Accounting Course Manual 1
Copyright Notice. Each module of the course manual may be viewed online, saved to disk, or printed (each is composed of 10 to 15 printed pages of text) by students enrolled in the author’s accounting course for use in that course. Otherwise, no part of the Course Manual or its modules may be reproduced or copied in any form or by any means—graphic, electronic, or mechanical, including photocopying, taping, or information storage and retrieval systems—without the written permission of the author. Requests for permission to use or reproduce these materials should be mailed to the author.
Module 3
Table of Contents / Instructions:Click on any of the underlined titles in the table of contents to be directed to that section of the module. Click on the <back> symbol to return to the table of contents.
a. / Assignments
I. / Importance of Income Statement
II. / Accrual Basis and Cash Basis Accounting
III. / Deferred Expense Items
IV. / Deferred Revenue Items
V. / Accrued Revenue and Expense Items
VI. / Adjusted Trial Balance, Vertical Analysis
i. / Supplemental Exercise 1, Mel’s Manor
ii. / Supplemental Exercise 2, Sally Sam’s
iii. / Solution to Mel’s Manor
iv. / Solution to Sally Sam’s
/ Module 3 Assignments / Many assignments are done on CengageNow. Click here for information and instructions.
Step 1
(a). Module 3 Reading Assignment:
Read this document from its beginning to the Step 2 Assignments box below. Read the textbook from the beginning of the chapter to page 108, “Accrued Revenues.”Note: Be sure to study Supplemental Exercise 1 on page 13 of this document. If you understand the adjusting entries illustrated in this exercise, then you have mastered adjusting entries for deferred revenues and expenses!
(b). View Course Manual Lecture 3-1
Right-click the following link and select “open in a new window.”
Module 3-1 Online Lecture Presentation
(c). Online CengageNow“Study Tools:”
No assignment.
(d).Online CengageNow “Assignments:”
Select “Assignments” in CengageNow, and work as many of the Practice Problems as you feel you need to work in order to fully understand the material. Practice problems are not scored and do not affect your grade. Next, complete the Assigned Problems in CengageNow. These assigned problems are scored and recorded and will affect your grade.
(1). Practice Problems:
Exercises #3-5, 6, 8, 18, 19
Note: Practice exercises and problems may be worked on CengageNow by selecting “Module 3 Practice” from the assignments list, or they may be done with paper and pencil. If they are done on CengageNow, answers will be displayed when the problem is submitted for correction. If done on paper, the solutions to the practice exercises can be found on the Moodle course site.
(2). Assigned Problems to be done on CengageNow:
No assignment.
After finishing the assigned problems on CengageNow, proceed to Step 2 below and complete the next set of listed assignments.
Module 3 Summary
I.Importance of the Income Statement.Profitability is a key concern of investors and managers. As we know, accountants measure profitability by determining net income (or net loss), which is the difference between revenues and expenses.
II.Accrual Basis, Cash Basis, and Adjusting Entries
A.Under GAAP, companies are required to report accounting information on an accrual basis, as opposed to a cash basis. Accrual basis accounting simply means that revenues are recorded when earned (whether payment has been received or not), and expenses are recorded when incurred (whether paid or not). It is the type of accounting we have been practicing all along in our course.
B.Under cash basis accounting, revenues are only recorded when cash is collected from the customer, and expenses are only recorded when cash has been spent to pay them. Cash basis accounting is not acceptable under GAAP!
C.Under the accrual basis of accounting, adjusting entries will be required at the end of the accounting period because some of the events that have affected revenues and expenses will not have been recorded during the period.
1.This will have happened because it was not convenient or not feasible to make these entries.
2.For example, wages expense is incurred each minute the employees work and supplies expense is incurred each time a paper clip is used, but no one would try to record these expenses on a minute-by-minute basis. Instead, the expense is measured and recorded at the end of the period. At that time the expense accounts must be updated in order to include some of the expenses that have been incurred but haven’t been recorded, so that they can be reported accurately on the income statement.
3.The same thing happens with revenues that are earned as services are provided. We would not leave our work on a customer’s job every five minutes to go and record five minutes’ worth of revenues! Therefore, at the end of the accounting period, some of the revenue balances on the trial balance will be incomplete, and adjusting entries must be made to add the revenues that have been earned but have not yet been recorded.
D.Adjustments may be classified into two general types:
1.Adjustments to recognize deferred revenues and expenses.
2.Adjustments to recognize accrued revenues and expenses.
III.Adjustments to Recognize Deferred Expense Items.
A.In the case of “deferred expense items,” cash was paid at some earlier time and, because the payment provided future benefits to the company, an asset account was debited. Since an asset was recorded instead of an expense, the recording of expense was deferred(put off) until later, after the asset is used up and the expense had been incurred.
a.An example of a deferred expense item would be supplies, which are assets when they are first purchased, but become an expense as the supplies are used.
b.Other payments that would represent deferred expenses are payments for insurance coverage (debited to an asset account called Prepaid Insurance) or payment of rent in advance (Prepaid Rent).
BOver time and through use, the benefits these assets provide expires, and the asset is used up (either completely or partially). This was will not have been recorded, minute by minute, as it occurred, so it will be necessary to adjust the asset account balance, reducing it and recognizing an expense.
C.Theform of the adjusting entry for deferred expense items is almost always the same. The asset account is credited (decreased) and an expense account is increased (debited):
? Expense$ X
? Asset$ X
1.In the case of long-term building and equipment assets, the form of the entry does differ somewhat from the entry above. These assets are not used up in the course of business operations as supplies or prepaid assets are; instead they wear out, or depreciate. Since the cost concept(module 1) requires that assets be carried at historical cost, the asset account cannot be credited to record depreciation. Instead, a contra-account called Accumulated Depreciation is credited. Depreciation Expense is recorded as follows:
Depreciation Expense$X
Accumulated Depreciation$X
2.The Accumulated Depreciation account's credit balance is subtracted from the asset account's debit balance on the balance sheet. The resulting figure is called the asset's book value (also called carrying value), the amount at which it is “carried”in the company’s “books,” and it is the value that is reported on the balance sheet:
AssetMinus: Accumulated Depreciation / $X
( X) / = $ Book Value
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IV.Adjustments to Recognize Deferred Revenue Items
A.Deferred revenue items are recorded in the Unearned Revenue account.
1.Unearned Revenues represent prepayments received from customers for services to be rendered in the future. (That is, a customer pays in advance of actually receiving the service, before he or she is legally obligated to pay.
2.Since the payment received has not been earned and would have to be refunded if the customer changes his or her mind, revenue cannot be recorded. As long as the work for the customer has not been done, thepayment represents an obligation the company has to the customer. Therefore, the company records a credit to Unearned Revenues, a liability account, along with a debit to Cash, when the cash is received.
3.Once the company has rendered the services and earns the revenue, the Unearned Revenue account can be reduced and revenue can be recorded. At this point, the customer can no longer demand a refund.
B.Adjusting entries to the Unearned Revenue account will be required at the end of the accounting period.
1.Over time and through performance, some or all of the revenue will have been earned, but entries will not have been made during the period because it was not convenient to make them. Therefore, it will be necessary to adjust the liability account downward and record the revenue.
2.The form of the adjusting entry for deferred revenue items is always the same. The liability account is debited (decreased) and a revenue account is increased (credited):
Unearned ? Revenue$X
? Revenue$X
Sample ProblemTo clarify these types of adjusting entries for deferred expenses and deferred revenues, a supplemental exercise, Mel’s Merry Manor, is presented at the end of this document. A set of solutions is provided. Click here to jump to this supplement.
/ Module 3 Assignments / Many assignments are done on CengageNow. Click here for information and instructions.
Step 2
(a). Module 3Reading Assignment:
Read the remainder of this document, and the remainder of chapter 1 in the textbook. Note: Be sure to study Supplemental Exercise 2 on page 15 of this document. If you understand the adjusting entries illustrated in this exercise, then you have mastered adjusting entries for accrued revenues and expenses!
(b). View Course Manual Lecture 3-2
Right-click the following link and select “open in a new window.”
Module 3-2 Online Lecture Presentation
(c). Online CengageNow “Study Tools:”
Select “Study Tools” in CengageNow, and
- Play the CengageNow “Lectures” for all parts of the chapter.
- View all “Animated Examples” for all parts of the chapter.
- You are welcomed to use any of the other resources on CengageNow, but they are not assigned. All other activities are optional.
Select “Assignments” in CengageNow, and work as many of the Practice Problems as you feel you need to work in order to fully understand the material. Practice problems are not scored and do not affect your grade. Next, complete the Assigned Problems in CengageNow. These assigned problems are scored and recorded and will affect your grade.
(1). Practice Problems:
Exercises #3-10, 11, 12, 13
Problems #3-2A, 5A
(2). Assigned Problems:
Problems #3-2B, 5B
Note: Assigned problems must be done on CengageNow. Select “Module 3 Assignment” from the assignments list. Hint: Remember that problems 3-2A and 3-5A are similar to the assigned problems, and that the solutions to these problems are available on the Moodle course page. Refer to them and use them as a guide if you run into trouble with the assigned problems.
(3). Examination 1 over modules 1 through 3 is now due.
(e). After finishing the assigned problems on CengageNow, it will be time for you to take examination #1. Once examination #1 has been taken, proceed to Module 4 in the Online Course Manual.
V.Adjustments for Accrued Revenue and Expense Items.
A.In the case of accrued expenses, cash has not yet been paid because payment is not due, but the expense has been incurred and the company is obligated to pay. Therefore, it is necessary to adjust an expense account upward and then to record the liability for future payment.
1.Examples include the wages of employees, utility expense, and interest on bank loans.The form of the adjusting entry for accrued expense items is always the same. An expense account is debited (increased) and a liability account is credited (increased).
? Expense$X
? Payable$X
2.If adjustments for accrued expenses were made in the previous period, the bookkeeper must remember that a liability was recorded that must be reduced when payment is made, and that only a portion of the total payment is expense to recognize in the current period. The entry to record the future payment will be:
? Expense$X
? Payable$X
Cash$X
B.In the case ofaccrued revenue items, cash has not yet been received from a customer because payment is not due, but the revenue has been earned and the customer is obligated to pay. Therefore, it is necessary to adjust a revenue account upward and record an Account Receivable asset.
1.Examples include revenue earned for work performed but not yet billed because the job has not been completed, or interest revenue earned on loans made by the business.
2.The form of the adjusting entry for accrued revenue items is always the same. A revenue account is credited (increased) and an asset account (a receivable) is debited (increased):
Accounts Receivable$X
? Revenue$X
3.If adjustments for accrued expenses were made in the previous period, the bookkeeper must remember that a receivable was recorded that must be reduced when payment is received, and that only a portion of the total payment is revenue to recognize in the current period. The entry will be:
Cash$X
? Receivable$X
? Revenue$X
Another Example… To clarify these types of adjusting entries for accrued expenses and accrued revenues, a supplemental exercise, Sally Sam’s Custard Shop, is attached. A set of solutions is provided for this practice exercise. Click here to jump to this supplement.back
VI.The Adjusted Trial Balance, Vertical Analysis, and Accounting Concepts.
A.Once the adjusting entries have been journalized and posted to the general ledger accounts, it will be necessary to prepare another trial balance in order to check for errors that may have been made in the adjustment process. This trial balance is called the adjusted trial balance. The financial statements will be prepared using the figures from the adjusted trial balance.
B.The steps of the accounting cycle covered to date may be summarized as follows:
1.Journalize transactions from source documents as they occur.
2.At the end of the accounting period, post debit and credit entries from the general journal to the general ledger accounts.
3.Total account balances and prepare a trial balance.
4.Journalize and post adjusting entries, recalculate the account balances, then prepare an adjusted trial balance. (A worksheet may be used to facilitate this step).
5.Prepare financial statements.
C.Generally Accepted Accounting Principles are based upon a set of fundamental accounting principles, assumptions, and concepts that anyone completing a basic course in accounting should know about. The concepts introduced in this module are:
1.Accounting Period Concept -- For reporting purposes an organization's overall life can be divided into accounting periods (months, years, etc.) within which the revenues earned during the period and the expenses incurred during the period can be measured and reported. If the period is one year, a calendar year is often used (January 1 to December 31). Sometimes a fiscal year is used instead (a period beginning some time other than January 1 and ending 12 months later).
2.Going Concern assumption ("continuity assumption") -- unless there is evidence to the contrary, it is assumed that the business is a "going concern," able to meet its obligations and continue in business indefinitely. This allows us to apportion expenses (depreciation of long-lived buildings, for example) over many future accounting periods without having to worry about the length of the life of the business.
3.Revenue Recognition Concept -- Revenue is generally recognized (recorded) at the time that services are rendered or when goods are sold and delivered to the customer (that is, at the "point of sale"). It does not matter whether payment has been received or not.
4.Matching Concept -- Business expenses should be recognized (recorded) in the same period in which they were incurred. This way they will be "matched" against the revenues they helped to produce on the income statement prepared for that period.
D.Accrual basis accounting is an accounting method in which revenues are recorded when goods are sold or when services are rendered, and expenses are recorded when incurred. This is in accordance with the revenue recognition and matching concepts, and therefore is required under GAAP.Cash basis accounting is an accounting method in which revenues are only recognized when cash is collected and expenses are only recognized when paid. This creates distortions on the period's income statement since expenses and revenues are mismatched. Cash basis violates the revenue recognition and matching principles, but may be used by smaller businesses that are not legally required to follow GAAP.
E.Vertical analysis of the information on the statements is so called because the analyst works up and down the statements vertically, stating each reported figure as a percentage of some common base.
1.On the income statement, the base used is the revenuefigure. This is illustrated in the table below.
2.The analyst looks for relationships that reveal the causes of any improvement or deterioration in the company's profitability and liquidity position. From the vertical analysis presented in the table above it is clear that Wages Expense has consumed a much larger percentage of Revenues in 20X2 than it did in 20X1. The small improvement in Utilities Expense and Supplies Expense was not enough to prevent net income from falling drastically. In 20X2 the company’s profit was only 13 cents from every dollar of revenue that was earned, down from 24 cents in 20X1.
Vertical Analysis of XYZ CorporationConsolidated Statements of Income
for the Years Ended December 31, 20X1 and 20X2
20X2 / 20X1
Services Revenue / $120,000 / 100% / $100,000 / 100%
Wages Expense / (80,000) / 75% / (50,000) / 50%
Utilities Expense / (10,000) / 8% / (10,000) / 10%
Telephone Expense / (10,000) / 8% / (8,000) / 8%
Office Supplies Expense / (4,000) / 3% / (8,000) / 8%
Net Income / 16,000 / 13% / 24,000 / 24%
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