Download Review of a Company`s Accounting System

CHAPTER
Review of a Company’s
Accounting System
Objectives
After careful study of this chapter, you will be able to:
1.
Understand the components of an accounting system.
2.
Know the major steps in the accounting cycle.
3.
Prepare journal entries in the general journal.
4.
Post to the general ledger and prepare a trial balance.
5.
Prepare adjusting entries.
6.
Prepare financial statements.
7.
Prepare closing entries.
8.
Complete a worksheet (spreadsheet).
9.
Prepare reversing entries.
10.
Use subsidiary ledgers.
11.
Understand special journals.
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Synopsis
The Accounting System
1.
An accounting system is used to record and store a company’s financial and managerial information
from its transactions so that it can retrieve and report the information.
2.
A basic accounting equation provides the framework for the accounting system and is the basis for
recording transactions. This model for a corporation is called the residual equity theory and can be
expressed as follows:
Assets = Liabilities + Stockholders' Equity
Assets are the corporation's economic resources, Liabilities are its obligations owed to creditors, and
Stockholders' equity is the owners' residual interest in the corporate assets. Residual can be defined
as the quantity left over at the end of a process and this is the key to the residual equity theory. The
residual (stockholders’ equity) is what is left over after obligations to the creditors (liabilities) have
been paid from the corporation’s economic resources (assets).
3.
The accounting equation may be expanded to include other components: Contributed capital includes
stockholders' investments in shares of stock sold by the corporation. Retained earnings are the total
amount of net income reinvested in the corporation rather than distributed to stockholders. Dividends
(which are not expenses) are amounts distributed to stockholders as a return on their investment.
Revenues are charges to customers for goods and services. Expenses are the costs incurred by the
corporation in providing goods and services.
4.
In financial accounting, a transaction involves the transfer of something of value between the
company and another party. An event is a happening of consequence to the company. An event may
be (a) internal, such as the use of equipment in operations, or (b) external, such as a decline in price.
5.
Source documents are business documents (such as sales invoices, checks, and freight bills) that
provide initial information for recording transactions or events. A company keeps its source
documents to verify and substantiate the accounting records.
6.
A company uses specific accounts to store the recorded monetary information from transactions and
events. Accounts are organized by number in the company's chart of accounts, which is designed to
arrange the accounts efficiently and to minimize recording errors. Under the double entry system, the
total dollar amount of the debits that a company records for each transaction or event must equal the
total dollar amount of the credits it records.
7.
The balance of an account at a particular time is the difference between the total debits and total
credits recorded in that account. Accounts are classified as permanent (real) accounts or temporary
(nominal) accounts. Permanent accounts are the asset, liability, and stockholders' equity accounts
that carry balances forward from period to period. Temporary accounts are the revenue, expense,
and dividend accounts that are used to determine the change in retained earnings during a given
accounting period. A company does not carry temporary account balances forward from period to
period.
8.
A company sometimes uses a contra (negative) account to emphasize a reduction in a related
account. For example, Accumulated Depreciation is used as a contra account to Equipment.
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Chapter 3 Review of a Company’s Accounting System
9.
Financial statements derived from the accounting equation are generally prepared by a company at
the end of each accounting period. The annual set of financial statements and accompanying
supporting schedules and notes with other data, distributed to external users, is called the company's
annual report. Interim statements may also be prepared for shorter periods (such as three months).
10.
The three major statements of a company are the income statement, balance sheet, and statement
of cash flows. The income statement summarizes the results of the company's income-producing
activities for the accounting period. The balance sheet summarizes the amounts of assets, liabilities,
and stockholders' equity of the company on a particular date. The statement of cash flows
summarizes the cash receipts and cash payments of the company during the accounting period. The
income statement is tied to the balance sheet by a supporting schedule called the statement of
retained earnings, which summarizes the amount of a company's net income retained in the business.
The Accounting Cycle
11.
The accounting cycle is the series of steps completed by a company during each accounting period to
record, store, and report the accounting information contained in its transactions. The major steps
include: (a) recording transactions in a journal, (b) posting the journal entries to the accounts in the
ledger, (c) preparing and posting adjusting entries, (d) preparing the financial statements, and (e)
preparing and posting closing entries for the revenue, expense, and dividend accounts.
12.
A company's transactions and events are initially recorded in a journal. A company could record all
transactions in a single general journal, although many companies also use special journals for
particular types of transactions. A general journal includes columns for dates, account titles, account
numbers, debits, and credits. A written explanation of each recorded transaction is included below
each journal entry.
13.
A general ledger is composed of all of the accounts of a particular company. Physical forms of general
ledgers vary. A general ledger might, for example, be written on paper or stored on a computer disk.
14.
Journal entries are transferred to accounts in the general ledger by a process called posting. In
posting, the debit and credit amounts from each journal entry are transferred to the appropriate
accounts, so that the general ledger accounts contain the same information as the journal. After all
journal entries for a given accounting period have been posted, the balance in each account is
determined, and often a trial balance is prepared. The trial balance lists all of the company's general
ledger accounts and their balances. It is used to verify that the total of the debit balances equals the
total of the credit balances. If the total debits are not equal to the total credits, an error has been
made.
15.
A company using accrual accounting records revenues in the period when they are earned and
realized (or are realizable) and records (matches) expenses in the period when they are incurred,
regardless of when cash is received or paid. Accounts that are not up to date at the end of an
accounting period must be revised by the preparation and posting of adjusting entries. Adjusting
entries may be classified into three categories: (a) apportionment of prepaid expenses and deferred
revenues, (b) recording of accrued expenses and accrued revenues, and (c) recording of estimated
items.
16.
A prepaid expense (prepaid asset) represents goods or services purchased by a company for its
operations, but not fully used as of the end of the period. Examples include prepaid rent, supplies,
and prepaid insurance. The company usually records a prepaid expense initially as an asset.
Consequently, an adjusting entry is necessary to reduce the asset account balance and record as an
expense the portion of the prepaid expense that was used up during the period.
Chapter 3 Review of a Company’s Accounting System
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17.
Deferred (unearned) revenue represents payments received from a customer prior to the delivery of
a product or performance of a service. A company usually records a liability for unearned revenue,
because the company is obligated to provide future goods and services. When such goods and
services have been provided during the accounting period, an adjusting entry is needed to reduce the
liability and to recognize revenue earned.
18.
Accrued expenses are expenses that have been incurred by a company during the accounting period,
but have been neither paid nor recorded. Examples of accrued expenses include accrued salaries,
interest, and income taxes. An adjusting entry is required to recognize the expense and associated
liability, thereby matching the expense with related revenue of the appropriate time period.
19.
Accrued revenues are revenues that have been earned by a company during the accounting period,
but have been neither received nor recorded. An adjusting entry is necessary to recognize such
revenue and the associated receivable.
20.
A company also needs adjusting entries to recognize certain accounting estimates at the end of the
accounting period. Two examples are estimation of depreciation on assets such as buildings and
equipment, and estimation of uncollectible receivables from credit sales. The company systematically
and rationally allocates the cost of depreciable assets as an expense to each period when the assets
are used. It records depreciation in a contra (negative) asset account that is subtracted from the
asset account to determine the book or carrying value of an asset. The company must recognize the
bad debt expense from uncollectible accounts in the period of the sale, and must reduce net
receivables. Because the identities of defaulting customers are not known in the period of sale,
Accounts Receivable is not directly reduced. Instead, the company deducts a contra-asset account,
Allowance for Doubtful Accounts, from Accounts Receivable on the balance sheet.
21.
After a company records and posts adjusting entries to the general ledger, it recalculates account
balances, if necessary. Next, it may prepare an adjusted trial balance. This adjusted trial balance lists
all the accounts and their balances after adjusting entries. It verifies that the total of the general
ledger debit balances still equals the total of the credit balances, after adjustments. The adjusted trial
balance checks the accuracy of the accounting process and helps in the preparation of the financial
statements. The income statement, statement of retained earnings, and balance sheet are prepared
directly from information on the adjusted trial balance.
22.
Closing entries are journal entries made by a company at the end of the period, after preparation of
the financial statements, to (a) reduce the balances in all temporary accounts (revenue, expense, and
dividend accounts) to zero, and (b) update the retained earnings and inventory accounts. Each
temporary income statement account is closed, that is, debited or credited for the amount that will
result in a zero balance in that account. The total of the credits to these accounts is recorded as a
debit to the temporary closing account Income Summary. The total of the debits to these accounts is
recorded as a credit to Income Summary. Closing entries are shown in specific order in the text: (1)
The temporary income statement accounts with credit balances, including all the revenue accounts,
are closed first. (2) The amount of the ending inventory, determined by the physical year-end count,
is recorded. (3) The temporary income statement accounts with debit balances, including all the
expense accounts, are closed. (4) The amount of the beginning inventory is eliminated. A credit
balance in Income Summary at this point will appear on the income statement as net income for the
period, while a debit balance will appear on the income statement as a net loss. (5) Income Summary
is closed to Retained Earnings. (6) The balance in the Dividends Distributed account is closed to
Retained Earnings.
23.
Many companies prepare a post-closing trial balance after all closing entries have been recorded. This
trial balance verifies that the total of the debit balances is equal to the total of the credit balances in
the permanent accounts. It checks once again the accuracy of the accounting process.
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Chapter 3 Review of a Company’s Accounting System
Worksheet
24.
A company often uses a worksheet to aid in preparation of adjusting and closing entries and financial
statements. A worksheet is prepared with pairs of debit/credit columns for the trial balance,
adjustments, income statement, retained earnings statement, and balance sheet. The worksheet
process involves five steps: (a) prepare trial balance; (b) analyze accounts and enter necessary
adjustments; (c) carry over adjusted amounts of each account to the proper column of the
appropriate financial statement; (d) subtotal the income statement debit and credit columns to
determine pretax income, and compute income tax; (e) total the financial statement debit and credit
columns in sequential order, computing net income or loss and determining that the system is in
balance. For formal financial statements, amounts from the worksheet columns for each statement
are simply rearranged into proper order.
Reversing Entries
25.
After closing the temporary accounts of the current period, many companies prepare reversing
entries dated on the first day of the new accounting period. Each reversing entry is the exact reverse
in accounts and amounts of an adjusting entry. Reversing entries are optional. Their purpose is to
simplify the recording of later transactions by eliminating the need to consider previous adjusting
entries. As a general guideline, a reversing entry should be made for any adjusting entry that
establishes a new balance sheet account.
26.
To illustrate the adjusting and reversing entry process, assume that a company accepted, on
December 1, 2011, a note that is payable in three months. The note earns interest of $30 a month,
all of which is payable at the time the note is collected. The company would make the following
adjusting and closing entries on December 31 (the end of its fiscal year):
12/31/11
Interest Receivable
Interest Revenue
To record accrued interest at year-end. (Adjusting entry)
30
12/31/11
Interest Revenue
Income Summary
To close Interest Revenue to Income Summary. (Closing entry)
30
1/1/12
Interest Revenue
Interest Receivable
To reverse the year-end adjusting entry. (Reversing entry)
30
2/28/12
Cash
90
Interest Revenue
90
To record collection of interest on the note. (Receipt of the principal would also be
recorded at this time.)
30
30
30
The Interest Revenue account at 2/28/12 now has a balance of $60 ($90 − $30), which is the
amount of interest earned on the note during 2012. If the reversing entry had not been made, the
entry on February 28 would have been more complicated, as follows, and recording errors would
have been more likely.
2/28/12
Cash
Interest Receivable
Interest Revenue
Chapter 3 Review of a Company’s Accounting System
90
30
60
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Subsidiary Ledgers
27.
Instead of using only a general ledger for accounts, a company may also establish subsidiary ledgers,
which are not part of the double-entry system. A subsidiary ledger is a group of accounts pertaining
to one specific company activity. Subsidiary ledgers are usually established for accounts receivable
and accounts payable. In addition, they are often maintained for property and equipment, selling
expenses, and administrative expenses. A control account is maintained in the general ledger for each
subsidiary ledger. The balance of a control account on any balance sheet date is equal to the total
balance of its associated subsidiary ledger. For example, an accounts receivable subsidiary ledger
contains the individual accounts of the company's charge customers, while the Accounts Receivable
control account in the general ledger has a debit balance equal to that of the total accounts
receivable subsidiary ledger.
Special Journals
28.
In a small business, a general journal may be used for all transactions. As a business becomes larger
and more complex, a more efficient means of recording common, high-volume transactions is
required. Special journals are, therefore, often used to group similar transactions. The major special
journals are the sales journal (used to record all sales of merchandise on account), purchases
journal (used to record all purchases of merchandise on account), cash receipts journal (used to
record all receipts of cash), and cash payments journal (used to record all payments of cash). (Note,
the text does not discuss a voucher system on page 31 during the discussion of special journals, nor
anywhere else I found. A general journal is always necessary to record adjusting, closing, and
reversing entries, and certain transactions that occur infrequently, such as purchases returns and
sales returns on credit.
Computer Software
29.
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Most companies use computers to process their accounting information. Software is the set of
computer programs used to operate a computer. Software packages are available for the subsidiary
ledgers and special journals, as well as other accounting functions such as accounts receivable,
accounts payable, inventory, payroll, and the general ledger. Flexible spreadsheets, or "electronic
worksheets," have also been developed and serve a variety of needs.
Chapter 3 Review of a Company’s Accounting System
True-False Questions
Determine whether each of the following statements is true or false.
1. Posting is the process of initially recording
a financial transaction or event.
Answer: False
2. Unusual and infrequent items are
recorded in the special journals.
Answer: False
3. "Contributed capital" is the term for
company earnings that are reinvested
rather than distributed to stockholders.
Answer: False
4. After closing entries have been completed,
the asset, liability and capital accounts
have a balance of zero.
Answer: False
5. A reversing entry is required whenever an
adjusting entry is made.
Answer: False
A company initially records its transactions
(and events) in a journal. Posting involves
transferring the information from the general
journal to general ledger. Thus, after posting,
the general ledger accounts contain the same
information as in the general journal, just in a
different format.
A special journal is a journal used by a
company to record its transactions with a
similar characteristic, but these items are not
usually unusual or infrequent. The most
common special journals are sales,
purchases, and cash. These journals are used
extensively in the course of business.
Contributed capital includes the amounts of
stockholder investments resulting from the
sale of shares of stock by the corporation.
Retained earnings is the term for company
earnings that are reinvested in the
corporation and not distributed to
stockholders.
Closing entries are made by a company at
the end of the accounting period to reduce
the balance in the temporary accounts
(namely, all the revenue, expense, and
dividend accounts) to zero, and to update the
retained earnings account. Therefore, the
revenue, expense, and dividend accounts
should have a zero balance after closing
entries have been made.
While most companies do prepare reversing
entries to simplify the recording of a later
transaction related to the adjusting entry,
they are not required entries.
Chapter 3 Review of a Company’s Accounting System
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6. Prepaid expenses are expenses that have
been incurred during the accounting
period but have been neither paid nor
recorded.
Answer: False
7. Adjusting entries are used to revise
accounts that are not up to date at the
end of the accounting period.
Answer: True
8. Certain accounting estimates, such as
estimates of depreciation on assets, are
entered at the end of the accounting
period in closing entries.
Answer: False
A prepaid expense (sometimes called a
prepaid asset) is a good or service purchased
by a company for its operations but not fully
used up by the end of the accounting period.
These prepaid items are recorded when
purchased.
Adjusting entries are journal entries made at
the end of the accounting period so that a
company’s financial statements include the
correct amounts for the current period.
Entries made at the end of the accounting
period to record accounting estimates such
as estimates of depreciation expense are
called adjusting entries, not closing entries.
Closing entries transfer the balances in the
temporary accounts to the permanent
accounts through the Income Summary
account.
9. "Permanent" accounts are also called
"nominal" accounts.
Answer: False
10. Depreciation expense is an example of a
contra account.
Answer: False
11. The balance sheet summarizes the
amounts of assets, liabilities, and
stockholders' equity as of a particular
date.
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“Permanent” accounts are also called “real”
accounts. “Temporary” accounts are also
called “nominal” accounts.
Depreciation expense is not a contra account.
It is a temporary account that records the
amount of depreciation that has been
estimated for the accounting period. A
contra (or negative) account is used to show
a reduction in a related account. In this
example, Accumulated depreciation is a
contra account that shows a reduction in the
related asset account.
Answer: True
The balance sheet does summarize the
amounts of assets, liabilities, and
stockholders' equity as of a particular date at
the end of an accounting period. This
summarization is only correct on that date
because new transactions will affect the
amounts listed.
Chapter 3 Review of a Company’s Accounting System
12. A post-closing trial balance verifies that
the total of the debit balances is equal to
the total of the credit balances in the
permanent accounts.
13. In financial accounting, an "event" always
involves the transfer of something
between the company and another party.
14. Sales invoices and freight bills are
examples of “documents of original entry.”
15. Adjusting entries ensure that the financial
statements include the correct amounts
for the current period under cash-basis
accounting.
Answer: True
A post-closing trial balance is prepared after
closing entries are completed. The closing
entries zero out all of a company’s temporary
accounts leaving only balances in the
permanent accounts, which must balance
with debits equal to credits.
Answer: False
An event is a “happening” that affects the
company and may be internal, such as using
equipment in operations, or external, such
as a decline in the value of an asset. A
transaction involves the transfer of
something valuable between the company
and another party.
Answer: False
Sales invoices and freight bills are examples
of “source” documents, not “documents of
original entry.” There are no documents of
original entry in accounting.
Answer: False
Under cash-basis accounting, a company
records revenues and expenses when they
are received or paid and does not need to
use adjusting entries. Under the accrual
basis of accounting, a company records
revenue when earned and expenses when
they are incurred and must adjust accounts
at the end of accounting period so that all its
revenues and expenses are recorded and its
balance sheet accounts have correct ending
balances.
16. When a company uses the double-entry
system, the total dollar amount of debits
recorded for a transaction equals the total
dollar amount of credits.
Answer: True
17. Statements that are prepared for a period
shorter than one year are called
“temporary” financial statements.
Answer: False
In the double-entry system, for each
transaction or event that a company records,
the total dollar amount of the debits entered
in all the related accounts must be equal to
the total dollar amount of the credits.
A company often prepares financial
statements for a shorter time period, such as
three months. These are called “interim” or
“quarterly” statements, not “temporary”
statements.
Chapter 3 Review of a Company’s Accounting System
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Multiple Choice Questions
Select the one best answer for each of the following questions.
1. Accumulated Depreciation is an example
of a:
(a) corporate liability.
(b) temporary account.
(c) contra account.
(d) control account.
Answer: (c) contra account
Accumulated depreciation is a contra
account. This contra (or negative) account is
used to show a reduction in a related account
while not actually affecting the related
account. Accumulated depreciation would be
a contra account to an asset account that is
being used over one than more accounting
period.
Answer (a) is incorrect because accumulated
depreciation is not a liability. A liability is an
obligation owed. Answer (b) is incorrect
because accumulated depreciation is a
permanent account, not temporary. It is not
closed during the closing process but remains
on the books as long as the asset is owned.
answer (d) is incorrect. A control account is
an account that has subsidiary accounts,
such as accounts receivable (control account)
and each individual account receivable
(subsidiary account).
2. The three major financial statements do
not include the:
(a) statement of retained earnings.
(b) income statement.
(c) balance sheet.
(d) statement of cash flows.
Answer: (a) statement of retained earnings
The statement of retained earnings is a
supporting schedule (statement) that is
usually prepared to tie the income statement
to the balance sheet. It is not a required
statement although almost all companies
provide a statement of retained earnings.
Answers (b), (c), and (d) are all major
financial statements.
3. The purposes of closing entries do not
include :
(a) reducing all temporary accounts to
zero.
(b) updating the Retained Earnings
account.
(c) updating the Inventory account.
(d) apportioning prepaid expenses and
unearned revenues to bring accounts
up to date.
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Answer: (d) apportioning prepaid expenses
and unearned revenues to bring accounts up
to date.
Prepaid expenses and unearned revenues are
apportioned to bring the accounts up to date
during the adjusting process, not the closing
process.
Answers (a), (b), and (c) are all valid
purposes of closing entries.
Chapter 3 Review of a Company’s Accounting System
4. Which of the following is not a temporary
account?
(a) Retained Earnings
(b) Warranty Expense
(c) Sales Revenue
(d) Interest Expense
Answer: (a) Retained Earnings
Permanent accounts are found on the
balance sheet (assets, liabilities, or
stockholders’ equity). Retained earnings is a
stockholders’ equity account and is a
permanent account.
Answers (b), (c), and (d) are all temporary
accounts. Temporary accounts consist of the
revenue, expense, and dividend accounts.
These accounts accumulate and summarize
information for net income and dividends for
that period. After the period is over and the
company’s financial statements are prepared,
the balances in these accounts are no longer
needed and they are closed; therefore, the
amounts are temporary, emptying at the end
of each period.
5. Which of the following accounts will be
reduced to zero by a year-end closing
entry?
(a) Accumulated Depreciation
(b) Sales Returns and Allowances
(c) Unearned Revenue
(d) Allowance for Doubtful Accounts
Answer: (b) Sales Returns and Allowances
Sales returns and allowances is a contra
account to Sales, which is a revenue account.
Revenue accounts are temporary accounts
and will be reduced to zero during the closing
process.
Answer (a) Accumulated Depreciation is
incorrect because it is a contra asset account
and is listed on the balance sheet. Answer (c)
Unearned Revenue is incorrect because it is a
liability account and is listed on the balance
sheet. Answer (d) Allowance for Doubtful
Accounts is incorrect because it is a contra
asset account and is listed on the balance
sheet. Balance sheet accounts are permanent
accounts and are not zeroed out during the
closing process.
Chapter 3 Review of a Company’s Accounting System
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6. Stockholders' equity is:
(a) the amount paid by investors for stock
at the time of original issuance.
(b) the residual interest of owners.
(c) corporate earnings reinvested in the
corporation rather than distributed.
(d) amounts received by stockholders as a
return on investment.
Answer: (b) the residual interest of owners
7. Cash received from a customer prior to
delivery of the product is:
(a) an accrued expense.
(b) an accrued revenue.
(c) a prepaid expense.
(d) a deferred revenue.
Answer: (d) a deferred revenue
Stockholders’ equity is the residual interest of
owners in the company. This can be
expressed in the accounting equation as:
Assets - Liabilities = Stockholders’ equity.
Answer (a) The amount paid by investors for
stock at the time of original issuance, is
called Contributed Capital. While it is a part
of stockholders’ equity, it does not represent
all of stockholders’ equity and is not correct.
Answer (c) Corporate earnings reinvested in
the corporation rather than distributed, is
called Retained Earnings, and like answer (a)
it only represents a portion of stockholders’
equity, not all of stockholders’ equity;
therefore it is an incorrect answer. Answer
(d) Amounts received by stockholders as a
return on investment is called Dividends. This
is actually a reduction from stockholders'
equity and is incorrect.
In this question, payment from the customer
is made before delivery of the product.
Because payment from a customer is
revenue, we know the correct answer is
either (b) or (d). We now must determine
whether this represents deferred revenue or
accrued revenue. An accrued revenue is a
revenue that a company has earned during
the accounting period but has neither
received nor recorded. On the other hand,
deferred (or unearned) revenue is payment
received by a company in advance for the
future sale of inventory or performance of
services. Therefore, the correct answer is (d)
and answer (b) is incorrect.
Answers (a) and (c) are incorrect because
they refer to expenses, which represent
payments by the company (prepaid
expenses) or future payments by the
company (accrued expenses).
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Chapter 3 Review of a Company’s Accounting System
8. The three categories of adjusting entries
necessary under accrual accounting do
not include:
(a) apportionment of prepaid expenses
and deferred revenues.
(b) apportionment of recorded revenues
and incurred expenses.
(c) recording of accrued expenses and
accrued revenues.
(d) recording of estimated items.
Answer: (b) apportionment of recorded
revenues and incurred expenses
The apportionment of recorded revenue and
incurred expenses occurs during the period
as these transactions occur. At the end of the
period, these items would have already been
recorded in the accounting records.
Therefore, these items would not require
adjusting entries and answer (b) is the
correct answer.
Answer (a) Apportionment of prepaid
expenses and deferred revenues, refers to
the process of determining which and by how
much the prepaid expenses have been used
and the deferred revenue has been earned.
This answer is incorrect because the
apportionment of these items is
accomplished at the end of each period
through the adjusting process. Answer (c)
Recording of accrued expenses and accrued
revenues, refers to the process of recording
new expenses and earned revenue that have
not been paid or received. This answer is also
incorrect because it too occurs at the end of
each period through the adjusting process.
Like answers (a) and (c), answer (d)
Recording of estimated items, is incorrect
because these estimations are determined
and entered at the end of the accounting
period through the adjusting process.
9. The accounting equation can be rewritten
as:
(a) Assets + Liabilities = Stockholders’
Equity
(b) Assets + Stockholders’ Equity =
Liabilities
(c) Assets - Liabilities = Stockholders’
Equity
(d) Liabilities - Stockholders’ Equity =
Assets
Answer: (c) Assets - Liabilities =
Stockholders’ Equity
The basic accounting equation is: Assets =
Liabilities + Stockholders’ Equity. Through
simple algebra, we can rearrange the
equation by subtracting Liabilities from both
sides of the equation to give us the new
equation: Assets - Liabilities = Stockholders’
Equity, which is answer (c).
Answers (a), (b), and (d) are all incorrect
algebraically.
Chapter 3 Review of a Company’s Accounting System
3-13
10. Which of the following statements
concerning deferred revenue is true?
(a) A liability is usually recorded initially
for deferred revenue.
(b) When accrual accounting is used, no
adjusting entry is necessary for
deferred revenue.
(c) Deferred revenue is usually recorded
initially as an expense.
(d) Deferred revenue is revenue that has
been earned during an accounting
period, but has been neither received
nor recorded.
11. Reversing entries:
(a) are generally made for adjusting
entries, which establish new balance
sheet accounts.
(b) are required under accrual accounting.
(c) are dated on the last day of the
accounting period.
(d) make the recording of later
transactions more complex.
Answer: (a) A liability is usually recorded
initially for deferred revenue.
With a deferred revenue the company initially
records a liability because it has an obligation
to provide the goods or services. When the
company has provided the goods or services
to the customer, it eliminates the liability and
records the revenue in an adjusting entry.
Therefore the correct answer is (a).
Answer (b) When accrual accounting is used,
no adjusting entry is necessary for deferred
revenue, is incorrect because adjusting
entries are required for accrual accounting.
Adjusting entries and the recording of
deferred revenue are not used in cash-basis
accounting. Answer (c) Deferred revenue is
usually recorded initially as an expense, is
incorrect because this does not represent an
expense to be paid by the company. Answer
(d) Deferred revenue is revenue that has
been earned during an accounting period,
but has been neither received nor recorded,
is incorrect because this is the definition of
accrued revenue, not deferred revenue.
Answer: (a) are generally made for
adjusting entries, which establish new
balance sheet accounts.
A reversing entry is the exact reverse
(accounts and amounts) of an adjusting
entry; therefore, answer (a) is correct. The
word "generally" is used in the answer choice
because not all adjusting entries will have
reversing entries.
A company usually makes reversing entries at
the same time as closing entries but dates
them the first day of the next accounting
period, not the last day of the accounting
period; therefore, answer (c) is incorrect. A
reversing entry is optional (therefore answer
(b) is incorrect) and has one purpose: to
simplify the recording of a later transaction
related to the adjusting entry; therefore
answer (d) is incorrect. A reversing entry
enables a company to routinely record the
later transaction, without having to consider
the possible impact of the prior adjusting
entry.
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Chapter 3 Review of a Company’s Accounting System
12. Which of the following statements is true
regarding prepaid expenses?
(a) Prepaid expenses represent payments
received from customers before the
delivery of products or the
performance of services.
(b) Prepaid rent and prepaid insurance are
common examples of prepaid
expenses.
(c) Prepaid expenses are always recorded
initially as expenses.
(d) Prepaid expenses are estimated when
preparing closing entries.
Answer: (b) Prepaid rent and prepaid
insurance are common examples of prepaid
expenses.
13. Usually financial transactions and events
are initially recorded in a:
(a) chart of accounts.
(b) general journal.
(c) trial balance.
(d) general ledger.
Answer: (b) general journal
Prepaid rent and prepaid insurance are
examples of assets that have been created
when expenses are paid in advance;
therefore, answer (b) is the correct answer.
Answer (a) Prepaid expenses represent
payments received from customers before
the delivery of products or the performance
of services, is incorrect because this is the
definition of deferred revenue, not prepaid
expenses. When the company initially
purchases a prepaid good or service, it
records the cost as an asset (such as prepaid
rent or prepaid insurance), not as an
expense; therefore answer (c) is incorrect.
Answer (d) is incorrect because prepaid
expenses are not estimated during closing
entries. The estimation and determination of
the amounts of prepaid expenses made
during the period is accomplished when
adjusting entries are made.
A company initially records its transactions
(and events) in a general journal.
The chart of accounts is a listing of all the
accounts that a company keeps track of in
their accounting system. Entries of
transactions are not made in the chart of
accounts; therefore, answer (a) is incorrect.
A trial balance is a working paper that lists all
of the company’s general ledger accounts
and their account balances. Entries are not
initially made into the trial balance; therefore,
answer (c) is incorrect. A general ledger is
the entire group of accounts for a company.
The general ledger maintains the balances of
all of the accounts. Entries are transferred (or
posted) to the general ledger after they have
been recorded in the general journal;
therefore, answer (d) is incorrect.
Chapter 3 Review of a Company’s Accounting System
3-15
14. Goods or services purchased for use by a
company but not fully used at the end of
the period are called:
(a) accrued expenses.
(b) accrued revenues.
(c) deferred (unearned) revenue.
(d) prepaid expenses.
Answer: (d) prepaid expenses
15. A payment received from a customer
before delivery of goods or performance
of a service is:
(a) accrued expenses.
(b) accrued revenues.
(c) deferred (unearned) revenue.
(d) prepaid expenses.
Answer: (c) deferred (unearned) revenue
16. Expenses that have been incurred during
the period, but that have been neither
paid nor recorded, are:
(a) accrued expenses.
(b) accrued revenues.
(c) deferred (unearned) revenue.
(d) prepaid expenses.
Answer: (a) accrued expenses
3-16
A prepaid expense (sometimes called a
prepaid asset) is a good or service purchased
by a company for its operations but not fully
used up by the end of the accounting period.
An accrued expense is an expense that a
company has incurred during the accounting
period but has neither paid nor recorded;
therefore answer (a) is incorrect. Accrued
revenue is revenue that a company has
earned during the accounting period but has
neither received nor recorded, therefore
answer (b) is incorrect. Deferred (or
unearned) revenue is payment received by a
company in advance for the future sale of
inventory or performance of services;
therefore answer (c) is incorrect.
Deferred (or unearned) revenue is payment
received by a company in advance for the
future sale of inventory or performance of
services.
An accrued expense is an expense that a
company has incurred during the accounting
period but has neither paid nor recorded;
therefore answer (a) is incorrect. Accrued
revenue is revenue that a company has
earned during the accounting period but has
neither received nor recorded, therefore
answer (b) is incorrect. A prepaid expense
(sometimes called a prepaid asset) is a good
or service purchased by a company for its
operations but not fully used up by the end
of the accounting period; therefore answer
(d) is incorrect.
An accrued expense is an expense that a
company has incurred during the accounting
period but has neither paid nor recorded.
Accrued revenue is revenue that a company
has earned during the accounting period but
has neither received nor recorded, therefore
answer (b) is incorrect. Deferred (or
unearned) revenue is payment received by a
company in advance for the future sale of
inventory or performance of services;
therefore, answer (c) is incorrect. A prepaid
expense (sometimes called a prepaid asset)
is a good or service purchased by a company
for its operations but not fully used up by the
end of the accounting period; therefore,
answer (d) is incorrect.
Chapter 3 Review of a Company’s Accounting System
17. Revenues that have been earned during
the period, but that have been neither
received nor recorded, are:
(a) accrued expenses.
(b) accrued revenues.
(c) deferred (unearned) revenue.
(d) prepaid expenses.
Answer: (b) accrued revenues
18. The journal entries made at the end of the
period to reduce temporary accounts to
zero and to update the retained earnings
and inventory accounts are:
(a) adjusting entries.
(b) temporary entries.
(c) closing entries.
(d) transaction entries.
Answer: (c) closing entries
Accrued revenue is revenue that a company
has earned during the accounting period but
has neither received nor recorded.
An accrued expense is an expense that a
company has incurred during the accounting
period but has neither paid nor recorded;
therefore, answer (a) is incorrect. Deferred
(or unearned) revenue is payment received
by a company in advance for the future sale
of inventory or performance of services;
therefore, answer (c) is incorrect. A prepaid
expense (sometimes called a prepaid asset)
is a good or service purchased by a company
for its operations but not fully used up by the
end of the accounting period; therefore,
answer (d) is incorrect.
Closing entries are journal entries that a
company makes at the end of the accounting
period to reduce the balance in each
temporary account to zero, and to update the
retained earnings account.
Adjusting entries are journal entries made at
the end of the accounting period so that a
company’s financial statements include the
correct amounts for the current period. These
entries update account balances and do not
reduce temporary accounts to zero. In fact,
adjusting entries add to temporary accounts
amounts that have been accrued or deferred
during the period; therefore, answer (a) is
incorrect. There is no such thing as a
“temporary entry”; therefore, answer (b) is
incorrect. Transaction entries is not a
commonly used term, however it could be
applied to entries that record transactions.
Because reducing temporary accounts to zero
and updating the retained earnings and
inventory accounts do not involve
transactions, answer (d) is incorrect.
Chapter 3 Review of a Company’s Accounting System
3-17
19. Permanent accounts would not include:
(a) Interest expense.
(b) Salaries payable.
(c) Prepaid rent.
(d) Accumulated depreciation.
Answer: (a) Interest expense
Permanent accounts are the asset, liability,
and stockholders' equity accounts that carry
balances forward from period to period.
Therefore, permanent accounts would not
include any accounts that are temporary.
Temporary accounts are the revenue,
expense, and dividend accounts that are
used to determine the change in retained
earnings during a given accounting period.
Interest expense is a temporary account.
Answers (b) Salaries payable, a liability
account, (c) Prepaid rent, an asset account,
and (d) Accumulated depreciation, a contra
asset account, are all permanent accounts
and are incorrect.
20. Which of the following would NOT be a
correct form for an adjusting entry?
(a) A debit to an expense and a credit to
a liability
(b) A debit to an asset and a credit to a
liability
(c) A debit to a liability and a credit to a
revenue
(d) A debit to a revenue and a credit to a
liability
Answer: (b) A debit to an asset and a
credit to a liability
21. Why are adjusting entries necessary?
(a) Transactions take place over more
than one accounting period.
(b) To make debits equal credits.
(c) To close temporary accounts at yearend.
(d) To correct erroneous balances in
accounts.
Answer: (a) Transactions take place over
more than one accounting period.
An adjusting entry affects both a permanent
(balance sheet) and a temporary (income
statement) account. Therefore, a debit to an
asset (a permanent account) and a credit to
a liability (also a permanent account) would
not be a correct form for an adjusting entry.
Answers (a), (c), and (d) all contain one
permanent account (asset or liability) and
one temporary account (expense or
revenue), therefore they could be correct
adjusting entries and are incorrect answers
for this question.
Under accrual accounting, a company records
revenues in the accounting period in which
they are earned and realized (or realizable)
and records (matches) expenses in the
accounting period in which they are incurred,
regardless of the inflow or outflow of cash.
These transactions flow across accounting
periods and need to be updated at the end of
each period.
Answer (b) is incorrect because while each
adjusting entry (as well as all other entries)
must have debits equal to credits, the
purpose of adjusting entries is to update
account balances. Closing entries are used to
close temporary accounts, not adjusting
entries, therefore answer (c) is incorrect.
Adjusting entries are not used to correct
erroneous balances, just to update the
balances, therefore answer (d) is incorrect.
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Chapter 3 Review of a Company’s Accounting System
22. After closing all the temporary (nominal)
accounts to the Income Summary
account, there is a credit balance in the
Income Summary account. This indicates
that:
(a) adjusting entries were incorrectly
entered.
(b) there was net income for the period.
(c) there was a net loss for the period.
(d) None of the above. There is always a
debit balance in the Income Summary
account.
Answer: (b) there was net income for the
period.
A credit balance in the Income Summary
account indicates that there was net income
for the period. In the closing process, all
expense accounts are closed by crediting the
balance in the expense accounts and debiting
the same amount in the Income Summary
account. Therefore, the debit side of the
Income Summary account is the total
expense for the period. In a similar manner,
all the revenue accounts for the period are
closed by debiting the balance in the revenue
accounts and crediting the same amount in
the Income Summary account. Therefore,
the credit side of the Income Summary
account is the total revenue for the period. If
there is more revenue than expense, there
will be a credit balance remaining in the
Income Summary account and this
represents the Net Income for the period.
Answer (c) is incorrect because there would
have to be a debit balance in the Income
Summary account for a net loss to occur.
Whether the adjusting entries were done
correctly or not cannot be determined from
looking at the balances in the Income
Summary. You would not expect the debit
and credit balances in the Income Summary
account to match unless the company did not
experience a loss or net income (revenue =
expenses) in the period; therefore answer (a)
is incorrect. Answer (d) is incorrect because
the balance in the Income Summary account
can be a debit or credit depending on the
amount of revenue and expenses recorded in
the period.
Chapter 3 Review of a Company’s Accounting System
3-19
23. Which of the following is a temporary
(nominal) account?
(a) Salary Expense
(b) Retained Earnings
(c) Inventory
(d) Unearned Revenue
Answer: (a) Salary Expense
Temporary accounts are the revenue,
expense, and dividend accounts that are
used to determine the change in retained
earnings during a given accounting period.
Salary expense is a temporary account.
Permanent accounts are the asset, liability,
and stockholders' equity accounts that carry
balances forward from period to period.
Therefore, permanent accounts would not
include any accounts that are temporary.
Answers (b) Retained earnings, a
stockholders’ equity account, (c) Inventory,
an asset account, and (d) Unearned revenue,
a liability account, are all permanent accounts
and are incorrect. Note that even though
unearned revenue has the word revenue
included, it is a liability because it represents
an obligation that requires us to provide
assets or services to satisfy.
Problem-Solving Strategies
Strategy: You will encounter numerous strategies that are general in nature in this chapter. Why?
Because this chapter is the foundation to accounting studies and must be mastered for you to
successfully complete this and future accounting courses. Despite this chapter being a review
from the first course in accounting, it should not be taken lightly. You need to fully understand
the concepts and steps associated with the accounting cycle before you move on to more
advanced concepts in future chapters. The better you know the accounting cycle the more
time you can devote to learning future topics.
Strategy: Assets = Liabilities + Stockholders’ Equity is the basic accounting equation. By now you have
seen this equation many times and are tired of looking at it, but in order to be successful in
accounting you have to know and understand what changes in the basic accounting equation
are taking place in each transaction. To understand the effects of transactions you need to
recognize the individual components of the accounting equation. In other words, you need to
understand what an asset, a liability, and stockholders’ equity are. Knowledge of these items
will also be needed when entering transactions in journal entries.
Analysis of Transaction
For each of the following transactions, determine which components of the basic accounting equation are
changing and whether the components increased or decreased.
1.
June 1
Bobcat Computer Repair issued 1,000 shares of common stock in
exchange for $10,000 in cash and furniture worth $12,000 with an
estimated life of five years.
2.
June 1
Bobcat purchased supplies to be used for computer repairs by paying
$500.
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Chapter 3 Review of a Company’s Accounting System
3.
June 2
Bobcat purchased a computer worth $3,600, with an estimated life of
three years, by paying $750 in cash and the balance on account.
4.
June 3
Rented a small office on Guadalupe Street for $500 per month. Bobcat
paid the first six months' rent in advance.
5.
June 5
Bobcat paid $150 for two ads placed in the Record and Star newspapers.
6.
June 15
Bobcat received $950 for computer repairs through the first half of the
month.
7.
June 20
Bobcat received a contract to repair computers for the local high school.
The school paid $8,000 in advance for a six-month service contract that
will run from July 1 to December 31.
8.
June 25
Bobcat paid the balance due on the computer purchased on June 2.
9.
June 28
Bobcat received $500 for computer repairs worth $1,200 performed for a
customer. The balance of the bill was to be paid next month.
10.
June 30
Bobcat received $1,800 for computer repairs performed in the second half
of the month.
Answer:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Note:
Assets
Cash ↑
Furniture ↑
Supplies ↑
Cash ↓
Computer ↑
Cash ↓
Prepaid Rent ↑
Cash ↓
Cash ↓
Cash ↑
Cash ↑
Cash ↓
Cash ↑
Accounts Receivable ↑
Cash ↑
=
Liabilities
+
Shareholders’ Equity
Common Stock ↑
Accounts Payable ↑
Ad Expense ↓ (see note)
Revenue ↑
Unearned Revenue ↑
Accounts Payable ↓
Revenue ↑
Revenue ↑
In transaction 5, the account “Ad Expense” actually goes up, but because an
expense causes a decrease in shareholders’ equity, the column shows a ↓.
Strategy: Many students initially have trouble with determining whether an account is going up or
down. For instance, when we pay a bill for an expense, such as the ad expense in the
problem above, many students have a hard time understanding that ad expense has gone
up. The key is to look at the accounts before and after the transaction. We have had more
expense AFTER this transaction then we had before, therefore ad expense has increased
because of this transaction.
Chapter 3 Review of a Company’s Accounting System
3-21
Journal Entries
Now that we have looked at the transactions and how they affect the basic accounting transaction, we can
move on to the first step in the accounting cycle. This first step in the accounting cycle is entering
transactions in the journal. We will now enter the transactions above into the journal.
Account
Date
June 1
Debit
Cash
Furniture
Common Stock
To record the initial investment in the company
10,000
12,000
June 1
Supplies
Cash
To record purchase of supplies
June 2
Computer
Cash
Accounts Payable
To record purchase of computer
3,600
June 3
Prepaid Rent
Cash
To record payment of six months' rent in advance
3,000
June 5
Ad Expense
Cash
To record payment of advertising expense
150
June 15
Cash
950
Cash
8,000
June 25
Accounts Payable
Cash
To record payment of account payable
2,850
June 28
Cash
Accounts Receivable
Revenue
To record revenue for computer repairs
June 20
June 30
500
Revenue
To record payment received for computer repairs
Unearned Revenue
To record payment for six-month service contract
Cash
500
700
Revenue
To record payment received for computer repairs
1,800
Credit
22,000
500
750
2,850
3,000
150
950
8,000
2,850
1,200
1,800
Strategy: After walking through the transactions above, this is a good time to review the rules of
double-entry accounting. The first thing to remember is that the term “credit” is not good or
bad, nor is the term “debit.” These terms simply mean left (debit) and right (credit); nothing
more, nothing less. The “normal balance” for any account is the side that increases that
account. Therefore, the normal balance for assets, expenses, and dividends is a debit balance,
while the normal balance for liabilities, stockholders’ equity, and revenue accounts is a credit
balance.
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Chapter 3 Review of a Company’s Accounting System
Strategy: Knowing which way accounts move with debits and credits is vital to your success in this
course. However, the good news is that you do not need to memorize each account type and
how they move. If you will just learn how assets are increased or decreased, you can
determine how to increase or decrease the remaining accounts. Remember: To increase an
asset you debit the account. To decrease an asset you credit the account. Liabilities and
stockholders’ equity are on the opposite side of the accounting equation, therefore their
movement is opposite of assets.
Strategy: By analyzing how revenues, expenses, and dividends affect stockholders' equity, you can also
determine how debits and credits affect these accounts. Because revenue increases
stockholders' equity, the same side that increases stockholders’ equity (credit) will increase a
revenue account. Expenses and dividends both decrease stockholders’ equity. In other words,
when expenses or dividends increase, stockholders’ equity will decrease. Because these
operate in opposite directions, they have opposite normal balances. Stockholders’ equity has a
credit normal balance while expenses and dividends have a debit normal balance.
Strategy: As mentioned above, it is imperative that you learn these rules and make them second nature
to improve your understanding of the more difficult concepts that lie ahead. You must also
know what type of account (asset, liability, stockholders’ equity, revenue, expense, or
dividend) each account is in order to properly account for transactions.
Posting
Once the transactions have been entered into the journal, the next step in the accounting cycle is to post
these entries to the ledger. Posting involves transferring the date and debit and credit amounts from the
journal entries in the general journal to the debit and credit sides of the accounts in the general ledger.
Thus, after posting, the general ledger accounts contain the same information as in the general journal,
just in a different format.
An example of posting is given below. This example shows the cash, furniture, and common stock
accounts after the first journal entry has been posted.
Cash
10,000
Furniture
12,000
Common Stock
22,000
To conserve space, a full set of posted accounts after adjusting and closing entries have been entered is
shown in Illustration 3-1 on the next page.
Chapter 3 Review of a Company’s Accounting System
3-23
Illustration 3-1 General Ledger
Cash
6/1
10,000
6/1
500
6/15
6/20
950
8,000
6/2
6/3
750
3,000
6/28
6/30
500
1,800
Bal. 14,000
6/5
6/25
150
2,850
Unearned Revenue
6/20
Common Stock
6/21
Accounts Receivable
6/28
700
500
Bal. 120
6/30
6/30
3,000
Bal. 2,500
6/30
Adj. 380
6/30
Adj. 500
6/5
6/30
6/30
Accumulated Depreciation: Furniture
Adj. 200
150
6/30
Cl. 150
Adj. 200
Adj. 100
6/30
Cl. 300
6/30
Adj. 380
6/30
Cl. 380
Rent Expense
3,600
6/30
Accumulated Depreciation: Computer
6/30
950
1,200
1,800
Supply Expense
Computer
6/2
6/15
6/28
6/30
Depreciation Expense
12,000
6/30
Cl. 3,950
Ad Expense
Furniture
6/1
Cl. 2,620
Revenue
Prepaid Rent
6/3
22,000
Retained Earnings
Supplies
6/1
8,000
Adj. 100
Adj. 500
6/30
Cl. 500
Income Summary
6/30
6/30
1,330
3,670
6/30
3,950
Accounts Payable
6/28
3-24
2,850
6/2
2,850
Chapter 3 Review of a Company’s Accounting System
Trial Balance
After posting is completed, a trial balance will be completed. The trial balance lists the totals for each
account and verifies that debits and credits are equal. While the trial balance helps to determine if
mechanical errors have been made, it cannot detect if there have been errors made in entering the
transaction. For instance, if an entry has been reversed, the debits and credits will still be equal, but the
amounts in the accounts will be in error. The trial balance has not been shown in this example. It will be
similar in appearance to the Adjusted Trial Balance that is shown in Illustration 3-2 below.
Adjusting Entries
Adjusting entries are required in the accrual accounting system to ensure that revenues and expenses are
recorded in the period that they are earned or incurred, which may or may not be the period in which they
are actually paid or received.
Adjusting entries may be classified into three categories. These categories and the types of balance sheet
accounts involved in the adjusting entries are:
1.
Apportionment of prepaid and deferred items
a. Prepaid expenses
b. Deferred revenues
2.
Recording of accrued items
a. Accrued expenses
b. Accrued revenues
3.
Recording estimated items
Strategy: Adjusting entries are one of the most difficult items with which students struggle. The
reason for this difficulty is that adjusting entries are not usually triggered by a transaction,
but instead are required by the simple passage of time. They require that a student analyze
each transaction when it is entered to determine if the original transaction reflects a
completed transaction or one that will require updating in the future.
Strategy: The first of the adjusting entries (prepaid expenses and deferred revenues) is the result of
a payment, either to the company or by the company, for services or products that have
yet to be delivered. If this prepayment extends beyond the end of the accounting period,
the portion of the payment that has been used or earned must be recorded to ensure that
the accounting records reflect this use or earning properly. Examples of these items include
unearned revenue, prepaid insurance, prepaid rent, etc.
Strategy: The second of the adjusting entries (accrued expenses and accrued revenues) is the
opposite of the prepayments discussed above. With accrued expenses and accrued
revenues, the cash flow occurs after the expense or revenue has been recognized. To
ensure that the accounting records are complete we record the items as expense or
revenue in the current period and then receive or pay the cash in a future period. Examples
of accounts affected by this type of adjusting entry are accounts receivable, salaries
payable, etc.
Strategy: The final set of adjusting entries is based on estimates to account for costs or expenses
associated with the use (depreciation) or sales of assets (bad debt expense or warranty
expense). These adjustments are necessary to adequately match expenses with the revenue
generated in the current period.
Chapter 3 Review of a Company’s Accounting System
3-25
1.
Because the furniture will last for an estimated five years, we need to allocate the $12,000 over the
entire period. This would result in depreciating the furniture at a rate of $200 per month. Therefore
the adjusting entry is:
June 30
2.
200
Supplies Expense
Supplies
380
380
Just like we allocated the cost of the furniture, we must do the same with the computer. Because the
computer is estimated to last for three years, we will expense it at a rate of $100 per month.
June 30
4.
200
Because the supplies that were purchased on June 1 will be used as needed, we need to determine
how much expense to charge for the month. Bobcat determines that there is still $120 worth of the
supplies remaining; therefore, $380 worth of supplies were used in the month. The entry to record
the use of the supplies would be:
June 30
3.
Depreciation Expense
Accumulated Depreciation - Furniture
Depreciation Expense
Accumulated Depreciation - Computer
100
100
We recorded the rent we paid in advance as an asset; prepaid rent. After one month we have used
up 1/6 of the asset. The entry to record this expense would be:
June 30
Rent Expense
Prepaid Rent
500
500
5.
The expense for the two ads is completed and does not need an adjusting entry.
6.
The entry to record the revenue we received on June 15 is complete and does not require an
adjusting entry.
7.
The contract that we were paid in advance for on June 20 will require an adjusting entry at the end
of each month we provide services. However, because the contract does not start until July 1, the
first entry will not be required until the end of July.
8.
The last three entries (June 25, June 28, and June 30) do not require adjusting entries.
Strategy:
Notice that each adjusting entry requires an entry to a permanent account (asset, liability,
or stockholders’ equity) and an entry to a temporary account (expense, revenue, or
dividends). This is because the adjusting entries recognize the expenses and revenue
associated with prepaids, deferrals, and accruals and adjusts the balance sheet accounts
affected.
Once adjusting entries have been entered in the journal, the entries are posted to the account balances
in the ledger (see Illustration 3-1).
Adjusted Trial Balance
After adjusting entries have been made, an adjusted trial balance is completed. As before, this trial
balance will check for mechanical errors in the adjusting entries. The adjusted trial balance is shown in
Illustration 3-2.
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Chapter 3 Review of a Company’s Accounting System
Illustration 3-2 Adjusted Trial Balance
Bobcat Computer Repair
Adjusted Trial Balance
June 30, 2011
Account
Debit
Cash
$14,000
Accounts Receivable
700
Supplies
120
Prepaid Rent
Furniture
2,500
12,000
Accumulated Depreciation: Furniture
Computer
Credit
$
200
3,600
Accumulated Depreciation: Computer
100
Unearned Revenue
8,000
Common Stock
22,000
Revenue
3,950
Ad Expense
150
Depreciation Expense
300
Supply Expense
380
Rent Expense
500
_____
$34,250
$34,250
Totals
Financial Statements
Once the adjusted trial balance has been completed, the financial statements can prepared. The income
statement (Illustration 3-3) is prepared first because it provides information (net income) that is used to
complete the statement of retained earnings. The statement of retained earnings (Illustration 3-4) is then
used to complete the balance sheet (Illustration 3-5). Preparation of the financial statements is discussed
further in future chapters. At this point, it is sufficient to know that on the income statement all of the
revenues and expenses are netted together to determine whether the company had net income or a net
loss for the period. This number is then used to determine the change in retained earnings for the period
in the statement of retained earnings. The new retained earnings balance is then used to complete the
balance sheet where the assets, liabilities, and stockholders’ equity are listed.
Closing Entries and the Post-Closing Trial Balance
After the financial statements are prepared, we need to close the temporary accounts. This will leave each
temporary account with a zero balance and ready to begin recording expenses and revenues in the next
accounting period. It is done by closing the temporary accounts to a new temporary account called Income
Summary. The income summary account is then closed to the retained earnings account. Because retained
earnings is a stockholders’ equity account, what we are doing is moving the revenues and expenses (net
income or net loss) to stockholders’ equity.
Chapter 3 Review of a Company’s Accounting System
3-27
Illustration 3-3
Bobcat Computer Repair
Income Statement
For the Month Ended June 30, 2011
Revenues
Debit
Credit
Computer Repair Revenue
$3,950
Expenses
Ad Expense
$150
Depreciation Expense
300
Supply Expense
380
Rent Expense
500
Total Expense
1,330
Net Income
Illustration 3-4
$2,620
Bobcat Computer Repair
Statement of Retained Earnings
For the Month Ended June 30, 2011
Retained Earnings, June 1, 2011
Net Income for the Month
Subtotal
Less Dividends
Retained Earnings, June 30, 2011
Illustration 3-5
Assets
Cash
Accounts Receivable
Supplies
Prepaid Rent
Furniture
Less Accumulated Depreciation
Computer
Less Accumulated Depreciation
Total Assets
3-28
$
0
2,620
2,620
0
$2,620
Bobcat Computer Repair
Balanced Sheet
June 30, 2011
$12,000
(200)
3,600
(100)
$14,000
700
120
2,500
11,800
3,500
$32,620
Liabilities
Unearned Revenue
Total Liabilities
Stockholders' Equity
Common Stock
Retained Earnings
Total Stockholders' Equity
Total Liabilities and
Stockholders' Equity
$8,000
$8,000
$22,000
2,620
$24,620
$32,620
Chapter 3 Review of a Company’s Accounting System
The first step is to close the revenue account to income summary by debiting the total in the revenue
account.
June 30
Revenue
Income Summary
3,950
3,950
After this is completed, all of the expense accounts are closed to income summary by crediting the total in
each expense account.
June 30
Income Summary
Ad Expense
Depreciation Expense
Supply Expense
Rent Expense
1,330
150
300
380
500
Unless expenses equal revenue, there will be a balance in the income summary account. This balance in
the income summary account is closed to retained earnings.
June 30
Income Summary
Retained Earnings
2,620
2,620
Strategy: If there was more revenue than expenses (net income) during the period, the income
summary will have a credit balance and will be closed to retained earnings by debiting the
income summary account. If there were more expenses than revenue (net loss) during the
period, the income summary will have a debit balance and will be closed to retained earnings
by crediting the income summary account.
After these entries have been posted, all of the temporary accounts should have a zero balance. To verify
the mechanical process a post-closing trial balance is completed.
Strategy: The importance of this chapter cannot be overemphasized. You must feel comfortable with
journal entries and the accounting cycle in order to concentrate on the more detailed and
technical aspects of accounting that will be presented in the coming chapters. Time spent now
learning this information will be rewarded in the future.
Test Your Knowledge
3-1. Prepare journal entries for each of the following transactions or indicate if an entry is not required.
(a) On December 1, Mountaineer Company purchased $400 of supplies on credit.
(b) On December 3, Mountaineer paid $3,000 an acre for 3.5 acres to be used as a site for a new
office.
Chapter 3 Review of a Company’s Accounting System
3-29
(c) On December 15, a new manager was hired. The new manager will be paid $2,500 per month
and starts on December 15. Salaries will be paid on the 30th of each month.
(d) On December 21, Mountaineer sells $2,500 of merchandise to a customer. The customer pays
$500 cash and the rest is put on their account.
(e) On December 26, the company receives an electricity bill for $275. The bill will be paid on
January 1.
3-2. For each item given below, prepare a year-end adjusting entry, or indicate that an adjusting entry is
not necessary.
(a) On December 1, the Jay Company paid $2,400 for one year of insurance coverage. The payment
was debited to Prepaid Insurance.
(b) On December 31, $3,000 of employee salaries had accrued. No entry for these salaries has been
recorded.
(c) On December 15, a customer paid $900 in advance for services to be performed in January. The
payment was credited to Deferred Revenue.
(d) Interest of $50 has accrued on a note receivable accepted by the company from a customer.
(e) The company credited all sales on account to Sales. On December 31, $200 of receivables is
estimated to be uncollectible.
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Chapter 3 Review of a Company’s Accounting System
3-3. The Trial Balance (unadjusted) for June 2011 for Dewey Corporation is presented below. Additional
information is also provided in the notes.
Trial Balance
Account
Cash
Accounts Receivable
Supplies
Prepaid Insurance
Equipment
Accumulated Depreciation
Accounts Payable
Common Stock
Revenue
Salaries Expense
Totals
Debit
19,000
3,400
3,200
6,400
120,000
9,000
$161,000
Credit
8,000
26,000
108,000
19,000
_______
$161,000
Notes:
1.
The company adjusts their accounts monthly.
2.
Performed $4,400 worth of services that have not been billed or paid for.
3.
An end-of-the-month inventory of supplies found $750 of supplies.
4.
Dewey’s cost for insurance is $500 per month.
5.
When purchased, the equipment was expected to last for 30 months.
6.
The employees are paid on the first of each month. They earn $150 per day. The total amount of
days worked in June is 21.
Prepare the necessary adjusting entries for Dewey Corporation on June 30, 2011.
Chapter 3 Review of a Company’s Accounting System
3-31
3-4. The Adjusted Trial Balance for October 2011 for Brooks, Inc. is presented below.
Adjusted Trial Balance
Account
Debit
Cash
$13,000
Accounts Receivable
5,500
Supplies
750
Prepaid Rent
6,500
Delivery Van
27,000
Accumulated Depreciation - Van
Accounts Payable
Common Stock
Retained Earnings
Revenue
Depreciation Expense
635
Supply Expense
2,950
Utilities Expense
560
Ad Expense
275
Insurance Expense
175
Salaries Expense
5,000
Totals
$62,345
Credit
13,500
2,750
25,000
12,595
8,500
$62,345
(a) Prepare the necessary closing entries for Brooks, Inc. on October 31, 2011.
(b) How much net income or net loss did Brooks, Inc. have for October 2011? Just by looking at the
journal entries for Income Summary, how can you determine this?
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Chapter 3 Review of a Company’s Accounting System
Test Your Knowledge Answers.
3-1. (a)
(b)
Supplies
Accounts Payable
To record purchase of supplies on account.
Land
Cash
To record purchase of land.
* 3.5 acres @ $3,000 per acre = $10,500
400
10,500*
400
10,500
(c)
No entry is required until either the new manager has been paid, or an adjusting entry at the
end of the accounting period is completed.
(d)
Cash
Accounts receivable
Sales
To record sales of merchandise on account and for cash.
(e)
3-2. (a)
Utilities Expense
Utilities payable
To record receipt of utilities bill.
500
2,000
2,500
275
275
Insurance Expense
200
Prepaid Insurance
200
To record expiration of one month of insurance coverage purchased on December 1.
(b)
Salaries Expense
Salaries Payable
To record salaries earned by employees but not yet paid.
(c)
No adjusting entry necessary.
(d)
Interest Receivable
50
Interest Revenue
To record interest accumulated on the note receivable accepted from a customer.
(e)
Bad Debts Expense
Allowance for Doubtful Accounts
To record estimated uncollectible accounts receivable.
Chapter 3 Review of a Company’s Accounting System
3,000
200
3,000
50
200
3-33
3-3. Adjusting entries for Dewey Corporation:
3.4
Account
Accounts receivable
Revenue
Debit
4,400
Supply Expense
Supplies
$3,200 − $750 = $2,450
2,450
Insurance Expense
Prepaid Insurance
500
Depreciation Expense
Accumulated Depreciation
$120,000 ÷ 30 months = $4,000 per month
4,000
Salary Expense
Salaries Payable
$150 per day × 21 days = $3,150
3,150
Credit
4,400
2,450
500
4,000
3,150
(a) Closing entries Brooks, Inc.
Account
Revenue
Income Summary
Debit
8,500
Income Summary
Depreciation Expense
Supply Expense
Utility Expense
Ad Expense
Insurance Expense
Salary Expense
9,595
Retained Earnings
Income Summary
1,095
Credit
8,500
635
2,950
560
275
175
5,000
1,095
(b) Brooks suffered a net loss of $1,095 for the period. The Income Summary account has a debit
balance after the revenue and expense accounts have been closed. This indicates that the
amount of the expenses accounts ($9,595) exceeded the amount in the revenue account
($8,500).
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Chapter 3 Review of a Company’s Accounting System