ADJUSTING ACCOUNTS AND

PREPARING FINANCIAL STATEMENTS

Chapter 3

© 2009 The McGraw-Hill Companies, Inc.,

All Rights Reserved
 WHAT WE HAVE LEARNED SO
FAR 2
1

Record relevant transactions

and events in a journal
Analyze each transaction and
event from source documents => Journalizing

4 3

Post journal
information
Prepare and analyze to ledger
the trial balance accounts

McGraw-Hill/Irwin => posting Slide 2

 WHAT WE HAVE LEARNED SO
FAR
ACCOUNT NAME: ACCOUNT No.

Date Description PR Debit Credit Balance

FASTFORWARD
Income Statement
For the Month Ended December 31, 2009
Revenues:
Consulting revenue $ 5,800
Rental revenue 300 FASTFORWARD
Total revenues $ 6,100 Balance Sheet
Expenses: December 31, 2009
Rent expense 1,000 Assets
Salaries expense 1,400 Cash $ 4,350
Utilities expense 230 Supplies 9,720
Total expenses 2,630 Prepaid insurance 2,400
Net income $ 3,470 Equipment 26,000
Total assets $ 42,470
Liabilities
Accounts payable $ 6,200
Unearned revenue 3,000
Total liabilities 9,200
Equity

C. Taylor, Capital $ 33,270

Total equity 33,270
McGraw-Hill/Irwin Total liabilities and equity $ 42,470 Slide 3
NOW WE CONTINUE THE ACCOUNTING
PROCESS

McGraw-Hill/Irwin Slide 4
 THE ACCOUNTING PERIOD (FINANCIAL
STATEMENTS (1-YEAR), INTERIM REPORT
C1
(LESS THAN ONE YEAR)
Annually = 12-month period; calendar year (Jan-Dec); fiscal
year (July/2019-June/2020); natural business year (ending at their
low point)

1 2
Semiannually
1 2 3 4
Quarterly
1 2 3 4 5 6 7 8 9 10 11 12
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Monthly
McGraw-Hill/Irwin Slide 5
C2 ACCRUAL BASIS VS.
CASH BASIS
Accrual Basis Cash Basis
Revenues are Revenues are
recognized when recognized when
earned and expenses cash is received and
are recognized when expenses recorded
incurred. when cash is paid.

Not GAAP
Accounting

McGraw-Hill/Irwin Slide 6
C2

ACCRUAL BASIS VS. CASH BASIS

Insurance Expense 2009

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 2009. No insurance
expense from this policy would be recognized in 2010 or
2011, periods covered by the policy.
McGraw-Hill/Irwin Slide 7
C2

ACCRUAL BASIS VS. CASH BASIS

Insurance Expense 2009
Jan Feb Mar Apr

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

$ - $ - $ - $ -
On the accrual basis
Sep Oct Nov Dec
$100 of insurance
expense is recognized in
$ - $ - $ - $ 100

Insurance Expense 2010

$
Jan
100
Feb
$
Mar
100 $
Apr
100 $ 100
2009, $1,200 in 2010,
$
May
100 $
Jun
100 $
Jul
100 $
Aug
100
and $1,100 in 2011. The
Sep Oct Nov Dec expense is matched with
$ 100 $ 100 $ 100 $ 100

Insurance Expense 2011

the periods benefited by
$
Jan
100
Feb
$
Mar
100 $
Apr
100 $ 100
the insurance coverage.
May Jun Jul Aug
$ 100 $ 100 $ 100 $ 100
Sep Oct Nov Dec
$ 100 $ 100 $ 100 $ -
McGraw-Hill/Irwin Slide 8
C2 RECOGNIZING REVENUES &
EXPENSES
Revenue Recognition Principle

We have delivered the

product to our customer,
so I think we should record
the revenue earned.

McGraw-Hill/Irwin Slide 9
C2 RECOGNIZING REVENUES &
EXPENSES
Revenue Recognition Principle
Matching Principle
Now that we have
Summary recognized the
the revenue,
of Expenses let’s see what expenses
Rent $1,000 we incurred to
Gasoline 500
generate
generate that revenue.
Advertising 2,000
Salaries 3,000
Utilities 450
and . . . . ....

McGraw-Hill/Irwin Slide 10
 QUICK CHECK
1. Interim financial statements refer to financial reports: 
A. That cover less than one year, usually spanning one, three, or six-
month periods.
B. That are prepared before any adjustments have been recorded.
C. That show the assets above the liabilities and the liabilities above the
equity.
D. Where revenues are reported on the income statement when cash is
received and expenses are reported when cash is paid.
E. Where the adjustment process is used to assign revenues to the
periods in which they are earned and to match expenses with revenues.

2. The 12-month period that ends when a company's activities are at their
lowest point is called the: 
A. Fiscal year.
B. Calendar year.
C. Natural business year.
D. Accounting period.
E. Interim period.
McGraw-Hill/Irwin Slide 11
 QUICK CHECK
3. The length of time covered by a set of periodic financial statements is
referred to as the:
A. Fiscal cycle.
B. Natural business year.
C. Accounting period.
D. Business cycle.
E. Operating cycle.

4. The broad principle that requires expenses to be reported in the same

period as the revenues that were earned as a result of the expenses is
the:
A. Recognition principle.
B. Cost principle.
C. Cash basis of accounting.
D. Matching principle.
E. Time period principle.

McGraw-Hill/Irwin Slide 12
 QUICK CHECK
5. The system of preparing financial statements based on recognizing
revenues when the cash is received and reporting expenses when the
cash is paid is called:
A. Accrual basis accounting.
B. Operating cycle accounting.
C. Cash basis accounting.
D. Revenue recognition accounting.
E. Current basis accounting.

6. The approach to preparing financial statements based on recognizing

revenues when they are earned and matching expenses to those
revenues is:
A. Cash basis accounting.
B. The matching principle.
C. The time period principle.
D. Accrual basis accounting.
E. Revenue basis accounting.

McGraw-Hill/Irwin Slide 13
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
Paid (or
(or received)
received) cash
cash before
before Paid
Paid (or
(or received)
received) cash
cash after
after
expense
expense (or(or revenue)
revenue) recognized
recognized expense
expense (or
(or revenue)
revenue) recognized
recognized

Prepaid
Prepaid Unearned
Unearned Accrued
Accrued Accrued
Accrued
(Deferred)
(Deferred) (Deferred)
(Deferred) expense
expense revenues
revenues
expenses*
expenses* revenues
revenues
*including depreciation
McGraw-Hill/Irwin Slide 14
P1 PREPAID (DEFERRED)
EXPENSES
Here
Here is
is the
the check
check
for
for my
my 24-month
Resources paid insurance
24-month
insurance policy.
policy.
for prior to
receiving the
actual benefits.

Asset Expense
Unadjusted Credit Debit
Balance Adjustment Adjustment

McGraw-Hill/Irwin Slide 15
P1

PREPAID INSURANCE
On 12/1/09, FastForward paid $2,400 for insurance for 2-
years (24-months, December 2009 through November
2011). FastForward recorded the expenditure as Prepaid
Insurance on 12/31/09.
What adjustment is required?

Dec. 31 Insurance Expense 100

Prepaid Insurance 100
To record first month's expired insurance

Prepaid Insurance 128 Insurance Expense 637

Dec. 1 2,400 Dec. 31 100 Dec. 31 100
Bal. 2,300

McGraw-Hill/Irwin Slide 16
P1

SUPPLIES
During 2009, FastForward purchased $9,720 of supplies.
FastForward recorded the expenditures in the asset account,
“Supplies.” On December 31, 2009, account of the supplies
indicated $8,670 on hand, so $1,050 of supplies were used
during December.
What adjustment is required?
Dec. 31 Supplies Expense 1,050
Supplies 1,050
To record supplies used during 2009
Supplies 126 Supplies Expense 652
Bought 9,720 Dec. 31 1,050 Dec. 31 1,050
Bal. 8,670

McGraw-Hill/Irwin Slide 17
 P1
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. 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.
In these special cases, we can record the cash paid with a
debit to the expense account instead of an asset
account.

McGraw-Hill/Irwin Slide 18
P1

DEPRECIATION
Depreciation is the process of allocating the
cost of a plant asset over its useful life in a
systematic and rational manner.

Straight-Line Asset Cost - Salvage Value

Depreciation =
Expense Useful Life

McGraw-Hill/Irwin Slide 19
P1

DEPRECIATION
On December 1, 2009, FastForward purchased
equipment for $26,000 cash. The equipment has an
estimated useful life of four years (48 months) and
FastForward expects to sell the equipment at the end of its
life for $8,000 cash.
Let’s record depreciation expense for the month ended
December 31, 2009.

Dec. 2009 $26,000 - $8,000

Depreciation = = $375 per month
Expense 48 months
McGraw-Hill/Irwin Slide 20
P1

DEPRECIATION
On December 1, 2009, FastForward purchased
equipment for $26,000 cash. The equipment has an
estimated useful life of four years (48 months) and
FastForward expects to sell the equipment at the end of its
life for $8,000 cash.
Let’s record depreciation expense for the month ended
December 31, 2009.

Dr. Cr.
Dec. 31 Depreciation Expense 375
Accumulated Depreciation - Equipment 375
To record monthly equipment depreciation

Accumulated
Accumulated depreciation
depreciation is
is
McGraw-Hill/Irwin aa contra
contra asset
asset account.
account. Slide 21
P1

DEPRECIATION
Dr. Cr.
Dec. 31 Depreciation Expense 375
Accumulated Depreciation - Equipment 375
To record monthly equipment depreciation

Equipment Depreciation Expense

12/1 26,000 12/31 375

Accumulated Depreciation
12/31 375

McGraw-Hill/Irwin Slide 22
P1

DEPRECIATION

Equipment is
$ shown net of
accumulated
accumulated
depreciation.

McGraw-Hill/Irwin Slide 23
P1 UNEARNED (DEFERRED)
REVENUES
We
We will
will apply
apply this
this cash
cash
Cash received in you
you gave
gave usus towards
towards
advance of providing your
your total
total consulting
consulting fees.
fees.
products or services.

Liability Revenue
Debit Unadjusted Credit
Adjustment Balance Adjustment

McGraw-Hill/Irwin Slide 24
P1 UNEARNED (DEFERRED)
REVENUES
On December 26, 2009, FastForward agrees to
provide consulting services to a client for a fixed fee
of $3,000 for 60 days. On this date, the client pays
the entire consulting fee in advance. FastForward
makes the following entry:
Dr. Cr.
Dec. 26 Cash 3,000
Unearned Revenue 3,000
Consulting fees received in advance

Unearned Revenue
Dec. 26 3,000
McGraw-Hill/Irwin Slide 25
P1 UNEARNED (DEFERRED)
REVENUES
On December 31, earns some of the 5-days of
consulting fees. Each day that passes results in
consulting fees of $50 ($3,000 ÷ 60).
Dr. Cr.
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

McGraw-Hill/Irwin Slide 26
P1

ACCRUED EXPENSES
We’re about one-half
Costs
Costs incurred
incurred in
in done with this job and
aa period
period that
that are
are want to be paid for
both
both unpaid
unpaid and
and our work!
unrecorded.
unrecorded.

Expense Liability
Debit Credit
Adjustment Adjustment

McGraw-Hill/Irwin Slide 27
P1

ACCRUED SALARIES EXPENSES

FastForward’s
FastForward’s employee
employee earnsearns $70
$70 per
per dayday and
and is
is paid
paid
every
every two
two weeks
weeks on
on Friday.
Friday. Year-end,
Year-end, 12/31/09,
12/31/09, falls
falls on
on aa
Wednesday.
Wednesday. The
The last
last payday
payday of of 2009,
2009, is
is Friday,
Friday, 12/26/09.
12/26/09.
From
From 12/26
12/26 until
until year-end
year-end isis three
three working
working days.
days. The
The
employee
employee has
has earned
earned salaries
salaries of
of $210
$210 for
for Monday
Monday through
through
Wednesday.
Wednesday. They
They will
will not
not be
be paid
paid until
until the
the next
next Friday.
Friday.

Last pay Next pay

date date
12/26/09 1/9/10

12/31/09 Record
Record adjusting
adjusting
Year end journal
journal entry.
entry.
McGraw-Hill/Irwin Slide 28
P1

ACCRUED SALARIES EXPENSES

FastForward’s
FastForward’s employee
employee earns
earns $70
$70 per
per day
day and
and is
is paid
paid
every
every two
two weeks
weeks on
on Friday.
Friday. Year-end,
Year-end, 12/31/09,
12/31/09, the
the
employee
employee has
has earned
earned salaries
salaries of
of $210.
$210.

Dr. Cr.
Dec. 31 Salaries Expense 210
Salaries Payable 210
To accrue 3 days' salary (3 x $70)
Salaries Expense Salaries Payable
Dec.12 700 Dec. 31 210
Dec.26 700
Dec. 31 210
Bal. 1,610

McGraw-Hill/Irwin Slide 29
P1 FUTURE PAYMENT OF
ACCRUED EXPENSES
On
On January
January 9,
9, 2010,
2010, FastForward
FastForward willwill pay
pay the
the payroll
payroll for
for
the
the two
two weeks
weeks from
from December
December 26,26, 2009
2009 through
through January
January
9,
9, 2010.
2010. Here
Here is
is the
the journal
journal entry
entry for
for the
the payroll:
payroll:
Dr. Cr.
Jan 9 Salaries Payable (3 days @ $70) 210
Salaries Expense (7 days @ $70) 490
Cash (10 days @ $70) 700
P a id t w o - w e e k s a la ry

McGraw-Hill/Irwin Slide 30
P1

ACCRUED INTEREST EXPENSE

FastForward
FastForward borrowed
borrowed $6,000
$6,000 from
from First
First National
National Bank
Bank on
on
December
December 1, 1, 2009.
2009. The
The note
note bears
bears interest
interest at
at the
the annual
annual
rate
rate of
of 6%
6% and
and is
is due
due toto be
be repaid
repaid in
in one
one year.
year. Let’s
Let’s accrue
accrue
interest
interest for
for the
the month
month ended
ended 12/31/09.
12/31/09.
Dr. Cr.
Dec. 31 Interest Expense 30
Interest Payable 30
To accrue interest ($6,000 × 6% × 30/360)

Interest Expense Interest Payable

Dec. 31 30 Dec. 31 30

McGraw-Hill/Irwin Slide 31
P1

ACCRUED REVENUES
Revenues earned Yes,
Yes, I’ve
I’ve completed
completed youryour
in a period that consulting
consulting job,
job, but
but have
have not
not
had
had time
time toto bill
bill you
you yet.
yet.
are both
unrecorded and not
yet received.

Asset Revenue
Debit Credit
Adjustment Adjustment

McGraw-Hill/Irwin Slide 32
P1

ACCRUED SERVICE REVENUES

On
On December
December 12,12, 2009,
2009, FastForward
FastForward agrees
agrees to to render
render
consulting
consulting services
services under
under aa 30-day
30-day fixed
fixed fee
fee contract
contract forfor
$2,700
$2,700 ($90
($90 per
per day).
day). All
All services
services are
are to
to be
be completed
completed by by
January
January 10,
10, 2010,
2010, when
when the
the client
client will
will pay
pay in
in full.
full.
Dr. Cr.
Dec. 31 Accounts Receivable 1,800
Consulting Revenue 1,800
To accrue revenue (20-days @ $90 per day)

Accounts Receivable Consulting Revenue

Other receivables Other revenues
1,900 Receipts 1,900 6,050
Dec. 31 1,800 Dec. 31 1,800
Bal. 1,800 Bal . 7,850
McGraw-Hill/Irwin Slide 33
P1 FUTURE RECEIPT OF
SERVICE REVENUES
On
On January
January 10,
10, 2010,
2010, FastForward
FastForward completed
completed its
its
obligation
obligation under
under the
the consulting
consulting contract.
contract. The
The client
client was
was
billed
billed $2,700
$2,700 and
and FastForward
FastForward received
received $2,700
$2,700 in
in cash
cash

Dr. Cr.
Jan 10 Cash 2,700
Accounts Receivable 1,800
Consulting Revenue 900
T o re c o rd c o m p le t io n o f c o n t ra c t a n d c a s h c o lle c t io n

Revenue in January
10 days @ $90 = $900
McGraw-Hill/Irwin Slide 34
A1 LINKS TO FINANCIAL
STATEMENTS
Summary of Adjustments and Financial Statement Links
Before Adjustment
Income
Balance Sheet Statement
Type Account Account 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

McGraw-Hill/Irwin Slide 35
P2
FastForward - Trial Balance - December 31, 2009

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

McGraw-Hill/Irwin Slide 36
P2 FastForward - Trial Balance - December 31, 2009

Next,
FastForward’s
adjustments
are added.

McGraw-Hill/Irwin Slide 37
P2 FastForward - Trial Balance - December 31, 2009

Finally, the
totals are
determined.

McGraw-Hill/Irwin Slide 38
P3 PREPARING FINANCIAL
STATEMENTS
Let’s use FastForward’s adjusted trial balance to
prepare the company’s financial statements.

McGraw-Hill/Irwin Slide 39
P3
1. Prepare the Income Statement

McGraw-Hill/Irwin Slide 40
P3 2. 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.

McGraw-Hill/Irwin Slide 41
P3 3. Prepare the Balance
Sheet

McGraw-Hill/Irwin Slide 42
A2

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

Profit Net Income

=
Margin Net Sales

$ in millions 2007 2006 2005 2004

Net income $ 676 $ 683 $ 705 $ 717
Net sales 10,671 9,699 9,408 8,934
Profit margin 6.3% 7.0% 7.5% 8.0%
Industry profit margin 1.6% 1.5% 1.4% 1.5%
McGraw-Hill/Irwin Slide 43
A2

PROFIT MARGIN
Comparison of profit margin at Limited Brands, Inc.
to the industry-wide profit margin.

McGraw-Hill/Irwin Slide 44
 QUICK CHECK
1. Prepaid expenses, depreciation, accrued expenses, unearned
revenues, and accrued revenues are all examples of:
A. Items that require contra accounts.
B. Items that require adjusting entries.
C. Asset and equity.
D. Asset accounts.
E. Income statement accounts.

2. Which of the following statements is incorrect?

A. Adjustments to prepaid expenses, depreciation, and unearned
revenues involve previously recorded assets and liabilities.
B. Accrued expenses and accrued revenues involve assets and liabilities
that had not previously been recorded.
C. Adjusting entries can be used to record both accrued expenses and
accrued revenues.
D. Prepaid expenses, depreciation, and unearned revenues often require
adjusting entries to record the effects of the passage of time.
E. Adjusting entries affect the cash account.
McGraw-Hill/Irwin Slide 45
 QUICK CHECK
On June 30, 2009, Apricot Co. paid $7,500 cash for management services to
be performed over a two-year period. Apricot follows a policy of recording all
prepaid expenses to asset accounts at the time of cash payment. 
3. On June 30, 2009 Apricot should record: 
A. A credit to an expense for $7,500.
B. A debit to an expense for $7,500.
C. A debit to a prepaid expense for $7,500.
D. A credit to a prepaid expense for $7,500.
E. A debit to Cash for $7,500.

4. The adjusting entry on December 31, 2009 for Apricot would include:
A. A debit to an expense for $5,625.
B. A debit to a prepaid expense for $5,625.
C. A debit to an expense for $1,875.
D. A debit to a prepaid expense for $1,875.
E. A credit to a liability for $1,875.

McGraw-Hill/Irwin Slide 46
 QUICK CHECK
5. Prior to recording adjusting entries, the Office Supplies account had
a $359 debit balance. A physical count of the supplies showed $105 of
unused supplies available. The required adjusting entry is:
A. Debit Office Supplies $105 and credit Office Supplies Expense $105.
B. Debit Office Supplies Expense $105 and credit Office Supplies $105.
C. Debit Office Supplies Expense $254 and credit Office Supplies $254.
D. Debit Office Supplies $254 and credit Office Supplies Expense $254.
E. Debit Office Supplies $105 and credit Supplies Expense $254.

6. Which of the following assets is not depreciated?

A. Store fixtures.
B. Computers.
C. Land.
D. Buildings.
E. All of these are depreciated.

McGraw-Hill/Irwin Slide 47
 QUICK CHECK
7. An adjusting entry could be made for each of the following except:
A. Prepaid expenses.
B. Depreciation.
C. Owner withdrawals.
D. Unearned revenues.
E. Accrued revenues.

8. An account linked with another account that has an opposite

normal balance and that is subtracted from the balance of the
related account is a(n):
A. Accrued expense.
B. Contra account.
C. Accrued revenue.
D. Intangible asset.
E. Adjunct account.

McGraw-Hill/Irwin Slide 48
 QUICK CHECK
9. PPW Co. leased a portion of its store to another company for eight
months beginning on October 1, 2009, at a monthly rate of $800. This other
company paid the entire $6,400 cash on October 1, which PPW Co.
recorded as unearned revenue. The journal entry made by PPW Co. at
year- end on December 31, 2009 would include:
A. A debit to Rent Earned for $2,400.
B. A credit to Unearned Rent for $2,400.
C. A debit to Cash for $6,400.
D. A credit to Rent Earned for $2,400.
E. A debit to Unearned Rent for $4,000.

10. The difference between the cost of an asset and the accumulated
depreciation for that asset is called 
A. Depreciation Expense.
B. Unearned Depreciation.
C. Prepaid Depreciation.
D. Depreciation Value.
E. Book Value.
McGraw-Hill/Irwin Slide 49
 END OF CHAPTER 3

McGraw-Hill/Irwin Slide 50