ADJUSTING ACCOUNTS AND

PREPARING FINANCIAL
STATEMENTS
Dr Winston Kwok

LEARNING OBJECTIVES
1. Prepare and explain the use of a trial balance
2. Explain accrual accounting and how it improves financial statements
3. Prepare and explain adjusting entries
LEARNING OBJECTIVE 1

Prepare and explain the use of a trial balance

ACCOUNTING PROCESS OR
ACCOUNTING CYCLE
 PREPARING A TRIAL BALANCE

List of all accounts and

balances as taken from
ledger.
Presented in account
number order: assets,
liabilities, equity, revenues,
DEBITS CREDITS expenses.
Ensures total debits posted
to ledger equals total
credits posted.
 PREPARING A TRIAL BALANCE

Preparing a trial balance involves three steps:

1.List each account title and its amount (from
ledger) in the trial balance. If an account has
a zero balance, list it with a zero in the
normal balance column (or omit it entirely).
2.Compute the total of debit balances and the
total of credit balances.
3.Verify (prove) total debit balances equal total
credit balances.
 PREPARING A TRIAL BALANCE
EXERCISES 2-7 AND 2-8 PAGE 80 OF TEXTBOOK
The trial balance
lists all account
balances in the
general ledger. If
recording is
correct, the total
debits will equal
the total credits.
 PREPARING A TRIAL BALANCE
EXERCISES 2-7 AND 2-8 PAGE 80 OF TEXTBOOK
From the trial balance,
the financial statements
can be prepared.

Statement of
Financial
Position

Statement of
Changes in Equity

Income Statement
 TRIAL BALANCE

Not the same thing as companys statement of financial

position
Merely allows assessment of accounting equation
integrity :

ASSETS = LIABILITIES + EQUITY

Does not tell
If journal entries were posted correctly
Whether journal entries were posted at all
 SEARCHING FOR AND
CORRECTING ERRORS
If the trial balance does not balance, the
error(s) must be found and corrected.

Make sure the trial Re-compute each

balance columns are account balance in the
correctly added. ledger.

Make sure account Verify that each journal

balances are correctly entry is posted correctly.
entered from the ledger.

See if debit or credit Verify that each original

accounts are mistakenly journal entry has equal
placed on the trial balance. debits and credits.
LEARNING OBJECTIVE 2

Explain accrual accounting and how it improves

financial statements
 ACCRUAL BASIS

GAAP help record business activities.

Recognizes revenues when earned.
Company sells products or provides services to
customers
Recognizes expenses when incurred.
Company uses internal or external resources or
services to conduct daily operations
 CASH BASIS VERSUS
ACCRUAL BASIS NET INCOME

Johns Tree Service provided tree trimming, tree

planting, and tree removal services to customers
during the month of July 2011.
Services performed = $15,000
Cash collected from customers = $6,000
Expensesincurred to provide services identified
above = $12,000
Cash paid to employees and suppliers = $9,000
 CASH BASIS NET INCOME

Revenue 15,000 JOHNS TREE SERVICE

Cash receipts 6,000 INCOME STATEMENT
FOR THE MONTH ENDED
Expenses 12,000
JULY 31, 2011
Cash payments 9,000

Revenues $6,000
Expenses 9,000
Net Loss $3,000
 ACCRUAL BASIS NET INCOME

Revenue 15,000 JOHNS TREE SERVICE

Cash receipts 6,000 INCOME STATEMENT
FOR THE MONTH ENDED
Expenses 12,000
JULY 31, 2011
Cash payments 9,000
Revenues $15,000
Expenses 12,000
Net Income $ 3,000
 A SIDE-BY-SIDE COMPARISON

CASH BASIS ACCRUAL BASIS

JOHNS TREE SERVICE JOHNS TREE SERVICE

INCOME STATEMENT INCOME STATEMENT
FOR THE MONTH ENDED FOR THE MONTH ENDED
JULY 31, 2011 JULY 31, 2011

Revenues $6,000 Revenues $15,000

Expenses 9,000 Expenses 12,000
Net Loss $3,000 Net Income $ 3,000
UNDER ACCRUAL BASIS
Sales on account:
Dr Accounts Receivable
Cr Revenue
Expenses incurred but not paid:
Dr Expense
Cr Accrued Expense / Payable
BUT UNDER CASH BASIS, NONE OF THE ABOVE
WOULD BE RECORDED, RESULTING IN:
Revenues understated
Expenses understated
Assets understated
Liabilities understated
 ACCRUAL BASIS VERSUS CASH BASIS
Accrual Basis Cash Basis
Revenues are Revenues are
recognized when recognized when cash
earned and expenses is received and
are recognized when expenses are recorded
incurred. when cash is paid.

Non-GAAP
 CASH BASIS ACCOUNTING

Records business transactions December 2011

when cash received or paid.
Revenues recognized (recorded)
when cash is received and
expenses recognized when cash January 2012
is paid.
Easy way to record but fails to
consider fact that some
transactions impact more than
one accounting period.
 ACCRUAL BASIS VERSUS CASH BASIS
FastForward paid $2,400 for a 24-month insurance
Example: policy beginning December 1, 2011.
Insurance Expense 2011
Jan Feb Mar Apr

$ - $ - $ - $ -
May Jun Jul Aug

$ - $ - $ - $ -
Sep Oct Nov Dec

$ - $ - $ - $ 2,400

On the cash basis, the entire $2,400 would be

recognized as insurance expense in 2011. No insurance
expense from this policy would be recognized in 2012
or 2013, periods covered by the policy.
 ACCRUAL BASIS VERSUS CASH BASIS
Insurance Expense 2011
Jan Feb Mar Apr

$ - $ - $ - $ -
May Jun Jul Aug
On the accrual basis,
$ - $ - $ - $ -
Sep Oct Nov Dec $100 of insurance
$ - $ - $ - $ 100
expense is recognized in
Insurance Expense 2012
Jan Feb Mar Apr 2011, $1,200 in 2012,
$ 100
May
$ 100
Jun
$ 100
Jul
$ 100
Aug and $1,100 in 2013. The
$ 100
Sep
$ 100
Oct
$ 100
Nov
$ 100
Dec expense is matched with
$ 100 $ 100 $ 100 $ 100
the periods benefited by
Insurance Expense 2013
Jan Feb Mar Apr the insurance coverage.
$ 100 $ 100 $ 100 $ 100
May Jun Jul Aug
$ 100 $ 100 $ 100 $ 100
Sep Oct Nov Dec
$ 100 $ 100 $ 100 $ -
LEARNING OBJECTIVE 3

Prepare and explain adjusting entries

 JOURNAL ENTRIES

Transactions with external entities:

E.g. Dr Cash
Cr Revenue
Internal transactions or events:
Need journal entries as they also affect the accounting
equation and can be measured reliably.
Often called adjusting journal entries or simply
adjusting entries.
 ADJUSTING ENTRIES
Adjusting entries are required at the end of each
accounting period for accrual basis accounting, prior
to preparing the financial statements.

* To update the statement of financial position.

* To reflect proper amounts of revenues and
expenses on the income statement.
 ADJUSTING ENTRIES

Each adjusting entry always involves at least

one income statement account and
one statement of financial position account.

Adjusting entries never involve cash.

Any transaction involving cash is a
business transaction that must be
recorded.
 ADJUSTING ENTRIES

Framework for Adjustments

Adjustments

Paid (or received) cash before Paid (or received) cash after
expense (or revenue) recognized expense (or revenue) recognized

Prepaid Unearned Accrued Accrued

(Deferred) (Deferred) expenses revenues
expenses* revenues

*including depreciation
 PREPAID (DEFERRED) EXPENSES
Assets become
expenses over time

Paid cash before expense recognized The original entry involves

increasing an asset and
decreasing cash.
Prepaid The adjusting entry
(Deferred) involves increasing an
expenses*
expense and decreasing
*including depreciation the asset originally
recorded.
 PREPAID (DEFERRED) EXPENSES
Here is my payment
for my 24-month
Resources paid insurance policy.
for prior to
receiving the
actual benefits.
 PREPAID INSURANCE
(a) On Dec 1, FastForward paid $2,400 for insurance for 2
years (24 months). FastForward recorded the expenditure
as an asset Prepaid Insurance on December 1.
What adjustment is required at year-end December 31?

Dec. 31 Insurance Expense 100

Prepaid Insurance 100
To record first month's expired insurance

Prepaid Insurance Insurance Expense

Dec. 1 2,400 Dec. 31 100 Dec. 31 100
Bal. 2,300
 SUPPLIES
(b) During December, FastForward purchased $9,720 of
supplies. FastForward recorded the expenditures in the asset
account Supplies. On December 31, a count of the supplies
indicated $8,670 on hand, so $1,050 of supplies was used
during December.
What adjustment is required?

Dec. 31 Supplies Expense 1,050

Supplies 1,050
To record supplies used

Supplies Supplies Expense

Bought 9,720 Dec. 31 1,050 Dec. 31 1,050
Bal. 8,670
 OTHER PREPAID EXPENSES
1. Other prepaid expenses, such as Prepaid Rent, are
accounted for exactly as Insurance and Supplies.
2. We should note that some prepaid expenses are both
paid for and fully used up within a single period.
3. For example, a company may pay monthly rent on the
first day of each month. This payment creates a prepaid
expense on the first day of the month that fully expires
by the end of the month.
4. In these special cases, we can record the cash paid with
a debit to the expense account instead of an asset
account.
 DEPRECIATION
Depreciation is the process of allocating the cost of an
item of property, plant and equipment to expense in
the accounting periods benefiting from its use.

Straight-Line Asset Cost - Residual Value

Depreciation =
Expense Useful Life
IAS 16 Property, plant and equipment:
Useful life is the period over which an asset is expected to be available for
use.
Residual value is the estimated amount that an entity would currently
obtain from disposal of the asset, after deducting the estimated costs of
disposal, if the asset were already of the age and in the condition expected
at the end of its useful life.
 DEPRECIATION
On December 1, FastForward purchased
equipment for $26,000. The equipment has an
estimated useful life of four years (48 months) and
its residual value is $8,000.
(c) Lets record depreciation expense for the
month ended December 31.

December $26,000 - $8,000

Depreciation = = $375 per month
Expense 48 months
 DEPRECIATION

Dec. 31 Depreciation Expense 375

Accumulated Depreciation - Equipment 375
To record monthly equipment depreciation

Contra asset account

Equipment Depreciation Expense

Dec. 1 26,000 Dec. 31 375

Accumulated Depreciation - Equipment

Dec. 31 375

This contra account allows readers to know both the full cost of the
equipment and the total depreciation since the equipment was bought.
 CONTRA ACCOUNT
Equipment
An account linked with
another account.
Balance is opposite to

the other accounts + -

Normal
balance.
An asset is debit, so the Accumulated
contra asset is credit. Depreciation

- +
Normal
 PRESENTATION ON
STATEMENT OF FINANCIAL POSITION

FastForward
Statement of Financial Position
December 31, 2011
Assets
Cash $
.
Equipment $ 26,000
Less: accumulated deprec. 375 25,625 $25,625 is the carrying
. amount (traditionally
. called net book value or
Total Assets book value.)

The company can also show the amount as $25,625 and

show details about accumulated depreciation in notes to
financial statements.
 UNEARNED (DEFERRED) REVENUES
Unearned revenues
(liabilities) are
earned over time

Received cash before revenue recognized The original entry involves

increasing cash and increasing
a liability.
Unearned The adjusting entry involves
(Deferred)
decreasing the liability
revenues
originally recorded and
increasing a revenue.
 UNEARNED (DEFERRED)
REVENUES
We will apply this cash
Cash received in you gave us towards
advance of providing your total consulting fees.
products or services.
 UNEARNED (DEFERRED)
REVENUES
FastForward agrees to provide consulting services to
a client for a fixed fee of $3,000 for 60 days starting
from December 27. On December 26, the client pays
the entire consulting fee in advance. FastForward
makes the following entry:

Dec. 26 Cash 3,000

Unearned Revenue 3,000
To record consulting fees received in advance

Unearned Revenue
Dec. 26 3,000
 UNEARNED (DEFERRED)
REVENUES
(d) On December 31, FastForward earns 5 days of
consulting fees. Each day that passes results in
consulting fee of $50 ($3,000 60), so FastForward
earned ($50 5 days) $250.

Dec. 31 Unearned Revenue 250

Consulting Revenue 250
To recognize 5 days of consulting fees

Unearned Revenue Consulting Revenue

Dec. 31 250 Dec. 26 3,000 Dec. 31 250
Bal. 2,750
 ACCRUED EXPENSES

Expenses recorded
due to matching
principle

Paid cash after expense recognized No original entry.

Accrued The adjusting entry

expenses involves increasing an
expense and increasing
a liability.
 ACCRUED EXPENSES
Costs incurred in Boss, we have done work
a period that are for you but not paid yet!
both unpaid and
unrecorded.
 ACCRUED SALARIES EXPENSE
FastForwards employee earns $70 per day and is paid
every two weeks on Friday. Year-end, December 31, falls
on a Wednesday. The last payday is Friday, December 26.
From December 26 until year-end is three working days
(December 29 to 31). The employee has earned salaries of
$210 for Monday through Wednesday and will not be paid
until the next Friday.
 ACCRUED SALARIES EXPENSE
(e) FastForwards employee has earned but not been paid
on December 31, $210.

Dec. 31 Salaries Expense 210

Salaries Payable 210
To accrue 3 days' salary (3 x $70)

Salaries Expense Salaries Payable

Dec. 31 210 Dec. 31 210
 FUTURE PAYMENT OF
ACCRUED EXPENSES
On January 9 the next year, FastForward will pay the payroll
for the two weeks from December 26 through January 9.
Here is the journal entry for the payroll:

Jan. 9 Salaries Payable (3 days @ $70) 210

Salaries Expense (7 days @ $70) 490
Cash (10 days @ $70) 700
T o record th e p aym en t of two weeks' salary
 ACCRUED REVENUES
Revenues recorded
due to revenue
recognition principle

Received cash after revenue recognized No original entry.

Accrued The adjusting entry involves

revenues increasing a receivable and
increasing a revenue.
 ACCRUED REVENUES
Revenues earned in a Yes, I have completed your
period that consulting job, but have not
had time to bill you yet.
are both not recorded
and not received.
 ACCRUED SERVICE REVENUE
In December , FastForward agrees to render consulting services
under a 30-day fixed fee contract for $2,700 ($90 per day). All
services are to be completed by January the next year when the
client will pay in full.
(f) On December 31, 20 days of services have already been
provided.

Dec. 31 Accounts Receivable 1,800

Consulting Revenue 1,800
To accrue revenue (20 days @ $90 per day)

Accounts Receivable Consulting Revenue

Dec. 31 1,800 Dec. 31 1,800
 FUTURE RECEIPT OF
ACCRUED REVENUES
On January 10 the next year, FastForward completed its
obligation under the consulting contract. The client was
billed $2,700 and FastForward received $2,700 in cash.

Jan 10 Cash 2,700

Accounts Receivable 1,800
Consulting Revenue 900
T o record com p letion of con tract an d cash collection

Revenue in January
10 days @ $90 = $900