Accounting and Financial

Reporting
Master of Business Administration
(MBA)

1
Lecture Week 4
Preparing Trial Balance, the Building Blocks of Accounting, and The Adjustments

2
 Learning Objectives

1. Preparing a trial balance.

2. A look on the building blocks of accounting: ethics, principles,
and assumptions in relation to financial statements.
3. Explaining financial leverage.
4. Explain the accrual basis of accounting and the reasons for
adjusting entries.

3
 Summarizing and Recording Process

Analyze each transaction and Record relevant transactions

event from source documents and events in a journal

Prepare and analyze

the trial balance Post journal information
to ledger accounts
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 Yazici Advertising The trial balance lists all
Trial Balance account balances in the
October 31, 2020 general ledger. If the
books are in balance, the
Debit Credit
total debits will equal
Cash ₺15,200 the total credits. If this is
Supplies 2,500 not the case, we may
Prepaid Insurance 600 have made an error
Equipment 5,000 posting the journal entry
Notes Payable ₺ 5,000 into the ledger. We
Accounts Payable 2,500 cannot prepare the
Unearned Service Revenue 1,200 financial statements
Owner’s Capital 10,000 until the books are in
Owner’s Drawings 500 balance as determined
Service Revenue 10,000 by the trial balance.
Salaries and Wages Expense 4,000
Rent Expense 900
₺28,700 ₺28,700 5
 Limitations of a Trial Balance
Trial balance may balance even when:
1. A transaction is not journalized.
2. A correct journal entry is not posted.
3. A journal entry is posted twice.
4. Incorrect accounts are used in journalizing or posting.
5. Offsetting errors are made in recording the amount of a transaction.

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 Trial Balance
Locating Errors
Errors in a trial balance generally result from
mathematical mistakes,
incorrect postings,
or simply transcribing data incorrectly.

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 Presentation Issues
Currency Signs
Do not appear in journals or ledgers
Typically used only in trial balance and financial statements
Shown only for first item in column and for the total of that
column
Underlining
Single line is placed under column of figures to be added or
subtracted
Totals are double-underlined

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 Quick Test; Trial Balance
A trial balance will not balance if:
a. a correct journal entry is posted twice.
b. the purchase of supplies on account is debited to
Supplies and credited to Cash.
c. a £100 cash drawing by the owner is debited to
Owner’s Drawings for £1,000 and credited to Cash
for £100.
d. a £450 payment on account is debited to Accounts
Payable for £45 and credited to Cash for £45.

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 Quick Test; Trial Balance Preparation
The following accounts come from the ledger of Bali Beach Supply at December 31, 2020.

157 Equipment R$88,000 301 Owner’s Capital R$20,000

306 Owner’s Drawings 8,000 212 Salaries and Wages 2,000

Payable
201 Accounts Payable 22,000
726 Salaries and Wages 200 Notes Payable
Expense (due in 3 months)
42,000 19,000
112 Accounts Receivable 4,000 732 Utilities Expense 3,000
400 Service Revenue 95,000 130 Prepaid Insurance 6,000
101 Cash 7,000
Prepare a trial balance in good form.
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 Bali Beach Supply
Trial Balance
December 31, 2020
Debit Credit
Cash R$ 7,000
Accounts Receivable 4,000
Prepaid Insurance 6,000
Equipment 88,000
Notes Payable R$ 19,000
Accounts Payable 22,000
Salaries and Wages Payable 2,000
Owner’s Capital 20,000
Owner’s Drawings 8,000
Service Revenue 95,000
Utilities Expense 3,000
Salaries and Wages Expense 42,000
R$158,000 R$158,000

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Ethics in Financial Reporting
• The standards of conduct by which actions are judged as right or wrong, honest or
dishonest, fair or not fair, are ethics.
• Effective financial reporting depends on sound ethical behavior.
• There is no doubt that a sound, well-functioning economy depends on accurate and
dependable financial reporting.
• Imagine trying to carry on a business or invest money if you could not depend on the
financial statements to be honestly prepared. Information would have no credibility.

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Ethical Issues
Steps in Analyzing Ethics Cases and Situations

Recognize an ethical situation Identify and analyze the Identify the alternatives, and
and the ethical issues involved principal elements in the weigh the impact of each
situation alternative on various
stakeholders

• Use your personal ethics • Identify the stakeholders— • Select the most ethical
to identify ethical persons or groups who alternative, considering all
situations and issues. may be harmed or the consequences.
Some businesses and benefited. Ask the Sometimes there will be
professional organizations question: What are the one right answer. Other
provide written codes of responsibilities and situations involve more
ethics for guidance in obligations of the parties than one right solution;
some business situations. involved? these situations require an
evaluation of each and a
selection of the best
alternative.

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Ethics Insight
“I felt the pressure.”
That’s what some of the employees of the now-defunct law firm of Dewey & LeBoeuf LLP indicated when
they helped to overstate revenue and use accounting tricks to hide losses and cover up cash shortages.
These employees worked for the former finance director and former chief financial officer (CFO) of the firm.
Here are some of their comments:
• “I was instructed by the CFO to create invoices, knowing they would not be sent to clients. When I
created these invoices, I knew that it was inappropriate.”
• “I intentionally gave the auditors incorrect information in the course of the audit.”
What happened here is that a small group of lower-level employees over a period of years carried out the
instructions of their bosses. Their bosses, however, seemed to have no concern as evidenced by various e-
mails with one another in which they referred to their financial manipulations as accounting tricks, cooking
the books, and fake income.
Source: Ashby Jones, “Guilty Pleas of Dewey Staff Detail the Alleged Fraud,” Wall Street Journal (March
28, 2014).
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Accounting Standards
• In order to ensure high-quality financial reporting, accountants present financial statements in
conformity with accounting standards that are issued by standard-setting bodies.
• Presently, there are two primary accounting standard-setting bodies—the International Accounting
Standards Board (IASB) and the Financial Accounting Standards Board (FASB).
• More than 149 countries follow standards referred to as International Financial Reporting Standards
(IFRS). IFRSs are determined by the IASB. The IASB is headquartered in London, with its 15 board
members drawn from around the world.
• Most companies in the United States follow standards issued by the FASB, referred to as generally
accepted accounting principles (GAAP).
• As markets become more global, it is often desirable to compare the results of companies from different
countries that report using different accounting standards. In order to increase comparability, in recent
years the two standard-setting bodies made efforts to reduce the differences between IFRS and U.S.
GAAP. This process is referred to as convergence.

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 GAAP and IFRS
Similarities
Transaction analysis is the same under IFRS and GAAP.
Currency signs are typically used only in the trial balance and the financial statements. The
same practice is followed under GAAP, using the U.S. dollar.
A trial balance under GAAP follows the same format under IFRS.
Differences
IFRS relies less on historical cost and more on fair value than U.S. companies.
The statement of financial position is often called the balance sheet in the United States.
U.S. GAAP balance sheets report current items first, while IFRS balance sheets normally (but
are not required to) present noncurrent items first, and equity before liabilities.

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 GAAP and IFRS
Looking to the Future

The basic recording process discussed previously is followed by companies across the
globe.
It is unlikely to change in the future.
The definitional structure of assets, liabilities, equity, revenues, and expenses may
change over time as the IASB and FASB evaluate their overall conceptual framework
for establishing accounting standards.

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Global Insight
If you think that accounting standards don’t matter, consider these events in South Korea. For many years,
international investors complained that the financial reports of South Korean companies were inadequate
and inaccurate. Accounting practices there often resulted in huge differences between stated revenues and
actual revenues. Because investors did not have faith in the accuracy of the numbers, they were unwilling to
pay as much for the shares of these companies relative to shares of comparable companies in different
countries. This difference in share price was often referred to as the “Korean discount.”
In response, Korean regulators decided that companies would have to comply with international
accounting standards. This change was motivated by a desire to “make the country’s businesses more
transparent” in order to build investor confidence and spur economic growth. Many other Asian countries,
including China, India, Japan, and Hong Kong, have also decided either to adopt international standards or
to create standards that are based on the international standards.

Source: Evan Ramstad, “End to ‘Korea Discount‛?” Wall Street Journal (March 16, 2007).

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Principles and Assumptions of Accounting
These are three fundamental assumptions of accounting underlying the preparation of financial statements.

Now Future

Going-Concern Assumption Time Period Assumption

Reflects assumption that the Presumes that the life of a company
business will continue operating can be divided into time periods,
instead of being closed or sold. such as months and years.

Monetary Unit Assumption

Include in accounting records only transaction data that can be
expressed in terms of money
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Financial Statements
We have four basic types of financial statements

1.Income Statement
2.Statement of Owner’s Equity
3.Financial Position Statement (Balance Sheet)
4.Statement of Cash Flows

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Principles and Assumptions of Accounting

Matching Principle
Revenue Recognition Principle (Expense Recognition Principle)

Recognize revenue when it is A company must record its expenses

earned (by delivering a product or incurred to generate the revenues
providing a service). Proceeds need reported (Expenses need to be
not be in cash. matched against revenues) in the
same accounting period.

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Income Statement
The income statement describes a company’s revenues and expenses along with the resulting net
income or loss over a period of time due to earnings activities.
The income statement describes the results of a company’s operations during a period of time
through revenues and expenses.
FASTFORWARD
Income Statement
For the Month Ended December 31, 2011
Revenues:
Consulting revenue $ 5,800
Rental revenue 300
Total revenues $ 6,100
Expenses:
Rent expense 1,000
Salaries expense 1,400
Utilities expense 230
Total expenses 2,630
Net income $ 3,470
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Principles and Assumptions of Accounting

Business Entity Assumption

A business is accounted for separately from other business
entities, including its owner.

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Statement of Owners’ Equity
FASTFORWARD
Statement of Owner's Equity
For the Month Ended December 31, 2011
C. Taylor, Capital 12/1/11 $ -

Connections
Net income for December 3,470
Plus: Investments by Owner 30,000
33,470
Less: Owner Withdrawals 200
C. Taylor, Capital, 12/31/11 $ 33,270

FASTFORWARD
Income Statement
For the Month Ended December 31, 2011
Revenues: The beginning balance in owner's equity
Consulting revenue $ 5,800
Rental revenue 300 was zero because the company was
Total revenues $ 6,100 started on December 1, 2011
Expenses:
Rent expense 1,000
Salaries expense 1,400
Utilities expense 230
Total expenses 2,630
Net income $ 3,470

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Principles and Assumptions of Accounting
IFRS generally uses one of two measurement principles
1. Historical Cost Principle (or cost principle)
Record assets at their cost.
For example, if Great Wall Manufacturing purchases land for ¥300,000,000, the company initially reports it in its accounting
records at ¥300,000,000. But what does Great Wall do if, by the end of the next year, the fair value of the land has
increased to ¥400,000,000?
Under the historical cost principle, it continues to report the land at ¥300,000,000.
2. Fair Value Principle
Assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability) .
Fair value information may be more useful than historical cost for certain types of assets and liabilities.
For example, certain investment securities are reported at fair value because market value information is usually readily
available for these types of assets.
Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation.
- Relevance means that financial information is capable of making a difference in a decision.
- Faithful representation means that the numbers and descriptions match what really existed or happened—they are factual.

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Principles and Assumptions of Accounting
• In determining which measurement principle to use, companies weigh the factual
nature of cost figures versus the relevance of fair value.
• In general, even though IFRS allows companies to revalue property, plant, and
equipment and other long-lived assets to fair value, most companies choose to use
cost.
• Only in situations where assets are actively traded, such as investment securities, do
companies apply the fair value principle extensively.

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Financial Position Statement (Balance Sheet)

The Balance Sheet describes a

company’s financial position at a
point in time.

It’s a summary of assets, liabilities

and equity at the end of the
accounting period.
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Financial Position Statement (Balance Sheet)
FASTFORWARD FASTFORWARD
Statement of Owner's Equity
For the Month Ended December 31, 2011 Balance Sheet
Taylor, Capital 12/1/11 $ 0 December 31, 2011
Plus: Investments by Owner 30,000 Assets
Cash $ 4,350
Net income for December 3,470
Supplies 9,720
33,470
Prepaid insurance 2,400
Less: Owner Withdrawals 200
Equipment 26,000
Taylor, Capital, 12/31/11 $ 33,270
Total assets $ 42,470
Liabilities
Accounts payable $ 6,200
Unearned revenue 3,000
Connections Total liabilities
Equity
9,200

C. Taylor, Capital $ 33,270

Total equity 33,270
Total liabilities and equity $ 42,470
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Principles and Assumptions of Accounting

Full Disclosure Principle

A company is required to report the details behind financial statements if the details so
disclosed would impact the users’ decision-making process. Most of the details are reported
in the notes to the financial statements.

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 Decision Analysis (Debt Ratio)
• Borrowing money is risky business; therefore, an important business objective is gathering information to help
assess a company’s risk of failing to pay its debts.
• The debt to assets ratio helps evaluate the level of debt risk.
• Companies finance their assets with either liabilities or equity. A company that finances a relatively large
portion of its assets with liabilities is said to have a high degree of financial leverage.
• Higher financial leverage involves greater risk because liabilities must be repaid and often require regular
interest payments (equity financing does not).
• We determine a company’s ability to pay its debts (liabilities) using the debt ratio.
• Debt Ratio is equal to Total Liabilities divided by Total Assets.

Debt Ratio = Total Liabilities

Total Assets
• A higher ratio indicates that there is greater probability a company will not be able to pay its debts in the future.

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 Debt Ratio Illustrated
• let’s look at Skechers’s liabilities, assets, and its debt ratio at the end of each year from 2005 to 2009.

• Skechers’s debt ratio ranges from a low of 0.23 to a high of 0.41.

• Also its ratio is lower, and has been generally declining, compared
with the industry ratio. This analysis implies a low risk from its
financial leverage.
• Is financial leverage good or bad for Skechers?
• To answer that question we need to compare the company’s return
on the borrowed money to the rate it is paying creditors. If the
company’s return is higher, it is successfully borrowing money to
make more money.
• A company’s success with making money from borrowed money
can quickly turn unprofitable if its own return drops below the rate
it is paying creditors. 31
 The Adjustments Process
A company needs to adjust its account balances to ensure that:
• All revenues have been recognized in the period earned
• All expenses have been recorded in the same period as the revenues they
helped generate
• All assets and liabilities are properly stated as of the Balance Sheet date.

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External Versus Internal Transactions
• We learned earlier how to prepare journal entries for external
transactions. These transactions with parties outside of the company
had source documents that triggered the journal entry process, for
example we purchased $5,000 of supplies on account and debited
supplies and credited accounts payable.

• The usage of those supplies is an internal transaction. There is no source

document prepared every time we use a sheet of paper. It wouldn’t be
practical, but since the supplies are being used up, the asset account
balance is becoming obsolete.
The adjustments process accounts for these internal transactions
through adjustments (adjusting entries).
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Accrual-Basis and Adjusting Entries
To provide timely information, accounting systems prepare reports at regular
intervals and divide the economic life of a business into artificial time periods
(Time Period Assumption).

.....
Jan. Feb. Mar. Apr. Dec.

Generally a
ALTERNATIVE TERMINOLOGY
• month, The time period assumption
is also called the
• quarter, or periodicity assumption.
• year. 34
 Fiscal and Calendar Years
• Monthly and quarterly time periods are called interim periods
• Most large companies must prepare both quarterly and annual
financial statements
• Fiscal Year = Accounting time period that is one year in length
• Calendar Year = January 1 to December 31
• When we divide business activities into arbitrary fixed periods of time,
it is often necessary to have special accounting for transactions that
cross from one time period to the next, which is accounted for during
the adjustments process.

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Quick Test; Fiscal and Calendar Years
The time period assumption states that:
a. companies must wait until the calendar year is completed to
prepare financial statements.
b. companies use the fiscal year to report financial information.
c. the economic life of a business can be divided into artificial time
periods.
d. companies record information in the time period in which the
events occur.

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Accrual- Versus Cash-Basis Accounting
Accrual-Basis Accounting
• Transactions recorded in the periods in which the events occur
• Companies recognize revenues when earned by performing
services or delivering products (rather than when they receive cash)
• Expenses are recognized when incurred (rather than when paid)
• In accordance with International Financial Reporting Standards
(IFRS)

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Accrual- Versus Cash-Basis Accounting
Cash-Basis Accounting
• Revenues recognized when cash is received
• Expenses recognized when cash is paid
• Cash-basis accounting is not in accordance with International
Financial Reporting Standards (IFRS)

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Recognizing Revenues and Expenses
Revenue Recognition Principle
Recognize revenue when earned in the accounting period in which the performance
obligation is satisfied (when the product or service is delivered to our customer).
We have delivered the
product to our customer,
so I think we should record
the revenue earned.

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Recognizing Revenues and Expenses
Expense Recognition Principle
Companies recognize expenses when incurred in the same accounting period as the revenues that are earned as a result of those
expenses “Let the expenses follow the revenues”.
Expenses need to be recognized in the period in which companies make efforts (consume assets or incur liabilities) to generate revenue.

Now that we have

Summary recognized the revenue,
of Expenses let’s see what expenses
Rent $1,000 we incurred to
Gasoline 500
generate that revenue.
Advertising 2,000
Salaries 3,000
Utilities 450
and . . . . ....

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Quick Test; Accrual Basis of Accounting
Which of the following statements about the accrual basis of accounting is false?
a. Events that change a company’s financial statements are recorded in the
periods in which the events occur.
b. Revenue is recognized in the period in which services are performed.
c. This basis is in accordance with International Financial Reporting Standards.
d. Revenue is recorded only when cash is received, and expense is recorded only
when cash is paid.

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IFRS Relationships in Revenue and Expense Recognition
Time Period Assumption

Economic life of business can be

divided into artificial time periods.

Revenue Recognition Expense Recognition

Principle Principle
Recognize revenue in the Recognize expense in the period
accounting period in which the that efforts are made to generate
performance obligation is satisfied. revenue.

Revenue and Expense

Recognition
In accordance with
International Financial
Reporting Standards (IFRS). 42
The Need for Adjusting Entries
Adjusting Entries
• Ensure that the revenue recognition and expense recognition principles
are followed.
• Necessary because the trial balance may not contain up-to-date and
complete data (effects of internal transactions)
• Required every time a company prepares financial statements to ensure
that all balances that appear in financial statements are adjusted.
• Will include one income statement account and one statement of
financial position account.

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The Need for Adjusting Entries

Journalize and post

Trial
Analyze Journalize Post adjusting entries:
Balance
deferrals/accruals

Adjusted
Financial Closing Post-Closing
Trial
Balance Statements Entries Trial Balance

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Quick Test; The Need for Adjusting Entries
Adjusting entries are made to ensure that:
a. expenses are recognized in the period in which they are incurred.
b. revenues are recorded in the period in which services are
performed.
c. statement of financial position and income statement accounts
have correct balances at the end of an accounting period.
d. All the responses above are correct.

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Types of Adjusting Entries

Deferrals Accruals
1. Prepaid Expenses. 1. Accrued Revenues.
Expenses paid in cash Revenues for services
before they are used or performed but not yet
consumed. received in cash or recorded.
2. Unearned Revenues. 2. Accrued Expenses.
Cash received before Expenses incurred but not
services are performed. yet paid in cash or recorded.

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Quick Test; Timing Concepts
Below is a list of timing concepts (a) Monthly and quarterly time periods.
in the left column, with a (b) Efforts (expenses) should be recognized in
description of the concept in the the period in which a company uses assets
right column. There are more or incurs liabilities to generate results
(revenues).
descriptions provided than
(c) Accountants divide the economic life of a
concepts. Match the description
business into artificial time periods.
to the concept
(d) Companies record revenues when they
f Accrual-basis accounting.
1. ___ receive cash and record expenses when
e Calendar year.
2. ___ they pay out cash.
(e) An accounting time period that starts on
3. ___
c Time period assumption. January 1 and ends on December 31.
4. ___
b Expense recognition (f) Companies record transactions in the
principle. period in which the events occur.

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References
• Wild, J., Shaw, K., Chiappetta, B. and Samaha, K., 2017. Fundamental
Accounting Principles. 2nd ed. McGraw-Hill Education.
• Weygandt, J., Kimmel, P. and Kieso, D., 2019. Accounting Principles
IFRS Version. Global Edition. Wiley.

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