4-1 ©2006 Prentice Hall, Inc.

4-2 ©2006 Prentice Hall, Inc. THE ACCTG INFO SYSTEM AND THE ACCTG CYCLE (1 of 2)  Learning objectives Learning objectives  Measuring income—recording revenues and expenses Measuring income—recording revenues and expenses  Timing differences Timing differences  Adjusting entries and preparing financial statements Adjusting entries and preparing financial statements

4-3 ©2006 Prentice Hall, Inc. THE ACCTG INFO SYSTEM AND THE ACCTG CYCLE (2 of 2)  Closing revenue and expense accounts Closing revenue and expense accounts  Financial statement analysis Financial statement analysis  Business risk, control, and ethics Business risk, control, and ethics

4-4 ©2006 Prentice Hall, Inc. Learning Objectives (1 of 2)  Define accrual accounting and explain how income is measured  Explain accruals and deferrals and how they affect financial statements  Make adjusting entries and prepare the four financial statements

4-5 ©2006 Prentice Hall, Inc. Learning Objectives (2 of 2)  Explain closing the books, and why it is done  Compute and explain the debt-to- total-assets ratio  Identify the five essential components of an internal control system

4-6 ©2006 Prentice Hall, Inc. Measuring Income—Recording Revenues and Expenses (1 of 3)  Accrual accounting  Revenue  Earned when company delivers a product or performs a service  Expenses  Incurred when company uses resources or services to help generate revenue  Receipt or payment of cash does not affect revenue or expense recognition

4-7 ©2006 Prentice Hall, Inc. Measuring Income—Recording Revenues and Expenses (2 of 3)  Cash accounting  Revenue earned when cash is received  Expenses incurred when cash is paid  Does not require expenses to be reported in same period related revenue earned

4-8 ©2006 Prentice Hall, Inc. Measuring Income—Recording Revenues and Expenses (3 of 3)  Time period assumption  Business activities evaluated using specific time periods  E.g., months, quarters, years

4-9 ©2006 Prentice Hall, Inc. Timing Differences (1 of 3)  Difference between when item is recognized and actual cash flow  Cash received/paid before revenue/expense recognized  Recognition deferred (postponed)  Cash received/paid after revenue/expense recognized  Recognition accrued

4-10 ©2006 Prentice Hall, Inc. Timing Differences (2 of 3)  Difference between recognition and cash flow (continued)  No timing difference when cash received/paid at same time revenue/expense is recognized  Recognition occurs when cash flow occurs

4-11 ©2006 Prentice Hall, Inc. Timing Differences (3 of 3) Rev/ExpCash Rev/Exp Accural Action Before $$ Deferral $$ Before Action

4-12 ©2006 Prentice Hall, Inc. Adjusting Entries and Preparing Financial Statements  The accounting cycle The accounting cycle  Adjusting entries Adjusting entries  Financial statements Financial statements

4-13 ©2006 Prentice Hall, Inc. The Accounting Cycle (1 of 2)  Steps in the accounting cycle 1. Analyze and record transactions in journal 2. Post journal entries to general ledger 3. Prepare unadjusted trial balance  At end of the accounting period 4. Prepare adjusting journal entries  Post them to general ledger

4-14 ©2006 Prentice Hall, Inc. The Accounting Cycle (2 of 2)  Steps in the accounting cycle (cont’d) 5. Prepare an adjusted trial balance 6. Prepare the financial statements 7. Prepare closing entries  Close temporary accounts  Post temporary accounts to general ledger 8. Prepare post-closing trial balance sheet

4-15 ©2006 Prentice Hall, Inc. Adjusting Entries  Accrued revenues Accrued revenues  Accrued expenses Accrued expenses  Deferred revenues Deferred revenues  Deferred expenses Deferred expenses

4-16 ©2006 Prentice Hall, Inc. Accrued Revenues  Revenue earned but not yet  Received in cash  Previously recorded  Types of accrued revenue adjustments  Interest Revenue Interest Revenue  Receivables with interest Receivables with interest  Other accrued revenue Other accrued revenue

4-17 ©2006 Prentice Hall, Inc. Interest Revenue  Income earned from letting someone else use your money  Time passing is the action related to interest income  Interest = Principal x Rate x Time  Principal - amount loaned  Rate - annual interest rate  Time - portion of year loan outstanding

4-18 ©2006 Prentice Hall, Inc. Receivables with Interest (1 of 3)  On 10/1/08 SpongeCo loaned an employee $4,000 at 5%, for 3months DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-19 ©2006 Prentice Hall, Inc. Receivables with Interest (2 of 3)  Record the adjusting entry on 12/31/08 to accrue 3 months of Interest Revenue DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-20 ©2006 Prentice Hall, Inc. Receivables with Interest (3 of 3)  Record receiving repayment of principal and interest on 1/1/09 DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-21 ©2006 Prentice Hall, Inc. Other Accrued Revenue  Companies need to accrue revenue for income that has been earned from providing goods and/or services  Even though the customer has not yet been billed for the goods/services, or  The customer has received the bill, but the company has not yet received payment

4-22 ©2006 Prentice Hall, Inc. Accrued Expenses  Expenses incurred but not yet  Paid in cash  Previously recorded  Types of accrued expense adjustments  Interest Expense Interest Expense  Other accrued expenses Other accrued expenses

4-23 ©2006 Prentice Hall, Inc. Accrued Interest Expense (1 of 3)  On 5/1/08 SpongeCo borrowed $20,000 from Shark Bank at 6%, for 8 months DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-24 ©2006 Prentice Hall, Inc. Accrued Interest Expense (2 of 3)  Record the adjusting entry on 12/31/08 to accrue 8 months of Interest Expense DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-25 ©2006 Prentice Hall, Inc. Accrued Interest Expense (3 of 3)  Record repayment of principal and interest on 1/1/09 DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-26 ©2006 Prentice Hall, Inc. Other Accrued Expenses (1 of 2)  Some expenses are recorded at the end of the year because the accounting period ends after the expense was incurred and before it has been paid  Salary expense is one of the most common year-end accrued expenses

4-27 ©2006 Prentice Hall, Inc. Other Accrued Expenses (2 of 2)  SpongeCo employees are paid a total of $20,000 per week for a 5-day week. 12/31 is a Thurs. Accrue the salary expense on 12/31. DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-28 ©2006 Prentice Hall, Inc. Deferred Revenues (1 of 3)  Deferred revenues  Dollars have been received in a prior transaction  Adjustment made for revenue earned related to cash previously received  Often called unearned revenue  Is unearned revenue an asset, liability, revenue, or expense?

4-29 ©2006 Prentice Hall, Inc. Deferred Revenues (2 of 3)  On 7/1/08 SpongeCo received $72,000 from customers for 24-month subscriptions to Square Pants Magazine DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-30 ©2006 Prentice Hall, Inc. Deferred Revenues (3 of 3)  Record the adjusting entry on 12/31/08 to recognize 6 months of subscription revenue DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-31 ©2006 Prentice Hall, Inc. Deferred Expenses (1 of 2)  Deferred expenses  Dollars were paid in a prior transaction  Adjustment made for expense incurred in current accounting period related to cash previously received  Often called prepaid expenses  Are prepaid expenses assets, liabilities, revenues, or expenses?

4-32 ©2006 Prentice Hall, Inc. Deferred Expenses (2 of 2)  Common prepaid expenses  Insurance Insurance  Rent  Supplies Supplies  Equipment (depreciation) Equipment (depreciation)

4-33 ©2006 Prentice Hall, Inc. Prepaid Insurance (1 of 2)  On 4/1/08, SpongeCo purchased a 1-year flood insurance policy DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-34 ©2006 Prentice Hall, Inc. Prepaid Insurance (2 of 2)  12/31/08: Recognize the expense for the portion of insurance policy used up during DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-35 ©2006 Prentice Hall, Inc. Supplies (1 of 4)  Purchase of supplies is an asset exchange  Supplies Expense should reflect only supplies used up during the period  Supplies on hand at the end of the period should be recorded as an asset  Are supplies a current or non-current asset?  Why don’t we record Supplies Expense when we purchase them?

4-36 ©2006 Prentice Hall, Inc. Supplies (2 of 4)  Supplies Expense computation Beginning Balance +Purchases -Ending Balance _ Supplies Used (expense)

4-37 ©2006 Prentice Hall, Inc. Supplies (3 of 4)  During May, SpongeCo purchases $800 of supplies. It had a beginning balance of $200. DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-38 ©2006 Prentice Hall, Inc. Supplies (4 of 4)  On May 31, SpongeCo had $225 of supplies on hand. Record the adjusting entry DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-39 ©2006 Prentice Hall, Inc. Depreciation (1 of 5)  Equipment that lasts longer than one year should be treated like any other prepaid expense  We should allocate the cost of the asset to the periods that benefit from the use of the asset  This is called depreciation  Depreciation has NOTHING to do with the FAIR MARKET VALUE of an asset

4-40 ©2006 Prentice Hall, Inc. Depreciation (2 of 5)  A separate account is used to accumulate all depreciation related to an asset  Accumulated Depreciation is a contra-asset because it reduces the value of the asset on the books  Book value is the cost of an asset less Accumulated Depreciation  Why don’t we reduce the asset account directly for depreciation?

4-41 ©2006 Prentice Hall, Inc. Depreciation (3 of 5)  Straight-line depreciation  Allocates an equal amount of the cost of the asset to each accounting period.  Annual depreciation formula Asset cost _ useful life (in years)

4-42 ©2006 Prentice Hall, Inc. Depreciation (4 of 5)  On 1/1/08, SpongeCo purchased a new machine w/ a useful life of 3 yrs for $60,000 DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-43 ©2006 Prentice Hall, Inc. Depreciation (5 of 5)  12/31/08: Record the depreciation expense for 2008 DateTransactionDebitCredit Assets = Liab. + Cont. Cap. + R/E

4-44 ©2006 Prentice Hall, Inc. Preparing Financial Statements  Prior to preparing financial statements, the steps below in the accounting cycle are performed 1. Record transactions 2. Posting transactions to the general ledger 3. Prepare an unadjusted trial balance 4. Prepare and post adjusting entries 5. Prepare an adjusted trial balance

4-45 ©2006 Prentice Hall, Inc. Closing Revenue and Expense Accounts (1 of 5)  After preparing the financial statements, revenues and expenses as well as dividends have to be transferred from those temporary accounts to retained earnings.  After this process, the income stmt. and div. accounts are reset to zero.

4-46 ©2006 Prentice Hall, Inc. Closing Revenue and Expense Accounts (2 of 5) 1. Revenue accounts are reset to zero.  Since they have credit balances, we use a DEBIT to decrease the accounts to zero (a zero balance).  The retained earnings account is CREDITED because revenues increase retained earnings.

4-47 ©2006 Prentice Hall, Inc. Closing Revenue and Expense Accounts (3 of 5) 2. Expense accounts are reset to zero.  Since they have DEBIT balances, we use a CREDIT to decrease the accounts to zero (a zero balance).  The retained earnings account is DEBITED because expenses decrease retained earnings.

4-48 ©2006 Prentice Hall, Inc. Closing Revenue and Expense Accounts (4 of 5) 3. Dividends account is reset to zero.  Since it has a DEBIT balance, we use a CREDIT to decrease the account to zero (a zero balance).  The retained earnings account is DEBITED because dividends decrease retained earnings.  A post-closing trial balance is prepared, showing only permanent accounts.

4-49 ©2006 Prentice Hall, Inc. Closing Revenue and Expense Accounts (5 of 5)  Prepare closing entries for the following accounts. Retained Earnings Dr. Cr. 500 beg bal Service Revenue Dr. Cr. 100 Rent Expense Dr. Cr. 20 Wage Expense Dr. Cr. 40 Dividends Dr. Cr. 10

4-50 ©2006 Prentice Hall, Inc. Financial Statement Analysis  Debt-to-assets ratio  Measure of long-term liquidity  What are two measures of short-term liquidity?  Also called a solvency ratio Total Liabilities Total Assets  Is a higher or lower ratio desirable?

4-51 ©2006 Prentice Hall, Inc. Business Risk, Control, and Ethics  Controls that help a firm make sure all of its transactions are recorded  Pre-numbered documents  Segregation of duties  The person who does the record-keeping for an asset does not have control of the asset  How can the segregation of duties control be circumvented?

Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business 4-52 ©2006 Prentice Hall, Inc.