Week 2 Key Concepts

Question 1

adjusting journal entries

Answer 1

Adjust the account balances to achieve:
a proper matching of costs and expenses with revenue
each period

to achieve a proper matching of costs and expenses with revenue, we must adjust the account balances at the end of each accounting period before financial statements
are prepared to reflect what has been earned and expensed in the period (income statement) and
what remains to be used or paid in future terms (balance sheet).

Question 1

deferred costs

Answer 1

recognizing expense in a future period despite cash was paid and recorded

Question 2

accrue expenses

Answer 2

recognizing expense in the current period even before cash is paid.

Question 3

accrue revenue

Answer 3

recognizing revenue in this period even before cash is received.

Question 4

deferred revenue

Answer 4

recognizing revenue in a future period despite cash was received and recorded.

Question 5

trial balance

Answer 5

lists all accounts and report their ending balances. If done before Adjusting Journal
entries it is an unadjusted trial balance; if done after AJE, it is an adjusted trial balance. A balanced
trial balance simply proves that as recorded, debits equal credits.

Question 6

sequence of financial statement preparation

Answer 6

prepare the income statement first, the bottom line
of this statement (net income or loss) is needed to prepare the Statement of Owner’s Equity. The
new total in this second statement is then used in the Owner’s Equity section of the Balance Sheet.
The linkage of these three statements is called “articulation”.

Question 7

proprietorship

Answer 7

The simplest form of organization, in which a single individual, who typically
also manages the business, owns an unincorporated business. Proprietorships do not report income
taxes on their income statements and show only a single amount, called Owner’s or Proprietor’s
Equity or Capital, on their balance sheet.

Question 8

corporation

Answer 8

: is a separate legal entity distinct from its owners, its shareholders. A corporation
issues shares to raise capital. The liability of a shareholder is limited to their investment in the
shares of the corporation. Ter balance sheet reports amounts received from share issue (Share
Capital or Capital Stock) separately from Retained Earnings - the accumulated earnings from the
time the corporation began, less the total of any distributions to shareholders (Dividends).

Question 9

partnership

Answer 9

is an agreement between partners who have unlimited liability. It is now possible to
form Limited Liability Partnerships so that the liability of all but a general partner is more limited.
Tax and accounting treatments is similar to a proprietorship.

Question 10

accounting cycle (manual records)

Answer 10

1. Analyze transaction
2. Journalize transaction
3. Post journal entry
4. Trial balance (unadjusted)
5. Adjusting entries
6. Trial balance (adjusted)
7. Financial Statements

Question: How do these steps differ if we are using
computerized accounting software?
Same….but computer handles 3, 4, 6 & 7

Question 11

The system of debits and credits

Answer 11

is a syntax for describing accounting transactions and their posting (recording) in accounts. The system is concise and helps prevent and detect entry errors

Question 12

Adjusting entry needed when:

Answer 12

revenue and expenses are
recognized in different periods than the period in which cash is exchanged

(deferred costs and revenues)

Always have to do AJE’s
before preparing F/S

Question 13

Accrue

Answer 13

recognize expense or
revenue in the
current period

• cash is exchanged in
  a future period

Question 14

Defer

Answer 14

put off recognizing
expense or revenue

• cash has already
  been exchanged

Question 15

Example of deferred costs

Answer 15

Example:
buy supplies for $1000 and set up as prepaid
asset

–by end of period some probably used up (say $300)
–need to reallocate costs from balance sheet to income
statement
–Balance Sheet can be viewed as pool of “unexpired
costs” on an inevitable march to the income statement
as they expire

Deferred cost example
Purchase initially recorded as asset
Dr Supplies on hand $1,000
Cr Cash or A/P $1,000
And if $300 of supplies was used during the
period then the adjusting entry is:
Dr Supplies expense $ 300
Cr Supplies on hand $ 300

Question 16

Example of deferred revenue

Answer 16

Example:
Magazine subscription for 36 months received
from customer

Assume the 36 month subscription was for $360
Dr Cash 360
Cr Unearned Subscription Revenue 360
and a third of it was earned during the first year (no
monthly financials) then the adjusting entry is:
Dr Unearned Subscription Revenue 120
Cr Revenue 120

Question 17

Example of expenses that need to be accrued

Answer 17

Example:
Company uses hydro and water and has
not yet been billed by the city

We have provided (sold) water and hydro to
customers but have not yet sent out invoices

If we prepare a monthly income statement we want it
to reflect this revenue since it is earned

Question 18

The “backwards” system

Answer 18

The “backwards system” is an accounting method where instead of immediately counting cash transactions as revenue or expenses, they are first recorded as deferred on the balance sheet. At the end of the period, any unused portion is then adjusted back onto the balance sheet.

Question 19

Example of backward system:

Answer 19

If three months rent is paid on the first of the month
and is initially recorded fully as an expense
Dr Rent $ 750
Cr Cash $ 750

But if the rent for the month is only $250 then the adjusting entry
is:
Dr Prepaid Rent $ 500
Cr Rent Expense $ 500

Question 20

Adjusting Journal Entries
At period end before financials can be
prepared:

Answer 20

– Deferred costs and revenues on the B/S may
need potential allocation to the I/S
– Revenues earned and costs incurred but not
yet set up must be properly accrued

Question 21

AJE Example: an expense that needs accruing

Answer 21

If workers work but are not paid during the month an adjusting entry is required

dr Wage expense
cr Wages Payable

and then when workers are actually paid the wages owed in a later period, the Wages Payable account is debited

dr Wages Payable
cr Cash

Note that the expense recognition is all in the previous period when it was actually incurred

If a company had not yet invoiced for
services it rendered, at period end an
adjusting entry would be required

Dr Accounts receivable
Cr Service Fees Revenue

If a company had not yet been invoiced for
services rendered to it, at period end an
adjusting entry would be required

Dr Service Expense
Cr Accounts Payable

Question 22

Depreciation

Answer 22

• Classic example of an adjusting entry

Any asset with multi-period utility to create revenue streams is
initially stored on the Balance Sheet
* Each period some of that utility is consumed and we must
recognize this by transferring part of it from the Balance
Sheet asset (the place for unexpired costs with future utility) to the
Income Statement as expense (where we send expired costs)

Question 23

Formula for Straight Line Depreciation

Answer 23

Period expense to be recognized = (original asset cost – residual value) / (number of periods of expected utility)

Question 24

Depreciation Example

Answer 24

Recall in Week 1 we had a business buy a taxi for
$38,000 that was expected to last for 3 years at which
time it is a piece of junk and can be sold to a needy
2500 student for $2000.

• Period expense =
  ($38,000 - $2,000) / (36)
  = $1,000 per month (or $12,000 per year)

At time of purchase:
Dr Equipment
Cr Cash

Monthly adjusting entry:
Dr Depreciation expense
Cr Accumulated Depreciation

Entry to set up the asset:
Dr Automobiles $38,000
Cr Cash $38,000

Entry for monthly depreciation
Dr Depreciation Expense $1,000
Cr Accumulated Depreciation $1,000

Question 25

• After adjusting entries and trial balance

Answer 25

Statements can be copied from the T/B
*Formatting Conventions exist
*Order matters (because of articulation)

*Income Statement 1st
*Owner’s Equity Statement 2nd
*Balance Sheet 3rd
*Cash Flow Statement 4th

Question 26

Income Statement Template

Answer 26

NI = revenues - expenses

Question 27

Owner’s Equity Template

Answer 27

Opening Balance of Owners Equity+ Additional Investment
-Drawings (or withdraws)
+ Net Income (or minus net loss)
= Ending Balance of Owner’s Equity

Note the articulation:
- Opening balance from last year B/S
- Net Income from Income Statement
- Ending balance goes to this year’s B/S

Question 28

Statement of Retained Earnings Template

Answer 28

Opening Balance of Retained Earnings
- Dividends
+ Net Income (or minus net loss)
= Ending Balance of Retained Earnings

Question 29

Balance Sheet Template

Answer 29

Equity = assets - liabilities

Question 30

Shareholders Equity on B/S

Answer 30

Shareholders Equity
Capital Stock……………$$$
Retained Earnings………$$$
Total………………………$$$

Question 31

Template for Cash Flow Statement

Answer 31

Cash Provided By:
Operations
Financing activities
Investing activities
Total………………………………$$$

Cash Applied To:
Financing activities
Investing Activities
Total………………………………$$$

Net Change in Cash for the period….……………..$$$

Note there are two allowed GAAP formats (the other format is condensed and just
shows net investment and net financing)

Question 32

Cash from Operations

Answer 32

Operations over the long run must be the primary
source of cash for every business

• You cant keep borrowing cash forever
• Investors wont keep pumping in more
  investment forever
• A firm that repeatedly has negative cash flow
  from operations is on a boat ride to oblivion

Question 33

Financing Activities

Answer 33

Principally:
*Acquiring & retiring long term debt
*Making additional equity investment or
divestment

Question 34

Investing Activities

Answer 34

Principally:
Buying & selling of long term assets