Chapter 3 Adjusting Accounts and Preparing Financial Statements

Chapter 3 Adjusting Accounts and Preparing Financial Statements Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -2 Conceptual Chapter Objectives C 1: Explain the importance of periodic reporting and the time period principle C 2: Explain accrual accounting and how it improves financial statements C 3: Identify the types of adjustments and their purpose C 4: Explain why temporary accounts are closed each period C 5: Identify steps in the accounting cycle C 6: Explain and prepare a classified balance sheet Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -3 Analytical Chapter Objectives A 1: Explain how accounting adjustments link to financial statements A 2: Compute profit margin and describe its use in analyzing company performance A 3: Compute the current ratio and describe what it reveals about a company’s financial condition Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -4 Procedural Chapter Objectives P 1: Prepare and explain adjusting entries P 2: Explain and prepare an adjusted trial balance P 3: Prepare financial statements from an adjusted trial balance P 4: Describe and prepare closing entries P 5: Explain and prepare a post-closing trial balance Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

Procedural Chapter Objectives (Continued) 3 -5 P 6: Appendix A: Explain alternatives in accounting for prepaids P 7: Appendix B: Prepare a work sheet and explain its usefulness P 8: Appendix C: Prepare reversing entries and explain their purpose Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -6 C 1 The Accounting Period Annually 1 2 Semiannually 1 2 3 4 Quarterly 1 Jan Mc. Graw-Hill/Irwin 2 3 4 Feb Mar Apr 5 6 7 May Jun Jul 8 9 10 Aug Sep Oct Monthly 11 12 Nov Dec © The Mc. Graw-Hill Companies, Inc. , 2008

3 -7 C 1 Accrual Basis vs. Cash Basis Accrual Basis Cash Basis Revenues are recognized when earned and expenses are recognized when incurred. Revenues are recognized when cash is received and expenses recorded when cash is paid. Not GAAP Accounting Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -8 C 1 Accrual Basis vs. Cash Basis On the cash basis the entire $2, 400 would be recognized as insurance expense in 2007. No insurance expense from this policy would be recognized in 2008 or 2009, periods covered by the policy. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -9 C 1 Accrual Basis vs. Cash Basis On the accrual basis $100 of insurance expense is recognized in 2007, $1, 200 in 2008, and $1, 100 in 2009. The expense is matched with the periods benefited by the insurance coverage. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -10 Recognizing Revenues C 1 n Revenue Recognition We have delivered the product to our customer, so I think we should record the revenue earned. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -11 Recognizing Expenses C 1 n n Revenue Recognition Matching Now that we have Summary of Expenses Rent Gasoline Advertising Salaries Utilities and. . Mc. Graw-Hill/Irwin $1, 000 500 2, 000 3, 000 450. . recognized the revenue, let’s see what expenses we incurred to generate that revenue. © The Mc. Graw-Hill Companies, Inc. , 2008

3 -12 C 3 Adjusting Accounts An adjusting entry is recorded to bring an asset or liability account balance to its proper amount. Framework for Adjustments Paid (or received) cash before expense (or revenue) recognized Prepaid (Deferred) expenses* Mc. Graw-Hill/Irwin Unearned (Deferred) revenues *including depreciation Paid (or received) cash after expense (or revenue) recognized Accrued expense Accrued revenues © The Mc. Graw-Hill Companies, Inc. , 2008

3 -13 P 1 Prepaid (Deferred) Expenses Resources paid for prior to receiving the actual benefits. Asset Unadjusted Balance Mc. Graw-Hill/Irwin Credit Adjustment Here is the check for my first 6 months’ insurance. Expense Debit Adjustment © The Mc. Graw-Hill Companies, Inc. , 2008

3 -14 P 1 Prepaid Insurance On December 1, 2007, Scott Company paid $12, 000 to cover insurance for December 2007 through May 2008. Scott recorded the expenditure as Prepaid Insurance on December 1. What adjustment is required? 637 Mc. Graw-Hill/Irwin 128 © The Mc. Graw-Hill Companies, Inc. , 2008

3 -15 Supplies P 1 During 2007, 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? 126 Mc. Graw-Hill/Irwin 652 © The Mc. Graw-Hill Companies, Inc. , 2008

3 -16 Depreciation P 1 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 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -17 Depreciation P 1 On January 1, 2007, 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. Let’s record depreciation expense for the year ended December 31, 2007 $62, 000 - $2, 000 Depreciation = = Expense 5 Mc. Graw-Hill/Irwin $12, 000 © The Mc. Graw-Hill Companies, Inc. , 2008

3 -18 Depreciation P 1 On January 1, 2007, 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. Let’s record depreciation expense for the year ended December 31, 2007. Accumulated depreciation is a contra asset account. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -19 Depreciation P 1 Equipment 1/1 62, 000 Depreciation Expense 12/31 12, 000 Accumulated Depreciation 12/31 12, 000 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -20 P 1 Depreciation $ Mc. Graw-Hill/Irwin Equipment is shown net of accumulated depreciation. © The Mc. Graw-Hill Companies, Inc. , 2008

3 -21 P 1 Unearned (Deferred) Revenues Cash received in advance of providing products or services. Liability Debit Adjustment Mc. Graw-Hill/Irwin Unadjusted Balance Buy your season tickets for all home basketball games NOW! “Go Big Blue” Revenue Credit Adjustment © The Mc. Graw-Hill Companies, Inc. , 2008

3 -22 P 1 Unearned (Deferred) Revenues On October 1, 2007, Ox University sold 1, 000 season tickets to its 20 home basketball games for $100 each. Ox University makes the following entry: Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -23 P 1 Unearned (Deferred) Revenues On December 31, Ox University has played 10 of its regular home games, winning 2 and losing 8. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -24 Accrued Expenses P 1 Costs incurred in a period that are both unpaid and unrecorded. Expense Debit Adjustment Mc. Graw-Hill/Irwin We’re about one-half done with this job and want to be paid for our work! Liability Credit Adjustment © The Mc. Graw-Hill Companies, Inc. , 2008

3 -25 Accrued Expenses P 1 Barton, Inc. pays its employees every Friday. Yearend, 12/31/07, falls on a Wednesday. As of 12/31/07, the employees have earned salaries of $47, 250 for Monday through Wednesday. Last pay date 12/26/07 12/1/07 Mc. Graw-Hill/Irwin Next pay date 12/31/07 Year end Record adjusting journal entry. © The Mc. Graw-Hill Companies, Inc. , 2008

3 -26 Accrued Expenses P 1 Barton, Inc. pays its employees every Friday. Yearend, 12/31/07, falls on a Wednesday. As of 12/31/07, the employees have earned salaries of $47, 250 for Monday through Wednesday. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -27 Accrued Revenues P 1 Revenues earned in a period that are both unrecorded and not yet received. Asset Debit Adjustment Mc. Graw-Hill/Irwin Yes, I’ve completed your tax return, but have not had time to bill you yet. Revenue Credit Adjustment © The Mc. Graw-Hill Companies, Inc. , 2008

Accrued Revenues P 1 3 -28 Smith & Jones, CPAs, had $31, 200 of work completed but not yet billed to clients. Let’s make the adjusting entry necessary on December 31, 2007, the end of the company’s fiscal year. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -29 A 1 Links to Financial Statements Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -30 P 2 Fast. Forward - Trial Balance - December 31, 2007 $ Mc. Graw-Hill/Irwin First, the initial unadjusted amounts are added to the work sheet. © The Mc. Graw-Hill Companies, Inc. , 2008

3 -31 P 2 Fast. Forward - Trial Balance - December 31, 2007 Next, Fast. Forward’s adjustments are added. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -32 P 2 Fast. Forward - Trial Balance - December 31, 2007 Finally, the totals are determined. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

P 3 Preparing Financial Statements 3 -33 Let’s use Fast. Forward’s adjusted trial balance to prepare the company’s financial statements. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -34 P 3 Mc. Graw-Hill/Irwin 1. Prepare the Income Statement © The Mc. Graw-Hill Companies, Inc. , 2008

3 -35 P 3 2. Prepare Statement of Retained Earnings Note: Net Income from the Income Statement carries to the Statement of Retained Earnings. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -36 P 3 Mc. Graw-Hill/Irwin 3. Prepare Balance Sheet © The Mc. Graw-Hill Companies, Inc. , 2008

C 4 Temporary and Permanent Accounts 3 -37 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. ” Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -38 P 4 Recording Closing Entries 1. Close revenue accounts. 2. Close expense accounts. 3. Close the income summary account. 4. Close dividends account. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -39 P 4 Recording Closing Entries Salaries Expenses $ 18, 100 Consulting Revenues Examine the accounts presented. Income Summary $ 25, 000 Retained Earnings $ 7, 000 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -40 P 4 Recording Closing Entries Salaries Expenses $ 25, 000 $ 18, 100 Income Summary $ 25, 000 Mc. Graw-Hill/Irwin Consulting Revenues $ 25, 000 Close revenues with a debit to the revenue account and a credit to Income Summary. © The Mc. Graw-Hill Companies, Inc. , 2008

3 -41 P 4 Recording Closing Entries Salaries Expenses $ 18, 100 Income Summary $ 18, 100 Mc. Graw-Hill/Irwin $ 25, 000 Consulting Revenues $ 25, 000 Close expense accounts with a credit to expenses and a debit to Income Summary. © The Mc. Graw-Hill Companies, Inc. , 2008

3 -42 P 4 Recording Closing Entries Salaries Expenses $ 18, 100 Income Summary $ 18, 100 $ 25, 000 $ 6, 900 Mc. Graw-Hill/Irwin Consulting Revenues $ 25, 000 Determine the balance in the Income Summary account. © The Mc. Graw-Hill Companies, Inc. , 2008

3 -43 P 4 Recording Closing Entries Salaries Expenses $ 18, 100 Income Summary $ 18, 100 $ 6, 900 Mc. Graw-Hill/Irwin $ 25, 000 $ 6, 900 Close the Income Summary to Retained Earnings $ 7, 000 $ 6, 900 © The Mc. Graw-Hill Companies, Inc. , 2008

3 -44 P 4 Recording Closing Entries The dividends account is closed to Retained Earnings. Dividends $ 2, 000 Mc. Graw-Hill/Irwin $ 2, 000 Retained Earnings $ 2, 000 $ 7, 000 6, 900 © The Mc. Graw-Hill Companies, Inc. , 2008

3 -45 P 4 Recording Closing Entries The dividends account is closed to Retained Earnings. Dividends $ 2, 000 Retained Earnings $ 2, 000 Determine the ending balance in Retained Earnings. Mc. Graw-Hill/Irwin $ 7, 000 6, 900 $ 11, 900 © The Mc. Graw-Hill Companies, Inc. , 2008

3 -46 Post Closing Trial Balance n n n Mc. Graw-Hill/Irwin 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. © The Mc. Graw-Hill Companies, Inc. , 2008

3 -47 The Accounting Cycle C 5 Start Analyze transactions Reverse (optional) Prepare post-closing trial balance Close Journalize Post Prepare statements Prepare unadjusted trial balance Prepare adjusted trial balance Mc. Graw-Hill/Irwin Adjust © The Mc. Graw-Hill Companies, Inc. , 2008

3 -48 Classified Balance Sheet C 6 Current items are those expected to come due (either collected or owed) within one year or the company’s operating cycle, whichever is longer. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -49 Classified Balance Sheet C 6 Current Assets 1. Cash, 2. Short-term investments, 3. Accounts receivable, 4. Short-term notes receivable, 5. Inventory for sale, and 6. Prepaid expenses. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -50 Classified Balance Sheet C 6 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -51 Classified Balance Sheet C 6 Plant Assets Plant 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -52 C 6 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -53 Current Liabilities C 6 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -54 Long-Term Liabilities C 6 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -55 Classified Balance Sheet Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -56 Profit Margin A 2 The profit margin ratio measures the company’s net income to net sales. Profit Net Income = Margin Net Sales Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -57 A 3 Current Ratio This ratio is an important measure of a company’s ability to pay its short-term obligations. Current assets = ratio Current liabilities Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008

3 -58 End of Chapter 3 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2008