Chapter 3

Adjusting Accounts and Preparing Financial Statements

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Conceptual Chapter Objectives

C1: Explain the importance of periodic reporting and the time period principle C2: Explain accrual accounting and how it improves financial statements C3: Identify the types of adjustments and their purpose C4: Explain why temporary accounts are closed each period C5: Identify steps in the accounting cycle C6: Explain and prepare a classified balance sheet

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Analytical Chapter Objectives

A1: Explain how accounting adjustments link to financial statements A2: Compute profit margin and describe its use in analyzing company performance A3: Compute the current ratio and describe what it reveals about a companys financial condition
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Procedural Chapter Objectives

P1: Prepare and explain adjusting entries P2: Explain and prepare an adjusted trial balance P3: Prepare financial statements from an adjusted trial balance P4: Describe and prepare closing entries P5: Explain and prepare a post-closing trial balance
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Procedural Chapter Objectives (Continued)

P6: Appendix 3A: Explain alternatives in accounting for prepaids P7: Appendix 3B: Prepare a work sheet and explain its usefulness P8: Appendix 3C: Prepare reversing entries and explain their purpose

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C1

The Accounting Period

Annually
1 2

Semiannually
1 2
3 4 5 6 7

3
8 9 10

4
11 12

Quarterly
1 2

Jan

Feb

Mar

Apr

May Jun Jul

Aug Sep Oct

Nov Dec

Monthly
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C2

Accrual Basis vs. Cash Basis

Accrual Basis Revenues are recognized when earned and expenses are recognized when incurred. Cash Basis

Revenues are recognized when cash is received and expenses recorded when cash is paid.

Not GAAP
Accounting

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C2

Accrual Basis vs. Cash Basis

FastForward paid $2,400 for a 24-month insurance policy beginning December 1, 2009.
Insurance Expense 2009 Jan Feb Mar Apr $ May Sep $ Jun Oct $ Jul Nov $ Aug Dec

Example:

$ 2,400

On the cash basis the entire $2,400 would be recognized as insurance expense in 2009. No insurance expense from this policy would be recognized in 2010 or 2011, periods covered by the policy.
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C2

Accrual Basis vs. Cash Basis

Insurance Expense 2009 Jan Feb Mar Apr $ May Sep $ Jun Oct $ Jul Nov $ Aug Dec 100

Insurance Expense 2010 Jan Feb Mar Apr $ $ $ 100 May 100 Sep 100 $ $ $ 100 Jun 100 Oct 100 $ $ $ 100 Jul 100 Nov 100 $ $ $ 100 Aug 100 Dec 100

Insurance Expense 2011 Jan Feb Mar Apr $ $ 100 May 100 Sep $ $ 100 Jun 100 Oct 100 $ $ $ 100 Jul 100 Nov 100 $ $ $ 100 Aug 100 Dec -

On the accrual basis $100 of insurance expense is recognized in 2009, $1,200 in 2010, and $1,100 in 2011. The expense is matched with the periods benefited by the insurance coverage.

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C2

Recognizing Revenues

Revenue Recognition
We have delivered the product to our customer, so I think we should record the revenue earned.

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C2

Recognizing Expenses

Revenue Recognition Matching Now that we have

Summary of Expenses
Rent Gasoline Advertising Salaries Utilities and . . . . $1,000 500 2,000 3,000 450 ....

recognized the revenue, lets see what expenses we incurred to generate that revenue.

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C3

Adjusting Accounts
An adjusting entry is recorded to bring an asset or liability account balance to its proper amount.

Framework for Adjustments

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

Prepaid (Deferred) expenses*

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Unearned (Deferred) revenues

Accrued expense

Accrued revenues

*including depreciation

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P1

Prepaid (Deferred) Expenses

Resources paid for prior to receiving the actual benefits.
Asset
Unadjusted Balance Credit Adjustment

Here is the check for my first 6 months insurance.

Expense
Debit Adjustment

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P1

Prepaid Insurance
On December 1, 2009, Scott Company paid $12,000 to cover insurance for December 2009 through May 2010. Scott recorded the expenditure as Prepaid Insurance on December 1. What adjustment is required?
Dec. 31 Insurance Expense Prepaid Insurance 2,000 2,000
128

To record first month's expired insurance

Prepaid Insurance Dec. 1 12,000 Dec. 31 Bal. 10,000

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637

2,000

Insurance Expense Dec. 31 2,000

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P1

Supplies
During 2009, Scott Company purchased $15,500 of supplies. Scott recorded the expenditures as Supplies. On December 31, a count of the supplies indicated $2,655 on hand. What adjustment is required?
Dec. 31 Supplies Expense Supplies
126 Supplies Bought 15,500 Dec. 31 12,845 Bal. 2,655

12,845 12,845
652

To record supplies used during 2009

Supplies Expense Dec. 31 12,845

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P1

Depreciation
Depreciation is the process of computing expense from allocating the cost of plant and equipment over their expected useful lives.
Straight-Line Asset Cost - Salvage Value Depreciation = Useful Life Expense

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P1

Depreciation
On January 1, 2009, Barton, Inc. purchased equipment for $62,000 cash. The equipment has an estimated useful life of 5 years and Barton expects to sell the equipment at the end of its life for $2,000 cash. Lets record depreciation expense for the year ended December 31, 2009.
2009 $62,000 - $2,000 Depreciation = = Expense 5

$12,000

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P1

Depreciation
On January 1, 2009, Barton, Inc. purchased equipment for $62,000 cash. The equipment has an estimated useful life of 5 years and Barton expects to sell the equipment at the end of its life for $2,000 cash. Lets record depreciation expense for the year ended December 31, 2009.

Dec. 31 Depreciation Expense Accumulated Depreciation - Equipment

To record equipment depreciation

12,000 12,000

Accumulated depreciation is a contra asset account.

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P1

Depreciation
12,000 12,000

Dec. 31 Depreciation Expense Accumulated Depreciation - Equipment

To record equipment depreciation

Equipment
1/1 62,000

Depreciation Expense
12/31 12,000

Accumulated Depreciation
12/31 12,000

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P1

Depreciation

Barton, Inc. Partial Balance Sheet At December 31, 2009 Assets Cash . Equipment Less: accumulated deprec. . . Total Assets

$ 62,000 (12,000)

Equipment is shown net of accumulated depreciation.

50,000

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P1

Unearned (Deferred) Revenues

Cash received in advance of providing products or services.

Buy your season tickets for all home basketball games NOW!

Go Big Blue

Liability
Debit Adjustment Unadjusted Balance

Revenue
Credit Adjustment

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P1

Unearned (Deferred) Revenues

On October 1, 2009, Ox University sold 1,000 season tickets to its 20 home basketball games for $100 each. Ox University makes the following entry:
Oct. 1 Cash Unearned Revenue
Unearned Revenue Oct.1 100,000

100,000 100,000
Basketball revenue received in advance

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P1

Unearned (Deferred) Revenues

On December 31, Ox University has played 10 of its regular home games, winning 2 and losing 8.
Dec. 31 Unearned Revenue 50,000 Basketball Revenue

50,000

To recognize 10-games of revenue

Unearned Revenue Dec. 31 50,000 Oct. 1 100,000 Bal. 50,000
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Basketball Revenue Dec. 31 50,000

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P1

Accrued Expenses
Costs incurred in a period that are both unpaid and unrecorded.
Were about one-half done with this job and want to be paid for our work!

Expense
Debit Adjustment

Liability
Credit Adjustment

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P1

Accrued Expenses
Barton, Inc. pays its employees every Friday. Year-end, 12/31/09, falls on a Wednesday. As of 12/31/09, the employees have earned salaries of $47,250 for Monday through Wednesday.

Last pay date 12/26/09 12/1/09 12/31/09 Year end

Next pay date

Record adjusting journal entry.

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P1

Accrued Expenses
Barton, Inc. pays its employees every Friday. Year-end, 12/31/09, falls on a Wednesday. As of 12/31/09, the employees have earned salaries of $47,250 for Monday through Wednesday.
Dec. 31 Salaries Expense Salaries Payable
Salaries Expense Other salaries 657,500 Dec. 31 47,250 Bal. 704,750

47,250 47,250
Salaries Payable Dec. 31 47,250

To accrue 3-days' salary

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P1

Accrued Revenues
Revenues earned in a period that are both unrecorded and not yet received.
Yes, Ive completed your tax return, but have not had time to bill you yet.

Asset
Debit Adjustment

Revenue
Credit Adjustment

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P1

Accrued Revenues
Smith & Jones, CPAs, had $31,200 of work completed but not yet billed to clients. Lets make the adjusting entry necessary on December 31, 2009, the end of the companys fiscal year.
Dec. 31 Accounts Receivable Service Revenue
Accounts Receivable Other receivables 1,325,268 Dec. 31 31,200 Bal. 1,356,468

31,200 31,200
Service Revenue Other revenues 6,589,500 Dec. 31 31,200 Bal . 6,620,700

To accrue revenue earned

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A1

Links to Financial Statements

Summary of Adjustments and Financial Statement Links Before Adjustment Income Balance Sheet Statement Account Account Type Adjusting Entry Prepaid Asset Overstated Expense Dr. Expense Expenses Equity Overstated Understated Cr. Asset Unearned Liability Overstated Revenue Dr. Liability Revenues Equity Understated Understated Cr. Revenue Accrued Liability Understated Expense Dr. Expense Expenses Equity Overstated Understated Cr. Liability Accrued Asset Understated Revenue Dr. Asset Revenues Equity Understated Understated Cr. Revenue
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P2

FastForward - Trial Balance - December 31, 2009

Trial Balance Dr. Cr. 3,950 9,720 2,400 26,000 Adjustments Dr. Cr. Adjusted Trial Balance Dr. Cr.

Cash Accounts receivable Supplies Prepaid insurance Equipment Accum. depr. - Equip. Accounts payable Salaries payable Unearned revenue Common Stock Retained Earnings Dividends Consulting revenue Rental revenue Depr. expense Salaries expense Insurance expense Rent expense Supplies expense Utilities expense Totals

6,200 3,000 30,000 0 5,800 300

600

1,400 1,000 230 45,300

First, the initial unadjusted amounts are added to the work sheet.

45,300

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P2

FastForward - Trial Balance - December 31, 2009

Cash Accounts receivable Supplies Prepaid insurance Equipment Accum. depr. - Equip. Accounts payable Salaries payable Unearned revenue Common Stock Retained Earnings Dividends Consulting revenue Rental revenue Depr. expense Salaries expense Insurance expense Rent expense Supplies expense Utilities expense Totals McGraw-Hill/Irwin

Unadjusted Trial Balance Dr. Cr. 3,950 9,720 2,400 26,000

Adjustments Dr. f 1,800 b a c e 250

Cr.

Adjusted Trial Balance Dr. Cr.

1,050 100 375 210

6,200 3,000 d 30,000 0 600 5,800 300 1,400 1,000 230 $45,300 c e a b $45,300

Next, FastForwards adjustments are added.

d f 375 210 100 1,050 $3,785

250 1,800

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P2

FastForward - Trial Balance - December 31, 2009

Unadjusted Trial Balance Dr. Cr. 3,950 9,720 2,400 26,000 Adjustments Dr. f 1,800 b a c e 250 600 5,800 300 1,400 1,000 230 $45,300 c e a b $45,300 375 210 100 1,050 $3,785 $3,785 d f 250 1,800 7,850 300 1,050 100 375 210 Adjusted Trial Balance Dr. Cr. 3,950 1,800 8,670 2,300 26,000 375 6,200 210 2,750 30,000 -

Cr.

Cash Accounts receivable Supplies Prepaid insurance Equipment Accum. depr. - Equip. Accounts payable Salaries payable Unearned revenue Common Stock Retained Earnings Dividends Consulting revenue Rental revenue Depr. expense Salaries expense Insurance expense Rent expense Supplies expense Utilities expense Totals
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6,200 3,000 d 30,000 600

Finally, the totals are determined.

375 1,610 100 1,000 1,050 230 $47,685

$47,685

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P3

Preparing Financial Statements

Lets use FastForwards adjusted trial balance to prepare the companys financial statements.

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P3

1. Prepare the Income Statement

Adjusted Trial Balance December 31, 2009 Dr. Cr. Cash Accounts receivable Supplies Prepaid insurance Equipment Accum. depr. - Equip. Accounts payable Salaries payable Unearned revenue Common Stock Retained Earnings Dividends Consulting revenue Rental revenue Depr. expense Salaries expense Insurance expense Rent expense Supplies expense Utilities expense McGraw-Hill/Irwin Totals
$ 3,950 1,800 8,670 2,300 26,000 $ 375 6,200 210 2,750 30,000 600 7,850 300 375 1,610 100 1,000 1,050 230 $ 47,685 $ 47,685

FastForward Income Statement For the Month Ended December 31, Revenues: Consulting revenue $ Rental revenue Operating expenses: Depr. expense - Equip. $ 375 Salaries expense 1,610 Insurance expense 100 Rent expense 1,000 Supplies expense 1,050 Utilities expense 230 Total expenses Net income $

2009 7,850 300

4,365 3,785

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P3

2. Prepare Statement of Retained Earnings

Note: Net Income from the Income Statement carries to the Statement of Retained Earnings.
FastForward Income Statement For the Month Ended December 31, 2009 Revenues: Consulting revenue $ 7,850 Rental revenue 300 Operating expenses: Depr. expense - Equip. $ 375 Salaries expense 1,610 Insurance expense 100 Rent expense 1,000 Supplies expense 1,050 Utilities expense 230 Total expenses 4,365 Net income $ 3,785
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FastForward Statement of Retained Earnings For the Month Ended December 31, 2009 Retained earnings, 12/1/09 Add: Net income Less: Dividends Retained earnings 12/31/09 $ -03,785 600 $ 3,185

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P3

3. Prepare Balance Sheet

Adjusted Trial Balance Dr. Cr. Cash $ 3,950 Accounts receivable 1,800 Supplies 8,670 Prepaid insurance 2,300 Equipment 26,000 Accum. depr. - Equip. $ 375 Accounts payable 6,200 Salaries payable 210 FastForward Unearned revenue 2,750 Statement of Retained Earnings Chuck Taylor, Capital 30,000 For the Month Ended December 31, 2009 Chuck Taylor, Withd'l. 600 Consulting revenue 7,850 Rental revenue Retained earnings, 12/1/07 $ 300 -0Depr. expense 375 Add: Net income 3,785 Salaries expense 1,610 Less: Dividends 600 Insurance expense 100 Rent expenseearnings 12/31/07 1,000 Retained $ 3,185 Supplies expense 1,050 Utilities expense 230 Totals $ 47,685 $ 47,685

FastForward Balance Sheet December 31, 2009

Assets
Cash Accounts receivable Supplies Prepaid insurance Equipment Less: accum. depr. Total assets $ 3,950 1,800 8,670 2,300 25,625 42,345

26,000 (375) $ $ 6,200 210 2,750 $

Liabilities
Accounts payable Salaries payable Unearned revenue Total liabilities

9,160 30,000 3,185 42,345

Equity
Common stock Retained earnings Total liabilities and equity $

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C4

Temporary and Permanent Accounts

Temporary (nominal) accounts accumulate data related to one accounting period. They include all income statement accounts, the dividends account, and the Income Summary account. These accounts are closed at the end of the period to get ready for the next accounting period.

Permanent (real) accounts report activities related to one or more future accounting periods. They carry ending balances to the next accounting period and are not closed.
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P4

Recording Closing Entries

1. 2. 3. 4.
Close revenue accounts. Close expense accounts. Close the income summary account.

Close dividends account.

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P4

Recording Closing Entries

Salaries Expenses
$ 18,100

Consulting Revenues
$ 25,000

Examine the accounts presented.

Income Summary

Retained Earnings
$ 7,000

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P4

Recording Closing Entries

Salaries Expenses
$ 18,100

Consulting Revenues
$ 25,000 $ 25,000

Income Summary
$ 25,000

Close revenues with a debit to the revenue account and a credit to Income Summary.
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P4

Recording Closing Entries

Salaries Expenses
$ 18,100 $ 18,100

Consulting Revenues
$ 25,000 $ 25,000

Income Summary
$ 18,100 $ 25,000

Close expense accounts with a credit to expenses and a debit to Income Summary.
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P4

Recording Closing Entries

Salaries Expenses
$ 18,100 $ 18,100

Consulting Revenues
$ 25,000 $ 25,000

Income Summary
$ 18,100 $ 25,000

$ 6,900

Determine the balance in the Income Summary account.

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P4

Recording Closing Entries

Salaries Expenses
$ 18,100 $ 18,100

Close the Income Summary to Retained Earnings.

Income Summary
$ 18,100 $ 6,900 $ 25,000 $ 6,900

Retained Earnings
$ 7,000 $ 6,900

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P4

Recording Closing Entries

The dividends account is closed to Retained Earnings.
Dividends
$ 2,000

Retained Earnings
$ 2,000
$ 7,000 6,900

$ 2,000

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P4

Recording Closing Entries

The dividends account is closed to Retained Earnings.
Dividends
$ 2,000
$ 2,000

Retained Earnings
$ 2,000 $ 7,000 6,900 $ 11,900

Determine the ending balance in Retained Earnings.

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P5

Post Closing Trial Balance

Trial Balance prepared after the closing entries have been posted. The purpose is to insure that all nominal or temporary accounts have been closed. The only accounts on this trial balance should be assets, liabilities, and equity accounts.
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C5

The Accounting Cycle

Start Analyze transactions Reverse (optional) Prepare post-closing trial balance Close

Journalize
Post Prepare unadjusted trial balance
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Prepare statements
Prepare adjusted trial balance
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Adjust

C6

Classified Balance Sheet

Assets Current assets Noncurrent assets: Long-term investments Plant assets Intangible assets Liabilities and Equity Current liabilities Noncurrent liabilities Equity

Current items are those expected to come due (either collected or owed) within one year or the companys operating cycle, whichever is longer.

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C6

Classified Balance Sheet

Current Assets
1. Cash, 2. Short-term investments, 3. Accounts receivable, 4. Short-term notes receivable, 5. Inventory for sale, and 6. Prepaid expenses.

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C6

Classified Balance Sheet

Long-Term Investments
Notes receivable and investments in stocks and bonds of other companies that will be held for the longer of one year or the operating cycle. Land held for future expansion is also a longterm investment.

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C6

Classified Balance Sheet

Property, plant and equipment Assets
Property, plant and equipment assets are tangible assets that are both long lived and used to produce or sell products or services. Examples include equipment, machinery, buildings, and land that are used to produce or sell products and services.

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C6

Classified Balance Sheet

Intangible Assets

Long-term resources that benefit business operations. They usually lack physical form and have uncertain benefits. Examples include patents, trademarks, copyrights, franchises, and goodwill.

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C6

Current Liabilities
Obligations due to be paid or settled within one year or the operating cycle, whichever is longer. Current liabilities include: 1. Accounts payable,

2. Notes payable,
3. Taxes payable, 4. Interest payable, 5. Unearned revenues, 6. Wages payable.
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C6

Long-Term Liabilities
Obligations not due within one year or the operating cycle, whichever is longer. Long-term liabilities include: 1. Notes payable,

2. Mortgages payable,
3. Bonds payable, and

4. Lease obligations.

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FastForward Balance Sheet December 31, 2009

Assets Current Assets Cash Accounts receivable Supplies Prepaid insurance Total Current Assets Plant Assets Equipm ent Less: accum . depr. Total assets Liabilities Current Liabilities Accounts payable Salaries payable Unearned revenue Total liabilities Equity
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3,950 1,800 8,670 2,300 16,720

Classified Balance Sheet

26,000 (375) $ 25,625 42,345

6,200 210 2,750 $ 9,160

A2

Profit Margin
The profit margin ratio measures the companys net income to net sales.

Profit Net Income = Margin Net Sales

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A3

Current Ratio

This ratio is an important measure of a companys ability to pay its short-term obligations. Current Current assets = ratio Current liabilities

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End of Chapter 3

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