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Financial Accounting Chapter Notes (MGM221)

Test #1

Notes for Theory Questions:

Study Liquidity Formulas and how they are interpreted and

what they mean for the company and in comparison, to other
(P2-5B, P2-6A, E2-7)

Study the Qualitative Characteristics of Useful Financial


Explain how each statement is correlated with the next

*Chapter 1: The Purpose and Use of Financial Statements*

Internal and External Users

Accounting: Is the information system that identifies and records the

economic events of an organization, and then communicates them to a wide
variety of interested users

Labelled as the language of business

Users of accounting can be divided broadly into types

Internal Users: Users plan, organized and run companies. They work for
the company. These include finance directors, marketing managers, human
resource personnel, productive supervisors and company officers. Accounting
provides a variety of internal reports such as financial comparisons of
operating alternatives, projections of profit from new sales campaign,
analyses of sales costs, etc.

External Users: Users include Investors who uses accounting

information to make decisions to buy, hold or sell their ownership interest,
Lenders such as bankers who use accounting information to evaluate the
risk of lending money. Other Creditors such as suppliers who use
accounting information to decide whether or no not to grant credit to a

Forms of Business Ownership

Proprietorship: A business owned by one person, the owner has no


Only a relatively small amount of money is needed to start in business as a

proprietorship. The owner receives any profits, suffers any losses and is
personally liable for all debts of the business known as unlimited liability.
There is no legal distinction between the business as an economic unit and
the owner.

The life of the proprietorship is limited to the life of the owner. The
business profits are reported as self employment income and taxed on the
owners personal income tax return.

The Reporting Entity Concept: Requires that the economic activity that
can be identified with a particular company be kept separate and distinct
from the activities of the owner and of all other economic activities.

Ex. of Proprietorships: Hair salons, plumbers and mechanics, farms and small
retail stores.

Partnerships: A business owned by more than one person. Formed

because one person does not have enough economic resources to start of
expand the business or because partners bring unique skills or other
resources to the partnership. Each partner generally has unlimited liability for
all debts of the partnership, even if one of the other partners created the

The profits of the partnership are reported as self employment income and
taxed on each partners personal income tax return. Partnerships follow the
reporting entity concept. Partnerships are typically used to organize
professional service businesses such as the practises of lawyers, doctors,
architects, engineers and accountants.

Corporations: A business organized as a separate legal entity owned by

shareholders. As an investor you receive shares to indicate your ownership
claim. Corporations are separate reporting entities under the reporting entity
concept. Since a corporation is a single legal entity, its life is indefinite which
means that in continues on regardless of who owns its shares.

Shareholders are not responsible for corporate debts unless they have
personally guaranteed them. Most shareholders enjoy limited liability since
they only risk losing the amount they have invested in the companys shares.

Easier to raise capital as opposed to proprietorships and partnerships as it

has advantages like indefinite life, ease of transferring ownership and limited
liability. Corporations pay income tax as separate legal entities on any
corporate profits.

Public Corporation: Required to distribute their financial statements to

investors, lenders, other creditors, other interested parties and the general
public. Shares are listed on Canadian or other stock exchanges.

Private Corporation: Issue shares but they do no make them available to

the general public nor are they traded on public stock exchanges. Private
corporations never distribute their financial statements publicly
Generally Accepted Accounting Principles: broad policies and
practises as well as rules and procedures that have substantiated support
and agreement about how to record and report economic issues.

Business Activities

All businesses involve three types of activities

Financing: Raising outside funds for the corporation. Involves borrowing

money (debt financing) and issuing/selling shares (equity financing). Amount
owed to lenders and other creditors in the form of debt and other obligations
are called liabilities.

When a company uses its operating line of credit to cover cash shortfalls
and overdraws its bank account, it results in a liability called bank

Long term debt can include: mortgage payable, bonds payable, finance
lease obligations and other types of debt securities borrowed for longer
periods of time. A corporation may obtain equity financing by selling shares
of ownership to investors.

Common Share: Describes the amount paid by investors for shares of

ownership in a company. Share capital = Preferred shares + Common Shares.

As a lender or other creditor, you have the legal right to be paid at the
agreed time. In the event of a non-payment, you may force the company to
sell assets to pay its debts.

Many companies pay shareholders a return on their investment on a

regular basis, as long as there is enough cash to cover required payments to
lenders and creditors. Payments to shareholders are called Dividends and
are normally in the form of cash.

Investing: Involve the purchase of long lived assents that a company

needs in order to operate. Assets are resources that a company owns or
controls, the can be short or long lived.

Furniture, equipment, computers, vehicles, buildings and land are all

examples of long lived assets that are referred to as Property, Plant and

Goodwill: results from the acquisition of another company when the price
paid is higher than the value of the purchased companys net identifiable

Intangible Assets: Assets that do not have any physical substance

themselves but represent a privilege or a right granted to, or held by, a
company. Ex. include: patents, copyrights, trademarks.
Investing activities means investing in the long lives assets necessary to
run the company and not just purchasing an investment on which to earn a
return for the long term such as interest or dividends.

Operating: Results from day to day operations can include revenues and
expenses and related accounts such as receivables, supplies, inventory and

Revenue: The amounts earned from the sales of goods, increases in

economic benefits that result from the sale of a product or service in the
normal course of business. Sources of revenues include: Sales revenue,
Service revenue, Interest revenue and Rent revenue.

Accounts Receivable: The right to receive money in the future, amounts

owed to the company by customers who purchased products or services on
credit an are normally supported with an invoice.

When goods are sold, they are no longer an asset with future benefits but
an expense, the cost of inventory sold is an expense called cost of goods
sold. Expenses: the cost of assets that are consumed or services that are
used in the process of generating revenues. Examples of expenses include:
Cost of goods sold, operating and administrative expenses, interest expense
and income tax expense.

Accounts Payable: The obligations to pay for goods, it may also have
interest payable on the outstanding liability amounts owed to various
lenders and other creditors, Dividends payable to shareholders, Salaries
payable to employees, Property tax payable to the municipal and
provincial governments and Sales tax payable to the provincial and federal

When revenues are more than expenses a Profit results, when expenses
exceed revenues a loss occurs. Revenues - Expenses = Profit.

The Four Financial Statements

Income Statement: Reports revenues and expenses to show how

successfully a company performed during a period of time

Reports the success or failure of the companys operations for a period of

time, lists the companys revenues first then expenses. Expenses are
deducted from revenues to determine profit before income tax, Profit is
determined by deducting the income tax expense.

Investors are interested in a companys part profits because these

numbers provide information that may help predict future profits.

Statement of Changes in Equity: Shows the changes in each

component of shareholders equity as well as total equity during a period of
The statement of changes in equity starts with the beginning balance of
share capital. The statement then foes on to add any changes in share capital
due to new shares issued to arrive at the ending balance of share capital.
Common Shares + Common Shares Issued - Common Shares
repurchased = Common Shares.

The statement of changes in equity also shows the amount and causes of
changes in retained earnings. The profit for the period is added and dividends
are deducted from the beginning balance to calculate the retained earnings
at the end of the period. Revenues - Expenses = Profit (or loss) +
Retained Earnings (Beginning of the period) - Dividends = Retained

By monitoring the statement of changes in equity for a publicly traded

corporation, financial statement users can evaluate the use of equity for
financing purposes. They can determine the amount of shares that were
issued during the period.

Statement of Financial Position: Presents a picture of what a company

owns (assets) what it owes (its liabilities) and the resulting difference (its
shareholders equity) at a specific point in time.

Accounting Equation: Assets = Liabilities + Shareholders Equity

Lenders and other creditors analyze a companys statement of financial

position to determine the likelihood that they will be repaid. Managers use
this statement to determine whether inventory is adequate to support future
sales and whether cash on hand is sufficient for immediate cash needs.

Statement of Cash Flows: Shows where a company obtained cash during

a period of time and how that cash was used.

Reports the effects on cash of a companys operating activities, financing

activities and investing activities during the period of time.

Financial Statements must be produced annually, as well as quarterly by

public corporations. An accounting time period that is one year in length is
called a Fiscal Year.

Relationships between the Statements

The statement of changes in equity depends, in part on the results of the

income statement. This amount is added to the beginning amount of retained
earning as part of the process of determining ending retained earnings.

The statement of financial position and statement of changes in equity are

interrelated; the ending balance of shareholders equity in the statement of
changes in equity is the same as the ending balance in the statement of
financial position.
The statement of Cash flows and the statement of financial position are
interrelated, the ending amount of cash shown on the statement of cash
flows agrees with the amount of cash shown in the assets section of the
statement of financial position.

Order: Income Statement, Statement of Changes in Equity, Statement of

Financial Position, Statement of Cash Flows.

*Chapter 2: A Further Look at Financial Statements*

The Classified Statement of Financial Position: Also known as the

balance sheet, presents a snapshot of a companys financial position - its
assets, liabilities and shareholders equity at a point in time.

Determines such things as whether the company has enough assets to pay
its debts as they come due and the claims of short term and long term
creditors and lenders on the companys total assets.


Assets include those resources whose benefits will be realized within one
year (current assets) and those resources that will be realized over more that
one year (non current assets).

Current Assets: Assets that are expected to be converted into cash or will
be sold or used up within one year of the companys financial statement date
or its operating cycle, whichever is longer. Common types of current assets
include: Cash, trading investments, accounts receivables, notes receivables,
merchandise inventory, supplies, prepaid expenses.

Operating Cycle: The average period of time it takes for a business to

pay cash to obtain products or services then receive cash from customers for
these products or services.

Trading investments: Investments in debt securities such as bonds of

another company or equity securities such as shares of another company
that are bought with the intention of selling the investments after a short
period of time in order to earn a profit from their price fluctuations.

Accrued Revenues: Payments for revenues earned by the company that

have no yet been received in cash.

Note receivable: Amounts owed to the company by customers or others

that are supported by a written promise to repay.

Merchandise Inventory: Goods held for sale to customers

Supplies: Consumable items like office supplies and cleaning supplies,
they are current assets because we expect that these will be used by the
business within one year.

Prepaid Expenses: Represent the cost of expenses like rent and

insurance paid in advance of use.

Non Current Assets: Assets that are not expected to be converted into
cash, sold or used up by the business within one year of the financial
statement date or its operating cycle. Common types of non current assets
include: Investments, Property plant and equipment, Intangible assets and
goodwill, and other assets.

Long Term Investments: Include multi year investments in debt

securities (Ex. loans, notes, bonds and mortgages) that management intends
to hold to earn interest and equity securities (Ex. shares) that management
plans to hold for many years to generate investment revenue for strategic

Property, Plant and Equipment: Tangible assets with relatively long

useful lives that are currently being used in operating the business. This
includes land, buildings, equipment and furniture. These items are usually
listed in their order of permanency. Because these assets benefit future
periods, their cost is allocated over their estimated useful lives through a
process called depreciation. Companies calculate depreciation by
systematically assigning a portion of the assets cost to depreciation expense
each year. The cost of land is never depreciated. Assets that are depreciated
are reported on the statement of financial position at cost less their
accumulated depreciation. The difference between cost and accumulated
depreciation is referred to as the Carrying Amount.

Intangible Assets: non current assets that do not have physical

substance and that represent a privilege or a right granted to or held by a
company. Ex. include: patents, copyrights, franchises, trademarks, trade
names and licenses. Intangible assets are divided into 2 categories: those
with definite lives and those with indefinite lives. Intangible assets with
definite lives are allocated through amortization (the same as depreciation for
property, plant and equipment)

Goodwill: Results from acquisition of another company when the price

paid for the company is higher than the fair value of the purchased
companys net identifiable assets. It had no physical value and will generate
future value but cannot be separated from the company and sold. Goodwill is
not amortized and is reported separately from other intangibles.


Obligations that result from past transactions, classified as current and non
Current Liabilities: Obligations that are to be paid or settled within one
year of the companys statement date or its operating cycle. Common
examples of current liabilities include: Bank indebtedness, Accounts payable,
unearned revenue, Notes payable, current maturities of long term debts.

Bank Indebtedness: Short term loan from a bank

Accounts Payable: Amounts owed by the company to suppliers for

purchases made on credit. Include amounts owed by the company for
salaries, interest, sales tax, rent, income tax, etc.

Accrued payables: Expenses incurred by the company have not yet been
paid in cash

Unearned Revenue: Cash received in advance from a customer before

revenue is earned

Notes Payables: Amounts owed, often to banks but also to suppliers or

other, that are supported by a written promise to repay. May be current or
non current, non current note payables have a portion repayable each year,
the portion of the payment due to be made sometime during the next year is
a classified current maturities of long term debt.

Non Current Liabilities: Obligations that are expected to be paid or

settled after one year. Examples of non current liabilities include: Notes
payable (bank loans payable, mortgage payable, bonds payable) Lease
obligations, Pension and benefit obligations and Deferred income tax

Mortgage Payable: Long term payable that have property pledged as

security for the loan

Bonds Payable: used by large corporations and governments to borrow

large sums of money

Lease Obligations: Amounts to be paid in the future on long term rental

contract used for equipment or other property.

Pension and Benefit Obligations: Amounts company owe past and

current employees for retirement benefits

Deferred Income Tax Liabilities: Income tax related to the current

years profit that is expected to be paid in a later year or years when a
company prepares its future corporate income return.

Shareholders Equity

Shareholders equity is divided into two parts: Share Capital and Retained
Share Capital: Shareholders purchase shares in a company by investing
cash. When the company receives these assets, it issues ownership
certificates to these investors in the form of common or preferred shares, the
total of all classes of shares issues is classified as Share Capital.

Retained Earnings: The cumulative profits that have been retained for
use in a company are known as retained earnings. The ending balance of
share capital and retained earnings are combined and reported as
shareholders equity on the statement of financial position.

Order of Liquidity
Current Assets, Non Current Assets, Current Liabilities, Non Current
Liabilities, Shareholders Equity.

Using the Financial Statements

Ratio Analysis: Expresses the relationship between selected items of

financial statement data. Liquidity, Solvency and Profitability are the three
general types of ratios that are used to analyze financial statements

Intracompany Comparisons: Covering two or more periods for the same


Intercompany Comparisons: Based on comparisons with a competitor in

the same industry

Industry Average Comparisons: Based on average ratios for particular

industries with specific company ratios


Ability to pay obligations that are expected to become due within the next
year. Liquidity Ratios: Measure a companys short term ability to pay its
maturing obligations and to meet unexpected needs for cash. Two Examples
include: Working Capital and Current Ratio.

Working Capital: Difference between current assets and current

liabilities, when the working capital is positive there is a greater likelihood
that the company will be able to pay its liabilities. When it is negative, a
company may have to borrow money to pay short term creditors. Current
Assets - Current Liabilities

Current Ratios: Measures the relative relationship between current

assets and current liabilities. Current Assets/Current Liabilities.

Ex. 0.1: 1 means that for every dollar of current liabilities, you have 10 cents
of current assets. For a company to be in good shape it should exceed a value
of at least 1 to 1. The current ratio does not take into account the
composition of the current assets.

Ability to pay interest as it comes due and to repay the face value of debt
at maturity. Solvency Ratios: Measure a companys ability to survive over a
long period of time by having enough assets to settle its liabilities as they fall

Debt to Total Assets Ratio: Measures the percentage of assets that are
financed by lenders and other creditors rather than shareholders. Financing
provided by lenders and creditors is riskier than financing by shareholders
because debt must be repaid at specific point in time, equity does not have
to be repaid and there is no requirement for companies to pay dividends.
Total Debt (Current + Non Current Liabilities)/Total Assets

The higher the percentage of debt to total assets, the greater is the risk
that the company may be unable to pay its debts as they come due.


Profitability Ratios: Measures a companys operating success for a

specific period of time. Two examples of profitability ratios are:

Earnings Per Share: Measures the profit earned on each common share.
Profit - Preferred Share Dividends/Common Shares

Price Earnings Ratio: Measures the ratio of the stock market price of
each common share to its earnings per share. Market Price per Share/
Earnings per Share. The price earnings ratio shows what investors expect
of a companys future profitability, this ratio will be higher if investors think
that current profits will increase and it will be lower if investors think that
profits will decline.

Framework for the Preparation and Presentation of Financial Statements

Conceptual Framework: A coherent system of interrelated objectives and

fundamentals that can lead to consistent standards and that prescribes the
nature, function and limits of financial accounting statements. Key conceptual
frameworks include:

Objective of Financial Reporting: To provide financial information about

a company that is useful to existing and potential investors, lender and other
creditors in making decisions (buying, selling, holding equity, providing or
settling loans, etc.) about providing resources to the company.

Financial statement provide information about the companys economic

resources and the claims against these resources. They also provide
information about the effects of transactions and other events that change
companys economic resources and claims.
Accrual basis for accounting: The effects of transactions on a
companys economic resources and claims are recorded in the period when a
transaction occurs and not when cash is received or paid.

Qualitative Characteristics of Useful Financial Information

The two fundamental qualitative characteristics of useful financial

information are:

1. Relevance: Accounting Information has relevance if knowledge of it will

influence a users decision. Relevant information may have:

Predictive Value: If it helps users make predictions about future events

Confirmatory Value: If it helps users confirm or correct their previous

predictions or expectations

Materiality: Information is considered to be material if its omission or

misstatement could influence the decisions of users.

2. Faithful Presentation: Information must be complete (nothing

important is omitted, neutral (not biased toward one position or another)
and free from material error. Faithful presentation does no necessarily
mean accuracy in all respects.

The conceptual framework also describes four enhancing qualities of useful

information, these include:

1. Comparability: Results when users can identity and understand

similarities and differences among items. Consistency aids comparability
when a company uses the same accounting principles and methods from
year to year or when companies with similar circumstances use the same
accounting principles.

2. Verifiability: Information has verifiability if different knowledge and

independent users can reach consensus that the information is faithfully

3. Timeliness: Information must be made available to decision makers

before it loses its ability to influence decisions

4. Understandability: Information has the quality of Understandability if it

is classified, characterized and presented clearly and concisely. Users with a
reasonable knowledge of business can interpret the information and
comprehend its meaning.

Cost Constraint on Useful Financial Reporting

Cost Constraint: A pervasive constraint that ensures that the value of the
information provided in financial reporting is greater than the cost of
providing it. The benefits of financial reporting information should justify the
cost of providing it and using it.

Underlying Assumption

Going Concern Assumption: Assumes that a company will continue to

operate for the foreseeable future. If a company is assumed to be a going
concern, then reporting assets such as equipment, as non current makes
sense because those assets are expected to be used for more than one year.

Elements of Financial Statements

Elements of financial statements include: assets, liabilities, equity,

income and expenses.

Measurement of the Elements

Two basis of measurement:

1. Historical Cost:

Cost basis of Accounting: States that assets and liabilities should be

recorded at their cost at the time of acquisition.

2. Fair Value:

Fair Value of Accounting: States that certain assets and liabilities should
be recorded and reported at fair value (The price that would be received to
sell an asset or paid to transfer a liability).

*Refer to Illustration 2-20 on Pg. 77*

*Chapter 3: The Accounting Information System*

Accounting Information System: A system of collecting and processing

transaction data and communicate financial information to decision makers

Accounting Transaction: Occurs when assets, liabilities or shareholders

equity items change as a result of an economic event.

Expenses reduce retained earnings and ultimately shareholders


Payments of expenses that will benefit more than one accounting period
are assets and are identified as prepaid expenses or prepayments.

A purchase on account or on credit means that instead of paying cash,

the company incurs a liability usually an account payable, by promising to
pay cash in the future. When a company provides services on account or on
credit, the company receives an asset known as accounts receivable.
Revenue is earned when services are performed.

Unearned revenue is a payable account even though the word payable is

not used.

An increase in dividends reduces both retained earnings and

shareholders equity.

Each transaction must be analyzed for its effect on the three primary
components of the accounting equation (assets, liabilities and shareholders
equity) and the two sides of the equation must always be equal.

The Account

An Account: Is an individual accounting record of increases and decreases

in a specific asset, liability or shareholders equity item.

Consists of three parts: the title of the account, a left or debit side and a
right or credit side. The alignment of these parts of an account is referred to
as a T account.

Debit: means left, Debiting: Making an entry on the left side

Credit: means right, Crediting: Making an entry on the right side

Debit and Credit are merely directional signals in the recording process to
describe where entries are made in the accounts.

An account will have a debit balance if the total of the debit amounts
recorded exceed the total of the credit amounts recorded and vice versa.

At all times the credit movements in the accounts must equal the debit
movements in the accounts.

Double Entry Accounting System: The equality of debits and credits,

the effects of each transaction is recorded in appropriate accounts.

Increases in an asset account are recorded as debits while decreases are

recorded as credits. Increases and decreases in liabilities and shareholders
equity have to be recorded opposite from increases and decreases in assets.
Thus, increases in liabilities and shareholders equity are recorded by credits
and decreases by debits.

Asset accounts normally show debit (left side) balances, debits to a specific
asset account should exceed credits to that account which results in a debit
Liability accounts normally show credit (right side) balances, credits to a
specific liability account should exceed debits to that account which results in
a credit balance.

Shareholders Equity consists of different components and they do not all

move in the same direction.

Increases in Shareholders Equity: Common shares and retained

earnings both increase shareholders equity, retained earnings are increased
by revenues. The common shares, retained earnings and revenue accounts
are increased by credits and decreased by debits, The normal balance on
these accounts is a credit balance.

Decreases in Shareholders Equity: Expenses and dividends both

decrease retained earnings (which in turn decrease shareholders equity).
Expense accounts are increased by debits and decreased by credits.
Dividends are a distribution to shareholders of retained earnings, which
reduces retained earnings. Increases in the dividends account are recorded
with debits and decreases are recorded with credits. The normal balance in
these accounts is a debit balance.

*Refer to Illustration 3-5*

The Journal (2nd Step)

The second step of the accounting cycle, the transaction information is

recorded as a journal entry in the general journal

Accounting Cycle: A series of nine steps to record transactions and

prepare financial statements

1. Analyze business transaction

2. Journalize the transactions
3. Post to general ledger
4. Prepare a trial balance

Evidence of the transaction comes from a source document, such as a

sales slip, cheque, bill or cash register tape.

General Journal: records transactions in chronological order, helps

prevent and locate errors (because the credit and debit accounts can be
quickly compared), it discloses the complete effect of a transaction in one
place, including an explanation and, where applicable, identification of the
source document. Entering transaction data in the general journal is know as

Regardless of the number of accounts used in the journal entry, the total
debit and credit amount must be equal.

The Ledger (3rd Step)

The third step of the accounting cycle is to transfer the journal entries
recorded in the general journal to the appropriate accounts in the general

A General Ledger: contains all the asset, liability, shareholders equity,

revenue and expense accounts. Starts with the statement of financial position
accounts, then the income statement accounts - the asset accounts come
first, followed by the liability accounts, and then shareholders equity
accounts, including share capital, retained earnings, and dividend accounts,
followed by revenue and expense accounts.

Charts of Accounts: The framework for the accounting database, it lists

the accounts and the account numbers that identify where the accounts are
in the ledger.

Posting: The procedure of transferring journal entries from the general

journal to the general ledger accounts. Posting should be done in
chronological order.

*Refer to Pg. 123 - 129 - Illustrations for Transactions 1 - 13 + GJ +


The Trial Balance (4th Step)

The fourth step in the accounting cycle is to prepare a trial balance.

A Trial Balance: is a list of general ledger accounts and their balances at a

specific time. The accounts are listed in the order in which they appear in the
ledger. The main purpose of the trial balance is to prove that the debits equal
credits after posting, the trial balance can help uncover errors in journalizing
and posting.

The retained earnings balance that is listed on the trial balance is the
retained earnings balance at the beginning of the period.

Errors may exist in a trial balance even though the trial balance column
agree. The trial balance may balance when: a transaction is not journalized, a
correct journal entry is not posted, a journal entry is posted twice, incorrect
accounts are used in journalizing or posting, errors that cancel each others
effect are made in recording the amount of a transaction

Chapter 4: Accrual Accounting Concepts

Interim Periods: Accounting periods that are shorter than 1 year

Revenue Recognition occurs when three conditions:

The sales or performance effort is substantially complete

The revenue amount is determinable (measureable)

The collection of the revenue is reasonably assured

Expense Recognition: Linked to revenue recognition when there is a

direct association between the expenses incurred and the generation of
revenue, this is known as Matching.

Accrual Basis Accounting: Transactions affecting a companys financial

statements are recorded in the periods in which the events occur rather than
when the company actually receives or pays cash.

This means recognizing revenues when they are earned rather than only
when cash is received. Likewise, expenses are recognized in the period in
which goods are consumed or services are used, rather than only when cash
is paid.

Cash Basis Accounts: An alternative to Accrual Basis Accounting, revenue

is recorded only when cash is received, and an expense is recorded only
when cash is paid.

The Basics of Adjusting Entries

For revenues to be recorded in the period in which they are earned and for
expenses to be recorded when incurred, we may have to record Adjusting
Entries to update accounts at the end of the accounting period.

Adjusting entries ensure that revenue recognition and expense recognition

are properly applied and make it possible to produce up to date and relevant
financial information at the end of the accounting period.

Adjusting entries are necessary because the trial balance may not contain
complete and up to date data. This is true because:

Some events are not recorded daily because it would not be useful or
efficient to do so, ex. supplies and the earning of salaries.

Some costs like rent, insurance and depreciation are not recorded during
the accounting period as they expire with the passage of time

Some items may be unrecorded like utilities expense which is not received
until the next accounting period.

Each account in the trial balance will need to be analyzed to see if it

is complete and up to date, because many of the amounts listed in the
trial balance are incomplete until adjusting entries are prepared, this
trial balance is referred to as an unadjusted trial balance, which
means it was prepared before adjusting entries have been made.
Adjusting entries can be classified as either prepayments or accruals,
each class has two subcategories:

Prepaid expenses (Prepayment): Expenses paid in cash and

recorded as assets before they are used. When such a cost is incurred,
an asset (prepaid) account is debited to show the service or benefit
that will be received in the future and cash is credited. Prepaid
expenses are costs that expire either with the passage of time
(Insurance) or through use (Supplies).

Prepayments increase current assets such as prepaid expenses and

also affect certain types of non current assets such as buildings and
equipment. A prepayment can be received rather than paid, in which
case the prepayment increases current liabilities such as unearned

Adjusting entries are made to record the expenses (expired costs)

applicable to the current account period and to show the remaining
amounts (unexpired costs) in the asset accounts.

Adjusting Entry: adjusting entries for prepaid expenses

result in an increase (a debit) to an expense account and a
decrease (a credit) to an asset account (prepaid expenses)

Reasons for Adjustment: Prepaid Expenses recorded in asset

accounts have been used.

Accounts before Adjustment: Expenses are understated and Assets

are overstated.

* Refer to Pg. 173 for Summary for Prepaid Expenses*

Until prepaid expenses are adjusted, assets are overstated and

expenses are understated which result in profit and shareholders
equity to be overstated.

Types of prepaid expenses include

Supplies: Supplies expense is recognized at the end of the

accounting period, the company must count the remaining supplies.
The difference between the balance in the supplies account and the
actual cost of supplies on hand gives the supplies used for that period.

*Refer to Pg. 169 - 170 for how the transaction is posted and
Insurance: Insurance payments made in advance are normally
recorded in the asset account Prepaid insurance. At the financial
statement date, it is necessary to make an adjustment to increase
(debit) Insurance expense and decrease (Credit) Prepaid insurance for
the cost of insurance that has expired during the period.

*Refer to Pg. 170 for how the transaction is posted and


Depreciation: The process of allocation the cost of a long lives or

non current asset, such as buildings and equipment, to expense over
its useful life, the term amortization is used in relation to intangible
assets. The straight line method divides the cost of the asset by its
useful life. Depreciation is an estimate is an estimate rather than a
factual measurement of the cost that has expired. Accumulated
Depreciation is a Contra asset account: It is offset against an asset
account, equipment on the statement of financial position. It normal
balance is a credit - the opposite of the normal debit balance of its
related account, equipment. The difference between the cost of a
depreciable asset and its related accumulated depreciation is referred
to as the carrying amount of that asset.

*Refer to Pg. 172 for how the transaction is posted and


Unearned Revenues (Prepayment): Cash received and recorded

as liabilities before revenue is earned.

Results when cash is received in advance for items like rent, magazine
subscriptions and customer deposits - received for services that will provided
in the future.

Cash is increased and the liability account unearned revenues increased to

recognize that the company has received cash in advance and has an
obligation to provide a service in the future or refund the cash.

Adjusting Entry: The adjusted entry results in a decrease (debit) to

the liability (unearned revenue) account and an increase (credit) to a
revenue account.

Reasons for Adjustment: Unearned revenues recorded in liability

accounts have been earned.

Accounts before Adjustment: Liabilities overstate and Revenues

* Refer to Pg. 174 for Summary on Unearned Revenues*

Each simple adjusting entry for prepayments, whether a prepaid expense

or an unearned revenue, affects one statement of financial position account
and one income statement account.

Accrued Revenues (Accruals): Revenues earned but not yet

received in cash or recorded. An adjusting entry is required for two
purposes: To show the receivable that exists at the end of the period,
and to record the revenues are understated.

Adjusting Entry: An adjusting entry for accrued revenues

results in an increase (a debit) to an asset account and an
increase (a credit) to a revenue account.

Accounts before Adjustment Assets are understated and Revenues

are understated.

Reasons for Adjustments: Revenues have been earned but not yet
received in cash or recorded.

*Refer to Pg. 176 - 177 for Examples on Accrued Revenues*

Accrued Expenses (Accruals): Expenses incurred but not yet paid

in cash or recorded. An adjusting entry is required for two purposes: to
record the obligations that exist at the end of the period and to
recognize the expenses that apply to the current accounting period.

Adjusting Entry: An adjusting entry for accrued expenses results in

an increase (debit) to an expense account and an increase (credit) to
a liability account.

Types of accrued expense accounts include:

Interest: Interest rates are always expressed in annual terms. The

amount of interest accumulation is determined by the principal amount of the
loan, the interest rate which is always expressed as an annual rate and the
length of time that the loan is outstanding (unpaid).

Ex. a bank loan for 5,000$, repayable in 3 months at a annual interest rate
of 6% results in a total interest of 75$ (5,000 x 6% x 3/12) for three months.
Debit interest expense and credit interest payable.

Interest = Principal amount x Annual Interest Rate x Time in Terms

or One year

Salaries: Ex. Salaries are paid every 2 weeks, Four employees are
to be paid, each receive a salary of 500$ a week for a five day
workweek. Accrual salaries are 2000$ (5 days x $100/day x 4
employees). Debit salaries expense and credit salaries payable.

Reasons for Adjustment: Expenses have been incurred but not yet
paid in cash or recorded.

Accounts before adjustments: Expenses are understated and

Liabilities are understated.

Adjusting entries never involve the cash accounts, In the case of

prepayments, cash has already been received or paid and recorded in the
original journal entries. The adjusting entry simply reallocates amounts
between a statement of financial position account and an income statement

* Refer to Pg. 177 - 180 for Examples on Accrued Expenses*

* Refer to Pg. 181 - 182 for a journal entries and general ledger on
the 2 subcategories (Prepayments and Accruals)*

The Adjusted Trial Balance and Financial Statements

After all adjusting entries have been journalized and posted, another trial
balance is prepared from the general ledger accounts. This trial balance is
called an Adjusted Trial Balance.

The Adjusted trial balance lists the accounts in the general ledger and
proves that the totals of the debit and credit balances in the ledger are equal
after all adjustments have been recorded and posted (similar to the
unadjusted trial balance)

* Refer to Pg 184 for Example and Pg. 185 to see affects in Financial

Closing the Books

Because revenues, expenses and dividends relate to activities over a

particular accounting period, they are considered Temporary Accounts. In
contrast, all statement of financial position accounts are considered
Permanent Accounts because their balances are carried forward into future
accounting periods.

Temporary: All expense accounts, all revenue accounts, dividend

Permanent: All asset accounts, all liability accounts, all shareholders
At the end of the accounting period, the temporary account balances are
transferred to the permanent shareholders equity account Retained Earnings
through the preparation of closing entries.

Closing Entries: Formally record in the general journal and the ledger the
transfer of the balances in the revenue, expense, and dividends accounts to
the Retained Earnings account, thereby updating that account to its end of
period balance.

After closing entries are recorded and posted, the balance in retained
earnings is the end of period balance. Before then it was the balance at
the beginning of the period.

In addition to updating Retained Earnings to its ending balance,

closing entries produce a zero balance in each temporary account.
These accounts are ready to accumulate data about revenues,
expenses and dividends for the next accounting period. Permanent
accounts are not closed.

When closing entries are prepared, each revenue and expense

account could be closed directly to Retained Earnings. The Revenue
and Expense accounts are first closed to another temporary account,
Income Summary. Only the resulting total amount (profit or loss) is
transferred from this account to the Retained Earnings account

To prepare closing entries:

1. To close revenue accounts: Debit each individual revenue account

for its balance, and create Income Summary for total revenues. After
this all revenue accounts will have zero balances.

2. To close Expense accounts: Debit Income Summary for total

expenses, and credit each individual expense accounts for it
balance. After this, all expense accounts with have zero balances.

3. To close Income Summary: Debit Income Summary for the balance

in the account (or credit it if there a loss) and credit (debit) Retained
Earnings. After this Income Summary account balance is zero

4. To close the Dividends account. Debit Retained Earnings for the

balance in the dividends account, and credit dividends, thereby
bringing the balance in this account to zero. Do not close Dividends
to the Income Summary account along with expenses. Dividends are
not expenses and do not affect profit, they are a distribution of
retained earnings.

*Refer to Pg. 189 - 191 for Closing Journal Entries, Closing General
ledger and post closing trial balance.*
Make sure that after closing the entries you check that:

The balance in the Income Summary before the final closing entry
to transfer the balance to the Retained Earnings accounts, should
equal the profit ( or loss) reported on the Income Statement.

All temporary accounts (Revenues, Expenses, Income Summary

and Dividends) should have zero balances

The balance in the Retained Earnings accounts should equal the

ending balance reported in the statement of changes in equity and
statement of financial position.

After all the closing entries are journalized and posted, another trial
balance, called the Post Closing Trial Balance is prepared from the ledger,
it lists all permanent accounts and their balances after closing entries are
journalized and posted. The preparation of the post closing trial balance is the
last step in the accounting cycle:

1. Analyze Business Transactions

2. Journalize the Transactions
3. Post to general ledger accounts
4. Prepare a Trial balance
5. Journalize and post adjusting entries: Prepayments/Accruals
6. Prepare an adjusted Trial Balance
7. Prepare Financial Statements (Income, changes in equity, financial
position, cash flows)
8. Journalize and Post closing entries
9. Prepare a post closing trial balance.