Lecture Principles of financial accouting - Chapter 3: Adjusting accounts and preparing financial statements

After completing this chapter you should be able to: Explain the importance of periodic reporting and the time period assumption, explain accrual accounting and how it improves financial statements, identify the types of adjustments and their purpose.

PowerPoint Authors:

Susan Coomer Galbreath, Ph.D., CPA Charles W Caldwell, D.B.A., CMA Jon A Booker, Ph.D., CPA, CIA Cynthia J Rooney, Ph.D., CPA Winston Kwok, Ph.D., CPA

McGraw­Hill/Irwin         Copyright © 2011 by The McGraw­Hill Companies, Inc. All rights reserved.

Adjusting Accounts and Preparing

Financial Statements

The Accounting Period

Accrual Basis versus 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 are recorded when cash is paid.

C 2

Cash Basis

Revenues are recognized when cash

is received and expenses are recorded when cash is paid.

Accrual Basis versus Cash Basis

Non-GAAP

Accrual Basis

Revenues are

recognized when

earned and expenses

are recognized when

incurred.

Accrual Basis versus Cash Basis

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

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

2011, $1,200 in 2012, and $1,100 in 2013 The expense is matched with the periods benefited by the insurance coverage.

On the accrual basis ,

$100 of insurance expense is recognized in

2011 , $1,200 in 2012 ,

expense is matched with the periods benefited by the insurance coverage.

We have delivered the product to our customer,

so I think we should record

the revenue earned.

We have delivered the product to our customer,

so I think we should record

the revenue earned.

Recognizing Revenues & Expenses

Revenue Recognition Principle

C 2

Recognizing Revenues & Expenses

Revenue Recognition Principle

Matching Principle

Summary

of Expenses

Rent Gasoline Advertising Salaries Utilities and

$1,000 500 2,000 3,000 450

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

we incurred to generate that revenue.

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

we incurred to generate that revenue.

  An adjusting entry is recorded to bring an asset or

liability account balance to its proper amount.

Unearned (Deferred) revenues

Accrued expense

Accrued expense revenues Accrued

Accrued revenues

Framework for Adjustments

Paid (or received) cash before

expense (or revenue) recognized

Paid (or received) cash before

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

Paid (or received) cash after

expense (or revenue) recognized

Adjustments

C 3

Here is the check for my 24-month insurance policy.

Here is the check for my 24-month insurance policy.

Prepaid (Deferred) Expenses

Resources paid

for prior to receiving the actual benefits.

Resources paid

for prior to receiving the actual benefits.

Prepaid Insurance

(a) On 12/1/11, FastForward paid $2,400 for insurance for

2-years (24-months, December 2011 through November 2013) FastForward recorded the expenditure as Prepaid

Insurance on 12/31/11

What adjustment is required?

(a) On 12/1/11, FastForward paid $2,400 for insurance for

2-years (24-months, December 2011 through November

2013) FastForward recorded the expenditure as Prepaid

Insurance on 12/31/11

What adjustment is required?

What adjustment is required?

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.

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.

P 1

Straight-Line Depreciation Expense

= Asset Cost - Residual Value

Useful Life

Depreciation

Depreciation is the process of allocating the

cost of a plant asset over its useful life in a

systematic and rational manner.

the end of its life for $8,000 cash.

(c) Let’s record depreciation expense for the

month ended December 31, 2011.

P 1

Equipment Depreciation Expense

Accumulated Depreciation

12/31 375

Dec 31 Depreciation Expense 375

Accumulated Depreciation - Equipment 375

To record monthly equipment depreciation

Depreciation

Contra asset account

Equipment is  shown net of  accumulated  depreciation.

Equipment is  shown net of  accumulated  depreciation.

$

Depreciation

P 1

We will apply this cash you gave us towards your total consulting fees.

We will apply this cash you gave us towards your total consulting fees.

Cash received in

advance of providing

products or services.

(d) On December 31, FastForward earns 5-days of consulting fees Each day that passes results in consulting fees of $50 ($3,000 ÷ 60), so FastForward

We’re about one-half done with this job and want to be paid for

our work!

We’re about one-half done with this job and want to be paid for

our work!

Costs incurred in

a period that are

both unpaid and

unrecorded.

Costs incurred in

a period that are

both unpaid and

unrecorded.

Accrued Expenses

P 1

FastForward’s employee earns $70 per day and is paid

every two weeks on Friday Year-end, 12/31/11, falls on a Wednesday The last payday of 2011, is Friday, 12/26/11 From 12/26 until year-end is three working days The

employee has earned salaries of $210 for Monday through Wednesday They will not be paid until the next Friday

FastForward’s employee earns $70 per day and is paid

every two weeks on Friday Year-end, 12/31/11, falls on a

Wednesday The last payday of 2011, is Friday, 12/26/11

From 12/26 until year-end is three working days The

employee has earned salaries of $210 for Monday through Wednesday They will not be paid until the next Friday

Accrued Salaries Expenses

Dec 31 Salaries Expense 210

(e) FastForward’s employee has earned but not been paid

Accrued Expenses

On January 9, 2012, FastForward will pay the payroll for

the two weeks from December 26, 2011 through January

9, 2012 Here is the journal entry for the payroll:

On January 9, 2012, FastForward will pay the payroll for

the two weeks from December 26, 2011 through January

9, 2012 Here is the journal entry for the payroll:

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

Salaries Expense (7 days @ $70) 490

P aid  two­we e k s alary

Dec 31 Interest Expense 30

ACCRUED INTEREST EXPENSES

FastForward borrowed $6,000 from First National Bank on December 1, 2011 The note bears interest at the annual

rate of 6% and is due to be repaid in one year Let’s accrue

interest for the month ended 12/31/11

FastForward borrowed $6,000 from First National Bank on

December 1, 2011 The note bears interest at the annual

rate of 6% and is due to be repaid in one year Let’s accrue

interest for the month ended 12/31/11

P 1

Yes, I’ve completed your consulting job, but have not had time to bill you yet.

Yes, I’ve completed your consulting job, but have not had time to bill you yet.

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.

Accrued Service Revenue

(f) On December 12, 2011, 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 10, 2012, when the client will pay

in full

(f) On December 12, 2011, 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 10, 2012, when the client will pay

Consulting Revenue

P 1

Service Revenues

On January 10, 2012, FastForward completed its obligation under the consulting contract The client was

billed $2,700 and FastForward received $2,700 in cash

On January 10, 2012, FastForward completed its obligation under the consulting contract The client was

billed $2,700 and FastForward received $2,700 in cash

Accounts Receivable 1,800 Consulting Revenue 900

T o re c ord  c om p le tion of c ontrac t and  c as h c olle c tion

Revenue in January

10 days @ $90 = $900

Links to Financial Statements

A 1

First, the initial unadjusted amounts are added to the worksheet.

First, the initial unadjusted amounts are added to the worksheet.

Unadjusted  Trial Balance Adjustments Trial Balance Adjusted 

Next, FastForward’s adjustments are added.

Next, FastForward’s adjustments are added.

P  2 FastForward - Trial Balance - December 31, 2011

Unadjusted  Trial Balance Adjustments Trial Balance Adjusted 

Finally, the totals are determined.

Finally, the totals are determined.

Unadjusted  Trial Balance Adjustments Trial Balance Adjusted 

Preparing Financial Statements

Let’s use FastForward’s adjusted trial balance to

prepare the company’s financial statements.

P  3

1 Prepare the Income Statement

Note: Net Income from the Income Statement carries to the Statement of Changes in Equity.

OF CHANGES IN EQUITY

3 Prepare The Balance Sheet

Profit Margin

The profit margin ratio measures the company’s

net income to net sales.

Profit Margin

Net Income Net Sales

10,671

9,699

Accounting for Prepayments

An alternative method is to record all prepaid expenses

with debits to expense accounts

The adjusting entry depends on how the original payment

was recorded

END OF CHAPTER 3