ACCOUNTING

Forms of business organizations

• Sole proprietorship
• Partnership
• Corporations
 Sole proprietorship
• A single person owns the business, and is
personally responsible for all of its debts
• Pays no separate income taxes
• Owner is personally liable for all business
obligations.
• Unlimited liability (A type of investment in
which a partner or investor can lose an
unlimited amount of money)
• Difficulty in raising capital
• Makes the transfer of ownership more difficult
 Partnership
• A partnership is similar to a proprietorship, except
there is more than one owner
• No income tax
• Relative to a proprietorship, a greater amount of
capital can often be raised.
• General partnership: all partners have unlimited
liability)
• Limited partnership: limited partners contribute
capital and have liability confined to the amount of
capital.
• Limited partners do not participate in the operation
of the business; that is left to the general partner(s)
 Corporation
• A business form legally separate from its owners.
• It is an artificial entity created by law
• It can own assets and incur liabilities
• Corporation exists legally separate and apart from its
owners.
• Limited liability of owners
• Capital can be raised in the corporation’s name
• Ownership itself is evidenced by shares of stock
• These shares are easily transferable
• The life of a corporation is not by the lives of the
owners
• A possible disadvantage of a corporation is tax
related.
• Corporate profits are subjects to double
taxation
• The company pays tax on the income it earns,
and stockholder is also taxed when he or she
receives income in the form of a cash
dividend.
• A corporation is more difficult to establish
than either a proprietorship or a partnership.
 Accounting
definition
The systematic and comprehensive recording
of financial transactions pertaining to a
business
Or
The systematic recording, reporting,
and analysis of financial transactions of a
business
Accounting Information
A MEANS TO AN END
• The primary purpose of accounting is to provide
information that is useful for decision-making
purposes.
• The final product of accounting information is the
decision that is ultimately enhanced by the use of
accounting information, whether that decision is
made by owners, management, creditors,
government regulatory bodies, labor unions, or
many other groups that have an interest in the
financial performance of an enterprise.
• Accounting is widely used to describe all types of
business activity, it is sometimes referred to as
the language of business.
 Types of accounting

• Financial Accounting
• Management Accounting
• Tax Accounting
 Financial Accounting

Financial accounting is the process of

producing information for external use usually
in the form of financial statements. Financial
Statements reflect an entity's past
performance and current position based on a
set of standards and guidelines known as
GAAP (Generally Accepted Accounting
Principles).
 Management accounting
• Management Accounting produces information primarily for
internal use by the company's management. The information
produced is generally more detailed than that produced for
external use to enable effective organization control and the
fulfillment of the strategic aims and objectives of the entity.
Information may be in the form budgets and forecasts,
enabling an enterprise to plan effectively for its future or may
include an assessment based on its past performance and
results. The form and content of any report produced in the
process is purely upon management's discretion.
• Cost Accounting is a branch of management accounting and
involves the application of various techniques to monitor and
control costs. Its application is more suited to manufacturing
concerns.
 Tax Accounting
• Tax Accounting refers to accounting for the
tax related matters. It is governed by the tax
rules prescribed by the tax laws of a
jurisdiction. Often these rules are different
from the rules that govern the preparation of
financial statements for public use (i.e. GAAP).
 Accounting Systems
• The basic purpose of the accounting system is to
meet the organization’s needs for accounting
information as efficiently as possible.
• In a very small businesses, the accounting system
may consist of little more than a cash register, a
checkbook, and an annual trip to an income tax
preparer.
• In large businesses, an accounting system includes
computers, highly trained personnel, and accounting
reports that affect the daily operations of every
department.
 The types of accounting information that a
company must develop vary with such factors:
1) Size of the organization
2) Whether it is publicly owned
3) Philosophy of management
 External users of accounting
information
• External users of accounting information are individuals and
other enterprises that have a financial interest in the
reporting enterprise, but are not involved in the day-to-day
operations of that enterprise.
• Owners or an investor(he is not an owner-manager)
• Creditors
• Labor unions
• Governmental agencies
• Suppliers
• Customers
• Trade associations
• General public
 Objectives of external financial
reporting
information investors Creditors
Return on investment Periodic dividends (e.g. Periodic interest (e.g.
annually) monthly)
Return of investment Sale of ownership at a Repayment of loan at a
future date future date
 Internal users of accounting
information
• Board of directors
• Chief executive officer
• Chief financial office
• Vice-presidents (information systems, human
resources, treasurer, and so forth)
• Business unit managers
• Plant managers
• Store managers
• Line supervisors
 Standards for the preparation of
accounting information
• Accounting information that is communicated
externally to investors and creditors must be
prepared in accordance with standards that are
understood by both the preparers and users of
that information. We call these standards
Generally Accepted Accounting Principles,
often shortened to GAAP.
• GAAP includes broad principles of measurement and
presentation, as well as detailed rules that are used by
professional accountants in preparing accounting
information and reports.
• Accounting principles are developed by people in
light of what we consider to be the most important
objectives of financial reporting.
• Accounting principles vary somewhat from country
to country.
• 2 organizations are particularly important in
establishing generally accepted accounting
principles- the financial accounting standards
board (FASB) and the securities and exchange
commission (SEC)
 financial accounting standards
board (FASB)
• The Financial Accounting Standards Board (FASB) is a
private, not-for-profit organization whose primary purpose is
to develop generally accepted accounting principles (GAAP)
within the United States in the public's interest. The Securities
and Exchange Commission (SEC) designated the FASB as the
organization responsible for setting accounting standards for
public companies in the U.S.
• The FASB's mission is "to establish and improve standards of
financial accounting and reporting for the guidance and
education of the public, including issuers, auditors, and users
of financial information."
 SECP
• The Securities and Exchange Commission of
Pakistan (SECP) is the financial regulatory
agency in Pakistan whose objective is to
develop a modern and
efficient corporate sector and a capital
market based on sound regulatory principles,
in order to encourage investment and
foster economic growth and prosperity in
Pakistan
Institute of Chartered Accountants
of Pakistan
ICAP is a professional accountancy body in Pakistan. The
institute was established on July 1, 1961 to regulate the
profession of accountancy in Pakistan. It is a statutory
autonomous body established under the Chartered Accountants
Ordinance 1961.
Mission statement:
"To achieve excellence in professional competence, add value
to businesses and economy, safeguard public interest; ensure
ethical practices and good corporate governance while
recognizing the needs of globalization."
International Financial Reporting
Standards (IFRS)
IFRS (IFRS) are designed as a common global
language for business affairs so that company
accounts are understandable and comparable across
international boundaries. They are a consequence of
growing international shareholding and trade and are
particularly important for companies that have
dealings in several countries. They are progressively
replacing the many different national accounting
standards. The rules to be followed by accountants
to maintain books of accounts which is comparable,
understandable, reliable and relevant as per the
users internal or external.
 ACTIVITY FOR STUDENTS
• What is meant by the professional
designations CPA, CMA, and CIA, and how do
these designations add to the integrity of
accounting information?
• What is the primary mission of the Institute Of
Management Accountants?
• Why is it important for accounting information
to have the quality of integrity?
 CHAPTER #2

BASIC FINANCIAL STATEMENTS

 FINANCIAL STATEMENT
• A financial statement is simply a declaration
of what is believed to be true communicated
in terms of a monetary unit, such as the dollar.
• Financial statements are written records that
convey the business activities and the
financial performance of a company.
• Time is an important factor in preparing and
understanding an enterprise’s financial
statements.
 Order in which financial statements
are prepared
1) Income statement
2) Statement of Retained earnings
3) Statement of equity
4) Balance sheet
5) Statement of cash-flows
 3 primary financial statements
• Balance sheet (a financial statement that describes
where the enterprise stands at a specific date)
• Income statement (it is an activity statement that
depicts the revenues and expenses for a designated
period of time)
• Statement of cash flows (it depicts the ways cash has
changed during a designated period-the cash
received from revenues and other transactions as
well as the cash paid for certain expenses and other
acquisitions during the period)
 Balance Sheet
• The purpose of this statement is to
demonstrate where the company stands, in
financial terms, at a specific date.
• The basic features of balance sheet: the name
of the business entity, the name of the
financial statement and the date.
• The body of the balance sheet also consists of
3 distinct sections: assets, liabilities and
owner’s equity.
 ASSETS
• Assets are economic resources that are owned
by a business and are expected to benefit
future operations.
• In most cases, the benefit to future operations
come in the form of future cash flows.
• Buildings, machinery, or an inventory of
merchandise (assets in tangible form);
amounts due from customers, investments in
government bonds, and patent rights (assets
in intangible form)
 liabilities
• Liabilities are debts
• The person or organization to whom the debt is owed is called
a creditor.
• Accounts payable (Money which a
company owes to vendors for products and services
purchased on credit)
• Notes payable (a written promise to repay the amount owed
by a particular date and usually calls for the payment of
interest as well)
• Liabilities are usually listed in the order in which they
expected to be repaid.
 Owner’s Equity
• Represents the owner’s claim to the assets of
the business.
• Owner’s equity is a residual amount.
• Increase in owner’s equity:
1) Investment of cash or other assets by the
owner
2) Earnings from profitable operations of the
business
• Decrease in owner’s equity:
1) Withdrawals of cash or other assets by the
owner
2) Losses from unprofitable operations of the
business
 Equity (in case of corporations)
• Capital stock:
It represents the amount that the stockholders
originally invested in the business in exchange
for shares of the company’s stock.
• Retained Earnings:
It represents the increase in stockholder’s
equity that has accumulated over the years as a
result of profitable operations.
 GAAP
1) The concept of business entity
2) The cost principle
3) The going-concern assumption
4) The objectivity principle
5) The stable-dollar assumption
The Accounting Equation
 Effects of business transactions
Michael McBryan-owns an automotive repair
business:

OVERNIGHT AUTO SERVICE

• Nov 1, 2001:
McBryan officially started Overnight on
November 1, 2001. Michael McBryan started
the business by depositing $80,000 in a
company bank account.
• Nov 3, 2001:
Michael McBryan purchased land for $52,000
paying cash.
• Nov 5, 2001:
Purchased a building for $36,000, paying
$6000 in cash and issuing a note payable for
the remaining $30,000 (90-day non-interest
bearing).
• Nov 17, 2001:
Purchased tools and equipment on account,
$13,800.
• Nov 20, 2001:
Sold some of the tools at a price equal to their
costs, $1,800, collectible within 45 days.
• Nov 25, 2001:
Received $600 in partial payment of the
account receivable from the sale of tools.
• Nov 26, 2001:
Paid $6,800 in partial payment of an account
payable.
• Nov 30, 2001:
Recorded $2,200 of sales revenue received in
cash.
• Nov 30, 2001:
Paid $1,400 of operating expenses in cash-
$200 for utilities and $1,200 for wages.
Income Statement
• It displays revenues and expenses for a period
of time.
• Revenues are increases in the company’s
assets from its profit-directed activities, and
they result in positive cash flows.
• Expenses are decreases in the company’s
assets from its profit-directed activities, and
they result in negative cash flows.
• The resulting net income represents an
addition to the owner’s equity in the
enterprise.
FORMAT
Statement Of Cash Flows
• It shows how cash changed during the period
• Operating activities (cash effects of revenue
and expense transactions)
• Investing activities (cash effects of purchasing
and selling assets OR cash effects of
purchasing and selling long-term assets )
• Financing activities (cash effects of the owner
investing in the company and the creditors
loaning money to the company and the
repayment of either or both)
Relationship Among Financial
Statements
 ARTICULATION
• The balance sheet, income statement and
statement of cash flows are derived from the
same underlying financial information, they
are said to ‘articulate’ or relate closely to each
other.
• The relationship among the financial
statements is called articulation.
 Problem 2.3
(Activity For Students)
Nova Communications was organized on December 1 of the current year and had the
following account balances at December 31.
Cash = $37,000
Land = $95,000
Building = $125,000
Office equipment = $51,250
Notes payable =$80,000
Accounts payable =$28,250
Owner’s capital =$200,000
Early in January, the following transactions were carried out by Nova Communications:
1) The owner deposited $25,000 of personal funds into the business’s bank account.
2) Purchased land and a small office building for a total price of $90,000, of which $35,000
was the value of the land and $55,000 was the value of the building. Paid $22,500 in cash
and signed a note payable for the remaining $67,500.
3) Bought several computer systems on credit for $8,500 (30-day open account)
4) Obtained a loan from Capital Bank in the amount of $10,000. Signed a note payable.
5) Paid the $28,250 account payable owed as of December 31.

INSTRUCTIONS:
List the december 31 balances of assets, liabilities, and owner’s equity in tabular form and
record the effects of each transaction.
 Problem 2.5
HERE COME THE CLOWNS! Is the name of a traveling circus owned by Red Costello. The ledger
accounts of the business at June 30, 2001 are listed here in alphabetical order:
• Accounts payable= $26,100
• Accounts receivable= $7,450
• Animals= $189,060
• Cages= $24,630
• Cash=?
• Costumes=$31,500
• Notes payable= $180,000
• Notes receivable=$9,500
• Props and equipment=$89,580
• Capital= $337,230
• Salaries payable= $9,750
• Tents= 63,000
• Trucks and wagons= $105,840

Instructions:
• Prepare a balance sheet on June 30, 2001.
• Assume that late in the evening of June 30, after your balance sheet had been prepared, a fire destroyed one
of the tents, which had costs $14,300. the tent was not insured. Explain what changes would be required in
your June 30 balance sheet to reflect the loss of this asset.
McBryan officially started Overnight on November 1, 2001. Michael McBryan
started the business by depositing $80,000 in a company bank account.
Nov 3, 2001: Michael McBryan purchased land for $52,000 paying cash
Nov 5, 2001: Purchased a building for $36,000, paying $6000 in cash and issuing a
note payable for the remaining $30,000 (90-day non-interest bearing).
Nov 17, 2001: Purchased tools and equipment on account, $13,800.
Nov 20, 2001: Sold some of the tools at a price equal to their costs, $1,800,
collectible within 45 days.
Nov 25, 2001: Received $600 in partial payment of the account receivable from the
sale of tools
Nov 26, 2001: Paid $6,800 in partial payment of an account payable.
Nov 30, 2001: Recorded $2,200 of sales revenue received in cash.
Nov 30, 2001: Paid $1,400 of operating expenses in cash-$200 for utilities and
$1,200 for wages.

Prepare a balance sheet at November 30, 2001. Prepare an income statement and a
statement of cash flows for the month ended November 30, 2001.
PROBLEM 2.8
(Activity For Students)
The balance sheet items of THE ORIGINAL MALT SHOP were as follows at the close of the
business on September 30, 2001.

Cash = $7,400
Land = $55,000
Building = $45,500
Notes payable =?
Accounts payable =$8,500
Accounts receivable =$1,250
Furniture and fixtures= $20,000
Martin, capital= $54,090
Supplies= $3,440

The transactions occurred during the first week of October were:

October 3: Martin invested additional $30,000 cash in the business. The accounts payable
were paid in full.
October 6: More furniture was purchased on account at a cost of $18,000, to be paid within
30 days. Supplies were purchased for $1000 cash from a restaurant supply center that was
going out of business. These supplies would have cost $1875 if purchased under normal
condition.
October 1-6: Revenues of $5,500 were earned and paid in cash. Expenses required to earn
the revenues of $4000 were incurred and paid in cash.

REQUIREMENT:
Prepare a balance sheet at September 30, 2001
Prepare a balance sheet at October 6, 2001.
Also prepare an income statement and a statement of cash flows for the period October 1-6,
2001. In your statement of cash flows, treat the purchases of supplies and the payment of
accounts payable as operating activities.
 CHAPTER #3

THE ACCOUNTING CYCLE

• The sequence of accounting procedures used
to record, classify, and summarize accounting
information is often termed the accounting
cycle.
• The accounting cycle begins with the initial
recording of business transactions and
concludes with the preparation of formal
financial statements.
 THE ACCOUNTING CYCLE
1) Journal
2) Ledger
3) Trial balance
4) Adjusting entries
5) Adjusted trial balance
6) Financial statements
7) Closing entries
8) After closing trial balance
 Journal
• Journal is a chronological record of business
transactions.
• The simplest type of journal is called a general
journal.
 RULE
• Increase in asset accounts are recorded by
debits and increase in liability and owner’s
equity account are recorded by credits.
• Revenue is recorded by a credit (as revenue
increases owner’s equity) and expenses are
recorded by a debit (as expenses decreases
owner’s equity)
 Double-Entry Accounting
• Any change in the left side of the equation
must be accompanied by an equal change in
the right-hand side.
• The phrase ‘double-entry’ refers to the need
for both debit entries and credit entries, equal
in dollar amount, to record every transaction.
 Journal entries for November transactions of
Overnight Auto Service
EXAMPLE
• Nov 1, 2001: Michael McBryan started the
business by depositing $80,000 in a company
bank account.
• Nov 3, 2001: Michael McBryan purchased
land for $52,000 paying cash.
• Nov 5, 2001:
Purchased a building for $36,000, paying
$6000 in cash and issuing a note payable for
the remaining $30,000.
 Journal Entries For November Transactions Of Overnight Auto Service
FOR STUDENTS

• Nov 17, 2001:

Purchased tools and equipment on account, $13,800.
• Nov 20, 2001:
Sold some of the tools at a price equal to their costs, $1,800,
collectible within 45 days.
• Nov 25, 2001:
Received $600 in partial payment of the account receivable
from the sale of tools.
• Nov 26, 2001:
Paid $6,800 in partial payment of an account payable.
 Exercise 3.2
ACTIVITY FOR STUDENTS
Enter the following selected transactions in the two-column journal for
Fraser Appliance Center. Include a brief explanation of the transaction as
part of each journal entry.

• Oct.1: The owner invested an additional $80,000 cash in the business.

• Oct. 5: Purchased an adjacent vacant lot for use as parking space. The price
was $102,000 of which $30,600 was paid in cash; a note payable was
issued for the balance.
• Oct.15: Issued a check for $976 in full payment of an account payable to
Hampton Supply Co.
• Oct.18: Borrowed $30,000 cash from the bank by signing a 90-day note
payable
• Oct.23: Collected an account receivable of $2,900 from a customer,
Jocelyn Scott.
• Oct. 30: Acquired office equipment from Tower Company for $6200.
Made a cash down payment of $1500; balance to be paid within 30 days.
 Ledger
• Ledger is simply an account. It is a record used
to keep track of the increases and decreases in
the financial statement items.
• An account has 3 elements: (1) a title (2) a left
side, which is called the debt side and (3) a
right side, which is called the credit side.
• It is called a “T” account.
• Transactions are recorded first in the journal.
Ledger accounts are updated later, through a
process called posting.
 EXPENSES
• Expenses are the costs of the goods and
services used up in the process of earning
revenue. Expenses are often called the ‘costs
of doing business’, that is, the costs of various
activities necessary to carry on a business.
• Examples include the cost of employees’
salaries, advertising, rent, utilities, and gradual
wearing-out (depreciation) of such assets as
buildings, automobiles, and office equipment.
 GAAP
• Time-period principle
• The realization principle (The realization
principle indicates that revenue should be
recognized at the time goods are sold or
services are rendered)
• The matching principle (Expenses are incurred
for the purpose of producing revenue. The
concept of offsetting expenses against
revenue on the basis of ‘cause and effect’ is
called the matching principle)
 Expenditures Benefiting More Than One Accounting Period

• Many expenditures made by a business benefit two or more accounting

periods
• Fire insurance policies, for example, usually cover a period of 12 months.
• If a company prepares monthly income statements, a portion of the cost of
such a policy should be allocated to insurance expense each month that the
policy is in force.
• Not all the transactions can be so precisely divided by accounting periods.
The purchase of a building, furniture and fixtures, machinery, a typewriter,
or an automobile provides benefits to the business over all the years in
which an asset is used.
• The accountant must estimate what portion of the cost of the building and
other long-lived assets is applicable to the current year. Since the
allocations of these costs are estimates rather than precise measurements, it
follows that income statements should be regarded as useful
approximations of net income rather than as absolutely correct
measurements.
 The Accrual And Cash Basis Of
Accounting
The cash method accounts for revenue only
when the money is received and for expenses
only when the money is paid out. On the other
hand, the accrual method accounts for revenue
when it is earned and expenses goods and
services when they are incurred. The revenue
is recorded even if cash has not been received
or if expenses have been incurred but no cash
has been paid. Accrual accounting is the most
common method used by businesses.
 Investments And Withdrawals By The Owner

• Investments of assets by the owner are recorded by

debiting the assets accounts and crediting the
owner’s capital account.
• Withdrawals reduce the assets and owner’s equity of
the business, but they are not expenses. Expenses
are incurred for the purpose of generating revenue,
and withdrawals by the owner do not serve this
purpose.
• Withdrawals could be recorded by debiting the
owner’s capital account.
TRANSACTIONS
• DEC 1: Paid Daily Tribune $360 cash for newspaper advertising to be run
during December.
• DEC 2: Purchased radio advertising from KRAM to be aired in December.
The cost was $470, payable within 30 days.
• DEC 4: Purchased various shop supplies at a cost of $1400 due in 30 days.
These supplies are expected to meet Overnight’s needs for three or four
,months.
• DEC 15: Collected $4,980 cash for repairs made to vehicles of Airport
Shuttle Service.
• DEC 23: The owner withdrew $3,100 cash from the company’s bank
account for his personal use.
• DEC 29: The owner found that he did not need all of the cash he had
withdrawn on December 23, so he re-deposited $1000 in Overnight’s bank
account.
• DEC 31: Billed Harbor Company $5400 for maintenance and repair
services rendered during December. The agreement with Harbor Company
calls for payment to be received by January 10.
• DEC 31: Paid all employees wages for December, $4,900.
 Problem 3.4
Garwood Marine is a boat repair yard. During august its transactions included the
following:
August 1: Paid rent for the month of august $4,400.
August 3: At request of Kiwi Insurance, Inc., made repairs on boat of Michael Fay.
Sent bill for $5620 for services rendered to Kiwi Insurance, Inc (credit repair
service revenue)
August 9: Made repairs to boat of Dennis Conner and collected in full the charge
of $2830.
August 14: Placed advertisement in Yachting World to be published in issue of
August 20, at cost of $165, payment to be made within 30 days.
August 25: Received a check for $5620 from Kiwi Insurance, Inc representing
collection of the receivable of august 3.
August 26: Made repairs on the vessel Independent totaling $1890. Collected $400
cash; balance due within 30 days.
August 30: Sent check to Yachting World in payment of the liability incurred on
August 14.
August 31: Barbara Garwood, the owner, withdrew $7600 for personal use.
Instructions:
Prepare a journal entry (including explanation) for each of the above transactions.
 ACTIVITY FOR STUDENTS
• Problem 3.1
• Problem 3.3
 The trial balance
• A trial balance proves the equality of debits and credits.
• The sum of all the debits in the ledger must be equal to the sum of all the
credits.
• A trial balance is a two-column schedule listing the names and the
balances of all the accounts in the order in which they appear in the
ledger; the debit balances are listed in the left-hand column and the credit
balances in the right-hand column.
• The trial balance contains income statement accounts as well as balance
sheet accounts.
 PROBLEM 3.5
• In June 2001, Pat Campbell organized a corporation to provide crop dusting services.
Transactions during the month of June were as follows:
June 1: Campbell deposited $60,000 cash in a bank account in the name of the business.
June 3: Purchased a crop-dusting aircraft from Utility Aircraft for $220,000. Made a $40,000
cash down payment and issued a note payable for $180,000.
June 4: Paid Woodrow Airport $2500 to rent office and hanger space for the month.
June 15: Billed customers $8320 for crop-dusting services rendered during the first half of
june.
June 15: Paid $5880 salaries to employees for services rendered during the first half of June.
June 18: Paid Hannigan’s Hanger $1890 for maintenance and repair services.
June 25: Collected $4910 of the amounts billed to customers on June 15.
June 30: Billed customers $16450 for crop-dusting services rendered during the second half
of the month
June 30: Paid $6000 in salaries to employees for services rendered during the second half of
June.
June 30: Received a fuel bill from Henry’s Feed And Fuel for $2510 of aircraft fuel purchased
during June. This amount is due by July 10.
June 30: Campbell withdrew $2000 cash from the business for personal use.
Instructions:
a) Prepare a journal entries.
b) Post to ledger accounts
c) prepare a trial balance at june 30, 2001.
Adjusting Entries
• Many transactions affect the revenue or expenses of two or more accounting
periods
• For example, a business may purchase equipment that will last for many years, an
insurance policy that covers 12 months etc.
• Initially, the costs of such items are recorded as assets, because they will benefit
the business in future accounting periods. Overtime, these assets are used up, and
their costs become expenses of the periods in which the goods or services are
used.
• The businesses allocate the costs of such assets to expense by making adjusting
entries at the end of each accounting period.
• The purpose of these entries is to assign to each accounting period the
appropriate amounts of revenue and expense.
• These entries ‘adjust’ the balances of various ledger accounts-hence the name,
adjusting entries.
 EXAMPLE
• DEC 4: Purchased various shop supplies at a cost of $1400 due in 30 days.
These supplies are expected to meet Overnight’s needs for three or four
,months.
• Journal Entry:

• As these supplies are used, this asset gradually becomes an expense.

Assume that during December, $400 worth of supplies was used in
business operations.
• The adjusting entry at December 31 will be:
• Adjusting Entry:

• The $400 used during December should be recognized as expense in that

month; the $1000 in supplies still on hand should appear in the December
31 balance sheet as an asset.
The Concept Of Depreciation
• Depreciable assets are physical objects that retain
their size and shape but that eventually wear out or
become obsolete.
• Their economic usefulness diminishes over time.
• Examples of depreciable assets include buildings and
all types of equipment, fixtures, furnishings-and even
railroad tracks.
• Land, however, is not viewed as a depreciable asset,
as it has an unlimited useful life.
• Each period, a portion of a depreciable asset’s
usefulness expires. Therefore, a corresponding
portion of its cost is recognized as depreiation
expense.
• In accounting, the term depreciation means the
systematic allocation of the cost of a depreciable asset
over the asset’s useful life.
• Depreciation expense occurs continuously over the
life of the asset, but there are no daily depreciation
transactions.
• In effect, depreciation expense is paid in advance
when the asset is originally purchased.
• Therefore, adjusting entries are needed at the each
accounting period to transfer an appropriate amount
of the asset’s cost to depreciation expense.
• The appropriate amount of depreciation
expense is only an estimate.
• Straight-line method of depreciation is the
most widely used means of estimating periodic
depreciation expense.
• Formula
• Under the straight-line approach, an equal
portion of the asset’s cost is allocated to
depreciation expense in every period of the
asset’s estimated useful life.
 EXAMPLE
Adjusting entry to record depreciation of the
building for the month of December
• Cost of building= $36,000
• Useful life= 20 years
• Accumulated depreciation is a "contra-asset"
account, meaning it is an asset account with a
credit balance, and it cuts against the values
recorded in the associated asset accounts.
• Accumulated Depreciation is a contra-asset
account. As long as the original asset is listed
on the balance sheet, its corresponding
accumulated depreciation should be too.
 BASIC IDEA
• Adjusting entries are needed at the each
accounting period to transfer an appropriate
amount of the asset’s cost to depreciation
expense.
Exercise 3.11
Adjusted Trial Balance
• An adjusted trial balance is prepared to prove that the
ledger is still in balance
• It differs from the trial balance it includes several new
account titles, and the balances in some existing
accounts have been adjusted.
• Financial statements are prepared directly from the
adjusted trial balance.
• Every account in the adjusted trial balance contains
its end-of-the-period balance, with the exception of
the owner’s capital account.
• The balance in the owner’s capital account in the
adjusted trial balance is not completely up to date.
Preparing Financial Statements
 Order in which financial statements
are prepared
1) Income statement
2) Statement of Retained earnings
3) Statement of equity
4) Balance sheet
5) Statement of cash-flows
• Income statement summarize the operating results of a business by
matching the revenue earned during a given time period with the expenses
incurred in obtaining that revenue.
• The statement of owner’s equity summarizes the increases and decreases in
the amount of owner’s equity during the accounting period. Increases result
from earning net income and from additional investment by the owner;
decreases result from net losses and from withdrawals of assets by the
owner.
• Balance sheet: Account Form (with assets on the left and liabilities and
owner’s equity on the right) and Report Form
• Statement of cash flows:
Cash flows from operating activities: revenue and expense transactions
Cash flows from investing activities: purchase and sale of long-term assets
Cash flows from operating activities: cash effects of owners having
invested in the company, creditors having loaned money to the company,
any repayments made to the creditors, or any withdrawals from the
company by the owners.
 Problem 3.11
The operations of Hempstead Realty consist of obtaining listings of houses
being offered. The company earns revenue in the form of commissions. The
building and office equipment used in the building were acquired on
January 1st of the current year and were immediately placed in used. Useful
life of the building was estimated to be 30 years and that of the office
equipment 5 years. The company closes its accounts monthly; on March 31
of the current year, the trial balance is as follows:
 Hempstead Realty
Trial balance
March 31, 2001
Cash 9750
Accounts receivable 7500
Office supplies 850
Land 30000
Building 90000
Accumulated depreciation: building 500
Office equipment 21000
Accumulated depreciation: O/E 700
Accounts payable 14750
Valentino, capital 136650
Valentino, drawing 4500
Commissions earned 20000
Advertising expense 900
Automobile rental expense 500
Salaries expenses 7000
Telephone expense 600

Prepare the following as of March 31, 2001.

 Adjusting entries for depreciation during March of building and of office equipment
 Adjusting entry to recognize as expense the cost of office supplies used in March. At the end of
March, the supplies on hand are estimated to have a cost of $500.
 Adjusted trial balance
 Income statement and a statement of owner’s equity for the month of March, and a balance sheet
at March 31 in report form. Assume no additional investment by owner during March.
 Problem 3.8 (Class Practice)
• Requirement ‘a’ and ‘b’
 Closing The Temporary Equity Accounts
• Separate ledger accounts are maintained to measure each type of revenue
and expense, and owner’s drawings.
• The revenue, expense, and drawing accounts are called temporary
accounts, or nominal accounts, because they accumulate the transactions of
only one accounting period.
• At the end of this accounting period, the changes in owner’s equity
accumulated in these temporary accounts are transferred into the owner’s
capital account.
• The owner’s capital account and other balance sheet accounts are called
permanent or real accounts because these balances continue to exist beyond
the current accounting period.
• The process of transferring the balances of the temporary accounts into the
owner’s capital account is called closing the accounts.
• The journal entries made for the purpose of closing the temporary accounts
are called closing entries.
• Revenue and expense accounts are closed at the end of each accounting
period by transferring their balances to a summary account called income
summary.
• If the revenue (credit balances) exceeds the expenses (debit balances), the
income summary account will have a credit balance representing net
income. Conversely, if expenses exceeds revenue, the income summary
will have a debit balance representing net loss. This is consistent with the
rule that increase in owner’s equity are recorded by credits and decreases
are recorded by debits.
 ACCOUNTS
• Repair service revenue = $10,380

• Advertising expense=$830
• Wages expense=$4,900
• Supplies expense=$400
• Depreciation expense: building=$150
• Depreciation expense: tools and equipment=$200

• Michael McBryan,Drawing=$3,100

Prepare the LEDGER accounts, followed by closing these

accounts
• Closing Entries For Revenue Accounts

• Closing Entries For Expense Accounts

• Closing The Income Summary Account

• Closing The Owner’s Drawing Account

 Hempstead Realty
Adjusted Trial balance
March 31, 2001
Cash 9750
Accounts receivable 7500
Office supplies 500
Land 30000
Building 90000
Accumulated depreciation: building 750
Office equipment 21000
Accumulated depreciation: O/E 1050
Accounts payable 14750
Valentino, capital 136650
Valentino, drawing 4500
Commissions earned 20000
Advertising expense 900
Automobile rental expense 500
Salaries expenses 7000
Telephone expense 600
Depreciation expense: building 250
Depreciation expense: office 350
equipment
Office supplies expense 350
173200 173200
• Closing entries for revenue accounts

• Closing entries for expense accounts

 Closing The Income Summary Account:
Debit column of income summary= $9,950 (expense)
Credit column of income summary= $20,000 (revenue)

The account has a credit balance of $ 10,050- the net income. The net
income earned by the company causes the owner’s equity to increase. The
credit balance of the income summary account is therefore transferred to
the owner’s equity account by the following closing entry.
CLOSING ENTRY:

After this closing entry has been posted, the income summary
account has a zero balance.
 Closing The Owner’s Drawing Account:
• Withdrawals reduce the assets and owner’s equity of the business, but they
are not expenses. Expenses are incurred for the purpose of generating
revenue, and withdrawals by the owner do not serve this purpose.
• The owner’s drawing account is closed not into the income summary
account but directly to the owner’s capital account.
• Closing the owner’s drawing account into the owner’s capital account-the
balance of the owner’s capital account in the ledger be the same as the
amount of owner’s equity appearing in the balance sheet.
• In problem 3.11 the owner’s equity amount reported in march 31,2001
balance sheet= $142,200

• CALCULATION:
 AFTER-CLOSING TRIAL BALANCE

• After the revenue and expense accounts have

been closed, it is desirable to prepare an after-
closing trial balance.
• It consists of balance sheet accounts only.
• After-closing trial balance is prepared from the
ledger.
Preparing Financial Statements
(Class Practice)
 The balance sheet items of THE ORIGINAL MALT SHOP were as follows at the close of the business on
September 30, 2001.
Cash = $7,400
Land = $55,000
Building = $45,500
Notes payable = ?
Accounts payable =$8,500
Accounts receivable =$1,250
Furniture and fixtures= $20,000
Martin, capital= $54,090
Supplies= $3,440
October 3: Martin invested an additional $30,000 cash in the business. The accounts payable were paid in
full.
October 6: More furniture was purchased on account at a cost of $18,000, to be paid within 30 days.
Supplies were purchased for $1000 cash from a restaurant supply center that was going out of business.
These supplies would have cost $1875 if purchased under normal condition.
October 1-6: Revenues of $5,500 were earned and paid in cash. Expenses required to earn the revenues of
$4000 were incurred and paid in cash.
REQUIREMENT:
• Prepare a balance sheet at September 30, 2001
• Prepare a balance sheet at October 6, 2001. also prepare an income statement and a statement of cash flows
for the period October 1-6, 2001. in your statement of cash flows treat the purchase of supplies and the
payment of accounts payable as operating activities.
 CLASS PRACTICE
• EXERCISE 3.12
• EXERCISE 3.13
• PROBLEM 3.6
• PROBLEM 3.7
 CHAPTER# 4

The Accounting Cycle

Preparing An Annual Report
 ANNUAL REPORT
• An annual report includes comparative financial statements for several
years and a wealth of other information about the company’s financial
position, business operations, and future prospects.
• Before these reports are issued, the financial statements must be audited by
a firm of certified public accountants.
• Publicly owned companies also must file their audited financial statements
and detailed supporting schedules with the securities and exchange
commission.
• A company’s fiscal year need not coincide with the calendar year.
• In chapter 4, the focus is on end-of-period adjusting entries and the
preparation of financial statements.
 Adjusting Entries
The Need For Adjusting Entries
• Some transactions affect the revenue and expenses of more than one period.
Therefore, adjusting entries are needed at the end of each period. The
purpose of these entries is to assign to each period the appropriate amounts
of revenue and expenses.
• Adjusting entries assign revenues to the periods in which they are earned,
and expenses to the periods in which the related goods or services are used.
 Characteristics Of Adjusting Entries
• Every adjusting entry involves the recognition of either revenue or
expenses. Revenue and expenses represent changes in owner’s equity.
However, owner’s equity cannot change by itself; there also must be a
corresponding change in either assets or liabilities.
• Adjusting entries are based on the concepts of accrual accounting.
• In many businesses, the adjusting entries are made by the company’s
controller or by a professional accountant, rather than by the regular
accounting staff.
 Types Of Adjusting Entries

• Entries to apportion recorded costs

• Entries to apportion unearned revenue
• Entries to record unrecorded expense
• Entries to record unrecorded revenue
 Overnight Auto Service
Trial balance
December 31, 2002
Cash 29,550
Accounts receivable 6,500
Shop supplies 1,800
Unexpired insurance 3,000
Land 52,000
Building 36,000
Accumulated depreciation: building 1,800
Tools and equipment 15,000
Accumulated depreciation: T/E 2,950
Notes payable 40,000
Accounts payable 2,690
Unearned rent revenue 6,000
M.McBryan, capital 82,600
M.McBryan, drawing 44,800
Repair service revenue 161,460
Advertising expense 3,900
Wages expense 56,800
Supplies expenses 6,900
Depreciation expense: building 1,650
Depreciation expense: tools and 2,200
equipment
Utilities expense 19,400
Insurance expense 15,000
Interest expense 3,000
$297,500 $297,500
 Apportioning recorded costs
• When a business makes an expenditure that will benefit more than one
accounting period, the amount usually is debited to an asset account.
• At the end of each period benefiting from the expenditure, an adjusting
entry is made to transfer an appropriate portion of the cost from the asset
account to an expense account
• This adjusting entry reflects the fact that part of the asset has been used up-
or become expense- during the current accounting period.
• An adjusting entry to apportion a previously recorded cash expenditure (or
cost) consists of a debit to an expense account and a credit to an asset
account.
 Prepaid Expense
• Payments in advance are often made for such items as
insurance, and office supplies.
• Prepaid expenses are assets representing payments of
the expenses of future accounting periods.
• If the advance payment will benefit more than just the
current accounting period, the cost represents an asset
rather than an expense.
• Prepaid expenses are assets; they become expenses
only as the goods or services are used up.
 Shop Supplies
• Assume that at December 31, the owner
estimates that about $1200 worth of shop
supplies remaining on hand.
• Adjusting Entry:
 Insurance Policies
• Insurance policies also are a prepaid expense.
• As the time passes, the insurance policy
expires-that is, it is used up in business
operations.
• Assume that on February 1, the business
purchased for $18,000 a one-year insurance
policy providing comprehensive liability
insurance and insurance against fire and
damage to customers’ vehicles.
• Assume that on February 1, the business
purchased for $18,000 a one-year insurance
policy providing comprehensive liability
insurance and insurance against fire and
damage to customers’ vehicles.
Journal Entry:
• Unexpired insurance is an asset account.
• This $18,000 expenditure provides insurance
coverage for a period of one year.
• Every month $1500 of this cost is recognized
as insurance expense.
• Adjusting Entry:
Depreciation Of Buildings
Depreciation On Tools And Equipment
Apportioning Unearned Revenue
• In some instances, customers may pay in advance for the services to be rendered in
later accounting periods.

• Example:
A football team collects much of its revenue in advance through the sale of season
tickets or airlines sell many of their tickets well in advance of a scheduled flight.
• Amounts collected from customers in advance are recorded by debiting the cash
account and crediting an unearned revenue account. Unearned revenue also may be
called deferred revenue.
• When a company collects money in advance from its customers, it has an obligation
to render services in the future. Therefore, the balance of an unearned revenue
account is considered to be a liability account; it appears in the liability section of
the balance sheet, not in the income statement. Unearned revenue differs from other
liabilities because it usually will be settled by rendering services, rather than by
making payment in cash.
• Assume that on December 1, Harbor Company agreed to rent space in
overnight’s building to provide in-door storage for some of its cabs. The
agreed-upon rent is $2000 per month, and harbor paid for the first 3 months
in advance.
• Journal entry: December 31

• Unearned rent revenue is a liability account; not a revenue account. At the

end of each of the 3 month, overnight will make an adjusting entry.
• Adjusting entry: December 31
• At the end of each of these 3 months, the business will make an adjusting
entry, transferring $2000 from the unearned rent revenue account to an
earned revenue account.
• After this adjusting entry has been posted, the unearned rent revenue
account will have a $4000 credit balance. This balance represents
overnight’s obligation to render $4000 worth of services over the next two
months and will appear in the liability of the company’s balance sheet. The
rent revenue earned account will in overnight’s income statement.
 Recording advance collections directly in the revenue
accounts
• We have stressed that amounts collected from customers in
advance represents liabilities, not revenue. However, some
companies follow an accounting policy of crediting these
advance collections directly to revenue accounts. The adjusting
entry then should consist of a debit to a revenue account and a
credit to the unearned revenue account for the portion of the
advance payments not yet earned. This alternative accounting
practice leads to the same results.
 EXERCISE 4.3
The outlaws, a professional football team, prepare financial statements on a
monthly basis. Football season begins in august, but in July the team
engaged in the following transactions:

a) Paid $15,00,000 to dodge city as advance rent for use of dodge city
stadium for the 5 month period from august 1 through December 31.
b) Collected $25,60,000 cash from sales of season tickets for the team’s eight
home games.

During the month of august , the outlaws played one home game and two
games on the road. Their record was two wins, one loss.
Prepare the two adjusting entries required at august 31 to apportion this
recorded cost and recorded revenue.
Recording Unrecorded Expenses
• This type of adjusting entry recognizes expenses that will be paid in future
transactions; therefore, no cost has yet been recorded in the accounting
records.
• Example: salaries of employees and interest on borrowed money
• These expenses are said to accrue over time, that is, to grow or to
accumulate.
• Since these expenses will be paid at a future date, the adjusting entry
consists of a debit to an expense and a credit to a liability account.
Accrual of wages (or salaries) expense
 Accrual of interest expense
• In November 2001, overnight purchased its building, an old bus garage,
from Transit District. The business issued a $30,000 short-term note
payable for much of the purchase price. Unfortunately, Overnight has
never been able to arrange long-term financing on the old bus garage.
Instead, it has had to arrange a series of short-term loans-usually only 3 to
6 months in terms.
• On November 30, overnight borrowed $40,000 from American National
Bank. This loan is to be repaid in 3 months (on February 28), along with
the interest computed at an annual rate of 9%. The entry made on
November 30 to record this borrowing transaction appears as follows:
• ENTRY:
• The following adjusting entry is made at
December 31 to charge December operations
with one month’s interest expense and to
record the amount of interest owed to the
bank at month end.
• Adjusting entry:
• Adjusting entry: January 31:

• Adjusting entry: february 28:

 EXERCISE 4.2
S.S Company adjusts its accounts at the end of the month. On November
30, adjusting entries are prepared to record:
1) Depreciation expense for November
2) Interest expense that has been accrued during November
3) Revenue earned during November that has not yet been billed to
customers
4) Salaries payable to company employees, that have accrued since the last
payday in November
5) The portion of the company’s prepaid insurance that has expired during
November
6) Earning a portion of the amount collected in advance from a customer

Indicate the effect of each of these adjusting entries on company’s revenue,

expense, net income, assets, liabilities and owner’s equity.
Recording Unrecorded Revenue
• A business may earn revenue during the
current accounting period but not bill the
customer until a future accounting period.
• Any revenue that has been earned but not
recorded during the current accounting period
should be recorded at the end of the period
by means of an adjusting entry.
 Example
• Assume that in December, overnight entered into an agreement to perform routine
maintenance on several vans owned by Airport Shuttle Service. Overnight agreed to
maintain these vans for a flat fee of $1500 per month, payable on the 15th of each
month.
• Overnight began rendering services on December 15, but the first monthly payment
will not be received until January 15. therefore, overnight should make the
following adjusting entry at December 31 to record the revenue earned from Airport
Shuttle during the month.

• DECEMBER 31:
 The collection of the first monthly fee from
the Airport Shuttle will occur in the next
accounting period (January 15, to be exact).
January 15:
Adjusting Entries And Accounting
Principles
• Adjusting entries are tools by which
accountants apply the realization and
matching principles.
 Exercise 4.4
The law firm of Dale and Clark prepares its financial statements on a monthly basis.
Among the items requiring adjustment at December 31 are the following:
• Salaries to staff attorneys are paid on the 15th day of each month. Salaries accrued
since December 15 amount to $17,800 and have not yet been recorded.
• The firm is defending J.R. Stone in a civil lawsuit. The agreed-upon legal fees are
$2100 per the trial is in progress. The trial has been in progress for 9 days during
December and is not expected to end until late January. No legal fees has yet been
billed to Stone. (legal fees are recorded in an account entitled legal fees earned).
1) Prepare the 2 adjusting entries required at December 31 to record the accrued
salaries expense and the accrued legal fees revenue.
2) Assume that salaries paid to staff attorneys on January 15 amount to $35000 for the
period December 15 through January 15. How much this amount is considered
salaries expense of January?
3) Assume that on January 29, Dale and Clark receives $60,900 from J.R. Stone in full
settlement of legal fees for services in the civil lawsuit. What portion of this amount
constitutes revenue earned in January?
 Exercise 4.7
Hill company adjusts its accounts at the end of each month. Prepare the adjusting entries
required at December 31 based on the following information. (not all of these items may
require adjusting entries) .
1) A bank loan had been obtained on December 1. Accrued interest on the loan at December 31
amounts to $1050. No interest expense has yet been recorded.
2) Depreciation of O/E is based on an estimated life of 5 years. The balance in the O/E account
is $24,000; no change has occurred in the account during the year.
3) Interest revenue earned on US government bonds during December amount to $750. This
accrued interest revenue has not been recorded or received as of December 31.
4) On December 31, an agreement was signed to lease a truck for 12 months beginning January
1 at the rate of 35 cents a mile. Usage is expected to be 2000 miles per month, and the
contract specifies a minimum payment equivalent to $18,000 miles a year.
5) The company's policy is to pay all employees up-to-date each Friday. Since December 31 fell
on Monday, there was a liability to employees at December 31 for one day’s pay amounting to
$2800.
What’s the effect:
• Assume that prior to making December 31 adjusting entries, Hill company’s net income was
$129,350. compute net income after December 31 adjustments have been recorded. Show
your work.
 Problem 4.2
Silver spur ranch, a dude ranch and resort, adjusts its accounts monthly and closes its accounts
on December 31. Most guests of the ranch pay at the time they check out, and the amounts
collected are credited to rental revenue. The following information is available as a source for
preparing adjusting entries at December 31.
a) Among the assets owned by silver spur is an investment in government bonds in the face
amount of $175,000. Accrued interest receivable on the bonds at December 31 was computed
to be $875. None of the interest has yet been received.
b) A 12-month bank loan in the amount of $90,000 had been obtained on November 1. interest to
be computed at an annual rate of 10% and is payable when the loan becomes due.
c) Depreciation on a station wagon owned by the ranch was based on a 4-year life. The vehicle
had been purchased new on September 1 of the current year at the cost of $25,200.
d) Management of the ranch signed an agreement on December 28 to lease a truck from ace
motors for a period of 6 months beginning January 1 at a rate of 20 cents per mile, with a
clause providing for a minimum monthly charge of $400.
e) Salaries earned by employees but not yet paid amounted to $9900 at the end of the year.
f) As of December 31, silver spur has earned $12,500 rental revenue from current guests who
will not be billed until they are ready to check out.
g) A portion of land owned by silver spur had been leased on august 1 of the current year to a
service station operator at a yearly rental rate of $18,000. Six month’s rent was collected in
advance at the date of the lease and credited to unearned rental revenue.
h) A bus to carry guests to and from town and the airport had been rented early on December 10
at the daily rate of $50. No rental payment has been made, although silver spur has had use of
the bus for 22 days in December.
 Problem 4.2
Instructions:
• For each of the above lettered paragraphs, draft a separate adjusting journal entry (including
explanation) if the information indicated that an adjusting entry is needed. One or more of the
above paragraphs may not require any adjusting entry.
• What is the amount of interest expense recognized during the year on the $90,000 bank loan
obtained on November 1?
• Compute the book value of station wagon described in item [c] above as of December 31.
Nick Charles operates a private investigating business called Nick Charles Investigations. Some
citizens are required to pay in advance for the company’s services, while others are billed after
the services have been rendered. The business adjusts its accounts each month and closes its
accounts at the end of each quarter. At March 31, the end of the first quarter, the trial balance
appears as follows:
Nick Charles Investigations
Trial balance
March 31, 2001
Cash 17,150
Fees Receivable 37,800
Unexpired Insurance 1,600
Prepaid Rent 5,400
Office Supplies 1,050
Office Equipment 17,100
Accumulated Depreciation: O/E 5,700
Accounts Payable 3,900
Unearned Retainer Fees 24,000
NC, Capital 45,300
NC, Drawing 3,200
Fees Earned 33,320
Depreciation Expense 570
Rent Expense 3,000
Office Supplies Expense 450
Insurance Expense 800
Telephone Expense 1,200
Travel Expense 3,400
Salaries Expense 19,500
112,220 112,220
Other data:
a) The useful life of the O/E estimated at 5 years.
b) Fees of $8,400 were earned during the month from services performed for clients who
had paid in advance
c) Salaries earned by employees during the month but not yet recorded or paid amounted to
$1,665
d) On March 1, the business moved into a new office and paid the first 3 month’s rent in
advance.
e) Investigative services rendered during the month but not yet collected or billed to clients
amounted to $3,900
f) Office supplies on hand march 31 amounted to $700.
g) On January 1, $2,400 was paid as the premium for 6 months’ liability insurance.
 Problem 4.4
Instructions:
• Prepare the adjusting entries required at march 31 (use a straight-line
depreciation method)
• Determine the amount of net income to be reported in the company’s
income statement for the quarter ended march 31, 2001.
• Did the monthly rent of NCI increases or decreases as a result of the move
to a new office on march 1?
• Ashraf, J. and Ghani, W.I.. (2005). Accounting development in Pakistan. The International Journal of
Accounting, 40(2005), 175-201.
• Rashid, A. R., Amin, F., & Farooqui, A. (2012). International financial reporting standards (ifrs) and its
influence on pakistan. Journal of Applied Finance & Banking, 2(2), 1-13.