Intermediate Accounting

Intermediate Accounting
Seventeenth Edition Kieso ● Weygandt ● Warfield Chapter 3 The Accounting Information System This slide deck contains animations. Please disable animations if they cause issues with your device.

Copyright ©2019 John Wiley & Sons, Inc.
Learning Objectives After studying this chapter, you should be able to: Describe the basic accounting information system. Record and summarize basic transactions. Identify and prepare adjusting entries. Prepare financial statements from the adjusted trial balance and prepare closing entries. Prepare financial statements for a merchandising company. Copyright ©2019 John Wiley & Sons, Inc.

Preview of Chapter 3 (1 of 5)
The Accounting Information System Accounting Information System Basic terminology Debits and credits Accounting equation Financial statements and ownership structure The accounting cycle Copyright ©2016 John Wiley & Sons, Inc

Learning Objective 1 Describe the Basic Accounting Information System
Copyright ©2019 John Wiley & Sons, Inc.

Accounting Information System (1 of 4)
Collects and processes transaction data Disseminates financial information to interested parties Copyright ©2019 John Wiley & Sons, Inc.

Helps management answer such questions as: 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? Copyright ©2019 John Wiley & Sons, Inc.

Basic Terminology Event Transaction Account Real Account Nominal Account Ledger Journal Posting Trial Balance Adjusting Entries Financial Statements Closing Entries Copyright ©2019 John Wiley & Sons, Inc.

Debits and Credits An account shows the effect of transactions on a given asset, liability, equity, revenue, or expense account Double-entry accounting system (two-sided effect) Recording done by debiting at least one account and crediting another Debits must equal Credits Copyright ©2019 John Wiley & Sons, Inc.

Debits and Credits (1 of 5)
The Account Record of increases and decreases in a specific asset, liability, stockholders’ equity, revenue, or expense item. Debit = “Left” Credit = “Right” Account Name Debit Credit An account can be illustrated in a T-account form. Copyright ©2019 John Wiley & Sons, Inc.

If the sum of Debit entries are greater than the sum of Credit entries, the account will have a debit balance. Account Name Debit Credit Transaction #1 $10,000 $3,000 Transaction #2 Transaction #3 8,000 Balance $15,000 Copyright ©2019 John Wiley & Sons, Inc.

If the sum of Credit entries are greater than the sum of Debit entries, the account will have a credit balance. Account Name Debit Credit Transaction #1 $10,000 $3,000 Transaction #2 8,000 Transaction #3 Balance $1,000 Copyright ©2019 John Wiley & Sons, Inc.

Normal Balance – Credit Liability Accounts Debit Credit - (decrease) + (increase) Stockholders’ Equity Accounts Revenue Accounts Normal Balance – Debit Asset Accounts Debit Credit + (increase) - (decrease) Expense Accounts Copyright ©2019 John Wiley & Sons, Inc.

The Accounting Equation
Relationship among the assets, liabilities and stockholders’ equity accounts of a business: The equation must be in balance after every transaction. For every Debit there must be a Credit. Copyright ©2019 John Wiley & Sons, Inc.

The Accounting Equation (1 of 4)
Owners invest $40,000 in exchange for common stock. 2. Disburse $600 cash for administrative wages. Copyright ©2019 John Wiley & Sons, Inc.

Financial Statements and Ownership Structure
Stockholders’ equity section of the balance sheet reports common stock and retained earnings Income statement reports revenues and expenses Retained earnings statement reports net income/loss and dividends Because dividends, revenues, and expenses are transferred to retained earnings at the end of the period, a change in any one of these three items affects stockholders’ equity Copyright ©2019 John Wiley & Sons, Inc.

Ownership Structure Effects of Transactions on Equity Accounts
Proprietorships and Partnerships Corporations Transaction Affecting Owners’ or Stockholder’ Equity Impact on Owners’ or Stockholder’ Equity Nominal (Temporary) Accounts Real (Permanent) Accounts Investment by owner(s) Increase Capital Common Stock and related accounts Revenues recognized Expenses incurred Withdrawal by owner(s) Decrease Revenue Expense Drawings Dividends Retained Earnings Copyright ©2019 John Wiley & Sons, Inc.

Identify and Recording Transactions and Other Events
What to Record? The F A S B uses the phrase “transactions and other events and circumstances that affect a business enterprise.” Types of Events: External – between an entity and its environment Internal – event occurring entirely within an entity Copyright ©2019 John Wiley & Sons, Inc.

Learning Objective 2 Record and Summarize Basic Transactions

Journalizing A company records in accounts those transactions and events that affect assets, liabilities, equities, revenues, and expenses. General Ledger – contains all the asset, liability, stockholders’ equity, revenue, and expense accounts. General Journal – a chronological record of transactions. Journal Entries are recorded in the journal. Copyright ©2019 John Wiley & Sons, Inc.

Account Titles and Explanations
Journalizing Illustration: On September 1, stockholders invested $15,000 cash in the corporation in exchange for shares of stock and purchased computer equipment for $7,000 cash. GENERAL JOURNAL J1 Date Account Titles and Explanations Ref. Debit Credit 2020 Sept. 1 Cash 15,000 Common Stock 1 Equipment 7,000 Copyright ©2019 John Wiley & Sons, Inc.

Chart of Accounts (1 of 2) Illustration: On September 1, stockholders invested $15,000 cash in the corporation in exchange for shares of stock and purchased computer equipment for $7,000 cash. Copyright ©2019 John Wiley & Sons, Inc.

Chart of Accounts (2 of 2) Assets Stockholder's Equity 101 Cash 311 Common Stock 112 Accounts Receivable 320 Retained Earnings 113 Allowance for Doubtful Accounts Dividends 126 Supplies 350 Income Summary 130 Prepaid Insurance 157 Equipment Revenues 158 Accumulated Depreciation—Equipment 400 Service Revenue Liabilities Expenses 200 Notes Payable 631 Supplies Expense 201 Accounts Payable 711 Depreciation Expense 209 Unearned Service Revenue 722 Insurance Expense 212 Salaries and Wages Payable 726 Salaries and Wages Expense 230 Interest Payable 729 Rent Expense 732 Utilities Expense 905 Interest Expense 919 Bad Debt Expense Copyright ©2019 John Wiley & Sons, Inc.

Recording Process Illustrated (1 of 11)
The following illustrations show the basic steps in the recording process, using the October transactions of Pioneer Advertising. Pioneer’s accounting period is a month A basic analysis and a debit-credit analysis precede the journalizing and posting of each transaction We use the T-account form in the illustrations instead of the standard account form Copyright ©2019 John Wiley & Sons, Inc.

Trial Balance (1 of 3) List of accounts and their balances at a given time Usually prepared at end of an accounting period Lists accounts in order they appear in ledger, with debit balances listed in left column and credit balances in right column Totals of the two columns must agree Proves mathematical equality of debits and credits after posting Also uncovers errors in journalizing and posting Copyright ©2019 John Wiley & Sons, Inc.

Trial Balance (3 of 3) Does not prove that a company recorded all transactions or that the ledger is correct. Trial balance may balance even when a company: Fails to journalize a transaction. Omits posting a correct journal entry. Posts a journal entry twice. Uses incorrect accounts in journalizing or posting. Makes offsetting errors in recording the amount of a transaction. Copyright ©2019 John Wiley & Sons, Inc.

Learning Objective 3 Identify and Prepare Adjusting Entries

Adjusting Entries Makes it possible to: Report on balance sheet appropriate assets, liabilities, and stockholders’ equity at statement date Report on income statement proper revenues and expenses for the period Are required every time a company prepares financial statements Copyright ©2019 John Wiley & Sons, Inc.

Types of Adjusting Entries
Deferrals: 1. Prepaid expenses: Expenses paid in cash before they are used or consumed. 2. Unearned revenues: Cash received before services are performed. Accruals: 1. Accrued revenues: Revenues for services performed but not yet received in cash or recorded. 2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded. Copyright ©2019 John Wiley & Sons, Inc.

Adjusting Entries for Deferrals

Prepaid Expenses (1 of 7) Prepaid Expenses. Assets paid for and recorded before a company uses them. Cash Payment Before Expense Recorded Prepayments often occur in regard to: Insurance Supplies Advertising Rent Buildings and equipment Copyright ©2019 John Wiley & Sons, Inc.

Prepaid Expenses (2 of 7) Supplies. Pioneer Advertising purchased advertising supplies costing $25,000 on October 5. This account shows a balance of $25,000 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $10,000 of supplies are still on hand. Thus, the cost of supplies used is $15,000 ($25,000 − $10,000). The analysis and adjustment for advertising supplies is summarized in the following illustration. Copyright ©2019 John Wiley & Sons, Inc.

Prepaid Expenses (4 of 7) Insurance. On October 4, Pioneer Advertising paid $6,000 for a one-year fire insurance policy. Coverage began on October 1. Pioneer debited the cost of the premium to Prepaid Insurance at that time. This account still shows a balance of $6,000 in the October 31 trial Insurance Policy balance. The analysis and adjustment for insurance is summarized in the following illustration. Copyright ©2019 John Wiley & Sons, Inc.

Prepaid Expenses (6 of 7) Depreciation. The process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner. Pioneer Advertising estimates depreciation on its office equipment to be $4,800 a year (cost $50,000 less salvage value $2,000 divided by useful life of 10 years), or $400 per month. The analysis and adjustment for depreciation is summarized in the following illustration. Copyright ©2019 John Wiley & Sons, Inc.

Depreciation Statement Presentation. Accumulated Depreciation— Equipment is a contra asset account. A contra asset account offsets an asset account on the balance sheet. Equipment $50,000 Less: Accumulated depreciation—equipment 400 $49,600 The book value of any depreciable asset is the difference between its cost and its related accumulated depreciation. Copyright ©2019 John Wiley & Sons, Inc.

Unearned Revenues (1 of 3)
Receipt of cash before the services are performed is recorded as a liability called unearned revenues. Cash Receipt Before Revenue Recorded Unearned revenues often occur in regard to: Rent Airline tickets Tuition Magazine subscriptions Customer deposits Copyright ©2019 John Wiley & Sons, Inc.

Pioneer Advertising received $12,000 on October 2 from R. Knox for advertising services expected to be completed by December 31. Pioneer credited the payment to Unearned Service Revenue. This liability account shows a balance of $12,000 in the October 31 trial balance. Based on an evaluation of the service Pioneer performed for Knox during October, the company determines that it should recognize $4,000 of revenue in October. The analysis and adjustment for unearned revenue is summarized in the following illustration. Copyright ©2019 John Wiley & Sons, Inc.

Adjusting Entries for Accruals

Accrued Revenues (1 of 3) Revenues recorded for services performed but cash has yet to be received at the statement date. Adjusting entry results in: Revenue Recorded Before Cash Receipt Accrued expenses often occur in regard to: Rent Interest Services performed Copyright ©2019 John Wiley & Sons, Inc.

Accrued Revenues (2 of 3) In October, Pioneer Advertising performed services worth $2,000 that were not billed to clients on or before October 31. Because these services are not billed, they are not recorded. The accrual of unrecorded service revenue increases an asset account, Accounts Receivable. It also increases stockholders’ equity by increasing a revenue account, Service Revenue. The analysis and adjustment for accrued revenue is summarized in the following illustration. Copyright ©2019 John Wiley & Sons, Inc.

Adjusting Entries for Accrued Expenses
Expenses incurred but not yet paid in cash or recorded. Adjusting entry results in: Expense Recorded Before Cash Payment Accrued expenses often occur in regard to: Rent Interest Taxes Salaries Copyright ©2019 John Wiley & Sons, Inc.

Accrued Expenses (1 of 9) Accrued Interest. Pioneer Advertising signed a three- month 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: Copyright ©2019 John Wiley & Sons, Inc.

Accrued Expenses (4 of 9) Accrued Salaries and Wages. At October 31, the salaries and wages for these days represent an accrued expense and a related liability to Pioneer. The employees receive total salaries of $10,000 for a five-day work week, or $2,000 per day. Copyright ©2019 John Wiley & Sons, Inc.

Accrued Expenses (5 of 9) Accrued Salaries and Wages. At October 31, the salaries and wages for these days represent an accrued expense and a related liability to Pioneer. The employees receive total salaries and wages of $10,000 for a five-day work week, or $2,000 per day. Thus, accrued salaries and wages at October 31 are $6,000 ($2,000 × 3). The analysis and adjustment process is summarized in the following illustration. Copyright ©2019 John Wiley & Sons, Inc.

Accrued Expenses (7 of 9) Accrued Salaries and Wages. On November 23, Pioneer will again pay total salaries and wages of $40,000. Prepare the entry to record the payment of salaries on November 23. Salaries and Wages Payable 6,000 Salaries and Wages Expense 34,000 Cash 40,000 Copyright ©2019 John Wiley & Sons, Inc.

Copyright ©2016 John Wiley & Sons, Inc
Accrued Expenses (8 of 9) Bad Debts. Companies estimate uncollectible accounts at the end of each period. This ensures that receivables are reported on the balance sheet at their net realizable value. Assume that, based on past experience, Pioneer Advertising reasonably estimates a bad debt expense for the month of $1,600. The analysis and adjustment process for bad debts is summarized in the following illustration. Copyright ©2016 John Wiley & Sons, Inc

Preparing Financial Statements (1 of 3)
Financial Statements are prepared directly from the Adjusted Trial Balance. Income Statement Retained Earnings Statement Balance Sheet Copyright ©2019 John Wiley & Sons, Inc.

Closing Closing Entries To reduce balance of nominal (temporary) accounts to zero in order to prepare accounts for next period’s transactions To transfer all income statement account balances to the Retained Earnings account in owner’s equity Balance sheet (asset, liability, and equity) accounts are not closed Dividends are closed directly to the Retained Earnings account. Copyright ©2019 John Wiley & Sons, Inc.

Posting Closing Entries

Post-Closing Trial Balance

Accounting Cycle Summarized
Enter the transactions of the period in appropriate journals. Post from the journals to the ledger (or ledgers). Take an unadjusted trial balance (trial balance). Prepare adjusting journal entries and post to the ledger(s). Take a trial balance after adjusting (adjusted trial balance). Prepare the financial statements from the second trial balance. Prepare closing journal entries and post to the ledger(s). Take a post-closing trial balance (optional). Prepare reversing entries (optional) and post to the ledger(s). Copyright ©2019 John Wiley & Sons, Inc.

Statements of a Merchandising Company (1 of 3)

Appendix 3A: Cash-Basis Accounting Versus Accrual-Basis Accounting (1 of 3) Most companies use accrual-basis accounting. They recognize revenue when the performance obligation is satisfied 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 record expenses only when they disperse cash Financial statements are not in conformity with GAAP. Copyright ©2019 John Wiley & Sons, Inc.

Appendix 3A: Cash-Basis Accounting Versus Accrual-Basis Accounting (2 of 3) 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. Copyright ©2019 John Wiley & Sons, Inc.

Conversion from Cash Basis to Accrual Basis (1 of 4)
Illustration: Dr. Diane Windsor, like many small business owners, keeps her accounting records on a cash basis. In the year 2020, 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, 2020, she has accounts receivable, unearned service revenue, accrued liabilities, and prepaid expenses as shown here. Copyright ©2019 John Wiley & Sons, Inc.

Appendix 3A: Cash-Basis Accounting Versus Accrual-Basis Accounting
Theoretical Weaknesses of the Cash Basis 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 a company’s future cash flows. Copyright ©2019 John Wiley & Sons, Inc.

Summary of Reversing Entries All accruals should be reversed. All deferrals for which a company debited or credited the original cash transaction to an expense or revenue account should be reversed. Adjusting entries for depreciation and bad debts are not reversed. Recognize that reversing entries do not have to be used. Therefore, some accountants avoid them entirely. Copyright ©2019 John Wiley & Sons, Inc.

Learning Objective 8 Prepare a 10-Column Worksheet

Appendix 3C: Using a Worksheet: The Accounting Cycle Revisited (1 of 3) A company prepares a worksheet either on columnar paper or within a computer spreadsheet. A company uses the worksheet to adjust account balances and to prepare financial statements. Copyright ©2019 John Wiley & Sons, Inc.

I F R S Insights (1 of 4) Relevant Facts Similarities International companies use the same set of procedures and records to keep track of transaction data. Thus, the material in Chapter 3 dealing with the account, general rules of debit and credit, and steps in the recording process—the journal, ledger, and chart of accounts—is the same under both GAAP and IFRS. Transaction analysis is the same under I F R S and G A A P but, as you will see in later chapters, different standards sometimes impact how transactions are recorded. Both the I A S B and F A S B go beyond the basic definitions provided in this textbook for the key elements of financial statements, that is, assets, liabilities, equity, revenues, and expenses. Copyright ©2019 John Wiley & Sons, Inc.

I F R S Insights (2 of 4) Relevant Facts Similarities A trial balance under IFRS follows the same format as shown in the text. As shown in the text, dollar signs are typically used only in the trial balance and the financial statements. The same practice is followed under IFRS, using the currency of the country in which the reporting company is headquartered. Differences 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 double-entry accounting system is the basis of accounting systems worldwide. Copyright ©2019 John Wiley & Sons, Inc.

I F R S Insights (3 of 4) Relevant Facts Differences Internal controls are a system of checks and balances designed to prevent and detect fraud and errors. While most companies have these systems in place, many have never completely documented them nor had an independent auditor attest to their effectiveness. Both of these actions are required under S O X. Enhanced internal control standards apply only to large public companies listed on U.S. exchanges. Copyright ©2019 John Wiley & Sons, Inc.

I F R S Insights (4 of 4) On the Horizon The basic recording process shown in this text is followed by companies around the globe. It is unlikely to change in the future. The definitional structure of assets, liabilities, equity, revenues, and expenses may change over time as the IASB and FASB evaluate their overall conceptual framework for establishing accounting standards. In addition, high-quality international accounting requires both high-quality accounting standards and high-quality auditing. Similar to the convergence of GAAP and IFRS, there is a movement to improve international auditing standards. The International Auditing and Assurance Standards Board (IAASB) functions as an independent standard-setting body. It works to establish high- quality auditing and assurance and quality-control standards throughout the world. Whether the IAASB adopts internal control provisions similar to those in SOX remains to be seen. Copyright ©2019 John Wiley & Sons, Inc.

All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. Copyright ©2019 John Wiley & Sons, Inc.

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