Download Accounting Final Cycle notes and more Lecture notes Accounting in PDF only on Docsity!
A Review of the Accounting Cycle
Overview
This chapter covers the nuts and bolts of basic accounting, or rather basic bookkeeping. Accounting tends to cover much wider territory, and it features much more analysis, when compared with bookkeeping. Accountants do need to know how to do bookkeeping, however. If for no other reason, then they at least need to learn bookkeeping to be able to understand much of the remainder of the textbook which relies on a solid foundation in understanding how the accounting cycle works and how transactions flow through an accounting system.
Accounting entries can be broken down into three categories: recording entries (LO2), adjusting entries (LO3), and closing entries (LO3). The vast majority of entries fall into the first category. The final category of closing entries are only made once a month, quarter, or year depending on how often the company closes out it books in order to issue financial statements.
Finally, the chapter discusses the importance, an ever-increasing role, of computers in the field of accounting.
Learning Objectives
Refer to the Review of Learning Objectives at the end of the chapter. It is crucial that this section of the chapter is second nature to you before you attempt the homework, a quiz, or exam. This important piece of the chapter serves as your CliffsNotes or “cheat sheet” to the basic concepts and principles that must be mastered.
If after reading this section of the chapter you still don’t feel comfortable with all of the Learning Objectives covered, you will need to spend additional time and effort reviewing those concepts that you are struggling with.
The following “Tips, Hints, and Things to Remember” are organized according to the Learning Objectives (LOs) in the chapter and should be gone over after reading each of the LOs in the textbook.
2-2 Chapter 2
Tips, Hints, and Things to Remember
LO1 – Identify and explain the basic steps in the accounting process
(accounting cycle).
How? Synthesize the steps of the accounting process down into these easy-to- remember components. There are three types, or categories, of accounting entries as mentioned on page 2-1. In between those entries come trial balances, and at or near the end of the process come the financial statements.
LO2 – Analyze transactions and make and post journal entries.
How? Debits and credits, credits and debits: How is one to ever remember which is which? Do I really have to memorize something as complicated as Exhibit 2-2? The answer is no. Debits and credits are much simpler than that. You really only need to remember two things: the basic format of a balance sheet and that debits are on the left. Everything else flows out of those two easy-to-remember items.
In this textbook balance sheets usually have assets at the top, followed by liabilities and equity. Instead, picture in your mind (or better yet sketch out) a balance sheet with assets on the left and liabilities/equity on the right. This way the totals for both columns will be equal in the same row at the bottom since Assets = Liabilities + Equity.
Next, think of the income statement as part of equity. We learned in this chapter that nominal or temporary (income statement) accounts get closed out to equity. (Ultimately, revenue and gains will increase equity and expenses and losses will decrease equity. So revenue moves in the same direction as equity and expenses move in the opposite direction.)
With that nested income statement in a balance sheet in mind, the only thing left to remember is that debits are on the left. The effects of debits and credits flow out of this model with ease. Since assets are on the left of our balance sheet they increase with debits (and decrease with credits). Since liabilities and equity are on the right of our balance sheet they increase with credits (and decrease with debits). Again, think of the income statement as part of equity with revenue and gains being the same as equity for debit/credit purposes and expenses and losses being the opposite (since they decrease equity).
This is also a good way to remember that your debits and credits must always equal. If they didn’t, your balance sheet would no longer balance.
That’s it! You’ve now got debits and credits down without having to memorize more than a dozen items (which you’d surely get confused or backwards at times) like you’ll find in illustrations like Exhibit 2-2.
2-4 Chapter 2
Why? Are journals and ledgers even used in today’s computerized environment? The answer is yes and no. Fewer transactions are entered into journals with today’s software programs. However, most software programs still keep the journals in the background, which are available more as a kind of report now than anything else. Adjusting and infrequent entries are also still frequently recorded through the general journal. Common entries, such as sales and purchases, are now generally run through a sales order system or a purchasing system which “journalize” the transactions into the correct accounts behind the scenes. Posting is one item that has been rendered nearly obsolete due to the computer. Posting still happens, of course, but it is typically automatic and not usually subject to the common user errors (forgetting to post, posting to the wrong account, or transposing numbers upon posting) that existed in manual accounting systems. Ledgers are just as important in a computerized environment as ever.
LO3 – Make adjusting entries, produce financial statements, and close
nominal accounts.
How? Adjusting entries is an area that students frequently struggle with. Part of the problem is that there is more than one way to enter an original transaction or the corresponding adjusting entry. For instance, let’s say I purchase some supplies. Should I debit an asset called “Supplies” or an expense called “Supplies Expense”? The answer is it doesn’t matter. If you don’t plan to use the supplies before the next accounting period ends then an asset is probably better, and if you plan to use them all before the end of the period then an expense is probably better. But if you plan to use up only some of the supplies then it doesn’t matter at all. What does matter is that you adjust your account balances before issuing your financial statements.
So here is the key concept to get down when it comes to adjusting entries: Account balances need to be adjusted so they are correctly stated. That is it. If your physical count of supplies indicates that you have $500 in supplies, it doesn’t matter if your current supplies balance per your books is $0 or $50,000, you need to move the balance to $500. Perhaps “adjusting entry” isn’t even the best term to describe the process. What we are really doing is correcting entries.
Another struggle students encounter is what accounts should be adjusted. Take the above example. Let’s say our Supplies balance per books is $0 but I have $500 in supplies on hand at the end of the fiscal period. I know, therefore, that I must debit Supplies by $500 but what do I credit? Students sometimes make the error of hitting the missing debit or credit to Cash. There are two things to remember about adjusting entries:
- Adjusting entries will always affect at least one balance sheet and at least one income statement account.
- Cash is never adjusted in an adjusting entry (except in the rare instance in which cash per count doesn’t equal the Cash account on the books—an indication of other problems to be sure!).
Chapter 2 2-
So getting back to our missing credit… Since Supplies is a balance sheet account, we should be looking to credit an income statement account (not ever Cash). What income statement account goes along with our balance sheet account of Supplies? Supplies Expense, of course. You’ll find similar related accounts for other adjusting entries as well. (Prepaid Rent with Rent Expense, Prepaid Insurance with Insurance Expense, Interest Payable with Interest Expense, Wages Payable with Wages Expense, Unearned Revenue with Sales Revenue, etc.)
LO4 – Distinguish between accrual and cash-basis accounting.
How? Students sometimes have difficulty understanding the accrual-basis concept. And then once they do master it, they seem to forget how to do cash-basis which isn’t as difficult. So how does one keep the two separate in their mind? Think of the accrual- basis of accounting as being accounting based on when events transpire without ever considering cash. Contrast this with the cash-basis of accounting which is basically checkbook accounting—everything is based on cash.
LO5 – Discuss the importance and expanding role of computers to the
accounting process.
See the Why? under LO2 on page 2-4.
The following sections, featuring various multiple choice questions, matching exercises, and problems, along with solutions and approaches to arriving at the solutions, is intended to develop your problem-solving and critical-thinking abilities. While learning through trial and error can be effective for improving your quiz and exam scores, and it can be a more interesting way to study than merely re-reading a chapter, that is only a secondary objective in presenting this information in this format.
The main goal of the following sections is to get you thinking, “How can I best approach this problem to arrive at the correct solution—even if I don’t know enough at this point to easily arrive at the proper results?” There is not one simple approach that can be applied to all questions to arrive at the right answer. Think of the following approaches as possibilities, as tools that you can place in your problem-solving toolkit—a toolkit that should be consistently added to. Some of the tools have yet to even be created or thought of. Through practice, creative thinking, and an ever-expanding knowledge base, you will be the creator of the additional tools.
Chapter 2 2-
MC2-7 (LO3) Failure to record the expired amount of Prepaid Insurance Expense would NOT a. understate expenses. b. overstate net income. c. overstate owners' equity. d. understate liabilities.
MC2-8 (LO3) The balance in an Unearned Revenue account represents an amount that is Earned Collected a. Yes Yes b. Yes No c. No Yes d. No No
MC2-9 (LO4) Which of the following statements regarding accrual versus cash-basis accounting is TRUE? a. The FASB believes that cash-basis accounting is appropriate for some smaller companies, especially those in the service industry. b. Cash-basis accounting is sometimes used by small, unincorporated businesses. c. Application of cash-basis accounting results in an income statement reporting revenues and expenses. d. Cash-basis accounting requires a complete set of double-entry records.
MC2-10 (LO5) The use of computers in processing accounting data a. places responsibility on the information systems designer. b. eliminates the double-entry system as a basis for analyzing transactions. c. eliminates the need for financial reporting standards such as those promulgated by the FASB. d. always increases document trails used to verify accounting records.
2-8 Chapter 2
Matching
Matching 2-1 (LO2) Listed below are the terms and associated definitions from the chapter for LO2. Match the correct definition letter with each term number.
___ 1. accounting process (or cycle) ___ 2. accounting system ___ 3. transactions ___ 4. double-entry accounting ___ 5. debit ___ 6. credit ___ 7. journal entry ___ 8. business (or source) document ___ 9. journals ___ 10. special journals ___ 11. general journal ___ 12. account ___ 13. ledger ___ 14. control account ___ 15. posting ___ 16. general ledger ___ 17. subsidiary ledgers
a. exchanges of goods or services between/among two or more entities or some other event having an economic impact on a business enterprise b. an accounting record used to list a particular type of frequently recurring transaction c. a record used to classify and summarize the effects of transactions d. an entry on the right side of an account e. a record used as the basis for analyzing and recording transactions; examples include invoices, check stubs, and receipts f. a collection of accounts maintained by a business g. procedures used for analyzing, recording, classifying, and summarizing the information to be presented in accounting reports h. an entry on the left side of an account i. procedures and methods used, including data processing equipment, to collect and report accounting data j. an accounting record used to record all business activities for which a special journal is not maintained k. the process of summarizing transactions by transferring amounts from the journals to the ledger accounts l. the grouping of supporting accounts that in total equal the balance of a control account in the general ledger m. the general ledger account that summarizes the detailed information in a subsidiary ledger n. a collection of all the accounts used by a business that could appear on the financial statements o. a system of recording transactions in a way that maintains the equality of the accounting equation p. records in which transactions are first entered, providing a chronological record of business activity q. the recording of a transaction in which debits equal credits; it usually includes a date and an explanation of the transaction
2-10 Chapter 2
Exercise 2-2 (LO3) For each of the following accounts, indicate by letter with an N (for nominal) or an R (for real) whether the account is a nominal (temporary) account or a real (permanent) account.
___ 1. Accumulated Depreciation ___ 2. Buildings ___ 3. Cash ___ 4. Dividends ___ 5. Dividends Payable ___ 6. Allowance for Bad Debts ___ 7. Accounts Receivable ___ 8. Cost of Goods Sold ___ 9. Depreciation Expense ___ 10. Sales Revenue ___ 11. Retained Earnings ___ 12. Common Stock ___ 13. Income Tax Expense ___ 14. Income Tax Payable ___ 15. Advertising Expense ___ 16. Prepaid Advertising ___ 17. Unearned Revenue ___ 18. Bad Debt Expense
Problems
Problem 2-1 (LO2) Record the following transactions and events of the Renato Galasso Company in general journal form. If the item does not require a journal entry, write “no entry.”
a. Sold services worth $8,000 for $1,000 cash and $7,000 on account. b. Purchased land and building for $80,000 cash and a $320,000 mortgage. The land was recently appraised at $70,000 and the building at $330,000. c. Received payment on account, $5,000. d. Estimated that utilities expense for the coming six months will total $10,000. e. Paid a cash dividend totaling $13,000.
Chapter 2 2-
Problem 2-2 (LO2) For each of the journal entries below, write a description of the underlying event.
a. Cash xxx Capital Stock xxx
b. Interest Expense xxx Notes Payable xxx Cash xxx
c. Cash xxx Unearned Revenue xxx
d. Supplies xxx Cash xxx
e. Cash xxx Accounts Receivable xxx
Problem 2-3 (LO3) The information listed below was obtained from the accounting records, by taking physical counts, and through inquiry of employees of Ringrose Company as of December 31, 2011.
a. Interest on a note receivable of $400 had been earned, but none of it had been received or recorded by December 31, 2011. b. On December 28, 2011, Ringrose received $5,000 in cash in advance for services to be performed in 2012. The $5,000 was credited to Sales Revenue. c. Building and land were purchased in 2000 for $780,000. The building's fair market value was $650,000 at the time of purchase. The building is being depreciated over a 25-year life using the straight-line method, and assuming no salvage value. d. On November 1, 2011, $100,000 was loaned to a shareholder on a 6-month note with interest at an annual rate of 12 percent. Interest is due at maturity. No interest was accrued at the end of November. e. Accrued salaries and wages are $3,100 at December 31, 2011. They will be paid on January 4, 2012. f. The Office Supplies account has a balance of $3,500. An inventory of supplies revealed a total of only $500 actually on hand.
Prepare journal entries to adjust the books of Ringrose Company at December 31,
Chapter 2 2-
Problem 2-5 (LO3) Presented below is the December 31 trial balance of Coles Company.
Coles Company Trial Balance December 31, 2011
Debit Credit Cash $ 14, Accounts Receivable 33, Allowances for Bad Debts $ 2, Inventory 62, Furniture and Equipment 67, Accumulated Depreciation 26, Prepaid Insurance 4, Notes Payable 22, Common Stock 72, Sales 480, Cost of Goods Sold 320, Sales Salaries Expense 40, Advertising Expense 5, Administrative Salaries Expense 52, Office Expense 4, $603,440 $603,
Prepare the closing entries for Coles Company. What was Coles Company’s net income for the period just ended?
Problem 2-6 (LO4) Manami Company earned $50,000 during 2011 and incurred expenses (except taxes) of $30,000. They only collected $30,000 of their earnings, however, as their Accounts Receivable balance increased by $20,000 during 2011. Manami Company incurred all of their expenses on credit, paying off $20,000 of them, meaning their Accounts Payable account increased by $10,000 during 2011.
Manami Company obtained a loan of $10,000 on the last day of the year. Assuming a 30 percent tax rate and $5,000 in taxes actually paid, what is Manami Company’s net income on an accrual basis for 2011? On a cash basis, did their cash increase or decrease and by how much for 2011?
2-14 Chapter 2
Solutions, Approaches, and Explanations
MC2-
Answer: b Approach and explanation: Notice the not. Underline it, highlight it, circle it, or do whatever it takes so that you don’t just immediately choose the first choice that is one of the first four steps.
Always examine the exhibits in the chapter. Don’t skip them just because they aren’t part of the main text body or because some are quite large. They aren’t put there merely to take up space and allow you to read a long chapter faster by only having to deal with the main body of text. Some are of critical importance and some should actually be committed to memory. Exhibit 2-1 is one that should be read but need not be memorized. Get a feel for the accounting process and where things fit, but there is little value in knowing, for instance, that Step 5 is “Adjustments.”
Notice, from Exhibit 2-1, that the first few steps involve getting a company’s day-to-day transactions into the system. That is only logical. A company can’t close the books or issue financial statements without first processing the normal transactions. The latter stages of the accounting process are going to be the items that come after the day-to- day transactions, at month, quarter, or year end (what accountants in the industry refer to as “the close”), which is their busiest time of the month. These items include adjusting the books, closing the books, and the creation of financial statements.
So for a question like this, if it asks for first steps you are looking for day-to-day transaction activity, and if it asks for last steps (as in this case), you are going to look for end-of-period activity. Choices a , c , and d are the day-to-day activities so choice b , an end-of-period activity, is going to be the only logical choice.
MC2- Answer: c Approach and explanation: If you are a visual learner, it may help to sketch out T- accounts for the accounts involved. There are examples of T-accounts in the textbook in LO3 for this chapter. Basically, one for Cash would look like the following:
Cash
A T-account represents what is happening to an account’s balance in the general ledger. Numbers on the left are debits that increase asset account balances, and numbers on the right are credits that decrease asset account balances.
2-16 Chapter 2
MC2-
Answer: d Approach and explanation: First, think of the definition of accrual (which is covered in LO4—not LO2). Under the accrual method, revenues are earned when a good is delivered or when a service is performed—not necessarily when cash is received. Expenses are recognized when an item is consumed or as incurred—not necessarily when cash is paid. Therefore, choice b cannot be correct. The other choices have more to do with an accounting system than accrual measurement.
Remember that debits go on the left and credits on the right. Debits and credits are no more mysterious than that. One isn’t “good” or “bad.” Therefore, choice d is a true statement. Choices a and c are both false because assets (left-hand side of the balance sheet) and expenses (contra-kind of account to equity which is on the right-hand side of the balance sheet) both have normal debit balances.
MC2- Answer: a Approach and explanation: Remember from the How? under LO2 on page 2-3 that transactions start in journals and then move on to ledgers. From the ledgers, a trial balance can be derived. Financial statements are the last step in the process, the data used to prepare them coming from the trial balance. There are no debits and credits in the financial statements, but there are in the other three choices. So the question gets back to which comes first and that would be the journal. The debits and credits first determined (to initially record the entry in a journal) merely flows through to the other items. The numbers don’t switch from being a debit to being a credit (or vice versa) when they are posted to ledgers or when eventually listed as part of an account balance in a trial balance.
MC2- Answer: b Approach and explanation: What do adjusting entries involve? At least one balance sheet and at least one income statement account. With that in mind, you can safely cross out choices a and c. Since the expense has not yet been recorded, you know that the answer has to include an expense account, so that eliminates choice d. Through a process of elimination, you now know that the correct choice must be b.
Incurred (or accrued) expenses are frequently the most common type of adjusting entry. Examples include wages earned by employees but not yet paid, interest incurred on debt that is not due until the following month or at maturity of the debt, taxes for the period that will be paid in the following period, and utilities and other kinds of bills that have been received for costs that have been incurred (or costs that have been incurred for which the bill has yet to be received) which are still owed at period end and will be paid in a subsequent period.
Chapter 2 2-
MC2-
Answer: b Approach and explanation: Before looking at the choices, write down what the journal entry is to record the accrual of wages as follows:
Salaries and Wages Expense xxx Salaries and Wages Payable xxx
Then think of what this (or rather the lack of the above entry) means to the accounting system. It means that expenses are understated, and hence, income is overstated and so is equity once income is closed out to Retained Earnings. It also means that liabilities are understated.
MC2- Answer: d Approach and explanation: There are two things you should do before ever looking at the choices. The first is to circle, underline, or highlight not in the question. The second is to write out what the entry would be to record expired prepaid insurance. You should come up with the following:
Insurance Expense xxx Prepaid Insurance Expense xxx
Then, looking at the above entry, think, or better yet write out, what would happen if this didn’t take place. Answers include the following: Expenses are understated. Net income is overstated. Retained earnings will eventually (after the closing entry) be overstated. Equity will eventually (after the closing entry) be overstated. Assets are overstated.
Now you can look at the choices and see that three of them match the list. Liabilities aren’t affected, so it being off is the correct choice (since we are looking for the not ).
One final point to make, in case you missed it while reading the chapter in the textbook, is that Prepaid Rent Expense or Prepaid Insurance Expense is a tricky name for an asset. A caution in the textbook explained that prepaids are always assets and should not be confused with expenses found on the income statement even if they have the word expense in the account name. (In practice you will see the accounts called various names including, for instance, Prepaid Insurance Expense or just Prepaid Insurance which reduces the confusion.)
Chapter 2 2-
MC2-
Answer: a Approach and explanation: The key point made in LO5 is that professional judgment is just as important as ever with the advent of computers processing accounting data. Other points made included that document trails can be lost if the system isn’t adequately designed and the importance of a good design in the creation of the information system.
Financial reporting standards are not affected by computers at all. Hence, choice c can be eliminated. Answers that include the word “always” are always suspect (pun intended). Circle the word “always” or “never” when you encounter it in a multiple choice question just like you would the word “not.” Choices with “always” or “never” are seldom the correct answer and choice d is no exception. If choice b were the correct one, do you really think the chapter would also talk about the double-entry system?
Matching 2-
- g
- i
- a
- o
- h
- d
- q
- e
- p
- b
- j
- c
- f
- m
- k
- n
- l
Complete these terminology matching exercises without looking back to the textbook or on to the glossary. After all, you probably won’t have those as a reference at test time. Learning through trial and error causes the item to be learned better and to stick in your memory longer than if you just look to the textbook, glossary, or a dictionary and “cook book” the answers. Sure you may get the answer correct on your first attempt, but missing something is sometimes best for retention. Don’t be afraid of failure while studying and practicing.
2-20 Chapter 2
Matching 2-
- f
- h
- a
- c
- g
- d
- e
- b
Exercise 2- If debits and credits are still giving you problems, sketch out the diagram on page 2- for the first nine of these accounts. Then cover it up for the last nine and see how you do. If you miss any, try doing this exercise again tomorrow until you have debits and credits down well.
- D (Remember that Accumulated Depreciation is a contra-asset account, so it moves in the opposite direction typical assets move.)
- I
- I
- I (Be careful! Although Dividends move like expenses, they do not show up on an income statement.)
- D
- D (Allowance for Bad Debts is similar to Accumulated Depreciation in that it is a contra-asset account.)
- I
- I (As counter-intuitive as it may seem at first glance, expenses do move in the same direction as assets. Remember that debits are not good or bad things. They are merely the left side of entries.)
- I (Since this account increases when Accumulated Depreciation does, it makes sense that it moves in the opposite direction as Accumulated Depreciation.)
- D
- D
- D
- I
- D
- I
- I
- D
- I
