© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin1 Adjusting Accounts and Preparing...

© The McGraw-Hill Companies, Inc., 2006McGraw-Hill/Irwin1

Adjusting Accounts and Preparing Financial Statements

Chapter

33


Learning objectiveLearning objective Explain the importance of periodic reporting and the

time period principle. Explain accrual accounting and how it makes financial

statements more useful. Identify the types of adjustments and their purpose. Explain how accounting adjustments link to financial

statements. Explain and prepare an adjusted trial balance. Prepare financial statements from an adjusted trial

balance. Use adjusted trial balance to prepare the company’s

financial statements.


Learning objectiveLearning objective

Explain the importance of periodic reporting and the time period principle.


1 2 3 4 5 6 7 8 9 10 11 12

1 2 3 4

Annual

1 2

Monthly

Quarterly

Semiannual

The Accounting PeriodThe Accounting Period

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec


The Time Period PrincipleThe Time Period Principle

The time period principle assumes that an organization’s activities can be divided into specific time periods such as a month, a quarter, a six-month interval, or a year.

Fiscal year versus calendar year (Jan. 1 ~ Dec. 31).



Explain accrual accounting and how it makes financial statements more useful.


Accounting

Accrual Basis vs. Cash BasisAccrual 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 GAAPNot GAAPNot GAAPNot GAAP


Accrual Basis vs. Cash BasisAccrual Basis vs. Cash Basis

On the cash basis the entire $2,400 would be recognized as insurance expense in 2004. No insurance expense from this policy would be recognized in 2005 or

2006, periods covered by the policy.

On the cash basis the entire $2,400 would be recognized as insurance expense in 2004. No insurance expense from this policy would be recognized in 2005 or

2006, periods covered by the policy.

Jan Feb Mar Apr

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

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

-$ -$ -$ 2,400$

Insurance Expense 2004


Accrual Basis vs. Cash BasisAccrual Basis vs. Cash BasisJan Feb Mar Apr

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

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

-$ -$ -$ 100$

Jan Feb Mar Apr

100$ 100$ 100$ 100$ May Jun Jul Aug

100$ 100$ 100$ 100$ Sep Oct Nov Dec

100$ 100$ 100$ 100$

Jan Feb Mar Apr

100$ 100$ 100$ 100$ May Jun Jul Aug

100$ 100$ 100$ 100$ Sep Oct Nov Dec

100$ 100$ 100$ -$




On the accrual basis $100 of insurance

expense is recognized in 2004, $1,200 in 2005,

and $1,100 in 2006. The expense is matched with the periods benefited by the insurance coverage.

On the accrual basis $100 of insurance

expense is recognized in 2004, $1,200 in 2005,

and $1,100 in 2006. The expense is matched with the periods benefited by the insurance coverage.


We have delivered theproduct to our customer,

so I think we should recordthe revenue earned.

We have delivered theproduct to our customer,

so I think we should recordthe revenue earned.

Recognizing Revenues and ExpensesRecognizing Revenues and Expenses

Revenue Recognition



Revenue Recognition Matching

Summaryof Expenses

Rent

Gasoline

Advertising

Salaries

Utilities

and . . . .

$1,000

500

2,000

3,000

450

. . . .

Now that we haverecognized the revenue,let’s see what expenses

we incurred togenerate that revenue.

Now that we haverecognized the revenue,let’s see what expenses

we incurred togenerate that revenue.



Revenue recognition principle requires that revenue be recorded when earned, not before or after.

Matching principle intends to record expenses in the same accounting period as the revenues that are earned as a result of these expenses.


Revenues and ExpensesRevenues and Expenses



Can revenue and expense recognition be used to manipulate earnings?

Accelerate revenue recognition Postpone expense recognition

Postpone revenue recognition Accelerate expense recognition

Are they all?



What are the usual intentions to manipulate earnings?

Executive compensationMeet certain targets Changes of CEOPolitical motivationsTaxation reasons Initial Public Offering



Identify the types of adjustments and their purpose.


AdjustmentsAdjustments

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

Adjusting AccountsAdjusting Accounts

Paid (or received) cash before expense (or revenue) recognizedPaid (or received) cash before

expense (or revenue) recognizedPaid (or received) cash after

expense (or revenue) recognizedPaid (or received) cash after

expense (or revenue) recognized

Prepaid (Deferred) expenses*

Prepaid (Deferred) expenses*

Unearned (Deferred) revenues

Unearned (Deferred) revenues

AccruedexpenseAccruedexpense

AccruedrevenuesAccruedrevenues

Framework for Adjustments

*including depreciation


Adjusting Accounts – Prepaid expensesAdjusting Accounts – Prepaid expenses

Paid Cash Actually used

Accounting Period 1

Accounting Period 2

Accounting Period 3

Accounting Period 4

When should expenses be recognized?

Cash basis: At the beginning of period 1 recognize all cash payment as expense.

Dr. Rent Expense 4 million

Cr. Cash 4 million

No entry at later periods.

E.g. Paid 4 years rental fee $ 4 million


Paid Cash Actually used

Accounting Period 1

Accounting Period 2

Accounting Period 3

Accounting Period 4

Accrual basis: At the beginning of period 1 recognize all cash payment as prepaid expense (asset account):

Dr. Prepaid Rent Expense 4 million

Cr. Cash 4 million

At the end of each accounting period recognize the portion that is used

Dr. Rent Expense 1 million

Cr. Prepaid Rent Expense 1 million

Adjusting Accounts – Prepaid expensesAdjusting Accounts – Prepaid expensesE.g. Paid 4 years

rental fee $ 4 million


Adjusting Accounts – Unearned revenueAdjusting Accounts – Unearned revenue

Received Cash Revenue Earned

Accounting Period 1

Accounting Period 2

Accounting Period 3

Accounting Period 4

When should revenues be recognized?

E.g. Long-term contract: Received $40m in

advance to build a ship

Cash basis: At the beginning of period 1 recognize all cash receipt as revenue.

Dr. Cash 40 million

Cr. Revenue 40 million

No entry at later periods.


Received Cash Revenue Earned

Accounting Period 1

Accounting Period 2

Accounting Period 3

Accounting Period 4

Accrual basis: At the beginning of period 1 recognize all cash receipt as unearned revenue (liability account).

Dr. Cash 40 million

Cr. Unearned revenue 40 million

At the end of each accounting period recognize the portion that is earned:

Dr. Unearned revenue 10 million


Adjusting Accounts – Unearned revenueAdjusting Accounts – Unearned revenueE.g. Long-term contract:

Received $40m in

advance to build a ship


Adjusting Accounts – Accrued expensesAdjusting Accounts – Accrued expenses

Paid CashActually used

Accounting Period 1

Accounting Period 2

Accounting Period 3

Accounting Period 4

When should expenses be recognized?

Cash basis: When borrowing money:

Dr. Cash 40 million

Cr. Bank loan 40 million

At the end of period 4:

Dr. Interest Expense 16 million

Dr. Bank loan 40 million

Cr. Cash 56 million

E.g. Borrow 40 million from bank.

Annual interest rate

is 10%. Interest and principal are paid at the end of 4th

year.


Adjusting Accounts – Accrued expensesAdjusting Accounts – Accrued expenses

Paid CashActually used

Accounting Period 1

Accounting Period 2

Accounting Period 3

Accounting Period 4

Accrual basis: At the end of each period (1 to 4) recognize the portion that is due but not paid:

Dr. Interest Expense 4 million

Cr. interest payable 4 million

At the end of the period 4:

Dr. Interest payable 16 million

Dr. Bank loan 40 million

Cr. Cash 56 million


Adjusting Accounts – Accrued revenuesAdjusting Accounts – Accrued revenues

Received Cash

Accounting Period 1

Accounting Period 2

Accounting Period 3

Accounting Period 4

When should revenues be recognized?

Revenue Earned

Cash basis: No entry from accounting period 1 to 3


Dr. Cash 40 million


Long-term

Contract: Received $40 million after building one

ship


Adjusting Accounts – Accrued revenuesAdjusting Accounts – Accrued revenues

Received Cash

Accounting Period 1

Accounting Period 2

Accounting Period 3

Accounting Period 4

Revenue Earned

Accrual basis: At the end of each accounting period (1 to 4) recognize the portion of revenue that is earned but not received:

Dr. Accounts Receivable 10 million



Dr. Cash 40 million

Cr. Accounts receivable 40 million

Long-term

Contract


Here is the checkfor my first

6 months’ rent.

Here is the checkfor my first

6 months’ rent.

Adjusting Prepaid (Deferred) ExpensesAdjusting Prepaid (Deferred) Expenses

Resources paid for prior to

receiving the actual benefits.

Resources paid for prior to

receiving the actual benefits.

Asset Expense

UnadjustedBalance

CreditAdjustment

DebitAdjustment


Prepaid InsurancePrepaid Insurance

On December 1, 2004, Scott Company paid $12,000 to cover rent for December 2004 through May 2005.

Scott recorded the expenditure as Prepaid Insurance on December 1. What adjustment is required at

Dec.31, 2004?

On December 1, 2004, Scott Company paid $12,000 to cover rent for December 2004 through May 2005.

Scott recorded the expenditure as Prepaid Insurance on December 1. What adjustment is required at

Dec.31, 2004?

Dec. 31 Insurance Expense 2,000 Prepaid Insurance 2,000

To record first month's expired insurance

Dec. 1 12,000 Dec. 31 2,000Bal. 10,000

Prepaid Insurance 637

Dec. 31 2,000Insurance Expense 128


SuppliesSupplies

During 2004, Scott Company purchase $15,500 of supplies. Scott recorded the expenditures as Supplies.

At December 31, a count of the supplies indicated $2,655 on hand. What adjustment is required?

During 2004, Scott Company purchase $15,500 of supplies. Scott recorded the expenditures as Supplies.

At December 31, a count of the supplies indicated $2,655 on hand. What adjustment is required?

Dec. 31 Supplies Expense 12,845 Supplies 12,845

To record supplies used during 2004

Bought 15,500 Dec. 31 12,845Bal. 2,655

Supplies 126Dec. 31 12,845

Supplies Expense 652


Straight-LineDepreciationExpense

= Asset Cost - Salvage Value

Useful Life

Adjusting for DepreciationAdjusting for Depreciation

Depreciation is the process of computing expense from allocating the cost of plant and equipment over their

expected useful lives.



On January 1, 2004, 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, 2004.

2004Depreciation

Expense= $62,000 - $2,000

5= $12,000



On January 1, 2004, 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, 2004.

Dec. 31 Depreciation Expense 12,000 Accumulated Depreciation - Equipment 12,000

To record equipment depreciation

Accumulated depreciation isa contra asset account.

Accumulated depreciation isa contra asset account.


contra accountcontra account

A contra account is an account linked with another account, it has an opposite normal balance, and it is reported as a subtraction from that other account’s balance.

A contra account allow information users to know both the full costs of assets and the total amount of depreciation.


Equipment Depreciation Expense

1/1 62,000 12/31 12,000

Accumulated Depreciation12/31 12,000

Adjusting for DepreciationAdjusting for DepreciationDec. 31 Depreciation Expense 12,000

Accumulated Depreciation - Equipment 12,000 To record equipment depreciation



Equipment is shown net of accumulated depreciation.

$



A company spent 42 million to buy a machine, which can produce 50 million units of LCD monitor. The useful life is estimated to be 2 years and the salvage value is estimated to be 2 million. The depreciation for each year is 20 million.

When the company bought the machine: Dr. Machinery 42 million Cr. Cash 42 million



At the end of first year:

Dr. Depreciation expense 20 m

Cr. Machinery 20 m

Dr. Depreciation expense 20 m

Cr. Accumulated depreciation-machinery 20 m

Correct



With the contra account, balance sheet indicates: …… Machinery 42 million Less accumulated depreciation (20 million) 22 million

If not: …… Machinery 22 million Such information would be misleading, since it could not indicate

the correct production capacity of the company.


Buy your season tickets forall home basketball games NOW!

““Go Big Blue”Go Big Blue”

Adjusting Unearned (Deferred) RevenuesAdjusting Unearned (Deferred) Revenues

Cash received in advance of providing

products or services.

Cash received in advance of providing

products or services.

Liability RevenueUnadjusted

BalanceCredit

AdjustmentDebit

Adjustment



On October 1, 2004, 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 100,000 Unearned Revenue 100,000

Basketball revenue received in advance

Oct. 1 100,000Unearned Revenue



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 recognized 10-game basketball revenue

Dec. 31 50,000 Oct. 1 100,000Bal. 50,000

Unearned RevenueDec. 31 50,000

Basketball Revenue


We’re about one-halfdone with this job and

want to be paid forour work!

We’re about one-halfdone with this job and

want to be paid forour work!

Costs incurred in a period that are

both unpaid and unrecorded.

Costs incurred in a period that are

both unpaid and unrecorded.

Adjusting for Accrued ExpensesAdjusting for Accrued Expenses

Expense LiabilityCredit

AdjustmentDebit

Adjustment


12/1/04 12/31/04Year end

Last paydate

12/26/04

Next paydate

1/2/05

Record adjustingjournal entry.

Record adjustingjournal entry.


Barton, Inc. pays its employees every Friday. Year-end, 12/31/04, falls on a Wednesday. As of 12/31/04, the employees have earned salaries of $47,250 for Monday

through Wednesday of the week ended 1/02/05.









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

To accrue 3-days' salary

Other salaries657,500

Dec. 31 47,250Bal. 704,750

Salaries Expense

Dec. 31 47,250Salaries Payable


Yes, I’ve completed yourtax return, but have not had

time to bill you yet.

Yes, I’ve completed yourtax return, but have not had

time to bill you yet.

Adjusting Accrued RevenuesAdjusting Accrued Revenues

Revenues earned in a period that

are both unrecorded and not yet received.

Revenues earned in a period that

are both unrecorded and not yet received.

Asset Revenue

CreditAdjustment

DebitAdjustment


Adjusting for Accrued RevenuesAdjusting for Accrued Revenues

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, 2004, the end of the company’s fiscal year.

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, 2004, the end of the company’s fiscal year.

Dec. 31 Accounts Receivable 31,200 Service Revenue 31,200

To accrue revenue earned

Other receivables1,325,268

Dec. 31 31,200Bal. 1,356,468

Accounts ReceivableOther revenues

6,589,500 Dec. 31 31,200Bal . 6,620,700

Service Revenue



In the 2nd week of Dec, FastForward agreed to provide 30 days of consulting services to a local sports club for a fixed fee of $2700, beginning from Dec 12. The club agrees to pay FastForward on Jan 10, 2005.

Dec. 31 Dr. Accounts Receivable 1,800 Cr. Consulting Revenue 1,800

To accrue revenue earned



Dec.12 1,900 Dec. 22 1,900Dec.31 1,800

Bal. 1,800

Accounts Receivable

Dec.5 4,200Dec. 12 1,600Dec. 31 250Dec. 31 1,800Balance 7,850

Consulting Revenue


Future receipts of accrued revenuesFuture receipts of accrued revenues

FastForward received $2,700 cash on Jan 10 for the entire contract amount.

Jan 10: Dr. Cash 2,700

Cr. Accounts Receivable 1,800

Cr. Consulting Revenue 900



Explain how accounting adjustments link to financial statements.


Type

Balance Sheet Account

Income Statement Account Adjusting Entry

Prepaid Asset Expense Dr. ExpenseExpenses Overstated Understated Cr. Asset

Unearned Liability Revenue Dr. LiabilityRevenues Overstated Understated Cr. Revenue

Accrued Liability Expense Dr. ExpenseExpenses Understated Understated Cr. Liability

Accrued Asset Revenue Dr. AssetRevenues Understated Understated Cr. Revenue

Before Adjustment

Summary of Adjustments and Financial Statement Links

Links to Financial StatementsLinks to Financial Statements



Explain and prepare an adjusted trial balance. Prepare financial statements from an adjusted

trial balance.


FastForwardTrial Balance

December 31, 2004

First, the initial

unadjusted amounts are added to the worksheet.

First, the initial

unadjusted amounts are added to the worksheet.

$

$

$$


Next, FastForward’s adjustments are added.

Next, FastForward’s adjustments are added.


December 31, 2004

$

$

$$

$$

$$



December 31, 2004Finally, the totals are determined.

Finally, the totals are determined.

$

$

$$

$$

$$

$

$

$$


Preparing Financial StatementsPreparing Financial Statements

Let’s use FastForward’s adjusted trial balance to prepare the company’s financial statements.


Prepare the IncomeStatement.


Prepare the Statement of Changes in Owner’s Equity.Note: Net Income from the Income Statement carries to the Statement of Changes in Owner’s Equity.


Prepare the Balance Sheet.

FastForwardBalance Sheet

December 31, 2001

AssetsCash 4,400$ Accounts receivable 1,800 Supplies 8,220 Prepaid insurance 2,300 Equipment 26,000 Less: accum. depr. (375) 25,625 Total assets 42,345$

LiabilitiesAccounts payable 6,200$ Salaries payable 210 Unearned consulting revenues 2,750 Total liabilities 9,160$

Owner's EquityChuck Taylor, Capital 33,185 Total liabilities and equity 42,345$


The profit margin ratio measures the company’s net income to sales.

ProfitMargin

Net Income Net Sales

=

Profit MarginProfit Margin


Profit MarginProfit Margin

SmarTone: 13.85% Hutchison Telecom: 0.48% City Telecom: 4.24% Sunday: 0.48% Peoples: 14.96%


Homework for chapter 3Homework for chapter 3

Ex 3-1, 3-2, 3-9 Problem 3-2A Due on June 19,2006 (Monday)


End of Chapter 3End of Chapter 3

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin1 Adjusting Accounts and Preparing...

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Transcript of © The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin1 Adjusting Accounts and Preparing...