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PROBLEMS ments identified by .

Recording Transactions
P2-1
Obj. 2 Surf-The-Net.com had the following events occur during October:
1. Paid $5,800 for utilities.
2. Made cash sales to customers that totaled $89,460. The merchandise had cost Surf-The-
Net.com $60,000
3. Paid $28,600 for new equipment.
4. Repaid a $4,900 bank loan.
5. Borrowed $65,000 from local bank.
6. Paid $59,430 to employees for salaries.
7. Paid $11,900 for maintenance and repair.
8. Received $48,600 from investors.
9. Paid $3,750 for supplies that were used.

Required
A. Record transactions 1–9 using the format illustrated in the chapter.
B. What issues must a manager consider before making a financing decision or investing
decision?

Classifying Activities as Operating, Investing, or Financing
P2-2
Objs. 1, 3, 4 Refer to the information provided in P2-1.

Required Identify each transaction in P2-1 as a financing, investing, or operating activity.

The Accounting Equation
P2-3
Obj. 2 Apollo Corporation reported the following accounts and balances in its financial statements:

Cash $10,000
Merchandise Inventory 30,000
Equipment 45,000
Notes Payable 20,000
Contributed Capital 35,000
Retained Earnings 30,000

Required Arrange the accounts and balances into the accounting equation as shown below:

Assets Liabilities Equity

Recording Transactions
P2-4
Obj. 2 Davidson Enterprises had the following transactions during its first month of business, June 2004.
June 1 Lynne Davidson set up a bank account in the business name and deposited $8,000
of her personal funds to it.
2 June’s rent of $525 per month for a store-front location was paid in cash.
7 Goods for resale costing $3,600 were purchased using cash.
12 Paid advertising costs of $1,000 for the firm’s Gala Grand Opening.
26 Goods costing $3,000 were sold during June for $7,200 in cash.
30 Workers were paid $850 and the utility company was paid $228 for June services.
(Continued)
F72 SECTION F1: The Accounting Information System
71
Business Activities - The Source of Accounting Information

Required
A. Use the format illustrated below to show how these transactions would be recorded.
B. Prepare an income statement that reports the firm’s profit during June.
C. Prepare a balance sheet that reports the firm’s assets, liabilities, and equity at June 30.


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Beginning Amounts 0 0 0 0 0




P2-5 Classifying Transactions as Financing, Investing, or Operating
Objs. 1, 3, 4
Refer to the information provided in P2-4.

Required Identify each transaction in P2-4 as financing, investing, or operating.


Recording Transactions
P2-6
Obj. 2 Carmen Bay Company sells a variety of souvenirs to tourists on the beach. Teenagers are paid
20 percent of the sales price to hawk the wares up and down the beach and are paid daily. The
company was formed only recently and given approval by the local city council to operate.
The following events are the first in the company’s short history:
1. The company was formed when Carmen Bay contributed $2,150 to the firm.
2. A local bank loaned the firm $4,000 in exchange for the firm’s one-year note
payable.
3. Merchandise costing $4,100 was purchased with cash.
4. Goods costing $825 were sold to tourists for a total of $2,250 in cash, and the teenagers
were paid their commissions.
5. A payment of $1,500 was made to the local bank on the note payable.
6. Carmen Bay withdrew $500 cash for personal use (Hint: reduce retained earnings).
Assume the company uses the following set of accounts:

Cash Notes Payable
Cost of Sales Merchandise Inventory
Sales Contributed Capital
Retained Earnings Commissions Expense

Required Determine how each event affects the company, and record the events using the
format shown below.



ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Beginning Amounts 0 0 0 0 0




Recording Transactions
P2-7
Obj. 2 Randi had a hard time finding a summer job when she went home from college, so she de-
cided to go into business for herself mowing lawns. She had the following business activities
during the month of June.
F73
CHAPTER F2: Business Activities—The Source of Accounting Information
72 Business Activities - The Source of Accounting Information

June 1 Used $200 of her own money and borrowed $450 from her father to start the busi-
ness.
2 Rented a used pickup truck from an uncle for $85 per month. Paid for the first
month’s use.
3 Rented a lawnmower ($75 per month), an edger ($50 per month), and a wheelbar-
row ($10 per month) at an equipment rental store. Paid the first month’s rental fees
in full.
16 During the first two weeks, performed $528 of lawn-mowing services. Customers
paid in cash. Paid out $52 for gas, oil, and other supplies.
18 Paid $35 for a newspaper advertisement that had appeared earlier in the month.
30 During the last half of the month, performed $507 of lawn-mowing services and
collected the cash.
30 Paid out $107 for gas, oil, and other supplies.
30 Paid back one-half of the amount she had borrowed from her father plus $5 for in-
terest.

Randi knew from taking an accounting class at college that the following accounts would be
needed to keep track of her business activities.

Cash Equipment Rental Expense
Note Payable—Dad Contributed Capital
Service Revenue Retained Earnings
Gas and Oil Expense Advertising Expense

Required
A. Show how each event would be entered into the accounting system.
B. Prepare an income statement for Randi’s Lawn-mowing Service for the month of June.
C. Prepare a balance sheet as of June 30.
D. Did Randi make a smart decision when she started her own business? What factors
might be considered in making that evaluation?

Reconstructing Events from Information in the Accounting Database
P2-8
Obj. 2 Jill Jones has just established a security alarm maintenance service. She charges $20 per hour
per person and is paid by check upon completion of the job. Her expenses are rather low—
usually only supplies and transportation. Following are the entries to the accounting system
that were made for the first seven transactions of the company.


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
1 Cash 5,000
Contributed Capital 5,000
2 Supplies Inventory 300
Cash 300
3 Cash 4,200
Service Revenues 4,200
4 Utilities Expense 450
Cash 450
5 Transportation Expense 500
Cash 500
6 Insurance Expense 700
Cash 700
7 Retained Earnings 1,300
Cash 1,300
Ending Amounts 5,950 300 5,000 1,250

(Continued)
F74 SECTION F1: The Accounting Information System
73
Business Activities - The Source of Accounting Information

Required
A. For each transaction, describe the event that caused the entry to be made.
B. How much income (or loss) did the company earn?

Understanding Information in the Accounting Information System
P2-9
Obj. 2 Jacqueline owns and operates a specialty cosmetics manufacturing firm. Distribution is pri-
marily through boutique shops in regional shopping centers, although some items are sold di-
rectly through a network of beauty consultants. Raw materials consist of various lotions,
potions, fragrances, oils, and powders. The transactions that occurred during the month of
March were entered into the accounting system as follows.


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Mar. 1 Cash 10,000
Contributed Capital 10,000
Mar. 3 Cash 7,000
Notes Payable 7,000
Mar. 5 Merchandise Inventory 8,100
Cash 8,100
Mar. 18 Cash 15,250
Sales Revenue 15,250
Cost of Goods Sold 7,500
Merchandise Inventory 7,500
Mar. 18 Wages Expense 650
Cash 650
Mar. 23 Notes Payable 2,500
Cash 2,500
Mar. 31 Retained Earnings 2,000
Cash 2,000
Ending Amounts 19,000 600 4,500 10,000 5,100




Required
A. Describe each of the firm’s transactions. Specify as much detail about each transaction
as you can.
B. Assume an income statement and balance sheet are prepared immediately after the last
transaction.
1. What amount of net income would be reported?
2. What total amount of owners’ equity would be reported on the balance sheet?


Reconstructing Events from the Financial Statements
P2-10
Obj. 2 Costantino Company just started in business. The first seven transactions have been entered
into and processed by the company’s computerized accounting information system. To be
sure the accounting system is operating properly, Jim Costantino, the owner, has printed out
the financial statements as produced by the accounting system after seven transactions.
F75
CHAPTER F2: Business Activities—The Source of Accounting Information
74 Business Activities - The Source of Accounting Information


Assets: Liabilities and Equity:
Cash $22,850 Payable to bank $ 6,285
Equipment 11,000 Payable for equipment 11,000
Owner investment 15,000
Retained earnings 1,565
Total assets $33,850 Total liabilities and equity $33,850
Revenues $ 2,250
Expenses:
Rent (400)
Wages (250)
Internet service (35)
Net income $ 1,565




Required Identify the seven transactions and as much detail about each transaction as you
can.

Recording Transactions and Preparing Financial Statements
P2-11
Objs. 2, 5 Assume that you began a small business in May 2004 by (1) investing $10,000 and (2) bor-
rowing $30,000 from a bank. You (3) purchased equipment for $25,000 cash and (4) pur-
chased merchandise for $12,000 using cash. During the first month of operations, your
company (5) sold merchandise for $27,000 in cash. (6) The cost of merchandise sold during
the month was $10,000. You (7) repaid $300 of the amount borrowed from the bank. You (8)
withdrew $800 from the business for personal use. The name of your business is Sand Dune
Trading Company.

Required
A. Record transactions 1–8 using the format illustrated in the chapter.
B. Prepare an income statement for May 2004, the first month of operations.
C. Prepare a balance sheet at the end of the first month.

Identifying Financial Statements
P2-12
Obj. 5 Refer to the information about financial statements below.
1. The statement provides information about resources consumed during an accounting
period.
2. The statement is dated as of a specific point in time.
3. The amounts that are owed to other organizations or individuals are reported.
4. The total amount of capital that has been contributed to the organization is reported.
5. The cash used for investing activities is reported.
6. Information is reported regarding the rewards that have been earned from serving cus-
tomers during the accounting period just ended.
7. The cash received from financing activities is reported.
8. The statement is not as of a specific date, but covers a period of time.
9. The statement contains information about the financial obligations that were made to
acquire resources.
10. The statement reports cash inflows and outflows.

Required For each item above, indicate the financial statement for which the information
is true. Use I to indicate income statement, B to indicate balance sheet, C to indicate cash flow
statement. If an item is not true for any of the three financial statements, indicate with an N.

Summarizing the Results of Financial Activities
P2-13
Obj. 5 The accounting staff at Moonbeam Enterprises prepares monthly financial statements. At the
end of April 2004 the company had the following account balances:
(Continued)
F76 SECTION F1: The Accounting Information System
75
Business Activities - The Source of Accounting Information

Land $45,000
Notes payable 33,000
Merchandise inventory 12,480
Buildings 50,000
Cash 10,360
Contributed capital 38,770
Retained earnings, April 30 46,070
Cost of goods sold 15,050
Sales revenue 26,000
Supplies expense 1,300
Income tax expense 1,060
Wage expense 1,500
Insurance expense 550
Interest expense 900

Required Prepare an income statement and balance sheet in good form. For each statement,
use a three-line heading on the statement that includes (a) the name of the company, (b) the
name of the statement, and (c) the appropriate time period or date.

Recording Transactions
P2-14
Objs. 2, 5 Larrisa Enterprises, Inc., owns and operates a chain of mini-mart stores in a popular summer
resort area. Business is highly seasonal with about 80% of annual sales occurring during June,
July, and August. Shown below are transactions that occurred during the first week of June.

June 3 Merchandise costing $120,000 was purchased from a supplier using cash.
4 Dividends of $25,000 were distributed to owners for their own personal use. (Hint:
Dividends reduce Retained Earnings.)
5 Goods costing $112,000 were sold to customers for $140,000 cash.
5 Advertising was run in local newspapers during the first week. The bill, for $9,000,
was paid on June 5.
6 Electricity, water, natural gas, and Internet charges totaling $450 were paid in cash.
6 Display equipment was purchased for $15,000 cash.
7 Employees were paid a total of $12,900 for all work performed through the end of
the first week of June.

Required Show how the events above would be entered into the accounting system using
the format demonstrated in the chapter. Beginning balances are provided below:

ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Beginning Amounts 90,000 150,000 80,000 60,000 100,000



Classifying Transactions as Financing, Investing, or Operating Activities
P2-15
Objs. 1, 3, 4 Refer to the information provided in P2-14.

Required Identify each transaction in P2-14 as a financing, investing, or operating activity.

Preparing a Statement of Cash Flows
P2-16
Obj. 5 Crimson Florist had the following cash flows for the month of July 2004.

Cash paid for wages $ 5,000
Cash paid for supplies 2,500
Cash received from sales to customers 15,000
Cash paid for equipment 5,000
Cash received from owners 13,000
Cash paid for utilities 3,500
Cash received from creditors 8,500
F77
CHAPTER F2: Business Activities—The Source of Accounting Information
76 Business Activities - The Source of Accounting Information

The cash balance on July 1 was $3,200.
Required
A. Prepare a statement of cash flows for Crimson Florist.
B. What is the purpose of the statement of cash flows?

Preparing a Statement of Cash Flows
P2-17
Obj. 5 During January, The College Shop had the following cash flows:
Cash paid for merchandise $ 4,000
Cash paid for rent 5,300
Cash received from sales to customers 13,000
Cash paid for utilities 200
Cash received from owners 9,000
Cash paid for equipment 7,000
Cash paid for insurance 2,500
Cash received from a bank loan 10,500
Cash paid for wages 1,200
The beginning cash balance was $4,000.
Required Prepare a statement of cash flows for The College Shop.

Financial Analysis
P2-18
Obj. 5 Holiday Travel Store is a retailer that sells merchandise at a family campground. The com-
pany’s most recent income statement and balance sheet are presented below:


Holiday Travel Store
Income Statement
For the Year Ended December 31, 2004

Sales revenue $75,000
Cost of goods sold (43,000)
Wages expense (15,000)
Supplies expense (3,500)
Utilities expense (2,000)
Rent expense (8,000)
Net income $ 3,500




Holiday Travel Store
Balance Sheet
December 31, 2004

Assets
Cash $ 900
Merchandise inventory 7,000
Equipment 20,000
Total assets $27,900
Liabilities and Owners’ Equity
Notes payable $15,500
Contributed capital 10,000
Retained earnings 2,400
Total liabilities and owners’ equity $27,900



Required
A. Calculate Holiday Travel Store’s return on assets.
B. Explain what the ratio means.
C. What kinds of changes might the owners make if the return on assets is not acceptable?
F78 SECTION F1: The Accounting Information System
77
Business Activities - The Source of Accounting Information

P2-19 Recording Transactions Using the Debit and Credit Format
Obj. 2, Appendix
Refer to the information provided in P2-6.

Required For each transaction described in P2-6, record the transaction using the debit and
credit format illustrated in the appendix.


Recording Transactions Using the Debit and Credit Format
P2-20
Obj. 2, Appendix Refer to the information provided in P2-7.

Required For each transaction described in P2-7, record the transaction using the debit and
credit format illustrated in the appendix.


Excel in Action
P2-21
Millie and Milo Wermz are the owners of The Book Wermz. The business is operated as a
corporation. The Wermz invested $100,000 in the company when they started it in 1996. This
investment represents the company’s stockholders’ equity. The company’s account balances
on September 30, 2004—the end of the fiscal year—were: Cash $4,238.72, Inventory of Books
$235,892.35, Supplies $2,343.28, Equipment $43,297.00, Notes Payable $123,452.88, Invest-
SPREADSHEET
ment by Owners $100,000, and Retained Earnings $62,318.47.
Summary transactions for The Book Wermz for October 2004 included:

Cash sales $38,246.50
Cost of goods sold 27,318.93

Required Use a spreadsheet to keep track of account balances for The Book Wermz. Enter
the titles of accounts in row 1. Use column A for dates. Enter account balances for Septem-
ber 30, 2004 in row 2. A partial spreadsheet is illustrated below as an example:
Use the Format menu to ad-
just cell formats as needed to wrap
text for long titles. Use the comma
button to format dollar amounts.
See instructions from Chapter 1 if
you need help with formatting.
Include columns for Sales and
Cost of Goods Sold. The begin-
ning balances for these two ac-
counts will be $0.
In Row 3, enter the sales transaction for October, and in Row 4 enter the Cost of Goods
Sold transaction. Use 10/31/04 as dates for these transactions. Using the illustration of clos-
ing the accounts in this chapter, close the revenue and expense accounts for October in Row
5. In Row 6, calculate the account balance for each account at October 31, 2004. Use the Sum
function [ Sum(B2:B5)] or button for this purpose. Note that Sum(B2:B5) performs
the same operation as B2 B3 B4 B5. The ending balances for revenue and expense ac-
counts should be $0 after these accounts have been closed.
Beginning in Row 9, prepare a balance sheet and income statement for The Book Wermz
for October 2004. Use the format illustrated in Exhibits 13 and 14 in this chapter. You may
need to make some of the columns in the spreadsheet wider to accommodate captions. For-
mat cells with the currency format so that they display $, as shown in Exhibits 13 and 14.
You can use the Currency and Comma buttons for this purpose. Cells containing to-
tals should be formatted to contain double underlines. Use the Borders button for this
purpose.
Use cell references in the financial statements to identify amounts for each account. For
example: Cash B6
Also, use the Sum function or button to calculate totals in the balance sheet and income
statement. You should be able to change any of the numbers in the transactions at the top of
the spreadsheet and have the financial statements change automatically in response to the new
amounts.
F79
CHAPTER F2: Business Activities—The Source of Accounting Information
78 Business Activities - The Source of Accounting Information

P2-22 Multiple Choice Overview of the Chapter
1. Which of the following is a financing activity?
a. A manufacturing company purchases supplies.
b. A retail company borrows $40,000 from a bank.
c. A manufacturing company acquires a new building.
d. A service organization pays the monthly utility bill.
2. If a company borrows cash from a bank, the effect on the accounting equation is as follows:
a. Assets increase, Liabilities increase
b. Assets decrease, Liabilities increase
c. Assets increase, Liabilities decrease
d. Assets decrease, Liabilities decrease
3. The balance sheet describes a company’s assets. Financial resources to acquire these as-
sets are obtained from
a. investing activities.
b. financing activities and revenues earned.
c. investing activities and expenses paid during a fiscal period.
d. none of the above.
4. Which of the following is an investing activity?
a. A manufacturer borrows from creditors.
b. A service firm pays a return to its stockholders.
c. A retailer sells goods to a not-for-profit agency at cost.
d. A government agency purchases a new mainframe computer system.
5. Which of the following is not an operating activity?
a. Merchandise is sold to customers.
b. Utility bills are paid.
c. Merchandise is shipped to customers.
d. Equipment is purchased for use in manufacturing.
6. Return on assets represents
a. cash that is returned to investors.
b. merchandise that is returned by customers.
c. the ratio of income to total assets.
d. the ratio of merchandise returned by customers to sales.
7. Accounting information is
Needed by managers for Needed by managers for
internal decision making persons outside the firm
a. Yes Yes
b. Yes No
c. No Yes
d. No No
8. Liability and owners’ equity accounts usually arise from which type of activities?
a. Investing activities
b. Financing activities
c. Operating activities
d. Manufacturing activities
9. Expresso Delivery Service purchased a new delivery truck for $21,000 by making a
$4,000 cash payment and giving a $17,000 note payable to the seller. How were each of
the following affected when this event was recorded in the firm’s accounting informa-
tion system?
Assets Liabilities
a. Increased Increased
b. No change Increased
c. Increased Decreased
d. Decreased Increased
F80 SECTION F1: The Accounting Information System
79
Business Activities - The Source of Accounting Information

10. The statement of cash flows for the Halyard Exploration Company reported the follow-
ing:

Cash paid for equipment $ 300,000
Cash paid to employees 400,000
Cash paid to owners 150,000
Cash paid to suppliers 560,000
Cash received from customers 1,200,000

What were Halyard’s net cash flows from operating, investing, and financing activities?

Operating Investing Financing
a. $240,000 ($300,000) $(150,000)
b. $500,000 ($860,000) $200,000
c. $640,000 ($860,000) $200,000
d. $240,000 ($860,000) $200,000

11. When an investor contributes cash to a business, the transaction is recorded as follows:

Debit Credit
a. Cash Retained Earnings
b. Cash Contributed Capital
c. Contributed Capital Cash
d. Retained Earnings Cash



CASE
Designing an Accounting Information System
C2-1
Obj. 6 For about a year, Frank Poppa has been operating a hot dog stand in the parking lot of a ma-
jor discount retailer in a suburban area. The stand appears to be a pushcart but is actually a
small trailer that is towed from home each day. Frank cleverly designed the stand to include
storage compartments, napkins, and the like. What started out as a “weekend gig” to pick up
a few extra bucks has turned into a full-time occupation. Frank soon found that on a hot sum-
mer day, he could easily take in more than $1,000 from sales of a full line of fancy hot dogs
and cold sodas.
About four months ago, Frank decided to expand to more locations. He found that large
discount retailers were quite happy to provide him adequate space near the front door be-
cause customers enjoyed the convenience and the stand helped build traffic for the retailer.
Frank formed Poppa’s Dogs Company and negotiated contracts with several retailers to pro-
vide pushcart operations outside their stores. The contracts generally call for Poppa’s Dogs to
pay a location fee to the retailer plus 3% of the pushcart’s sales.
Frank plans to be very careful when hiring the people necessary to operate the five new
pushcart locations. He is confident that he can assess good moral character and avoid hiring
anyone who would take advantage of him. Frank will have to spend about $3,000 for each
new pushcart and related equipment. In addition, he will have to finance an inventory of hot
dogs, condiments, and sodas for each location. A local bank has agreed to provide financing.
Until now, Frank has maintained an informal accounting system consisting of an enve-
lope full of receipts and his personal checking account. The system has served him well enough
so far, but he is finding that more and more he is getting his personal financial activities con-
fused with those of his business. Frank is positive that the business is profitable because he
seems to have more money left at the end of the month than he did when he was working full
time as an auto mechanic. He has decided he needs a better accounting system and has de-
cided to consult with a CPA he knows to see what she might recommend.

Required What information does Frank’s current accounting system provide him? What
additional information should Frank want from an improved accounting system? Make rec-
ommendations to Frank regarding how he can improve his accounting system and identify a
chart (list) of accounts that you would expect to find in Frank’s new accounting system. For
each account, identify whether it is an asset, liability, owner’s equity, revenue, or expense.
F81
CHAPTER F2: Business Activities—The Source of Accounting Information
80 Business Activities - The Source of Accounting Information

Financing, Investing, and Operating Activities as Part of the
C2-2
Transformation Process
Objs. 1, 3, 4
Environmental Housing Company designs and builds log homes. Financing is provided by
owners and creditors, primarily banks. The company owns buildings and equipment it uses
in the management, design, transportation, and construction process. It purchases logs and
other building materials from other companies. These materials are shipped by the sellers.
Homes are designed for customers. Logs are cut to the dimensions called for in a design and
shipped to the customer’s building site with other materials for assembly. Environmental
Housing employs design engineers, construction and assembly workers, maintenance person-
nel, and marketing and service personnel, in addition to its management and office staff. The
company is in charge of the construction process until the home is completed and ready for
occupancy. The company gives warranties for one year after completion that state the com-
pleted home is free of defects from materials or construction.

Required List decisions involving the acquisition, use, or disposal of resources that Envi-
ronmental Housing’s managers would make at each stage (financing, investing, and operat-
ing) of the transformation process.
F3 3
MEASURING REVENUES
AND EXPENSES
How do we know how much profit our business has
earned?

W ith their accountant’s help, Maria and Stan set up an accounting system for record-
ing the business activities of Mom’s Cookie Company. They prepared financial
statements for January from information recorded in their accounting system. However,
certain types of transactions were not considered in preparing those statements. A business
requires an accounting system that ensures that all revenues and expenses are recorded in
the appropriate fiscal period.


FOOD FOR THOUGHT
If you were running a business, how would you know when to record revenues and expenses? It’s easy to
keep track of cash when your business receives it at the time goods are sold or services are provided.
What would you do if your goods are transferred or services are provided to customers in one fiscal
period and cash is received in a different period? You might consume resources in one fiscal period but
pay for those resources in a different period. When should you recognize the expense? Now that they
understand some basic accounting procedures, Maria and Stan discuss the appropriate recognition of
revenues and expenses with their accountant, Ellen.


We recorded transactions and prepared financial statements for January, but it seems like we haven’t
Stan:
included all the business activities that occurred during January. We owe interest on our loan to the bank,
and we used equipment we purchased in January without recording any expense.
You’re correct. We created a basic accounting system for recording transactions in January. Now we need
Ellen:
to expand that system to include all transactions that should be recorded each month.
Does it really matter that much if we don’t include everything in the appropriate month?
Maria:
Businesses are required to record revenues and expenses in the fiscal period in which revenues are
Ellen:
earned and expenses incurred. Careful identification of the proper amount of revenues and expenses is
important to provide accurate and reliable information about your company’s performance. If you fail to do
so, you may report misleading information. That could cause you to make bad decisions and it may affect
decisions by creditors and other stakeholders.
How can we know if we have recorded all the transactions we need to record each month?
Stan:
You need to follow the proper accounting rules and procedures. Once you identify the kinds of events that
Ellen:
need to be recorded each month, following these rules and procedures will help make sure your financial
statements are accurate and reliable. Let’s look at these rules and procedures and learn how to apply
them to your company.
F83
CHAPTER F3: Measuring Revenues and Expenses
82 Measuring Revenues and Expenses


OBJECTIVES

Once you have completed this chapter, you 4 Identify and record adjusting entries at the
should be able to: end of a fiscal period.
1 Explain the concept of accrual accounting 5 Prepare closing entries and financial
and why it is used. statements at the end of a fiscal period.
2 Record revenue transactions using accrual 6 Identify steps in the accounting cycle.
accounting.
3 Record expense transactions using accrual
accounting.




ACCRUAL ACCOUNTING
Almost all of the transactions we examined in Chapter F2 involved receipt or payment
OBJECTIVE 1
of cash. Cash often is received from customers at the time goods are sold. Cash often
Explain the concept of is paid when equipment, merchandise inventory, and supplies are purchased. These
accrual accounting and transactions involve increasing or decreasing the cash account and recording an offset-
why it is used. ting amount to the revenue or expense account that explains the cause of the increase
or decrease in cash.
In many cases a company earns revenue or incurs expenses in a fiscal period other
than the one in which cash is received or paid. Consider the following examples for
Mom’s Cookie Company for the first three months of operation:

• Money was borrowed in January, but repayment of principal was not made until
later.
• Interest was incurred on debt in January and February, but the interest was not
paid until March.
• Goods were sold to customers on credit in February, but cash was not received un-
til March.
• Employees worked in February and earned wages, but the wages were paid in March.
• Customers ordered goods in February and paid cash at the time of the order, but
the goods were not delivered to the customers until March.
• Rent was paid on a building in February for use of the building in February, March,
and April.

These types of transactions are common for most companies. To accommodate
these types of events, businesses use a form of accounting known as accrual account-
ing. Accrual accounting is a form of accounting in which revenues are recognized
when they are earned and expenses are recognized when they are incurred. To rec-
ognize revenues and expenses means to record them as accounting transactions. Nor-
mally, revenues are earned when goods are transferred or when services are provided.
Expenses are incurred when resources are consumed in the processes of acquiring and
selling goods and services. Accrual accounting focuses on business activities to deter-
mine when to record revenues and expenses.
A company does not have to receive or pay cash at the time revenues or expenses
are recorded. However, the accounting process is more complicated when revenues or
expenses are recorded in one period and cash is received or paid in another. Let’s con-
sider some examples for Mom’s Cookie Company.
F84 SECTION F1: The Accounting Information System
83
Measuring Revenues and Expenses


REVENUE TRANSACTIONS
On February 12, 2004, Mom’s Cookie Company sold boxes of cookies to a customer
OBJECTIVE 2
for $600 on credit. The boxes cost Mom’s Cookie Company $400. The customer paid
for the goods on March 10, 2004. Because the revenue was earned in February, Mom’s
Record revenue
transactions using accrual Cookie Company must recognize the revenue in February. The transaction to record
accounting. the sale would be as follows:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Feb. 12 Accounts Receivable 600
Sales Revenue 600
Feb. 12 Cost of Goods Sold 400
Merchandise Inventory 400




Neither of these transactions involves cash. Cash was not received from the customer
at the time of the sale. Cash was not paid by Mom’s Cookie Company for the mer-
chandise at the time of sale, either. The company was selling merchandise that it had
already purchased.
Accounts Receivable is an asset account that increases when goods are sold on
credit. It represents an amount a customer owes to a company. Revenue is recognized
because the goods have been transferred to the customer. Mom’s Cookie Company has
done the work necessary to earn revenue, and accrual accounting requires revenue to
be recognized when it is earned.
The sale transaction is linked to a second transaction that occurs on March 10. When
the customer pays for the goods, Mom’s Cookie Company records the following:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Mar. 10 Cash 600
Accounts Receivable 600




Cash increases because it has been received from the customer. Accounts Receiv-
able decreases because the customer has fulfilled the obligation to pay for the goods
sold in February. Revenue is not recognized at the time cash is received because it has
already been recognized when goods were sold. Because the sale occurs at one time
and cash is received at a different time, two transactions are needed to record the sale
and cash receipt. Accounts Receivable provides a means of linking the two transactions.
It records the amount the customer owes the company until the customer pays for the
goods. Exhibit 1 describes the effect of the transactions on the Cash, Accounts Receiv-
able, and Sales Revenue accounts.
Accounts Receivable increases at the time of sale in February. The amount the cus-
tomer owes is decreased when the customer pays cash in March, reducing the Accounts
Receivable balance for this sale to zero. The net result of the two transactions is the same
as if the customer had paid cash for the goods. However, two transactions are necessary
to achieve this result. The first transaction is important because Maria and Stan and other
decision makers are interested in when a company sells goods. All of the sales that oc-
F85
CHAPTER F3: Measuring Revenues and Expenses
84 Measuring Revenues and Expenses

Exhibit 1 Accounts Sales
Linking Revenue and Date Cash Receivable Revenue
Cash through Accounts
Feb. 12 600 600
Receivable
Mar. 10 600 600
Net result 600 0 600




cur in February should appear on Mom’s Cookie Company’s income statement for Feb-
ruary. The income statement provides information about business activities that occurred
during a particular fiscal period. If a company waited until cash was received from cus-
tomers to record revenues, it would appear that the business sold the goods in the pe-
riod when cash was received. Instead, accrual accounting ensures that decision makers
have information about sales activities for the period in which the sales occurred. In ad-
dition, recording accounts receivable provides information about the amount owed by
customers that a company expects to collect in a future fiscal period.
Sometimes a company receives cash from a customer before a sale is made. For ex-
ample, Mom’s Cookie Company received an order from a customer on February 24, 2004,
for more goods than the company had in its inventory. Maria and Stan agreed to fill the
order for the customer but required the customer to pay for the goods at the time of the
order. The customer paid $3,000 on February 24, and Mom’s Cookie Company ordered
the goods from its supplier. The goods were delivered to the customer on March 3.
The payment transaction would be recorded as follows:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Feb. 24 Cash 3,000
Unearned Revenue 3,000




Cash increases by the amount received from the customer. Revenue has not been
earned, however, because goods have not been transferred to the customer. Instead,
Mom’s Cookie Company has incurred a liability as represented by the Unearned Rev-
enue account. Unearned Revenue is a liability account that results when a company
receives cash from a customer for goods or services to be provided in the future. The
liability results from the obligation Mom’s Cookie Company has to order the goods
and provide them to the customer. If the company fails to complete the obligation, it
will be required to refund the $3,000 to the customer.
The sales transaction is recorded on March 3 when goods are transferred to the
customer.


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Mar. 3 Unearned Revenue 3,000
Sales Revenue 3,000
Mar. 3 Cost of Goods Sold 2,000
Merchandise Inventory 2,000
F86 SECTION F1: The Accounting Information System
85
Measuring Revenues and Expenses

Once the goods are transferred to the customer on March 3, the obligation has been
fulfilled and the liability is eliminated. In most sales transactions, Sales Revenue is rec-
ognized when the goods are transferred to the customer. The cost of the merchandise
to Mom’s Cookie Company of $2,000 is also recognized when the goods are transferred
to the customer. Again, this process results in revenue being recognized in the period
in which it is earned rather than when cash is received. Expenses are recognized when
resources are consumed. Exhibit 2 illustrates the effects of these activities on the com-
pany’s accounts.


Exhibit 2 Unearned Sales
Linking Cash and Date Cash Revenue Revenue
Revenue through
Feb. 24 3,000 3,000
Unearned Revenue
Mar. 3 3,000 3,000
Net result 3,000 0 3,000




Unearned Revenue is an account used to link the receipt of cash in February with
the revenue earned in March. This time, cash was received before revenue was recog-
nized. Like Accounts Receivable, amounts are added or subtracted from Unearned Rev-
enue as needed to ensure the proper timing of revenue recognition. The net result of
these transactions is the same as if goods were sold for cash.
Transactions in which cash is received before revenue is earned are common for
some types of companies. Examples include airlines, magazine publishers, and com-
munications companies. Passengers often purchase airline tickets prior to their flights.
At the time of the purchase, the airline records unearned revenue. When the passenger
uses the ticket, the airline eliminates the unearned revenue and records passenger rev-
enue. Similarly, subscribers often pay for magazine subscriptions before receiving the
issues. At the time of purchase, the magazine records unearned revenue. As issues are
published and mailed to subscribers, the amount of unearned revenue is reduced and
subscription revenue is recognized. As an example, AOL Time Warner, owner of Time,
Life, and other magazines, reported unearned revenues of $1.456 billion for the fiscal
year ended December 31, 2001.
To summarize, companies recognize revenues in
LEARNING NOTE the period in which they are earned. Typically, the
earnings process is considered complete at the time
Account titles vary in practice. For example, Unearned Revenue
goods are transferred to customers or services are pro-
might appear as Customer Deposits, Air Traffic Liability, Prepaid
vided to customers. Exhibit 3 illustrates the relation-
Subscriptions, or Deferred Revenues.
ship between revenue recognition and cash inflow.


Exhibit 3 Timing Effect First Period Second Period Linking Account
Revenue Recognition
No Accrual or Revenue Earned None
and Cash Flows
Deferral Needed Cash Received

Accrued Revenue Revenue Earned Cash Received Accounts
Receivable

Deferred Revenue Cash Received Revenue Earned Unearned Revenue




Three possibilities exist concerning the relationship. In all three possibilities, revenue
is recognized when it is earned. Cash may be received at the time revenue is earned. In
this situation, Revenue and Cash are the only accounts necessary for the transaction. If
F87
CHAPTER F3: Measuring Revenues and Expenses
86 Measuring Revenues and Expenses

revenue is earned before cash is received, the revenue is accrued. Accrued revenue is rev-
enue recognized prior to the receipt of cash. In this situation, Accounts Receivable is
used to connect Revenue and Cash. If cash is received before revenue is earned, the rev-
enue is deferred. Deferred revenue is revenue recognized after cash has been received.
Unearned Revenue is used to connect Cash and Revenue.



EXPENSE TRANSACTIONS
In addition to recognizing expenses at the time cash is paid, expenses may also be ac-
OBJECTIVE 3
crued or deferred. Accrued expenses result when expenses are recognized prior to the
Record expense payment of cash. Deferred expenses result when expenses are recognized after the
transactions using accrual payment of cash.
accounting. For example, assume Mom’s Cookie Company purchases $400 of supplies on Feb-
ruary 16, 2004. The supplies are not consumed at the time they are purchased. Instead of
paying cash for the supplies, the company purchases them on credit, agreeing to pay the
supplier by March 16. On March 15, 2004, Mom’s Cookie Company sends a check to the
supplier. Mom’s Cookie Company should record this purchase of supplies as follows:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Feb. 16 Supplies 400
Accounts Payable 400




This transaction records the supplies as an asset and the amount owed the supplier as
a liability. Accounts Payable is a liability account that identifies an obligation to pay
suppliers in the near future.
When Mom’s Cookie Company uses the supplies, it records an expense. Suppose
that the supplies have been consumed by the end of February. The company would
record this amount as:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Feb. 28 Supplies Expense 400
Supplies 400




This transaction records the expense in the fiscal period in which resources were consumed.
Another transaction is necessary to record payment for the supplies. If Mom’s
Cookie Company sends a check to the supplier on March 15, it would record this:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Mar. 15 Accounts Payable 400
Cash 400
F88 SECTION F1: The Accounting Information System
87
Measuring Revenues and Expenses

An expense is not recorded at the time the pay-
LEARNING NOTE
ment is made because the supplies were consumed in
In Chapter F2, we recorded the purchase of supplies as an ex-
February. Exhibit 4 illustrates the use of the Accounts
pense at the time the supplies were acquired because the sup-
Payable account to link expenses recognized in one
plies were used in January. In theory, it is preferable to record
period with cash paid in a subsequent period. The net
the purchase as an asset and then expense the supplies when
result of these transactions is the same as if cash had
they are used. Practically, however, it does not matter whether
been paid for supplies at the time they were con-
the supplies are recorded as an asset initially if all of the sup-
sumed. The transaction was recorded initially to the
plies are consumed in the same fiscal period as they were ac-
supplies account. Since the supplies were consumed
quired. Either way, the amount will be an expense by the end of
in February, the transaction could have been
the fiscal period.
recorded initially to supplies expense.


Exhibit 4 Accounts Supplies
Linking Expense and Date Cash Supplies Payable Expense
Cash through Accounts
Feb. 16 400 400
Payable
Feb. 28 400 400
Mar. 15 400 400
Net result 400 0 0 400




Expenses also may be recognized after cash is paid. For example, assume Mom’s
Cookie Company pays $600 for rent for use of a building on February 26. However,
the rent is for March. The payment would be recorded as follows:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Feb. 26 Prepaid Rent 600
Cash 600




The February transaction records the payment for
LEARNING NOTE rent. Prepaid Rent is an example of a prepaid expense
account. A Prepaid Expense is an asset account that
Accounts Payable is an example of a general category of liabili-
identifies a resource that has been paid for but not
ties known as accrued liabilities. Accrued liabilities record the
obligation to make payments for expenses that have been incurred used. The purchase is an asset because a resource has
or for assets that have been acquired but for which payment has been acquired that will be used in the future. The
not been made. Other examples of accrued liabilities include March transaction records use of the resource. The
Wages Payable, Interest Payable, and Income Taxes Payable. expense should be recognized in March, when the re-
source is consumed, rather than in February when
cash is paid. The expense has been deferred from the
time of the payment to March, when the building is used. By the end of March the rental
service has been consumed and the expense would be recorded as follows:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Mar. 31 Rent Expense 600
Prepaid Rent 600
F89
CHAPTER F3: Measuring Revenues and Expenses
88 Measuring Revenues and Expenses

Exhibit 5 illustrates the use of the prepaid rent account to link cash paid in one pe-
riod with expense recognized in a subsequent period. Prepaid Rent increases when cash
is paid for next month’s rent and decreases when the rent is consumed.


Exhibit 5 Prepaid Rent
Linking Expense and Date Cash Rent Expense
Cash through Prepaid
Feb. 26 600 600
Rent
Mar. 31 600 600
Net result 600 0 600




In summary, accrual accounting records expenses when resources are consumed,
not necessarily when cash is paid for those resources. Exhibit 6 illustrates the relation-
ship between expense recognition and cash outflow.


Exhibit 6 Timing Effect First Period Second Period Linking Account
Expense Recognition
No Accrual or Expense Incurred None
and Cash Flows
Deferral Needed Cash Paid

Accrued Expense Expense Incurred Cash Paid Accounts Payable

Deferred Expense Cash Paid Expense Incurred Prepaid Expense




Three possibilities exist concerning the relationship. In all three possibilities, ex-
pense is recognized when it is incurred. Cash may be paid at the time expense is in-
curred. In this situation, Expense and Cash are the only accounts necessary for the
transaction. If expense is incurred before cash is paid, the expense is accrued. That is,
it is recognized prior to the payment of cash. In this situation, Accounts Payable is used
to connect Expense and Cash. If cash is paid before expense is incurred, the expense is
deferred. That is, it is recognized after the cash is paid. Prepaid Expense is used to con-
nect Cash and Expense.
By recording revenues when earned and expenses when incurred, a company
matches resources consumed by business activities with revenues created by those ac-
tivities. Consequently, net income (revenues minus expenses) measures business activ-
ity for a fiscal period. It is not a measure of how much cash a company received or
paid. An important concept in accounting is the matching principle, which requires
companies to recognize the expenses used to generate revenue in the same account-
ing period in which the revenues are recognized.
An important responsibility of accountants is to make decisions about when rev-
enues and expenses should be recognized. They examine a company’s business activi-
ties and use appropriate accounting rules to ensure the proper recording of revenue
and expense transactions in the fiscal period in which those transactions occur.




1 SELF-STUDY PROBLEM The following events occurred for Kirkland Co. in January and
February:
1. Goods priced at $5,000 were sold on credit on January 15.
2. The cost of the goods sold in transaction 1 was $3,000.
F90 SECTION F1: The Accounting Information System
89
Measuring Revenues and Expenses

3. Cash of $400 was received on January 23 for goods that will be transferred to cus-
tomers in February.
4. Cash of $750 was paid on January 25 for supplies that will be used in February.
5. By January 31, employees had earned wages of $2,500 that will be paid in February.
6. On February 3, cash of $2,500 was paid to employees for wages earned in January.
7. On February 6, cash was collected from customers for the sales on January 15.
8. On February 8, goods were transferred to customers that had been paid for on Jan-
uary 23.
9. By February 28, the supplies purchased on January 25 had been consumed.

Required Record all transactions associated with these events in the order in which
they occurred.
The solution to Self-Study Problem 1 appears at the end of the chapter.



ADJUSTING ACCOUNT BALANCES
Some revenues and many expenses are associated with the passage of time. Rent, in-
OBJECTIVE 4
surance, and equipment are resources that are purchased in one period and used dur-
Identify and record ing future periods. Wages relate to specific periods in which employees work, whether
adjusting entries at the or not they are paid during those periods. Interest on debt accumulates over time. Rev-
end of a fiscal period. enues associated with some services, such as repair and maintenance contracts, also may
be earned over time.
These activities often result in an expense or revenue that must be recognized for
a fiscal period even though no specific event occurs to create the expense or revenue
other than the passage of time. In these situations, a company must adjust its accounts
at the end of a fiscal period to record the expenses and revenues that should be recog-
nized for that period.
Let’s consider some examples of adjustments for Mom’s Cookie Company. Sup-
pose in mid-February, Mom’s Cookie Company decided to move to a new building on
March 1. The rent for the new offices is $600 a month. On February 24 rent is paid for
March and April. The transaction for February would be:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Feb. 24 Prepaid Rent 1,200
Cash 1,200




The transaction involves payment of rent for two months. The Prepaid Rent ac-
count is an asset that identifies the resource available for future use. At the end of March
and April, Mom’s Cookie Company must record Rent Expense for each month:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Mar. 31 Rent Expense 600
Prepaid Rent 600
Apr. 30 Rent Expense 600
Prepaid Rent 600
F91
CHAPTER F3: Measuring Revenues and Expenses
90 Measuring Revenues and Expenses

The accounting entries for March and April are adjusting entries. An adjusting
entry is a transaction recorded in the accounting system to ensure the correct account
balances are reported for a particular fiscal period. Usually, adjusting entries are made
at the end of the fiscal period.
Another example of adjusting entries for Mom’s Cookie Company involves inter-
est. As indicated in Chapter F2, the company borrowed $30,000 ($8,000 $22,000) in
January. The bank charges $200 of interest each month but permits the interest to be
paid the day after the end of each quarter. Accordingly, Mom’s Cookie Company’s first
interest payment is not due until April 1, 2004. Nevertheless, interest expense accrues
each month and should be recognized in the fiscal period in which it is incurred. Mom’s
Cookie Company would record the following adjusting entries at the end of January,
February, and March:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Jan. 31 Interest Expense 200
Interest Payable 200
Feb. 28 Interest Expense 200
Interest Payable 200
Mar. 31 Interest Expense 200
Interest Payable 200




An expense is recorded each month for the interest incurred on the loan. A liabil-
ity is recorded as well because the interest is not being paid until the end of March.
Consequently, an obligation exists for the unpaid interest. Every adjusting entry, like
the three above, includes at least one balance sheet and at least one income statement
account. Adjusting entries always involve recognition of a revenue or expense during
a fiscal period.
Another transaction at the beginning of April records payment of the liability that
accumulated over the three months. This entry is not an adjusting entry; it is a pay-
ment of an obligation when it becomes due. The payment is recorded as follows:


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Apr. 1 Interest Payable 600
Cash 600




Another example of adjustments involves the use of equipment. Mom’s Cookie
Company purchased equipment in January for $31,000 ($6,000 $25,000). The
equipment was recorded as an asset at that time. However, equipment and other
physical assets usually wear out over time and eventually need to be replaced. Be-
cause resources are consumed over a number of fiscal periods, the usage should be
recognized as an expense of each of the periods that benefits from that use. Depre-
ciation is the allocation of the cost of assets to the fiscal periods that benefit from
the assets’ use. Mom’s Cookie Company expenses its equipment at the rate of $520
per month. Consequently, it would record the following adjustments at the end of
January and February:
F92 SECTION F1: The Accounting Information System
91
Measuring Revenues and Expenses


ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Jan. 31 Depreciation Expense 520
Accumulated Depreciation 520
Feb. 28 Depreciation Expense 520
Accumulated Depreciation 520




Depreciation Expense identifies the estimated amount of the asset consumed.
Accumulated Depreciation is a contra-asset account used to identify the total amount
of depreciation recorded for a company’s assets. It is subtracted from the related as-
set accounts on the company’s balance sheet, and therefore is known as a contra ac-
count. A contra account is an account that offsets another account.
To understand Accumulated Depreciation, consider the effect the adjusting entries
would have on the Accumulated Depreciation account. At the end of January, the ac-
count will have a balance of $520, depreciation for January. At the end of February,
the account will have a balance of $1,040, depreciation for January and February.
Mom’s Cookie Company’s balance sheet for January and February will report the
following:

January February
Equipment, at cost $31,000 $31,000
Less: accumulated depreciation 520 1,040
Equipment, net of depreciation $30,480 $29,960

The cost of the equipment continues to be reported at its cost of $31,000. The
amount of accumulated depreciation increases each month, and the net amount of
equipment reported each month decreases at the rate of $520 per month. We examine
how depreciation amounts are determined in a later chapter.
The process of recording and reporting depreciation is necessary to make sure a
company reports the appropriate expense each fiscal period. The use of Accumulated
Depreciation provides useful information to decision makers. Examination of the bal-
ance sheet data for Mom’s Cookie Company provides Maria and Stan with information
about the cost of equipment and about how long the equipment has been used. Credi-
tors and other external users of the company’s financial statements might be especially
interested in this information. They may want to know if a company’s assets are replaced
on a regular basis and if plans are being made for replacement as assets age.
Companies record transactions throughout each fiscal period. Accountants determine
necessary adjustments for a company and develop and maintain information systems that
allow them to determine interest, depreciation, and other expenses and revenues accu-
rately. They adjust accounts at the end of each fiscal period prior to preparing financial
statements. The next section considers the final steps in preparing these statements.




2 SELF-STUDY PROBLEM The following events occurred for Davis Co. during 2004:

1. On September 27, the company paid rent for the following three months of $1,500
per month.
2. The company incurs interest expense of $800 per month. Interest was paid on Oc-
tober 31 for a three-month period, ending with October.
3. The company purchased equipment for $200,000 on January 2, 2004. The equip-
ment is depreciated at the rate of $4,000 per month.
F93
CHAPTER F3: Measuring Revenues and Expenses
92 Measuring Revenues and Expenses

4. The company paid $12,000 for property insurance on January 4, 2004. The insur-
ance is for the 12 months ended December 31, 2004.

Required Record the adjusting entries associated with these events for October.
The solution to Self-Study Problem 2 appears at the end of the chapter.




LEDGER ACCOUNTS
Transactions, like those in this and the preceding chapter, are initially recorded by a
company in a journal. A journal is a chronological record of a company’s transactions.
The format we have used in this chapter to record transactions is an example of a par-
ticular journal format. Each transaction is recorded according to the date the transac-
tion occurred. The accounts affected by the transaction are listed along with the amounts
associated with each account. Most companies use a computerized accounting system.
Journal entries are recorded on a computer using a format that provides a place for each
account to be identified and the amount to be entered. Regardless of the format, jour-
nal entries provide for a means of entering transactions in an accounting system.
Once transactions have been entered into a journal, the effects of transactions on
particular accounts need to be transferred to those accounts. A ledger is a file in which
each of a company’s accounts and the balances of those accounts are maintained. A
record is maintained for each account. Each time a transaction is recorded, the effects
of that transaction are transferred to the ledger. Posting is the process of transferring
transactions to specific accounts in a company’s ledger. Exhibit 7 illustrates this process.


Exhibit 7 Posting Transactions to the Ledger
Journal

ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Jan. 31 Depreciation Expense 520
Accumulated Depreciation 520
Feb. 28 Depreciation Expense 520
Accumulated Depreciation 520




Ledger

Accumulated Depreciation

Date Amount Balance
Jan. 31 520 520
Feb. 28 520 1,040




Initially a transaction is recorded using the journal format. The transaction is then
posted to the ledger accounts affected by the transaction. The balance of the account is
updated to show the effect of the transaction. Thus, after transactions have been posted,
the ledger provides a current record of the balance of each of a company’s accounts. These
balances are the primary source of data for preparing a company’s financial statements.
F94 SECTION F1: The Accounting Information System
93
Measuring Revenues and Expenses

The primary ledger a company uses to record its account balances is referred to
as the general ledger. Companies often use other special ledgers to maintain informa-
tion about specific types of account balances. For example, each customer who has pur-
chased goods from a company on credit would be listed in the company’s accounts
receivable ledger. The accounts in the special ledger are referred to as subsidiary ac-
counts. Subsidiary accounts are accounts of a specific type that are associated with a
control account in the general ledger. The total of the balances of all of the subsidiary
accounts of a specific type is equal to the balance of the general ledger control account.
To illustrate, assume Mom’s Cookie Company sells goods on credit to three stores:
Hopkins’ Grocery, Lori’s Market, and Samson’s Foods. Mom’s Cookie Company main-
tains a subsidiary accounts receivable account for each store. The amounts owed by
each of these stores at the end of February is the subsidiary account balance. The total
of these amounts is the balance of accounts receivable for Mom’s Cookie Company.

Subsidiary Accounts Receivable:
Hopkins’ Grocery $1,300
Lori’s Market 600
Samson’s Foods 900
Accounts Receivable Control $2,800

The subsidiary accounts are used to keep track of amounts owed by each customer.
The control account balance is the amount reported in the company’s financial state-
ments.



CLOSING ENTRIES FINANCIAL STATEMENTS
AND
At the end of each month, Maria and Stan, with the help of their accountant, prepare fi-
OBJECTIVE 5
nancial statements for Mom’s Cookie Company. The financial statements report a com-
Prepare closing entries pany’s business activities to help managers, creditors, and other stakeholders make decisions.
and financial statements
at the end of a fiscal
Summary of Account Balances
period.

To illustrate this process, we begin with a review of all the transactions for Mom’s Cookie
Company for January. These are presented in Exhibit 8 and include the adjusting en-
tries for interest expense and depreciation expense described in this chapter.
Next we examine a summary of general ledger account balances for Mom’s Cookie
Company at the end of January. Exhibit 9, on page F96, provides balances for each
of the company’s general ledger accounts at January 31. The amounts shown are those
from Exhibit 12 in Chapter F2, adjusted for interest and depreciation, as described
in this chapter.
A purpose of the summary is to make sure that the accounting equation is in bal-
ance prior to preparing the financial statements. We can determine that the equation
is in balance by reference to Exhibit 9 because:

Assets Liabilities Owners’ Equity
$41,180 $30,200 $10,980


Income Statement
Balances of revenue and expense accounts appear in Mom’s Cookie Company’s Income
Statement for January. Exhibit 10, on page F96, provides this statement. As discussed
in Chapter F2, the income statement reports results of operating activities for a partic-
ular fiscal period. The statement shows that Mom’s Cookie Company earned $980 of
profit in January. This amount is less than that reported in Chapter F2 because of the
adjusting entries that were considered in this chapter.
F95
CHAPTER F3: Measuring Revenues and Expenses
94 Measuring Revenues and Expenses

Exhibit 8 Transactions for Mom’s Cookie Company for January

ASSETS LIABILITIES OWNERS’ EQUITY
Other Contributed Retained
Date Accounts Cash Assets Capital Earnings
Beginning Amounts 0 0 0 0 0
Jan. 2 Cash 10,000
Contributed Capital 10,000
Jan. 3 Cash 8,000
Notes Payable 8,000
Jan. 5 Equipment 6,000
Cash 6,000
Jan. 6 Equipment 25,000
Cash 3,000
Notes Payable 22,000
Jan. 6 Supplies Expense 300
Cash 300
Jan. 7 Merchandise Inventory 9,000
Cash 9,000
Jan. 8 Rent Expense 600
Cash 600
Jan. 31 Cash 11,400
Sales Revenue 11,400
Jan. 31 Cost of Goods Sold 7,600
Merchandise Inventory 7,600
Jan. 31 Wages Expense 1,000
Cash 1,000
Jan. 31 Utilities Expense 200
Cash 200
Jan. 31 Interest Expense 200
Interest Payable 200
Jan. 31 Depreciation Expense 520
Accumulated Depreciation 520
Ending Amounts 9,300 31,880 30,200 10,000 980




Closing Entries
An intermediate step in preparing financial statements is closing the revenue and ex-
pense account balances. Before preparing a balance sheet, the company’s accountant
closes Mom’s Cookie Company’s revenue and expense account balances at the end of
February. Closing these accounts transfers the balances in these accounts to Retained
Earnings. Exhibit 11, on page F97, provides the closing entries for January.
The closing process includes two transactions. In the first, revenue accounts are
transferred to Retained Earnings. The closing transaction leaves the revenue account
with a zero balance by subtracting the amount of revenue earned during the month
from the Sales Revenue account and transferring the balance to Retained Earnings.

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