Chapter 3

Adjusting Accounts and Preparing

Financial Statements

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

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 3-2

C1

The Accounting Period

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C2

Accrual Basis versus Cash Basis

Accrual Basis Cash Basis
Revenues are Revenues are
recognized when recognized when cash
earned and expenses is received and
are recognized when expenses are recorded
incurred. when cash is paid.
 3-4

C2

Accrual Basis versus Cash Basis

Accrual Basis Cash Basis
Revenues are Revenues are
recognized when recognized when cash
earned and expenses is received and
are recognized when expenses are recorded
incurred. when cash is paid.

Non-GAAP
 3-5

C2

Accrual Basis versus 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 2011. No insurance
expense from this policy would be recognized in 2012 or
2013, periods covered by the policy.
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C2

Accrual Basis versus 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
100
Mar
$
Apr
100 $ 100
2011, $1,200 in 2012,
$
May
100 $
Jun
100 $
Jul
100 $
Aug
100
and $1,100 in 2013. The
Sep Oct Nov Dec expense is matched with
$ 100 $ 100 $ 100 $ 100

Insurance Expense 2011

the periods benefited by
$
Jan
100 $
Feb
100
Mar
$
Apr
100 $ 100
the insurance coverage.
May Jun Jul Aug
$ 100 $ 100 $ 100 $ 100
Sep Oct Nov Dec
$ 100 $ 100 $ 100 $ -
 3-7

C2

Recognizing Revenues & Expenses

Revenue Recognition Principle

We
We have
have delivered
delivered the
the
product
product to our
our customer,
so I think we should
should record
the
the revenue
revenue earned.
earned.
 3-8

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 . . . . ....
 3-9

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
 3 - 10

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.
 3 - 11

P1

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?

Dec. 31 Insurance Expense 100

Prepaid Insurance 100
To record first month's expired insurance

Prepaid Insurance 637 Insurance Expense 128

Dec. 1 2,400 Dec. 31 100 Dec. 31 100
Bal. 2,300
 3 - 12

P1

Supplies
(b) During 2011, FastForward purchased $9,720 of supplies.
FastForward recorded the expenditures in the asset account,
“Supplies.” On December 31, 2011, a count 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 2011

Supplies 126 Supplies Expense 652

Bought 9,720 Dec. 31 1,050 Dec. 31 1,050
Bal. 8,670
 3 - 13

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.
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.
 3 - 14

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 - Residual Value

Depreciation =
Expense Useful Life
 3 - 15

P1

Depreciation
On December 1, 2011, 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.
(c) Let’s record depreciation expense for the
month ended December 31, 2011.
 3 - 16

P1

Depreciation

Dec. 31 Depreciation Expense 375

Accumulated Depreciation - Equipment 375
To record monthly equipment depreciation

Contra asset account

Equipment Depreciation Expense

12/1 26,000 12/31 375

Accumulated Depreciation
12/31 375
 3 - 17

P1

Depreciation

Equipment
Equipment isis
shown
shown net
net of
of
$
accumulated
accumulated
depreciation.
depreciation.
 3 - 18

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.
 3 - 19

P1 Unearned (Deferred)
Revenues
On December 26, 2011, 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:

Dec. 26 Cash 3,000

Unearned Revenue 3,000
Consulting fees received in advance

Unearned Revenue
Dec. 26 3,000
 3 - 20

P1 Unearned (Deferred)
Revenues
(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
earned ($50 × 5 days) $250.

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
 3 - 21

P1

Accrued Expenses
We’re
We’re about
about one-half
one-half
Costs
Costs incurred
incurred in
in done
done with
with this
this job
job and
and
aa period
period that
that are
are want to be paid for
our
our work!
work!
both
both unpaid
unpaid and
and
unrecorded.
unrecorded.
 3 - 22

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, 12/31/11,
12/31/11, falls
falls on
on aa
Wednesday.
Wednesday. The
The last
last payday
payday of of 2011,
2011, is
is Friday,
Friday, 12/26/11.
12/26/11.
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.
 3 - 23

P1

Accrued Salaries Expenses

(e) FastForward’s employee has earned but not been paid
on December 31, 2011, $210.

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
 3 - 24

P1 Future Payment of
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:

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

Salaries Expense (7 days @ $70) 490
Cash (10 days @ $70) 700
P aid two-we e k s alary
 3 - 25

P1

ACCRUED INTEREST EXPENSES

FastForward
FastForward borrowed
borrowed $6,000
$6,000 from
from First
First National
National Bank
Bank on
on
December
December 1, 1, 2011.
2011. 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 12/31/11.
12/31/11.

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
 3 - 26

P1

Accrued Revenues
Revenues
Revenues earned
earned Yes,
Yes, I’ve
I’ve completed
completed youryour
in
in aa period
period that
that consulting
consulting job,
job, but
but have
have not
not
had
had time
time to
to bill
bill you
you yet.
yet.
are
are both
both
unrecorded
unrecorded and and not
not
yet
yet received.
received.
 3 - 27

Accrued Service Revenue

P1

(f)
(f) On
On December
December 12, 12, 2011,
2011, 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 for
for $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, 2012,
2012, when
when the
the client
client will
will pay
pay
in
in full.
full.

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
 3 - 28

P1 Future Receipt of
Service Revenues
On
On January
January 10,
10, 2012,
2012, FastForward
FastForward completed
completed itsits
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.

Jan 10 Cash 2,700

Accounts Receivable 1,800
Consulting Revenue 900
T o re c ord c om p le tion of c on trac t an d c as h c olle c tion

Revenue in January
10 days @ $90 = $900
 3 - 29

A1

Links to Financial Statements

 3 - 30

P2 FastForward - Trial Balance - December 31, 2011

Unadjusted Adjusted
Trial Balance Adjustments Trial Balance

First, the
initial
unadjusted
amounts are
added to the
worksheet.
 3 - 31

P 2
FastForward - Trial Balance - December 31, 2011

Unadjusted Adjusted
Trial Balance Adjustments Trial Balance

Next,
Next,
FastForward’s
adjustments
are added.
 3 - 32

P 2 FastForward – Adjusted Trial Balance - December 31, 2011

Unadjusted Adjusted
Trial Balance Adjustments Trial Balance

Finally,
Finally, the
the
totals
totals are
are
determined.
determined.
 3 - 33

P 3

Preparing Financial Statements

Let’s use FastForward’s adjusted trial balance to
prepare the company’s financial statements.
 3 - 34

P 3

1. Prepare the Income Statement

 3 - 35

P 3
2. PREPARE THE STATEMENT
OF CHANGES IN EQUITY

Note: Net Income from the Income

Statement carries to the Statement of
Changes in Equity.
 3 - 36

P 3

3. Prepare The Balance Sheet

 3 - 37

Profit Margin
A2

The profit margin ratio measures the company’s

net income to net sales.
Profit Net Income
=
Margin Net Sales

Limited Brands, Inc.

$ in millions 2009 2008 2007 2006

Net income $ 220 $ 718 $ 676 $ 683

Net sales 9,043 10,134 10,671 9,699

Profit margin 2.4% 7.1% 6.3% 7.0%
Industry profit margin 0.3% 1.1% 1.6% 1.5%
 3 - 38

P4 Appendix 3A: Alternative

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.
 3 - 39

END OF CHAPTER 3