Accounting Module - 2018-2019

Topic (1)
Accounting in Action
What is Accounting?
Accounting is an information system that identifies,
Records, and communicates the economic events of an
Organization to interested users.
• Identifies: Selecting those events that represent economic

Activities of the organization (selling goods,
Providing services, collecting from customers,
and payment of wages are examples of
economic events).
• Records: Keeping a chronological diary of events

Measured in dollars in an orderly and
Systematic manner. In recording, economic
Events are classified and summarized.
• Communicates the economic events of an organization to

interested users through the preparation and distribution
of accounting reports. When communicating economic
events to users, the accountant must be able to analyze
and interpret the reported information.
Who Uses Accounting Data:

Users of financial information can be divided into two groups:
1. Internal users: are users from inside the organization,
Mainly managers who plan, organize,
and run the business. These include
marketing managers, production
supervisors, finance directors, and
company officers. This group needs
detailed information on a timely basis.
2. External Users: Are users from outside the
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organization such as:
 Investors who need information to decide on
whether to buy, hold, or sell stock.
 Creditors such as suppliers and banks who need
information to decide on whether to grant credit
or lend money to the organization.
 Taxing authorities.
 Regulatory agencies (the SEC for example).
 Labor unions.
 Economic planners.
 Customers.
External users need summarized information
about the organization.
Distinguishing Between Bookkeeping and accounting:

 Bookkeeping involves only the recording of
economic events and is often performed by
individuals with limited skills in accounting.
 Accounting involves the entire process of

identification, recording and communication. It
is performed by skilled individuals (accountants).
 Accounting is also divided into financial versus

managerial accounting. Financial accounting is
the field of accounting that provides economic
and financial information for investors,
creditors, and other external users. Managerial
accounting provides economic and financial
information for managers and other internal
users.
Generally Accepted Accounting Principles:

 Generally accepted accounting principles are a
common set of guidelines (standards) used by
accountants in reporting economic events.
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 The Securities and Exchange Commission (SEC)
is the agency of the U.S government that oversees
U.S financial markets and accounting standard-
setting bodies. The primary accounting standard-
setting body in the U.S is The Financial
Accounting Standards Board (FASB).
 Countries outside the U.S have adopted the

accounting standards issued by the International
Accounting Standards Board (IASB). These
standards are called International Financial
Reporting Standards (IFRS).
 One important principle is the cost principle,

which states that assets should be recorded at
their acquisition cost—the amount paid to
acquire the asset.
Assumptions:
In developing GAAP, certain basic assumptions are
made. There are two main assumptions:
1. The Monetary Unit Assumption: This assumption
requires that only transaction data that can be
expressed in terms of money be included in the
accounting records.
2. The Economic Entity Assumption: This assumption

requires that the activities of the entity be kept
separate and distinct from:
a) the activities of its owners, and
b) all other economic entities.
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Types of Business Enterprises:
There are three types of business enterprises:
* Proprietorship:
1. Has a single owner, the proprietor,
2. Examples include small retail stores,
3. From an accounting viewpoint, the proprietorship is
distinct from the proprietor,
4. From a legal perspective, the proprietor (owner) has
personal liability for the debts of the business.
* Partnerships:
1. Has two or more owners (partners),
2. Examples include professional organizations
(attorneys),
3. Accounting treats the partnership as a separate
organization, distinct from the personal affairs of
each partner,
4. From a legal perspective, partners are personally
liable for the debts of the business.
* Corporations:
1. A business owned by many investors who are called
stockholders or shareholders (people who own shares
of ownership in the business)
2. Unlike proprietorships or partnerships, corporations
has an indefinite life,
3. Stockholders may transfer (sell) their stock to other
investors at any time
4. Stockholders have limited liability for corporate debts.
Basic Accounting Equation:

 The two basic elements of any business are what
it owns and what it owes.
 Assets are the resources owned by a business.

Equities are the sources of those assets. Equities
represent the claims against those assets (who
provided those assets or who has rights to those
assets).
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 Since each and every asset owned by a business
must have a source (someone must have a right to
that asset), this relationship can be expressed in
an equation called the basic accounting equation
as follows:
Assets = Equities
 Equities (claims against assets) can be divided

into two components:
1. Claims of creditors which are called
liabilities.
2. Claims of owners which are called owners’
equity.
 Based on the above classification of equities, the

basic accounting equation can be expressed as
follows:
Assets = Liabilities + Owners’ Equity
 Because creditors’ claims are paid before owners’

claims if the business is liquidated, liabilities are
shown before owners’ equity in the basic
accounting equation.
 The accounting equation applies to all economic

entities regardless of size, nature of business, or
form of business organization.
 Now let us look in more detail at the components

of the basic accounting equation:
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Assets:
 Assets are resources owned by a business.
 They are things of value used in carrying out such
activities as production and exchange.
 The common characteristic possessed by all assets
is the capacity to provide future services or
benefits to the entities that use them.
 Examples of assets include: Cash, accounts
receivable, supplies, delivery truck, furniture,
equipment, land, building etc.
Liabilities:
 Liabilities are creditors’ claims against assets.
 They are existing debts and obligations.
 Most claims of creditors attach to total enterprise
assets rather than to the specific asset provided
by the creditor.
 Examples: accounts payable, loans.
Owners’ Equity:
• Owner’s Equity = total assets minus total liabilities.
OE = A - L
• Owner’s Equity represents the owners’ claims against
assets.
• In proprietorships, there are four subdivisions of owner's
equity:
Investments by Owner (Capital):

• Are the assets the owner puts in the business.
• Investments by owner increase owner’s equity.
Drawings:
• Are withdrawals of cash or other assets by the
owner for personal use.
• Drawings decrease owner’s equity.
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Revenues:
• Revenues represent the gross increases in owner’s
equity from business activities entered into for the
purpose of earning income.
• Revenues may result from sale of merchandise,
provision of services, rental of property, or lending
money.
Expenses:
• Expenses are decreases in owner’s equity that result
from operating the business.
• They are the cost of assets consumed or services
used in the process of earning revenue.
• Examples: utility expense, rent expense, supplies
expense, salaries expense, and advertising expense.
In summary, subdivisions of Owner’s Equity and the

effect of each subdivision on owners’ equity are:
1. Investments by Owner or Capital (+).
2. Drawing (-).
3. Revenues (+).
4. Expenses (-).
Revenues and expenses determine if a net income or

net loss occurs as follows:
a. Revenues > Expenses: Net Income.
b. Revenues < Expenses: Net Loss.
Business Transactions and Transaction Analysis:

 Transactions are the economic events of the
enterprise that are recorded.
 Transactions may be identified as external or

internal.
1. External transactions involve economic
events between the company and some
outside enterprise or party.
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2. Internal transactions are economic events
that occur entirely within the company.
 Each transaction must be analyzed in terms of its

effect (increase or decrease) on the components of
the basic accounting equation.
 The analysis must identify the specific items

affected and the amount of the change (increase
or decrease) in each item.
 Each transaction has a dual effect on the

equation. For example, if an individual asset is
increased, there must be a corresponding:
a. decrease in another asset, or
b. increase in a specific liability, or
c. increase in owner's equity.
 A tabular summary may be prepared to show the

cumulative effect of transactions on the basic
accounting equation. The summary demonstrates
that:
a. Each transaction must be analyzed in
terms of its effect on the three
components of the equation, and the
specific items within each component.
b. The two sides of the equation must always
be equal.
c. The causes of each change in the owner's
claim on assets must be indicated in the
owners' equity column.
Examples:
The following examples are business transactions for a
computer programming g business called Softbyte during its
first month of operations:
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Transactions (1): Investment by Owner
• Ray Neal decides to open a computer programming
service which he names Softbyte.
• On September 1, he invests $15,000 cash in the business.
Transaction analysis:
 Increase in the asset Cash by $15,000, and
 Increase in the owner’s equity, R. Neal, Capital
by $15,000.
Transactions (2): Purchase of Equipment for Cash

• Softbyte purchases computer equipment for $7,000 cash.
 Increase in the asset Equipment by $7,000, and
 Decrease in the asset cash by $7,000.
Observe that total assets equal total liabilities plus

owners’ equity after transaction (2).
Transactions (3): Purchase of Supplies on Credit

• Softbyte purchases supplies expected to last for several
months for $1,600 from Acme Supply Company.
• Acme agrees to allow Softbyte to pay this bill next month,

in October.
• This transaction is referred to as a purchase on account
or a credit purchase.
 Increase in the asset Supplies by $1,600, and
 Increase in the liability accounts payable (A/P) by
$1,600.
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Transactions (4): Services Provided for Cash

• Softbyte receives $1,200 cash from customers for
programming services it has provided.
• This transaction represents the Softbyte’s principal

revenue-producing activity.
 Increase in the asset cash by $1,200, and
 Increase in the R. Neal Capital by $1,200. The
source of the increase in owners’ equity is
indicated as service revenue.

Transactions (5): Purchase of Advertising on Credit

• Softbyte receives a bill for $250 from the Daily News for
advertising but postpones payment of the bill until a later
date.
 Increase in the liability Accounts Payable (A/P)
by $250, and
 Decrease in owners’ equity, the R. Neal Capital
by $250. The source of the decrease in owners’
equity is indicated as advertising expense.
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Transactions (6): Services Provided for Cash and Credit

• Softbyte provides $3,500 of programming services for
customers.
• Cash of $1,500 is received from customers, and the
balance of $2,000 is billed on account.
 Increase in the asset cash by $1,500, and
 Increase in the asset Accounts Receivable (A/R)
by $2,000, and
 Increase in owners’ equity, the R. Neal Capital by
$3,500. The source of the increase in owners’
equity is indicated as service revenue. Revenue is
earned when the services are provided regardless
of whether the total amount of services provided
are collected or not.

Transactions (7): Payment of Expenses

• Expenses paid in cash for September are store rent, $600;
employees’ salaries, $900; and utilities, $200.
 Decrease in the asset cash by $1,700 (600 + 900 +
200), and
by $1,700. The source of the decrease in owners’
equity is indicated as rent expense, salaries
expense, and utilities expense.
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Transactions (8): Payment of Accounts Payable

• Softbyte pays its $250 Daily News advertising bill in
cash.
 Decrease in the asset cash by $250, and
 Decrease in the liability Accounts Payable (A/P)
by $250.
 Since the expense was previously recorded, it is
not recorded now. This transaction involves only
a payment of a liability.

Transactions (9): Receipt of Cash on Account

• The sum of $600 in cash is received from customers who
have previously been billed for services (in Transaction
6).
 Increase in the asset cash by $600, and
 Decrease in the asset Accounts Receivable (A/R)
by $600.
 Note that a collection on account for services
previously billed and recorded does not affect
owners’ equity. The revenue was already
recorded in transaction (6) and should not be
recorded again. This transaction involves
collection from customers on account which
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results in an increase in one asset (cash), and a
decrease in another asset (accounts receivable).

Transactions (10): Withdrawal of Cash by Owner

• Ray Neal withdraws $1,300 in cash from the business for
his personal use.
 Decrease in the asset cash by $1,300 , and
by $1,300.
 Observe that the effect of a cash withdrawal by
the owner is the opposite of the investment by the
owner.
 Owner’s drawings are not considered expenses of
the business.

* For a tabular summary of Softbyte transactions, see

illustration 1-8 page 19.
Financial Statements:
• Four financial statements are prepared from the
summarized accounting data:
• Income Statement
revenues and expenses and resulting net income or net
loss for a specific period of time.
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• Owner’s Equity Statement
changes in owner’s equity for a specific period of time.
• Balance Sheet
assets, liabilities, and owner’s equity at a specific date
• Statement of Cash Flows

cash inflows (receipts) and outflows (payments) for a
specific period of time.
We will focus only on the first three statements. See page 20

for the preparation of the first three statements and the
relationship between the three statements.
Financial Statements in Equation Form:

 The balance sheet:
1) Assets = Liabilities + Owners’ Equity
 The income statement:

2) Net income = Revenues – Expenses
 The statement of owners’ equity:

3) Owners’ Equity,
end of period = OE, beginning of period +
additional investment + net
income - drawings
4) Owners’ Equity,
end of period = OE, beginning of period +
additional investment +
revenues – expenses - drawings
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Topic (2)
The Recording Process
The Account:
• An account is an individual accounting record of
increases and decreases in a specific asset, liability, or
owner’s equity item.
• There are separate accounts for the items we used in

transactions such as cash, salaries expense, accounts
payable, etc.
Basic Form of Account:

• In its simplest form, an account consists of three parts:
1. the title of the account,
2. a left or debit side, and
3. a right or credit side.
• The alignment of these parts resembles the letter T.

Therefore, it is referred to as a T-account.
Title of Account
Left or Debit Side Right or Credit Side
Debits and Credits:

• The term debit and credit mean in accounting left and
right, respectively
• Recording an amount on the left side of an account is
called debiting the account.
• Recording an amount on the right side is called crediting
the account.
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• Debit is abbreviated as Dr. and credit is abbreviated as
Cr.
• The balance of an account is the difference between the
total amount recorded on the debit side, and the total
amount recorded on the credit side.
• If the total of debit amounts is bigger than the total of the
credit amounts, the account will have a debit balance.
• If the total of credit amounts is bigger than the total of
the debit amounts, the account will have a credit balance.
Double-Entry System:
 Remember from chapter 1, that each transaction must
affect two or more items in the accounting equation to
keep the basic accounting equation in balance.
 Since each item in the accounting equation has an

account, we could say that each transaction must affect
two or more accounts to keep the accounting equation in
balance.
 For each transaction, debits must equal credits in the

accounts. The equality of debits and credits provides the
basis for the double-entry system of recording
transactions.
 Under the double-entry system, the dual (two-sided)

effect of each transaction is recorded in the appropriate
accounts.
 Every account has a designated normal balance.

It is either a debit or credit.
Examples- Recording Rules:
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Apply the recording rules to the ten transactions of
chapter 1.
Steps in the Recording Process:

The basic steps in the recording process are:
1. Analyze each transaction in terms of its effect on the
accounts (increase, or decrease).
2. Enter the transaction information in a journal (book of
original entry).
3. Transfer the journal information to the appropriate
accounts in the ledger (book of accounts).
The Journal:
• Transactions are initially recorded in chronological order
in a journal before they are transferred to the ledger
accounts.
• A general journal has:
1. Spaces for dates
2. Account titles and explanations
3. References, and
4. Two amount columns (two money columns).
A journal makes several contributions to recording process:

1. It discloses in one place the complete effect of a
transaction.
2. It provides a chronological record of transactions.
3. It helps to prevent or locate errors as debit and
credit amounts for each entry can be compared.
Journalizing:
• Entering transaction data in the journal is known as
journalizing.
• Separate journal entries are made for each transaction.
• A complete entry consists of:
1. The date of the transaction,
2. The accounts and amounts to be debited and credited,
3. A brief explanation of the transaction.
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The Ledger:
* The entire group of accounts maintained by a company
is called the ledger.
* A general ledger contains all the assets, liabilities, and

owner’s equity accounts.
* The ledger accounts starts with assets, followed by

liabilities, then owners’ equity (capital, drawing, revenue
accounts, and expense accounts). Each account is numbered
for easier identification.
Posting:
The procedure of transferring entries to the ledger
accounts is called posting. This phase of the recording process
accumulates the effect of the journalized transactions in the
individual accounts.
Example:
Review class examples for posting.
Chart of Accounts:
A Chart of Accounts lists the accounts and the account
numbers which identify their location in the ledger.
The Trial Balance:

• The trial balance is a list of accounts and their balances at
a given time.
• The primary purpose of a trial balance is to prove debits

= credits after posting.
• If debits and credits do not agree, the trial balance can be

used to uncover errors in journalizing and posting.
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The Steps in preparing the Trial Balance are:
1. List the account titles and balances.
2. Total the debit and credit columns.
3. Prove the equality of the two columns.
Limitation of a Trial Balance:

• A trial balance does not prove all transactions have been
recorded or the ledger is correct.
• Numerous errors may exist even though the trial balance

columns agree. For example, the trial balance may
balance even when:
– a transaction is not journalized,
– a correct journal entry is not posted,
– a journal entry is posted twice,
– incorrect accounts used in journalizing or posting,
– offsetting errors are made in recording.
Topic (3)
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Adjusting the Accounts
The Time Period Assumption (Periodicity Assumption):

The time period assumption indicates that the economic life of
a business is divided into artificial time periods. The time period
could be a month, a quarter, or a year.
Accrual- vs. Cash Basis Accounting:

 Accrual-Basis Accounting:
1. Transactions are recorded in the period in which the
events occur not in the period in which the company
receives or pays cash.
2. Revenues are recognized (recorded) when earned,
rather than when cash is received.
3. Expenses are recognized (recorded) when incurred,
rather than when paid.
 Cash-Basis Accounting:
1. Revenues are recognized (recorded) when cash is
received.
2. Expenses are recognized (recorded) when cash is paid.
3. Cash-basis accounting is not in accordance with
(GAAP).
Recognizing Revenues and Expenses:

 In order to measure net income (or net loss) for the period, the
company must determine the amount of revenues and expenses
to report in a given accounting period. Two principles help in
that task: the revenue recognition principle, and the matching
principle.
The Revenue Recognition Principle:

1. Companies recognize revenue in the accounting period in
which it is earned.
2. In a service enterprise, revenue is considered to be earned at
the time the service is performed (completed).
The Matching Principle:
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Expenses are recorded in the period in which they help
generate revenues. That is, expenses follow the revenues.
The Reasons for Adjusting Entries:

 Adjusting entries are made at the end of the accounting period
before preparation of the financial statements.
 Adjusting entries are made to ensure that the revenue

recognition principle and the matching principle are followed.
 That is, to ensure that revenues are recorded in the period

in which they are earned and that expenses are recorded in the
period in which they are incurred.
 Adjusting entries make it possible to report the correct

amounts on the balance sheet and on the income statement.
Types of Adjusting Entries:

A. Deferrals:
1. Prepaid Expenses: Expenses paid in cash and
recorded as assets before they are used up or
consumed.
2. Unearned Revenue: Revenues received in cash and
recorded as liabilities before they are earned.
B. Accruals:
1. Accrued Revenue: Revenues earned but not yet
received in cash or recorded.
2. Accrued Expenses: Expenses incurred but not yet
paid in cash or recorded.
Examples and explanations of each type of adjustment will be

based on the October 31 trial balance of Pioneer Advertising Agency
in illustration 3-3 page 85. This trial balance is provided below:
Pioneer Advertising Agency
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Trial Balance
October 31, 2012
Account Title Dr. Cr.
Cash $15200
Advertising Supplies 2500
Prepaid Insurance 600
Office Equipment 5000
Notes Payable $5000
Accounts payable 2500
Unearned Revenue 1200
C. R. Byrd, Capital 10000
C. R. Byrd, Drawing 500
Service Revenue 10000
Salaries Expense 4000
Rent Expense 900
$28700 $28700
A. Adjusting Entries for Deferrals:

* Deferrals are either:
1. Prepaid expenses, or
2. Unearned revenues.
*Adjusting Entries for deferrals are required to:

1. Record (as an expense) the portion of the asset that is
used up or consumed, or
2. Record (as a revenue) the portion of the liability
(unearned revenue) that has been earned in the
current accounting period.
1. Prepaid Expenses:
* Prepaid expenses are expenses paid in cash and recorded as
assets before they are used up or consumed.
* Prepaid expenses expire with the passage of time such as

prepaid insurance or prepaid rent, or through use and
consumption such as supplies.
* The expiration of the assets occurs daily, however, the
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recognition of asset expiration is postponed until the end of
the accounting period when there is a need to prepare
financial statements.
* At this point, an adjusting entry is made to recognize the

portion of the asset that has expired which should be
recorded as an expense, an in the meantime to correct
(reduce) the asset.
* An asset-expense account relationship exists with prepaid

expenses.
* Before the adjustment, assets are overstated and expenses are

understated. Therefore, we need to transfer the portion
of the asset that has expired into an expense. That is, we need
to increase the expense by the amount of the asset that has
expired and decrease the asset by the same amount.
* The adjusting entry that accomplishes that is to debit the

expense and to credit the asset.
* If the adjusting entry for prepaid expenses is not made:

1. Expenses will be understated,
2. Net income will be overstated,
3. Owner’s equity will be overstated, and
4. Assets will be overstated.
Examples:
Supplies:
 On October 5, Pioneer Advertising Agency purchased
advertising supplies costing $2500.
 The trial balance for Pioneer Advertising Agency on October
31, shows a balance of $2500 for supplies before adjustment.
 An inventory count on October 31, reveals that $1000 of
supplies are still on hand.
 Required: prepare the necessary adjusting entry on October 31.
Answer:
 Supplies expense represents the portion of the asset (supplies)
that has been used up (consumed) during the period (during
October). Supplies expense is computed as follows:
 Supplies Expense = $2500 supplies before adjustment - $1000
remaining supplies at the end of October =
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$1500.
 The adjusting entry to record supplies expense on October 31

is:
Date Accounts and Explanation Dr. Cr.

Adjusting Entry
Oct. 31 Advertising Supplies Expense 1500
To record supplies used.
 After posting the adjusting entry, the asset “Advertising

Supplies” shows a balance of $1000 which represents the
actual supplies remaining at the end of October, and
“Supplies Expense” shows a balance of $1500 which
represents the supplies used during October.
 If this adjusting entry is not made:

1. Expenses will be understated by $1500.
2. Net income will be overstated by $1500.
3. Owner’s equity will be overstated by $1500.
4. Assets will be overstated by $1500.
Insurance:
 On October 4, Pioneer Advertising Agency purchased a one-
year insurance policy for $600. Coverage began on October
1.
 The trial balance for Pioneer Advertising Agency on

October 31, shows a balance of $600 for prepaid insurance
before adjustment.
 A portion of the asset “Prepaid Insurance” expires every

month (with the passage of time). This portion should be
recorded as “Insurance Expense”. Insurance expense is
computed as follows:
 Insurance Expense = $600 prepaid Insurance ÷ 12 months =

$50 per month.
 The adjusting entry to record insurance expense on

October 31 is:
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Adjusting Entry
Oct. 31 Insurance Expense 50
To record insurance expired.
 After posting the adjusting entry, the asset “Prepaid

Insurance” shows a balance of $550 which represents the
unexpired portion of the asset at the end of October, and
“Insurance Expense” shows a balance of $50 which
represents the insurance expired during October.

1. Expenses will be understated by $50.
2. Net income will be overstated by $50.
3. Owner’s equity will be overstated by $50.
4. Assets will be overstated by $50.
Depreciation:
 Any business owns a variety of assets such as equipment,
building, trucks,….etc., These long-lived assets provide
services for a number of years called the useful life of the
asset.
 According to the matching principle, a portion of the cost of

the long-lived asset should be reported as an expense during
each period of the asset’s useful life.
 Depreciation is the process of allocating the cost of the long-

lived asset to expense over its useful life in a systematic
manner.
 From an accounting standpoint, the purchase of equipment

or a building is viewed as a long –term prepayment for
services.
 Companies need to make periodic adjusting entries for

depreciation. These entries record the portion of the asset
that has been used (an expense) during the period, and
report the unexpired portion (an asset) at the end of the
period.
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 A common procedure in computing depreciation is to divide
the cost of the asset by its useful life.
 Pioneer Advertising Agency estimates depreciation on the

office equipment to be $480 a year, or $40 per month.
 The adjusting entry to record depreciation expense on

October 31 is:

Adjusting Entry
Oct. 31 Depreciation Expense 40
Accumulated Depreciation- Off. Eq 40
To record monthly depreciation on
office equipment.
 Accumulated Depreciation-Office Equipment is a contra

asset account. That means that it is offset against an asset
account (Office Equipment) on the balance sheet. Its
normal balance is a credit.
 The contra account is used because it discloses (shows) the

original cost of the equipment and the total cost that has
expired to date (the accumulated depreciation account holds
the sum of all the depreciation recorded for the asset).
 In the balance sheet Pioneer deducts Accumulated

Depreciation-Office Equipment from the related asset
account : Office Equipment) as follows:
Office Equipment $5000

Less: Accumulated Depreciation-Off. Eq. 40
$4960
 The difference between the cost of any depreciable asset and

its related accumulated depreciation is called the book
value.
2. Unearned Revenues:
 When cash is received in advance from customers for
services to be provided in a future accounting period, a
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liability account called “Unearned Revenue” is credited to
recognize the obligation that exists.
 Unearned revenues are subsequently earned by providing

the services to the customer. However, the recognition of
that revenue is delayed until the end of the period and is
done through an adjusting entry.
 A liability-revenue account relationship exists with

unearned revenues.
 Before the adjustment, liabilities (the Unearned Revenue)

are overstated and revenues are understated. Therefore, we
need to decrease the liability “Unearned Revenue” by the
amount of services provided to the customer, and increase
revenues by the same amount.
 The adjusting entry that accomplishes that is to debit the

Unearned Revenue account by the amount of services
provided to the customer, and to credit the Service Revenue
account by the same amount.
 If the adjusting entry for unearned revenues is not made:

1. Revenues will be understated,
2. Net income will be understated,
3. Owner’s equity will be understated, and
4. Liabilities will be overstated.
Example:
 On October 2, Pioneer Advertising Agency received $1200
from a client for advertising services that are expected to be
completed by December 31.
 The trial balance for Pioneer Advertising Agency on October
31, shows a balance of $1200 for unearned revenue before
adjustment.
 Analysis reveals that the company earned $400 of those fees in
October
 Required: prepare the necessary adjusting entry on October 31.
Answer:
 Pioneer Advertising Agency should increase Service Revenue
by $400 for the amount of services completed during October,
27
and decrease the liability “Unearned Revenue” by the same
amount.
 The necessary adjusting entry on October 31, to record the

portion of the unearned revenue that has been earned during
October is shown below:

Adjusting Entry
Oct. 31 Unearned Revenue 400
Service Revenue 400
To record revenue for services
provided.
 After posting the adjusting entry, the liability “Unearned

Revenue” shows a balance of $800 which represents the
remaining liability at the end of October. At the same time,
Service Revenue is increased by $400 to show a total of
$10400 earned during October.

1. Revenues will be understated by $400.
2. Net income will be understated by $400.
3. Owner’s equity will be understated by $400.
4. Liabilities will be overstated by $400.
B. Adjusting Entries for Accruals:

* Adjusting entries for accruals are required to:
1. Record revenues earned in the current accounting
period that have not been recognized.
2. Record expenses incurred in the current accounting
period that have not been recognized.
1. Accrued Revenues:
 Accrued revenue may accumulate (accrue) with the
passage of time as in the case of interest revenue, or may
result from services that have been performed but neither
billed nor collected in cash.
 An Adjusting entry is required at the end of the period to:
1. To record the receivables that exist at the balance
sheet date, and
28
2. To record the revenue that has been earned during
the period.
 An asset-revenue account relationship exists with accrued

revenues.
 Before the adjustment, assets are understated and revenues

are understated.
 The adjusting entry must increase the asset by debiting the

asset account, and increase the revenues by crediting the
revenue account.
 If the adjusting entry for accrued revenues are not made:

1. Revenues will be understated,
2. Net income will be understated,
3. Owner’s equity will be understated, and
4. Assets will be understated.
Example:
 In October, Pioneer Advertising Agency earned $200 for
advertising services that have not been recorded.
 Required: prepare the necessary adjusting entry on October

31.
Answer:
 Pioneer Advertising Agency should increase the asset
“Accounts Receivable” by $200 for amount of services
provided but has not been collected yet in October, and
increase “Service Revenue” by the same amount.
 The necessary adjusting entry on October 31, is shown
below:

Adjusting Entry
Oct. 31 Accounts Receivable 200
Service Revenue 200
To record revenue for services provided.
1. Revenues will be understated by $200.
2. Net income will be understated by $200.
29
3. Owner’s equity will be understated by $200.
4. Assets (A/R) will be understated by $200.
2. Accrued Expenses:
 Accrued expenses are expenses incurred but not paid yet in
cash.
 An adjusting entry is needed to record the expense that has

not been recorded, and also to record the liability that exists
at the balance sheet date.
 A liability-expense account relationship exists with accrued

expenses.
 Before the adjustment, both expenses and liabilities are

understated. Therefore, we need to increase the expense
and increase the liability.
 The adjusting entry that accomplishes that is to debit the

expense account, and to credit the liability account.
 If the adjusting entry for accrued expenses is not made:

1. Expenses will be understated,
2. Net income will be overstated,
3. Owner’s equity will be overstated,
4. Liabilities will be understated.
Examples:
Accrued Interest:
 On October 1, Pioneer Advertising Agency signed a $5000,
3-month, 12% note payable.
 Three factors determine the amount of interest

accumulated:
1. The face value of the note ($5000).
2. The interest rate, which is expressed as an annual rate
(12%).
3. The length of the time is outstanding (one month:
October 1 to October 31).
31 to record accrued interest.
30
Answer:
 Interest Expense = $5000 × 12% × 1/12 = $50
 The adjusting entry should increase interest expense by $50

by debiting the “Interest Expense” account, and increase the
liability “Interest Payable” by the same amount (since this
interest is accrued, at the end of October, the interest is paid
at the end of the three months).

below:

Adjusting Entry
Oct. 31 Interest Expense 50
Interest Payable 50
To record interest on notes payable.
 After posting this entry, the “Interest Expense” account will

show a balance of $50, and the liability account “Interest
Payable will show a balance of $50.

1. Expenses will be understated by $50,
2. Net income will be overstated $50,
3. Owner’s equity will be overstated, $50, and
4. Liabilities will be understated $50.
Accrued Salaries:
 Accrued salaries for Pioneer Advertising Agency at October
31 amounted to $1200.

31 to record accrued salaries.

below:

Adjusting Entry
Oct. 31 Salaries Expense 1200
31
Salaries Payable 1200
To record accrued salaries.
 After posting this entry, the “Salaries Expense” account will

show a balance of $5200 ($4000 paid during October, and
$1200 accrued salaries), and the liability account “Salaries
Payable will show a balance of $1200.

1. Expenses will be understated by $1200,
2. Net income will be overstated $1200,
3. Owner’s equity will be overstated, $1200, and
4. Liabilities will be understated $1200.
* All the adjusting entries for Pioneer Advertising Agency at

October 31 are presented below:

Adjusting Entries
Oct. 31 Advertising Supplies Expense 1500
To record supplies used.
Oct. 31 Insurance Expense 50
To record insurance expired.
Oct. 31 Depreciation Expense-Off. Equip 40
Accumulated Dep-Off. Equip 40
To record monthly depreciation.
Oct. 31 Unearned Revenue 400
Service Revenue 400
provided.
Oct. 31 Accounts Receivable 200
Service Revenue 200
provided.
Oct. 31 Interest Expense 50
Interest Payable 50
To record interest on notes payable.
Oct. 31 Salaries Expense 1200
To record accrued salaries.
32
* The adjusting entries presented above are then posted to the
appropriate ledger accounts, and then an adjusted trial balance is
prepared.
The Adjusted Trial Balance:

 An adjusted trial balance is prepared after all adjusting
entries have been journalized and posted.
 The adjusted trial balance shows the balances of all

accounts at the end of the accounting period and the effects
of all the financial events that have occurred during the
period.
 It proves the equality of the total debit and credit balances

in the ledger after all adjustments have been made.
 The adjusted trial balance for Pioneer Advertising Agency

at October 31 is Shown below (also on page 99 of the text):

Adjusted Trial Balance
October 3130, 2008
33
Cash $15200
Accounts receivable 200
Accumulated Depreciation-Off. Equip $40
Notes Payable 5000
Accounts Payable 2500
Interest Payable 50
C. R. Byrd, capital 10000
Advertising Supplies Expense 1500
Rent Expense 900
Insurance Expense 50
Interest Expense 50
Depreciation Expense 40
$30190 $30190
The Financial Statements:

The financial statements can be prepared directly from the
adjusted trial balance, see textbook pages 100 - 101.
Topic (4)
Completing the Accounting Cycle
34
Closing the Books:
 At the end of the accounting period, the company makes the
accounts ready for the next accounting period. This is called
“closing the books”
 In closing the books, it is necessary to distinguish between

temporary and permanent accounts.
 Temporary Accounts:
1. Relate to only one accounting period,
2. Include all income statement accounts (all revenue and
expense accounts), and the drawing account.
3. All temporary accounts are closed at the end of the
accounting period after preparation of the financial
statements,
4. Closing an account means reducing the balance of the
account to zero.
 Permanent Accounts:
1. Relate to one or more future accounting period,
2. Include all balance sheet accounts (assets, liabilities,
and the capital account). They include also all contra
accounts such as accumulated depreciation,
3. Permanent accounts are not closed at the end of the
accounting period.
Preparing Closing entries:

 At the end of the accounting period, the temporary account
balances are transferred to the permanent owner’s equity
account, the owner’s capital account through the preparation
of closing entries.
 Closing entries formally recognize in the ledger the transfer of

net income (or net loss), and owner’s drawing to the owner’s
capital account as shown in the statement of owner’s equity.
 Closing entries produce a zero balance in each temporary

account.
35
 A temporary account called “Income Summary” is used in
closing revenue and expense accounts and only the net income
or net loss is transferred from the income summary account to
the capital account.
 Four closing entries are required to close the books:

1. To close the revenue accounts: debit each revenue
account for its balance and credit income summary
for total revenue.
2. To close expense accounts: debit income summary for
total expenses and credit each expense account for its
balance.
3. To close the income summary account: debit the
income summary account and credit the capital
account for the amount of net income for the period.
An opposite entry is made in the case of net loss.
4. To close the drawing account: debit the capital
account for the balance in the drawing account and
credit the drawing account for the same amount.
Example:
36
Shown below is the adjusted trial balance for Pioneer
Advertising Agency at October 31, 2012:

Adjusted Trial Balance
October 3130, 2012
Cash $15200
Accounts receivable 200
Accumulated Depreciation-Off. Equip $40
Notes Payable 5000
Interest Payable 50
C. R. Byrd, capital 10000
Rent Expense 900
Interest Expense 50
$30190 $30190
Required: Prepare the necessary closing entries at October 31, 2012.
Answer:
37
Closing entries could be prepared from the adjusted trial
balance, or from the information included in the income statement
and the owner’s equity statement.
Date Account Title and Explanation Dr. Cr.

Oct. 31 Closing Entries
(1)
Income Summary 10600
To close the revenue account.
(2)
Income Summary 7740
Rent Expense 900
Interest Expense 50
To close the expense accounts.
(3)
Income Summary 2860
Byrd, Capital 2860
To close the income summary account.
(Transferring net income to the owner’s
capital account).
(4)
Byrd, Capital 500
Byrd, Drawing 500
To close the drawing account.
(Transferring drawings to the owner’s
capital account).
 After posting the closing entries:

1. All temporary accounts (all revenue, expense, and
drawing accounts) are closed. That is, they will have a
zero balance.
2. The capital account ending balance will agree with the
owner’s capital at the end of the period (October 31,
2012) shown in statement of owner’s equity.
38
Post-Closing Trial Balance:
 After all closing entries have been journalized and posted, a
post-closing trial balance is prepared.
 The post-closing trial balance lists permanent accounts and

their balances after journalizing and posting of closing entries.
 The purpose of this trial balance is to prove the equality of the

permanent account balances that are carried forward into the
next accounting period.
 Since all temporary accounts will have zero balances, the post-
closing trial balance will contain only permanent-balance
sheet-accounts.
 The post-closing trial balance for Pioneer Advertising Agency

at October 31, 2012 (page 140) is shown below:

Post-Closing Trial Balance
October 31, 2012
Account Title Debit Credit
Cash $15200
Accounts Receivable 200
Accumulated depreciation - Off. Equip $40
Notes Payable 5000
Interest Payable 50
Byrd, Capital 12360
$21950 $21950
39
Steps of the Accounting Cycle:
1. Analyze business transactions.
2. Journalize the transactions.
3. Post to ledger accounts.
4. Prepare trial balance.
5. Journalize and post adjusting entries for deferrals and
accruals.
6. Prepare an adjusted trial balance.
7. Prepare financial statements.
a) Income Statement.
b) Owner’s Equity Statement.
c) Balance Sheet.
8. Journalize and Post closing entries.
9. Prepare a post-closing trial balance.
The Classified Balance Sheet:

 To improve users’ understanding of a company’s financial
position, companies group similar assets and similar liabilities
together.
 A classified balance sheet generally contains the following

standard classifications:
Assets:
Current Assets:
 Current assets are assets that a company expects to convert to
cash or use up within one year or the operating cycle,
whichever is longer.
 The operating cycle is the average time it takes from the

purchase of inventory to the collection of cash from customers.
 Current assets are listed in order of their liquidity. That is, in

the order in which they are expected to be converted into cash.
 Examples of current assets are: cash, accounts receivable,

inventory, prepaid insurance, prepaid rent, and supplies.
Property, Plant, and Equipment:

 Property, plant, and equipment are assets with long useful lives
that the company uses in operating the business.
40
 This category includes: land, buildings, machinery and
equipment, delivery equipment, and furniture.
Liabilities:
Current Liabilities:
 Current liabilities are obligations that the company expects to
pay within the coming year.
 Examples include: Notes Payable, Accounts Payable, Salaries

Payable, Interest Payable, and Unearned Revenue.
Long-Term Liabilities:
 Long-term liabilities are obligations that a company expects to
pay after one year.
 Examples include: Bonds Payable, Mortgage Payable, Long-

term Notes Payable.
Owner’s Equity:
The contents of the owner’s equity section varies with the form
of business organization:
 Proprietorship - one capital account.
 Partnership - capital account for each partner.
 Corporation - Capital Stock and Retained Earnings.
41
Topic (5)
Accounting for Merchandising Operations
Merchandising Operations
 A merchandising company is an enterprise that buys and
sells goods to earn a profit.
 Measuring net income for a merchandising company is the

same as for a service company through matching of
expenses with revenues.
 In a merchandising company, the primary source of revenue

is the sale of merchandise, which is called sales revenue or
sales.
 Expenses for merchandising company are divided into two

groups:
1. Cost of goods sold: is the total cost of
merchandise sold during the period.
2. Operating expenses: are expenses incurred in
the process of earning sales revenue such as
salary expense, advertising expense, rent
expense, insurance expense, and utilities
expense.
 Net income for a merchandising company is measured in

two steps in the income statement:
1. Sales revenue – cost of goods sold = Gross profit
2. Gross profit – operating expenses = Net income
Inventory Systems:
In accounting for merchandising transactions, either of the two
following systems may be used:
1. Perpetual inventory system.
2. Periodic inventory system.
Perpetual Inventory System:

 Detailed records of the cost of each inventory purchase and
sale are maintained and continuously (perpetually) show the
inventory that should be on hand for every item.
42
 The cost of goods sold is determined and recorded each time
a sale occurs.
Periodic Inventory System:

 No detailed inventory records are kept for the goods on
hand during the period.
 The cost of goods sold is determined only at the end of the

accounting period when a physical inventory count is taken
to determine the cost of ending inventory.
 The cost of goods sold under a periodic inventory system is

determined at the end of the accounting period in the
following manner:
Beginning inventory XX
Add: Cost of goods purchased XX
Cost of goods available for sale XX
Less: Ending inventory XX
= Cost of goods sold XX
** We will focus only on merchandising companies that follow a

periodic inventory system. Before we record transactions for a
merchandising company that uses a periodic inventory system, it
would be very helpful to present the income statement of a
merchandising company that uses a periodic inventory system.
43
PW AUDIO SUPPLY, INC.
Income Statement
For the Year Ended December 31, 2012
Sales Revenue
Sales $480000
Less: Sales returns and allowances 12000
Sales Discount 8000 20000
Net sales 460000
Cost of Goods Sold
Inventory, January 1 36000
Purchases 325000
Less: Purchases returns and allowances 10400
Purchase discount 6800 17200
Net purchases 307800
Add: Freight-in 12200
Cost of goods purchased 320000
Cost of goods available for sale 356000
Inventory, December 31 40000
Cost of goods sold 316000
Gross profit 144000
Operating Expenses:
Salary expense 45000
Rent expense 19000
Utilities expense 17000
Advertising expense 16000
Depreciation expense 8000
Insurance expense 2000
Freight-out 7000
Total operating expenses 114000
Net income $30000
Recording Transactions (Periodic Inventory System):

To illustrate the recording of merchandise transactions under a
periodic inventory system, we will use the purchase / sale
transactions between Sauk Stereo, and PW Audio Supply.
(A) Recording Purchase of Merchandise:

On May 4, Sauk Stereo Company purchased merchandise for
$3800 on account from PW Audio Supply Company, terms 2/10,
n/30.
44
This transaction is recorded in the journal of Sauk Stereo
Company as follows:

May 4 Purchases 3800
To record goods purchased on account,
terms “2/10, n/30”.
 The terms “2/10, n/30” mean that Sauk company will get
2% discount if it pays the amount due to PW Audio
company within 10 days. If the amount is not paid within
the 10 days, no discount will be given to Sauk company and
the full amount must be paid in 30 days. The 10 days period
is called the “discount period”, and the 30 days period is
called the “credit period”.
 The purchases account is a temporary account that has a

normal debit balance.
Freight-in (transportation-in) cost:

 When the merchandise is purchased with terms “FOB
shipping point” (free on board shipping point), it means that
the purchaser will pay for the freight-in cost.
 When the merchandise is purchased with terms “FOB

destination”, it means that the seller will pay for the freight
cost and it is called in this case freight-out.
 Freight-in is actually an expense account for the purchaser.
 Freight-in is part of the cost of goods purchased.
Example:
On May 6, Sauk Stereo pays $150 freight-in on its purchase
from PW Audio Supply Company.

Company as follows:
45
May 6 Freight-in 150
Cash 150
To record payment of freight on goods
purchased.
Purchase Returns and Allowances:

 A purchaser may be dissatisfied with the merchandise
because goods received are defective, or not in accord with
specifications.
 If the purchaser actually returns part of the merchandise

purchased, the transaction is called purchase return.
 If the purchaser keeps the defective merchandise and gets

an allowance (a deduction) from the purchase price, the
transaction is called purchase allowance.
 Whether the transaction is considered a purchase return or

allowance, the amount is credited to the “Purchase Returns
and Allowances” account.
Example:
On May 8, Sauk Stereo Company returns $300 of goods to PW
Audio Supply Company.

Company as follows:

May 8 Accounts Payable 300
Purchase Returns and Allowances 300
To record the return of goods
purchased on account, from PW Audio
Supply Company.
 The Purchase Returns and Allowances account is a

temporary account that has a normal credit balance.
46
Purchase Discount:
 On May 14, Sauk Stereo Company paid the amount due on
account to PW Audio Company tacking the 2% cash
discount granted by PW Audio Company for payment
within 10 days.
 Before we record this transaction, we must determine the

amount due to PW Audio Supply Company. To do that, we
must post the two transactions on May 4 and May 8 to the
Account Payable. The account was credited for $3800 on
May 4, and was debited for $300 on May 8. Accordingly,
the balance due to PW Audio Supply Company is $3500.
The purchase discount = $3500 × 2% = $70

Cash paid = $3500 – 70 = $3430
 The May 14 transaction is then recorded in the journal of

Sauk Stereo Company as follows:

May 14 Accounts Payable 3500
Cash 3430
Purchas e Discount 70
To record payment to PW Audio
Supply Company within the discount
period.
 The purchase discount account is a temporary account that

has a normal credit balance.
(B) Recording Sales of Merchandise:

Example:
On May 4 PW Audio Supply Company sold a $3800 of
merchandise to Chelsea Company terms “2/10, n/30”.
 This transaction is recorded in the journal of PW Audio

Supply Company as follows:
May 4 Accounts Receivable 3800
Sales 3800
To record sale of merchandise on account
to Sauk Stereo, terms “2/10, n/30”.
47
 The sales account is a temporary account that has a normal
credit balance.
Sales Returns and Allowance:

 On May 8, a $300 worth of merchandise was returned from
Sauk Stereo Company.

May 8 Sales Returns and Allowances 300
Account Receivable 300
To record return of merchandise from
Sauk Stereo Company.
 The sales returns and allowance account is a temporary

account that has a normal debit balance.
Sales Discount:
 On May 14, PW Audio Supply Company collected the
amount due on account from Sauk Stereo Company.
 The Account Receivable account for Sauk Stereo Company
has a balance of $3500 (Accounts Receivable was debited for
$3800 on May 4, and was credited for $300 on May 8).
 Since the amount due from Sauk Stereo Company was
collected within the discount period, Sauk Stereo Company
will take advantage of the discount.
Sales discount = 3500 × 2% = $70

Cash collected = $3500 - $70 = $3430

May 14 Cash 3430
Sales Discount 70
Accounts Receivable 3500
To record collection from Sauk Stereo
Company within the discount period.
 The sales discount account is a temporary account that has

a normal debit balance.
48
The income statement for a merchandising company in equation
form:
(1) Net Sales = Sales – Sales Returns and Allowances – Sales

Discounts
(2) Net Purchases = Purchases - Purchase Returns and Allowances

– Purchase Discounts
(3) Cost of Goods Purchased = Net Purchases + Freight in
(4) Cost of Goods Available for Sale = Beginning Inventory + Cost

of Goods Purchased
(5) Cost of Goods Sold = Cost of Goods Available for Sale –

Ending Inventory
(6) Gross Profit = Net Sales – Cost of Goods Sold
(7) Net Income = Gross Profit – Operating Expenses
 Equation # 7 assumes that there are no non-operating

activities.
49
Topic (6)
Inventories
Inventory Costing Under a Periodic Inventory System:
 Under a periodic inventory system, cost of goods sold is
determined at the end of the accounting period for the
purpose of preparing the income statement.
 The cost of goods sold is determined in two steps:

1. Determine the cost of ending inventory using one of
the cost flow methods.
2. Determine the cost of goods sold as follows:
Beginning Inventory XX
+ Cost of goods purchased XX
= Cost of goods available for sale XX
- Ending inventory (from step 1 above) XX
= Cost of goods sold XX
Cost Flow Methods:

The cost of ending inventory is determined using one of the
following cost flow methods:
1. First-in, First-out (FIFO) method.
2. Average cost method.
To illustrate these inventory cost flow methods, we will assume

that Houston Electronics uses a periodic inventory system and
has the information shown below for one of its inventory items:
Date Units Unit Cost Total Cost

Jan. 1 Beginning Inv. 100 $10 $1,000
Apr. 15 Purchases 200 11 2,200
Aug. 24 Purchases 300 12 3,600
Nov. 27 Purchases 400 13 5,200
Total 1,000 $12,000
During the year, 550 units were sold and 450 units are on hand
at December 31.
Required:
Determine the cost of ending inventory at December
50
31, and the cost of goods sold under each of the two
cost flow methods.
First-in, First-out (FIFO):

 The FIFO method assumes that the units purchased first are
the first to be sold.
 Accordingly, the ending inventory must consist of the units

that were purchased last.
 The cost of ending inventory, and the cost of goods sold are
determined under the FIFO method as follows:
Beginning Inventory $1000

+ Purchases 11000
= Cost of goods available for sale 12000
a) The Cost of Ending Inventory:

Units Unit Cost Total Cost
400 $13 $5200
50 12 600
Total 450 $5800
b) The Cost of Goods Sold:
- Ending Inventory 5800
= Cost of goods sold $6200
Average-Cost:
 Under the average cost method, an average cost per unit is
computed as follows:
Average cost per unit = Cost of goods available for sale ÷

Number of units available for sale
 The average cost per unit is then used in computing the cost
of ending inventory as follows:
Cost of ending Inventory = Average cost per unit × Units in

ending inventory
 Finally, the cost of ending inventory is used in computing

the cost of goods sold as shown earlier.
51
 The computations under the average cost method are shown
below:
a) The Cost of Ending Inventory:
Average cost per unit = $12000 ÷ 1000 units = $12
The cost of ending inventory = $12 × 450 units = $5400
b) The Cost of Goods Sold:

- Ending Inventory 5400
= Cost of goods sold $6600
** The ending inventory for merchandising companies is

considered a current asset in the balance sheet.
Topic (7)
52
Accounting for Accounts Receivable
In this chapter, we are going to focus only on: Distinguishing between
the methods and bases companies use to value accounts receivable.
Valuing Accounts Receivables:

 Uncollectible Accounts Receivable: sales on account raise the
possibility of accounts not being collected.
 Credit losses are considered to be a normal and necessary risk

of doing business on a credit basis.
 In accounting, credit losses are debited to Bad Debts Expense.
 Two methods are used in accounting for uncollectible accounts:

(a) the direct write-off method, and (b) the allowance method.
Direct Write-off Method:

 Under the direct write-off method, when the company
determines a particular account to be uncollectible, the loss is
charged to Bad Debt Expense.
 Accordingly, under this method, bad debt expense will show

only actual losses from uncollectible accounts receivable. In
addition, accounts receivable will be reported in the balance
sheet at gross amount
 This method makes no attempt to match bad debts expense to

sales revenue in the income statement or to show the net (cash)
realizable value of the accounts receivable in the balance sheet.
 This method is not acceptable for financial reporting

purposes, unless bad debt losses are insignificant.
Example:
On December 12, Warden Company writes off as uncollectible M.
Doran’s $200 balance. Prepare the journal entry to record this write off
assuming that the company uses the direct write-off method in accounting
for uncollectible accounts.
53
Dec. 12 Bad Debt Expense 200
Accounts Receivable – M. Doran 200
(To record the write-off of M. Doran
account).
The Allowance Method:

Under the allowance method,
1. At the end of the accounting period, the company estimates
uncollectible accounts receivable. This estimated expense is
matched against revenues in the same accounting period in which
the company records the revenues.
2. An adjusting entry is made by debiting the estimated uncollectible

accounts receivable to Bad Debt Expense and crediting the amount
to Allowance for Doubtful Accounts (a contra-asset account).
3. When the company writes off a specific account, it debits actual

uncollectible amount of accounts receivable to Allowance for
Doubtful Accounts and credit the amount to Accounts Receivable.
4. This method ensures that accounts receivable are reported in the

balance sheet at their net (cash) realizable value which is the net
amount expected to be collected from customers in cash. Net
realizable value = accounts receivable – allowance for doubtful
accounts.
Recording Estimated Uncollectibles:

Example:
In 2013, Hampton Company has credit sales of $1,200,000. Of this

amount, $200,000 remains uncollected at December 31(accounts
receivable balance at Dec. 31). The credit manager estimates that
$12,000 of credit sales will be uncollectible. Prepare the necessary
adjusting entry to record the estimated uncollectible accounts
assuming that the company uses the allowance method.

2013 Bad Debt Expense 12,000
Dec. 31 Allowance for Doubtful Accounts 12,000
(To record estimated bad debt expense).
* Accounts receivable are reported on December 31, 2013 in the

balance sheet as follows:
54
Balance Sheet December 31, 2014 (partial)
Assets
Accounts Receivable $200,000

Less: Allowance for Doubtful Accounts 12,000
$188000
* The $188,000 is the net (cash) realizable value on December 31,

2013 (the amount expected to be collected in cash from customers).
Recording the Write-off of an Uncollectible Account:

Example:
On March 1, 2014, Hampton Company determined that the $500

balance owed by R. Ware is uncollectible and decided to write off that
account. Prepare the necessary journal entry to record the write of Ward
account.

2014 Allowance for Doubtful Accounts 500
March 1 Accounts Receivable – R. Ware 500
(To record the write off of R. Ware
account).
Recovery of an Uncollectible accounts:

When there is a recovery of an account that has been written off as
uncollectible, two entries are needed:
a) Reverse the entry made when the account was written off,
and
b) Record the collection in the usual manner.
Example:
Assume that on July 1, 2014 R. Ware pays the $500 amount that
Hampton had written off on March 1. Prepare the necessary journal
entries.

2011 Accounts Receivable – R. Ware 500
55
July 1 Allowance for Doubtful Accounts 500
(To reinstate R. Ware account).
July 1 Cash 500
Accounts Receivable – R. Ware 500
(To record collection from R. Ware)
Bases Used for Allowance Method:

The two bases of estimating uncollectible accounts receivable are:
(1) Percentage-of-sales, and
(2) Percentage-of- receivables.
The Percentage of Sales:
 Management estimates what percentage of credit sales will be
uncollectible. The company applies this percentage to either total
credit sales or net credit sales of the current year.
 This method emphasizes the matching of expenses with revenues.
 When the company makes the adjusting entry, it disregards the

existing balance in the allowance for doubtful accounts before
adjustments.
Example (1) :
The following data are available at December 31 2013 before
adjustments:
Credit sales $500,000

Estimated % of credit sales not collected 1.25%
Accounts receivable balance $72,500
Required:
1. Journalize the adjusting entry at December 31, 2013 to record
bad debt expense assuming that the company uses the
percentage of sales base to estimate bad debt expense and that
the Allowance for Doubtful Accounts has a credit balance of
$150 before adjustments.
2. Post the adjusting entry in part (1) above to the allowance for
doubtful accounts and determine the balance of the account on
December 31, after adjustment.
3. Show the balance sheet presentation of accounts receivable at

December 31, 2013.
56
Solution:
1. Bad debt expense = $500,000 × 1.25% = $6,250

(To record bad debt expense for 2008).
2.
Allowance for Doubtful Accounts
Balance before Adj. 150
Dec. 31 Adj. 6,250
Balance Dec. 31 6,400
After Adj.
3. Balance Sheet Presentation of Accounts Receivable:
Accounts Receivable $72500

$66,100
Example (2):
Assume the same facts as in example (1) except that the allowance
for doubtful accounts has a debit balance of $150 before adjustments.
Required: Same requirements as in example 1.
1. Bad debt expense = $500,000 × 1.25% = $6,250

2.
Balance before Adj 150 Dec. 31 Adj. 6,250
3 Balance Sheet Presentation:

Accounts Receivable $72500
57
$66,400
The Percentage of Receivables:

 Management estimates what percentage of receivable will be
uncollectible. This percentage is applied to total receivables. The
resulting amount represents the required balance in the allowance
for doubtful accounts after adjustment (at the balance sheet date).
 The amount of the bad debt expense for the period depends on
whether the existing balance in the allowance for doubtful accounts
before adjustments is a credit balance or a debit balance.
 Bad debt expense = Required balance in the allowance – existing

credit balance in the allowance or
 Bad debt expense = Required balance in the allowance + existing

debit balance in the allowance
Example (1) :
The following data are available at December 31 2013 before
adjustments:
Accounts receivable balance $72,500

Estimated % of A/R not collected 8%
Required:
1. Journalize the adjusting entry at December 31, 2013 to record
bad debt expense assuming that the company uses the
percentage of receivable base to estimate bad debts assuming
that the allowance for doubtful has a credit balance of $150
before adjustments.
2. Post the adjusting entry in part (1) above to the allowance for
doubtful accounts and determine the balance of the account at
december31, after adjustment .
3. Show the balance sheet presentation of accounts receivable at

December 31, 2013.
1.
Required Balance in Allowance = $72,500 × 8% = $5,800
58
Bad debt expense = Required balance in allowance – credit
Balance in allowance before adjustment
= $5,800 - $150 = $5,650

2.
Balance Before 150
Dec. 31 Adj. 5,650

$66,700
Example (2):
Assume the same facts as in example (1) except that the allowance
for doubtful accounts has a debit balance of $150 before adjustments.
Required: Same requirements as in example 1.
1.
Required Balance in Allowance = $72,500 × 8% = $5,800
Bad debt expense = Required balance in allowance + Debit

Balance in allowance before adjustment
= $5800 +$150 = $5,950

Dec. 31 Bad Debt Expense 5,950
Allowance for Doubtful Accounts 5,950
2.
59
Balance 150 Dec. 31 Adj. 5,950

$66,700
The Percentage of Receivables:

Aging of Accounts Receivable:
 When estimating losses using Percentage of Receivables,

companies often prepare an aging schedule which classifies
customer balances by the length of time they have been unpaid.
 An aging schedule of accounts receivable is shown below:
 According to the aging schedule shown below, the required

balance in the allowance for doubtful accounts after adjustment
is $2,228.
 Bad debt expense for the period depends on whether the

balance in the allowance for doubtful accounts before
adjustment is a debit balance or a credit balance as indicated
earlier.
60
Topic (8)
Plant Assets
 Plant assets are tangible resources that are used in the
operation of business and are not intended for sale to
customers.
 Examples of plant assets include: land, buildings, Equipment,

delivery trucks, buses, etc.
 Plant assets are recorded at their acquisition cost in accordance

with the cost principle.
 Cost consists of all expenditures necessary to acquire the asset

and make it ready for its intended use. The cost includes
61
purchase price, freight costs, installation costs, and testing
costs.
Depreciation:
 Depreciation is the process of allocating to expense the cost of a
plant asset over its useful life in a rational and systematic
manner.
 Cost allocation provides the proper matching of expenses with

revenues in accordance with the matching principle.
Factors in Computing Depreciation:

Factors that affect the computation of depreciation expense
are:
1. Cost: all expenditures necessary to acquire the asset and
make it ready for its intended use.
2. Useful life: an estimate of the expected productive life of the

asset.
3. Salvage value: an estimate of the asset’s value at the end of

its useful life.
Depreciation Methods:
Depreciation expense is generally computed using one of the
following methods:
1. Straight-line.
2. Declining-balance.
3. Units-of-activity.
The following example will be used in computing depreciation

expense under the different methods:
Example:
On January 1, 2010, Mark Company purchased a small
delivery truck. The following information relates to that truck:
Cost $13,000
Expected salvage value 1,000
Estimated useful life in years 5
62
Estimated useful life in miles 100,000
Straight-line Method:
Under the straight-line method:
1. Depreciation expense is the same for each year of the asset’s
useful life.
2. Depreciation is measured solely by the passage of time.
3. Depreciation expense is computed using the following

formula:
Depreciation Expense = Cost – Salvage value

Useful life in years
Using the information in the truck example:
Depreciation expense each year = $13,000 - $1,000 = $2,400

5 years
Declining-Balance Method:
 The declining-balance method produces a decreasing annual
depreciation expense over the useful life of the asset.
 The calculation of periodic depreciation is based on a declining

book value (cost of the asset less accumulated depreciation)
 The book value for the first year is the cost of the asset since
accumulated depreciation has a zero balance at the beginning
of the first year of the asset’s useful life.
 The following formula is used for computing depreciation

expense in each year:
Depreciation expense = Book value at beginning of year ×
Declining-balance rate
63
 A common application of the declining-balance method is the
double-declining-balance method in which the depreciation
rate is double the straight-line rate.
 Unlike other depreciation methods, salvage value is ignored in

determining the amount to which the declining-balance rate is
applied. The salvage value is considered only in determining
depreciation expense in the last year as illustrated later.
 Assuming that Mark Company uses the double-declining

balance method the computations proceeds as follows:
Straight-line Rate = 100% = 100% = 20%

Useful life 5 years
Double-declining balance Rate = 20% × 2 = 40%
The depreciation Schedule over the 5-year period is

shown below:
(1) (2) (3) (4)

Year Cost Annual Depreciation Expense Accumulated Book
= Book Value Beginning of Depreciation Value
Year × Depreciation Rate Old (3) + (2) (1) – (3)
First $13,000 $13,000 × 40% = $5,200 $5,200 $7,800
Second $13,000 $7,800 × 40% = $3,120 8,320 4,680
Third $13,000 $4,680 × 40% = $1,872 10,192 2,808
Fourth $13,000 2,808 × 40% = $1,123 11,315 1,685
Fifth $13,000 $1,685 - $1,000 salvage = $685 12,000 1,000
Units-of-Activity Method:
 Under the units-of-activity method, the useful life of the asset is
expressed in terms of the total units of production or expected
use from the asset, rather than as a time period.
 Depreciation expense is computed as follows:
64
1. Depreciation cost Per unit = Cost – Salvage Value
Useful life in units of activity
2. Depreciation expense any year= Depreciation cost per unit ×

Actual units of activity
during the year
 Using the information in the truck example, compute

depreciation expense in the first year assuming that total miles
used in the first year amounted to 15,000 miles.
Depreciation cost per mile = $13,000 - $1,000 = $0.12 per mile

100,000 miles
Depreciation expense first year = 15,000 miles × $0.12 = $1,800
Topic (9)
Profit Planning: The Master Budget
The Basic Framework of Budgeting:
 A budget is a detailed quantitative plan for acquiring and using

financial and other resources over a specified forthcoming time
period.
 The act of preparing a budget is called budgeting.
The use of budgets to control an organization’s activity is known

as budgetary control.
 To be effective, a good budgeting system must provide for both

planning and control.
 Planning – involves developing objectives and preparing various
65
budgets to achieve these objectives.
 Control – involves the steps taken by management that attempt

to ensure that objectives are attained.
Advantages of Budgeting:
1. Budgets communicate management’s plans throughout the

organization.
2. Budgets force managers to think about and plan for the future.
3. The budgeting process is a means of allocating

resources to those parts of the organization where they can be
used most effectively.
4. The budgeting process can uncover potential

bottlenecks.
5. Budgets coordinate the activities of the entire organization by

integrating the plans of the various parts.
6. Budgets define goals and objectives that can serve as

benchmarks for evaluating subsequent performance.
Choosing the Budget Period:
 Operating budgets ordinarily cover a one-year period

corresponding to a company’s fiscal year. Many companies
divide their annual budget into four quarters.
 A continuous or perpetual budget is a twelve-month budget that

rolls forward one month (or quarter) as the current month (or
quarter) is completed. This approach keeps managers focused
on the future at least one year ahead.
Self-Imposed Budget:
A self-imposed budget or participative budget is a budget that

is prepared with the full cooperation and participation of managers
at all levels. It is a particularly useful approach if the budget will be
used to evaluate managerial performance.
66
Advantages of Self-Imposed Budgets:
1. Individuals at all levels of the organization are viewed as

members of the team whose judgments are valued by top
management.
2. Budget estimates prepared by front-line managers are often

more accurate than estimates prepared by top managers.
3. Motivation is generally higher when individuals participate in

setting their own goals than when the goals are imposed from
above.
4. A manager who is not able to meet a budget imposed from

above can claim that it was unrealistic. Self-imposed budgets
eliminate this excuse.
Human Factors in Budgeting:
The success of budgeting depends upon three important

factors:
1. Top management must be enthusiastic and committed to the

budget process.
2. Top management must not use the budget to pressure

employees or blame them when something goes wrong.
3. Highly achievable budget targets are usually preferred when

managers are rewarded based on meeting budget targets.
The Master Budget: An Overview:
 The master budget consists of a number of separate but

interdependent budgets. See Exhibit 9-2 page 378.
67
 The sales budget shows the expected sales for the budget period
expressed in dollars and units. It is usually based on a
company’s sales forecast. All other parts of the master budget
are dependent on the sales budget.
 The production budget is prepared after the sales budget. It lists

the number of units that must be produced during each budget
period to meet sales needs and to provide for the desired
ending inventory.
 The production budget in turn directly influences the direct
materials, direct labor, and manufacturing overhead budgets,
which in turn enable the preparation of the ending finished
goods inventory budget.
 These budgets are then combined with data from the sales
budget and the selling and administrative expense budget to
determine the cash budget.
 The cash budget is a detailed plan showing how cash resources

will be acquired and used over a specified time period. All of
the operating budgets have an impact on the cash budget.
 The last step of the process is to prepare a budgeted income

statement and a budgeted balance sheet.
Budgeting Example:
 Royal Company is preparing budgets for the second quarter

ending June 30.
 Budgeted sales for the next five months are:

April 20,000 units
May 50,000 units
June 30,000 units
July 25,000 units
August 15,000 units.
 The selling price is $10 per unit.

The Sales Budget:
 Royal sells only one product and that product has a selling price
of $10 per unit. To calculate the total sales in dollars for any
period, we multiply the projected sales in units times the unit
68
selling price as shown below.
 As you can see, Royal forecasts unit sales of 100,000 and total
sales revenue of $1,000,000 for the quarter ended June 30th.
Royal Company
Sales Budget for the Second Quarter
 Once we complete the sales budget, we can move on to the

expected cash collections from sales.
Expected Cash Collections:

•All sales are on account.
•Royal’s collection pattern is:
70% collected in the month of sale,
25% collected in the month following sale,
5% estimated to be uncollectible.
•The March 31 accounts receivable balance of $30,000 will be
collected in full.
 Let’s prepare the schedule of expected cash collections on sales.
Schedule of Expected Cash Collections
69
 We expect to collect all $30,000 in accounts receivable during
the month of April.
 In addition to the $30,000, we expect to collect 70% of the

project sales for April of $200,000. So we will collect another
$140,000 in April.
 Notice that 25% of April projected sales will be collected in

May. In other words, $50,000 of April sales will be collected in
May.
 We follow a similar procedure for the months of May and

June.
 When we carry all the cash collections to the Quarter column,

you can see that we expect to collect $905,000 for the quarter.
 Now let’s turn our attention to the production budget.
The Production Budget:
 After we have budgeted our sales and expected cash collection,

we must make sure that our production is adequate to meet the
forecasted sales and provide a sufficient ending inventory.
70
 We need inventory on hand at the end of the period to
minimize the likelihood of an inventory stock-out.
• The management at Royal Company wants ending inventory to

be equal to 20% of the following month’s budgeted sales in
units.
• On March 31, 4,000 units were on hand. This is the beginning

of April finished goods inventory.
 Let’s prepare the production budget.
 The required production in units in any period is computed

using the following formula:
Required Production = Budgeted Sales + Desired

In Units Ending Finished Goods
Inventory – Beginning
Finished Goods Inventory
Royal Company
Production Budget for the Second Quarter
 Desired Ending Inventory for April

= 50,000 budgeted sales for May x 20% = 10,000
71
 Desired Ending Inventory for May
= 30,000 budgeted sales for June x 20% = 6,000
 Desired Ending Inventory for June

= 25,000 budgeted sales for July x 20% = 5,000
 Ending finished goods inventory for the quarter is the ending

finished goods inventory for the last month of the quarter
(June) which is 5,000 units.
 Beginning inventory for April 4,000 units (given).
 Beginning inventory for May is the ending inventory for April:

10,000 units.
 Beginning inventory for June is the ending inventory for May:

6,000 units.
 Beginning inventory for the quarter is the beginning inventory

for the first month of the quarter (April) which is 4,000 units.
The Direct Materials Budget:
• At Royal Company, 5 pounds of material are required per unit

of product.
• Management wants materials on hand at the end of each

month equal to 10% of the following month’s production.
• On March 31, 13,000 pounds of material are on hand.

Material cost is $0.40 per pound.
 Let’s prepare the direct materials budget.
 The raw materials to be purchased in any period is computed

using the following formula:
Raw Materials to = Raw Materials needed to meet

Be Purchased Production + Desired Ending
Inventory of Raw Materials –
72
Beginning Inventory of Raw
Materials
 Materials to be purchased are determined first in units

(pounds, gallons, yards, and so on), then in dollar amount by
multiplying the units to be purchased by the unit cost.
Royal Company
Direct Materials Budget for the Second Quarter
Cost of material per pound $0.40 $0.40 $0.40 $0.40

Cost of materials purchased $56,000 $88,600 $56,800 $201,400
 Desired ending inventory of raw materials for April = 230,000

production needs for May x 10% = 23,000.
 Desired ending inventory of raw materials for May = 145,000
production needs for May x 10% = 14,500.
 Desired ending inventory of raw materials for June is

calculated as follows:
Production Budget for July:

Sales for July 25,000
+ Desired ending Inv (15,000 Aug. sales x 20%) 3,000
= Total needs 28,000
Less: Beg. Inv for July (ending Inv. For June) 5,000
= Required Production for July 23,000
x Materials per unit (pounds) 5
Production needs of material for July 115,000
73
Desired ending inventory of raw materials for June = 115,000
production needs for July x 10% = 11,500.
 Ending raw materials inventory for the quarter is the ending

raw materials inventory for the last month of the quarter
(June) which is 11,500 pounds.
 Beginning raw materials inventory for April is the ending raw

materials inventory for March which 13,000 pounds (given).
 Beginning inventory of raw materials for May is the ending

raw materials inventory for April: 23,000 pounds.
 Beginning inventory of raw materials for June is the ending

raw materials inventory for May: 14,500 pounds.
 Beginning inventory of raw materials for the quarter is the

beginning raw materials inventory for the first month of the
quarter (April) which is 13,000 pounds.
Expected Cash Disbursement for Materials:
• Royal Company pays One-half of a month’s purchases in the

month of purchase; the other half is paid in the following
month.
• The March 31 accounts payable balance is $12,000.
 Let’s calculate expected cash disbursements for the second

quarter.
Royal Company
Expected Cash Disbursement for Materials
74
 Now let’s move to the direct labor budget.
The Direct Labor Budget:
• At Royal, each unit of product requires 0.05 hours (3 minutes)

of direct labor.
• The Company has a “no layoff” policy so all employees will be

paid for 40 hours of work each week.
• In exchange for the “no layoff” policy, workers agree to a wage

rate of $10 per hour regardless of the hours worked (no
overtime pay).
• For the next three months, the direct labor workforce will be
paid for a minimum of 1,500 hours per month.
 Let’s prepare the direct labor budget.
Royal Company
Direct Labor Budget for the Second Quarter
75
 Because of the no layoff policy, Royal is committed to paying
for a minimum of 1,500 hours per month. The number of hours
paid will be the greater of the direct labor hours required, or
1,500 hours.
 In April, Royal will pay for 1,500 direct labor hours when there
is only work for 1,300 hours. In May, Royal will pay for 2,300
direct labor hours, and the company will pay for 1,500 hours in
June. For the quarter, the company will pay for 5,300 direct
labor hours.
 With a straight time rate of $10 per hour, Royal will pay
$15,000 for direct labor in April, $23,000 in May, and $1,500 in
June, for a total of $53,000 for the quarter.
 Now let’s look at the manufacturing overhead budget.
Manufacturing Overhead Budget:
• At Royal, manufacturing overhead is applied to units of

product on the basis of direct labor hours.
• The variable manufacturing overhead rate is $20 per direct

labor hour.
• Fixed manufacturing overhead is $50,000 per month and

includes $20,000 of noncash costs (primarily depreciation of
plant assets).
76
 Let’s prepare the manufacturing overhead budget.
Royal Company
Manufacturing Overhead Budget
for the Second Quarter
 We begin by multiplying our variable manufacturing overhead

rate of $20 times the number of direct labor hours used in the
month. For April, we expect to apply $26,000 of variable
overhead.
 Next, we add the fixed overhead to our calculation of the

variable overhead rate. We estimate total overhead of $76,000
in April and for the quarter, we expect a total of $251,000.
 If we divide the manufacturing overhead of $251,000 by the

total labor hours required during the quarter, we get a
predetermined overhead rate of $49.70 ($251,000 / 5050 hours).
 Remember, when determining the overhead rate we use the

total labor hours required rather than the hours paid.
 If we subtract the noncash overhead costs (depreciation is a

noncash charge) from the total manufacturing overhead costs,
77
we get the cash paid for overhead costs. We will use this cash
overhead amount in our cash budget later on.
Ending Finished Goods Inventory Budget:
Royal Company
Ending Finished Goods Inventory Budget
Production costs per unit Quantity Cost Total
Direct materials 5.00 lbs. $ 0.40 $ 2.00
Direct labor 0.05 hrs. $ 10.00 0.50
Manufacturing overhead 0.05 hrs. $ 49.70 2.49
$ 4.99
Budgeted finished goods inventory
Ending inventory in units 5,000
Unit product cost $ 4.99
Ending finished goods inventory $ 24,950
 We estimate there will be 5,000 units in ending inventory (from

the production budget) and at a per unit cost of $4.99, we have
a total cost of $24,950.
 The finished goods inventory will appear on our budgeted

balance sheet.
Selling and Administrative Expense Budget:
• At Royal, the selling and administrative expenses budget is

divided into variable and fixed components.
• The variable selling and administrative expenses are $0.50 per
unit sold.
• Fixed selling and administrative expenses are $70,000 per
month.
• The fixed selling and administrative expenses include $10,000
in costs – primarily depreciation – that are not cash outflows of
the current month.
 Let’s prepare the company’s selling and administrative

expense budget.
Royal Company
Selling and Administrative Expense Budget
78
The Cash Budget:
 The preparation of the cash budget can be quite complex. We

have to pay close attention to details from our other budgets if
we are to be successful in preparing the cash budget.
 The cash budget is divided into four sections:

1. Cash receipts listing all cash inflows excluding borrowing;
2. Cash disbursements listing all payments excluding repayments

of principal and interest;
3. Cash excess or deficiency; and
4. The financing section listing all borrowings, repayments and

interest.
Royal:
 Maintains a 16% open line of credit for $75,000.
 Maintains a minimum cash balance of $30,000.
 Borrows on the first day of the month and repays loans on the
last day of the month.
 Pays a cash dividend of $49,000 in April
 Purchases $143,700 of equipment in May and $48,300 in June
(both purchases paid in cash)
 Has an April 1 cash balance of $40,000
79
The cash budget for Royal company is presented below:
Royal Company
The Cash Budget
 We began April with $40,000 in cash. To this amount, we add

our expected cash collections from sales of $170,000 for the
month of April. We complete the first section by calculating the
total cash available of $210,000.
 During April, we expect to pay $40,000 for raw materials,

$15,000 for direct labor, $56,000 for cash manufacturing
overhead, and $70,000 for selling and administrative expense.
 During April, the Board of Directors paid a cash dividend of

$49,000.
80
 The third section of the cash budget is to determine any cash
excess or deficiency. In the month of April, we expect to have a
cash deficiency of $20,000. Since Royal has a policy that the
company will always maintain an ending cash balance of
$30,000, it will have to borrow $50,000 against its line-of-credit
in April.
 After Royal borrows on its line-of-credit, it will have an ending

cash balance of $30,000 dollars. The ending cash balance for
April becomes the beginning cash balance for May.
 Let’s complete the cash budget for the month of May.
 Refer back to our previous budgets to get the cash collection,

cash disbursements for direct materials, direct labor,
manufacturing overhead, and selling and administrative
expenses. The new item in May is that the company plans to
purchase $143,000 worth of equipment.
 For May, the company will have a cash excess of $30,000, but it
will not be able to repay the money borrowed on the line-of-
credit or the accrued interest.
 Next we calculate the cash excess or deficiency for the month of

June. The cash excess for June is $95,000.
 At the end of June, Royal will have sufficient cash to repay the
$50,000 borrowed in April plus the interest on the loan.
 The interest on the loan is calculated below:
Interest = $50,000 × 16% × 3/12 = $2,000
 Royal will end the quarter with $43,000 cash on hand. This
cash balance will appear on our budgeted balance sheet.
The Budgeted Income Statement
 After we complete the cash budget, we can prepare the

Royal Company
Budgeted Income Statement
budgeted income statement for Royal.
For the Three Months Ended June 30
Sales (100,000 units @ $10) $ 1,000,000

Cost of goods sold (100,000 @ $4.99) 499,000
Gross margin 501,000
Selling and administrative expenses 260,000
Operating income 241,000 81
Interest expense 2,000
Net income $ 239,000
 Recall that Royal planned to sell 100,000 units during the
quarter at $10 per unit.
 We determined the unit cost at $4.99, so cost of goods sold will
be $499,000.
 Our selling and administrative expenses, including

depreciation, total $260,000, and we incurred $2,000 of interest
expense during the quarter.
 Our budgeted net income for the quarter is $239,000 as shown

above.
The Budgeted Balance Sheet
Royal reported the following account balances prior to preparing its

budgeted financial statements:
• Land - $50,000
• Common stock - $200,000
• Retained earnings - $146,150
• Equipment - $175,000
We will need this supplemental information to complete the budgeted

balance sheet.
 The budgeted balance sheet
Royalfor Royal Company is shown
Company
Budgeted Balance Sheet
below: June 30
Current assets
Cash $ 43,000
Accounts receivable 75,000
Raw materials inventory 4,600
Finished goods inventory 24,950
Total current assets 147,550
Property and equipment
Land 50,000
Equipment 367,000
Total property and equipment 417,000
Total assets $ 564,550
Accounts payable $ 28,400

Common stock 200,000
Retained earnings 336,150
82
Total liabilities and equities $ 564,550
 You can see our cash balance of $43,000 that comes directly
from the cash budget.
 Accounts Receivable is 25% of June sales of

$300,000.
 Raw materials inventory is 11,500 lbs. at $0.40/ per pound.
 Finished goods inventory is 5,000 units at $4.99 each.
 Accounts Payable is 50% of June purchases of $56,800.
 Next we will prepare a statement of retained earnings.
 We provided you with the beginning balance in retained

earnings. To arrive at the ending balance in retained earnings,
we need to add the budgeted net income of $239,000 and
subtract the cash dividend of $49,000 paid in April as shown
below:
Beginning balance $146,150

Add: net income 239,000
Deduct: dividends (49,000)
Ending balance $336,150
83

Accounting Module - 2018-2019

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Accounting Module - 2018-2019

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Topic (1)

• Identifies: Selecting those events that represent economic

• Records: Keeping a chronological diary of events

• Communicates the economic events of an organization to

Who Uses Accounting Data:

2. External Users: Are users from outside the

Distinguishing Between Bookkeeping and accounting:

 Accounting involves the entire process of

 Accounting is also divided into financial versus

Generally Accepted Accounting Principles:

 Countries outside the U.S have adopted the

 One important principle is the cost principle,

2. The Economic Entity Assumption: This assumption

Basic Accounting Equation:

 Assets are the resources owned by a business.

 Equities (claims against assets) can be divided

 Based on the above classification of equities, the

Assets = Liabilities + Owners’ Equity

 Because creditors’ claims are paid before owners’

 The accounting equation applies to all economic

 Now let us look in more detail at the components

Investments by Owner (Capital):

In summary, subdivisions of Owner’s Equity and the

Revenues and expenses determine if a net income or

Business Transactions and Transaction Analysis:

 Transactions may be identified as external or

 Each transaction must be analyzed in terms of its

 The analysis must identify the specific items

 Each transaction has a dual effect on the

 A tabular summary may be prepared to show the

Transactions (2): Purchase of Equipment for Cash

Observe that total assets equal total liabilities plus

Transactions (3): Purchase of Supplies on Credit

• Acme agrees to allow Softbyte to pay this bill next month,

Transactions (4): Services Provided for Cash

• This transaction represents the Softbyte’s principal

Observe that total assets equal total liabilities plus

Transactions (5): Purchase of Advertising on Credit

Transactions (6): Services Provided for Cash and Credit

Observe that total assets equal total liabilities plus

Transactions (7): Payment of Expenses

Transactions (8): Payment of Accounts Payable

Observe that total assets equal total liabilities plus

Transactions (9): Receipt of Cash on Account

Observe that total assets equal total liabilities plus

Transactions (10): Withdrawal of Cash by Owner

Observe that total assets equal total liabilities plus

* For a tabular summary of Softbyte transactions, see

• Statement of Cash Flows

We will focus only on the first three statements. See page 20

Financial Statements in Equation Form:

 The income statement:

 The statement of owners’ equity:

• There are separate accounts for the items we used in

Basic Form of Account:

• The alignment of these parts resembles the letter T.

Debits and Credits:

 Since each item in the accounting equation has an

 For each transaction, debits must equal credits in the

 Under the double-entry system, the dual (two-sided)

 Every account has a designated normal balance.

Examples- Recording Rules:

Steps in the Recording Process: