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Adjusting entries are recorded in the general journal and are posted to the accounts in the
general ledger in the same manner as other journal entries. Again note that each adjusting en-
try must involve at least one balance sheet account and at least one income statement account.
After this adjusting entry has been journalized and posted, the receivable will appear as an
asset on the balance sheet, and the lawn care revenue is reported on the income statement.
Through the adjusting entry, the asset (receivable) accounts are properly stated and revenues are
appropriately reported.

Unrecorded Liabilities
Just as assets are created from revenues being earned before they are collected or recorded, lia-
bilities can be created by expenses being incurred prior to being paid or recorded. These ex-
penses, along with their corresponding liabilities, should be recorded when incurred, no matter
when they are paid. Thus, adjusting entries are required at the end of an accounting period to
recognize any unrecorded liabilities in the proper period and to record the corresponding ex-
unrecorded liabilities Ex-
penses incurred during a penses. As the expense is recorded (increased by a debit), the offsetting liability is also recorded
period that have not been
(increased by a credit), showing the entity s obligation to pay for the expense. If such adjust-
recorded by the end of that
ments are not made, the net income measurement for the period will not reflect all appropriate
period.
expenses and the corresponding liabilities will be understated on the balance sheet.
To illustrate, we will assume that on December 31, 2003, our landscaping company has
determined the following:
1. Your brother has worked for the company since its inception. He is paid every two
fyi
weeks. The next payday is on Friday, January 5, 2004. On that day, your brother
Most companies don t have to
will be paid $700, the amount he earns every two weeks. Since December 31 falls
be reminded to search out un- halfway through the pay period, one-half of his wages should be allocated to 2003.
recorded assets and revenues 2. Recall from Chapter 3 that one of our options for financing our company was to bor-
and recognize them. On the row money from a bank. We borrowed $2,000 with the promise that on the first of
every month we would make a $178 payment a portion of that payment being at-
other hand, unrecorded liabili-
tributed to interest1 and a portion to principal. Our next payment is due on January
ties and expenses are things
1, 2004, but the interest expense associated with that payment should be attributed
companies would rather forget.
to the period in which the money was actually used December 2003. Assume that
Auditors must take care to en-
interest of $20 must be recognized on December 31, 2003.
sure that all unrecorded liabili-
ties and expenses are properly To represent its current financial position and earnings, our landscaping company
reported. must record the impact of these events in the accounts, even though cash transactions have
not yet occurred. The wages will not be paid until 2004. Under accrual-basis accounting,
however, these costs are expenses of 2003 and should be recognized on this year s income state-
ment, with the corresponding liability shown on the balance sheet as of the end of the year. To
fix the balance sheet, Wages Payable must be credited (increased) for $350; recognition of this
liability ensures that the balance sheet properly reports this liability, which was created during
2003 and exists as of the end of the year. The debit of this adjusting entry is to Wages Expense,
resulting in the proper inclusion of this expense in the 2003 income statement. The adjusting
journal entry is as follows:


Dec. 31 Wages Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
Wages Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
To record obligation for wages.


The liability for the interest for the month of December is recorded by a credit (increase)
to Interest Payable; this fixes the balance sheet. The debit of the adjusting entry is to Interest
1 As noted in Chapter 3, interest is the cost of using money. The amount borrowed or lent is the principal. The
interest rate is an annual rate stated as a percentage. The period of time involved may be stated in terms of a
year. For example, if interest is to be paid for 3 months, time is 3/12, or 1/4 of a year. If interest is to be paid for
90 days, time is 90/365 of a year. Thus, the formula for computing interest is Interest Principal Interest Rate
Time (fraction of a year).
138 f139
Completing The Accounting Cycle Chapter 4
Completing the Accounting Cycle


Expense, which properly includes this expense on the 2003 income statement. The ad-
caution
justing entry is:
A liability is not recorded for
the total amount of interest that
Dec. 31 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
will have to be paid over the en-
Interest Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
tire life of the loan. If we repay
To record interest incurred.
the loan on December 31, the
future interest will not have to
be paid, but the interest for the
The wages expense and interest expense would be shown on the income statement
month of December that has
for the year ended December 31, and the liabilities (wages payable and interest payable)
passed will still be due. would be shown on the balance sheet as of December 31. Because of the adjusting en-
tries, both the income statement and the balance sheet will more accurately reflect the fi-
nancial situation of our landscaping company.


Prepaid Expenses
Payments that a company makes in advance for items normally charged to expense are known
as prepaid expenses. An example would be the payment of an insurance premium for three
prepaid expenses Payments
made in advance for items years. Theoretically, every resource acquisition is an asset, at least temporarily. Thus, the entry
normally charged to ex-
to record an advance payment should be a debit to an asset account (Prepaid Expenses) and a
pense.
credit to Cash, showing the exchange of cash for another asset.
An expense is the using up of an asset. For example, when supplies are purchased,
caution they are recorded as assets; when they are used, their cost is transferred to an expense ac-
count. The purpose of making adjusting entries for prepaid expenses is to show the com-
Prepaid Expenses is a tricky
plete or partial consumption of an asset. If the original entry is to an asset account, the
name for an asset. Assets are
adjusting entry reduces the asset to an amount that reflects its remaining future benefit
reported in the balance sheet.
and at the same time recognizes the actual expense incurred for the period.
Don t make the mistake of in-
For the unrecorded assets and liabilities discussed earlier, there was no original en-
cluding Prepaid Expenses with
try; the adjusting entry was the first time these items were recorded in the accounting
the expenses on the income
records. For prepaid expenses, this is not the case. Because cash has already been paid
statement.
(in the case of prepaid expenses), an original entry has been made to record the cash
transaction. Therefore, the amount of the adjusting entry is the difference between
what the updated balance should be and the amount of the original entry already recorded.
To illustrate adjustments for Prepaid Expenses, we will assume the following about our land-
scaping company:
1. On November 1, 2003, we purchased a six-month insurance policy on our old truck, pay-
ing a $600 premium.
2. On December 15, 2003, we purchased several months worth of supplies (fertilizer, weed
killer, etc.) at a total cost of $350. At year-end, $225 worth of supplies were still on hand.
For the prepaid insurance, we record the payment of $600 on November 1 as follows:


Nov. 1 Prepaid Insurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600
Paid a six-month insurance premium in advance.



This entry shows that one asset (Cash) has been exchanged for another asset (Prepaid In-
surance). Over the next six months we will use the auto insurance and the asset, Prepaid Insur-
ance, will slowly be used up. As the asset is used, its cost is recorded as an expense.
At year-end, only those assets that still offer future benefits to the company should be reported
on the balance sheet. Thus, an adjustment is required to reduce the prepaid insurance account to
reflect the fact that only four months of prepaid insurance remain. See the following time line.
139
f140 Part 1 Completing The Accounting Cycle
Financial Reporting and the Accounting Cycle


$600 (6 months $100 per month)
April 30
November 1



4 months prepaid (asset)
2 months used up (expense)




December 31



The adjusting journal entry to bring the original amounts to their updated balances at year-
end is:


Dec. 31 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Prepaid Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
To record insurance expense for two months:
2 $100 $200.


When the adjusting entry is journalized and posted, the proper amount of insurance ex-
pense ($200) will be shown as an expense on the income statement and the proper amount of
prepaid insurance ($400) will be carried forward to the next period as an asset on the balance
sheet. This is illustrated in the following T-accounts:

Prepaid Insurance Cash Insurance Expense

Original entry (11/1/03) 600 600
Adjusting entry (12/31/03) 200 200
400 200
Updated balances (12/31/03)

To balance sheet To income statement


When supplies are consumed in the normal course of business, the asset account (Sup-
caution
plies on Hand) must be adjusted and the used up portion charged as an operating expense
The terms supplies and inven-
(Supplies Expense) on the income statement. Thus, the adjustment for supplies is han-
tory are often confused. Sup-
dled the same way as for any other prepaid asset.
plies include such items as pa-
We initially recorded $350 of supplies as an asset:
per, pencils, and soap that
might be used in an office or a
Dec. 15 Supplies on Hand. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
warehouse. Inventory includes
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
only those items held for resale
Purchased supplies.
to customers or for direct use
in the manufacture of products.
At year-end, an adjustment must be made to recognize that only $225 worth of sup-
plies remains. This also implies that $125 ($350 $225) of the supplies have been used and
should be charged to expense. The entries are summarized in the following T-accounts:



Supplies on Hand Cash Supplies Expense

Original entry (12/15/03) 350 350
Adjusting entry (12/31/03) 125 125
Updated balances (12/31/03) 225 125

To balance sheet To income statement
140 f141
Completing The Accounting Cycle Chapter 4
Completing the Accounting Cycle


The adjusting entry is:

Dec. 31 Supplies Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
Supplies on Hand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
To record the use of supplies.


Unearned Revenues
Amounts received before the actual earning of revenues are known as unearned revenues. They
unearned revenues Cash
amounts received before arise when customers pay in advance of the receipt of goods or services. Because the company
they have been earned.
has received cash but has not yet given the customer the purchased goods or services, the un-
earned revenues are in fact liabilities. That is, the company must provide something in return
for the amounts received. For example, a building contractor may require a deposit before pro-
ceeding on construction of a house. Upon receipt of the deposit, the contractor has unearned
revenue, a liability. The contractor must construct the house to earn the revenue. If the house
is not built, the contractor will be obligated to repay the deposit.
To illustrate the adjustments for unearned revenues, we will assume the following
about our landscaping company:
caution
On December 1, a client pays you $225 for three months of landscap-
Unearned Revenue is a tricky
ing services to be provided for the period beginning December 1, 2003,
name for a liability. Liabilities
and ending February 29, 2004. This client is going to Hawaii for an
are reported in the balance
extended vacation and would like you to take care of the grounds in
sheet. Don t make the mistake
her absence.
of including Unearned Revenue
Typically, the original entry to record unearned revenue involves a debit to Cash and
with the revenues on the in-
a credit to a liability account. In our example of landscaping revenue received three months
come statement.
in advance, the liability account would be Unearned Revenue, as shown on the next page.

The deposit received by a
building contractor prior to
the construction of a
house is classified as un-
earned revenue.
141
f142 Part 1 Completing The Accounting Cycle
Financial Reporting and the Accounting Cycle



Dec. 1 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Unearned Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Received three months revenue in advance:
$75 3 $225.


The credit to the liability account, Unearned Revenue, is logically correct; until we provide the
landscaping service, the revenue received in advance is unearned and is thus an obligation (lia-
bility).
The next step is to compute the updated balances at year-end. As illustrated with the fol-
lowing time line, on December 31, two months services (2 $75 $150) are still unearned
and should be shown as a liability, Unearned Revenue, on the balance sheet. At the same time,
$75, or one month s services, has been earned (1 $75 $75) and should be reported as Land-
scaping Revenue on the income statement.

$225 (3 months $75 per month)
February 29
December 1



2 months unearned (liability)
1 month earned (revenue)




December 31


Step 1 of the adjusting entry is to fix the balance sheet. The reported liability of $225 is
too much since some of the unearned revenue has been earned. The remaining obligation is
$150 (2 $75), so the liability must be reduced (debited) by $75 ($225 $150). The second
half of the adjusting entry is used to correct the income statement. The $75 credit is made to
Landscaping Revenue, reflecting the fact that one month s revenue has now been earned. The
appropriate adjusting entry is:


Dec. 31 Unearned Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Landscaping Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
To record landscaping revenue for one month:
$75 1 month $75.


These results are illustrated in the following T-accounts:

Unearned Revenue Cash Landscaping Revenue

225 225
Original entry (12/1/03)
75 75
Adjusting entry (12/31/03)
Updated balances (12/31/03) 150 75
To balance To income
sheet statement

After the adjusting entry has been made on December 31, our accounts show $225 of cash re-
ceived. Of this amount, $75 has been earned (1 month s service $75) and would be reported
as Landscaping Revenue on the income statement; $150 will not be earned until the next re-
porting period and would be shown as a liability on the balance sheet.
We should emphasize two characteristics of adjusting entries. First, adjusting entries made
at the end of an accounting period do not involve cash. Cash has either changed hands prior to
the end of the period (as is the case with prepaid expenses or unearned revenues), or cash will
142 f143
Completing The Accounting Cycle Chapter 4
Completing the Accounting Cycle


change hands in a future period (as is the case with many unrecorded receivables and unrecorded
liabilities). It is precisely because cash is not changing hands on the last day of the accounting
period that most adjusting entries must be made.
net work Second, each adjusting entry involves a balance sheet account and an income statement ac-
count. In each case requiring adjustment, we are either generating an asset, using up an asset,
Airlines have a large
amount of unearned rev- recording an incurred but unrecorded expense, or recording revenue that has yet to be earned.
enue because customers
Knowing that each adjusting entry has at least one balance sheet and one income statement ac-
pay for their tickets before
count makes the adjustment process a little easier. Once you have determined that an adjusting
the airlines provide the
travel service. Visit the Web entry involves a certain balance sheet account, you can then focus on identifying the corre-
site of UNITED AIRLINES:
sponding income statement account that requires adjustment.
http://www.ual.com
The 1999 financial statements for GENERAL MOTORS offer several illustrations of the
What title is given to Un-
potential impact of failing to make adjusting entries. GM reports that, as of December 31, 1999,
earned Revenue for an air-
line? What liability was re- it had unearned revenue totaling $9.504 billion. If GM had failed to make the adjustment nec-
ported for Unearned
essary to record this unearned revenue, total revenue for 1999 would have been overstated by
Revenue in the most recent
$9.504 billion, or 5.4%. In addition, GM reported that its total warranty liability as of De-
annual report?
cember 31, 1999, was $15.284 billion. This warranty liability falls in the category of unrecorded
liabilities that are not reported in the financial statements unless an appropriate adjusting entry
is made. Finally, GM also reported a $35.521 billion asset related to future tax deductions; this
asset would remain unrecorded unless a special adjusting entry were made at the end of the year
to reflect the future tax benefits of events that had occurred in 1999 and preceding years.



to summarize
To present financial statements that accurately report the financial position and
the results of operations on an accrual basis for specific periods of time, ad-
justing entries must be made. The four main categories of adjustments are un-
recorded receivables, unrecorded liabilities, prepaid expenses, and unearned
revenues. In analyzing accounts at the end of an accounting cycle, adjusting
entries are made in order to recognize all earned revenues and all incurred ex-
penses and to report the proper balances in the asset, liability, and owners
equity accounts. This requires a two-step analysis: (1) determine what adjust-
ments are necessary to ensure that all asset and liability amounts have been
properly recorded, and (2) determine which revenues or expenses must be ad-
justed to correspond with the changes in assets and liabilities recorded in step
1. With unrecorded receivables and unrecorded liabilities, there is no original
entry. With prepaid expenses, the original entry includes a credit to Cash and
a debit to an asset account. With unearned revenues, the original entry includes
a debit to Cash and a credit to a liability account.




3 PREPARING FINANCIAL STATEMENTS
Explain the preparation of
Once all transactions have been analyzed, journalized, and posted and all adjusting entries have
the financial statements,
the explanatory notes, and been made, the accounts can be summarized and presented in the form of financial statements.
the audit report.
Financial statements can be prepared directly from the data in the adjusted ledger accounts. The
data must only be organized into appropriate sections and categories so as to present them as
simply and clearly as possible. Once the financial statements are prepared, explanatory notes are
written. These notes clarify the methods and assumptions used in preparing the statements. In
addition, the auditor must review the financial statements to make sure they are accurate, rea-
sonable, and in accordance with generally accepted accounting principles. Finally, the financial
statements are distributed to external users who analyze them in order to learn more about the
financial condition of the company.
143
f144 Part 1 Completing The Accounting Cycle
Financial Reporting and the Accounting Cycle



Financial Statement Preparation
To illustrate the preparation of financial statements from adjusted ledger accounts, a simplified
adjusted trial balance for GENERAL MOTORS as of December 31, 1999, is provided in Ex-
hibit 4-4.
From these data, an income statement and a balance sheet may be prepared for General
Motors, as shown in Exhibits 4-5 and 4-6 on pages 145 and 146.
The ending retained earnings balance for General Motors for 1999 ($6,961), as reported
on the balance sheet, is computed as follows:
Beginning retained earnings balance $2,326)
(from the adjusted trial balance)
Add: Net income for the period 6,002)
(from the income statement)
Subtract: Dividends for the period (1,367)
(from the adjusted trial balance)
Ending retained earnings balance $6,961)



Simplified Adjusted Trial Balance
exhibit 4-4


General Motors Corporation
Simplified Adjusted Trial Balance
December 31, 1999
(in millions)

Debits Credits

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $010,442
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,519
Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86,721
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,638
Property and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,523
Intangible Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,527
Deferred Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,277
Other Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,676
Investment in Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,407
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $021,516
Accrued Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,854
Current Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,934
Long-Term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,745
Pensions and Other Retirement Benefits. . . . . . . . . . . . . . . . . 37,505
Other Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,532
Capital Stock and Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,683
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,326
Dividends. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,367
Revenue from Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152,635
Financing Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,734
Other Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,189
Cost of Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126,809
Selling, General and Administrative Expenses . . . . . . . . . . . . 18,845
Depreciation and Amortization . . . . . . . . . . . . . . . . . . . . . . . . 12,318
Interest Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,750
Income Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,118
Other Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,716
Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $446,653 $446,653
144 f145
Completing The Accounting Cycle Chapter 4
Completing the Accounting Cycle



Income Statement
exhibit 4-5


General Motors Corporation
Statement of Income
For the Year Ended December 31, 1999
(in millions)

Revenue from sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $152,635
Financing revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,734
Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $167,369
Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $126,809
Selling, general and administrative expenses . . . . . . . . . . . . . 18,845
Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . 12,318
Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 157,972
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,397
Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,189
Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,750)
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,118)
Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,716)
Total other revenues and expenses . . . . . . . . . . . . . . . . . . . (3,395)
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $006,002




This follows the computation of retained earnings discussed in Chapter 2.
A statement of cash flows is not shown here. To prepare a statement of cash flows, we need
more detailed information about the nature of the cash receipts and cash disbursements during
the year. The preparation of a statement of cash flows will be illustrated in Chapter 13.

The Notes
As discussed in Chapter 2, the notes to the financial statements tell about the assumptions and
methods used in preparing the financial statements and also give more detail about specific items.
A sample of the kind of information that appears in the notes for General Motors financial state-
ments is illustrated in Exhibit 4-7 on page 147. The first two notes, on revenue recognition and
credit losses, illustrate how financial statement notes can summarize the accounting policies and
assumptions that underlie the financial statements. The third note, on the debt associated with
GM s financing subsidiary (GMAC), provides detailed information about a summary number
that was reported in the financial statements. The fourth note, on GM s labor force, provides in-
formation that is deemed to be important to financial statement users, such as future labor costs,
but that does not directly affect any of the reported historical financial statement numbers.
The financial statement notes serve to augment the summarized, numerical information
contained in the financial statements. To highlight the importance of the notes, many financial
statements have the following message printed at the bottom: The notes are an integral part of
these financial statements.

The Audit
As mentioned in Chapter 2, an independent audit, by CPAs from outside the company, is of-
ten conducted to ensure that the financial statements have been prepared in conformity with
generally accepted accounting principles. With respect to the financial statements of General
Motors, the audit procedures conducted by the external auditor, DELOITTE & TOUCHE,
would probably include the following checks.

As you learned in the first part of this chapter, adjusting en-
REVIEW OF ADJUSTMENTS
tries usually require more analysis, and more judgment, than do the regular journal entries
recorded throughout the year. As part of the audit, the auditor will review these adjusting en-
145
f146 Part 1 Completing The Accounting Cycle
Financial Reporting and the Accounting Cycle



Balance Sheet
exhibit 4-6


General Motors Corporation
Balance Sheet
December 31, 1999
(in millions)

Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,442
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,519
Receivables. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86,721
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,638
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,320
Long-term assets:
Property and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . $38,523
Intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,527
Deferred taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,277
Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,676
Investment in leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,407
Total long-term assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154,410
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $274,730
Liabilities and Owners Equity
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $21,516
Accrued expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,854
Current debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,934
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . $125,304
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,745
Pensions and other retirement benefits . . . . . . . . . . . . . . . . . . 37,505
Other liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,532
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $254,086
Owners equity
Capital stock and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,683
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,961
Total owners equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,644
Total liabilities and owners equity . . . . . . . . . . . . . . . . . . . . $274,730

Note: This balance sheet is not an exact replica of General Motors actual balance sheet due to simpli-
fying modifications for this exhibit.




tries. Auditors pay particular attention to the adjustments involving unrecorded expenses. As
mentioned in the text, companies don t like making these adjusting entries, because they in-
crease reported liabilities and reduce reported net income. Accordingly, the auditor should re-
view the business events of the year to make sure that no expenses have been left unrecorded.

For a number of accounts, the auditor undertakes a
SAMPLE OF SELECTED ACCOUNTS
sampling process to see whether the items reported in the balance sheet actually exist. For exam-
ple, General Motors reports an ending cash and equivalents balance of $10,442,000,000. The au-
ditor will ask to see bank statements and will probably call the bank(s) to verify the existence of
the cash. For inventory, the auditor will ask to physically see the inventory and will conduct a spot
check to see whether the company inventory records match what is actually in the warehouse.

The auditor will also evaluate General Motors ac-
REVIEW OF ACCOUNTING SYSTEMS
counting systems. If a company has a good accounting system, with all transactions being recorded
146 f147
Completing The Accounting Cycle Chapter 4
Completing the Accounting Cycle



General Motors: Notes to the Financial Statements
exhibit 4-7


General Motors Corporation
Notes to the Financial Statements (partial list)
For the Year Ended December 31, 1999

Revenue Recognition: Sales are generally recorded when products are shipped . . . to
independent dealers.
Allowance for Credit Losses: Receivables are charged off [i.e., removed from the books]
as soon as it is determined that the collateral cannot be repossessed, generally not more
than 150 days after default.
Debt: Debt was as follows (in millions):

December 31,
Weighted-Average
Interest Rate 1999 1998

Payable within one year:
Current portion of debt 6.6% $014,996) $012,701)
Commercial paper 5.8% 33,229) 34,487)
All other 4.6% 18,727) 15,208)
Payable beyond one year:
2000 13,154)
2001 6.0% 16,854) 10,322)
2002 5.7% 15,100) 8,561)
2003 6.1% 8,786) 7,919)
2004 6.6% 5,550) 1,208)
2005 and after 7.4% 9,662) 4,864)
Unamortized discount (622) (671)
Total debt $122,282) $107,753)

Labor Force: The 1999 United Auto Workers (UAW) labor contract was ratified on October
13, 1999, covering a four-year term from 1999 2003. The contract included an annual
salary increase of 3% per year, an up-front signing bonus of $1,350 per UAW employee. . . .
The 1999 contract includes job security and sourcing provisions containing an
employment floor set at 95% of 1996 employment levels in the event of net outsourcing.



in an efficient, orderly way, then the auditor has greater reason to be confident that the finan-
cial statements are reliable. On the other hand, if the company s accounting system is haphaz-
ard, with many missing documents and unexplained discrepancies, then the auditor must do
more detailed work to verify the financial statements.
If the auditor finds that the financial statements have been prepared in conformance with
generally accepted accounting principles, then the auditor provides a report to that effect. This
report is attached and distributed as part of the financial statements. The audit report is dis-
cussed in more detail in Chapter 5.



to summarize
The adjusted trial balance provides the raw material for the preparation of the
balance sheet and the income statement. The notes to the financial statements
provide further information about the methods and assumptions used in prepar-
ing the financial statements as well as further detail about certain financial state-
ment items. The audit is conducted by a CPA from outside the company who
reviews the adjusting entries, performs tests to check the balances of selected
accounts, and reviews the condition of the accounting systems.
147
f148 Part 1 Completing The Accounting Cycle
Financial Reporting and the Accounting Cycle



4 ANALYZING FINANCIAL STATEMENTS
Perform a systematic
Financial statements are prepared in order to be used. Once the balance sheet, income state-
analysis of financial
statements. ment, statement of cash flows, notes, and audit report of a company are completed, the whole
package is distributed to bankers, suppliers, and investors to be used in evaluating the company s
financial health. Financial statement analysis was introduced in Chapter 2 with illustrations of
the computation and interpretation of selected financial ratios. That discussion is extended here
with the introduction of two general tools of financial statement analysis: the DuPont frame-
work and common-size financial statements.

DuPont Framework
As discussed in Chapter 2, return on equity (Net Income/Equity) is the single measure that
return on equity A measure
of the amount of profit summarizes the financial health of a company. Return on equity can be interpreted as the num-
earned per dollar of invest-
ber of cents of net income an investor earns in one year by investing one dollar in the company.
ment, computed by divid-
Return on equity (ROE) for GENERAL MOTORS for the year 1999 is computed below ($ in
ing net income by equity.
millions):

Net Income $6,002
Equity $20,644
Return on Equity 29.1%


The DuPont framework (named after a system of ratio analysis developed internally at
DuPont framework A sys-
tematic approach for break- DuPont in the early part of the twentieth century) provides a systematic approach to identify-
ing down return on equity ing general factors contributing to return on equity. The insight behind the DuPont framework
into three ratios: profit
is that ROE can be decomposed into three components, as shown below.
margin, asset turnover, and
assets-to-equity ratio.
Return on Equity Profitability Efficiency Leverage

Profit Margin Asset Turnover Assets-to-Equity Ratio

Net Income Net Income Revenue Assets
Equity Revenue Assets Equity


For each of the three ROE components profitability, efficiency, and leverage there is a cor-
relating ratio that summarizes a company s performance in that area. These ratios are as follows:
Profit margin is computed as (Net Income/Revenue) and is interpreted as the number of
profit margin A measure of
the number of pennies in pennies in profit generated from each dollar of revenue.
profit generated from each Asset turnover is computed as (Revenue/Assets) and is interpreted as the number of dol-
dollar of revenue; calcu-
lars in revenue generated by each dollar of assets.
lated by dividing net in-
Assets-to-equity ratio is computed as (Assets/Equity) and is interpreted as the number of
come by revenue.
dollars of assets a company is able to acquire using each dollar invested by stockholders.
asset turnover A measure
The DuPont analysis of General Motors ROE for 1999 is as follows:
of company efficiency,
computed by dividing rev-
enue by total assets. Net Income Revenue Assets
Return on Equity
Revenue Assets Equity
assets-to-equity ratio A
measure of the number of
$6,002 $6,002 $176,558 $274,730
dollars of assets a company
$20,644 $176,558 $274,730 $20,644
is able to acquire using
each dollar of equity; calcu- 29.1% 3.4% 0.64 13.31
lated by dividing assets by
equity.
These three ratio values can be interpreted as follows:
GM earned 3.4 cents in profit for each dollar in revenue.
GM generated $0.64 in revenue for every dollar of assets.
For every dollar invested by GM shareholders, GM was able to acquire $13.31 in assets;
additional assets were acquired with borrowed funds.
148 f149
Completing The Accounting Cycle Chapter 4
Completing the Accounting Cycle


Evaluation of whether these ratio values are too high or too low involves comparing the
computed values to the ratio values of other companies in the same industry as General Motors.
In addition, this year s ratio values can be compared to GM s own ratio values
Is it good for a company in past years. For example, if other companies in the auto industry have profit
margins of 7.0%, it appears that GM s profitability (3.4%) is lower than that
to have a high assets-to-equity ratio?
of its competitors. If the asset turnover value for GM s competitors is 1.00, the
0.64 value for GM suggests that GM is less efficient at using its assets to generate sales.

common-size financial Common-Size Financial Statements
statements Financial state-
A quick and easy way to get more information out of the financial statements is to divide all fi-
ments achieved by dividing
all financial statement num- nancial statement numbers for a given year by the total revenues for the year. The resulting fi-
bers by total revenues for
nancial statements, called common-size financial statements, show all amounts for a given year
the year.
as a percentage of revenues for that year. A common-size income statement for General Motors,
based on the income statement in Exhibit 4-5, is shown in Exhibit 4-8.
fyi If General Motors overall profitability is lower than its industry competitors, the
common-size income statement can be used to pinpoint exactly where the problem lies.
The amount of cash held by
For example, if General Motors competitors have cost of sales that is just 65.0% of total
General Motors is quite low
revenue, then the 71.8% for GM suggests that this expense may be too high.
5.9% of revenues. For compar-
A common-size balance sheet also expresses each amount as a percentage of total rev-
ison, look at MICROSOFT s fi-
enue for the year. A common-size balance sheet for General Motors, based on the balance
nancial statements at the end sheet in Exhibit 4-6, is shown in Exhibit 4-9.
of the text and you ll see that The most informative section of the common-size balance sheet is the asset section,
which can be used to determine how efficiently a company is using its assets. For exam-
Microsoft has a very high 1999
ple, assume that GM s competitors have inventory levels equal to 5.0% of total revenues.
cash balance equal to 87.3% of
This suggests that GM is maintaining higher inventory levels (6.0% of revenues) and is
total revenues.
thus using its inventory less efficiently.



to summarize
Financial statements are used by various interested parties to examine a
company s financial health. Two general techniques for financial statement


Common-Size Income Statement
exhibit 4-8


General Motors Corporation
Common-Size Income Statement
For the Year Ended December 31, 1999
(in millions)

Amounts % of Revenue

Revenue from sales . . . . . . . . . . . . . . . . . . . . . . $152,635
Financing revenues . . . . . . . . . . . . . . . . . . . . . . . 14,734
Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,189
Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . $176,558 100.0%
Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $126,809 71.8%
Selling, general and administrative expenses . . . 18,845 10.7%
Depreciation and amortization. . . . . . . . . . . . . . . 12,318 7.0%
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . 7,750 4.4%
Income tax expense . . . . . . . . . . . . . . . . . . . . . . 3,118 1.8%
Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 1,716 170,556 1.0%
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $006,002 3.4%
149
f150 Part 1 Completing The Accounting Cycle
Financial Reporting and the Accounting Cycle



Common-Size Balance Sheet
exhibit 4-9


General Motors Corporation
Common-Size Balance Sheet
December 31, 1999
(in millions)

Amounts % of Revenue

Assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $010,442 5.9%
Investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,519 7.1%
Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86,721 49.1%
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,638 6.0%
Property and equipment . . . . . . . . . . . . . . . . . . . . . 38,523 21.8%
Intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,527 4.8%
Deferred taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,277 8.7%
Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,676 31.5%
Investment in leases . . . . . . . . . . . . . . . . . . . . . . . . 36,407 20.6%
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $274,730 155.6%*

Liabilities and Owners Equity
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . $021,516 12.2%
Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . 32,854 18.6%
Current debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,934 40.2%
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,745 35.5%
Pensions and other retirement benefits . . . . . . . . . . 37,505 21.2%
Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,532 16.2%
Capital stock and other . . . . . . . . . . . . . . . . . . . . . . 13,683 7.7%
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 6,961 3.9%
Total liabilities and equities . . . . . . . . . . . . . . . . . $274,730 155.6%*

*Difference due to rounding.




business environment essay


Market Efficiency: Can Financial State- information, future movements in stock prices should
ment Analysis Help You Win in the be unpredictable.
Stock Market? An efficient market is It seems clear that stock markets in the United
one in which information is reflected States are efficient in a general sense, but accumu-
rapidly in prices. For example, if the real lated evidence suggests the existence of a number of
estate market in a city is efficient, then puzzling anomalies in the form of predictable pat-
news of an impending layoff at a major terns of stock returns. For example, prices tend to con-
employer in the city should quickly re- tinue to drift upward for weeks or months after fa-
sult in lower housing prices because of vorable earnings news is released. In addition, prices
an anticipated decrease in demand. The continue to climb for at least a year after a stock split
major stock exchanges in the United States are often is announced.
considered to be efficient markets in the sense that From an accounting standpoint, market efficiency
information about specific companies or about the relates to the usefulness of so-called fundamental
economy in general is reflected almost immediately analysis. Fundamental analysis is the practice of us-
in stock prices. One implication of market efficiency ing financial data to calculate the underlying value of
is that, since current stock prices reflect all available a firm and using this underlying value to identify over-
150 f151
Completing The Accounting Cycle Chapter 4
Completing the Accounting Cycle



analysis are the DuPont framework and common-size financial statements. The
DuPont framework is based on the insight that return on equity can be sepa-
rated into three components, each with a correlating ratio: profitability (profit
margin), efficiency (asset turnover), and leverage (assets-to-equity). Preparing
common-size financial statements involves dividing all financial statement
numbers by total revenue for the year.




5 CLOSING THE BOOKS
Complete the closing
We have almost reached the end of the accounting cycle. Thus far, the accounting cycle has in-
process in the accounting
cycle. cluded analyzing documents, journalizing transactions, posting to the ledger accounts, deter-
mining account balances, preparing a trial balance, making adjusting entries, and preparing the
financial statements. Just two additional steps are needed: (1) journalizing and posting closing
entries and (2) preparing a post-closing trial balance.

Real and Nominal Accounts
To explain the closing process, we must first define two new terms. Certain accounts are re-
ferred to as real accounts. These accounts report the cumulative increases and decreases in cer-
real accounts Accounts that
are not closed to a zero bal- tain account balances from the date the company was organized. Real accounts (assets, liabili-
ance at the end of each ac-
ties, and owners equity) appear on the balance sheet and are permanent; they are not closed to
counting period; permanent
a zero balance at the end of each accounting period. Balances existing in real accounts at the
accounts appearing on the
end of a period are carried forward to the next period.
balance sheet.
Other accounts are known as nominal accounts. These accounts (revenues, expenses, and
nominal accounts Accounts
dividends) are temporary; they are really just subcategories of Retained Earnings and are reduced
that are closed to a zero
to a zero balance through the closing process at the end of each accounting period. Thus, nom-
balance at the end of each
inal accounts begin with a zero balance at the start of each accounting cycle. Transactions through-
accounting period; tempo-
out the period (generally a year) are journalized and posted to the nominal accounts. These are
rary accounts generally ap-
pearing on the income used to accumulate and classify all revenue and expense items, and also dividends, for that
statement.




and underpriced stocks. The notion of fundamental one can selectively invest in companies and earn an
analysis is in conflict with market efficiency, because abnormal return of 13.2% per year. An abnormal re-
the analysis works only if current stock prices do not turn is the return over and above what one would earn
fully reflect all available accounting information. For with a diversified portfolio of stocks. So, contrary to
this reason, fundamental analysis has frequently been what is expected of an efficient stock market, it looks
like you can use publicly available accounting data to
regarded with skepticism by academics. A growing
body of academic research, however, suggests that make money in the U.S. stock market.
accounting data may be useful in predicting future
stock returns. Ou and Penman (1989) and Holthausen
Sources: Jane A. Ou and Stephen H. Penman, Financial Statement
and Larcker (1992) were the first to demonstrate that
Analysis and the Prediction of Stock Returns, Journal of Account-
financial ratios derived from publicly available finan- ing and Economics, November 1989, p. 295; Robert W. Holthausen
cial statements can be used to successfully forecast and David F. Larcker, The Prediction of Stock Returns Using Finan-
cial Statement Information, Journal of Accounting and Economics,
stock returns for the coming year. More recently,
June 1992, p. 373; Jeffery S. Abarbanell and Brian J. Bushee, Ab-
Abarbanell and Bushee (1998) showed that, using fi- normal Returns to a Fundamental Analysis Strategy, The Account-
nancial ratios to predict future earnings performance, ing Review, January 1998, p. 19.
151
f152 Part 1 Completing The Accounting Cycle
Financial Reporting and the Accounting Cycle


period. At the end of the accounting period, adjustments are made, the income statement
fyi
is prepared, and the balances in the temporary accounts are then closed to Retained Earn-
In a proprietorship or a part- ings, a permanent account. These closing entries bring the income statement accounts
nership, the nominal accounts back to a zero balance, which makes the accounts ready for a new accounting period. In
are closed to the owners per- addition, the closing entries transfer the net income or loss for the accounting period to
Retained Earnings and reduce Retained Earnings for any dividends. Without closing en-
manent capital accounts in-
tries, revenue and expense balances would extend from period to period, making it diffi-
stead of to Retained Earnings.
cult to isolate the operating results of each accounting period.

Closing Entries
The actual mechanics of the closing process are not complicated. Revenue accounts normally
have credit balances and are closed by being debited; expense accounts generally have debit bal-
ances and are closed by being credited. The difference between total revenues and total expenses
represents the net income (or net loss) of the entity. For a corporation, net income is credited
to Retained Earnings because income increases owners equity. A net loss would be debited to
Retained Earnings because a loss decreases owners equity.
To illustrate the closing process, we will again refer to GENERAL MOTORS financial in-
formation as discussed earlier on pages 144 146. The closing journal entry is:

Dec. 31 Revenue from Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . 152,635
Financing Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,734
Other Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,189
Cost of Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126,809
closing entries Entries that
reduce all nominal, or tem- Selling, General and Administrative Expenses . . . . . . 18,845
porary, accounts to a zero Depreciation and Amortization . . . . . . . . . . . . . . . . . . 12,318
balance at the end of each
Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,750
accounting period, transfer-
Income Tax Expense. . . . . . . . . . . . . . . . . . . . . . . . . . 3,118
ring their preclosing bal-
Other Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,716
ances to a permanent bal-
ance sheet account. Retained Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,002
To close revenues and expenses to Retained Earnings.


Closing entries must be posted to the appropriate ledger accounts. Once posted, all nom-
caution inal accounts will have a zero balance; that is, they will be closed.
Don t close real accounts! Con- The dividends account is also a nominal (temporary) account that must be closed at the
sider the negative implications end of the accounting period. However, dividends are not expenses and will not be reported
on an income statement; they are distributions to stockholders of part of a corporation s earn-
of eliminating all your asset ac-
ings. Thus, dividends reduce retained earnings. When dividends are declared by the board of
counts at the end of the year.
directors of a corporation, the amount that will be paid is debited to Dividends and credited
Nominal accounts are closed
to a liability account, Dividends Payable, or to Cash if paid immediately. Because Dividends
because they are just tempo-
is a temporary account, it must be closed to Retained Earnings at the end of the accounting
rary subaccounts of Retained
period. The dividends account is closed by crediting it and by debiting Retained Earnings,
Earnings.
thereby reducing owners equity, as illustrated below for General Motors.

Dec. 31 Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,367
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,367
To close Dividends to Retained Earnings.
post-closing trial balance A
listing of all real account
The books are now ready for a new accounting cycle. The closing process for the revenues, ex-
balances after the closing
process has been com- penses, and dividends of a corporation is shown schematically in Exhibit 4-10.
pleted; provides a means of
testing whether total debits
Preparing a Post-Closing Trial Balance
equal total credits for all
real accounts prior to be-
An optional last step in the accounting cycle is to balance the accounts and to prepare a post-
ginning a new accounting
closing trial balance. The accounts are to be balanced debits and credits added and a balance
cycle.
152 f153
Completing The Accounting Cycle Chapter 4
Completing the Accounting Cycle



The Closing Process
exhibit 4-10

Revenues
(Nominal Accounts) Retained Earnings
(Real Account)
Bal.
xxx xxx
To close
Beg. Bal. xxx


Total Expenses
Expenses xxx xxx
(Nominal Accounts) Total Revenues
se xx
To clo
xxx
Bal. xxx
xxx
End Bal.
ds
en
id
Div
Dividends
(Nominal Account)

xx
Bal. xx To close




determined only after the closing entries have been recorded and posted in the general ledger.
The information for the post-closing trial balance is then taken from the ledger. The nominal ac-
counts will not be shown since they have been closed and thus have zero balances. Only the real
accounts will have current balances. This step is designed to provide some assurance that the pre-
vious steps in the cycle have been performed properly, prior to the start of a new accounting pe-
riod. Exhibit 4-11 illustrates a post-closing trial balance for General Motors Corporation.


Post-Closing Trial Balance
exhibit 4-11


General Motors Corporation
Post-Closing Trial Balance
December 31, 1999
(in millions)

Debits Credits

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $010,442
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,519
Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86,721
Inventories. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,638
Property and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,523
Intangible Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,527
Deferred Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,277
Other Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,676
Investment in Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,407
Accounts Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $021,516
Accrued Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,854
Current Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,934
Long-Term Debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,745
Pensions and Other Retirement Benefits . . . . . . . . . . . . . . . . 37,505
Other Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,532
Capital Stock and Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,683
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,961
Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $274,730 $274,730
153
f154 Part 1 Completing The Accounting Cycle
Financial Reporting and the Accounting Cycle




to summarize
As part of the closing process, all nominal (temporary) accounts are closed to a
zero balance. All real (permanent) accounts (balance sheet accounts for assets,
liabilities, and owners equity) are carried forward to the new reporting period.
All nominal accounts (revenues, expenses, and dividends) are closed to Retained
Earnings. Revenue accounts are closed by being debited; expense accounts are
closed by being credited. Dividends also must be closed to Retained Earnings
by being credited. A post-closing trial balance may be prepared to provide some
assurance that the previous steps in the cycle have been performed properly.




6 A SUMMARY OF THE ACCOUNTING CYCLE
Understand how all the
We have now completed our discussion of the steps in the accounting cycle. By way of review,
steps in the accounting
cycle fit together. Exhibit 4-12 lists the sequence of the accounting cycle (presented earlier in Chapter 3). Many
of the steps, such as analyzing transactions, occur continuously. Other steps, such as preparing
the financial statements, generally occur only once during the cycle.
The financial statements that result from the accounting cycle provide useful information
to investors, creditors, and other external users. These statements are included in the annual re-



Sequence of the Accounting Cycle
exhibit 4-12

Exchange Transactions
(Businesses enter into exchange transactions
signaling the beginning of the accounting cycle)




1 Analyze transactions.
Step




2
Step Record the effects of transactions.




3 Summarize the effects of transactions.
1. Posting journal entries.
Step
2. Preparing a trial balance.




4 Prepare reports.
1. Adjusting entries.
2. Preparing financial statements.
3. Closing the books.
Step
154 f155
Completing The Accounting Cycle EM Chapter 4
Completing the Accounting Cycle


ports provided to stockholders. As illustrated earlier in the chapter, once the financial statements
are made available to users, they can then be analyzed and compared to the financial statements
of similar firms to detect strengths and weaknesses.




Earlier in the chapter, the adjusting entries for prepaid expenses were made

assuming that the prepayments were initially recorded as assets. Alternatively,
the prepayments can be initially recorded as expenses; the correct amounts

of assets and expenses can still be achieved through an appropriate year-end

adjusting entry. Similarly, cash receipts in advance are sometimes initially
recorded as revenues instead of as liabilities. Again, although not conceptu-

ally correct, it is done in the normal course of bookkeeping; any necessary ad-
justments can be made at year-end.



ADJUSTING ENTRIES: ORIGINAL ENTRIES TO
7
EXPENSE OR REVENUE
Make adjusting entries for
prepaid expenses and
unearned revenues when
To illustrate the necessary adjusting process when expense prepayments are debited to an ex-
the original cash amounts
pense account, we will use the prepaid insurance example for the landscaping company that was
are recorded as expenses
and revenues. illustrated earlier:
On November 1, 2003, the landscaping company purchased a six-
month insurance policy on its old truck, paying a $600 premium.
Assume that the $600 insurance prepayment was initially recorded as follows:


Nov. 1 Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600
Paid six months insurance in advance:
6 $100 $600.


Notice that the debit is to Insurance Expense instead of Prepaid Insurance (as illustrated ear-
lier). In order to fix the balance sheet at December 31, the asset Prepaid Insurance must be deb-
ited (increased) for $400 (4 $100) to reflect the fact that four months of prepaid insurance
still remain. The entire $400 is debited to Prepaid Insurance because, with the original debit to
Insurance Expense, the existing balance in Prepaid Insurance is $0. The credit half of the ad-
justing entry is used to fix the income statement. The $400 credit is to Insurance Expense, rep-
resenting the fact that too much insurance expense was initially recorded and some is being re-
moved. The appropriate adjusting entry is as follows:

Dec. 31 Prepaid Insurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Insurance Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
To record prepaid insurance for four months:
4 $100 $400.
155
f156 Completing The Accounting Cycle
Part 1 EM Financial Reporting and the Accounting Cycle


Although this adjusting entry is different from the one shown previously, the net effect of the
original and adjusting entries is exactly the same, as illustrated below.

Original debit to Insurance Expense:

Prepaid Insurance Cash Insurance Expense

Original entry (11/1/03) 600 600
Adjusting entry (12/31/03) 400 400
Updated balances (12/31/03) 400 200

To balance sheet To income statement


Original debit to Prepaid Insurance (illustrated earlier on page 140):

Prepaid Insurance Cash Insurance Expense

Original entry (11/1/03) 600 600
Adjusting entry (12/31/03) 200 200
400 200
Updated balances (12/31/03)

To balance sheet To income statement


Whether the initial debit for a prepaid expense is to a prepaid asset or to an expense, the
key thing to remember in constructing the necessary adjusting entry is to first fix the balance
sheet; the other half of the adjusting entry is used to fix the income statement.
Why would a company To illustrate the necessary adjusting process when revenue received in ad-
debit an insurance prepayment to Insurance vance is initially credited to a revenue account, we will use the unearned rev-
Expense rather than adopting a more theo- enue example for our landscaping company that was illustrated earlier:
retically sound policy of debiting Prepaid In- On December 1, a client pays $225 for landscaping services to be
surance? provided over the period December 1, 2003, to February 29, 2004.
Assume that the $225 cash received for services was initially recorded as follows:

Dec. 1 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Landscaping Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
Received three months revenue in advance:
$75 3 $225.


On December 31, an adjusting entry must be made to reflect the fact that two months worth
of this revenue is still unearned and represents a liability. This adjustment is made through a
credit (increase) to Unearned Revenue of $150 ($75 2), thereby fixing the balance sheet. The
corresponding debit is used to fix the income statement. A debit to Landscaping Revenue rep-
resents a decrease in revenue because some of the revenue originally recorded on December 1
has not yet been earned. The necessary adjusting entry is as follows:

Dec. 31 Landscaping Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Unearned Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
To record unearned revenue for two months:
$75 2 $150.


The sequence of entries differs when the original credit is to Landscaping Revenue rather than
Unearned Revenue, but the end result is the same. Compare the ending balances in the fol-
lowing T-accounts:
156 f157
Completing The Accounting Cycle EM Chapter 4
Completing the Accounting Cycle



Original credit to Landscaping Revenue:

Unearned Revenue Cash Landscaping Revenue

225 225
Original entry (12/1/03)
150 150
Adjusting entry (12/31/03)
150 75
Updated balances (12/31/03)

To balance To income
sheet statement


Original credit to Unearned Revenue (illustrated earlier on page 142):

Unearned Revenue Cash Landscaping Revenue

Original entry (12/1/03) 225 225
Adjusting entry (12/31/03) 75 75
Updated balances (12/31/03) 150 75

To balance To income
sheet statement




to summarize
Prepayments are sometimes initially recorded as expenses instead of as pre-
paid expenses (assets); cash receipts for revenue in advance are sometimes
initially recorded as revenues instead of as unearned revenues (liabilities). This
requires an adjusting process that differs somewhat from that illustrated ear-
lier in the chapter. No matter which approach is used, however, the resulting
amounts reported in the balance sheet and the income statement are the same
if the adjusting entries are made correctly.




APPENDIX A: USING A WORK SHEET
A work sheet is a tool used by accountants to facilitate the preparation of financial statements.
work sheet A columnar
schedule used to summa- Unlike the financial statements, work sheets are for internal use only; they are not distributed
rize accounting data. to outsiders. Although the use of work sheets is optional, most accountants find them help-
ful for organizing large quantities of data. Many work sheets are now prepared on electronic
spreadsheets, using a software package such as Lotus 1-2-3, Excel, or Quattro Pro.

Preparing a Work Sheet
In preparing a work sheet, accountants first list the trial balance, then add any adjusting entries,
and finally extend the combined amounts into the appropriate financial statement columns. The
figures in these columns are used in preparing the income statement and the balance sheet. Ad-
ditional analysis is required to prepare the statement of cash flows (see Chapter 13).
A work sheet will usually have a minimum of eight columns, as shown in Exhibit 4-13.
The accounts are listed on the left side, and columns 1 and 2 indicate the account balances prior
to adjustments (the unadjusted trial balance). Columns 3 and 4 are for adjusting entries. It
should be noted that even when a work sheet is used to prepare financial statements, the ad-
justing entries still must be journalized and posted to the ledger accounts, as explained earlier
in the chapter.
157
f158 Part 1 Completing The Accounting Cycle
Financial Reporting and the Accounting Cycle



Eight-Column Work Sheet
exhibit 4-13


ITEC, Inc.
Work Sheet
December 31, 2003

Trial Balance Adjustments Income Statement Balance Sheet

Account Titles Debits Credits Debits Credits Debits Credits Debits Credits

Cash 24,270 24,270
Accounts Receivable 3,000 3,000
Inventory 3,000 3,000
Supplies on Hand 250 (d) 140 110
Prepaid Insurance 480 (b) 40 440
Accounts Payable 3,000 3,000
Unearned Rent Revenue 600 (c) 100 500
Capital Stock 20,000 20,000
Sales 34,700 34,700
Cost of Goods Sold 21,000 21,000
Salaries Expense 1,500 (a) 700 2,200
Truck Rental Expense 4,800 (e) 4,400 400
58,300 58,300
Salaries Payable (a) 700 700
Insurance Expense (b) 40 40
Rent Revenue (c) 100 100
Supplies Expense (d) 140 140
Prepaid Truck Rental (e) 4,400 4,400
5,380 5,380 23,780 34,800 35,220 24,200
Net Income (to balance) 11,020 11,020
34,800 34,800 35,220 35,220


Adjustments:
(a) Salaries Payable, $700
(b) Insurance Expense, $40
($480 12 $40 a month)
(c) Rent Revenue Earned, $100
(d) Supplies Expense, $140 ($250 $110)
(e) Prepaid Truck Rental, $4,400
($4,800 12 $400; $400 11 months)




The last four columns of a work sheet are used for extending the unadjusted trial balance fig-
ures, plus or minus adjustments, into the appropriate financial statement columns. Revenue and
expense accounts are extended into the income statement columns; asset, liability, and owners eq-
uity accounts into the balance sheet columns. The exact form of a work sheet is flexible, and its
content depends on the type of business and the way a company handles certain transactions.
To illustrate the use of a work sheet, we will examine the operating activities for one year
for ITEC, Inc. The work sheet for ITEC, Inc., using the eight-column format, is shown in Ex-
hibit 4-13. The amounts in the trial balance columns are based on the following transactions.
(Note that the company was organized on January 1, 2003.)
1. Issued capital stock for $20,000 cash.
2. Paid $4,800 cash to lease a truck for one year; one month s expense applicable to 2003.
3. Received $600 on December 1 from a tenant for six months rent ($100 per month).
158 f159
Completing The Accounting Cycle Chapter 4
Completing the Accounting Cycle


4. Paid $480 for a one-year insurance policy; one month is expense applicable to 2003.
5. Purchased supplies for $250 cash.
6. Purchased inventory for $10,000 on account.
7. Sold inventory for $15,000 on account; cost of the merchandise sold was $8,000.
8. Collected $12,000 cash from customers accounts receivable.
9. Paid $7,000 cash for inventories bought in item (6) above.
10. Paid $1,500 for sales representatives salaries.
11. Purchased inventory for $14,000 cash.
12. Sold inventory for $19,700 cash; cost of the merchandise sold was $13,000.
After all transactions have been journalized and posted, the balances in the accounts can be listed
in the first two columns of the work sheet as the unadjusted trial balance (see Exhibit 4-13).
The columns are then added to make sure that total debits equal total credits. The following
data are applicable to the necessary adjusting entries at December 31:
a. Salaries payable, $700. In item (10), $1,500 was paid to sales representatives. By the end
of the year, an additional $700 in sales salaries had been earned but not yet paid.
b. Insurance expense, $40. In item (4), $480 was paid for insurance, debiting Prepaid Insur-
ance. At the end of the year, only one-twelfth of this annual fee should be expensed ($480
12 $40); the balance ($440) should be shown as an asset, Prepaid Insurance.
c. Monthly rent revenue earned, $100. See item (3).
d. Supplies on hand, $110. Of the supplies purchased in item (5), some remain on hand and
some have been used.
e. Prepaid truck rental, $4,400. In item (2), a truck was leased for one year for $4,800, payable
in advance. (A lease is a formal rental agreement.) At the end of December, eleven-twelfths
of the annual lease should be shown as an asset, Prepaid Truck Rental ($4,800 12
$400; $400 11 months $4,400); one-twelfth ($400) should be shown as an expense.
As illustrated in Exhibit 4-13, these adjustments appear in the adjustments columns and are
identified as entries (a) through (e). A key for the adjustments is usually included at the bottom
of the work sheet. Some accounts that are involved in the adjusting entries have a zero balance
before adjustments and are therefore not included in the trial balance. These accounts are added
below those listed on the trial balance. The adjustments are then added to or subtracted from
the account balances. If an eight-column work sheet is used, as in Exhibit 4-13, the results are
extended to the appropriate income statement or balance sheet columns as debits or credits, re-
spectively.
Note in Exhibit 4-13 that the income statement and the balance sheet column subtotals do
not show the equality of debits and credits. A balancing figure must be added to both the income
statement and the balance sheet to make total debits equal total credits. If credits (revenues) ex-
ceed debits (expenses) for the income statement column subtotals, a balancing debit amount
($11,020 in this case) must be added, reflecting pretax net income for the period. The same amount
must also be added as a credit to the balance sheet columns, showing an increase in owners eq-
uity. If debits exceed credits for the income statement subtotals, there is a net loss for the period.
This would be presented as a balancing credit amount on the income statement and a balancing
debit amount on the balance sheet, showing a reduction in owners equity. In either case, a bal-
ancing figure is required to bring total debits equal to total credits for each set of columns.


Special Considerations in Using a Work Sheet
Two items relating to ITEC s work sheet (Exhibit 4-13) require additional explanation: (1) the
work sheet adjustment for income taxes and (2) reporting the ending retained earnings balance.


To keep the ITEC illustration sim-
WORK SHEET ADJUSTMENT FOR INCOME TAXES
ple, we ignored income taxes. When a corporation earns income, however, it must pay income
taxes. A year-end adjustment is required, debiting Income Tax Expense and crediting Income

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