Chapter 3

Chapter 3 - 09/01/2011 09/01/2011 Welcome to ACC 325!...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: 09/01/2011 09/01/2011 Welcome to ACC 325! Discussion of Syllabus Objectives of the course Grading Academic Wileyplus Honesty Chapter 3 -- THE ACCOUNTING Chapter 3 THE ACCOUNTING Chapter Chapter INFORMATION SYSTEM IINFORMATION SYSTEM NFORMATION INFORMATION 1.. 1 Understand basic accounting terminology. 2. Explain double­entry rules. 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 financial statement from the adjusted trial balance. 7. Prepare closing entries The Accounting Information System The Accounting Information System Accounting Accounting Information System Information Basic terminology Debits and credits Accounting equation Financial statements Financial and ownership structure structure The Accounting The Cycle Cycle Identifying and recording Identifying Journalizing Posting Trial balance Adjusting entries Adjusted trial balance Preparing financial Preparing statements statements Closing Post-closing trial balance Reversing entries Financial Financial Statements for Merchandisers Merchandisers Income statement Statement of retained Statement earnings earnings Balance sheet Closing entries Accounting Information System Accounting Information System Accounting Information System (AIS) Collects and processes transaction data. Disseminates the information to interested parties. Accounting Information System Accounting Information System He lp s m a n a g e m e nt a ns we r s uc h q ue s tio ns a s : How much and what kind of debt is outstanding? Were 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 stockholders? Is our rate of return on net assets increasing? Basic Terminology Basic Terminology Basic Event Journal Transaction Posting Account Trial Balance Real Account Adjusting Entries Nominal Account Financial Statements Ledger Closing Entries Debits and Credits Debits and Credits Debits An Account s h o ws th e e ffe c t o f tra n s a c tio ns o n a g ive n a s s e t, lia b ility, e q uity, re ve n ue , o r e xp e ns e a c c o un t. Double-entry a c c o un tin g s ys te m (two ­s id e d e ffe c t) . Double-entry R e c o rd in g d o n e b y d e b iting a t le a s t o ne a c c o un t a nd c re d iting a no th e r. DEBITS must equal CREDITS. must Debits and Credits Debits and Credits Debits Account An arrangement that shows the effect of transactions on an account. Debit = “Left” Credit = “Right” An Account can An be illustrated in a T-Account form. T-Account Account Name Debit / Dr. Credit / Cr. Debits and Credits Debits and Credits Debits If Debit entries are greater than Credit entries, the greater account will have a debit balance. Account Name Debit / Dr. Credit / Cr. Transaction #1 $10,000 $3,000 Transaction #3 8,000 Balance $15,000 Transaction #2 Debits and Credits Debits and Credits Debits If Credit entries are greater than Debit entries, the greater account will have a credit balance. Account Name Debit / Dr. Transaction #1 $3,000 Transaction #2 8,000 Balance $10,000 Credit / Cr. Transaction #3 $1,000 Debits and Credits Summary Debits and Credits Summary Liabilit ies Normal Normal Balance Balance Debit Debit Normal Normal Balance Balance Credit Credit Asset s Credit / Cr. Normal Balance Normal Chapter 3-24 Equit y Credit / Cr. Debit / Dr. Debit / Dr. Debit / Dr. Credit / Cr. Normal Balance Normal Normal Balance Normal Chapter 3-23 Expense Debit / Dr. Revenue Chapter 3-25 Credit / Cr. Debit / Dr. Normal Balance Normal Chapter 3-27 Credit / Cr. Normal Balance Normal Chapter 3-26 Debits and Credits Summary Debits and Credits Summary Ba la n c e S h e e t Inc o m e S ta te m e nt Asset = Liability + Equity Debit Credit Revenu - Expens = e e The Accounting Equation The Accounting Equation The Relationship among the assets, liabilities and stockholders’ equity of a business: Illustration 3-3 The equation must be in balance after every transaction. For every Debit there must be a Credit. Double-Entry System Illustration Double-Entry System Illustration Double-Entry 1. Owners invest $40,000 in exchange for common stock. As s e ts As s e ts + 40,000 = Lia b ilitie s Lia b ilitie s + Stockholders’ Stockholders’ Equity Equity + 40,000 Double-Entry System Illustration Double-Entry System Illustration 2. Disburse $600 cash for secretarial wages. As s e ts A s s e ts - 600 = Lia b ilitie s Lia b ilitie s + Stockholders’ Stockholders’ Equity Equity - 600 (expense) Double-Entry System Illustration Double-Entry System Illustration Double-Entry 3. Purchase office equipment priced at $5,200, giving a 10 percent promissory note in exchange. As s e ts As s e ts + 5,200 = Lia b ilitie s Lia b ilitie s + 5,200 + Stockholders’ Stockholders’ Equity Equity Double-Entry System Illustration Double-Entry System Illustration Double-Entry 4. Received $4,000 cash for services rendered. As s e ts As s e ts + 4,000 = Lia b ilitie s Lia b ilitie s + Stockholders’ Stockholders’ Equity Equity + 4,000 (revenue) Double-Entry System Illustration Double-Entry System Illustration Double-Entry 5. Pay off a short­term liability of $7,000. As s e ts As s e ts - 7,000 = Lia b ilitie s Lia b ilitie s - 7,000 + Stockholders’ Stockholders’ Equity Equity Double-Entry System Illustration Double-Entry System Illustration 6. Declared a cash dividend of $5,000. As s e ts A s s e ts = Lia b ilitie s Lia b ilitie s + 5,000 + Stockholders’ Stockholders’ Equity Equity - 5,000 Double-Entry System Illustration Double-Entry System Illustration Double-Entry 7. Convert a long­term liability of $80,000 into common stock. As s e ts As s e ts = Lia b ilitie s Lia b ilitie s - 80,000 + Stockholders’ Stockholders’ Equity Equity + 80,000 Double-Entry System Illustration Double-Entry System Illustration Double-Entry 8. Pay cash of $16,000 for a delivery van. As s e ts As s e ts = Lia b ilitie s Lia b ilitie s + Stockholders’ Stockholders’ Equity Equity - 16,000 + 16,000 Note that the accounting equation equality is maintained after Note that the accounting equation equality is maintained after recording each transaction. recording each transaction. Financial Statements and Ownership Structure Financial Statements and Ownership Structure Ownership structure dictates the types of accounts that are part of the equity section. Proprietorship or Proprietorship or Partnership Partnership Capital Account Drawing Account Corporation Corporation Common Stock Additional Paid-in Capital Dividends Retained Declared Earnings Financial Statements and Ownership Structure Financial Statements and Ownership Structure Financial Illustration 3­4 Balance Sheet Stockholders’ Equity Common Stock (Investment by Common Stock (Investment by stockholders) stockholders) Dividends Retained Earnings (Net Retained Earnings (Net income retained in business) income retained in business) Net income or Net loss ((Revenues Revenues less expenses) less expenses) Income Statement Statement of Retained Earnings The Accounting Cycle The Accounting Cycle The Illustration 3­6 Transactions 9. Reversing entries 1. Journalization 8. Post­closing trail balance 2. Posting 7. Closing entries 3. Trial balance 6. Financial Statements Work Sheet 5. Adjusted trial balance 4. Adjustments Identify and Recording Transactions Identify and Recording Transactions Identify What to Record? FASB states, “transactions and other events and circumstances that affect a business enterprise.” Types of Events: External – between a business and its environment. Internal – event occurring entirely within a business. Review “Transactions and Events” Review “Transactions and Events” External Internal Not Recorded 1. A supplier of a company‘s raw material is paid an amount owed on account. External 2. A customer pays its open account. External 3. A new chief executive officer is hired. 4. The biweekly payroll is paid. External 5. Raw materials are entered into production. Internal 6. A new advertising agency is hired. 7. The accountant determines the federal income taxes owed based on the income earned. Not Recorded Not Recorded Internal 1. Journalizing 1. Journalizing General Journal – a chronological record of transactions. Journal General Entries are recorded in the journal. September 1: Stockholders invested $15,000 cash in the corporation in exchange for shares of stock. Illustration 3-7 2. Posting 2. Posting Posting – the process of transferring amounts from the journal to the ledger accounts. Illustration 3-7 Illustration 3-8 2. Posting 2. Posting Posting – Transferring amounts from journal to ledger. Illustration 3-8 2. Posting 2. Posting Expanded Example Expanded The purpose of transaction analysis is (1) to identify the type of account involved, and (2) to determine whether a debit or a credit is required. Keep in mind that every journal entry affects one or more of the following items: assets, liabilities, stockholders’ equity, revenues, or expense. 2. Posting 2. Posting 1. October 1: Stockholders invest $100,000 cash in an advertising venture to be known as Pioneer Advertising Agency Inc. Oct. 1 Cash 100,000 Common stock Cash Debit 100,000 100,000 Common Stock Credit Debit Credit 100,000 2. Posting 2. Posting 2. October 1: Pioneer Advertising purchases office equipment costing $50,000 by signing a 3­month, 12%, $50,000 note payable. Oct. 1 Office equipment 50,000 Notes payable Office Equipment Debit 50,000 Credit 50,000 Notes Payable Debit Credit 50,000 2. Posting 2. Posting 3. October 2: Pioneer Advertising receives a $12,000 cash advance from KC, a client, for advertising services that are expected to be completed by December 31. Oct. 2 Cash 12,000 Unearned service revenue Cash Debit 100,000 12,000 12,000 Unearned Service Revenue Credit Debit Credit 12,000 2. Posting 2. Posting 4. October 3: Pioneer Advertising pays $9,000 office rent, in cash, for October. Oct. 3 Rent expense 9,000 Cash 9,000 Cash Debit 100,000 12,000 Rent Expense Credit 9,000 Debit 9,000 Credit 2. Posting 2. Posting 5. October 4: Pioneer Advertising pays $6,000 for a one­year insurance policy that will expire next year on September 30. Oct. 4 Prepaid insurance 6,000 Cash 6,000 Cash Debit 100,000 12,000 Prepaid Insurance Credit 9,000 6,000 Debit 6,000 Credit 2. Posting 2. Posting 6. October 5: Pioneer Advertising purchases, for $25,000 on account, an estimated 3­month supply of advertising materials from Aero Supply. Oct. 5 Advertising supplies 25,000 Accounts payable Advertising Supplies Debit 25,000 Credit 25,000 Accounts Payable Debit Credit 25,000 2. Posting 2. Posting 7. October 9: Pioneer Advertising signs a contract with a local newspaper for advertising inserts (flyers) to be distributedstarting the last Sunday in November. Pioneer will start work on the content of the flyers in November. Payment of $7,000 is due following delivery of the Sunday papers containing the flyers. 2. Posting 2. Posting 8. October 20: Pioneer Advertising’s board of directors declares and pays a $5,000 cash dividend to stockholders. Oct. 20 Dividends 5,000 Cash 5,000 Cash Debit 100,000 12,000 Dividends Credit 9,000 6,000 5,000 Debit 5,000 Credit 2. Posting 2. Posting 9. October 26: Employees are paid every four weeks. The total payroll is $2,000 per day. The pay period ended on Friday, October 26, with salaries of $40,000 being paid. Oct. 26 Salaries expense 40,000 Cash 40,000 Cash Debit 100,000 12,000 Salaries Expense Credit 9,000 6,000 5,000 40,000 Debit 40,000 Credit 2. Posting 2. Posting 10. October 31: Pioneer Advertising receives $28,000 in cash and bills Copa Company $72,000 for advertising services of $100,000 provided in October. Oct. 31 Cash Accounts receivable Service revenue Cash Debit 100,000 12,000 28,000 80,000 28,000 72,000 Accounts Receivable Credit 9,000 6,000 5,000 40,000 Debit 72,000 Credit 100,000 Service Revenue Debit Credit 100,000 3. Trial Balance 3. Trial Balance Illustration 3-19 Trial Balance – Trial A list of each account and its balance; used to prove equality of debit and credit balances. 4.. Adjusting Entries 4. Adjusting Entries 4 Revenues ­ recorded in the period in which they are earned. Expenses ­ recognized in the period in which they are incurred. Expenses ­ recognized in the period in which they are incurred Adjusting entries ­ needed to ensure that the revenue recognition and matching principles are followed. Types of Adjusting Entries Types of Adjusting Entries Types Illustration 3-20 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. Adjusting Entries for Deferrals Adjusting Entries for Deferrals Deferrals are either prepaid expenses or unearned revenues. Illustration 3-21 Adjusting Entries for “Prepaid Expenses” Adjusting Entries for “Prepaid Expenses” Payment of cash that is recorded as an asset because service or benefit Payment of cash that is recorded as an asset because service or benefit will be received in the future. Cash Payment BEFORE Expense Recorded Prepayments often occur in regard to: insurance supplies advertising rent maintenance on equipment fixed assets Adjusting Entries for “Prepaid Expenses” Adjusting Entries for “Prepaid Expenses” Supplies. Pioneer purchased advertising supplies costing Supplies. $25,000 on October 5. Prepare the journal entry to record the purchase of the supplies. Oct. 5 Advertising supplies 25,000 Cash 25,000 Advertising Supplies Debit 25,000 Credit Cash Debit Credit 25,000 Adjusting Entries for “Prepaid Expenses” Adjusting Entries for “Prepaid Expenses” Supplies. An inventory count at the close of business on October 31 reveals that $10,000 of the advertising supplies are still on hand. Oct. 31 Advertising supplies expense 15,000 Advertising supplies Advertising Supplies Debit 25,000 10,000 Credit 15,000 15,000 Advertising Supplies Expense Debit 15,000 Credit Adjusting Entries for “Prepaid Expenses” Adjusting Entries for “Prepaid Expenses” Illustration 3-35 Statement Presentation: Advertising supplies identifies that portion of the asset’s cost that will provide future economic benefit. Adjusting Entries for “Prepaid Expenses” Adjusting Entries for “Prepaid Expenses” Illustration 3-34 Statement Presentation: Advertising expense identifies that portion of the asset’s cost that expired in October. Adjusting Entries for “Prepaid Expenses” Adjusting Entries for “Prepaid Expenses” Insurance. On Oct. 4th, Pioneer paid $6,000 for a one­year fire insurance policy, beginning October 1. Show the entry to record the purchase of the insurance. Oct. 4 Prepaid insurance 6,000 Cash 6,000 Prepaid Insurance Debit 6,000 Credit Cash Debit Credit 6,000 Adjusting Entries for “Prepaid Expenses” Adjusting Entries for “Prepaid Expenses” Insurance. An analysis of the policy reveals that $500 ($6,000 / 12) of insurance expires each month. Thus, Pioneer makes the following adjusting entry. Oct. 31 Insurance expense 500 Prepaid insurance Prepaid Insurance Debit 6,000 5,500 500 Insurance Expense Credit Debit 500 Credit 500 Adjusting Entries for “Prepaid Expenses” Adjusting Entries for “Prepaid Expenses” Illustration 3-35 Statement Presentation: Prepaid insurance identifies that portion of the asset’s cost that will provide future economic benefit. Adjusting Entries for “Prepaid Expenses” Adjusting Entries for “Prepaid Expenses” Illustration 3-34 Statement Presentation: Insurance expense identifies that portion of the asset’s cost that expired in October. Adjusting Entries for “Prepaid Expenses” Adjusting Entries for “Prepaid Expenses” Depreciation. Pioneer Advertising estimates depreciation on its office equipment to be $400 per month. Accordingly, Pioneer recognizes depreciation for October by the following adjusting entry. Oct. 31 Depreciation expense 400 Accumulated depreciation Depreciation Expense Debit Credit 400 400 Accumulated Depreciation Debit Credit 400 Adjusting Entries for “Prepaid Expenses” Adjusting Entries for “Prepaid Expenses” Illustration 3-35 Statement Presentation: Accumulated Depreciation—is a contra asset account. Adjusting Entries for “Prepaid Expenses” Adjusting Entries for “Prepaid Expenses” Illustration 3-34 Statement Presentation: Depreciation expense identifies that portion of the asset’s cost that expired in October. Adjusting Entries for “Unearned Revenues” Adjusting Entries for “Unearned Revenues” Receipt of cash that is recorded as a liability because the revenue has Receipt of cash that is recorded as a liability because the revenue has not been earned. Cash Receipt Revenue Recorded BEFORE Unearned revenues often occur in regard to: rent airline tickets school tuition magazine subscriptions customer deposits Adjusting Entries for “Unearned Revenues” Adjusting Entries for “Unearned Revenues” Unearned Revenue. Pioneer Advertising received $12,000 on October 2 from KC for advertising services expected to be completed by December 31. Show the journal entry to record the receipt on Oct. 2nd. Oct. 2 Cash 12,000 Unearned advertising revenue Cash Debit 12,000 12,000 Unearned Rent Revenue Credit Debit Credit 12,000 Adjusting Entries for “Unearned Revenues” Adjusting Entries for “Unearned Revenues” Unearned Revenues. Analysis reveals that Pioneer earned $4,000 of the advertising services in October. Thus, Pioneer makes the following adjusting entry. Oct. 31 Unearned service revenue 4,000 Service revenue Service Revenue Debit Credit 100,000 4,000 4,000 Unearned Service Revenue Debit 4,000 Credit 12,000 8,000 Adjusting Entries for “Unearned Revenues” Adjusting Entries for “Unearned Revenues” Adjusting Illustration 3-35 Statement Presentation Unearned service revenue identifies that portion of the liability that has not been earned. Adjusting Entries for Accruals Adjusting Entries for Accruals Accruals are either accrued revenues or accrued expenses. Illustration 3-27 Adjusting Entries for “Accrued Revenues” Adjusting Entries for “Accrued Revenues” Revenues earned but not yet received in cash or recorded. Revenues earned but not yet received in cash or recorded. Adjusting entry results in: Revenue Recorded BEFORE Accrued revenues often occur in regard to: rent interest services performed Cash Receipt Adjusting Entries for “Accrued Revenues” Adjusting Entries for “Accrued Revenues” Accrued Revenues. In October Pioneer earned $2,000 for advertising services that it did not bill to clients before October 31. Thus, Pioneer makes the following adjusting entry. Oct. 31 Accounts receivable 2,000 Service revenue Accounts Receivable Debit 72,000 2,000 74,000 Credit 2,000 Service Revenue Debit Credit 100,000 4,000 2,000 106,000 Adjusting Entries for “Unearned Revenues” Adjusting Entries for “Unearned Revenues” Illustration 3-34 Statement Presentation Illustration 3-35 Adjusting Entries for “Accrued Expenses” Adjusting Entries for “Accrued Expenses” Expenses incurred but not yet paid in cash or recorded. Expenses incurred but not yet paid in cash or recorded. Adjusting entry results in: Expense Recorded BEFORE Accrued expenses often occur in regard to: rent interest taxes salaries bad debts* Cash Payment, if any* Adjusting Entries for “Accrued Expenses” Adjusting Entries for “Accrued Expenses” Adjusting Accrued Interest. Pioneer signed a three­month, 12%, note payable in the amount of $50,000 on October 1. The note requires interest at an annual rate of 12 percent. Three factors determine the amount of the interest accumulation: 1 2 3 Illustration 3-29 Adjusting Entries for “Accrued Expenses” Adjusting Entries for “Accrued Expenses” Accrued Interest. Pioneer signed a three­month, 12%, note payable in the amount of $50,000 on October 1. Prepare the adjusting entry on Oct. 31 to record the accrual of interest. Oct. 31 Interest expense 500 Interest payable Interest Expense Debit Credit 500 500 Interest Payable Debit Credit 500 Adjusting Entries for “Accrued Expenses” Adjusting Entries for “Accrued Expenses” Illustration 3-34 Statement Presentation Illustration 3-35 Adjusting Entries for “Accrued Expenses” Adjusting Entries for “Accrued Expenses” Adjusting Accrued Salaries. At October 31, the salaries for these days represent an accrued expense and a related liability to Pioneer. The employees receive total salaries of $10,000 for a five­day work week, or $2,000 per day. Adjusting Entries for “Accrued Expenses” Adjusting Entries for “Accrued Expenses” Accrued Salaries. Employees receive total salaries of $10,000 for a five­day work week, or $2,000 per day. Prepare the adjusting entry on Oct. 31 to record accrual for salaries. Oct. 31 Salaries expense 6,000 Salaries payable Salaries Expense Debit 40,000 6,000 46,000 Credit 6,000 Salaries Payable Debit Credit 6,000 Adjusting Entries for “Accrued Expenses” Adjusting Entries for “Accrued Expenses” Illustration 3-34 Statement Presentation Illustration 3-35 Adjusting Entries for “Accrued Expenses” Adjusting Entries for “Accrued Expenses” Accrued Salaries. On November 23, Pioneer will again pay total salaries of $40,000. Prepare the entry to record the payment of salaries on November 23. Nov. 23 Salaries payable 6,000 Salaries expense 34,000 Cash 40,000 Salaries Expense Debit 34,000 Credit Salaries Payable Debit 6,000 Credit 6,000 Adjusting Entries for “Accrued Expenses” Adjusting Entries for “Accrued Expenses” Adjusting Bad Debts. Assume Pioneer reasonably estimates a bad debt expense for the month of $1,600. It makes the adjusting entry for bad debts as follows. Illustration 3-32 5. Adjusted Trial Balance 5. Adjusted Trial Balance Illustration 3-33 Shows the balance of all accounts, after adjusting entries, at the end of the accounting period. 6..Preparing Financial Statements 6. Preparing Financial Statements 6 Financial Statements are prepared directly from the Adjusted Trial Financial Statements are prepared directly from the Adjusted Trial Balance. Balance. Income Statement Statement of Retained Earnings Balance Sheet 6..Preparing Financial Statements 6. Preparing Financial Statements 6 Illustration 3-34 6..Preparing Financial Statements 6. Preparing Financial Statements 6 Illustration 3-35 7.. Closing Entries 7. Closing Entries 7 To reduce the balance of the income statement (revenue and expense) accounts to zero. To transfer net income or net loss to owner’s equity. Balance sheet (asset, liability, and equity) accounts are not closed. Dividends are closed directly to the Retained Earnings account. 7.. Closing Entries 7. Closing Entries 7 Illustration 3-33 Closing Journal Entries: Retained earnings Dividends 5,000 Service revenue 5,000 106,000 Salaries expense 46,000 Advertising expense 15,000 Rent expense 9,000 Insurance expense 500 Interest expense 500 Depreciation expense 400 Bad debt expense Retained earnings 1,600 33,000 7.. Closing 7. Closing 7 7. Entries Entries Entries Entries Illustration 3-37 LO 7 Prepare closing entries. LO 8.. Post-Closing Trial Balance 8. Post-Closing Trial Balance 8 Illustration 3-38 9..Reversing Entries 9. Reversing Entries 9 After preparing the financial statements and closing the books, a company may reverse some of the adjusting entries before recording the regular transactions of the next period. Accounting Cycle Summarized Accounting Cycle Summarized Accounting 1. Enter the transactions of the period in appropriate journals. 2. Post from the journals to the ledger (or ledgers). 3. Take an unadjusted trial balance (trial balance). 4. Prepare adjusting journal entries and post to the ledger(s). 5. Take 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. Take a trial balance after closing (post­closing trial balance). 9. Prepare reversing entries (optional) and post to the ledger(s). Financial Statements of a Merchandising Company Financial Statements of a Merchandising Company Financial Illustration 3-39 Financial Statements of a Merchandising Company Financial Statements of a Merchandising Company Financial Illustration 3-40 Financial Statements of a Merchandising Company Financial Statements of a Merchandising Company Financial Illustration 3-41 International companies use the same set of procedures and records to keep track of transaction data. Thus, the material in Chapter 3 is the same under both GAAP and IFRS. Transaction analysis is the same under IFRS and GAAP but, as you will see in later chapters, different standards sometimes impact how transactions are recorded. Rules for accounting for specific events sometimes differ across countries. For example, European companies rely less on historical cost and more on fair value than U.S. companies. Despite the differences, the double­entry accounting system is the basis of accounting systems worldwide. Most companies use accrual-basis accounting recognize revenue when it is earned and expenses in the period incurred, without regard to the time of receipt or payment of cash. Under the strict cash basis, companies record revenue only when they receive cash, and record expenses only when they disperse cash. Cash basis financial statements are not in conformity with GAAP. Illustration: Quality Contractor signs an agreement to construct a garage for $22,000. In January, Quality begins construction, incurs costs of $18,000 on credit, and by the end of January delivers a finished garage to the buyer. In February, Quality collects $22,000 cash from the customer. In March, Quality pays the $18,000 due the creditors. Illustration 3A-1 Illustration: Quality Contractor signs an agreement to construct a garage for $22,000. In January, Quality begins construction, incurs costs of $18,000 on credit, and by the end of January delivers a finished garage to the buyer. In February, Quality collects $22,000 cash from the customer. In March, Quality pays the $18,000 due the creditors. Illustration 3A-2 Conversion From Cash Basis To Accrual Basis Conversion Illustration: Dr. Diane Windsor, like many small business owners, keeps her accounting records on a cash basis. In the year 2010, Dr. Windsor received $300,000 from her patients and paid $170,000 for operating expenses, resulting in an excess of cash receipts over disbursements of $130,000 ($300,000 ­ $170,000). At January 1 and December 31, 2010, she has accounts receivable, unearned service revenue, accrued liabilities, and prepaid expenses as shown in Illustration 3A­5. Illustration 3A-5 Conversion From Cash Basis To Accrual Basis Conversion Illustration: Calculate service revenue on an accrual basis. Illustration 3A-8 Illustration 3A-5 Conversion From Cash Basis To Accrual Basis Conversion Illustration: Calculate operating expenses on an accrual basis. Illustration 3A-5 Conversion From Cash Basis To Accrual Basis Conversion Illustration 3A-12 Theoretical Weaknesses of the Cash Basis Theoretical Today’s economy is considerably more lubricated by credit than by cash. The accrual basis, not the cash basis, recognizes all aspects of the credit phenomenon. Investors, creditors, and other decision makers seek timely information about an enterprise’s future cash flows. ...
View Full Document

Ask a homework question - tutors are online