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More free books @ www.BingEbook.com Chapter 3: Getting Started in the Bookkeeping Cycle Q. The investing and financing activities for the year of a new, start-up business corporation are summarized as follows: Property, Plant, & Equipment Cash • Received $10,000,000 from a venture capital (VC) firm; in exchange, the business signed a $5 million note payable (interest-bearing, of course) to the VC firm and issued shares of stock to the VC firm equal to 10 percent of the total number of shares of stock issued by the business Make the journal entries for these investing and financing activities. The journal entries for these investing and financing activities are as follows: Cash 29. $10,000,000 Notes Payable $5,000,000 Owners’ Equity — Invested Capital $5,000,000 A business corporation needed more capital to expand and grow, so it issued additional stock shares for a total of $25,000,000. What journal entry should be made for this financing transaction? Solve It $6,000,000 One-half of the money invested in the startup business by the VC firm is secured by a note payable on which the business has to pay interest. This transaction is recorded in the notes payable liability account to indicate that the business has the legal obligation to pay interest and to pay the loan at its maturity date. The other half of the money that the VC firm put in the business is attributed to the account for capital stock shares issued by the business. The account title property, plant, and equipment is a generic title for long-term operating assets. The business would maintain more-specific accounts for each major asset purchased, such as buildings, machinery, vehicles, and so on. • Purchased various long-term operating assets for total cash payments of $6,000,000 A. $6,000,000 30. A business has had a very good year; its $58,000,000 net income for the year is an all-time high. Being in a generous mood, its board of directors declares a whopping cash distribution of $30,000,000 based on the business’s record-setting performance. What journal entry should be made for this financing transaction? Solve It 67 More free books @ www.BingEbook.com 68 Part I: Business Accounting Basics Answers to Problems on the Bookkeeping Cycle The following are the answers to the practice questions presented earlier in this chapter. a A business rents the building that houses its retail store, its warehouse, and its administrative offices. It pays rent in cash, so obviously the business needs a cash account. Should the business include an expense account for rent in its chart of accounts? Sure; the business definitely needs a rent expense account in which to record the payments to the landlord. b A business borrows money from its bank. Identify the liability account and the expense account that it should include in its chart of accounts for the borrowing of money. The business needs a notes payable liability account and an interest expense account. In fact, it needs a separate note payable liability account for each loan from the bank, although it probably needs only one interest expense account. c A business employs a typical range of employees — janitors, salespeople, bookkeepers, truck drivers, managers, and so on. It provides a basic retirement plan and pays the premiums for employees’ medical and hospital insurance. The annual income tax return filed with the IRS requires the following information: compensation of officers; salaries and wages; employee benefit program; and pension and profit-sharing plans. Should the business include a separate expense account for each of these compensation elements in its chart of accounts? Because the business needs to separate out information for the various components of its total cost of labor according to the categories required in its income tax return, it should set up a separate expense account for each of the categories listed in the question. Most businesses don’t disclose detailed information about their labor costs in their income statements as required in their federal income tax returns. If total labor cost is disclosed — and not all businesses disclose this expense separately — it’s typically reported as one total amount. You seldom see compensation of officers reported as a separate expense in an income statement, although there’s no rule against doing so. d The income tax Form 1120 for business corporations requires the reporting of the following assets: trade notes and accounts receivables; buildings and other depreciable assets; and loans to shareholders. Should the business include separate accounts for each of these assets in its chart of accounts? (These are only three of many items of information that the IRS requires to be reported in the balance sheet that must be included in a business’s annual income tax returns.) The fairly obvious answer is that a business should establish separate accounts for these different assets. Typical titles for these accounts are: accounts receivable; notes receivable; buildings; machinery; equipment; vehicles; and loans to offices and shareholders. Exact titles vary from business to business. e Suppose a business just opened its doors on the first day of the year, and not a single transaction has taken place yet in the new year. Which of the following accounts have balances in them, and which don’t? • Cash • Notes payable • Sales revenue More free books @ www.BingEbook.com Chapter 3: Getting Started in the Bookkeeping Cycle • Owners’ equity — Invested capital • Wages and salaries expense • Inventory The real accounts, which are cash, notes payable, owners’ equity — invested capital, and inventory, start the year with balances. The nominal accounts, which are sales revenue and wages and salaries expense, start the year with zero balances. f This question focuses on just two accounts taken from the chart of accounts of a business that makes credit sales. (Even a small business keeps hundreds of accounts.) The first is a real account, accounts receivable. The second is a nominal account, sales revenue. Are increases and decreases recorded in both accounts during the year, or are only increases recorded during the year? Both increases and decreases are recorded in the accounts receivable asset account. Increases are recorded for sales made on credit, and decreases are recorded for collections from customers. In contrast, the sales revenue account records only increases during the year. To be more precise, some decreases may be recorded in this revenue account, but they’re the exception rather than the rule. After recording sales revenue, an error may be discovered that requires a decrease in the account to correct the error. g The following condensed balance sheet presents eight core accounts of a business. Which of the eight accounts have a high frequency of transactions recorded in them during the year, and which have a low frequency of transactions? In other words, which of these eight are busy accounts, and which are not? Condensed Balance Sheet Cash $250,000 Operating liabilities $350,000 Receivables $300,000 Interest-bearing liabilities $500,000 Inventory $400,000 Owners’ invested capital $250,000 PP&E, net $550,000 Owners’ retained earnings $400,000 Assets $1,500,000 = Liabilities and Owners’ equity $1,500,000 The high frequency accounts are cash; receivables; inventory; and operating liabilities. The low frequency accounts are PP&E, net; interest-bearing liabilities; owners’ invested capital; and owners’ retained earnings. h A good friend is reading the most recent financial report of your business. In the balance sheet, she comes across an account called “Owners’ equity — Retained earnings.” She asks you, “Is this an asset account? If it is, is it money in the bank?” How do you answer? No, no, no, no! Many people assume that retained earnings is an asset account and, in particular, that it’s money stashed away someplace. (The title of the account may suggest this misleading interpretation.) You should stress that assets are listed under assets in the balance sheet and that assets aren’t tucked under owners’ equity on the other side of the balance sheet. Retained earnings is no more an asset than notes payable. Retained earnings is one of the sources of assets accounts reported on the right-hand side of the balance sheet. Basically, it says that $400,000 of the $1,500,000 total assets of the business is from the earning of profit over the years that has been retained and not distributed to its shareowners. i The business purchases products for inventory and pays $3,500 cash for the purchase. How should this transaction be recorded in the accounts? Inventory $3,500 Cash $3,500 69 More free books @ www.BingEbook.com 70 Part I: Business Accounting Basics j The business pays the $425 liability for the operating expenses noted in the example question’s transaction list. How should this transaction be recorded in the accounts? Liability for Unpaid Expenses $425 k Cash $5,000 The owners invest an additional $25,000 in the business. How should this transaction be recorded in the accounts? Cash $25,000 m $425 The business pays a note payable that came due in the amount of $5,000. (Ignore interest expense.) How should this transaction be recorded in the accounts? Notes payable $5,000 l Cash Owners’ Equity $25,000 What is the explanation for this journal entry? Inventory Accounts Payable $48,325 $48,325 This entry records purchase of products on credit. n What is the explanation for this journal entry? Cash Notes Payable $250,000 $250,000 This entry records the borrowing of money on the basis of an interest-bearing note. o What is the explanation for this journal entry? Rent Expense Cash $48,325 $48,325 This entry records rent payments to the landlord. p What is the explanation for this journal entry? Accounts Payable Cash $19,250 $19,250 This entry records the payment of amounts owed for previous purchases on credit. More free books @ www.BingEbook.com Chapter 3: Getting Started in the Bookkeeping Cycle q For the day, a business makes $38,900 credit sales to other businesses. How should these credit sales be recorded? Accounts Receivable Sales Revenue r $38,900 For the day, a business makes $48,000 credit card sales to individuals. It immediately sends the credit card information to its bank, which deducts 1.5 percent on credit card charges and puts the remainder in the business’s checking account. How should these credit card sales be recorded? Cash Credit Card Discount Expense Sales Revenue s $38,900 $47,280 $720 $48,000 Over the course of a business day, a few customers return products to the business. For the day, the total of customer returns is $2,300, and the business refunds cash to these customers. How should the product returns be recorded? Sales Returns & Allowances Cash $2,300 $2,300 In this scenario, the debit isn’t in the sales revenue account but rather in sales returns and allowances account, which is the contra account to sales revenue. The balance in this account is deducted from sales revenue to determine net sales revenue, and the balance in sales returns and allowances is compared with the balance in sales revenue to gauge the returns against sales. (Also, I should mention that a second entry should be made to record the return of products to inventory. The question doesn’t give the cost of the goods returned by customers, so you’re not asked to include this entry.) t A business invests in short-term government securities to earn income on excess cash that it doesn’t need for its day-to-day operations. It just received a $4,500 check from the government for interest earned over the last six months. None of this income has been recorded yet. How should this income be recorded? Cash Investment Income u $4,500 The business’s cost of goods sold for its sales during the period is $938,450. The sales revenue for these sales has been recorded. What journal entry should be made for this expense? Cost of Goods Sold Expense Inventory v $4,500 $938,450 $938,450 The business just received a bill for $15,000 from the outside security firm that guards its warehouse and offices. No entry has been made for this expense yet, and the business normally waits several weeks to pay this bill. What journal entry should be made for this expense? Security Guard Expense Accounts Payable $15,000 $15,000 71 More free books @ www.BingEbook.com 72 Part I: Business Accounting Basics w Its actuarial firm informs the business that the cost of its employees’ retirement pension benefit for the period is $565,000. According to the contract with its employees, the business decides to transfer $300,000 to the trustee of the pension plan and to defer payment of the remainder until a later time (which it has the option to do). No entry has been made for this expense yet. What journal entry should be made for this expense? Employees’ Benefit Expense Cash Employees’ Retirement Liability $565,000 $300,000 $265,000 Determining the annual cost of a defined benefits pension plan is an exceedingly complex computation. The Financial Accounting Standards Board (FASB) lays down the general rules for United States businesses. You have to be a CPA to wade through all these rules, and even some CPAs find it tough going. I should mention that many business corporations defer funding of their employee pension plans. Some of these companies have gone into bankruptcy, making their ability to fully fund their pension plans doubtful. x Unfortunately, one of the major customers of the business declared bankruptcy. This customer owes the business $35,000. The business has already recorded the credit sale to the customer and the cost of goods sold for the sale. After careful analysis, the business comes to the conclusion that it will not collect a dime from this customer. The business doesn’t record an expense caused by uncollectible receivables until it actually writes off the receivable. What journal entry should be made for this expense? Bad Debts Expense Accounts Receivable $35,000 $35,000 I deliberately made this bad debt that has to be written off as uncollectible a relatively large amount in order to call your attention to this problem. Basically, the business gave away its products for nothing. That really smarts! Of course, the business should shut off credit privileges to this customer and also consider reporting this incident to credit-rating agencies. y The business buys on credit a large supply of shipping containers that should be enough for the next six months of deliveries. The bill for the purchase is $26,500, and the business will pay it in about 30 days. What journal entry should be made for this transaction? Prepaid Expenses Accounts Payable $26,500 $26,500 When some of the containers are used to ship the products sold to customers, an entry is made to remove the appropriate amount from the prepaid expenses asset account and to charge this amount to an expense, such as transportation or shipping expense. The prepaid expense account may be called something more specific, such as shipping containers. A The business receives $49,000 from customers in payment for their previous purchases on credit from the business. To encourage prompt payment, the business offered its customers a 2 percent discount off the sales invoice amount if they paid within ten days of sale, and all the customers took advantage of this incentive. What journal entry should be made for this transaction? Cash Sales Discounts Accounts Receivable $49,000 $1,000 $50,000 More free books @ www.BingEbook.com Chapter 3: Getting Started in the Bookkeeping Cycle In recording sales, you record the full amount (before any prompt payment discount) in the sales revenue account and in the accounts receivable account. Therefore, the accounts receivable account for these sales has a balance of $50,000. This amount is fully discharged when the customers take the 2 percent prompt payment discount ($50,000 × 2 percent = $1,000). The business records $1,000 in the sales discounts account, which is usually viewed as a sales revenue contra account (not an expense account). B The business enters into a contract with a major supplier in which it agrees to buys a minimum amount of products every month over the next five years. Also, set prices are established in the contract. As of yet, the business hasn’t made a purchase under this contract, but it expects to do so in the near future. Should a journal entry be made for entering into this contract? Even though it’s an important event, no entry is made for entering into this purchase contract. However, financial reporting disclosure standards require that salient details of this contract be presented in a footnote to the financial statements. The one escape clause, or loophole, in this disclosure standard is that the business doesn’t have to disclose the details of the contract if it judges that the contract isn’t material, or significant in the affairs of its operations. C A few days after recording the purchase of products on credit, the business discovers that some of the products are defective. The business hasn’t paid for the purchase yet, and the vendor agrees to accept return of these defective products for full credit. The products returned to the vendor cost $16,300. What journal entry should be made for this transaction? Accounts Payable Inventory $16,300 $16,300 Some accountants argue that instead of crediting the asset inventory in a scenario such as this, a contra account called purchase returns and allowances should be credited. The balance in this contra account is deducted from total purchases for the year to determine net purchases. Unless purchase returns are a serious problem, I favor the entry shown above. D A business corporation needed more capital to expand and grow, so it issued additional stock shares for a total of $25,000,000. What journal entry should be made for this financing transaction? Cash Owners’ Equity — Invested Capital E $25,000,000 $25,000,000 A business has had a very good year; its $58,000,000 net income for the year is an all-time high. Being in a generous mood, its board of directors declares a whopping cash distribution of $30,000,000 based on the business’s record-setting performance. What journal entry should be made for this financing transaction? Owners’ Equity — Retained Earnings Cash $30,000,000 $30,000,000 Instead of directly debiting (decreasing) the retained earnings account, as shown in the entry above, some accountants favor making two entries for dividends, as follows: Dividends Cash Owners’ Equity — Retained Earnings Dividends $30,000,000 $30,000,000 $30,000,000 $30,000,000 As you can see, the end result is the same: The retained earnings account is decreased by the amount of the dividends. 73 More free books @ www.BingEbook.com 74 Part I: Business Accounting Basics More free books @ www.BingEbook.com Chapter 4 The Bookkeeping Cycle: Adjusting and Closing Entries In This Chapter 䊳 Understanding the need for year-end adjusting entries 䊳 Recording various adjusting entries 䊳 Closing the books at year-end 䊳 Protecting against errors, thievery, and fraud T he end of its fiscal year is a very important time for a business. Accountants prepare the business’s income statement and statement of cash flows for the year as well as its balance sheet. The board of directors critically reviews these financial statements to assess the business’s financial performance and position and to plan the future course of the business. The financial statements are sent to lenders and shareowners who make their lending and investment decisions based on these accounting reports. In short, the annual financial statements of a business are extraordinarily important. Accordingly, the financial statements require extraordinarily good accounting; financial statements are no better than the quality of accounting behind them. As I explain in Chapter 3, good accounting demands a well-designed and reliable recordkeeping system, one that records the business’s transactions during the period completely and accurately. This chapter moves on to the additional accounting procedures done at the end of the period. An accountant can’t use a business’s various accounts to prepare financial statements until these end-of-period accounting steps are completed. As the saying goes, “It ain’t over until the fat lady sings.” Getting Accurate with Adjusting Entries During an accounting period, certain expenses either aren’t recorded or aren’t fully recorded. The accountant waits until the end of the period and records adjusting entries for these expenses. In addition to expenses, revenue and income accounts may also need adjusting entries at the end of the period. Adjusting entries complete the profit accounting process for the period. The term “adjusting” doesn’t mean “fiddling with.” Adjusting entries aren’t made to manipulate profit, such as to move profit closer to the forecast target for the period. Rather, an accountant makes adjusting entries to make profit for the period as accurate as possible. In other words, adjusting entries make revenue and expenses correct for the period, and More free books @ www.BingEbook.com 76 Part I: Business Accounting Basics without them, the bottom-line net income for the period would be wrong. Keep in mind that the managers, directors, lenders, and shareowners of a business rely on the profit number more than any other figure in the business’s financial statements. As you may know, businesses prepare quarterly (three-month) financial statements. In this chapter, I focus on the annual (twelve-month) accounting period. In the business world (and for economic analysis in general), one year is the standard time unit. One year includes the complete cycle of seasonal variations that many businesses experience. The annual income statement draws the most attention in business financial reporting, and everyone holds the annual income statement to high standards of accounting. In broad overview, year-end adjusting entries are needed for two reasons: ⻬ To correct errors that may have crept into the recordkeeping process ⻬ To make final entries for the year in revenue, income, expense, and loss accounts so that the profit or loss for the year is accurate (or as accurate as possible given the inherent accounting problems of measuring profit and loss) An accounting system involves an enormous amount of data and detail, so safeguards and procedures should be put in place to prevent bookkeeping errors. A business is well-advised to conduct a thorough search at the end of the year for bookkeeping errors that have gone undetected. In the section “Instituting Internal Controls” later in the chapter, I discuss internal accounting controls that should be put into place to minimize bookkeeping errors. Despite their best efforts, most businesses find that errors sneak into their bookkeeping systems. Q. At year-end, the business searches for bookkeeping errors that may have gone undetected. Based on its year-end review, the business discovers that some office and computer supplies were thrown away and no entry was made. (The supplies were thrown out because they were no longer of any use, but the bookkeeping department wasn’t informed that the supplies had been put in the Dumpster.) In general, at the time of purchase, the costs of office and computer supplies are entered (debited) in an asset account called prepaid expenses. As these supplies are used, the appropriate amount of cost is removed from the asset account and recorded to expense. The cost of the discarded supplies was $4,800. What adjusting entry should be made to correct this error? A. The entry to correct the error of not recording the cost of supplies thrown away is: Office and Computer Supplies Expense Prepaid Expenses $4,800 $4,800 You could argue that throwing away office and computer supplies causes a special type of loss that should be recorded in a separate loss account, but I think that most accountants would put the cost of discarded office and computer supplies in the regular expense account.