Financial Accounting Basics for Foundation Management Experience (FME)

8/14/2019 Financial Accounting Basics for Foundation Management Experience (FME)

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Financial Accounting Basics

For

Foundation Management Experience(FME)


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Financial Accounting Basics

For

Foundation Management Experience

Copyright 2003 by Dr. Henry N. Deneault and Dawna Travis Dewire of Babson College.

All rights reserved. This material may not be reproduced in any manner or form without the

authors prior, written permission.


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INTRODUCTION

This booklet has been created for use in Babson Colleges Foundation Management

Experience (FME) course. The Foundation Management Experience course is a full-yearintroductory course designed to expose students to key management and information

systems principles and techniques.

Central to the course is a learn by doing approach and sensitivity toward sociallyresponsible and ethical behavior. Students in FME organize into groups of 30 and are

responsible for developing and implementing an actual business for which the Collegeprovides seed capital. The seed money is expected to be paid back to the College. Profits

generated by the business activity are used to support a charitable project that the students

are required to coordinate. This booklet contains the financial accounting basics well becovering in FME. The Appendix should prove especially useful to students as they createtheir own set of accounting records for the FME businesses theyll be running during the

Spring Semester.


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TABLE OF CONTENTS

INTRODUCTION..................................................................................................... 4Chapter 1 The Basics of Financial Accounting .............................................................. 9

1.1 What Is Accounting ? ................................................................................9

1.2 Who Uses Accounting Information ?............................................................. 91.3 Basic Accounting Terminology................................................................... 10

Assets................................................................................................. 10

Liabilities ............................................................................................. 10

Equity ................................................................................................. 10Revenue .............................................................................................. 10

Expenses ............................................................................................. 11Net Income .......................................................................................... 11

1.4 Financial Statements............................................................................... 11

Income Statement................................................................................. 11

Statement of Retained Earnings ............................................................... 12Balance Sheet....................................................................................... 13

Statement of Cash Flows ........................................................................ 141.5 Financial Accounting Standards (GAAP) ...................................................... 15

1.6 Summary .............................................................................................. 15

1.7 Key Terms from Chapter 1 ....................................................................... 15Chapter 2 Business Transactions.............................................................................17

2.1 The Financial Position Of A Firm ................................................................ 17

2.2 Investing in the Firm............................................................................... 17

Investment by Owners ........................................................................... 18Additional Cash Provided by Borrowing ...................................................... 18

2.3 Purchasing Assets................................................................................... 19Purchasing Assets with Cash.................................................................... 19Purchasing Assets on Credit .................................................................... 19

Purchasing an Asset with Cash and Credit .................................................. 20

2.4 Making a Sale Earning Revenue.............................................................. 20Earning Revenue and Receiving Cash ........................................................ 20

Earning Revenue through Credit Sales....................................................... 212.5 Collection of an Account Receivable ........................................................... 21

2.6 Payment of a Liability.............................................................................. 22

2.7 Paying Expenses .................................................................................... 222.8 Paying a Dividend................................................................................... 232.9 Summary............................................................................................... 26

2.10 Key Terms from Chapter 2 ...................................................................... 27

Practice Problems for Chapter 2 ...................................................................... 28BBP in August ....................................................................................... 28

Phranques Photography Studio, Inc.......................................................... 29Chapter 3 Accrual Accounting.................................................................................31

3.1 Accrual Accounting and The Matching Principle ............................................. 31

3.2 The Matching Principle.............................................................................. 32

3.3 Accounting Periods And The Need For Adjustments....................................... 323.4 Types Of Adjusting Entries ........................................................................ 32

3.5 Deferred Expenses.................................................................................. 32Prepaid Rent......................................................................................... 33

Prepaid Insurance.................................................................................. 34

Supplies............................................................................................... 34


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3.6 Depreciation .......................................................................................... 35Straight-Line Method.............................................................................. 36

3.7 Deferred Revenue................................................................................... 37

3.8 Accrued Expenses................................................................................... 38

Accrued Wages ..................................................................................... 38Accrued Interest.................................................................................... 39

3.9 Accrued Revenues .................................................................................. 403.10 Summary ............................................................................................ 41

3.11 Key Terms for Chapter 3 ........................................................................ 42

Practice Problems for Chapter 3 ...................................................................... 43Chapter 4 Merchandising Operations .......................................................................45

4.1 Comparison of Income Statements............................................................. 45

4.2 Cost of Goods Sold .................................................................................. 46

4.3 Gross Margin ......................................................................................... 474.4 Operating Expenses ................................................................................. 47

4.5 Net Income Before and After Taxes ........................................................... 474.6 Periodic And Perpetual Inventory Systems .................................................. 48

Perpetual Inventory System.................................................................... 48

Periodic Inventory System...................................................................... 49

4.7 Methods For Valuing Inventory ................................................................. 50Specific Identification Method .................................................................. 51

Average Cost Method ............................................................................. 51First-In, First-Out (FIFO) Method.............................................................. 52

Last-In, First-Out (LIFO) Method .............................................................. 53

4.8 Selection of Inventory Valuation Methods ................................................... 544.9 Summary .............................................................................................. 54Key Terms for Chapter 4................................................................................ 54

Chapter 5 The Statement of Cash Flows....................................................................57

5.1 Classifying Activities On The Statement Of Cash Flows .................................. 57Operating Activities................................................................................ 57

Investing Activities ................................................................................ 57

Financing Activities................................................................................ 585.2 Preparing The Statement Of Cash Flows ..................................................... 58

A Comment about Cash Flow from Operating Activities................................. 585.3 Step #1: Determining Cash Flow from Operating Activities ........................... 59

Determining Cash Receipts from Sales ...................................................... 60

Determining Cash Payments for Purchases................................................. 61

Determining Cash Payments for Operating Expenses ................................... 63Determining Cash Payments for Interest.................................................... 64

Determining Cash Payments for Taxes ...................................................... 655.4 Step #2: Determining Cash Flows from Investing Activities........................... 66

5.5 Step #3: Determining Cash Flows from Financing Activities ........................... 67

5.6 Step #4: Putting It All Together Completing The Statement of Cash Flows... 68Practice Problem for Chapter 5........................................................................ 69

Chapter 6 A Basic Introduction To Analyzing Financial Statements.................................736.1 Purposes of Financial Statement Analysis ..................................................... 736.2 Sources Of Financial Information................................................................ 73

6.3 Types of Financial Analysis ........................................................................ 74

Horizontal Analysis ................................................................................ 74Vertical Analysis .................................................................................... 76

6.3 Ratio Analysis ........................................................................................ 78

Tests of Liquidity................................................................................... 78

Current Ratio ........................................................................................ 78


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Quick Ratio ........................................................................................... 78Receivables Turnover............................................................................. 79

Accounts Receivable Period ..................................................................... 80

Inventory Turnover................................................................................ 80

Inventory Days On Hand (DOH) ............................................................... 816.4 Tests Of Profitability................................................................................. 81

Gross Profit Margin ................................................................................ 81Net Profit Margin ................................................................................... 82

Asset Turnover...................................................................................... 82

Return On Assets (ROA) ......................................................................... 83Financial Leverage Ratio ......................................................................... 84Return On Equity (ROE).......................................................................... 84

Analysis Of ROE Components (Aka Dupont Analysis).................................... 85

Earnings Per Share (EPS)........................................................................ 856.5 Tests Of Solvency.................................................................................... 86

Debt To Equity Ratio .............................................................................. 86Interest Coverage Ratio (Times Interest Earned)......................................... 86

6.6 Tests Of Market Strength.......................................................................... 87

Price/Earnings Ratio (P/E Ratio) ............................................................... 87

6.7 Summary............................................................................................... 88Illustrations for Chapters 1-4................................................................... 89

Solutions To Practice Problems ........................................................................ 93For Chapter 2............................................................................................... 93

Practice Problem #1 from Chapter 2 ......................................................... 93

Practice Problem #2 from Chapter 2 ......................................................... 96Practice Problems from Chapter 3............................................................. 99

Practice Problems For Chapter 4.....................................................................100

Practice Problems from Chapter 5............................................................102


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Chapter 1

The Basics of Financial Accounting

1.1 What Is Accounting ?

All organizations, whether they are profit-seeking businesses, not-for-profit

organizations, or even governments need accounting information. Managers in theseorganizations rely on having up-to-date, accurate and relevant financial information in order

to understand and evaluate financial and operating performance and to use in makingdecisions about the future. This information is provided by an organizations accounting

information systems. For businesses, accounting is the process of measuring, recording,storing, summarizing and communicating economic information.

As students in FME, you will be creating and operating actualbusinesses during your first year at Babson. Consequently, youllneed to produce, understand and evaluate accounting information

in order to assess the performance of your FME businesses on anongoing basis. In fact, the communication of accounting

information about the financial and operating performance of your

businesses will constitute a major portion of the presentations youwill be doing in the fall term as you work to develop your business

concept, the weekly presentations you will do in the spring termto communicate the progress your business has made, and the

final presentation youll be required to make at the end of thespring term.

1.2 Who Uses Accounting Information ?

Theres no question that managers need accounting information. Otherwise, how would

they know if their company was achieving its financial objectives if it was profitable? Onwhat basis would a companys managers be able to make financial and other decisions

affecting the firms future without the data provided by an accounting information system?

Many individuals and institutions with a direct financial interest in a company rely

heavily on the information the firms accounting systems provides. Current owners areinterested in a companys profitability and want to know what kind of return theyre gettingon their investment. Prospective investors are interested in studying a companys financial

situation carefully to assess possible risks and try to project the potential rewards

associated with making an investment in the firm. Banks and other lending institutions

want to know about the financial health of a company and are especially interested inprojecting the firms ability to repay loans when they are due. Suppliers may wish to

analyze a companys financial condition before allowing it to make purchases on credit.Other interested consumers of accounting information about companies include the

Internal Revenue Service, state governments and other taxing authorities (for obvious

reasons). Government regulatory agencies comprise still another set of users of accountinginformation. For example, all publicly-held corporations must periodically provide financial

information to the Securities and Exchange Commission (SEC). Labor unions, consumers

groups, customers, and the general public add to the list of users of accounting information.

Accounting is theprocess of

measuring,recording, storing,

summarizing andcommunicating

economicinformation.


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1.3 Basic Accounting Terminology

In order to get started in your understanding of financial accounting, we need to firstcover some basic accounting terminology. Lots of folks frequently refer to accounting asthe language of business. So, how do you begin learning a new language? You begin by

mastering some basic vocabulary. Heres some important accounting terms youre going to

see and use over and over again.

Assets

Assets are economic resources (i.e., things of value) owned by

a business that are expected to provide benefit to the firm in thefuture. Assets are economic resources (i.e., things of value)

owned by a business that are expected to provide benefit to the

firm in the future. Some assets are monetary in nature, such ascash or accounts receivable (money owed the company by itscustomers who have purchased goods and/or services on credit).

Other assets are physical in nature. Examples include land,

buildings, equipment, supplies, merchandise inventories and raw

materials. Still other assets are intangible in nature (e.g., patents, copyrights).

Liabilities

Liabilities represent the obligations a business has to pay

others. In a sense, liabilities represent the claims creditors haveon the assets of the firm. Typical examples of liabilities include

money owed to suppliers for items purchased on credit (i.e.,accounts payable), bank loans, wages owed to employees, andtaxes owed the government. Liabilities may also include

obligations to provide future services for which the firm has already been paid (e.g., the

mailing of magazines to subscribers).

EquityEquity refers to the economic resources owned by a business

that are expected to provide benefit to the firm in the future. Also

called capital or net worth, equity represents the claims of a firmsowners on the assets of the business and usually consists of two

components: contributed capital and retained earnings.Contributed capital includes direct investments made byindividuals in return for an ownership interest in the firm.

Retained earnings represents the cumulative total of acompanys income since its inception less any dividend payments

(distributions of profits) made to the firms owners over the years.

Revenue

Revenue represents the inflow of assets a firm receives (cashor accounts receivable) as a result of carrying out its operations

and providing goods and/or services to its customers. Forexample, the sale of two end zone tickets for $55 each wouldrepresent $110 in revenue for the New England Patriots. Revenue

has the effect of increasing a firms equity (via its retained

earnings).

Assets areeconomic resources

owned by a

business that areexpected to providebenefit to the firm

in the future.

Liabilitiesrepresent the

obligations abusiness has to pay

Equity refers tothe economic

resources ownedby a business that

are expected to

provide benefit tothe firm in thefuture.

Revenue

represents theinflow of assets a

firm receives as a

results of carryingout its operationsand providing

goods and/or

services to itscustomers.


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revenue to produce a net income before taxes of $2,150. (Well ignore taxes for now.)Companies are required to prepare an Income Statement at least once a year. Many firms

prepare financial statements on a quarterly basis. Still other firms prepare statements

every month.

Boyle Brothers Painting, Inc.Income Statement

For the Month Ended July 31, 20xx

Revenue:

Sales from House Painting $ 3,700

Expenses:Wage Expense $ 600

Rent Expense 300Utilities Expense 150

Supplies Expense 500

Total Expenses 1,550Net Income Before Taxes $ 2,150

Statement of Retained Earnings

A Statement of Retained Earnings is completed each time an

Income Statement and Balance Sheet are prepared and showshow a firms retained earnings have changed over a specific

period of time. In the case of BBP, Inc., the Statement of

Retained Earnings shows the changes in retained earnings fromthe beginning of July, 20xx until the end of the month.

Boyle Brothers Painting, Inc.

Statement of Retained EarningsFor the Month Ended July 31, 20xx

Retained Earnings, July 1, 20xx $ 0

Add: Net Income 2,150Subtotal 2,150

Less: Dividends 1,500Retained Earnings, July 31, 20xx $ 650

The Statement of Retained Earnings for BBP, Inc. shows that the company began the

month with no retained earnings, added income of $2,150, and then deducted dividends of$1,500 to arrive at its end-of-month retained earnings balance of $650. In the next section

you will see that retained earnings make up part of a firms equity.

The Statement of

RetainedEarnings shows

how a firms

retained earningshave changed over

a specific period oftime.


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Balance Sheet

The Balance Sheet presents the financial position of a business

at a specific point in time. BBPs Balance Sheet (below) shows

the monetary values associated with the firms assets, liabilitiesand equity as of the close of business on July 31, 20xx. Since the

Balance Sheet shows a firms financial position at a specific pointin time, you might consider it as sort of a financial photograph.

Notice that the total assets ($23,650) equal the total claims

against them by creditors (liabilities of $13,000) and the firmsowners (equity of $10,650), hence the name of the statement

the Balance Sheet. As you will learn, this reflects what is called the Balance SheetEquation: Assets = Liabilities + Equities.

By viewing the firms assets, we can see that BBP had $12,850 in cash (on hand and in

the bank) at the end of July. We also know that $500 remains to be collected from thefirms customers (Accounts Receivable), and that $300 worth of supplies are on hand as of

July 31. Beyond this, the company owns equipment costing $1,500 and a truck costing

$8,500.


Balance Sheet

As of J uly 31, 20xx

Assets Liabilities

Cash $ 12,850 Accounts Payable $ 1,000

Accounts Receivable 500 Notes Payable 12,000Supplies 300 Total Liabilities $ 13,000

Equipment 1,500

Truck 8,500 Stockholders Equity

Common Stock $ 10,000

Retained Earnings 650Total Stockholders

Equity $ 10,650

Total LiabilitiesTotal Assets $ 23,650 & Equity $ 23,650

Claims against these assets come from both the firms creditors and its owners. BBPowes a total of $13,000 as of July 31, 20xx (i.e., $1,000 in accounts payable; $12,000 innotes payable). The amount of direct funds invested into the business by the owners total

$10,000. In addition, BBP has $650 in retained earnings (i.e., profits that have been kept

within the business as opposed to being paid out to the firms owners as dividends). Notethat the $650 in retained earnings appearing in the equity section of the Balance Sheet hasbeen provided by the calculation performed on the Statement of Retained Earnings (shown

earlier).

The Balance

Sheet presents thefinancial position of

a business at aspecific point in

time.


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actually used to purchase the equipment (as you will see, BBP only paid $500 on theladders and such that they bought as equipment).

1.5 Financial Accounting Standards (GAAP )

Lets assume youre a financial advisor with clients who rely on you for investment

advice. Or, perhaps, youre a bank loan officer responsible for reviewing loan applications

from hundreds of companies each year. Think how difficult (if not impossible) your job

would be if every set of financial statements you reviewed were prepared differently. Ifthere were no rules or guidelines governing the preparation and presentation of accounting

information, there would be chaos. With everyone following different methods formeasuring, recording, summarizing and communicating accounting information, there would

be no way to compare the performance of one company versus another, or to have even a

basic level of confidence in the reliability of the information being reviewed.

Fortunately, we are not faced with the scenario described above. A set of rules,

guidelines and procedures, referred to as Generally Accepted Accounting Principles (GAAP),

has been developed over time to define what constitutes acceptable accounting methods

and practice. The Financial Accounting Standards Board (FASB), a private-sector bodyconsisting of seven members selected from the accounting profession, business,government and academia, has responsibility for establishing accounting standards.

Through its pronouncements, called Statements of Financial Accounting Standards, the

FASB helps guide accounting practice and the methods behind the measurements anddisclosures provided in the major financial statements.

1.6 Summary

So far, youve learned that accounting is the process of measuring, recording, storing,summarizing and communicating economic information about an organization. Youve been

introduced to some basic accounting terminology and the four standard financial

statements. The next chapter helps you understand how those statements are generated.

1.7 Key Terms from Chapter 1

Accounting: Accounting is the process of measuring, recording, storing, summarizing andcommunicating economic information about an organization.

Asset: Assets are economic resources (i.e., things of value) owned by a business that are

expected to provide benefit to the firm in the future. They may be monetary, physical or

intangible in nature.

Balance Sheet: The Balance Sheet presents the financial position of a business at aspecific point in time. It is a detailed view of the basic accounting equation and

summarizes the monetary values associated with the firms assets, liabilities and equity.

Contributed Capital: Part of owners equity, contributed capital represents the monetaryvalue of direct investments made into a business by individuals in return for an ownership

interest in the company.

Dividends: Dividends are distributions of earnings paid to the owners of a corporation.


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Equity: Also called capital or net worth, equity represents the claims of a firms owners onthe assets of the business and usually consists of two components: contributed capital and

retained earnings.

Expenses: Expenses are the costs a firm incurs in generating revenue. The cost ofmerchandise sold, wages, advertising costs, interest on loans, sales commissions,

insurance, rent, utilities and taxes are all examples of business expenses. Expenses havethe effect of decreasing a firms equity (i.e., its retained earnings).

Financial Statements: Financial statements are the reports prepared by companies tosummarize and disclose their financial condition. The primary financial statements include:the Balance Sheet, the Income Statement, the Statement of Retained Earnings and the

Statement of Cash Flows.

Income Statement: The Income Statement (also called a Statement of Profit and Loss)

summarizes the revenues earned and expenses incurred by a business over a specific periodof time.

Liabilities: Liabilities represent the obligations of a business has to pay others. They

represent the claims creditors have on the assets of the firm. Typical examples of liabilitiesinclude: accounts payable, notes payable, wages owed to emp loyees, and taxes owed the

government.

Net Income: When revenue for a specific period of time exceeds expenses for the same

period, the difference is called net income. Net Income adds to the equity of a firm (i.e., itsretained earnings).

Net Loss: When expenses for a specific period of time exceed revenue for the same

period, the difference is called a net loss. Net losses reduce the equity of a firm (i.e., itsretained earnings).

Retained Earnings: Retained earnings represents the cumulative total of a companysincome since its inception less and dividend payments made to the firms owners over the

years.

Revenue: Revenue represents the inflow of assets a firm receives (cash or accounts

receivable) as a result of carrying out its operations and providing goods and/or services to

its customers.

Statement of Retained Earnings: A Statement of Retained Earnings is completed eachtime an Income Statement is prepared and shows how a firms retained earnings have

changed over a specific period of time.


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Chapter 2

Business Transactions

2.1 The Financial Position Of A Firm

A companys financial position refers to its economic possessions (assets) and theclaims against them by creditors (liabilities) and the firms owners (equity). Simply put, this

means that everything of value that a firm possesses has been supplied by either the firms

creditors or its owners (or both). This relationship is described by the following basicaccounting equation:

Assets = Liabilities + Owners Equity

As the basic accounting equation suggests, the value of a firms assets at any given time

must equal the total of the claims against them by the firms creditors and owners. Thus,the two sides of the basic accounting equation must always be equal, or in balance. This

relationship provides the foundation for one of the major financial statements we will be

learning about a little later the Balance Sheet.By rearranging the elements in the basic accounting equation, as follows:

Assets - Liabilities = Owners Equity

we can express the relationship between a firms assets, liabilities and equity a little

differently. We can say that what a firm owns (assets) less what it owes (liabilities) isequal to what the firm is worth (owners equity).

An accounting transaction is any economic event or activity involving a businessthat has an impact on its financial position (and the basic accounting equation). Forexample, when a retail clothing store purchases merchandise inventory on credit, it is

engaging in a business transaction. Taking out a bank loan, paying wages, and purchasingsupplies on credit are all examples of business transactions that

affect one or both sides of the basic accounting equation.

Every transaction impacts two or more accounts. An

account is the name given to any basic storage unit foraccumulating accounting data. Cash, Common Stock, and Notes

Payable are all names of accounts.

Weve already looked at Boyle Brothers Painting, Inc.s

financial statements. Lets follow their business activities throughtheir first month of operation and record their business transactions using the basic

accounting equation to see how these financial statements were derived.

2.2 Investing in the Firm

Cash is invested in a business by its founders, often with financial assistance fromfriends, relatives and other investors. Anyone who invests in a company becomes one of

An account is the

name given to aunit for

accumulating

accounting data.


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the owners of the business. In the case of corporations, their ownership is evidenced by theissuance of common stock and the total amount invested appears in the equity section of

the firms balance sheet. In many cases, companies also borrow funds for help in getting

started. Funds provided by lenders become liabilities of the firm since the loans must

eventually be repaid. Unlike investors who directly invest funds into a firm, lenders are notconsidered owners.

Investment by Owners

Assume that Pete and Steve Boyle had asked their father, a local lawyer, to file the

necessary Articles of Incorporation with the state in order to incorporate their new business.As soon as the process was completed, Pete and Steve (armed with their new corporate

Charter) headed off to the bank to get the wheels turning on their new business BoyleBrothers Painting, Inc. At the bank, the brothers opened a checking account in the name of

the business and each deposited $5,000 into the account. In return for their investment,

each brother received 5,000 shares of $1 par value stock in BBP, Inc. Assume all this took

place on July 1, 20xx.

Lets take a look at the impact of this transaction on BBPs financial position and the

basic accounting equation.

Asse ts = Liabili ties + Equity

(a) Cash + 10,000 Common Stock + 10,000

Following this initial transaction, the assets of BBP, Inc. have increased by the $10,000investment made by the Boyle Brothers. Specifically, Cash has increased by $10,000. At

the same time, the firms equity has increased by a similar amount as evidenced by theincrease in Common Stock (i.e., the category showing the owners direct financial

investment in the company). Following this transaction, you should notice that the basic

accounting equation has remained in balance (i.e., assets = liabilities + equity).

Additional Cash Provided by Borrow ing

Although Pete and Steve had invested all the cash they could spare into their new

business, theyve decided that more cash would be needed to get the business up and

running. As such, lets assume they borrowed $12,000 and signed a promissory note with

the bank. The first payment would not be due until September 30, 20xx. Notice that thebasic accounting equation remains in balance following this transaction (shown as item (b)

below).

Assets = Liabili ties + Equity

(b) Cash + 12,000 Notes Payable + 12,000

BBPs liabilities have increased by $12,000. This is shown above by the fact that a

liability account called Notes Payable has increased by $12,000. The fact that liabilitieshave increased by $12,000 is off-set by the $12,000 increase in Cash. Thus, the basic

accounting equation remains in balance. Total assets equal $22,000; the total of the firmsliabilities ($12,000) and equity ($10,000) also equals $22,000.


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2.3 Purchasing Assets

Assets are things of value that are owned by the company. They are consideredeconomic resources that will provide benefit to the firm in the future. Assets may bemonetary, physical or intangible.

Purchasing Assets with Cash

Armed with $22,000 in the company checking account, the Boyle brothers set out tolocate a good used truck for the business. After a few days they located a real cream puff -a 1996 fully-loaded Dodge Ram pickup with racing stripes and fairly low mileage. After

some serious negotiating, a price is agreed upon with the owner and the brothers purchased

the truck for $8,500. They paid cash and wrote a check for the full amount.

As you can see below, this transaction does not change the amount of assets, liabilitiesor equity for the business. The only change occurs in the mix of assets. Simply put, the

brothers have exchanged one form of asset (i.e., cash) for another form of asset (i.e.,

equipment the truck). Consequently, the financial position of the firm has not changed,nor has the fact that the basic accounting equation remains in balance (as it should

following any transaction). The firm still has $22,000 of assets and its liabilities and equitystill total $22,000.

Assets = Liabi lities + Equity

(c) Cash - 8,500

Truck + 8,500

Purchasing Assets on Credit

Next, it was off to Home Depot to buy the supplies needed to get started. After hoursof shopping, Pete and Steve managed to accumulate $800 worth of paint, brushes, dropcloths, pails, paint thinner, sandpaper, etc. They opened an instant charge account with

Home Depot and promised to pay their bill once they had completed a couple of jobs andgenerated some revenue. Heres how this transaction impacts on the firms financialposition.

Assets = Liabiliti es + Equity

(d) Supplies + 800 Accounts Payable + 800

This transaction increases both the assets and the liabilities of BBP, Inc. Supplies have

been acquired, but an obligation to pay $800 at some future point in time has also been

created. An account called Accounts Payable is typically used to designate money owedto suppliers or others from who purchases on credit have been made.

Recall that an earlier liability called Notes Payable was mentioned. The basic

difference between an account payable and a note payable is that the creation of a note

payable is a more formal procedure. When a liability involves a note payable, the borrowerhas signed a formal legal document a promissory note (promise to pay a specified amountof money, typically the amount borrowed along with a designated amount of interest, at a

agreed-upon future date). An account payable is less formal and does not involve signing a

formal legal document. In a sense, its equivalent to simply saying Ill charge it, or merelydelaying payment at the time goods and/or services are purchased.


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Purchasing an Asset w ith Cash and Credit

Pete and Steve sat around beaming over the fact that they were finally in business for

themselves true entrepreneurs. Suddenly, something dawned on them. Its pretty

difficult to paint houses without ladders and staging. They wondered how they could havebeen so dense as to forget these important pieces of equipment. So, it was off to Home

Depot once again. One hour later theyd purchased the necessary equipment at a total costof $1,500. The boys wrote a check for $500 and charged the remaining $1,000.

Assets = Liabiliti es + Equit y

(e) Equipment + 1,500 Accounts Payable + 1,000

Cash - 500

BBP, Inc. has added $1,500 worth of equipment to its assets. This was made

possible through a $500 cash payment (causing the $500 decrease in Cash) and the factthat $1,000 was purchased on credit (evidenced by a $1,000 increase in Accounts Payable).Once again, the basic accounting equation remains in balance. There is a net addition of

$1,000 in assets ($1,500 in equipment less the depletion of $500 of cash) balanced by an

increase of $1,000 in liabilities.

At this point, you should be starting to notice that every accounting transaction (ifrecorded properly) contains additions and/or deletions to assets, liabilities and equity in a

way that will always result in a balance being struck in the basic accounting equation (i.e.,the financial position of the firm).

2.4 Making a Sale Earning Revenue

Revenue is the inflow of assets a firm receives for providing goods and/or services to its

customers. An organization receives either cash (or credit card compensation) for theearned revenue or recognizes it as an accounts receivable the customer owes them the

funds (like an IOU).

Earning Revenue and Receiving Cash

Following a week of worrying, Pete and Steve landed their first house-painting job. Itwas a two-story colonial. Although Pete doesnt like heights, the job went along smoothly

and quickly. The job was completed in five days, thanks to the added labor provided by aretired painter BBP placed on the payroll on an as-needed basis. Pete and Steve were

overcome with joy when they received their check from the homeowner a whopping$2,200. The boys quickly deposited it in the bank. Lets scope out the impact of this

revenue transaction on BBPs financial position.

Youll notice that weve broken down equity into two new categories. Retained earnings

is a component of Equity (as discussed in Chapter 1). Retained earnings is increased ordecreased from the previous period based on the net profit (or net loss) from the current

period. Net profit (loss) is revenue less expenses. From a transaction point of view, thetransactions that impact revenue and expenses can then be considered as equity in the

accounting equation.

Asse ts = Liabilities + Equity + Revenue - Expenses

(f) Cash + 2,200 Revenue + 2,200


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This transaction recognizes an increase in Cash along with an increase in the firmsEquity. Revenue has the impact of increasing Retained Earnings while expenses (and

dividends which are distributions of earnings to the firms owners) reduce a firms retained

earnings.

Earning Revenue through Credit Sales

No sooner had Pete and Steve completed their first painting job when another camealong. This time it was a small ranch for an elderly lady living in their neighborhood. Since

they knew the lady, they quoted her a special rate of $1,500, which she readily accepted.

The boys completed the job within a few days and accepted their neighbors promise to payfor the work in a week or so.

Asse ts = Liabilities + Equity + Revenue - Expenses

(g) Accounts Receivable + 1,500 Revenue + 1,500

The fact that BBP, Inc. did not receive cash upon completionof the job does not alter the fact that it had earned the revenue

from the job. As you will see in more detail later, revenue isrecognized as being earned upon completion of the services to

be delivered (or upon the transfer of title to goods being sold in

the case of merchandising or manufacturing firms), notnecessarily when the cash is received. Since BBP, Inc. hadcompleted painting the house, it had earned the revenue from

the job. In essence, the firm had provided a service in returnfor a promise from its customer to pay at a later date. The

firms claim against the customer for future payment (called an

Account Receivable and often abbreviated as A/R) has valueto the firm and is recognized as an asset. Following this transaction, both BBPs assets and

its equity have increased by $1,500.

Note that when we refer to credit, we are not referring to credit card sales. For ourpurposes, a sale transacted with a credit card is considered a cash transaction. Credit sales

refer to a sale resulting in an accounts receivable.

2.5 Collection of an Account Receivable

True to her word, the elderly lady in Pete and Steves neighborhood made good on herpromise to pay for the house painting job performed earlier in the month. Although she

hadnt been able to accumulate all the money she owed, she did send along a check for

$1,000 with a note indicating the that remaining $500 would be sent in a couple of weeks.Pete and Steve deposited the check the next morning.

Asse ts = Liab . + Equit y + Rev. - Expenses

(h) Cash + 1,000

Accounts Receivable - 1,000

This transaction doesnt affect the amount of assets held by BBP, Inc. It merely changes

the composition (or mix) of the firms assets. Cash is increased by $1,000 reflecting thereceipt of the check. At the same time, the amount of the outstanding claim the firm has

Revenue is

recognized as beingearned uponcompletion of the

services to bedelivered or upon

the transfer of title

to goods beingsold.


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against the customer for payment (i.e., accounts receivable) is reduced by $1,000. Its alsoimportant to note that there is no change in the firms equity as a result of receiving this

payment, since the revenue had already been recognized (i.e., accounted for) at the time

the house painting job was completed earlier in the month.

2.6 Payment of a Liability

Since Pete and Steve were anxious to establish a good credit rating for their new

business, they decided to pay Home Depot the money they owed for the supplies theypurchased earlier in the month. So, on their way down to Wendys for lunch, they stopped

at Home Depot and dropped off a check for $800.

Asse ts = Liabilities + Equity + Rev. - Expenses

(i) Cash - 800 Accounts Payable - 800

Upon payment of the $800, we notice that both assets (Cash) and liabilities (Accounts

Payable) decreased by the same amount. Again, the basic accounting equation remains in

balance.

2.7 Paying Expenses

It was the end of BBPs first month of operation and the Boyle brothers were anxious to

pay some bills that had been mounting up. First, they wrote a check for $600 to pay their

painting helper (see j). Next, the boys sent a $300 rent payment for the month justended to the owner of the small building BBP has been occupying (see k). In addition, the

first months utility bill had just arrived. Pete immediately paid the bill and mailed off acheck for $150 (see l). While Pete wrote checks, Steve went to the storage room to count

up the supplies still on hand (i.e., taking inventory) at the end of the month. Although $800of supplies had been purchased at the beginning of the month, Steves count revealed that

only $300 worth of supplies remain on hand at months end. Thus, $500 of supplies hadbeen consumed and needed to be recognized as an expense (see m).

Asse ts = Liab + Equity + Revenue - Expenses

(j) Cash - 600 Wage Expense - 600

(k) Cash - 300 Rent Expense - 300(l) Cash - 150 Utilities Expense - 150(m) Supplies - 500 Supplies Expense - 500

The first three transactions (j, k. and l) shown above reduce both the firms assets(Cash) and its equity. (Just as revenues increase equity, expenses reduce equity.) The

treatment of supplies (see m) in the above example issomewhat different from paying for various expenses with cash.

In the case of supplies, recall that these were already paid

for with cash earlier in the month. At the time of purchase, thesesupply items were considered additions to the assets of the firm.

Now, at the end of the month, any of the supplies that had beenconsumed (used up) in the operation of the business need to be

recognized as expenses. Thus, we see that expenses are

Expenses are

recognized when

they are incurred,not necessarilywhen they are paid

for.


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recognized when they are incurred, not necessarily when they are paid for. Do you noticethe similarity between the treatment of expenses and our earlier treatment of revenues?

Remember, we noted earlier that revenue is recognized when it is earned, not necessarily

when we collect the money. This method of recognizing revenues and expenses is a very

important accounting concept that we will go into is greater detail in the next chapter.

2.8 Paying a Dividend

It was the end of the month and the Boyle brothers decided to pay themselves adividend. So, they declared and paid out a $1,500 dividend. Since the two brothers are the

sole stockholders in the firm with each holding fifty percent of the ownership (each owns5,000 of the 10,000 shares issued by the firm), each brothers receives a check for $750.

Asse ts = Liab. + Equit y + Revenue - Expenses

(n) Cash - 1,500 Dividends - 1,500

Dividends are not expenses. They are distributions of earnings made to the firms

shareholders. But, like expenses, they reduce a firms equity. Dividends constitute areduction in Retained Earnings. Companies have two choices when it comes to earnings:

(a) they can retain them within the firm to support future growth and operations, or (b)they can distribute all or some of the earnings to the firms owners as dividends. Since the

dividend checks are written on the firms bank account, the payment of dividends to theBoyle brothers reduces an asset (Cash) and reduces BBPs equity (Retained Earnings).

BBP used Excel to keep track of these transactions. Lets take a look at a summary of

BBP, Inc.s transactions for the month.

Look at the account totals for BBP, Inc. at the end of its first month of operation. You

may recall from our earlier discussion that an account is a storage unit for accumulatingaccounting information. Since we measure accounting transactions in monetary units, an

account balance is the monetary amount remaining in an account when we net all theadditions and deletions occurring in that account against one another. For example, recallthat we originally added $800 of supplies to the Supplies account. Later, we reduced the

Supplies account by $500 to reflect the amount of supplies used up during the month.

Thus, the Supplies account balance is $300 ($800 - $500) at the end of the month.Similarly, the Common Stock account was originally increased from 0 to $10,000. Since

theres been no activity in the account during the month, the balance of the Common Stockaccount at months end remains at $10,000.


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Lets review the financial statements presented in the first chapter and reproduced

here. An Income Statement shows revenue and expenses activities during a time period in this case, July. Note the correlation between the account totals in the Revenue andExpense categories of our transactions and the amounts presented in the Income

Statement.


Income Statement

For the Month Ended July 31, 20xx

Revenue:

Sales from House Painting $ 3,700

Expenses:Wage Expense $ 600

Rent Expense 300Utilities Expense 150

Supplies Expense 500Total Expenses 1,550

Net Income Before Taxes $ 2,150

The Statement of Retained Earnings reflects the amount in the Dividend column of the

worksheet as well as the Net Income shown on the Income Statement for the period.

Note that Dividends only appear on the Statement of Retained Earnings and as an itemon the Statement of Cash Flows.


Statement of Retained Earn ingsFor the Month Ended July 31, 20xx

Retained Earnings, July 1, 20xx $ 0Add: Net Income 2,150

Subtotal 2,150Less: Dividends 1,500Retained Earnings, July 31, 20xx $ 650

A Balance Sheet shows the balance in accounts at a specific point in time, typically

at the end of a period. These ending balances are determined by reviewing the previous

time periods ending account balances (which become this time periods beginning accountbalances) and applying the transactions to those balances. In this case, BBP had all zero


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balances since July was their first time period of recording keeping. Consequently, thebalances for the accounts during the month are also the balances at the end of July.

Boyle Brothers P ainting, Inc.Balance Sheet


Assets Liabilities

Cash $ 12,850 Accounts Payable $ 1,000Accounts Receivable 500 Notes Payable 12,000

Supplies 300 Total Liabilities $ 13,000Equipment 1,500

Truck 8,500 Stockholders Equity

Common Stock 10,000

Retained Earnings 650Total Stockholders

Equity 10,650

Total Liabilities

Total Assets $ 23,650 & Equity $ 23,650

The Statement of Cash Flows is generated from the entries in the Cash column of their

worksheet.

The funds received from customers includes the cash from the first painting job

($2,200) plus the $1,000 that was paid a week after the work was done on the second job.

This does not agree with the Revenue shown on the Income Statement because the elderlylady living in their neighborhood still owes BBP $500 (as shown on the Balance Sheet as an

Accounts Receivable).

The amount paid for ladders and such does not agree with the value shown in theBalance sheet for equipment because BBP has only paid $500 so far to Home Depot for

them. BBP still owes $300 to Home Depot for the ladders and staging, which is part of theAccounts Payable shown on the Balance Sheet.

2.9 Summary

After measuring the impact of a variety of common business transactions on the

financial position of a business, you learned how to take the various account balances anduse them to create some of the primary financial statements used in accounting: Income

Statement, Balance Sheet, Statement of Retained Earnings, and Statement of Cash Flows.

This is probably a good time for you to try the first self-study problem for this chapter.The first exercise takes BBP through their second month of operation. The second exercise

is for a new company.


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You can find it following the listing of key terms appearing on the next few pages. Thesolution to the self-study exercises may be found at the back of this booklet.

Boyle Brothers Painting, Inc.Statement of Cash Flow s


Operating A ctivitiesReceived from customers $ 3,200

Paid for wages (600)Paid for rent (300)

Paid for supplies (800)Paid for utilities (150)

Net Cash Flow from Operating Activities $ 1,350

Investing ActivitiesPaid for Equipment

Truck ($ 8,500)Ladders, etc. (500)

Net Cash flow from Investing Activities ($ 9,000)

Financing Activities

Received from creditors 12,000

Received from Owners 10,000Paid to Owners (1,500)

Net Cash flow from Financing Activities $ 20,500

Net cash flow for July $ 12,850

Cash Balance July 1 0Cash Balance July 31 $ 12,850

2.10 Key Terms from Chapter 2

Account: An account is the name given to the basic storage unit for accumulating

accounting data. Examples include: cash, accounts receivable, common stock, notespayable and retained earnings.

Account Receivable: A firms claim against its customers for future payment of goods

and/or services purchased. An account receivable is established when a customerpurchases goods or services from a company on credit.

Accounting Transaction: An accounting transaction is any economic event or activityinvolving a business that has an impact on its financial position (and basic accountingequation).

Accounts Payable: Designates money owed to suppliers and others from whom purchases

on credit have been made.


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Basic Accounting Equation: Assets = liabilities + owners equity. The basic accounting

equation is an expression of a firms financial position.

Financial Position: A companys financial position refers to its economic positions (assets)and the claims against them by creditors (liabilities) and the firms owners (equity).

Notes Payable: A liability whereby the business entity has signed a promissory note to

repay borrowed money at a specified future date along with a designated amount of

interest.

Practice Problems for Chapter 2

(The solution to these problems can be found at the end of this book.)

BBP in August

Peter and Steve start August with high expectations of another stellar month. However,

August turned out to be very rainy. They only completed three jobs. During August, the

business engaged in the following business transactions:

a) They bought more supplies ($1,200) at Home Depot in expectation of a stellarmonth. They used their Home Depot credit card.

b) They did a job for $2,400 and were paid cash when they finished.c) They bought some more supplies ($400) at Home Depot using their credit card.

d) The elderly lady sent them the remainder of what she owed them ($500).e) They painted a house for $1750 and were paid $1,000 when they finished the

remainder was promised within a couple of weeks.f) They got one more house painted for $2,000. The couple said they would pay them

in three weeks. Since Peter and Steve knew the couple, they said they would wait.

g) They paid their part time worker $750.

h) They paid their landlord the rent $300.i) They paid their utility bill which was $175 this month.j) They paid $2,000 on their Home Depot credit card

k) When they did inventory of the remaining supplies at the end of the month, theyonly had $300 left.

l) They paid themselves a $1,000 dividend each.

Required:

1. Set up a worksheet in Excel showing Assets = Liabilities + Equity + Revenue Expenses

and use the worksheet to show the impact of each of the above transactions on thebasic accounting equation (i.e., financial position of the firm).

2. Use the data from your worksheet to produce the following financial statements for BBP,Inc. for August:* Income Statement

* Statement of Retained Earnings

* Balance Sheet* Statement of Cash Flows

Note: You will need the Balance Sheet from July 20xx that is printed in this chapter toproduce the Balance Sheet for August.


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Phranques P hotography Studio, Inc.

Phranques Photography Studio, Inc. was started in September, 20xx. During

September, the business engaged in the following business transactions:

(a) Phranque Farquhar, the studios founder, deposited $15,000 into a checkingaccount in the name of the corporation. In return, he received 15,000 shares of$1 par value common stock in the business.

(b) Phranque paid his landlord $800 rent for September for the store space he had

leased in a nearby shopping mall.

(c) He paid $6,000 cash for the photography equipment he would need to beginoperations.

(d) Paid $500 cash for photography supplies.(e) Received $1,400 payment for his first photography job a wedding.

(f) He completed another job and billed the customer for the $1,000 price theydagreed upon.

(g) Paid wages to a part-time employee amounting to $500.(h) Purchased more photography supplies on credit for $700.(i) Received one-half ($500) from customer previously billed.

(j) Paid the utility bill for September in the amount of $200.(k) Paid the telephone bill for September in the amount of $90.(l) Paid one-half (or $350) on the bill for photography supplies purchased earlier in

the month.(m) Did inventory of remaining suppliers and only had $300 left.

Required:

1. Set up a worksheet in Excel showing Assets = Liabilities + Equity + Revenue Expensesand use the worksheet to show the impact of each of the above transactions on the

basic accounting equation (i.e., financial position of the firm).

2. Use the data from your chart to produce the following financial statements forPhranquess Photography Studio, Inc. for September:

* Income Statement* Statement of Retained Earnings

* Balance Sheet* Statement of Cash Flows


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Chapter 3

Accrual Accounting

3.1 Accrual Accounting and The Matching Principle

Think back to the business transactions we covered in Chapter 2. Do you recall thetransaction where the Boyle brothers completed a painting job for the elderly lady in their

neighborhood? Something very interesting happened regarding

this event. The amount the Boyle brothers charged for the job($1,500) was recorded as revenue for BBP, Inc., even though

the company had not been yet been paid. The way this was

treated provides an excellent example of what is referred to asthe accrual basis of accounting. Accrual accounting recognizesrevenue when services have been performed or sales of products

have been made (i.e., title passes from seller to buyer),regardless of when payment is received from the customer.

Accrual accounting is a very important financial accountingconcept. Lets consider the impact of what would have happened

if BBP hadnt followed the accrual concept if we had onlyrecognized revenue when cash was received for goods and

services (i.e., accounting on a cash basis). What would havebeen the impact of not recognizing the $1,500 mentioned above

as revenue at the time the painting job was completed? First,BBP, Inc.s revenue for July would have been understated. The

company would not have acknowledged in its accounting records that it had expended labor

and materials and had, in fact, earned its fee. Consequently, BBPs accounting recordswould not have reflected the true extent of its revenues (and ultimately, its income). At thesame time, an asset had also been created. By finishing the painting job, BBP had

established a claim against its customer for the eventual payment of the $1,500. By notreflecting this fact in the firms accounting records (i.e., recording the $1,500 as an account

receivable), BBP would have understated the true level of its assets. Can you see why not

following the accrual concept would lead to a distorted picture a the firms financialcondition?

Refer, again, to our example of BBP, Inc. This time think about how we treated the

supplies that were purchased. You may recall that BBP initially purchased $800 worth ofsupplies and had $300 remaining at the end of July. As a result, BBP, Inc. recognized $500

in supplies expense for the month of July the amount of

supplies consumed. Again, BBP, Inc. followed the accrualmethod of accounting. Accrual accounting recognizes expenses

when they are incurred (i.e., used to produce revenue),regardless of when cash is paid.

Consider again what would have happened if the accrualmethod of accounting had not been followed if BBP would have

recognized the entire $800 spent on supplies as an expense at the

time they were purchased. If that had been the case, the result

Accrual accountingrecognizesrevenue when

services have beenperformed or sales

of products havebeen ma de (i.e.,

title passes fromseller to buyer),

regardless of when

payment isreceived from the

customer.

Accrual accountingrecognizes

expenses whenthey are used to

produce revenue,regardless of when

cash is paid.


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would have been to overstate the amount of expenses incurred during the month of July by$300. This would have had the impact of understating BBPs income for the month. Also,

assets would have been understated at the end of the month since there would still have

been $300 in unused supplies (assets) remaining on hand. Once again, failure to use the

concepts of accrual accounting would have provided a distorted view of BBPs actualperformance and financial condition.

3.2 The Matching Principle

Accrual accounting is the method used to apply the Matching Principle one of the

fundamental and most important principles of financial accounting.

According to the Matching Principle, revenues must be recognized during

the period in which goods are sold or services provided; expenses must berecognized during the period in which they are used to generate revenue.

In essence, we match expenses to the revenues they helped to produce.

3.3 Accounting Periods And The Need For Adjustments

Companies prepare financial statements (i.e., Balance Sheet, Income Statement, etc.)

for specific periods of time called accounting periods. They may be one month inlength, one quarter (3-months), or an entire year. All firms must prepare financial

statements for every twelve-month period of time (i.e., every fiscal year). A fiscal year isa one-year accounting period. For example, Babsons fiscal year runs from July 1 through

the following June 30th.

The fact that firms prepare financial statements for specificaccounting periods, coupled with the need to adhere to the

matching principle, makes it necessary for firms to make

adjusting entries (i.e., adjustments to certain accounts in thefirms accounting records) to ensure that revenues and expenses

are matched within the appropriate accounting period. Adjustingentries are made at the end of an accounting period prior to thepreparation of financial statements.

3.4 Types Of Adjusting Entries

Adjusting entries provide accountants with a way of applying the matching principle to

economic events that cover more than one accounting period. These entries fall into two

categories: deferrals and accruals. Deferrals involve making adjustments based onaccounting transactions that have already been recorded. Accruals involve adjusting

entries to reflect economic activity that has not yet been recorded in the firms accountingsystem. All adjusting entries involve making at least one entry into a Balance Sheet

account and one entry into an Income Statement account.

3.5 Deferred Expenses

Firms frequently pay for expenses that will benefit one or more future accounting

periods. Initially, they defer (or postpone) the recognition of these expenditures asexpenses by recording them as assets. Later, at the end of each subsequent accounting

Adjusting entries

ensure that

revenues andexpenses are

matched within theappropriateaccounting period.


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period, the amount that has been consumed is converted from anasset account to an expense account through the use of an

adjusting entry . Examples of deferred expenses include prepaid

expenses (e.g., prepaid rent, prepaid insurance, supplies) and

depreciation.

Prepaid Rent

Prepaid rent is a terrific example of an expenditure originally

recorded as an asset that will be recognized as an expense as it is

consumed (used up) over time. Lets assume that FME Products, Inc. begins operationson September 1 and rents store space in nearby shopping mall. On that date, the company

pays its landlord three months rent in advance totaling $2,400. On September 1, the firmhas not yet received any benefit from the rent payment since no time has elapsed. As

such, the transaction is recorded as an increase to an asset account called prepaid rent.

The account represents a claim the firm has against the landlord to provide three months of

store space. When the transaction is made, its impact on the firms financial position (andbasic accounting equation) is merely a change in the mix in assets replacing $2,400 of

cash with $2,400 worth of prepaid rent.


9/1 Cash - 2,4009/1 Prepaid Rent + 2,400

Assuming FME Products, Inc. produces financial statements at the end of each month,it will be necessary for the firm to make an adjusting entry on September 30 to reflect the

fact that one months worth of prepaid rent has now been consumed. At this point, FME

Products needs to reduce the prepaid rent account by $800 (1/3 of the total rent paid) toreflect the fact the asset has now diminished in value (i.e., the claim against the landlord is

now for two months occupancy - $1,600 worth). At the same time, FME Products needs toreflect in its accounting records and financial statements at the end of September that it has

incurred one months worth of rent expense.


9/1 Cash - 2,400

9/1 Prepaid Rent + 2,400

9/30 Prepaid Rent - 800 Rent Expense - 800

On October 31, FME Products, Inc. will make another adjusting entry similar to the one

made on September 30. This entry will reflect the consumption of another months worth ofprepaid rent and reduce the balance in the prepaid rent account to $800. Another $800 in

rent expense will be recognized at the end of October. The remaining adjusting entry willbe made at the end of November. At that time, the balance in the asset account (prepaid

rent) will be reduced to zero and yet another $800 will be recognized as rent expense. So,

at the end of the three-month period, a total of $2,400 in rent expense will have been

recognized ($800 per month over each of the three months).

Deferred

expenses areexpenses that,

when paid, will

benefit one or morefuture accounting

periods.


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Prepaid Insurance

When a company purchases an insurance policy, it creates an asset that will provide

benefits over a specified future period of time. As time passes, the value of that asset will

gradually expire. Assume FME Products, Inc. purchases a one-year insurance policy onJanuary 2 for $1,200. This transaction is recorded by increasing an asset account called

prepaid insurance. On January 31, one months worth of insurance protection providedby the policy will have expired its value having diminished by 1/12th (or $100). At thesame time, $100 of insurance expense will have been incurred since one months worth of

insurance protection will have been consumed. Again, assuming FME Products prepares

financial statements at the end of each month, the firm will need to record this fact with anadjusting entry . The impact of the purchase of the insurance policy and the adjusting

entry made one month later on the firms financial position is shown below.


1/2 Prepaid Insurance + 1,200

1/2 Cash - 1,200

1/31 Prepaid Insurance - 100 Ins. Expense - 100

As you can see, prepaid rent and prepaid insurance are treated in a similar fashion.

With the passage of time, the value of these kinds of assets gradually diminishes as theexpired portions are recognized as expenses.

Supplies

Not all prepaid assets expire automatically with the passage of time. Some prepaid

assets expire based upon an actual rate of usage that can vary from period to period. Forexample, supplies are purchased by virtually every business often in bulk. These itemsare recorded as increases in assets at the time they are purchased and remain so until they

are consumed in the operation of the business. A physical count of supplies in inventory

must be made at the end of each accounting period to determine the amount consumed(and therefore the amount of expense to recognize).

Heres the two formulas needed to identify the level of supplies consumed:

As you can see, if we know how much in supplies were on hand at the beginning of an

accounting period and how much in additional supplies were added during the period, we

can determine the total amount of supplies available for the firm to draw upon. Thedifference between this aggregate pool of supplies available during the period and what still

remains at the end of the period is the amount consumed in the operation of the business.

Assume FME Products begins the month of June with $250 of supplies on hand. On June

10, the company purchases an additional $300 of supplies for cash. Another $275 worth ofsupplies is then purchased on credit on June 20. A physical count of the firms supplies

Beginning Supplies Inventory + Purchases = Total Supplies Available

Total Supplies Available Ending Supplies Inventory = Supplies Used


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inventory on June 30 reveals that $150 in supplies remains on hand. Therefore, the amountof supplies consumed during June equals $675, as follows:

Beginning Supplies Inventory, June 1 $ 250

Add: Supplies Purchased, June 10 300Add: Supplies Purchased, June 20 275

Total Supplies Available for Use $ 825

Less: Supplies Inventory, June 30 150Supplies Used during June $ 675

At the end of June, an adjusting entry would be made to recognize the amount of

supplies expense incurred and to reduce the amount of supplies contained in the suppliesaccount. As a result of this adjusting entry (below), both assets and equity are reduced:


6/30 Supplies - 675 Supplies Expense - 675

3.6 Depreciation

Prepaid rent, prepaid insurance and supplies are all examples of items that are originally

recorded on a companys books as assets because they contain value and will providebenefits over some future period of time. Admittedly, these

benefits are usually gained in a relatively short period. Otherassets, such as buildings, equipment, vehicles, furniture and

fixtures also provide future benefits, but over a much longer

period of time. For example, while an insurance policy mayprovide future benefits for up to two or three years, a building

may be in service for 40 years. Just as in the case of prepaid rentor insurance, these long-term assets (e.g., buildings,machinery, equipment, etc.) are eventually consumed in the

operation of the business (i.e., eventually recognized as

expenses). The process of spreading the cost of a long-termasset over the period of time during which it will provide service is

called depreciation and the amount of cost recognized as anexpense during each accounting period is called depreciation

expense.

Consider the following simple example. Assume FME Products,Inc. purchases a used delivery truck on July 1, 2003 for $9,000.

At this point, three decisions need to be made in order to arrive atthe right amount of depreciation to recognize at the end of eachaccounting period. The folks at FME Products need to:

(1) Estimate the trucks useful life;(2) Estimate its salvage value; and

(3) Select a method for recognizing depreciation expense.

Depreciation

spreads the cost ofa long-term assetover the period of

time during whichit will provide

service.

The amount of cost

recognized as anexpense during

each accountingperiod is called

depreciation

expense.


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its entire useful life. The difference between the cost of an asset and its accumulateddepreciation is referred to as the assets book value . Thus, one year after purchasing the

truck, its book value is $7,000. This is the amount that will be added to all of the other

assets on the Balance Sheet to arrive at the firms total assets. After one year, the delivery

truck will appear on FME Productss Balance Sheet as follows:

Truck $ 9,000Less: Accumulated Depreciation 2,000 $ 7,000

On June 30, 2005, another $2,000 in depreciation will be recognized through use of anadjusting entry at the end of the year. The truck along with its accumulated depreciationwill appear on the Balance Sheets as follows:

Truck $ 9,000Less: Accumulated Depreciation 4,000 $ 5,000

Still another $2,000 will be recognized for 2006. Finally, on June 30, 2007, the last

depreciation entry will be made for the truck. Following this entry, the delivery truck will

appear on FME Productss Balance Sheet as follows:

Truck $ 9,000

Less: Accumulated Depreciation 8,000 $ 1,000

On June 30, 2007 the delivery truck has been fully depreciated. Its book value

appearing on the Balance Sheet will be equal to its estimated salvage value. The truck willremain in the listing of assets on the firms Balance Sheet until it is sold or otherwisedisposed of.

3.7 Deferred Revenue

Sometimes a company receives payments in advance for

goods and services that it will provide at a future time. These arecalled deferred revenues and create an obligation (liability) onthe part of the company receiving payment to deliver goods or

perform services in the future. For example, the revenue receivedby the New York Jets from its season ticket holders represents an

obligation (liability) for the Jets to admit the season ticket

holders to a specific number of games. The Jets will earnrevenue as each game is played. Magazine subscriptions involveadvance payments for magazines that will be delivered over a future period of time. These

payments are initially recorded as liabilities since they represent obligations on the part of

the company to deliver magazines during future months. Initially, the firm has deferredthe recognition of revenue even though subscription money has already been received.

As the magazines are delivered, the company reduces its liability and recognizes therevenue earned by each magazine shipped. This represents yet another example of how

accrual accounting recognizes revenues when services are provided or goods are delivered,

not necessarily when payment is received.

Refer back to the Boyle Brothers. Assume that on August 5th a farmer hires the Boyle

brothers to paint a large barn and pays them $2,000 in advance the entire cost of the job.This transaction would have the following impact on BBPs accounting records:

Deferred

revenues arepayments made inadvance of the

delivery of goods

and services.


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Asse ts = Liab. + Equ ity + Rev. - Expenses

8/5 Cash + 2,000 Unearned Revenue + 2,000

Upon receipt of the money, BBPs assets have increased by $2,000. At the same time, aliability (unearned revenue) has been created. BBP now has the obligation to provide a$2,000 barn painting job for the client. This liability will remain until the work has been

completed. Lets assume the Boyle brothers finish painting the barn on August 10. The

impact of completing the painting job on BBPs financial position is as follows:

Assets = Liab. + Equit y + Revenue - Exp.

8/10 Unearned Revenue - 2,000 Revenue + 2,000

Once the painting is completed, BBP will have satisfied its liability to the farmer and will beable to recognize the $2,000 as revenue since it now has actually been earned.

3.8 Accrued Expenses

Accrued expenses are expenses that have been

incurred, but have not been recorded in a firms accounting

records. In a sense, theyve been accumulating (oraccruing) and need to be recognized as expenses at the endof the accounting period. Failure to do so would both

understate a firms expenses and overstate its income for

the period. Accrued expenses are recognized at the end ofan accounting period by making the appropriate adjusting

entries. Wages and interest are good examples of accrued

expenses.

Accrued Wages

Lets assume that FME Products, Inc. pays its employees twelve times per year - on the

15th of each month. Also assume that its payroll amounts to $14,000 each pay period. Itsnow June 30 and FME Products accountants are busily preparing the firms financialstatements for the fiscal year just ended. The fact that FME Productss employees are owed

one-half months wages at the end of June for which they will not receive payment until July

15 has created an accrued expense that must be recognized. As of June 30, FME Productsowes one-half of its periodic pay (i.e., $7,000). The adjusting entry thats needed to

properly reflect this fact appears below.

Assets = Liab. + Equ ity + Rev. - Expenses

6/30 Wages Payable + 7,000 Wage Expense - 7,000

A liability account (Wages Payable) has been established to recognize the fact that

$7,000 in wages is owed to the employees. Theyve worked through the second half ofJune; therefore, theyve earned their pay but must wait until July 15 to receive their

paychecks. Also, $7,000 has been added to the Wage Expense account to reflect the fact

Accruedexpenses areexpenses thathave incurred buthave not yetbeen recorded.


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that the expense has, indeed, been incurred (i.e., FME Products has already received thebenefit of the workers efforts from June 16 through June 30).

The following entries will be made on July 15 when the workers receive their wages.

Recall that the total payroll for each pay period is $14,000.

Asse ts = Liab. + Equity + Rev. - Expenses

7/15 Cash - 14,000 Wages Payable - 7,000 Wage Expense - 7,000

Notice that a total of $14,000 is paid out in wages on July 15. This covers the entire payperiod running from June 16 through July 15. Also, you should note that this payment is

offset by a reduction of $7,000 in wages owed to the workers (wages payable) that wererecognized at year-end, coupled with a reduction in equity to recognize the remaining 7,000

in wage expense incurred.

Accrued Interest

Interest owed on borrowed funds accumulates with every passing day. Assume thatFME Products borrows $10,000 on July 1, 2003 and signs a promissory note to repay the

$10,000 plus $1,000 in interest one year later on June 30, 2004. On the day FME Products

receives the loan, no interest is owed since no time has elapsed. But, with each passingday that FME Products has benefit of the loan, the interest it owes is adding up. Letsassume FME Products prepares financial statements on December 31, 2003. As of that

date, FME has had the loan for six months. Therefore, it now owes one-half ($500) of theinterest (that is, one half of the interest expense on the note has accrued). This fact must

be reflected in FME Productss financial statements. Consequently, an adjusting entry will

need to be made at year-end prior to preparing FME Productss financial statements.

Lets take a look at how all of this impacts FME Productss financial position. The entriesshown below reflect the following:

* 7/1/03 FME signs the note and receives the $10,000 loan

* 12/31/03 Adjusting entry to reflect the fact that one-half of theinterest on the note has been accrued

* 6/30/04 Repayment of the note and interest

Asse ts = Liab. + Equity + Rev. - Expenses

07/1/03 Cash + 10,000 Notes Payable + 10,000

12/31/03 Interest Payable + 500 Interest Exp. - 500

06/30/04 Cash - 11,000 Notes Payable - 10,000

Interest Payable - 500 Interest Exp.- 500

The first entry (on 7/1/03) shows the impact of signing the note and receiving the$10,000 loan back on July 1, 2003. As you can see, FME Productss assets (cash) increased


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at the end of this chapter to see if youve got a handle on accrual accounting and theadjusting entry process.

3.11 Key Terms for Chapter 3

Accelerated Depreciation: A method of depreciation that recognizes higher levels of

depreciation expense during the early years of an assets useful life.

Accounting Period: Any specific peri

Financial Accounting Basics for Foundation Management Experience (FME)

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