is made to return to the expense account the cost of unconsumed supplies. The entity then continues to debit Office Supplies Expense for additional purchases of office supplies during the next period. With respect to prepaid items, why are all such items not entered originally into real accounts (assets and liabilities), thus making reversing entries unnecessary? Sometimes this practice is followed. It is particularly advantageous for items that need to be apportioned over several periods (e.g. supplies and parts inventories). However, items that do not follow this regular pattern and that may or may not involve two or more periods are ordinarily entered initially in revenue or expense accounts. The revenue and expense accounts may not require adjusting and are systematically closed to Income Summary. Using the nominal accounts adds consistency to the accounting system. It also makes the recording more efficient, particularly when a large number of such transactions occur during the year. For example, the bookkeeper knows that when an invoice is received for other than a capital asset acquisition, the amount is expensed. The bookkeeper need not worry at the time the invoice is received whether or not the item will result in a prepaid expense at the end of the period, because adjustments will be made at the end of the period. Summary of reversing entries A summary of guidelines for reversing entries is as follows: 1. All accrued items should be reversed. 2. All prepaid items for which the original cash transaction was debited or credited to an expense or revenue account should be reversed. 3. Adjusting entries for depreciation and bad debts are not reversed. Recognise that reversing entries do not have to be used. Therefore, some accountants avoid them entirely. 102 Fundamentals of intermediate accounting Summary of learning objective for appendix 3A 9. Identify adjusting entries that may be reversed. Reversing entries are most often used to reverse two types of adjusting entries — accrued revenues and accrued expenses. Prepayments may also be reversed if the initial entry to record the transaction is made to an expense or revenue account. Note: All asterisked questions, exercises, problems and cases relate to material contained in the appendix to the chapter. Questions 1. Give an example of a transaction that results in: (a) a decrease in an asset and a decrease in a liability (b) a decrease in one asset and an increase in another asset (c) a decrease in one liability and an increase in another liability. 2. Do the following events represent business transactions? Explain your answer. (a) A computer is purchased on account. (b) A customer returns merchandise and is given credit on account. (c) A prospective employee is interviewed. (d) The owner of the business withdraws cash from the business for personal use. (e) Merchandise is ordered for delivery next month. 3. Name the accounts debited and credited for each of the following transactions. (a) Invoicing a customer for work done. (b) Receipt of cash from a customer on account. (c) Purchase of office supplies on account. (d) Purchase of 15 litres of petrol for the delivery truck. 4. Why are revenue and expense accounts called temporary or nominal accounts? 5. Omar Azmi, a fellow student, contends that the double-entry system means that each transaction must be recorded twice. Is Omar correct? Explain. 6. Is it necessary for a trial balance to be taken periodically? What purpose does it serve? 7. Indicate whether each of the items below is a real or nominal account and whether it appears in the balance sheet or the income statement. (a) Prepaid Rent (e) Office Equipment (f) Income from Services (b) Salaries and Wages Payable (g) Office Salaries Expense (c) Merchandise Inventory (h) Supplies on Hand (d) Accumulated Depreciation 8. Employees are paid every Saturday for the preceding working week. If a balance sheet is prepared on Wednesday 30 June, what does the amount of wages earned during the first 3 days of the week (28, 29 and 30 June) represent? Explain. 9. (a) How do the components of revenues and expenses differ between a merchandising entity and a service entity? (b) Explain the income measurement process of a merchandising entity. 10. What is the purpose of the Cost of Sales account? (Assume a periodic inventory system.) 11. Under a perpetual system, what is the purpose of the Cost of Sales account? 12. If the $3900 cost of a new computer and printer purchased for office use were recorded as a debit to Purchases, what would be the effect of the error on the balance sheet and income statement in the period in which the error was made? 13. What differences are there between the trial balance before closing and the trial balance after closing with respect to the following accounts? (d) Retained Earnings (a) Accounts Payable (e) Cash (b) Expense accounts (c) Revenue accounts C H A P T E R 3 The accounting information system 103 14. What are adjusting entries and why are they necessary? 15. What are closing entries and why are they necessary? 16. Paul Molitor, maintenance supervisor for Blue Jay Insurance Co., has purchased a rideon lawnmower and accessories to be used in maintaining the grounds around the head office. He has sent the following information to the accounting department: Cost of mower and accessories $3000 Date purchased 1 January 2007 Monthly salary of groundskeeper $1100 Estimated useful life 5 years Estimated annual fuel cost $150 Calculate the amount of depreciation expense (related to the mower and accessories) that should be reported on Blue Jay’s 30 June 2007 income statement. Assume straightline depreciation. 17. Selanne & Co. made the following entry on 30 June 2007: June 30 Interest Expense 10 000 Interest Payable 10 000 (To record interest expense due on loan from ANA Bank) What entry would ANA Bank make regarding its outstanding loan to Selanne & Co.? Explain why this must be the case. 18. ‘A worksheet is a permanent accounting record, and its use is required in the accounting cycle.’ Do you agree? Explain. *19. What are reversing entries, and why are they used? Brief exercises BE3.1 Transactions for Anhui & Co. for the month of May are presented below. Prepare journal entries for each of these transactions. (You may omit explanations.) May 1 BD Anhui invests $3000 cash in exchange for ordinary shares in a small welding company. May 13 Buys equipment on account for $1100. May 13 BE3.2 Pays $400 to landlord for May rent. May 21 Invoices Noble Ltd $500 for welding work done. Beijing Repair Shop had the following transactions during the first month of business. Record the following transactions in the general journal. Aug. 2 Invested $12 000 cash and $2500 of equipment in the business. Augu 7 Purchased supplies on account for $400. (Debit asset account.) Aug 12 Performed services for clients, for which $1300 was collected in cash and $670 was invoiced to clients. Aug 15 Paid August rent, $600. Aug 19 Counted supplies and determined that only $270 of the supplies purchased on 7 August are still on hand. BE3.3 BE3.4 Using the data in BE3.3, record the entry on 1 January and the adjusting entry on 30 June for Hebei Insurance Co. Hebei Insurance uses the accounts Unearned Insurance Revenue and Insurance Revenue. BE3.5 104 On 1 January 2007, Blair & Co. pays $18 000 to Hebei Insurance Co. for a 3-year insurance contract. Both entities have financial years ending on 30 June. For Blair & Co., record the journal entry on 1 January and the adjusting entry on 30 June. On 1 February, Guangxi Ltd paid $8400 in advance for 2 years insurance coverage. Prepare Guangxi’s 1 February journal entry and the annual adjusting entry on 30 June. Fundamentals of intermediate accounting BE3.6 Mongolia Ltd owns a warehouse. On 1 May, the company rented storage space to a lessee (tenant) for 3 months for a total cash payment of $2700 received in advance. Prepare Mongolia’s 1 May journal entry and the 30 June annual adjusting entry. BE3.7 Jiangsu Ltd’s weekly payroll, paid on Fridays, totals $6000. Employees work a 5-day week. Prepare Jiangsu’s adjusting entry on Wednesday 30 June, and the journal entry to record the $6000 cash payment on Friday 2 July. BE3.8 Included in Ningxia Ltd’s 30 June trial balance is a note receivable for $10 000. The note is a 4-month, 12% note dated 1 April. Prepare Ningxia’s 30 June adjusting entry to record $300 of accrued interest, and the 1 August journal entry to record receipt of $10 400 from the borrower. BE3.9 Prepare the following adjusting entries at 30 June for Jilin & Co. (a) Interest on notes payable of $400 is accrued. (b) Fees earned but not invoiced total $1400. (c) Salaries earned by employees of $700 have not been recorded. (d) Bad debt expense for the year is $900. Use the following account titles: Service Revenue, Accounts Receivable, Interest Expense, Interest Payable, Salaries Expense, Salaries Payable, Allowance for Doubtful Debts, and Bad Debt Expense. BE3.10 At the end of its first year of operations, the trial balance of Gansu Ltd shows Equipment $30 000 and zero balances in Accumulated Depreciation – Equipment and Depreciation Expense. Depreciation for the year is estimated to be $3000. Prepare the adjusting entry for depreciation at 30 June, and indicate the balance sheet presentation for the equipment at 30 June. BE3.11 Xinjiang Ltd has beginning inventory $81 000, Purchases $540 000, Freight Inwards $16 200, Purchase Returns $5800, Purchase Discounts $5000, and ending inventory $70 200. Calculate cost of sales. BE3.12 Liaoning Ltd has year-end account balances of Sales $828 900, Interest Revenue $13 500, Cost of Sales $556 200, Operating Expenses $189 000, Income Tax Expense $35 100, and Dividends $18 900. Prepare the year-end closing entries. *BE3.13 Zhejiang Ltd made a 30 June adjusting entry to debit Salaries Expense and credit Salaries Payable for $3600. On 2 July, Zhejiang Ltd paid the weekly payroll of $6000. Prepare the company’s (a) 1 July reversing entry; (b) 2 July entry (assuming the reversing entry was prepared); and (c) 2 July entry (assuming the reversing entry was not prepared). Exercises E3.1 (Transaction analysis — service company) Bev Crusher is a CPA. During the first month of operations of her business (a sole proprietorship), the following events and transactions occurred. April 2 April 12 April 3 April 7 April 11 April April April April 12 17 21 30 Invested $32 000 cash and equipment valued at $14 000 in the business. Hired a secretary-receptionist at a salary of $290 per week payable monthly. Purchased supplies on account $700 (debit an asset account). Paid office rent of $600 for the month. Completed a tax assignment and invoiced client $1100 for services rendered. (Use Service Revenue account.) Received $3200 advance on a management consulting engagement. Received cash of $2300 for services completed for Ferengi Ltd. Paid insurance expense $110. Paid secretary-receptionist $1160 for the month. C H A P T E R 3 The accounting information system 105 April 30 A count of supplies indicated that $120 of supplies had been used. April 30 Purchased a new computer for $6100 with personal funds. (The computer will be used exclusively for business purposes.) Required Record the transactions in the general journal. (Omit explanations.) E3.2 (Corrected trial balance) The trial balance of Landowska & Co. shown below does not balance. Your review of the ledger reveals the following: (a) each account had a normal balance; (b) the debit footings in Prepaid Insurance, Accounts Payable and Property Tax Expense were each understated by $100; (c) a transposition error was made in Accounts Receivable and Service Revenue — the correct balances are $2750 and $6690, respectively; (d) a debit posting to Advertising Expense of $300 was omitted; and (e) a $1500 cash drawing by the owner was debited to Landowska, Capital, and credited to Cash. LANDOWSKA & CO. Trial Balance as at 30 June 2007 Cash Accounts Receivable Prepaid Insurance Equipment Accounts Payable Rates Payable Wanda Landowska, Capital Service Revenue Salaries Expense Advertising Expense Rates Expense Debit $ 4 800 2 570 700 Credit $ 8 000 4 500 560 11 200 6 960 4 200 1 100 $20 890 800 $24 500 Required Prepare a correct trial balance. E3.3 (Corrected trial balance) The trial balance of Blues Traveller Pty Ltd does not balance. BLUES TRAVELLER PTY LTD Trial Balance as at 30 June 2007 Cash Accounts Receivable Supplies on Hand Furniture and Equipment Accounts Payable Share Capital Retained Earnings Service Revenue Office Expense Debit $ 5 912 5 240 2 967 6 100 Credit $ 7 044 8 000 2 000 5 200 4 320 $24 539 $22 244 An examination of the ledger shows the following errors: 1. Cash received from a customer on account was recorded (both debit and credit) as $1380 instead of $1830. 2. The purchase on account of a computer costing $3200 was recorded as a debit to Office Expense and a credit to Accounts Payable. 106 Fundamentals of intermediate accounting 3. Services were performed on account for a client, $2250, for which Accounts Receivable was debited $2250 and Service Revenue was credited $225. 4. A payment of $95 for telephone charges was entered as a debit to Office Expenses and a debit to Cash. 5. The Service Revenue account was totalled at $5200 instead of $5280. Required From this information, prepare a corrected trial balance. E3.4 (Corrected trial balance) The trial balance of Watteau & Co. shown below does not balance. WATTEAU & CO. Trial Balance as at 30 June 2007 Debit Cash Accounts Receivable Supplies Equipment Accounts Payable Unearned Service Revenue Share Capital Retained Earnings Service Revenue Wages Expense Office Expense Credit $ 2 870 $ 3 231 800 3 800 2 666 1 200 6 000 3 000 2 380 3 400 940 $ 13 371 $ 16 916 Each of the listed accounts has a normal balance per the general ledger. An examination of the ledger and journal reveals the following errors: 1. Cash received from a customer on account was debited for $570, and Accounts Receivable was credited for the same amount. The actual collection was for $750. 2. The purchase of a computer printer on account for $500 was recorded as a debit to Supplies for $500 and a credit to Accounts Payable for $500. 3. Services were performed on account for a client for $890. Accounts Receivable was debited for $890 and Service Revenue was credited for $89. 4. A payment of $65 for telephone charges was recorded as a debit to Office Expense for $65 and a debit to Cash for $65. 5. When the Unearned Service Revenue account was reviewed, it was found that $325 of the balance was earned 30 June. 6. A debit posting to Wages Expense of $670 was omitted. 7. A payment on account for $206 was credited to Cash for $206 and credited to Accounts Payable for $260. 8. A dividend of $575 was debited to Wages Expense for $575 and credited to Cash for $575. Required Prepare a correct trial balance. (Note: It may be necessary to add one or more accounts to the trial balance.) E3.5 (Adjusting entries) The ledger of Duggan Rental Agency on 31 March of the current year includes the selected accounts (shown on page 108) before adjusting entries have been prepared. An analysis of the accounts shows the following. 1. The equipment depreciates $250 per month. 2. One-third of the unearned rent was earned during the quarter. 3. Interest of $500 is accrued on the notes payable. C H A P T E R 3 The accounting information system 107 4. Supplies on hand total $850. 5. Insurance expires at the rate of $300 per month. Debit Prepaid Insurance $ 3 600 Supplies 2 800 Equipment 25 000 Accumulated Depreciation – Equipment Notes Payable Unearned Rent Revenue Rent Revenue Interest Expense — Wage Expense 14 000 Credit $ 8 400 20 000 9 300 60 000 Required Prepare the adjusting entries at 31 March, assuming that adjusting entries are made quarterly. Additional accounts are: Depreciation Expense, Insurance Expense, Interest Payable, and Supplies Expense. E3.6 (Adjusting entries) Karen Weller opened a dental practice on 1 January 2007. During the first month of operations the following transactions occurred: 1. Performed services for patients who had dental extras on their health insurance. At 31 January, $750 of such services was earned but not yet invoiced to the health insurance companies. 2. Electricity expenses incurred but not paid before 31 January totalled $520. 3. Purchased dental equipment on 1 January for $80 000, paying $20 000 in cash and signing a $60 000, 3-year note payable. The equipment depreciates $400 per month. Interest is $500 per month. 4. Purchased a 1-year malpractice insurance policy on 1 January for $12 000. 5. Purchased $1600 of dental supplies. On 31 January, determined that $500 of supplies were on hand. Required Prepare the adjusting entries on 31 January. Account titles are: Accumulated Depreciation – Dental Equipment, Depreciation Expense, Service Revenue, Accounts Receivable, Insurance Expense, Interest Expense, Interest Payable, Prepaid Insurance, Supplies, Supplies Expense, Electricity Expense, and Electricity Payable. E3.7 (Analyse adjusted data) A partial adjusted trial balance of Piper Pty Ltd at 31 January 2007 shows the following: PIPER PTY LTD Adjusted Trial Balance as at 31 January 2007 Supplies Prepaid Insurance Salaries Payable Unearned Revenue Supplies Expense Insurance Expense Salaries Expense Service Revenue Debit $ 700 2 400 Credit $ 800 750 950 400 1 800 2 000 Required Answer the following questions, assuming the year begins on 1 January: (a) If the amount in Supplies Expense is the 31 January adjusting entry, and $850 of supplies was purchased in January, what was the balance in Supplies on 1 January? 108 Fundamentals of intermediate accounting (b) If the amount in Insurance Expense is the 31 January adjusting entry, and the original insurance premium was for 1 year, what was the total premium and when was the policy purchased? (c) If $2500 of salaries was paid in January, what was the balance in Salaries Payable at 31 December 2006? (d) If $1600 was received in January for services performed in January, what was the balance in Unearned Revenue at 31 December 2006? E3.8 (Adjusting entries) Dylan James is the new owner of Ace Computer Services. At the end of August, his first month of ownership, Dylan is trying to prepare monthly financial statements. Below is some information related to unrecorded expenses that the business incurred during August. 1. At 31 August, Dylan owed his employees $1900 in wages that will be paid on 1 September. 2. At the end of the month he had not yet received the month’s power bill. Based on past experience, he estimated the bill would be approximately $600. 3. On 1 August, Dylan borrowed $30 000 from a local bank on a 15-year mortgage. The annual interest rate is 8%. 4. A telephone bill in the amount of $117 covering August charges is unpaid at 31 August. Required Prepare the adjusting journal entries as at 31 August suggested by the information above. E3.9 (Adjusting entries) Selected accounts of Urdu Ltd are shown below. Supplies Beg. Bal. 800 31/10 Accounts Receivable 470 17/10 31/10 Salaries Expense 15/10 31/10 Salaries Payable 800 600 31/10 Unearned Service Revenue 31/10 2 400 1 650 400 20/10 600 Supplies Expense 650 31/10 470 Service Revenue 17/10 31/10 31/10 2 400 1 650 400 Required From an analysis of the T-accounts, reconstruct (a) the October transaction entries, and (b) the adjusting journal entries that were made on 31 October 2007. E3.10 (Adjusting entries) Greco Resort opened for business on 1 June 2007 with eight airconditioned units. Its trial balance on 31 August is shown on page 110. Other data 1. The balance in Prepaid Insurance is a 1-year premium paid on 1 June 2007. 2. An inventory count on 31 August shows $450 of supplies on hand. 3. Annual depreciation rates are cottages (4%) and furniture (10%). Residual value is estimated to be 10% of cost. 4. Unearned Rent Revenue of $3800 was earned before 31 August. 5. Salaries of $375 were unpaid at 31 August. 6. Rentals of $800 were due from tenants at 31 August. 7. The mortgage interest rate is 8% per year. C H A P T E R 3 The accounting information system 109 GRECO RESORT Trial Balance as at 31 August 2007 Debit $ 19 600 4 500 2 600 20 000 120 000 16 000 Cash Prepaid Insurance Supplies Land Cottages Furniture Accounts Payable Unearned Rent Revenue Mortgage Payable Share Capital Retained Earnings Dividends Rent Revenue Salaries Expense Electricity Expense Repair Expense Credit $ 4 500 4 600 60 000 91 000 9 000 5 000 76 200 44 800 9 200 3 600 $ 245 300 $ 245 300 Required (a) Record the adjusting entries on 31 August for the 3-month period from 1 June to 31 August. (b) Prepare an adjusted trial balance as at 31 August. E3.11 (Closing entries) The adjusted trial balance of Lopez Ltd shows the following data pertaining to sales at the end of its financial year, 31 October 2007: Sales $800 000, Freight Outward $12 000, Sales Returns and Allowances $24 000, and Sales Discounts $15 000. Required (a) Prepare the sales revenue section of the income statement. (b) Prepare separate closing entries for (i) sales, and (ii) the contra accounts to sales. E3.12 (Closing entries) Presented below is information related to Gary Ltd for the month of January 2007. Cost of sales Freight outwards Insurance expense Rent expense $208 000 7 000 12 000 20 000 Salary expense Sales discounts Sales returns and allowances Sales $ 61 000 8 000 13 000 350 000 Required Prepare the necessary closing entries. E3.13 (Worksheet) Presented below are selected accounts for Alvin Ltd as reported in the worksheet at the end of May 2007. Adjusted trial balance Account titles Cash Merchandise Inventory Sales Sales Returns and Allowances Sales Discounts Cost of Sales 110 Fundamentals of intermediate accounting Dr Cr 9 000 80 000 450 000 10 000 5 000 250 000 Income statement Dr Cr Balance sheet Dr Cr Required Complete the worksheet by extending amounts reported in the adjusted trial balance to the appropriate columns in the worksheet. Do not total individual columns. E3.14 (Missing amounts) Presented below is financial information for two different companies. Alatorre Ltd Eduardo Ltd $90 000 (a) 80 000 56 000 (b) 15 000 (c) (d) $ 5 000 95 000 (e) 38 000 23 000 15 000 Sales Sales returns Net sales Cost of sales Gross profit Operating expenses Profit Required Calculate the missing amounts. E3.15 (Find missing amounts — periodic inventory) Financial information is presented below for four different entities. Pamela’s Cosmetics Sales Sales returns Net sales Beginning inventory Purchases Purchase returns Ending inventory Cost of sales Gross profit Dean’s Grocery Anderson Wholesalers Baywatch Supply Co. $78 000 (a) 74 000 16 000 88 000 6 000 (b) 64 000 10 000 (c) $ 5 000 94 000 (d) 100 000 10 000 48 000 72 000 22 000 $144 000 12 000 132 000 44 000 (e) 8 000 30 000 (f) 18 000 $100 000 9 000 (g) 24 000 85 000 (h) 28 000 72 000 (i) Required Determine the missing amounts (a) to (i). Show all calculations. E3.16 (Cost of sales section — periodic inventory) The trial balance of Mariner Ltd at the end of its financial year, 31 August 2007, includes the following accounts: Merchandise Inventory $17 500, Purchases $149 400, Sales $200 000, Freight Inwards $4000, Sales Returns and Allowances $4000, Freight Outwards $1000, and Purchase Returns and Allowances $2000. The ending merchandise inventory is $25 000. Required Prepare a cost of sales section for the year ending 31 August. E3.17 (Closing entries for a company) Presented below are selected account balances for Winslow Ltd as at 30 June 2007. Merchandise Inventory 30/6/07 Share Capital Retained Earnings Dividends Sales Returns and Allowances Sales Discounts Sales $ 60 000 75 000 45 000 18 000 12 000 15 000 410 000 Cost of Sales Selling Expenses Administrative Expenses Income Tax Expense $225 700 16 000 38 000 30 000 Required Prepare closing entries for Winslow Ltd as at 30 June 2007. C H A P T E R 3 The accounting information system 111 E3.18 (Worksheet preparation) The trial balance of Stein Roofing at 31 March 2007 is as follows. STEIN ROOFING Trial Balance as at 31 March 2007 Debit $ 2 300 2 600 1 100 6 000 Cash Accounts Receivable Roofing Supplies Equipment Accumulated Depreciation – Equipment Accounts Payable Unearned Service Revenue Share Capital Retained Earnings Service Revenue Salaries Expense Miscellaneous Expense Credit $ 1 200 1 100 300 6 400 600 3 000 500 100 $12 600 $12 600 Other data 1. A physical count reveals only $520 of roofing supplies on hand. 2. Equipment is depreciated at a rate of $120 per month. 3. Unearned service revenue amounted to $100 on 31 March. 4. Accrued salaries are $850. Required Enter the trial balance on a worksheet and complete the worksheet, assuming that the adjustments relate only to the month of March. (Ignore income tax.) E3.19 (Worksheet and balance sheet presentation) The adjusted trial balance of Bradley Pty Ltd worksheet for the month ended 30 April 2007 is shown below. BRADLEY PTY LTD Worksheet (Partial) for the month ended 30 April 2007 Adjusted trial balance Account titles Cash Accounts Receivable Prepaid Rent Equipment Accumulated Depreciation Notes Payable Accounts Payable Bradley, Capital Bradley, Drawings Service Revenue Salaries Expense Rent Expense Depreciation Expense Interest Expense Interest Payable Dr $ 19 472 6 920 2 280 18 050 5 000 Cr Income statement Dr Cr Balance sheet Dr Cr $ 4 895 5 700 5 472 34 960 6 500 11 590 6 840 2 260 145 83 83 Required Complete the worksheet, and prepare a balance sheet as illustrated in this chapter. 112 Fundamentals of intermediate accounting E3.20 (Partial worksheet preparation) Junee Park Ltd prepares monthly financial statements from a worksheet. Selected parts of the January worksheet showed the following data. JUNEE PARK LTD Worksheet (Partial) for month ended 31 January 2007 Trial balance Account titles Dr Supplies Accumulated Depreciation Interest Payable Supplies Expense Depreciation Expense Interest Expense Cr Adjustments 3 256 Dr Cr (a) 1 500 (b) 257 (c) 50 6 682 100 (a) 1 500 (b) 257 (c) 50 Adjusted trial balance Dr Cr 1 756 6 939 150 1 500 257 50 During February, no events occurred that affected these accounts, but at the end of February the following information was available. (a) (b) (c) Supplies on hand $715 Monthly depreciation $257 Accrued interest $50 Required Reproduce the data that would appear in the February worksheet, and indicate the amounts that would be shown in the February income statement. E3.21 (Transactions of a business, including investment and dividend) Scratch Miniature Golf and Driving Range Pty Ltd was opened by Laura Scratch on 1 March. The following selected events and transactions occurred during March. Mar. 1 Mar. 3 Mar. 5 Nov Mar. Mar. Mar. Mar. Mar. Mar. Mar. 6 10 18 25 30 30 31 Invested $50 000 cash in the business in exchange for ordinary shares. Purchased Janzen’s Golf Land for $38 000 cash. The price consists of land $10 000, building $22 000, and equipment $6000. (Make one compound entry.) Advertised the opening of the driving range and miniature golf course, paying advertising expenses of $1600. Paid cash $1480 for a 1-year insurance policy. Purchased golf equipment for $2500 from Sluman Ltd payable in 30 days. Received golf fees of $1200 cash. Declared and paid a $500 cash dividend. Paid wages of $900. Paid Sluman Ltd in full. Received $750 of fees in cash. Laura uses the following accounts: Cash, Prepaid Insurance, Land, Buildings, Equipment, Accounts Payable, Share Capital, Dividends, Service Revenue, Advertising Expense, and Wages Expense. Required Record the journal entires for the March transactions. *E3.22 (Closing and reversing entries) On 30 June, the adjusted trial balance of Dee Ltd shows the following selected data. Accounts Receivable Interest Expense Service Revenue Interest Payable $ 4 300 7 800 96 000 2 400 Analysis shows that adjusting entries were made for (1) $4300 of services performed but not invoiced, and (2) $2400 of accrued but unpaid interest. C H A P T E R 3 The accounting information system 113 Required (a) Prepare the closing entries for the temporary accounts at 30 June. (b) Prepare the reversing entries on 1 July. (c) Enter the adjusted trial balance data in the four accounts. Post the entries in (a) and (b) and balance the accounts. (Use T-accounts.) (d) Prepare the entries to record (i) the collection of the accrued commissions on 10 July, and (2) the payment of all interest due ($3000) on 15 July. (e) Post the entries in (d) to the temporary accounts. *E3.23 (Adjusting and reversing entries) When the accounts of Barenboim Ltd are examined, the adjusting data listed below are uncovered on 30 June, the end of the financial year. 1. The prepaid insurance account shows a debit of $5280, representing the cost of a 2-year fire insurance policy dated 1 February of the current year. 2. On 1 May, Rental Revenue was credited for $1800, representing revenue from a subrental for a 3-month period beginning on that date. 3. Purchase of advertising materials for $800 during the year was recorded in Advertising Expense. On 30 June, advertising materials of $290 are on hand. 4. Interest of $770 has accrued on notes payable. Required Prepare in general journal form: (a) the adjusting entry for each item; (b) the reversing entry for each item where appropriate. Problems P3.1 (Transactions, financial statements — service entity) Listed below are the transactions of Isao Aoki, dentist, for the month of September. Sept. 1 Sept. 2 Sept. Sept. Sept. Sept. Sept. Sept. Sept. Sept. Sept. Sept. Sept. 4 4 5 8 10 14 18 19 20 25 30 Sept. 30 Isao Aoki begins practice as a dentist and invests $20 000 cash. Purchases furniture and dental equipment on account from Green Jacket & Co. for $17 280. Rent rent for office space, $680 for the month. Employs a receptionist, Michael Bradley. Purchases dental supplies for cash, $942. Receives cash of $1690 from patients for services performed. Pays miscellaneous office expenses, $430. Invoices patients $5120 for services performed Pays Green Jacket & Co. on account, $3600. Withdraws $3000 cash from the business for personal use. Receives $980 from patients on account. Invoices patients $2110 for services performed. Pays the following expenses in cash: office salaries, $1400; miscellaneous office expenses, $85. Dental supplies used during September, $330. Required (a) Enter the transactions shown above in appropriate general ledger accounts. Use the following ledger accounts: Cash; Accounts Receivable; Supplies on Hand; Furniture and Equipment; Accumulated Depreciation; Accounts Payable; Isao Aoki, Capital; Service Revenue; Rent Expense; Miscellaneous Office Expense; Office Salaries Expense; Supplies Expense; Depreciation Expense; and Income Summary. Allow ten lines for the Cash and Income Summary accounts, and five lines for each of the other accounts. Record depreciation using a 5-year life on the furniture and equipment, the straightline method, and no residual value. Do not use a drawings account. (b) Prepare a trial balance. (c) Prepare an income statement, a balance sheet, and a statement of changes in equity. (d) Close the ledger. (e) Prepare a post-closing trial balance. 114 Fundamentals of intermediate accounting P3.2 (Adjusting entries and financial statements) Grant Advertising Agency Ltd started business in January 2002. Presented below are both the adjusted and unadjusted trial balances as at 31 December 2006. GRANT ADVERTISING AGENCY LTD Trial Balance as at 31 December 2006 Unadjusted Cash Accounts Receivable Art Supplies Prepaid Insurance Printing Equipment Accumulated Depreciation Accounts Payable Interest Payable Notes Payable Unearned Advertising Revenue Salaries Payable Share Capital Retained Earnings Advertising Revenue Salaries Expense Insurance Expense Interest Expense Depreciation Expense Art Supplies Expense Rent Expense Dr $ 11 000 20 000 8 400 3 350 60 000 Adjusted Cr Dr $ 11 000 21 500 5 000 2 500 60 000 $ 28 000 5 000 — 5 000 7 000 — 10 000 3 500 58 600 10 000 350 4 000 $ 117 100 $ 117 100 Cr $ 35 000 5 000 150 5 000 5 600 1 300 10 000 3 500 61 500 11 300 850 500 7 000 3 400 4 000 $ 127 050 $ 127 050 Required (a) Journalise the annual adjusting entries that were made. (b) Prepare an income statement for the year ending 31 December 2006, and a balance sheet as at 31 December. (c) Answer the following questions. (i) If the note has been outstanding 3 months, what is the annual interest rate on that note? (ii) If the company paid $13 500 in salaries in 2006, what was the balance in Salaries Payable on 31 December 2005? P3.3 (Adjusting entries) A review of the ledger of Ningxia Ltd at 31 December 2008 produces the following data pertaining to the preparation of annual adjusting entries. 1. Salaries Payable $0. There are eight salaried employees. Salaries are paid every Friday for the current week. Five employees receive a salary of $700 each per week, and three employees earn $500 each per week. 31 December is a Tuesday. Employees do not work weekends. All employees worked the last 2 days of December. 2. Unearned Rent Revenue $369 000. The company began subleasing office space in its new building on 1 November. Each tenant is required to pay a $5000 security deposit that is not refundable until occupancy is terminated. At 31 December, the company had the following rental contracts that are paid in full for the entire term of the lease. Date Term (in months) Monthly rent Number of leases Nov. 1 6 $4000 5 Dec. 1 6 $8500 4 C H A P T E R 3 The accounting information system 115 3. Prepaid Advertising $13 200. This balance consists of payments on two advertising contracts. The contracts provide for monthly advertising in two trade magazines. The terms of the contracts are as follows. Date Amount A650 Contract May 1 $6000 Number of magazine issues 12 B974 Oct. 1 $7200 24 The first advertisement runs in the month in which the contract is signed. 4. Notes Payable $80 000. This balance consists of a note for 1 year at an annual interest rate of 12%, dated 1 June. Required Prepare the adjusting entries at 31 December 2008. (Show all calculations). P3.4 (Financial statements and closing entries) The completed financial statement columns of the worksheet for Parsons Ltd are shown below. PARSONS LTD Worksheet for the year ended 30 June 2008 Account No. Account titles 101 112 130 157 167 201 212 301 306 400 622 711 722 726 732 Cash Accounts Receivable Prepaid Insurance Equipment Accum. Depreciation Accounts Payable Salaries Payable Share Capital Retained Earnings Service Revenue Repair Expense Depreciation Expense Insurance Expense Salaries Expense Electricity Expense Totals Loss Income statement Dr Cr Balance sheet Dr Cr 8 200 7 500 1 800 28 000 8 600 12 000 3 000 20 000 6 800 42 000 3 200 2 800 1 200 36 000 3 700 46 900 46 900 42 000 4 900 46 900 45 500 4 900 50 400 50 400 50 400 Required (a) Prepare an income statement and a classified balance sheet. (b) Prepare the closing entries. (c) Post the closing entries and balance the accounts. Use T-accounts. Income Summary is account no. 350. (d) Prepare a post-closing trial balance. P3.5 (Worksheet, balance sheet, adjusting and closing entries) Noah’s Ark has a financial year ending on 30 September. Selected data from the 30 September worksheet are presented on the next page. Required (a) Prepare a complete worksheet. (b) Prepare a classified balance sheet. (Note: $10 000 of the mortgage payable is due for payment in the next financial year.) (c) Prepare the adjusting entries using the worksheet as a basis. (d) Prepare the closing entries using the worksheet as a basis. (e) Prepare a post-closing trial balance. 116 Fundamentals of intermediate accounting NOAH’S ARK Worksheet for the year ended 30 September 2007 Trial balance Cash Supplies Prepaid Insurance Land Equipment Accumulated Depreciation Accounts Payable Unearned Admissions Revenue Mortgage Payable N Berge, Capital N Berge, Drawings Admissions Revenue Salaries Expense Repair Expense Advertising Expense Electricity Expense Rates Expense Interest Expense Totals Insurance Expense Supplies Expense Interest Payable Depreciation Expense Rates Payable Totals P3.6 Dr 37 400 18 600 31 900 80 000 120 000 Cr Adjusted trial balance Dr 37 400 1 200 3 900 80 000 120 000 36 200 14 600 2 700 50 000 109 700 14 000 43 000 14 600 1 700 50 000 109 700 14 000 278 500 109 000 30 500 9 400 16 900 18 000 6 000 491 700 Cr 279 500 109 000 30 500 9 400 16 900 21 000 12 000 491 700 28 000 17 400 6 000 6 800 507 500 3 000 507 500 (Financial statements, adjusting and closing entries) The trial balance of Becky’s Fashion Centre Pty Ltd contained the following accounts at 30 June 2007. BECKY’S FASHION CENTRE PTY LTD Trial Balance as at 30 June 2007 Cash Accounts Receivable Merchandise Inventory Store Supplies Store Equipment Accumulated Depreciation – Store Equipment Delivery Equipment Accumulated Depreciation – Delivery Equipment Notes Payable Accounts Payable Share Capital Retained Earnings Sales Sales Returns and Allowances Cost of Sales Salaries Expense Advertising Expense Electricity Expense Repair Expense Delivery Expense Rent Expense Debit $ 26 700 33 700 45 000 5 500 85 000 Credit $ 18 000 48 000 6 000 51 000 48 500 90 000 8 000 757 200 4 200 497 400 140 000 26 400 14 000 12 100 16 700 24 000 $ 978 700 $ 978 700 C H A P T E R 3 The accounting information system 117 Adjustment data 1. Store supplies on hand totalled $3500. 2. Depreciation is $9000 on the store equipment and $7000 on the delivery equipment. 3. Interest of $11 000 is accrued on notes payable at 30 June. Other data 1. Salaries expense is 70% selling and 30% administrative. 2. Rent expense and electricity expense are 80% selling and 20% administrative. 3. $30 000 of notes payable are due for payment next year. 4. Repair expense is 100% administrative. Required (a) Enter the trial balance on a worksheet and complete the worksheet. (b) Prepare an income statement for the year and a classified balance sheet as at 30 June 2007. (c) Record the adjusting journal entries. (d) Record the closing journal entries. (e) Prepare a post-closing trial balance. P3.7 (Financial statements, adjusting and closing entries) Asian Star Department Store Ltd is located near the shopping mall. At the end of the company’s financial year on 30 June 2007, the following accounts appeared in two of its trial balances. Unadjusted Accounts Payable Accounts Receivable Accumulated Depreciation – Building Accumulated Depreciation – Equipment Building Cash Share Capital Retained Earnings Cost of Sales Depreciation Expense – Building Depreciation Expense – Equipment Dividends Equipment Insurance Expense Interest Expense Interest Payable Interest Revenue Merchandise Inventory Mortgage Payable Office Salaries Expense Prepaid Insurance Rates Expense Rates Payable Sales Salaries Expense Sales Sales Commissions Expense Sales Commissions Payable Sales Returns and Allowances Electricity Expense Adjusted $ 79 300 50 300 42 100 29 600 190 000 23 000 160 000 16 600 412 700 $ 79 300 50 300 52 500 42 900 190 000 23 000 160 000 16 600 412 700 10 400 13 300 28 000 110 000 7 200 11 000 8 000 4 000 75 000 80 000 32 000 2 400 4 800 4 800 76 000 628 000 14 500 3 500 8 000 11 000 28 000 110 000 3 000 4 000 75 000 80 000 32 000 9 600 76 000 628 000 11 000 8 000 11 000 Analysis reveals the following additional data: 1. Insurance expense and electricity expense are 60% selling and 40% administrative. 2. $20 000 of the mortgage payable is due for payment next year. 3. Depreciation on the building and rates expense are administrative expenses; depreciation on the equipment is a selling expense. 118 Fundamentals of intermediate accounting Required (a) Prepare an income statement and a classified balance sheet. (b) Prepare the adjusting journal entries that were made. (c) Prepare the closing journal entries that were necessary. P3.8 (Adjusting entries) The accounts listed below appeared in the 30 June trial balance for the Alexander Theatre. Debit Equipment Accumulated Depreciation – Equipment Notes Payable Admissions Revenue Advertising Expense Salaries Expense Interest Expense Credit $ 192 000 $ 60 000 90 000 380 000 13 680 57 600 1 400 Required (a) From the account balances listed above and the information given below, prepare the annual adjusting entries necessary on 30 June. (i) The equipment has an estimated life of 16 years and a residual value of $40 000 at the end of that time. (Use the straight-line depreciation method.) (ii) The note payable is a 90-day note given to the bank on 20 April and bearing interest at 10%. (Use 360 days for the denominator.) (iii) In June, 2000 coupon admission books were sold at $25 each. They could be used for admission any time after 1 July. (iv) Advertising expense paid in advance and included in Advertising Expense, $1100. (v) Salaries accrued but unpaid, $4700. (b) What amounts should be shown for each of the following on the income statement for the year? (i) Interest expense (ii) Admissions revenue (iii) Advertising expense (iv) Salaries expense P3.9 (Adjusting entries and financial statements) Presented below is the trial balance of Angela Tran, a consulting engineer. ANGELA TRAN, CONSULTING ENGINEER Trial Balance as at 30 June 2007 Cash Accounts Receivable Allowance for Doubtful Debts Engineering Supplies Inventory Unexpired Insurance Furniture and Equipment Accumulated Depreciation – Furniture and Equipment Notes Payable Angela Tran, Capital Service Revenue Rent Expense Office Salaries Expense Heat, Light and Water Expense Miscellaneous Office Expense Debit $ 31 500 49 600 Credit $ 750 1 960 1 100 25 000 6 250 7 200 35 010 100 000 9 750 28 500 1 080 720 $ 149 210 $ 149 210 C H A P T E R 3 The accounting information system 119 Other information 1. Fees received in advance from clients, $6900. 2. Services performed for clients that were not recorded by 30 June, $4900. 3. Bad debt expense for the year is $1430. 4. Insurance expired during the year, $480. 5. Furniture and equipment are being depreciated at 12% per year. 6. Angela Tran gave the bank a 90-day, 10% note for $7200 on 1 June 2007. 7. Rent of the building is $750 per month. The rent for 2006–07 has been paid, as has that for July 2007. 8. Office salaries earned but unpaid at 30 June 2007, $2510. Required (a) From the trial balance and other information given, prepare annual adjusting entries as at 30 June 2007. (b) Prepare an income statement for 2006–07, a balance sheet, and a statement of changes in equity. Angela Tran withdrew $17 000 cash for personal use during the year. P3.10 (Adjusting entries and financial statements) Alicia Advertising Ltd was founded in July 2003. Presented below are both the adjusted and unadjusted trial balances as at 30 June 2007. ALICIA ADVERTISING LTD Trial Balance as at 30 June 2007 Unadjusted Cash Accounts Receivable Art Supplies Prepaid Insurance Printing Equipment Accumulated Depreciation Accounts Payable Interest Payable Notes Payable Unearned Service Revenue Salaries Payable Share Capital Retained Earnings Service Revenue Salaries Expense Insurance Expense Interest Expense Depreciation Expense Art Supplies Expense Rent Expense Dr $ 7 000 19 000 8 500 3 250 60 000 Adjusted Cr Dr $ 7 000 22 000 5 500 2 500 60 000 $ 27 000 5 000 $ 33 750 5 000 150 5 000 5 600 1 500 10 000 4 500 63 000 5 000 7 000 10 000 4 500 58 600 10 000 350 5 000 4 000 $ 117 100 $ 117 100 Cr 11 500 750 500 6 750 8 000 4 000 $ 128 500 $ 128 500 Required (a) Record the annual adjusting journal entries that were made. (b) Include an additional journal entry to record that dividends of $2200 have been declared but not yet paid. (c) Prepare an income statement and a statement of changes in equity for the year ended 30 June 2007, and a balance sheet as at 30 June. (d) Answer the following questions: (i) If the useful life of equipment is 8 years, what is the expected residual value? 120 Fundamentals of intermediate accounting (ii) If the note has been outstanding 3 months, what is the annual interest rate on that note? (iii) If the company paid $12 500 in salaries in 2006–07, what was the balance in Salaries Payable on 30 June 2006? P3.11 (Adjusting entries) Presented below is information related to Jane Anderson, Real Estate Agent, at the close of the financial year ending 30 June. 1. Jane had paid the local newspaper $335 for an advertisement to be run in July of the next financial year, charging it to Advertising Expense. 2. On 1 May, Jane borrowed $9000 from York Bank issuing a 90-day, 10% note. 3. Salaries and wages due and unpaid on 30 June: sales, $1420; office clerks, $1060. 4. Interest accrued to date on Grant May’s note, which Jane holds, $500. 5. Estimated loss on bad debts, $1210 for the period. 6. Stamps and stationery on hand, $110, charged to Stationery and Postage Expense account when purchased. 7. Jane has not yet paid the June rent on the building her business occupies, $1000. 8. Insurance paid in May for 1 year, $930, charged to Prepaid Insurance when paid. 9. Rates accrued, $1670. 10. On 1 June, Jane gave Laura Palmer her (Jane’s) 60-day, 12% note for $6000 on account. 11. On 30 April, Jane received $2580 from Dougal Raines in payment of 6 months rent for office space occupied by him in the building, and credited Unearned Rent Revenue. 12. On 1 March she paid 6 months rent in advance on a warehouse, $6600, and debited the asset account Prepaid Rent Expense. 13. The bill from Twin Peaks Light & Power Ltd for June has been received but not yet entered or paid, $510. 14. Estimated depreciation on furniture and equipment, $1400. Required Prepare annual adjusting entries as at 30 June. P3.12 (Adjusting and closing) Following is the trial balance of the Platteville Golf Club Ltd as at 30 June. The books are closed annually on 30 June. PLATTEVILLE GOLF CLUB LTD Trial Balance as at 30 June Cash Accounts Receivable Allowance for Doubtful Debts Land Buildings Accumulated Depreciation of Buildings Equipment Accumulated Depreciation of Equipment Unexpired Insurance Share Capital Retained Earnings Fees Revenue Green Fees Revenue Rental Revenue Electricity Expense Salaries Expense Maintenance Expense Debit $ 15 000 13 000 Credit $ 1 100 350 000 120 000 38 400 150 000 70 000 9 000 400 000 82 000 200 000 8 100 15 400 54 000 80 000 24 000 $ 815 000 $ 815 000 C H A P T E R 3 The accounting information system 121 Required (a) Enter the balances in ledger accounts. Allow five lines for each account. (b) From the trial balance and the information given, prepare annual adjusting entries and post to the ledger accounts. (i) The buildings have an estimated life of 25 years with no residual value (straight-line method). (ii) The equipment is depreciated at 10% per year. (iii) Insurance expired during the year, $3500. (iv) The rental revenue represents the amount received for 11 months for dining facilities. The June rent has not yet been received. (v) It is estimated that 15% of the accounts receivable will be uncollectable. (vi) Salaries earned but not paid by 30 June, $3600. (vii) Fees paid in advance by members, $8900. (c) Prepare an adjusted trial balance. (d) Prepare closing entries and post. P3.13 (Adjusting and closing) Presented below is the 30 June trial balance of Nancy’s Boutique Ltd. NANCY’S BOUTIQUE LTD Trial Balance as at 30 June Cash Accounts Receivable Allowance for Doubtful Debts Inventory, 30 June Furniture and Equipment Accum. Dep. of Furniture and Equipment Prepaid Insurance Notes Payable Share Capital Retained Earnings Sales Cost of Sales Sales Salaries Expense Advertising Expense Advertising Salaries Expense Office Expense Debit $ 18 500 42 000 Credit $ 700 80 000 84 000 35 000 5 100 28 000 80 600 10 000 600 000 398 000 50 000 6 700 65 000 5 000 $ 754 300 $ 754 300 Required (a) Construct T-accounts and enter the balances shown. (b) Prepare adjusting journal entries for the following and post to the T-accounts. Open additional T-accounts as necessary. (The books are closed yearly on 30 June.) (i) Bad debts are estimated to be $1400. (ii) Furniture and equipment are depreciated based on a 6-year life (no residual value). (iii) Insurance expired during the year, $2550. (iv) Interest accrued on notes payable, $3360. (v) Sales salaries earned but not paid, $2400. (vi) Advertising paid in advance, $700. (vii) Office supplies on hand, $1500, charged to Office Expense when purchased. (c) Prepare closing entries and post to the accounts. 122 Fundamentals of intermediate accounting Conceptual case C3.1 (Accounting information system) The following quote is from Paul Barry, Rich Kids (Bantam Books, Sydney, 2002, p. 185): One.Tel was increasingly in chaos. In just five years, it had grown from nothing to a business that spanned seven countries, employed 3000 staff and had annual sales close to $1 billion. And neither its managers nor its systems had been able to keep pace with this incredible growth. According to one senior accountant, ‘It was the perfect example of how not to manage a company. It was run like a family business or a fish and chip shop. It had 3000 employees, but it was still like a company with ten.’ Or as another put it, ‘The place was a joke. There were no structures, no accounting systems, no processes, and no controls.’1 Required For each of the following questions write a paragraph answer: (a) Why does a rapidly growing company need an effective accounting system? (b) Why would a company with 3000 employees need a more sophisticated information system than a company with 10 employees? Using your judgement Financial reporting problem Refer to Qantas Group’s website, www.qantas.com.au. Locate the annual financial statements for 2006 and the accompanying notes. Required (a) What were Qantas Group’s total assets as at 30 June 2006? at 30 June 2005? (b) How much cash (and cash equivalents) did Qantas Group have on 30 June 2006? (c) What was Qantas Group’s fuel costs in 2006? in 2005? (d) What were Qantas Group’s revenues in 2006? in 2005? (e) Use the financial statements and related notes to identify items that may have required adjusting entries for prepayments and accruals when preparing the financial statements. (f) What were the amounts of Qantas Group’s depreciation and amortisation expense in 2006 and 2005? Financial statement analysis case The Kellogg Company manufactures and sells ready-to-eat breakfast cereals and convenience foods. At one point the Kellogg Company outlined its plans for the future, which it described as its five point ‘strategy for growth’. A brief description of these plans follows: 1. Leading the food industry in innovation — Kellogg Company is rolling out a broader grainbased product portfolio, including great-tasting new cereals, innovative convenience foods, and new grain-based products outside the traditional lines. 2. Investing in the largest cereal markets — During year 3, Kellogg will invest in growth in the seven largest cereal markets. 3. Accelerating the global growth of the convenience foods business — Kellogg is focusing both on an expanded geographic distribution and new distribution channels, particularly singleserve channels. 4. Continuing to reduce cost — From ongoing cost-reduction programs, the company anticipates more than $50 million in incremental savings in year 3. 5. Creating a more focused and accountable organisation — Kellogg’s objective is to develop a talented, diverse global workforce with every person focused on the largest, most important activities. C H A P T E R 3 The accounting information system 123 Selected data from the appropriate Kellogg Company’s annual report follow (dollar amounts in millions): Year 3 Net sales $6 762.1 Cost of sales 3 282.6 Selling and administrative expense 2 513.9 Profit for the period 502.6 Year 2 $6 830.1 3 270.1 2 366.8 546.0 Year 1 $6 676.6 3 122.9 2 458.7 531.0 Required (a) For each of the strategies, describe how gross profit and profit for the period are likely to be affected. (b) Calculate the percentage change in sales, gross profit, operating costs (cost of sales plus selling and administrative expenses), and profit for the period from year to year for each of the three years shown. Evaluate Kellogg Company’s performance. Which trend seems to be least favourable? Do you think the global strategies described will improve that trend? Explain. Comparative analysis case The Foster’s Group and Asia Pacific Breweries Ltd released the following information at the end of their 2006 financial year ends. The Foster’s Group is an international beverage company based in Australia, which produces beer, wine and spirits including the Foster’s brand. Asia Pacific Breweries is a beverage company based in Singapore producing beer and spirits throughout South-East Asia, including the Tiger Beer brand. Asia Pacific Breweries Financial year ended 30 September 2006 (S$million) Foster’s Group Financial year ended 30 June 2006 (A$million) 2006 Total assets Revenue Profit for the period Cash from operations 2005 2006 2005 1 548 1 526 183 190 1 274 1 436 154 193 10 439 5 120 1 166 835 10 995 4 155 920 523 Note: Information for Asia Pacific Breweries is taken from the unaudited financial statements and dividend announcement for financial year-end 30 September 2006. Further information can be found from each company’s corporate website at www.apb. com.sg and www.fosters.com.au, respectively. Required (a) Which company had the greater percentage increase in total assets from 2005 to 2006? (b) Which company had the greater percentage increase in revenue, profits and cash from operations? (c) Which company had the better performance for 2006 based on the data provided? (d) Why might the companies be expected to grow at a similar rate? (e) Why might the companies be expected to grow at very different rates? Endnote 1. Adapted from P Barry, Rich kids, Bantam Books, Sydney, 2002, pp. 248–51, 298. 124 Fundamentals of intermediate accounting ...
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