978-0078025549 Chapter 3 Lecture Note Part 2

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Customers receiving $700 of services from a company have not been billed as of the end of

December. These customers will be billed on January 4 and are expected to pay the full amount

owed on January 9.

3. Compare the balances of retained earnings in the adjusted trial balance and the post-closing

trial balance.

Solution:

1. Closing entries

December 31 Debit Credit

Service Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,200

Retained Earnings . . . . . . . . . . . . . . . . . . 17,200

(Close revenues to retained earnings)

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . 14,800

Salaries Expense . . . . . . . . . . . . . . . . . . . 6,300

Supplies Expense . . . . . . . . . . . . . . . . . . 2,800

Advertising Expense . . . . . . . . . . . . . . . . 5,700

(Close expenses to retained earnings)

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . 1,300

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . 1,300

(Close dividends to retained earnings)

2. Post-closing trial balance

3. The balance of retained earnings increases by $1,100 from the adjusted trial balance to the

post-closing trial balance. The balance increases by the amount of net income ($2,400) and

decreases by the amount of dividends ($1,300).

Key Points by Learning Objective

LO3-1 Understand when revenues and expenses are recorded.

Swan Dance Academy

Post-Closing Trial Balance

December 31

Account Title Debit Credit

Cash $3,400

Accounts Receivable 6,200

Accounts Payable $1,300

Utilities Payable 800

Common Stock 4,000

Retained Earnings 3,500

Totals $9,600 $9,600

The revenue recognition principle states that we should recognize revenue in the period in which

we earn it, not necessarily in the period in which we receive cash.

Most expenses are recognized in the same period as the revenues they help to generate. Other

expenses indirectly related to producing revenues are recognized in the period they occur.

LO3-2 Distinguish between accrual-basis and cash-basis accounting.

The difference between accrual-basis accounting and cash-basis accounting is timing. Under

accrual-basis accounting, we record revenues when we earn them and record expenses with the

revenue they help to generate. Under cash-basis accounting, we record revenues when we

receive cash and expenses when we pay cash. Cash-basis accounting is not allowed for financial

reporting purposes for most major companies.

LO3-3 Demonstrate the purposes and recording of adjusting entries.

Adjusting entries are a necessary part of accrual-basis accounting. They help to record revenues

in the period earned and expenses in the period they are incurred to generate those revenues.

Another benefit is that, by properly recording revenues and expenses, we correctly state assets

and liabilities.

Adjusting entries are needed when cash flows or obligations occur before the earnings-related

activity (prepayment) or when cash flows occur after the earnings-related activity (accrual).

Adjusting entries are unnecessary in two cases: (1) for transactions that do not involve revenue

or expense activities and (2) for transactions that result in revenues or expenses being recorded at

the same time as the cash flow.

LO3-4 Post adjusting entries and prepare an adjusted trial balance.

We post adjusting entries to the T-accounts in the general ledger to update the account balances.

An adjusted trial balance is a list of all accounts and their balances at a particular date after we

have updated account balances for adjusting entries.

LO3-5 Prepare financial statements using the adjusted trial balance.

We prepare the income statement, statement of stockholders’ equity, and balance sheet from the

adjusted trial balance. The income statement provides a measure of net income (profitability),

calculated as revenues minus expenses. The balance sheet demonstrates that assets equal

liabilities plus stockholders’ equity (the basic accounting equation).

LO3-6 Demonstrate the purposes and recording of closing entries.

Closing entries serve two purposes: (1) to transfer the balances of temporary accounts (revenues,

expenses, and dividends) to the retained earnings account and (2) to reduce the balances of these

temporary accounts to zero to prepare them for measuring activity in the next period.

Closing entries increase the balance of retained earnings by the amount of revenues for the

period and decrease retained earnings by the amount of expenses and dividends for the period.

LO3-7 Post closing entries and prepare a post-closing trial balance.

After we post the closing entries to the T-accounts in the general ledger, the balance of Retained

Earnings equals the amount shown in the balance sheet. The balances of all revenue, expense,

and dividend accounts are zero at that point.

Common Mistakes

Common Mistake

When recording the interest payable on a borrowed amount, students

sometimes mistakenly credit the liability associated with the principal amount

(notes payable). We record interest payable in a separate account, to keep the

balance owed for principal separate from the balance owed for interest.

Common Mistake

Students sometimes mistakenly include the cash account in an adjusting entry.

Typically, adjusting entries will never include the cash account. Note that no

adjusting entries are posted to the cash account in Illustration 3–9.

Common Mistake

Students sometimes believe that closing entries are meant to reduce the

balance of Retained Earnings to zero. Retained Earnings is a permanent

account, representing the accumulation of all revenues, expenses, and

dividends over the life of the company.

Decision Points

Question Accounting

Information

Analysis & Decision

Can the company

earn revenues that

exceed the cost of

doing so?

Revenues and expenses

reported in the income

statement

Revenues measure the amount

earned during the year.

Expenses measure the cost of

earning those revenues.

Together, these two combine to

measure net income, or

profitability.

Question Accounting

Information

Analysis & Decision

The amounts

reported for

revenues and

expenses

represent activity

over what period

of time?

Income statement Revenue and expense accounts

measure activity only for the

current reporting period

usually a month, quarter, or

year). At the end of each

period, they are closed and

begin the next period at zero.

Career Corner

In practice, accountants do not prepare closing entries. Virtually all

companies have accounting software packages that automatically update the

Retained Earnings account and close the temporary accounts at the end of the

year. Of course, accounting information systems go far beyond automatic

closing entries. In today’s competitive global environment, businesses

demand information systems that can eliminate redundant tasks and quickly

gather, process, and disseminate information to decision makers. Ordinary

business processes—such as selling goods to customers, purchasing supplies,

managing employees, and managing inventory—can be handled more

efficiently with customized information systems. Employers recognize that

individuals with strong information technology skills mixed with accounting

knowledge add value to the company.

Ethical Dilemma

You have recently been employed by a large retail chain that sells sporting

goods. One of your tasks is to help prepare financial statements for external

distribution. The chain’s largest creditor, National Savings & Loan, requires

that financial statements be prepared according to generally accepted

accounting principles (GAAP). During the months of November and

December 2015, the company spent $1 million on a major TV advertising

campaign. The $1 million included the costs of producing the commercials as

well as the broadcast time purchased to run them.

Because the advertising will be aired in 2015 only, you decide to charge all

the costs to advertising expense in 2015, in accordance with requirements of

GAAP.

The company’s chief financial officer (CFO), who hired you, asks you for a

favor. Instead of charging the costs to advertising expense, he asks you to set

up an asset called “prepaid advertising,” and to wait until 2016 to record any

expense. The CFO explains, “This ad campaign has produced significant sales

in 2015; but I think it will continue to bring in customers throughout 2016.

By recording the ad costs as an asset, we can match the cost of the advertising

with the additional sales in 2016. Besides, if we expense the advertising in

2015, we will show an operating loss in our income statement. The bank

requires that we continue to show profits in order to maintain our loan in good

standing. Failure to remain in good standing could mean we’d have to fire

some of our recent hires.” As an employee, should you knowingly record

advertising costs incorrectly if asked to do so by your superior? Does your

answer change if you believe that misreporting will save employee jobs?

Key Issues

Recording all advertising expense in 2015 (instead of delaying a portion until 2016) has

the effect of reducing net income.

Since the bank requires the company to maintain profitability, recording all advertising

expenses in 2015 causes the company to lose good standing.

Strictly following the rules of accounting vs. the use of discretion.

What is the role of an employee? Do the right thing or do what your boss tells you?

Option 1: Expense advertising costs immediately as per GAAP

GAAP guidelines are in place for accountants to follow, and the correct action is to

expense the advertising costs in the current year, regardless of what the CFO says and

regardless of the consequences.

Not following GAAP would mislead financial statement users and the role of the

financial accountant is to both measure and communicate accurately and honestly.

Employees’ ethics should override pressure from our boss, and avenues probably exist to

report the circumstances anonymously.

Option 2: Establish a prepaid advertising account to delay the recognition of some expenses

Why do I have to be the employee to take on the burden of standing up to the CFO? Is

my job not to do as I am told?

The CFO has a point. If we don’t set up the prepaid account, long-term ramifications

such as violating the debt covenant with the bank would not be good for the company.

Plus, this prepaid account is just a timing issue, as we will still eventually report all of the

expense related to advertising.

Am I not simply protecting my fellow employees’ jobs by complying with the CFO’s

request?

GAAP is not a set of specific rules, as it allows managers discretion in applying the

principles of the rules. Thus, since the establishment of the prepaid account appears to

be justifiable (matching costs with future revenues), is this adjustment really such a bad

thing?