CHAPTER 1

1-1Nature of Business and Accounting

 Primary Purpose of Accounting: to provide useful information for decision making. Accounting is the language of
business.
 Accounting is an information system that provides reports to users about the economic activities and condition
of a business.
 Business: An organization in which basic resources (inputs), such as materials and labor, are assembled and
processed to provide goods or services (outputs) to customers.
 Three types of businesses operating for profit include service, merchandising, and manufacturing businesses.
 Accounting Principles Framework—Primary Purpose is to provide useful information for decision
making.
 Assumptions: Business Entity, Monetary Unity, Time Period
 Principles: Historical Cost, Revenue Recognition, Matching, Full disclosure
 Constraints: Materiality, Conservatism, Cost Benefit

1-1aTypes of Businesses
 Discuss types of businesses:
 Service – Delta, Disney, Hilton Hotels, Netflix
 Merchandising – Target, Belk, Walmart
 Manufacturing – Ford Motor, Boeing
 Combination - Microsoft
1-1bRole of Accounting in Business
 The process by which accounting provides information to users is as follows:
1. Identify users.
2. Assess users’ information needs.
3. Design the accounting information system to meet users’ needs.
4. Record economic data about business activities and events.
5. Prepare accounting reports for users.
 Managerial Accounting-The objective of managerial accounting is to provide relevant and timely information for
managers’ and employees’ decision-making needs. Oftentimes, such information is sensitive and is not
distributed outside the business. Mostly concerned with INTERNAL users (like board, management, CEO,
shareholders)
 Financial Accounting-The objective of financial accounting is to provide relevant and timely information for the
decision-making needs of users outside the business. Mostly concerned with EXTERNAL users (stockholders,
lenders, etc)
 General-purpose financial statements are one type of financial accounting report that is distributed to external
users. The term general-purpose refers to the wide range of decision-making needs that these reports are
designed to serve.
1-1cRole of Ethics in Accounting and Business
 **RESPONSIBILITY IS WITH MANAGEMENT, EXAM QUESTION**
 Management is ultimately responsibility for the accuracy of the company’s financial statements, not the
auditors.
 External auditors are authorized to issue an opinion on the fairness of management’s representations, giving
external users a level of assurance that the financial statements can be relied upon for decision making.
1-1dOpportunities for Accountants
 1-2Generally Accepted Accounting Principles
 US
 SEC=enforcer
 GAAP=umbrella term for standards accountants follow, name of rules
 FASB=SEC delegated authority to set rules (GAAP) to FASB
 Internationally
 IFRS=considered to be more “principles based” than GAAP, which is more “rules based”.
 IASB=Set the rules, IFRS standards
 
 Congress passed laws to monitor the behavior of accounting and business. For example, the Sarbanes-Oxley Act
(SOX) was enacted. SOX established a new oversight body for the accounting profession called the Public
Company Accounting Oversight Board (PCAOB). In addition, SOX established standards for independence,
corporate responsibility, and disclosure.
 Accountants who provide services on a fee basis are said to be employed in public accounting.
 Public accountants who have met a state’s education, experience, and examination requirements may become
Certified Public Accountants (CPAs).
1-2aBusiness Entity Concept Under the business entity concept, the activities of a business are recorded separately
from the activities of its owners, creditors, or other businesses.
• The business entity concept limits the economic data in an accounting system to data related directly to the
activities of the business. In other words, the business is viewed as an entity separate from its owners, creditors,
or other businesses.
 -Sole Prop—VERY VERY COMMON. No investrs, partners, etc. Problem=limited resources and unlimited
liability. Advantage=EASY to establish.
 -Partnership—Two or more owners. Problem=UNLIMITED LIABILITY. Easier to establish.
 -Corporation—Large. Owned by stockholders (public or private). Shareholders share vote but liability is
limited to investment. So limited liability and can raise lots of capital
 -LLC—combines parts of partnerships and corps. LLCs combine attributes of partnerships and
corporations; limited liability
 Economic entity – sometimes separate entity or reporting entity
 Time period – sometimes called periodicity
 Historical cost – sometimes cost principle or mixed-attribute measurement model
 Matching concept – sometimes expense recognition principle
 Revenue recognition – sometimes just recognition
 **Primary Purpose: to provide useful information for decision making**
1-2bTime Period Concept The time period concept requires a company to report its economic activities on a regular
basis for a specific period. Fiscal year.
 Annual accounting period adopted by a company is called its fiscal year Calendar year is the most commonly
used fiscal year
 Corporations may follow other periods as fiscal years
1-2cCost Concept Under the cost concept, amounts are initially recorded in the accounting records at their cost or
purchase price. The cost concept also involves the objectivity and unit of measure concepts
 The objectivity concept requires accounting records and the data reported in financial statements to be based
on objective evidence. Only the final agreed-upon amount is objective enough to be recorded in the accounting
records.
*Unit of measure concept-a concept of accounting requiring that economic data be recorded in dollars.
 Under the cost concept, amounts are initially recorded in the accounting records at their cost or purchase price
Unit of measure concept-a concept of accounting requiring that economic data be recorded in dollars.
 Resources owned by a business= assets. The rights or claims to the assets are divided into two types: (1) the
rights of creditors and (2) the rights of owners.

1-3The Accounting Equation

  Resources owned by a business= assets. The rights or claims to the assets are divided into two types: (1) the
rights of creditors and (2) the rights of owners.
 The rights of creditors are the debts of the business and are called liabilities. The rights of the owners of a
proprietorship, partnership, or limited liability company are called owner’s equity.
 The liability created by a purchase on account is called an account payable.
 An asset, called an account receivable, which is a claim against the customer. Fees earned on account are
recorded as increases in Accounts Receivable and Fees Earned. When customers pay their accounts, Cash
increases, and Accounts Receivable decreases.
 **Assets=Liabilities+Equity**
 ASSETS
 Asset: a future economic benefit
 Examples include:
 Cash
 Accounts Receivable – amounts due from customers
 Inventory – goods you are holding for sale
 Investments
 Buildings
 Equipment
 Land
 Owned by the business or receivable from others
 Prepayments of expenses, such as for insurance premiums, are called prepaid expenses.
Prepaid expenses are assets.
 LIABILITIES
 Liability: an obligation of a business
 Examples include:
 Accounts payable – amounts due to suppliers
 Salaries and wages payable
 Notes payable
 Bonds payable
 Amounts payable to others

 EQUITY
 What’s leftover.
 Rights of the owners
 Assets minus liabilities

 INCOME STATEMENT=REVENUE-EXPENSE
 income statement tells you what happens over a period, balance sheets are snapshots

1-4Business Transactions and the Accounting Equation

FOUR BASIC FINANCIAL STATEMENTS

1. Income Statement
 Summary of revenues and expenses over a period of time
 Net income equals revenues minus expenses
 Revenues-expenses=net income
 Revenue is recognized WHEN EARNED
 Expenses recognized WHEN INCURRED
 Revenues are inflows of assets resulting from the sale of goods or services
 Expenses are outflows of assets resulting from the sale of goods or services

2. Statement of Owner’s Equity

 Summary of changes to owner’s equity over a period of time
 Includes net income from the income statement
 Net income gets moved over to statement of owner’s equity
 The statement of owner’s equity reports the changes in the owner’s equity for a period of time. It is
prepared after the income statement because the net income or net loss for the period must be reported in
this statement.
 Similarly, it is prepared before the balance sheet because the amount of owner’s equity at the end of the
period must be reported on the balance sheet.
 SOE is often viewed as the connecting link between the income statement and balance sheet.
3. Balance Sheet
 Shows snapshot of financial position
 at a point in time
 DO THE QUIZLET FLASHCARDS IN GOVIEW, VOCAB TO BE ON EXAM
 Assets and liabilities recorded in order of liquidity

4. Statement of Cash Flows

 Statement of Cash Flows
 The statement of cash flows consists of the following three sections:
 operating activities
 investing activities
 financing activities
 Statement of cash flows FOLLOWS THE CASH—What happened to the cash
 If an asset is decreasing it is credited / increasing asset is a debit
**MEMORIZE**
1. The income statement is the first of all financial statements to be prepared by using inputs from the trial
balance. All the revenues and expenses relating to the reporting period are listed in the income statement.
2. The end result of the income statement is the net income which is calculated by deducting total revenue
from total expenses.
3. The statement of owner equity is prepared after the income statement. It reports additional capital
introduced in the business, withdrawals made and addition or reduction in retained earnings. The net income
will be used as an input in this statement, net income will be added to retained earnings and any dividend paid
will be deducted from it.
4. BALANCE SHEETThe final step in the financial statements preparation will be the balance sheet. The balance
sheet lists out all assets and liabilities. The owner’s equity and ending retained earnings calculated in the
owner’s equity statement will be an input for the balance sheet.

 Interrelationships among Financial Statements

Financing-taking on debt, paying back debt

Cash Flows from (Used for) Operating Activities

 This section reports a summary of cash receipts and cash payments from operations. The net cash flows from
operating activities normally differs from the amount of net income for the period. This difference occurs
because revenues and expenses may not be recorded at the same time that cash is received from customers or
paid to creditors.
Cash Flows from (Used for) Investing Activities
This section reports the cash transactions for the acquisition and sale of relatively permanent assets such as
land, buildings, and equipment.
Cash Flows from (Used for) Financing Activities
This section reports the cash transactions related to cash investments by the owner, borrowings, and
withdrawals by the owner.

1-6Financial Analysis and Interpretation: Ratio of Liabilities to Owner’s Equity

 Ratio of Liabilities to Owner’s Equity: The relationship between liabilities and owner’s equity, expressed as
a ratio of liabilities to owner’s equity.
 The rights of creditors to a business’s assets come before the rights of the owners or stockholders. This ratio is
useful in analyzing the ability of a company to pay its creditors.

 Items such as supplies that will be used in the business in the future are called prepaid expenses, which are
assets. Thus, the effect of this transaction is to increase assets (Supplies) and liabilities (Accounts Payable) by
$1,350, as follows:
 CHAPTER 2

MEMORIZE

Normal balance in green

Transaction Analysis are (Assets=Liability+Equity)

Accounting systems are designed to show the increases and decreases in each accounting equation element as a separate
record. This record is called an account. An account, in its simplest form, has three parts. (T Account)
5. A title, which is the name of the accounting equation element recorded in the account
6. A space for recording increases in the amount of the element
7. A space for recording decreases in the amount of the element
 Follow the event, NOT the cash

2-1aChart of Accounts
 Ledger: A group of accounts for a business entity.
 Chart of Accounts: A list of accounts in the ledger
  The accounts are normally listed in the order in which they appear in the financial statements.
o The balance sheet accounts are listed first, in the order of assets, liabilities, and owner’s equity.
o The income statement accounts are then listed in the order of revenues and expenses.
o Assets are resources owned by the business entity. Can be tangible like cash or supplies, or intangible
like patent, copyright or trademark. Includes Accounts Receivable, prepaid expenses (insurance)
building, equipment and land
o Liabilities are debts owed to outsiders (creditors). Liabilities are often identified on the balance sheet by
titles that include payable. Include accts payable, notes payable, wages payable. Cash received B4
services delivered, aka unearned revenue (think magazine subscription)
o Owner’s equity is the owner’s right to the assets of the business AFTER all liabilities have been paid. For
a proprietorship, the owner’s equity is represented by the balance of the owner’s capital account. A
drawing account represents the amount of withdrawals made by the owner.
o Revenues are increases in assets and owner’s equity b/c of selling services or products to customers.
Think fees earned, fares, commission and rent revenue
o Expenses result from using up assets or consuming services in the process of generating revenues. Think
wage expense, rent expense, utilities expense, supplies expense and misc expense
o The accounts within the chart of accounts are numbered for use as references. A numbering system is
normally used so that new accounts can be added without affecting other account numbers. The first
digit indicates the major account group of the ledger in which the account is located. Accounts
beginning with 1 represent assets; 2, liabilities; 3, owner’s equity; 4, revenue; and 5, expenses. The
second digit indicates the location of the account within its group.

o
2-2Double-Entry Accounting System
 Every business transaction to be recorded in at least two accounts. The total debits recorded for each
transaction to be equal to the total credits recorded.
 In the double-entry accounting system, specific rules for recording debits and credits based on the type of
account.
2-2aBalance Sheet Accounts
2-2bIncome Statement Accounts
 The debit and credit rules for income statement accounts are based on their relationship with owner’s equity.
 Owner’s equity accounts are increased by credits.
 Revenues increase owner’s equity, revenue accounts are increased by credits and decreased by debits.
Because owner’s equity accounts are decreased by debits, expense accounts are increased by debits and
decreased by credits.
 **RULE OF DEBIT AND CREDIT FOR REVENUE AND EXPENSE ACCOUNTS:

2-2cOwner Withdrawals
 An owner’s withdrawls decrease owner’s equity, owner’s drawing accounts is increased by debits. Owner’s

**drawing account is DECREASED by credits.

 DRAWINGS ACT LIKE AN EXPENSEEXPENSES DECREASE NET INCOME AND EQUITY
 Owner contribution is a CREDIT

2-2eJournalizing
Journal serves as a record of when transactions occurred and were recorded. Recording transactions=journalizing.
Two column Journal Steps:
2. Date
3. Title of account to be debited on LEFT and amount debited
4. Title of accounts to be credited to the RIGHT and amount
5. Description below credited account
6. Post Ref left blank initially
ANALYZING and JOURNALIZING TRANSACTIONS
1. Read description and determine asset, liability, OE, revenue, expense or drawing account is affected
2. For each acct affected, determine whether increase or decrease
3. Determine the increase/decrease should be recorded as debit or credit to the account
4. RECORD

MEMORIZE:
2-3Journalizing and Posting to Accounts
**a transaction is first recorded in a journal. Periodically, the journal entries are transferred to the accounts in the
ledger.
 The process of transferring the debits and credits from the journal entries to the accounts is
called posting.**
4 Column Accounting: An account format used for posting journal entries with columns for debits, credits, and a debit or
credit balance.
 IT HAS Item, and Posting Reference (Post. Ref.) columns as well as Debit and Credit columns for posting
transactions. In addition, the four-column account has Balance (Debit and Credit) columns for indicating the
current balance of the account, sometimes called a running balance.
The prepayment of rent is an asset THAT WILL EXPIRE. When an asset is purchased with the expectation that it will
be used up in a short period of time, such as a month, it is normal to debit an expense account initially.
This avoids having to transfer the balance from an asset account (Prepaid Rent) to an expense account (Rent
Expense) at the end of the month.
The liability created by receiving the cash in advance of providing the service is called unearned revenue
When a business allows a customer to pay for services provided at a later date, an account receivable is created. An
account receivable is a claim against the customer, and, thus, is an asset for the seller
When customers pay amounts owed for services they have previously received, one asset increases and another asset
decreases.

2-4Trial Balance
 Check for errors in posting of debits and credits from journal to ledger is to prepare a trial balance
 Trial balance will check that debits=credits
 TRIAL BALANCE STEPS
1. List name of co, title of trial balance, date of trial balance is prepped
2. List accts from ledger and enter their debits or credit balance in the DEBITS or CREDIT column of
trial balance
3. Total Debit and Credit columns of trial balance
4. Verify total debit=credit

2-4aErrors Affecting the Trial Balance

  If the trial balance totals are not equal, an error has occurred. A method useful in discovering errors is as

follows:
2-4bErrors Not Affecting the Trial Balance
 Sometimes this happens. LIKE, credit balance in supplies acct means error occurred. WHY? B/c you cannot have
“negative” supplies. IF the error has been journalized and posted to the ledger, correcting journal entry is
prepped.
2-5Financial Analysis and Interpretation: Horizontal Analysis
 A single item in a financial statement, such as net income, is often useful in interpreting the financial
performance of a company.
 Horizontal analysisthe amount of each item on a current financial statement is compared with the same item
on an earlier statement.
o The increase or decrease in the amount of the item is computed together with the percent of increase
or decrease.
o When two statements are being compared, the earlier statement is used as the base for computing the
amount and the percent of change.
**CHAPTER 2 SUMMARY**
 The simplest form of an account, a T account, has three parts: (1) a title, which is the name of the item
recorded in the account; (2) a left side, called the debit side; and (3) a right side, called the credit side.
Periodically, the debits in an account are added, the credits in the account are added, and the balance of the
account is determined. The system of accounts that make up a ledger is called a chart of accounts.
 Transactions are initially entered in a record called a journal. Each transaction is recorded so that the sum of the
debits=sum of the credits. The normal balance of an account is indicated by the side of the account (debit or
credit) that receives the increases.
 Transactions are journalized and posted to the ledger using the rules of debit and credit. The debits and credits
for each journal entry are posted to the accounts in the order in which they occur in the journal.
 A trial balance is prepared by listing the accounts from the ledger and their balances. The totals of the Debit
column and Credit column of the trial balance must be equal. If the two totals are not equal, an error has
 occurred. Errors may occur even though the trial balance totals are equal. Such errors may require a correcting
journal entry.
 In horizontal analysis, the amount of each item on a current financial statement is compared with the same
item on an earlier statement. The increase or decrease in the amount of the item is computed, together with
the percent of increase or decrease. When two statements are being compared, the earlier statement is used as
the base for computing the amount and the percent of change.

CHAPTER 3
Nature of the Adjusting Process

Before financial statements can be prepared, however, some accounts on the unadjusted trial balance must be adjusted.
3-1aAccrual and Cash Basis of Accounting
 Accrual basis of accounting, revenues and their related expenses are reported on the income statement in the
period in which a service has been performed or a product has been delivered. The accrual basis of accounting
also requires expenses to be recorded when they are incurred, not necessarily when cash is paid.
 GAAP requires accrual basis of accounting
 Some ppl use cash basis of accounting where revenue and expenses are reported on the income statement in
the period where cash is received or paid. EX—pay employees in cash
o Small svc businesses may use cash basis b/c they have few receivables

3-1bRevenue and Expense Recognition

The economic life of a business is divided into time periods (qtr, month, etc). Under accrual accounting, the net income
of a period is reported using revenue and expense recognition principles.
 Revenue recognition principle: revenues are recorded when they are earned, which is when services have been
performed or products have been delivered to customers. Revenue = the value of the assets received, such as
cash or accounts receivable. This process of recognizing revenue=revenue recognition.
 The expense recognition principle (aka the MATCHING PRINCIPLE) says the expenses incurred in generating
revenue must be reported in the same period as the related revenue.
o By matching revenue and expenses, net income or loss is properly reported.

3-1cThe Adjusting Process

 At the end of an accounting period, an unadjusted trial balance is prepared to verify that the total debit balances
equal the total credit balances.
 Some revenues and expenses may be unrecorded at the end of the accounting period. A company may have
provided services to customers that it has not billed or recorded at the end of the accounting period OR may not
pay employees until next accting period even tho employees have earned wages currently
  Some revenues and expenses are incurred as time passes rather than as separate transactions (rent received in
advance, prepaid insurance)
 Analysis + updating of accounts before financial statements prepared=ADJUSTING PROCESS
 Journal entries that bring accts up to date=adjusting entries. ALL ADJUSTING ENTRIES affect AT LEAST ONE
INCOME STATEMENT ACCT AND ONE BALANCE SHEET ACCOUNT. SO, an adjusting entry will ALWAYS INVOLVE a
revenue or an expense acct AND an asset or a liability acct.

3-1dTypes of Accounts Requiring Adjustment

The two general classifications of accounts requiring adjustment are:
5. Accruals An accrual occurs when revenue has been earned or an expense has been incurred
but has not been recorded.

6. Deferrals when $$ related to a future revenue or expense has been initially recorded as a
liability or an asset. If the cash received is related to future revenue, it is initially recorded as a
liability called unearned revenue. The adjusting entry in the period when the revenue is earned
debits an unearned revenue account and credits a revenue account. If the cash paid is related to
a future expense, it is initially recorded as an asset called prepaid expense.
3-2Adjusting Entries for Accruals

3-2aAccrued Revenues
 Some revenues are recorded only when cash is received. There may be revenue that has been earned but has
not been recorded. In such cases, the revenue is recorded by increasing (debiting) an asset account (Accounts
Receivable) and increasing (crediting) a revenue account (Fees Earned).
o The claim against the customer for payment is an account receivable (an asset).
3-2bAccrued Expenses
 Some types of services used in earning revenues are paid for after the service has been performed. At the end of
the accounting period, the amount of such accrued but unpaid items is an expense and a liability. Like hourly
employee paid weekly
3-3Adjusting Entries for Deferrals
3-3aUnearned Revenues
3-3bPrepaid Expenses Payments for prepaid expenses are sometimes made at the beginning of the period in which
they will be entirely used or consumed.
 Supplies-If either amount is known, the other can be determined. It is normally easier to determine the cost of
the supplies on hand at the end of the month than to record supplies used on a daily basis.

 Insurance-Prepaid insurance is an asset

o Like other prepaid expenses, when insurance has been paid in advance, it will be recorded in the
balance sheet under current assets and at the end of each month, the appropriate amount matching to
that month must be deducted from the prepaid insurance account by crediting it, and this would be
posted as a debit to the insurance expense account.
3-4Adjusting Entries for Depreciation
 Fixed/plant assets are physical resources that are owned and used by a biz that have permanent long life.
o Fixed assets are a type of long term prepaid expense
  As it loses ability to provide useful services, depreciates.
 AS A FIXED ASSET DEPRECIATES, portion of its cost should be recorded as an expense.
 DEPRECIATION EXPENSE account is INCREASED (debited) for the amount of depreciation. The fixed asset account
is NOT decreased (credited). INSTEAD, an account called ACCUMULATED DEPRECIATION is increased (credited)
 Accumulated Depreciation-CONTRA asset accounts. Accumulated depreciation. GOES ON THE DEBIT SIDE under
ASSETS. DEBIT DEPRECIATION EXPENSE, INCREASE EXPENSES, DECREASE EQUITY. CREDIT ACCUMULATED
DEPRECIATION.
o CONTRA ASSET ACCOUNTS=An account offset against another account.
 B/C normal balance of a fixed asset account is a debit, the normal balance of an accumulated depreciation
account is a credit.
 Accumulated depreciation appears on the balance sheet in the property, plant and the equipment section.
Fixed Asset Account Contra Asset Account
Land None—Land is not depreciated.
Buildings Accumulated Depreciation—Buildings
Store Equipment Accumulated Depreciation—Store Equipment
Office Equipment Accumulated Depreciation—Office Equipment
BOOK VALUE OF THE ASSET=The difference between the cost of a fixed asset and its accumulated depreciation.
 The market value of a fixed asset usually differs from its book value. This is because depreciation is an allocation
method, not a valuation method. That is, depreciation allocates the cost of a fixed asset to expense over its
estimated life. Depreciation does not measure changes in market values, which vary from year to year.
3-5Summary of Adjusting Process
3-6Adjusted Trial Balance
After the adjusting entries are posted, an adjusted trial balance is prepared. The adjusted trial balance verifies the
equality of the total debit and credit balances before the financial statements are prepared. If the adjusted trial
balance does not balance, an error has occurred.
FIVE TYPES OF ASSETS SHOWN IN ADJUSTED TRIAL BALANCE:
1. Assets
2. Liabilities
3. OE (owner’s capital+owner’s drawing)
4. Revenues
5. Expenses
3-7Financial Analysis and Interpretation: Vertical Analysis
Comparing each item on a financial statement with a total amount from the same statement is useful in analyzing
relationships within the financial statement. Vertical analysis is the term used to describe such comparisons.
In vertical analysis of a balance sheet, each asset item is stated as a percent of the total assets. Each liability and
owner’s equity item is stated as a % of total liabilities and owner’s equity.
In vertical analysis of an income statement, each item is stated as a percent of revenues or fees earned.
Vertical analysis is also useful for analyzing changes in financial statements over time.
Vertical analysis, however, provides a relative comparison
CHAPTER 4
4-1Flow of Accounting Information
 OBJECTIVES
o OBJ. 1 Describe the flow of accounting information from the unadjusted trial balance into the adjusted
trial balance and financial statements.
 Unadjusted trial balance is the first list of ledger account balances, compiled without making
any period end adjustments.
 **REMEMBER**: The unadjusted trial balance verifies that the total of the debit balances
equals the total of the credit balances. If the trial balance totals are unequal, an error has
occurred. Any errors must be found and corrected before the end-of-period process can
continue.

  Adjusted trial balance is the trial balance compiled after considering adjustment entries at the
close of the accounting period
 Adjusted trial balance used to CREATE financial statements
 Adjusted trial balance grouped by account type
 Adjusted Trial Balance includes the postings of the adjustments for the period in the
balance of the accounts.
Asset first
**REMEMBER-- Revenue, expenses and drawings flow into equity section
 Cross-referencing (by letters) the debit and credit of each adjustment is useful in reviewing
the effect of the adjustments on the unadjusted account balances.
o The adjustments are normally entered in the order in which the data are
assembled.
 The total of the Adjustments columns verifies that the total debits equal the total
credits for the adjusting entries. The total of the Debit column must equal the total of
the Credit column.
 the Adjusted Trial Balance columns of the spreadsheet illustrate the effect of the
adjusting entries on the unadjusted accounts. The totals of the Adjusted Trial Balance
columns verify that the totals of the debit and credit balances are equal after
adjustment.
The process by which accounts are adjusted: (EXHIBIT 1)

1. Journal entries
2. Post to ledger
3. Unadjusted trial balance
4. AJEs
5. Adjusted trial balance
6. Financial statements
7. Closing entries
8. Post-closing trial balance

NET INCOME transferred to statement of owner's equity

Remember Income statement contains REVENUES-EXPENSES=NET INCOME
Net income goes to statement of owner's equi
 o OBJ. 2 Prepare financial statements from adjusted account balances. Describe the accounting cycle.
o OBJ. 3 Prepare closing entries.
o OBJ. 4 Describe the accounting cycle.
o OBJ. 5 Illustrate the accounting cycle for one period.
o OBJ. 6 Describe and illustrate the use of working capital and the current ratio in evaluating a company’s
financial condition.

4-2Financial Statements
 4-2aIncome Statement
Miscellaneous expense is the last item, regardless of its amount
 4-2bStatement of Owner’s Equity
 The first item presented on the statement of owner’s equity is the balance of the owner’s capital account at the
beginning of the period.
o This is not always the account balance
o For the beginning balance and any additional investments, it is necessary to refer to the owner’s capital
account in the ledger.
 These amounts, along with the net income (or net loss) and the drawing account balance, are
used to determine the ending owner’s capital account balance.
 Other factors, such as additional investments or a net loss, also require some change in the
form,
 4-2cBalance Sheet
o The balance sheet is prepared directly from the Adjusted Trial Balance columns of the Exhibit 1
spreadsheet, beginning with Cash of $2,065. The asset and liability amounts are taken from the
spreadsheet. The owner’s equity amount, however, is taken from the statement of owner’s equity, as
illustrated in Exhibit 2.
 The balance sheet BELOW shows subsections for assets and liabilities. Such a balance sheet is
a classified balance sheet. These subsections are described next.

 A classified balance sheet is a financial statement with classifications like current assets and liabilities, long-term
liabilities and other things.
 By organizing the information into categories, it can be easier to read and extract the information you
need than if it was simply listed in a large number of line items.
 ASSETS: Assets are commonly divided into two sections on the balance sheet: (1) current assets and (2)
property, plant, and equipment.
 Current Assets: Cash and other assets that are expected to be converted to cash or sold or used up
usually within one year or less, through the normal operations of the business, are called current assets.
 In addition to cash, the current assets may include notes receivable, accounts receivable,
supplies, and other prepaid expenses.
 Notes receivable are amounts that customers owe. Written promises to pay the amount of the
note and interest.
 Accounts receivable are also amounts customers owe, but they are less formal than notes.
  Accounts receivable normally result from providing services or selling merchandise on
account
 **Notes receivable and accounts receivable are current assets because they are usually
converted to cash within one year or less.**
 FIXED assets--Property, plant and equipment:
 The Property, Plant, and Equipment section may also be described as fixed assets or plant
assets. These assets include equipment, machinery, buildings, and land.
 OTHER THAN LAND, fixed assets depreciate over a period of time. The original cost,
accumulated depreciation, and book value of each major type of fixed asset are normally
reported on the balance sheet or in the notes to the financial statements.
 LIABILITIES--the amounts the business owes to creditors. Liabilities are commonly divided into two sections on
the balance sheet: (1) current liabilities and (2) long-term liabilities.
 Current Liabilities -due within a short time (usually one year or less) and that are to be paid out of
current assets are called current liabilities. The most common liabilities in this group are notes payable
and accounts payable. Other current liability accounts may include Wages Payable, Interest Payable,
Taxes Payable, and Unearned Fees. Only liability that's not a payable is unearned revenue
 Unearned revenue is recorded on a company's balance sheet as a liability. It is treated as a
liability because the revenue has still not been earned and represents products or services owed
to a customer.
 Long-Term Liabilities-- will not be due for a long time (usually more than one year) are called long-term
liabilities.
 As long-term liabilities come due and are to be paid within one year, they are reported as
current liabilities. If they are to be renewed (not paid) continue to be reported as long term.
 When a long-term asset, such as a building, is pledged as security for a liability, the obligation
may be called a mortgage note payable or a mortgage payable.
 OWNER'S EQUITY-The owner’s right to the assets of the business is presented on the balance sheet below the
liabilities section.
 The owner’s equity is added to the total liabilities, and this total must be equal to the total assets.

4-3Closing Entries
 Treated differently when you close the accounts
 the adjusting entries are recorded in the journal at the end of the accounting period.
 The balances of the accounts reported on the balance sheet are carried forward from period to period.
o Because these accounts are carried forward from period to period, they are called permanent accounts
or real accounts
o Perm: roll forward year to year. NOT CLOSED at the end of an accounting period. Balance sheet accounts
Ex. Cash, Notes Payable
 EX of real accounts: Cash, Accounts Receivable, Equipment, Accumulated Depreciation,
Accounts Payable, and Owner’s Capital are permanent accounts.
o Temporary/Nominal Accounts: The balances of the accounts reported on the income statement are
not carried forward from year to year.
 Also, the balance of the owner’s drawing account, which is reported on the statement of
owner’s equity, is not carried forward. Because these accounts report amounts for only one
period. They dont carry forward because they relate only to one period.
 Revenues, Expenses, and Drawings They are closed at the end of an accounting period
 This closing process can have me seeing RED! RED IS NOT ON POST CLOSING ACCOUNT,
MEMORIZE
o **Closing entries transfer the balances of temporary accounts to the owner’s capital account.**
o CLOSING PROCESS: At the beginning of the next period, temporary accounts should have zero balances.
To achieve this, temporary account balances are transferred to permanent accounts at the end of the
accounting period. The entries that transfer these balances are called closing entries.
o The closing process involves the following two closing journal entries.
  First Closing Entry: Revenue and expense account balances are transferred to the owner’s
capital account. CLOSE revenue and expenses to owner's capital. Debit each revenue account for
its balance, credit each expense account for its balance, and credit (net income) or debit (net
loss) the owner’s capital account. Basically transferring net income to the capital account. Net
income=revenues-expenses

 Second Closing Entry:The balance of the owner’s drawing account is transferred to the owner’s capital account.
CLOSE the drawing account to owner's capital. Debit the owner’s capital account for the balance of the drawing
account and credit the drawing account.

o Closing occurs at the end of the accounting period, after all adjustments have been made, and the financial
statements have been prepared
 Assets and Liabilities: do not change Revenues and Expenses: balance transferred to owner’s capital
 Drawings: balance transferred to owner’s capital Temporary accounts (revenues, expenses, and
drawings) have a zero balance at the start of the next period
o CLOSING ENTRIES are recorded in the journal and dated as the last day of the accounting period. In the
JOURNAL, closing entries are recorded IMMEDIATELY following the adjusting entries. Sometimes us "closing
entries" caption to differentiate between adjusting.
STEP 1: Rev and Exp account balances are transferred to owner’s capital account
STEP 2: Balance of owner’s drawing acct is transferred to owner’s capital account

4-3aJournalizing and Posting Closing Entries

 Journalizing and Posting Closing Entries
o A line is often inserted in both balance columns after a closing entry is posted.
 This separates next period’s revenue, expense, and withdrawal transactions from those of the
current period.
o Next period’s transactions will be posted directly below the closing entry.
4-3bPost-Closing Trial Balance
o A post-closing trial balance is used to verify that the ledger is in balance at the beginning of the next period.
o The accounts and amounts should agree exactly with the accounts and amounts listed on the balance sheet at
the end of the period.
4-4Accounting Cycle
4-5Illustration of the Accounting Cycle
 Accounting Cycle: The accounting process that begins with analyzing and journalizing transactions and ends with
the post-closing trial balance. The steps in the accounting cycle are as follows:
0. Step 1. Transactions are analyzed and recorded in the journal.
 A company’s chart of accounts is useful in determining which accounts are affected by the
transaction.
 After analyzing each of the transactions, the journal entries are recorded as shown in Exhibit 10.
1. Step 2. Transactions are posted to the ledger.
 Posting Transactions to the Ledger: Periodically, the transactions recorded in the journal are
posted to the accounts in the ledger.
o The debits and credits for each journal entry are posted to the accounts in the order in
which they occur in the journal. As illustrated in Chapters 2 and 3, journal entries are
posted to the accounts using the following four steps:
o Step 1. The date is entered in the Date column of the account.
o Step 2. The amount is entered in the Debit or Credit column of the account.
o Step 3. The journal page number is entered in the Posting Reference column.
o Step 4. The account number is entered in the Posting Reference (Post. Ref.) column in
the journal.
2. Step 3. An unadjusted trial balance is prepared.
 Preparing an Unadjusted Trial Balance An unadjusted trial balance is prepared to determine
whether any errors have been made in posting the debits and credits to the ledger.
 The unadjusted trial balance does not provide complete proof of the accuracy of the ledger. It
indicates only that the debits and the credits are equal. This proof is of value, however, because
errors often affect the equality of debits and credits.
3. Step 4. Adjustment data are assembled and analyzed.
 **The four types of accounts that normally require adjustment (updating) include **
o prepaid expenses
o unearned revenue
o accrued revenue
o accrued expenses
 In addition, depreciation expense must be recorded for fixed assets other than land.
4. Step 5 An optional end-of-period spreadsheet is prepared.
 Although an end-of-period spreadsheet is not required, it is useful in showing the flow of
accounting information from the unadjusted trial balance to the adjusted trial balance
 1. Step 6. Adjusting entries are journalized and posted to the ledger.
 Each adjusting entry affects at least one income statement account and one balance sheet account.
Explanations for each adjustment including any computations are normally included with each adjusting
entry. The adjusting entries are identified in the ledger as “Adjusting.”
2. Step 7. An adjusted trial balance is prepared.
 The most important outcome of the accounting cycle is the financial statements
 The income statement is prepared first, followed by the statement of owner’s equity and then
the balance sheet.
 The statements can be prepared directly from the adjusted trial balance, the end-of-period
spreadsheet, or the ledger.
 The net income or net loss shown on the income statement is reported on the statement of
owner’s equity along with any additional investments by the owner and any withdrawals.
 The ending owner’s capital is reported on the balance sheet and is added with total liabilities to
equal total assets.
3. Step 8. Financial statements are prepared.
4. Step 9. Closing entries are journalized and posted to the ledger. THERE ARE TWO CLOSING ENTRIES. FIRST
CLOSE REVENUES AND EXPENSES, THEN CLOSE DRAWING ACCOUNTS
 As described earlier in this chapter, two closing entries are required at the end of an accounting period.
These two closing entries are as follows:
 FIRST closing entry-Debit each revenue account for its balance, credit each expense account for
its balance, and credit (net income) or debit (net loss) the owner’s capital account. Service
Revenue account should be closed to the capital account at the end of the year. As net income
derived from closing service revenue account it should be posted in capital account.
 SECOND closing entry-Debit the owner’s capital account for the balance of the drawing account
and credit the drawing account.
 The closing entries are normally identified in the ledger as “Closing.”
 In addition, a line is often inserted in both balance columns after a closing entry is posted. This
separates next period’s revenue, expense, and withdrawal transactions from those of the current
period.
5. Step 10. A post-closing trial balance is prepared.
 A post-closing trial balance is prepared after the closing entries have been posted. The purpose of the
post-closing trial balance is to verify that the ledger is in balance at the beginning of the next period.
 The post closing trial balance refers to the list of all accounts and it's balances after the closing entries
have already been journalized—Unearned rent appears here.
 Unearned rent relates to next year or coming period after current year so it is not adjusted to
income statement or owner's equity hence it appears in post closing trial balance

4-6Financial Analysis and Interpretation: Working Capital and Current Ratio

 o The ability to convert assets into cash is called liquidity. The closer to cash, the more liquid the asset.
o The ability of a business to pay its debts is called solvency.
o Two financial measures for evaluating a business’s liquidity and solvency are working capital and the current
ratio.
o Working capital = (excess of the current assets of a business)/(current liabilities)

o Current assets are more liquid than long-term assets.

o Thus, an increase in a company’s current assets increases or improves its liquidity.
 An increase in working capital increases or improves liquidity in the sense that current assets are
available for uses other than paying current liabilities.
 A positive working capital implies that the business is able to pay its current liabilities and is solvent.
Thus, an increase in working capital increases or improves a company’s short-term solvency.
o The current ratio is another means of expressing the relationship between current assets and current liabilities.
The current ratio is computed by dividing current assets by current liabilities, as follows:

o The current ratio is more useful than working capital in making comparisons across companies or with industry
averages.
 Current Ratio = Current Assets / Current Liabilities
o Current ratio greater than 1 indicates solvency
o Allows comparison between companies of different sizes
 Is 1.5 a good current ratio?
o It depends. Must compare with historical performance and industry norms
o Some industries are volatile and have higher current ratio and that’s normal and OK
o The purchase of inventory for cash will NOT CHANGE the ratioWhy, because buying something for cash
doesn’t change current assets

4-7Appendix 1: End-of-Period Spreadsheet

 Accountants often use spreadsheets for analyzing and summarizing data.


4-7aSTEPS
 The adjustments are entered in the Adjustments columns Cross-referencing (by letters) the debit and credit of
each adjustment is useful in reviewing the spreadsheet. t is also helpful for identifying the adjusting entries that
need to be recorded in the journal. This cross-referencing process is sometimes referred to as keying the
adjustments.
 The adjustments are normally entered in the order in which the data are assembled.
 If the titles of the accounts to be adjusted do not appear in the unadjusted trial balance, the accounts
are inserted in their proper order in the Account Title column.
 Cross-referencing (by letters) the debit and credit of each adjustment is useful in reviewing the
spreadsheet. It is also helpful for identifying the adjusting entries that need to be recorded in the
journal. This cross-referencing process is sometimes referred to as keying the adjustments.
 Step 4. Enter the Adjusted Trial Balance
 The adjusted trial balance is entered by combining the adjustments with the unadjusted balances for
each account. The adjusted amounts are then extended to the Adjusted Trial Balance columns.
 After the accounts and adjustments have been extended, the Adjusted Trial Balance columns are totaled
to verify the equality of debits and credits. The total of the Debit column must equal the total of the
Credit column.
 Step 5. Extend the Accounts to the Income Statement and Balance Sheet Columns The adjusted trial balance
amounts are extended to the Income Statement and Balance Sheet columns.
 The amounts for revenues and expenses are extended to the Income Statement columns. The amounts
for assets, liabilities, owner’s capital, and drawing are extended to the Balance Sheet columns.
 After the accounts and adjustments have been extended, the Adjusted Trial Balance columns are
totaled to verify the equality of debits and credits. The total of the Debit column must equal the total of
the Credit column.
 Step 6 Total the Income Statement and Balance Sheet Columns, Compute the Net Income or Net Loss, and
Complete the Spreadsheet
 After the account balances are extended to the Income Statement and Balance Sheet columns, each of
the columns is totaled. The difference between the two Income Statement column totals is the amount
of the net income or the net loss for the period. This difference (net income or net loss) will also be the
difference between the two Balance Sheet column totals.
 The difference between the two Income Statement column totals is the amount of the net income or
the net loss for the period.
o This difference (net income or net loss) will also be the difference between the two Balance
Sheet column totals.
o NET INCOME: If the Income Statement Credit column total (total revenue) is greater than the
Income Statement Debit column total (total expenses), the difference is the net income.
o NET LOSS: If the Income Statement Debit column total is greater than the Income Statement
Credit column total, the difference is a net loss.
 If there was a net loss instead of net income, the amount of the net loss would be
entered in the Income Statement Credit column and the Balance Sheet Debit column.
Net loss would also be entered in the Account Title column.
o The totals of the two Income Statement columns must now be equal. The totals of the two
Balance Sheet columns must also be equal.
 Step 7 Preparing the Financial Statements from the Spreadsheet
 Step 8
 Step 9
MEMORIZE
1. Journal entries
2. Post to ledger
3. Unadjusted trial balance
4. AJEs
5. Adjusted trial balance
6. Financial statements
 7. Closing entries
8. Post-closing trial balance-MEMORIZE WHAT GOES IN THESE

4-7gPreparing the Financial Statements from the Spreadsheet

 The income statement is normally prepared directly from the spreadsheet. The expenses are listed in the
income statement in Exhibit 2 in order of size, beginning with the larger items. Miscellaneous expense is the last
item, regardless of its amount.
 First item normally in statement of OE is balance of owner’s capital acct at the beginning of the period.
o It is necessary to refer to the capital account in the ledger. These amounts, along with the net income
(or net loss) and the drawing amount shown in the spreadsheet, are used to determine the ending
capital account balance.
o The balance sheet can be prepared directly from the spreadsheet columns except for the ending balance
of owner’s capital. The ending balance of owner’s capital is taken from the statement of owner’s equity.
4-8Appendix 2: Why Is the Accrual Basis of Accounting Required by GAAP?
4-8aCash Basis of Accounting
 To understand why the accrual basis of accounting is required, it is first necessary to consider alternative bases
of accounting. The primary alternative basis of accounting is the cash basis, which is simple and is often used by
small companies and individuals operating a part-time business.
 CASH
o Under the cash basis of accounting, revenues and expenses are recorded (recognized) when cash is
received or paid. Likewise, expenses are recorded when the cash is paid regardless of when the related
revenues are recorded. In other words, revenues and expenses are reported on the income statement in
the period in which cash is received or paid.
o Under the cash basis, accrual transactions like as purchasing on credit (accounts payable) or selling on
credit (accounts receivable) are not recorded until the cash is paid or received.
o Deferrals are not recorded under the cash basis until the cash is paid or received. As a result, adjusting
entries, which originate from accruals and deferrals, are not recorded under the cash basis.
 ACCRUAL
o The accrual basis reports net income using revenue and expense recognition principles. Under the
revenue recognition principle, revenues are recorded when earned, which is when the services have
been performed or products have been delivered to customers.
o Revenue is recorded at the amount expected to be received. Under the expense recognition principle,
the expenses incurred in generating revenue are recorded in the same period as the related revenue.
This is also called the matching principle
4-8bAccrual Basis of Accounting
4-8cIllustration of Cash and Accrual Accounting