Intermediate Accounting Chapter 2

The Accounting Cycle and Closing Process

• The accounting cycle concludes with two final procedural steps at the end of a reporting period:
  • Closing all temporary accounts.
  • Preparing a post-closing trial balance.
• Reporting Period Frequency:
  • Although year-end is the standard reporting period context, a company can choose to execute closing entries monthly if desired.

Temporary Accounts vs. Permanent Accounts

• Purpose of the Closing Process:
  • Reduce the balances of all temporary accounts to $0$ so they are ready for the next period's transactions.
  • Transfer the net balance of temporary accounts into Retained Earnings.
• Temporary Accounts Included:
  • Revenues
  • Expenses
  • Gains
  • Losses
  • Dividends
  • Cost of Goods Sold (COGS)
• Closing Mechanics for Corporations:
  • Temporary accounts are closed directly into Retained Earnings (rather than using an Income Summary account).
  • Dividends decrease Retained Earnings upon closing.

The Post-Closing Trial Balance

• Prepared immediately after closing entries are posted to the general ledger.
• Primary Purpose:
  • Verifies that closing entries were prepared and posted correctly.
  • Confirms the general ledger is in balance and ready for the next period.
• Key Verification Rule:
  • The post-closing trial balance contains ONLY permanent accounts (Assets, Liabilities, and Stockholders' Equity accounts).
  • If any temporary accounts (such as revenues, expenses, or COGS) appear on a post-closing trial balance, closing entries were omitted or posted incorrectly and must be rectified.

Financial Analysis of Omitted Adjusting Entries (Brief Exercises 2-11 & 2-12)

• Basic Income Statement Relationship:   $\text{Net Income} = \text{Revenues} - \text{Expenses}$
• Brief Exercise 2-11 Reference Entries:
  • Entry 1: Debit Insurance Expense, Credit Prepaid Insurance for $3,000$
  • Entry 2: Debit Interest Receivable, Credit Interest Revenue for $300$
  • Entry 3: Debit Depreciation Expense, Credit Accumulated Depreciation for $12,000$
• Brief Exercise 2-12 Income Impact Analysis (If Entries Were Omitted):
  • Entry 1 Omission (Failed to record Insurance Expense of $3,000$):
  • Expenses are understated by $3,000$.
  • Net Income is $3,000$ higher (too high).
  • Entry 2 Omission (Failed to record Interest Revenue of $300$):
  • Revenues are understated by $300$
  • Net Income is $300$ lower (too low).
  • Entry 3 Omission (Failed to record Depreciation Expense of $12,000$):
  • Expenses are understated by $12,000$.
  • Net Income is $12,000$ higher (too high).
  • Net Effect on Net Income:     $\text{Net Effect} = 3000 - 300 + 12000 = 14,700$
  • Overall Net Income is $14,700$ higher than it should be.
• Analytical Application:
  • Understanding these net effects allows financial analysts and auditors to identify errors and compute necessary corrections when analyzing financial statement accuracy.

Adjusting Entries Mechanics and Practice (Brief Exercise 2-13)

• Adjusting entries record unrecorded assets, liabilities, revenues, or expenses at the end of an accounting period to reflect accurate accruals and deferrals.
• Rule Regarding Cash:
  • Cash is NEVER debited or credited in an adjusting entry because cash transactions are recorded at the time of receipt or disbursement.
• Scenario 1: Unearned / Deferred Revenue:
  • Gene Gold Corporation received a $4,000$ payment from a customer and credited Deferred Service Revenue (a liability). Services were fully completed by $12/31/2027$
  • Adjusting Journal Entry ($12/31/2027$):
  • Debit Deferred Service Revenue: $4,000$
  • Credit Service Revenue: $4,000$
• Scenario 2: Prepaid Expense (Prepaid Advertising):
  • On $12/01/2027$, paid a local radio station $2,000$ for $40$ radio ads ($20$ ads per month across December and January). Prepaid Advertising was debited initially.
  • Half of the ads ($20$ of $40$) were aired in December: $\frac{1}{2} \times 2000 = 1,000$
  • Adjusting Journal Entry ($12/31/2027$):
  • Debit Advertising Expense: $1,000$
  • Credit Prepaid Advertising: $1,000$
  • Rationale: Failing to adjust leaves Prepaid Advertising (asset) and Net Income overstated, leading to an artificially higher tax liability.
• Scenario 3: Accrued Salaries:
  • Employee salaries for December totaled $16,000$, to be paid on $01/07/2028$
  • Adjusting Journal Entry ($12/31/2027$):
  • Debit Salaries Expense: $16,000$
  • Credit Salaries Payable: $16,000$
• Scenario 4: Accrued Interest Expense:
  • On $08/31/2027$, borrowed $60,000$ from a bank on a $1$-year note at $8\%$ interest due $08/31/2028$
  • Elapsed time from $08/31/2027$ to $12/31/2027$ = $4$ months (September, October, November, December).
  • Note interest rates are always stated on an annual basis.
  • Interest Calculation:     $\text{Interest} = 60000 \times 0.08 \times \frac{4}{12} = 1,600$
  • Adjusting Journal Entry ($12/31/2027$):
  • Debit Interest Expense: $1,600$
  • Credit Interest Payable: $1,600$

Balance Sheet Impact of Omitted Adjusting Entries (Brief Exercise 2-14)

• Fundamental Accounting Equation:   $\text{Assets} = \text{Liabilities} + \text{Stockholders' Equity}$
• Impact Breakdown by Transaction (If BE 2-13 Entries Were Omitted):
  • Item 1 (Deferred Service Revenue not adjusted):
  • Liabilities: Higher by $4,000$ (liability was not reduced).
  • Stockholders' Equity: Lower by $4,000$ (earned revenue was not credited).
  • Item 2 (Prepaid Advertising not adjusted):
  • Assets: Higher by $1,000$ (asset was not reduced).
  • Stockholders' Equity: Higher by $1,000$ (expense was omitted, overstating income/equity).
  • Item 3 (Accrued Salaries not recorded):
  • Liabilities: Lower by $16,000$ (liability was omitted).
  • Stockholders' Equity: Higher by $16,000$ (expense was omitted).
  • Item 4 (Accrued Interest Expense not recorded):
  • Liabilities: Lower by $1,600$ (liability was omitted).
  • Stockholders' Equity: Higher by $1,600$ (expense was omitted).
• Total Equation Effect Summary:
  • Total Assets Effect: Higher by $1,000$
  • Total Liabilities Effect: $+4000 - 16000 - 1600 =$ Lower by $13,600$
  • Total Stockholders' Equity Effect: $-4000 + 1000 + 16000 + 1600 =$ Higher by $14,600$
• Equilibrium Proof:   $\text{Liabilities} + \text{Equity} = -13600 + 14600 = +1,000$
  • The left side ($\text{Assets} = +1,000$) balances with the right side ($\text{Liabilities} + \text{Equity} = +1,000$).

Comprehensive Practice on Adjusting Entries (Brief Exercise 2-15)

• All entries performed as of $12/31/2027$
• Item 1: Accrued Interest Revenue on Notes Receivable:
  • On $03/31/2027$, loaned $50,000$ on a $1$-year note at $6\%$ interest due $03/31/2028$
  • Elapsed time: $9$ months (April through December; March is excluded since loan was made March 31).
  • Interest Calculation:     $\text{Interest} = 50000 \times 0.06 \times \frac{9}{12} = 2,250$
  • Journal Entry:
  • Debit Interest Receivable: $2,250$
  • Credit Interest Revenue: $2,250$
• Item 2: Prepaid Rent Expiration:
  • On $09/30/2027$, paid $12,000$ for $1$ year of rent ($09/30/2027$ to $09/30/2028$) and debited Prepaid Rent.
  • Elapsed time: $3$ months (October, November, December).
  • Calculation:     $\text{Rent Expense} = 12000 \times \frac{3}{12} = 3,000$
  • Journal Entry:
  • Debit Rent Expense: $3,000$
  • Credit Prepaid Rent: $3,000$
• Item 3: Supplies Usage (T-Account Computation):
  • Beginning Supplies balance: $3,000$
  • Supplies purchased during year: $5,000$
  • Total available supplies: $3000 + 5000 = 8,000$
  • Ending supplies on hand ($12/31/2027$): $4,200$
  • Supplies Used Calculation:     $\text{Supplies Used} = 8000 - 4200 = 3,800$
  • Journal Entry:
  • Debit Supplies Expense: $3,800$
  • Credit Supplies: $3,800$
• Item 4: Unrecorded Vacation Pay:
  • Earned vacation pay of $6,000$ for the year was unrecorded and unpaid.
  • Company policy records vacation pay in Salaries Expense.
  • Journal Entry:
  • Debit Salaries Expense: $6,000$
  • Credit Salaries Payable: $6,000$

Modern Closing Entry Structure

• Entry 1: Close Revenue Accounts
  • Debit Sales Revenue
  • Credit Retained Earnings
• Entry 2: Close Expense Accounts and Cost of Goods Sold
  • Cost of Goods Sold is subtracted from sales revenue to determine gross profit and is closed alongside expenses.
  • Debit Retained Earnings ($815,000$ total)
  • Credit Cost of Goods Sold
  • Credit Salaries Expense
  • Credit Rent Expense
  • Credit Interest Expense
• Entry 3: Close Dividends
  • Dividends carry a normal debit balance and decrease equity.
  • Debit Retained Earnings
  • Credit Dividends

Transaction Analysis and Accounting Equation (Exercise 2-1)

• Accounting Equation Structure:   $\text{Assets} = \text{Liabilities} + \text{Paid-in Capital} + \text{Retained Earnings}$
• Transaction 1: Issued $30,000$ shares of no-par common stock for $300,000$ cash.
  • Assets: $+300,000$ (Cash)
  • Paid-in Capital: $+300,000$ (Common Stock)
• Transaction 2: Purchased equipment for $40,000$; paid $10,000$ cash and signed a note for $30,000$
  • Assets: $+40,000$ (Equipment) and $-10,000$ (Cash)
  • Liabilities: $+30,000$ (Notes Payable)
• Transaction 3: Purchased inventory on account for $90,000$ using the perpetual inventory system.
  • Note on Systems: Perpetual system debits Inventory/Merchandise Inventory; periodic system uses Purchases.
  • Assets: $+90,000$ (Inventory)
  • Liabilities: $+90,000$ (Accounts Payable)
• Transaction 4: Sold goods to customers on account for $120,000$; Cost of Goods Sold was $70,000$
  • Sale impact:
  • Assets: $+120,000$ (Accounts Receivable)
  • Retained Earnings: $+120,000$ (Sales Revenue)
  • Inventory Cost impact:
  • Assets: $-70,000$ (Inventory)
  • Retained Earnings: $-70,000$ (Cost of Goods Sold Expense)
• Transaction 5: Paid $5,000$ rent on warehouse for March.
  • Assets: $-5,000$ (Cash)
  • Retained Earnings: $-5,000$ (Rent Expense)
• Transaction 6: Paid $6,000$ for a $1$-year insurance policy.
  • Assets: $+6,000$ (Prepaid Insurance) and $-6,000$ (Cash)
• Transaction 7: Paid $70,000$ on account for inventory purchased in Transaction 3.
  • Assets: $-70,000$ (Cash)
  • Liabilities: $-70,000$ (Accounts Payable)
• Transaction 8: Collected $55,000$ cash from customers on account.
  • Assets: $+55,000$ (Cash) and $-55,000$ (Accounts Receivable)

Account Classifications and Normal Balances (Exercise 2-6)

• The effect of a debit on specific account types based on normal balances:
  • Inventory (Asset): Increase
  • Depreciation Expense (Expense): Increase
  • Accounts Payable (Liability): Decrease
  • Prepaid Rent (Asset): Increase
  • Sales Revenue (Revenue): Decrease
  • Common Stock (Stockholders' Equity): Decrease
  • Salaries Payable (Liability): Decrease
  • Cost of Goods Sold (Expense): Increase
  • Utilities Expense (Expense): Increase
  • Equipment (Asset): Increase
  • Accounts Receivable (Asset): Increase
  • Utilities Payable (Liability): Decrease
  • Rent Expense (Expense): Increase
  • Interest Expense (Expense): Increase
  • Interest Revenue (Revenue): Decrease