Chapter 03 The Financial Reporting Process McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Part A Accrual-Basis Accounting 3-2

3-3 LO1 Revenue and Expense Reporting oAccounting information – necessary for decision making. oTo be useful in decision making – accountants must report revenues and expenses in a way that reflects the ability of the company to create value for its owners. oAccrual-basis accounting records revenues when earned (the revenue recognition principle) and expenses with related revenues (the matching principle).

3-4 Revenue Recognition Principle Recognize revenue when it is earned oCalvin books a cruise with Carnival Cruise Lines, the world’s largest cruise line. He makes reservations and pays for the cruise in November 2012, but the cruise is not scheduled to sail until April oWhen does Carnival report revenue from the ticket sale?

3-5 Revenue Recognition Principle 1.In November 2012??? No. Because it has not substantially fulfilled its obligation to Calvin. 2.In April 2013??? Yes. Because it is in April 2013 that the cruise occurs.

3-6 Revenue Recognition Principle Suppose that, anticipating the cruise, Calvin buys a Jimmy Buffet CD from Best Buy. Rather than paying cash, Calvin uses his Best Buy card to buy the CD on account. When does Best Buy recognize revenue?

3-7 Revenue Recognition Principle Even though Best Buy doesn’t receive cash immediately from Calvin, it still records the revenue at the time it sells the CD.

3-8 Matching Principle

3-10 LO2 Accrual–Basis Compared with Cash–Basis Accounting

3-11 Accrual–Basis Compared with Cash– Basis Accounting

3-12 Accrual–Basis Compared with Cash– Basis Accounting

Part B The Measurement Process

3-14 Closing Process LO3 Adjusting Entries Reporting Process

3-15 Purpose of Adjusting Entries oTo record events that have occurred but which have not been recorded. oTo record revenues in the period earned. oTo record expenses in the period they are incurred in the generation of those revenues. oTo correctly state assets and liabilities in the balance sheet.

3-16 Grouping Adjusting Entries Prepayments: oPrepaid expenses – we paid cash (or had an obligation to pay cash) for the purchase of an asset before we incurred the expense. oUnearned revenues – we received cash and recorded a liability before we earned the revenue. Accruals: oAccrued expenses – we paid cash after we incurred the expense and recorded a liability. oAccrued revenues – we received cash after we earned the revenue and recorded an asset.

3-17 Prepaid Expenses oCosts of assets acquired in one period that will be expensed in a future period. oExamples: Purchase of equipment or supplies, payment of rent in advance, payment of insurance in advance. Adjusting Entry: Debit expense account (increase an expense) Credit asset account (decrease an asset)

3-18 Example: Prepaid Rent Prepaid rent expires $500 Adjusting entry $5,500 Remaining prepaid rent Jan. 31 $6,000 Cash paid for prepaid rent Jan. 1

3-19 Example: Prepaid Rent

3-20 Unearned Revenues oOnce a company has provided products or services, they can record revenue earned and reduce the obligation to the customer. The adjusting entry for an unearned revenue always includes a debit to a liability account (decrease a liability) and a credit to a revenue account (increase a revenue). Adjusting entry: Debit liability account (decrease a liability) Credit revenue account (increase a revenue)

3-21 Example: Unearned Training Revenue Adjusting entry $540 Unearned revenue remains Jan. 31 $600 Cash received in advance Jan. 26 Services provided $60

3-22 Example: Unearned Training Revenue

3-23 Accrued Expenses oWhen a company has incurred an expense but hasn’t yet paid cash or recorded an obligation to pay, it still should record the expense. oExamples: Accrued salaries, accrued interest, accrued utility costs. Adjusting entry: Debit expense account (increase an expense) Credit liability account (increase a liability)

3-24 Example: Accrued Utility Costs oAt the end of January, Eagle receives a utility bill for $960 associated with operations in January. Eagle plans to pay the bill on February 6. oEven though it won’t pay the cash until February, Eagle must record the utility costs for January as an expense in January.

3-25 Example: Accrued Utility Costs Adjusting entry $960 Utilities owed Jan. 31 $960 Cash paid for utilities Feb. 6 Utilities used $960 Jan. 1

3-26 Example: Accrued Utility Costs

3-27 Accrued Revenues oWhen a company has earned revenue but hasn’t yet received cash or recorded an amount receivable, it still should record the revenue. This is referred to as an accrued revenue. oExamples: Interest receivable, accounts receivable Adjusting entry: Debit asset account (increase an asset) Credit revenue account (increase a revenue)

3-28 Example: Accounts Receivable oSuppose, Eagle provides $200 of golf training to customers from January 28 to January 31. However, it usually takes Eagle one week to mail bills to customers and another week for customers to pay. Therefore, Eagle expects to receive cash from these customers during February oIrrespective of when cash will be received, the revenue should be recognized in January.

3-29 Example: Accounts Receivable Adjusting entry $200 Owed from customers Jan. 31 $200 Cash received from customers Feb Revenues earned $200 Jan. 28

3-30 Example: Accounts Receivable

3-31 LO4 Post Adjusting Entries oPost adjusting entries to the T-accounts in the general ledger to update the account balances. oPrepare an adjusted trial balance. oAn adjusted trial balance is a list of all accounts and their balances after we have updated account balances for adjusting entries.

3-32 Unadjusted Trial Balance and Adjusted Trial Balance of Eagle Golf Academy

Part C The Reporting Process

3-34 LO5 Financial Statements

3-35 Income Statement

3-36 Statement of Stockholders’ Equity

3-37 Classified Balance Sheet Sheet January 31 EAGLE GOLF ACADEMY Classified Balance Assets Liabilities Current assets: Current liabilities: Cash $ 6,200 Accounts payable $ 2,300 Accounts receivable2,700 Unearned revenue540 Supplies1,500Salaries payable300 Prepaid rent5,500Utilities payable960 Total current assets15,90 0 Interest payable100 Total current liabilities4,200 Long-term assets: Equipment 24,00 0 Long-term liabilities: Accum. depr., equip. (400) Notes payable10,000 Total long-term assets 23,60 0 Total liabilities 14,200 Stockholders’ Equity Common stock25,000 Retained earnings300 Total stockholders’ equity$ 25,300 Total liabilities and stockholders’ equity$ 39,500 Total assets $ 39,50 0 Total assets equal current plus long- term assets. Total liabilities equal current plus long-term liabilities. Total stockholders’ equity includes common stock and retained earnings from the statement of stockholders’ equity. Total assets must equal total liabilities plus stockholders’ equity.

Part D The Closing Process

3-39 LO6 Closing Entries oTransfer the balance of all revenue, expense, and dividend accounts to the balance of retained earnings. oIncrease the retained earnings account by the amount of revenues and decrease retained earnings by the amount of expenses and dividends. oThe balance of each revenue, expense, and dividend account equals zero after closing entries. oDo not affect the balances of permanent accounts other than retained earnings.

3-40 Close to Retained Earnings

3-41 LO7 Post Closing Entries and Prepare Post–Closing Trial Balance

3-42 End of Chapter 03