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Chapter 3 Adjusting Accounts and Preparing Financial Statements.

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1 Chapter 3 Adjusting Accounts and Preparing Financial Statements

2 Conceptual Chapter Objectives CH 3 QUIZ: Concepts 1 – 4: C1: Explain the importance of periodic reporting and the time period principle. C2: Explain accrual accounting and how it improves financial statements. C3: Identify steps in the accounting cycle. C4: Explain and prepare a classified balance sheet. 3-2

3 Analytical Chapter Objectives A1: Explain how accounting adjustments link to financial statements. A2: Compute profit margin and describe its use in analyzing company performance. SELF STUDY A3: Compute the current ratio and describe what it reveals about a company’s financial condition. SELF STUDY 3-3

4 Procedural Chapter Objectives P1: Prepare and explain adjusting entries. P2: Explain and prepare an adjusted trial balance. P3: Prepare financial statements from an adjusted trial balance. P4: Describe and prepare closing entries. P5: Explain and prepare a post-closing trial balance. 3-4

5 Procedural Chapter Objectives (Continued) P6: Appendix 3A: Explain the alternatives in accounting for prepaids. NOT COVERED P7: Appendix 3B: Prepare a work sheet and explain its usefulness. NOT COVERED 3-5

6 The Accounting Cycle Start Analyze transactions Journalize Post Prepare unadjusted trial balance Adjusting Entries Prepare adjusted trial balance Prepare statements Closing Entries Prepare post-closing trial balance C3 Reverse (optional) 3-6 POST

7 The Accounting Period To provide timely information, accounting systems prepare periodic reports at regular intervals. 1. Time-period principle assumes that an organization’s activities can be divided into specific time periods such as a month, a three- month quarter, a six-month interval, or a year. Reports covering a one-year period are known as annual financial statements. Interim financial statements cover one, three, or six months of activity.

8 The Accounting Period 2. Annual reporting period: a. Calendar year —January 1 to December 31. b. Fiscal year —Any twelve consecutive months used to base annual financial reports on. c. Natural business year —a fiscal year that ends when a company's sales activities are at their lowest level for the year.

9 Annually 12 Monthly Quarterly Semiannually The Accounting Period Jan FebMar Apr MayJunJulAugSepOctNovDec C 1 3-9

10 The Adjustment Process Accounts are adjusted at the end of a period to record internal transactions and events that are not yet recorded. Two basic principles for recognizing Revenues and Expenses: 1. The revenue recognition principle requires revenue be recorded when earned, not before and not after. 2. The matching principle requires expenses be recorded in the same period as the revenues earned as a result of these expenses.

11 Accrual Basis versus Cash Basis Accrual basis accounting —uses the adjusting process to recognize revenue when earned and to match expenses with revenues. This means the economic effects of revenues and expenses are recorded when earned or incurred, not when cash is received or paid. Accrual basis is consistent with GAAP. Cash basis accounting —revenues are recognized when cash is received and expenses are recognized when cash paid. Cash basis is not consistent with GAAP. Accrual accounting also increases the comparability of financial statements from one period to another.

12 Accounting Accrual 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 GAAP C

13 Accrual Basis vs. Cash Basis On the cash basis the entire $2,400 would be recognized as insurance expense in No insurance expense from this policy would be recognized in 2010 or 2011, periods covered by the policy. C

14 Accrual Basis vs. Cash Basis On the accrual basis, Insurance expense is recognized as follows: $100 in 2009, $1,200 in 2010, and $1,100 in The expense is matched with the periods benefited by the insurance coverage. On the accrual basis, Insurance expense is recognized as follows: $100 in 2009, $1,200 in 2010, and $1,100 in The expense is matched with the periods benefited by the insurance coverage. C

15 Adjusting Accounts An adjusting entry is recorded to bring an asset or liability account balance to its proper amount. The adjusting process is based on ACCRUAL ACCOUNTING of Revenue Recognition and Matching Principle. Adjusting accounts is a 3-step process: (1) Determine the current account balance, (2) Determine what the current account balance should be, and (3) Record adjusting entry to get from step 1 to step 2.

16 Supplies During 2009, Scott Company purchased $15,500 of supplies. Scott recorded the expenditures as Supplies (Asset). On December 31, a count of the supplies indicated $2,655 on hand. What adjustment is required? During 2009, Scott Company purchased $15,500 of supplies. Scott recorded the expenditures as Supplies (Asset). On December 31, a count of the supplies indicated $2,655 on hand. What adjustment is required? P1 3-16

17 Adjustments Adjusting Accounts Paid (or received) cash before expense (or revenue) recognized Paid (or received) cash after expense (or revenue) recognized Prepaid (Deferred) expenses* Unearned (Deferred) revenues Accrued expenses Accrued revenues Framework for Adjustments * including depreciation C2, P1 3-17

18 Supplies During 2009, 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? During 2009, 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? P Prepaid (Deferred) Expenses

19 Straight-Line Depreciation Expense = Asset Cost - Salvage Value Useful Life Depreciation Depreciation is the process of computing expense from allocating the cost of plant and equipment over their expected useful lives. P1 3-19

20 Depreciation On January 1, 2009, 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, On January 1, 2009, 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, Depreciation Expense = $62,000 - $2,000 5 =$12,000 P1 3-20

21 Depreciation On January 1, 2009, 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, On January 1, 2009, 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, Accumulated depreciation is a contra asset account. Accumulated depreciation is a contra asset account. P1 3-21

22 Depreciation Equipment is shown net of accumulated depreciation. This amount is referred to as the asset’s book value $ P1 3-22

23 Unearned (Deferred) Revenues Revenue Buy your season tickets for all home basketball games NOW! “Go Big Blue” Cash received in advance of providing products or services. Liability Unadjusted Balance Credit Adjustment Debit Adjustment P1 3-23

24 Unearned (Deferred) Revenues On October 1, 2009, Ox University sold 1,000 season tickets to its 20 home basketball games for $100 each. Ox University makes the following entry: P1 3-24

25 Unearned (Deferred) Revenues On December 31, Ox University has played 10 of its regular home games, winning 2 and losing 8. P1 3-25

26 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 ExpenseLiability Credit Adjustment Debit Adjustment P1 3-26

27 12/1/09 12/31/09 Year end Last pay date 12/26/09 Next pay date Record adjusting journal entry. Record adjusting journal entry. Accrued Expenses Barton, Inc. pays its employees every Friday. Year-end, 12/31/09, falls on a Wednesday. As of 12/31/09, the employees have earned salaries of $47,250 for Monday through Wednesday. P1 3-27

28 Accrued Expenses Barton, Inc. pays its employees every Friday. Year-end, 12/31/09, falls on a Wednesday. As of 12/31/09, the employees have earned salaries of $47,250 for Monday through Wednesday. P1 3-28

29 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, 2009, the end of the company’s fiscal year. P1 3-29

30 Quick Study 2, 3, 4, 5 Exercise 2, 3

31 Links to Financial Statements A1 3-31

32 The Accounting Cycle Start Analyze transactions Journalize Post Prepare unadjusted trial balance Adjusting Entries Prepare adjusted trial balance Prepare statements Closing Entries Prepare post-closing trial balance C3 Reverse (optional) 3-32 POST

33 1.Prepare the Income Statement P3 3-33

34 2.Prepare Statement of Retained Earnings Note: Net Income from the Income Statement carries to the Statement of Retained Earnings. P3 3-34

35 3.Prepare Balance Sheet P3 3-35

36 The Closing Process: Temporary and Permanent Accounts 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.” C3 3-36

37 The Accounting Cycle Start Analyze transactions Journalize Post Prepare unadjusted trial balance Adjusting Entries Prepare adjusted trial balance Prepare statements Closing Entries Prepare post-closing trial balance C3 Reverse (optional) 3-37 POST

38 Recording Closing Entries 1. Close revenue accounts to Inc. Summary; 2. Close expense accounts to Inc. Summary; 3. Close the income summary to RE; 4. Close dividends account to RE. P4 3-38

39 Recording Closing Entries Income Summary Salaries ExpensesConsulting Revenues $ 18,100 $ 25,000 Retained Earnings $ 7,000 Examine the accounts presented. P4 3-39

40 $ 25,000 Close revenues with a debit to the revenue account and a credit to Income Summary. Recording Closing Entries $ 18,100 Salaries ExpensesConsulting Revenues Income Summary $ 25,000 P4 3-40

41 $ 25,000 Close expense accounts with a credit to expenses and a debit to Income Summary. $ 25,000 Recording Closing Entries $ 18,100 Salaries ExpensesConsulting Revenues Income Summary $ 18,100 P4 3-41

42 $ 18,100 $ 25,000 $ 18,100 $ 25,000 $ 18,100 Determine the balance in the Income Summary account. Recording Closing Entries Salaries ExpensesConsulting Revenues Income Summary $ 6,900 P4 3-42

43 $ 18,100 $ 25,000 $ 18,100 $ 7,000 Close the Income Summary to Retained Earnings. Recording Closing Entries $ 6,900 Salaries Expenses Income Summary Retained Earnings $ 6,900 P4 3-43

44 Recording Closing Entries Dividends $ 2,000 $ 7,000 6,900 Retained Earnings The dividends account is closed to Retained Earnings. $ 2,000 P4 3-44

45 Recording Closing Entries Dividends $ 2,000 Determine the ending balance in Retained Earnings. $ 11,900 $ 7,000 6,900 Retained Earnings The dividends account is closed to Retained Earnings. P4 3-45

46 The Accounting Cycle Start Analyze transactions Journalize Post Prepare unadjusted trial balance Adjusting Entries Prepare adjusted trial balance Prepare statements Closing Entries Prepare post-closing trial balance C3 Reverse (optional) 3-46 POST

47 Quick Study 10, 14, 15 Exercise 11

48 Post Closing Trial Balance 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. P5 3-48

49 Classified Balance Sheet Current items are those expected to come due (either collected or owed) within one year or the company’s operating cycle, whichever is longer. C

50 Classified Balance Sheet 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. C 4 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. 3-50

51 Long Term Liabilities Obligations due to be paid or settled within one year or the operating cycle, whichever is longer. C 4 Obligations not due within one year or the operating cycle, whichever is longer. Current Liabilities 3-51

52 Classified Balance Sheet 3-52

53 Profit Margin The profit margin ratio measures the company’s net income to net sales. Profit Margin Net Income Net Sales = A2 3-53

54 Current Ratio Current ratio Current assets Current liabilities = This ratio is an important measure of a company’s ability to pay its short-term obligations. A3 3-54

55 End of Chapter


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