The Financial Reporting Process Chapter03 The Financial Reporting Process Chapter 3: The Financial Reporting Process The chapter is divided into 4 parts. Part A gives a brief overview of accrual-basis accounting. Part B describes the measurement process. Part C specifies the reporting process. Part D throws light on the closing process. Lets start with Part A. McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Accrual-Basis Accounting Part A Accrual-Basis Accounting Part A: Gives a brief overview of accrual-basis accounting. 3-2

LO1 Revenue and Expense Reporting Accounting information – necessary for decision making. To 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. Accrual-basis accounting records revenues when earned (the revenue recognition principle) and expenses with related revenues (the matching principle). Net income is an essential aspect of good investment decisions. Proper computation of net income requires considerable attention to be paid to the proper measurement of the two primary components of net income – revenues and expenses. If accounting information is to be useful in making decisions, accountants must measure and report revenues and expenses in a way that clearly reflects the ability of the company to create value for its owners, the stockholders. To do this, we use accrual-basis accounting, where we record revenues when we earn them (the revenue recognition principle) and expenses with related revenues (the matching principle). We discuss these principles next. 3-3

Revenue Recognition Principle Recognize revenue when it is earned Calvin 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 2013. When does Carnival report revenue from the ticket sale? The revenue recognition principle states that we should recognize revenue in the period in which we earn it, not necessarily in the period in which we receive cash. This principle is explained with an example. Calvin 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 2013. When does Carnival report revenue from the ticket sale? 3-4

Matching Principle Expenses are reported with the revenues they help to generate There is a cause-and-effect relationship between revenue and expense recognition implicit in this principle. In a given period, we report revenue as it’s earned, according to the revenue recognition principle. It’s logical, then, that in the same period we should also record all expenses incurred to generate that revenue. The result is a measure – net income – that matches current period accomplishments (revenues) and sacrifices (expenses). That’s the matching principle. 3-5 5

Considering the previous example about Carnival Cruise Lines, the cost of generating revenue in April (ship supplies, the fuel used, and crew members’ salaries) should be expensed in April even though the cash flows occur in March, April, and May. The matching principle states that we recognize expenses in the same period as the revenues they help to generate. Expenses include those directly and indirectly related to producing revenues. 3-6 6

LO2 Accrual–Basis Compared with Cash–Basis Accounting Under accrual-basis accounting, we record revenue and expense transactions at the time the earnings-related activities occur. Under cash-basis accounting, we record revenues at the time we receive cash and expenses at the time we pay cash. Cash Basis accounting is not a part of GAAP. Cash-basis accounting is not allowed for financial-reporting purposes. 3-7

The Measurement Process Part B The Measurement Process Part B: Describes the measurement process. 3-8

LO3 Adjusting Entries Closing Process Reporting Process 3-9 The accounting cycle starts with recording of external transactions. We discussed external transactions in chapter 2. In this chapter, we complete the accounting cycle by recording adjusting entries (internal transactions), preparing financial statements, and recording closing entries. Closing Process Reporting Process 3-9

LO4 Post Adjusting Entries Post adjusting entries to the T-accounts in the general ledger to update the account balances. Prepare an adjusted trial balance. An adjusted trial balance is a list of all accounts and their balances after we have updated account balances for adjusting entries. To complete the measurement process, we need to update balances of assets, liabilities, revenues, and expenses for adjusting entries. An adjusted trial balance is then prepared with updated balances. An adjusted trial balance is a list of all accounts and their balances at a particular date after we have updated account balances for adjusting entries. 3-10

Part C The Reporting Process 3-11 Part C: Specifies the reporting process. 3-11

LO5 Financial Statement1s Once the adjusted trial balance is complete, we prepare financial statements. Revenue and expense accounts are reported in the income statement. The difference between total revenues and total expenses equals net income. All asset, liability, and stockholders’ equity accounts are reported in the balance sheet which confirms the equality of the basic accounting equation.   3-12

Income Statement The income statement demonstrates that Eagle Golf Academy earned a profit of $500 in the month of January. The revenues earned from providing service to customers exceed the costs of providing that service. 3-13

Statement of Stockholders’ Equity The statement of stockholders’ equity summarizes the changes in each stockholders’ equity account as well as in total stockholders’ equity and the accounting value of the company to stockholders (owners). It also reflects the retained earnings of the company. Retained earnings has three components: revenues, expenses, and dividends. In the adjusted trial balance, the balance of the retained earnings account equals its balance before all revenue, expense, and dividend transactions, which is the balance of retained earnings at the beginning of the accounting period. For Eagle Golf Academy, the beginning balance of retained earnings equals $0 since this is the first month of operations. Total stockholders’ equity increases from $0 at the beginning of January to $25,300 by the end of January. The increase occurs as a result of a $25,000 investment by the owners (stockholders) when they bought common stock plus an increase of $300 when the company earned a profit of $500 on behalf of its stockholders and after distributing $200 of dividends, retained $300 in the business. 3-14

Classified Balance Sheet EAGLE GOLF ACADEMY Classified Balance Sheet January 31 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. Assets Liabilities Current assets: Current liabilities: Cash $ 6,200 Accounts payable $ 2,300 Accounts receivable 2,700 Unearned revenue 540 Supplies 1,500 Salaries payable 300 Prepaid rent 5,500 Utilities payable 960 Total current assets 15,900 Interest payable 100 Total current liabilities 4,200 Long-term assets: Equipment 24,000 Long-term liabilities: Accum. depr., equip. (400) Notes payable 10,000 Total long-term assets 23,600 Total liabilities 14,200 Stockholders’ Equity Common stock 25,000 Retained earnings Total stockholders’ equity $ 25,300 Total liabilities and stockholders’ equity $ 39,500 Total assets The balance sheet includes all asset, liability, and permanent stockholders’ equity accounts. We can separate assets into those that provide a benefit over the next year (current assets) and those that provide a benefit for more than one year (long-term assets). Similarly, we can divide liabilities into those due over the next year (current liabilities) and those due in more than one year (long-term liabilities). 3-15

Part D The Closing Process 3-16 Part D: Throws light on the closing process. 3-16

LO6 Closing Entries Transfer the balance of all revenue, expense, and dividend accounts to the balance of retained earnings. Increase the retained earnings account by the amount of revenues and decrease retained earnings by the amount of expenses and dividends. The balance of each revenue, expense, and dividend account equals zero after closing entries. Do not affect the balances of permanent accounts other than retained earnings. The closing process will have the following effects: 1) Transfer of balance of all revenue, expense, and dividend accounts to the balance of retained earnings. 2) Increase in retained earnings account by the amount of revenues and decrease in retained earnings by the amount of expenses and dividends. 3) The balance of each revenue, expense, and dividend account will be reduced to zero. 4) Closing entries do not affect the balances of permanent accounts other than retained earnings. 3-17

Close to Retained Earnings The ending balance of retained earnings now includes all transactions affecting the components of the account. The ending balance of $300 represents all revenues and expenses over the life of the company (just the first month of operations in this example) less dividends. The ending balance of retained earnings in January will be its beginning balance in February. Then we’ll close February’s revenues, expenses, and dividends to retained earnings, and this cycle will continue each period 3-18 18

LO7 Post Closing Entries and Prepare Post–Closing Trial Balance The first and foremost step in closing process is to post, closing entries that transfer the balances of all temporary accounts (revenues, expenses, and dividends) to the balance of the retained earnings account. After we post the closing entries to the ledger accounts, we can prepare a post-closing trial balance. The post-closing trial balance is a list of all accounts and their balances at a particular date after we have updated account balances for closing entries. Notice that the post-closing trial balance does not include any revenues, expenses, or dividends, because these accounts all have zero balances after closing entries. The balance of retained earnings has been updated from the adjusted trial balance to include all revenues, expenses, and dividends for the period. 3-19

End of Chapter 03 End of Chapter 3 3-20