3 Adjusting The Accounts

Learning Objectives
Explain the accrual basis of accounting and the
1 reasons for adjusting entries.

2 Prepare adjusting entries for deferrals.

3 Prepare adjusting entries for accruals.

Describe the nature and purpose of an adjusted

4 trial balance.
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LEARNING Explain the accrual basis of accounting

1
OBJECTIVE and the reasons for adjusting entries.

Accountants divide the economic life of a business into

artificial time periods (Time Period Assumption).

.....
Jan. Feb. Mar. Apr. Dec.

Generally a
Alternative Terminology
 month, The time period assumption
is also called the
 quarter, or periodicity assumption.
 year.

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 Fiscal and Calendar Years

 Monthly and quarterly time periods are called interim

periods.

 Most large companies must prepare both quarterly

and annual financial statements.

 Fiscal Year = Accounting time period that is one year

in length.

 Calendar Year = January 1 to December 31.

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Fiscal and Calendar Years

Question
The time period assumption states that:

a. revenue should be recognized in the accounting

period in which it is earned.

b. expenses should be matched with revenues.

c. the economic life of a business can be divided into

artificial time periods.

d. the fiscal year should correspond with the calendar

year.

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 Accrual- versus Cash-Basis Accounting

Accrual-Basis Accounting
 Transactions recorded in the periods in which the
events occur.

 Companies recognize revenues when they perform

services (rather than when they receive cash).

 Expenses are recognized when incurred (rather than

when paid).

 In accordance with generally accepted accounting

principles (GAAP).

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Accrual- versus Cash-Basis Accounting

Cash-Basis Accounting
 Revenues recognized when cash is received.

 Expenses recognized when cash is paid.

 Cash-basis accounting is not in accordance with

generally accepted accounting principles (GAAP).

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 Recognizing Revenues and Expenses

REVENUE RECOGNITION PRINCIPLE

Recognize revenue in the
accounting period in which the
performance obligation is
satisfied.

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Recognizing Revenues and Expenses

EXPENSE RECOGNITION PRINCIPLE

Match expenses with revenues
in the period when the company
makes efforts that generate
those revenues.

“Let the expenses

follow the revenues.”

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 Illustration 3-1
GAAP relationships in
revenue and expense
recognition

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Recognizing Revenues and Expenses

Question
One of the following statements about the accrual basis of
accounting is false? That statement is:
a. Events that change a company’s financial statements are
recorded in the periods in which the events occur.
b. Revenue is recognized in the period in which the performance
obligation is satisfied.
c. The accrual basis of accounting is in accord with generally
accepted accounting principles.
d. Revenue is recorded only when cash is received, and
expenses are recorded only when cash is paid.
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The Need for Adjusting Entries

Adjusting Entries
 Ensure that the revenue recognition and expense
recognition principles are followed.

 Necessary because the trial balance may not contain

up-to-date and complete data.

 Required every time a company prepares financial

statements.

 Will include one income statement account and one

balance sheet account.

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 The Need for Adjusting Entries

Question
Adjusting entries are made to ensure that:
a. expenses are recognized in the period in which
they are incurred.
b. revenues are recorded in the period in which
services are performed.
c. balance sheet and income statement accounts
have correct balances at the end of an accounting
period.
d. all of the above.

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Types of Adjusting Entries

Illustration 3-2
Categories of adjusting entries

Deferrals Accruals

1. Prepaid Expenses. 1. Accrued Revenues.

Expenses paid in cash before Revenues for services
they are used or consumed. performed but not yet
received in cash or recorded.

2. Unearned Revenues. 2. Accrued Expenses.

Cash received before services Expenses incurred but not yet
are performed. paid in cash or recorded.

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 Types of Adjusting Entries

Trial Balance – Each account is analyzed to determine

whether it is complete and up-to-date.
Illustration 3-3

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DO IT! 1 Timing Concepts

A list of concepts is provided in the left column below, with a description of the
concept in the right column below. There are more descriptions provided than
concepts. Match the description of the concept to the concept.

f Accrual-basis accounting.
1. ___ (a) Monthly and quarterly time periods.
(b) Efforts (expenses) should be matched
e Calendar year.
2. ___
with results (revenues).
c Time period assumption.
3. ___ (c) Accountants divide the economic life of
b Expense recognition
4. ___ a business into artificial time periods.
principle. (d) Companies record revenues when they
receive cash and record expenses
when they pay out cash.
(e) An accounting time period that starts on
January 1 and ends on December 31.
(f) Companies record transactions in the
period in which the events occur.
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 LEARNING
OBJECTIVE
2 Prepare adjusting entries for deferrals.

Deferrals are expenses or revenues that are recognized

at a date later than the point when cash was originally
exchanged. There are two types:

 Prepaid expenses

 Unearned revenues

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Prepaid Expenses

Payment of cash, that is recorded as an asset to show

the service or benefit the company will receive in the
future.

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

 insurance  rent
 supplies  equipment
 advertising  buildings

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 Prepaid Expenses

 Expire either with the passage of time or through use.

 Adjusting entry:
► Increase (debit) to an expense account and

► Decrease (credit) to an asset account.

Illustration 3-4

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Supplies

Illustration: Pioneer Advertising

purchased supplies costing $2,500 on
October 5. Pioneer recorded the payment
by increasing (debiting) the asset
Supplies. This account shows a balance
of $2,500 in the October 31 trial balance.
An inventory count at the close of
business on October 31 reveals that
$1,000 of supplies are still on hand.

Oct. 31 Supplies Expense 1,500

Supplies 1,500

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 Supplies
Illustration 3-5

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Insurance

Illustration: On October 4, Pioneer

Advertising paid $600 for a one-year fire
insurance policy. Coverage began on October
1. Pioneer recorded the payment by
increasing (debiting) Prepaid Insurance. This
account shows a balance of $600 in the
October 31 trial balance. Insurance of $50
($600 ÷ 12) expires each month.

Oct. 31 Insurance Expense 50

Prepaid Insurance 50

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 Insurance
Illustration 3-6

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Depreciation

 Buildings, equipment, and motor vehicles

(assets that provide service for many years) are
recorded as assets, rather than an expense, on
the date acquired.

 Depreciation is the process of allocating the cost

of an asset to expense over its useful life.

 Depreciation does not attempt to report the actual

change in the value of the asset.

► Allocation concept, not a valuation concept.

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 Depreciation

Illustration: For Pioneer Advertising,

assume that depreciation on the equipment is
$480 a year, or $40 per month.

Oct. 31
Depreciation expense 40
Accumulated depreciation 40

Accumulated Depreciation is called

a contra asset account.

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Illustration 3-7

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 Depreciation

STATEMENT PRESENTATION
 Accumulated Depreciation is a contra asset account
(credit).
 Offsets related asset account on the balance sheet.
 Book value is the difference between the cost of any
depreciable asset and its accumulated depreciation.
Illustration 3-8

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Prepaid Expenses

Summary of the accounting for prepaid expenses.

Illustration 3-9
Accounting for prepaid expenses

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 Unearned Revenues

Receipt of cash that is recorded as a liability because

the service has not been performed.

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

 Rent  Magazine subscriptions

 Airline tickets  Customer deposits

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Unearned Revenues

 Adjusting entry is made to record the revenue for

services performed during the period and to show the
liability that remains at the end of the period.

 Results in a decrease (debit) to a liability account

and an increase (credit) to a revenue account.
Illustration 3-10

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 Unearned Revenues

Illustration: Pioneer Advertising received

$1,200 on October 2 from R. Knox for
advertising services expected to be
completed by December 31. Unearned
Service Revenue shows a balance of $1,200
in the October 31 trial balance. Analysis
reveals that the company performed $400 of
services in October.

Oct. 31 Unearned Service Revenue 400

Service Revenue 400

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Unearned Revenues
Illustration 3-11

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 Unearned Revenues

Summary of the accounting for unearned revenues.

Illustration 3-12

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 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond Company, on March 31, 2017, includes these

selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
An analysis of the accounts shows the following.
1. Insurance expires at the rate of $100 per month.
2. Supplies on hand total $800.
3. The equipment depreciates $200 a month.
4. During March, services were performed for one-half of the unearned
service revenue.
Prepare the adjusting entries for the month of March.

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DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond Company, on March 31, 2017, includes these

selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.

1. Insurance expires at the rate of $100 per month.

Insurance Expense 100

Prepaid Insurance 100

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 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond Company, on March 31, 2017, includes these

selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.

2. Supplies on hand total $800.

Supplies Expense 2,000

Supplies 2,000

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DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond Company, on March 31, 2017, includes these

selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.

3. The equipment depreciates $200 a month.

Depreciation Expense 200

Accumulated Depreciation—Equipment 200

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 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond Company, on March 31, 2017, includes these

selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.

4. During March, services were performed for one-half of the unearned

service revenue.

Unearned Service Revenue 4,600

Service Revenue 4,600

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LEARNING
OBJECTIVE
3 Prepare adjusting entries for accruals.

Accruals are made to record

 Revenues for services performed but not yet

recorded at the statement date.

 Expenses incurred but not yet paid or recorded at

the statement date.

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 Accrued Revenues

Revenues for services performed but not yet received

in cash or recorded.

Revenue Recorded BEFORE Cash Receipt

Accrued revenues often occur in regard to:

 Rent
 Interest
 Services

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Accrued Revenues

 Adjusting entry shows the receivable that exists and

records the revenues for services performed.

 Adjusting entry:
► Increases (debits) an asset account and
► Increases (credits) a revenue account.
Illustration 3-13

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 Accrued Revenues

Illustration: In October Pioneer Advertising

performed services worth $200 that were not
billed to clients on or before October 31.

Oct. 31
Accounts Receivable 200
Service Revenue 200

On November 10, Pioneer receives cash of $200 for the services

performed.

Nov. 10 Cash 200

Accounts Receivable 200
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Accrued Revenues
Illustration 3-14

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 Accrued Revenues

Summary of the accounting for accrued revenues.

Illustration 3-15

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Accrued Expenses

Expenses incurred but not yet paid in cash or recorded.

Expense Recorded BEFORE Cash Payment

Accrued expenses often occur in regard to:

 Rent  Taxes
 Interest  Salaries

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 Accrued Expenses

 Adjusting entry records the obligation and recognizes

the expense.

 Adjusting entry:
► Increase (debit) an expense account and
► Increase (credit) a liability account.
Illustration 3-16

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Accrued Expenses

ACCRUED INTEREST
Illustration: Pioneer Advertising signed a three-month note
payable in the amount of $5,000 on October 1. The note requires
Pioneer to pay interest at an annual rate of 12%.
Illustration 3-17

Oct. 31 Interest expense 50

Interest payable 50

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 Accrued Expenses
Illustration 3-18

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Accrued Expenses

ACCRUED SALARIES
Illustration: Pioneer Advertising paid salaries and wages on
October 26; the next payment of salaries will not occur until
November 9. The employees receive total salaries of $2,000 for a
five-day work week, or $400 per day.
Illustration 3-19

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 Accrued Expenses
Illustration 3-20

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Accrued Expenses

Summary of the accounting for accrued expenses.

Illustration 3-21

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Summary of Basic Relationships

Illustration 3-22

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 DO IT! 3 Adjusting Entries for Accruals

Micro Computer Services began operations on August 1, 2017. At the

end of August 2017, management prepares monthly financial
statements. The following information relates to August.
1. At August 31, the company owed its employees $800 in
salaries and wages that will be paid on September 1.
2. On August 1, the company borrowed $30,000 from a local bank
on a 15-year mortgage. The annual interest rate is 10%.
3. Revenue for services performed but unrecorded for August
totaled $1,100.
Prepare the adjusting entries needed at August 31, 2017.

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DO IT! 3 Adjusting Entries for Accruals

Prepare the adjusting entries needed at August 31, 2017.

1. At August 31, the company owed its employees $800 in
salaries and wages that will be paid on September 1.
Salaries and Wages Expense 800
Salaries and Wages Payable 800
2. On August 1, the company borrowed $30,000 from a local bank
on a 15-year mortgage. The annual interest rate is 10%.
Interest Expense 250
Interest Payable 250

3. Revenue for services performed but unrecorded for August

totaled $1,100.
Accounts Receivable 1,100
Service Revenue 1,100
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 LEARNING Describe the nature and purpose of an
4
OBJECTIVE adjusted trial balance.

Adjusted Trial Balance

 Prepared after all adjusting entries are journalized and
posted.

 Purpose is to prove the equality of debit balances and

credit balances in the ledger.

 Is the primary basis for the preparation of financial

statements.

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Illustration 3-25

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 Adjusted Trial Balance

Question
Which of the following statements is incorrect concerning the adjusted
trial balance?
a. An adjusted trial balance proves the equality of the total debit
balances and the total credit balances in the ledger after all
adjustments are made.
b. The adjusted trial balance provides the primary basis for the
preparation of financial statements.
c. The adjusted trial balance lists the account balances segregated
by assets and liabilities.
d. The adjusted trial balance is prepared after the adjusting entries
have been journalized and posted.

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Preparing Financial Statements

Financial Statements are prepared directly from the

Adjusted Trial Balance.

Owner’s
Income Balance
Equity
Statement Sheet
Statement

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 Illustration 3-26
Preparation of the income statement and owner’s
equity statement from the adjusted trial balance
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Illustration 3-27
Preparation of the balance sheet from
the adjusted trial balance

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 DO IT! 4 Trial Balance

(a) Determine the net income for the quarter April 1 to June 30.
(b) Determine the total assets and total liabilities at June 30, 2017, for Skolnick Co.
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(c) Determine the amount of owner’s capital at June 30, 2017. LO 4

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DO IT! 4 Trial Balance

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 DO IT! 4 Trial Balance

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DO IT! 4 Trial Balance

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 Prepaid Expenses

Company may choose to debit (increase) an expense account

rather than an asset account. This alternative treatment is simply
more convenient.
Illustration 3A-2

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Unearned Revenues

Company may credit (increase) a revenue account when they

receive cash for future services.
Illustration 3A-5

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 Summary of Additional Adjustments
Relationships
Illustration 3A-7

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LEARNING Prepare closing entries and a post-closing

5
OBJECTIVE trial balance.

At the end of the accounting period, the company makes the

accounts ready for the next period.

Illustration 4-8
Temporary versus permanent accounts
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 Preparing Closing Entries

Closing entries formally recognize in the ledger the transfer of

 net income (or net loss) and
 owner’s drawings

to owner’s capital.

Companies generally journalize and post closing entries only at the

end of the annual accounting period.
Closing entries produce a zero balance in each temporary account.

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Preparing Closing Entries

Illustration 4-9
Diagram of closing
process—proprietorship

Owner’s Capital is a
permanent account. All
other accounts are
temporary accounts.

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 Preparing Closing Entries

CLOSING
ENTRIES
ILLUSTRATED

Illustration 4-10
Closing entries
4-73 journalized

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Posting
Closing
Entries

Illustration 4-11

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Preparing a Post-Closing Trial Balance

Purpose is to prove the equality of the permanent account balances carried
forward into the next accounting period. Illustration 4-12
Post-closing trial balance

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 LEARNING Identify the sections of a classified balance
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OBJECTIVE sheet.

 Presents a snapshot at a point in time.

 To improve understanding, companies group similar assets

and similar liabilities together.

Standard Classifications Illustration 4-20

Assets Liabilities and Owner’s Equity

Current assets Current liabilities
Long-term investments Long-term liabilities
Property, plant, and equipment Owner’s (Stockholders’) equity
Intangible assets

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The Classified Balance Sheet

Illustration 4-21

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 The Classified Balance Sheet
Illustration 4-21

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Current Assets

 Assets that a company expects to convert to cash or

use up within one year or the operating cycle, whichever
is longer.

 Operating cycle is the average time that it takes to

purchase inventory, sell it on account, and then collect
cash from customers.

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 Current Assets
Illustration 4-22

Usually listed in the order they expect to convert them into cash.

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Current Assets

Question
The correct order of presentation in a classified balance sheet for the
following current assets is:

a. accounts receivable, cash, prepaid insurance, inventory.

b. cash, inventory, accounts receivable, prepaid insurance.

c. cash, accounts receivable, inventory, prepaid insurance.

d. inventory, cash, accounts receivable, prepaid insurance.

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 Long-Term Investments

 Investments in stocks and bonds of other companies.

 Investments in long-term assets such as land or buildings that is
not currently being used in operating activities.
 Long-term notes receivable.
Illustration 4-23

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Property, Plant, and Equipment

 Long useful lives.

 Currently used in operations.

 Depreciation - allocating the cost of assets to a number of

years.

 Accumulated depreciation - total amount of depreciation

expensed thus far in the asset’s life.

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 Property, Plant, and Equipment

Illustration 4-24

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Intangible Assets

 Long-lived assets that do not have physical substance.

Illustration 4-25

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 The Classified Balance Sheet

Question
Patents and copyrights are

a. Current assets.

b. Intangible assets.

c. Long-term investments.

d. Property, plant, and equipment.

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 Current Liabilities

 Obligations the company is to pay within the coming year or its

operating cycle, whichever is longer.

 Usually list notes payable first, followed by accounts payable.

Other items follow in order of magnitude.

 Common examples are accounts payable, salaries and wages

payable, notes payable, interest payable, income taxes payable
current maturities of long-term obligations.

 Liquidity - ability to pay obligations expected to be due within

the next year.

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Current Liabilities

Illustration 4-26

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Long-Term Liabilities

 Obligations a company expects to pay after one year.

Illustration 4-27

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 The Classified Balance Sheet

Question
Which of the following is not a long-term liability?

a. Bonds payable

b. Current maturities of long-term obligations

c. Long-term notes payable

d. Mortgages payable

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Owner’s Equity

 Proprietorship - one capital account.

 Partnership - capital account for each partner.
 Corporation - Common Stock and Retained Earnings.

Illustration 4-28

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 Qualities of Useful Information

Two fundamental qualities, relevance and faithful representation.

Faithful Representation
 Information accurately depicts what really happened.

 Information must be

► complete (nothing important has been omitted),

► neutral (is not biased toward one position or another), and

► free from error.

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Qualities of Useful Information

ENHANCING QUALITIES

Comparability Information is Information has the

results when different verifiable if quality of
companies use the independent understandability
same accounting observers, using the if it is presented in a
principles. same methods, obtain clear and concise
similar results. fashion.

Consistency means
that a company uses For accounting information
the same accounting to have relevance, it must
principles and methods be timely.
from year to year.

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 Assumptions in Financial Reporting
Illustration 3B-2

Monetary Unit Economic Entity

Requires that only those things States that every economic
that can be expressed in entity can be separately
money are included in the identified and accounted for.
accounting records.

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Assumptions in Financial Reporting

Illustration 3B-2

Time Period Going Concern

States that the life of a The business will remain in
business can be divided into operation for the
artificial time periods. foreseeable future.

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 Principles of Financial Reporting

MEASUREMENT PRINCIPLES

Historical Cost Fair Value

Or cost principle, Indicates that
dictates that assets and
companies record liabilities should be
assets at their reported at fair
cost. value (the price
received to sell an
asset or settle
a liability).

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Principles of Financial Reporting

Revenue Expense
Full Disclosure
Recognition Recognition
Principle
Principle Principle
Requires that Dictates that Requires that
companies efforts (expenses) companies disclose
recognize revenue be matched with all circumstances
in the accounting results (revenues). and events that
period in which the Thus, expenses would make a
performance follow revenues. difference to
obligation is financial statement
satisfied. users.

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