Adjusting Accounts and Preparing Financial Statements

Adjusting Accounts and Preparing Financial Statements
Chapter 3 Adjusting Accounts and Preparing Financial Statements In chapter three, we will look at the timing of reports and the need to adjust accounts. Adjusting entries are necessary because not all transactions begin and end in one accounting period. For example, a customer may purchase inventory at the end of December and not pay for it until January of the next year. Adjusting accounts is important for recognizing revenues and expenses in the proper period. Toward the end of the chapter we will review the preparation of our basic financial statements.

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

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

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

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

The Accounting Cycle Prepare post-closing trial balance Start Reverse
(optional) Analyze transactions POST Closing Entries Journalize Prepare statements This is a schematic of the entire accounting process. Post Prepare unadjusted trial balance Prepare adjusted trial balance Adjusting Entries POST 3-6

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.

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.

The Accounting Period Annually Semiannually Quarterly Monthly 1 2 1 2
3 4 Quarterly The most common account period is one month. Companies also prepare quarterly reports and semi-annual reports. At the end of each year, most companies prepare an annual report of operations and financial position. When we divide business activities into arbitrary fixed periods of time, it is often necessary to have special accounting for transactions that cross from one time period to the next. Most of our time will be spent looking at the special adjusting process for some of these transactions. 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 3-9 5 5

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.

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.

Accrual Basis vs. Cash 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 Part I The accrual basis dictates that revenues be recognized when earned and expenses be recognized when incurred. The accrual basis of accounting is considered to be in compliance with generally accepted accounting principles, or GAAP. The cash basis of accounting dictates that revenues be recognized when the cash is actually received and that expenses are recorded when the cash is paid. Part II The cash basis is not considered to be compliant with GAAP. While you may be on the cash basis for your transactions, almost all companies follow the accrual basis of accounting. We believe that the cash basis waits too long to recognize revenue and expenses and, therefore, misstates income. Accounting 3-12 9 9

In our first transaction, on December 1, 2009, FastForward paid twenty-four hundred dollars cash for a twenty-four month business insurance policy. On the cash basis, the entire twenty-four hundred dollars would be recognized as an expense in 2009 even though the policy provides protection for 2009, 2010 and Let’s look at how this type of transaction is handled in an accrual basis accounting system. 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. 3-13 9 9

On the accrual basis, Insurance expense is recognized as follows: $100 in 2009, $1,200 in 2010, and $1,100 in 2011. The expense is matched with the periods benefited by the insurance coverage. On the accrual basis, we would record one hundred dollars of insurance expense in the month of December, 2009, one hundred dollars for each month in 2010, and one hundred dollars for the months January through November in We match the expense with the periods benefited by the insurance coverage. We believe this is a better cost matching of revenues and expenses. 3-14 9 9

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 to step 2.

What adjustment is required?
Supplies P1 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? In our second transaction, Scott Company spent fifteen thousand, five hundred dollars on office supplies during When the supplies were purchased, an entry was made to debit, or increase, the asset account (Supplies), and the cash account was decreased. On December 31, 2009, the balance in the supplies account was fifteen thousand, five hundred dollars. On that date we conducted an inventory of the office supplies on hand and determined that we still had two thousand, six hundred fifty five dollars in supplies. We used the other supplies during Let’s make the adjusting entry required on December 31, 2009, to get the balance in the supplies account stated properly. Part II Debit, or increase, supplies expense by twelve thousand, eight hundred forty-five dollars, the amount of the supplies used, and credit, or reduce, the asset account, supplies, by the same amount. If we had supplies available of fifteen thousand, five hundred dollars and only had two thousand, six hundred fifty-five dollars on hand at the end of the year, we must have used twelve thousand, eight hundred forty-five dollars worth of supplies during Now let’s post our adjusting entry. Part III You can see that we now have the proper balance in the asset account, supplies, and we have fully recognized an expense for the supplies used during Now let’s look at a new type of adjusting entry. 126 652 3-16 16 16

Framework for Adjustments
Adjusting Accounts C2, P1 Framework for Adjustments Adjustments Paid (or received) cash before expense (or revenue) recognized Paid (or received) cash after expense (or revenue) recognized Here is a framework for adjusting the books of the company. There are two broad categories of adjustments. The first is when we pay or receive cash before the expense or revenue is recognized. This category includes prepaid or deferred expenses (including depreciation), and unearned or deferred revenues. The second major category of adjustments is when cash is paid or received after the expense or revenue is recognized. These are some very common adjustments. The category includes accrued expenses and accrued revenues. Prepaid (Deferred) expenses* Unearned (Deferred) revenues Accrued expenses Accrued revenues *including depreciation 3-17 12 12

Prepaid (Deferred) Expenses What adjustment is required?
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? In our second transaction, Scott Company spent fifteen thousand, five hundred dollars on office supplies during When the supplies were purchased, an entry was made to debit, or increase, the asset account (Supplies), and the cash account was decreased. On December 31, 2009, the balance in the supplies account was fifteen thousand, five hundred dollars. On that date we conducted an inventory of the office supplies on hand and determined that we still had two thousand, six hundred fifty five dollars in supplies. We used the other supplies during Let’s make the adjusting entry required on December 31, 2009, to get the balance in the supplies account stated properly. Part II Debit, or increase, supplies expense by twelve thousand, eight hundred forty-five dollars, the amount of the supplies used, and credit, or reduce, the asset account, supplies, by the same amount. If we had supplies available of fifteen thousand, five hundred dollars and only had two thousand, six hundred fifty-five dollars on hand at the end of the year, we must have used twelve thousand, eight hundred forty-five dollars worth of supplies during Now let’s post our adjusting entry. Part III You can see that we now have the proper balance in the asset account, supplies, and we have fully recognized an expense for the supplies used during Now let’s look at a new type of adjusting entry. 126 652 3-18 16 16

Asset Cost - Salvage Value
Depreciation P1 Depreciation is the process of computing expense from allocating the cost of plant and equipment over their expected useful lives. Straight-Line Depreciation Expense = Asset Cost - Salvage Value Useful Life Plant assets, with the exception of land, are depreciated over their useful lives. Depreciation is the process of allocating the cost of a plant asset over its useful life in a systematic and rational manner. At this point in the accounting process, we want to introduce you to a depreciation method known as straight-line depreciation. Straight line depreciation is the most popular method used by companies. They determine the amount of annual depreciation by taking the cost of the plant assets, subtracting the estimated salvage value and dividing that amount by the useful life of the asset. The salvage value is the amount we expect to receive for the asset when we dispose of it at the end of its useful life. In a later chapter, we will discuss other acceptable methods of depreciation. For now, let’s look at the adjusting entry to record depreciation expense. 3-19 19 19

Depreciation P1 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, 2009. Part I On January 1, 2009, Barton purchased equipment for sixty-two thousand dollars cash. The equipment has an estimated useful life of five years and an estimated salvage value of two thousand dollars. Can you determine the annual depreciation expense for 2009? Part II How did you do? The numerator of the equation is sixty thousand dollars, cost less salvage value, and the denominator is 5, so our annual depreciation expense is twelve thousand dollars. Now, let’s record the adjusting journal entry. 2009 Depreciation Expense = $62, $2,000 5 $12,000 3-20 20 20

Accumulated depreciation is
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, 2009. Part I On December 31, 2009, we will debit, or increase, depreciation expense for twelve thousand dollars and credit a new account called accumulated depreciation – (dash) -- equipment. Part II Accumulated depreciation is a contra asset account. A contra- account means that the amount in the account reduces the related asset account. In our case, accumulated depreciation will reduce the asset account, equipment. Because this is a new type of account, let’s look at the treatment of the contra and related asset account. We have posted the adjusting entry to record depreciation expense. We have also shown you the balance in the equipment account. The depreciation expense account will appear on our income statement for the year ended December 31, Let’s see how we will deal with the other two accounts. Accumulated depreciation is a contra asset account. 3-21 22 22

Depreciation P1 Equipment is shown net of accumulated depreciation. This amount is referred to as the asset’s book value $ The contra-account, accumulated depreciation, will be shown as a reduction in the cost of the asset, equipment. Cost of a plant asset less accumulated depreciation is known as book value. So the asset, equipment, will be shown on the balance sheet at its net amount, or book value, of fifty thousand dollars. Because the contra account appears on the balance sheet it will not be closed at the end of the period. It will be carried forward to 2010 and used to accumulate the depreciation related to the equipment. Now let’s move on to the second category of adjusting entries, deferred revenues. 3-22 24 24

Unearned (Deferred) Revenues
P1 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 Revenue Part I When accounting for deferred revenues, we are faced with a transaction where cash is received in advance of providing a product or service. In other words, we have received the cash, but have done nothing to earn it. In our example, we will examine accounting for the sale of season tickets to a University’s home basketball games. Part II When dealing with adjustments for deferred revenues we always debit, or reduce, a liability account and credit, or increase, a revenue account. Let’s move on to our season ticket example. Debit Adjustment Credit Adjustment 3-23 25 25

P1 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: Part I On October 1, 2009, Ox University sold one thousand season tickets to its 20 home basketball games for one hundred dollars each. On the date of sale, the university made a debit, or increase, to the cash account and a credit, or increase, to a liability account called unearned revenue. We know the use of the word revenue may be a little confusing for now, but remember that the key word is unearned. The university has done nothing to earn the revenue from the sale of the tickets. Let’s post the entry to the ledger account, unearned revenue. Part II Remember, the unearned revenue account is a liability account and will remain a liability until the University provides basketball games for the season ticket holders. Now, let’s look at the adjusting entry the University will make on December 31, 2009, the end of the accounting period. 3-24 27 27

P1 On December 31, Ox University has played 10 of its regular home games, winning 2 and losing 8. Part I As of December 31, 2009, the University had played ten home games and compiled a record of two wins and eight losses. Let’s make the adjusting entry. Part II The adjusting entry is to debit, or decrease, the liability account, unearned revenue and credit, or increase, the revenue account basketball revenue for fifty thousand dollars. The team has played one-half of its home games so one-half of the unearned revenue has now been earned. Let’s post the adjusting entry so we can look at the balances in the ledger account. Part III The unearned revenue account has a credit balance of fifty thousand dollars. This money will be recognized as more home games are played. The basketball revenue account has a credit balance of fifty thousand dollars. The revenue account will appear on the income statement and be closed at the end of the accounting period. The liability account, unearned revenue, will appear on the balance sheet on December 31, 2009. Now let’s change the subject and look at adjustments for accrued expenses. 3-25 28 28

want to be paid for our work!
Accrued Expenses P1 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. Expense Liability Credit Adjustment Debit Part I An accrued expense is defined as a cost incurred in the current period that is both unpaid and unrecorded. When you use your credit card, often you do not record the transaction until you pay your monthly invoice; even though you have incurred the cost. Part II For all accrued expense adjusting entries, we debit, or increase an expense account, and credit, or increase, a liability account. Let’s look at a specific example of an accrued expense. 3-26 31 31

Accrued Expenses P1 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. 12/1/09 12/31/09 Year end Last pay date 12/26/09 Next pay Record adjusting journal entry. Part I Barton, Inc. pays its employees every Friday. The current year end, December 31, 2009, falls on a Wednesday. As of December 31, 2009, the employees have earned salaries of forty-seven thousand, two hundred fifty dollars that will not be paid until the following Friday, January 2, 2010. Part II Here is a schematic of the dates. We need to record an adjusting entry on December 31, 2009, to recognize the salaries earned by employees but not paid. Let’s look at the adjusting entry. 3-27 33 33

Accrued Expenses P1 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. Part I In our adjusting journal entry we will debit, or increase, salaries expense and credit, or increase, salaries payable. After the adjustment, salaries expense for 2009 is stated properly. Let’s look at the posting to the ledger accounts. Part II Salaries expense recorded during the year amounted to six-hundred, fifty-seven thousand, five hundred dollars. After posting our adjusting entry, the new balance at the end of the year is seven hundred, four thousand, seven hundred fifty dollars. The salaries payable account will be eliminated when the employees are paid on January 2, Now let’s move on and look at accrued revenue. 3-28 34 34

Accrued Revenues P1 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. The term accrued revenues refers to revenues earned in a period that are both unrecorded and not yet received. Part I This adjusting entry is needed because many firms have delivered a product or provided a service but have not recorded the revenue in the current period. You can see our example of an accountant who prepared a tax return for a client but has yet to send that client a bill for the service. The accountant has earned the revenue, but has not recorded it at year-end. Part II In adjusting entries, to record accrued revenue, we will always debit, or increase, an asset account and credit, or increase, a revenue account. Let’s look at a specific example. In our example, Smith and Jones, CPAs, have completed work amounting to thirty one thousand, two hundred dollars at the end of the year but have not billed this amount to specific clients. Let’s look at the necessary adjusting entry. The company will debit, or increase, the asset, accounts receivable, and credit, or increase, the revenue account, service revenue for the thirty one thousand, two hundred dollars. Let’s look at the adjusted account balances. Part III Notice that the accounts receivable and service revenue accounts have been updated to include the earned but unbilled amount of services provided. On the next slide we have prepared a summary of the adjusting process. 3-29 38

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

Links to Financial Statements
This summary will prove very useful when completing your homework or studying for the next exam. Here is how we read the table. Before we record a prepaid expense, the assets of the company are overstated and the expenses are understated in the current period. The proper adjusting entry is to debit, or increase, an expense account and credit, or decrease, an asset account. Take a few minutes to go over the remaining three types of adjusting entries before going to the next slide where we will use a spreadsheet to prepare the adjusting entries and financial statements. 3-31 41

Prepare the Income Statement P3
You can see how we took the information directly from the work sheet and prepared the income statement for the month ended December 31, The income statement includes only the revenue and expense accounts. Net income reported by FastForward for the month is three thousand, seven hundred eighty-five dollars. We will see this amount again on the statement of retained earnings. 3-33

Prepare Statement of Retained Earnings
Note: Net Income from the Income Statement carries to the Statement of Retained Earnings. The statement of retained earnings adds net income to the beginning balance in the account and subtracts dividends paid of six hundred dollars. This item is needed to carry over to the balance sheet. That’s why the statement of retained earnings is prepared second. Now let’s prepare the balance sheet for FastForward. 3-34

Prepare Balance Sheet P3
Our third financial statement that we prepare is the balance sheet. We find all the asset and liability accounts on the worksheet and put them into proper form for the balance sheet. In addition, we bring forward the retained earnings balance that we calculated previously on the statement of retained earnings. The books are in balance because total assets are equal to total liabilities plus owner’s equity. Now, we have completed the adjusting process leading to the preparation of the financial statements of FastForward. 3-35

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. Once the formal financial statements have been prepared, we may begin the process of closing the books and getting ready for the next accounting period. Income is earned over a period of time. At the end of the time period, we start over and calculate income for the next period. The closing process’ goal is to reset all revenue, expense and dividends accounts to a zero balance at the end of the period. By doing this, we can start the next accounting period fresh. We will use a temporary account called income summary to facilitate the closing process. The account will never appear on any financial statement and will have a zero balance when the closing process is complete. All accounts that will be closed are known as temporary accounts. Temporary accounts include revenues, expenses, dividends, and the income summary. These accounts should all have a zero balance at the end of the period. Permanent accounts include assets, liabilities and owner’s equity. These accounts are permanent in nature because they are carried forward from one accounting period to the next. 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.” 3-36

Recording Closing Entries
P4 Close revenue accounts to Inc. Summary; Close expense accounts to Inc. Summary; Close the income summary to RE; Close dividends account to RE. Here are the four steps we always follow in the closing process. First, we close all revenue accounts to the income summary. We move the balance in all revenue accounts to the income summary. This process will cause all revenue accounts to have a zero balance. Remember that revenue accounts normally have a credit balance. Next, we close all expense accounts to the income summary. This will zero out all of our expense accounts. Expense accounts normally have a debit balance. Next, the income summary will show revenues and expenses, or net income. We must close the income summary, which contains net income, to retained earnings. This process zeroes out the income summary. The final closing entry will be to close dividends to the retained earnings account. This will cause the dividends account to have a zero balance. Let’s see how this process works. To prevent confusion when you first try to make closing entries, it is an excellent idea to follow these four steps exactly. 3-38

P4 Salaries Expenses Consulting Revenues $ 18,100 Examine the accounts presented. $ 25,000 Income Summary Retained Earnings To illustrate the closing process we will assume that the company has only one expense account and only one revenue account. The beginning credit balance in retained earnings is seven thousand dollars, and dividends of two thousand dollars have been paid. The first step in the closing process is to transfer all revenues to the income summary account. Let’s do this now. $ 7,000 3-39

P4 Salaries Expenses Consulting Revenues $ 18,100 $ 25,000 $ 25,000 Income Summary Close revenues with a debit to the revenue account and a credit to Income Summary. You can see that the closing entry requires a debit to the revenue account. The revenue account now has a zero balance. The credit portion of the entry is made to income summary. Revenues have been transferred from the revenue account to the income summary. The next step is to close all expense accounts. Let’s get started with that entry. 3-40

P4 Salaries Expenses Consulting Revenues $ 18,100 $ 18,100 $ 25,000 $ 25,000 Close expense accounts with a credit to expenses and a debit to Income Summary. Income Summary We close the expense account with a credit to that account and a debit to the income summary. The expense account now has a zero balance and the expenses appear on the debit side of the income summary. We know the company had net income because revenues are greater than expenses. Notice that all revenue and expense accounts now have a zero balance so we accomplished part of our goal. $ 25,000 3-41

P4 Salaries Expenses Consulting Revenues $ 18,100 $ 18,100 $ 25,000 $ 25,000 Income Summary Determine the balance in the Income Summary account. Net income for the period is sixty-nine hundred dollars. This balance must be transferred to the retained earnings account. $ 18,100 $ 25,000 $ 6,900 3-42

P4 Salaries Expenses Close the Income Summary to Retained Earnings. $ 18,100 $ 18,100 Income Summary Retained Earnings We debit the income summary for sixty-nine hundred dollars and credit retained earnings for the same amount. The balance in the income summary account is now zero. Our last closing entry involves dividends. $ 18,100 $ 25,000 $ 7,000 $ 6,900 $ 6,900 3-43

P4 The dividends account is closed to Retained Earnings. Retained Earnings Dividends $ 2,000 $ 2,000 $ 7,000 6,900 We close the dividends account with a credit and debit the retained earnings for two thousand dollars. The balance in the dividends account is zero. Let’s determine the balance in retained earnings after all closing entries have been made. 3-44

P4 The dividends account is closed to Retained Earnings. Dividends Retained Earnings $ 2,000 $ 2,000 $ 2,000 $ 7,000 6,900 Retained earnings has a balance of eleven thousand, nine hundred dollars. We arrive at this amount by adding together the beginning balance in the account and net income for the period, and subtracting dividends paid. We have now finished the closing process and we are ready to start the next accounting period. $ 11,900 Determine the ending balance in Retained Earnings. 3-45

Quick Study 10, 14, 15 Exercise

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. After the closing entries have been posted, then the next step is to prepare the post closing, or “after-closing,” trial balance. The purpose of this trial balance is to insure that all the nominal accounts have been closed out. The only accounts that should appear on this trial balance should be the permanent, or real accounts. These would include asset, liability, and equity accounts. Of course, the purpose of any trial balance is to insure that debits equal credits. This is one more feature that insures that the closing process has been successfully completed. 3-48

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. A classified balance sheet is the most popular format used by business. On the asset side of the balance sheet, we group assets as current or noncurrent. A current asset is one that is expected to be converted into cash in one year or the company’s normal operating cycle, whichever is longer. The operating cycle of a service company is the time it takes to acquire resources devoted to providing a service, plus the time it takes to provide that service, and finally, the time it takes to collect the cash from that service provider. For many companies the operating cycle is less than one year. These companies would classify an asset as current as long as that asset is expected to be converted into cash within one year. Current assets normally include cash, short-term investments, accounts receivable, merchandise inventory, office supplies, and prepaid expenses. Short-term investments are expected to be sold within one year or the normal operating cycle, whichever is longer. Merchandise inventory contains inventory items we expect to sell to customers in the normal course of business. For a service business, like an attorney, we would not expect to find a merchandise inventory account. The next major section of the classified balance sheet includes long-term investments, meaning those we expect to hold for more than one year. Some common long-term investments includes notes receivable, investments in the stock or bonds of another company, and land that a company is holding for a future plant site. Companies often purchase stock of another company in order to control or own the other company. 3-49

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. Intangible Assets The third section of the classified balance sheet shows our property, plant and equipment. This section includes productive assets of the company along with any land containing structures such as buildings. Productive assets include machinery, equipment, furniture and fixtures, and buildings. Productive assets are normally depreciated over their useful life. The cost of the asset less any accumulated depreciation is called book value. We do not depreciate land. The final category of assets on the classified balance sheet include intangible assets. Intangibles include long-term resources that lack physical form -- accounts like patents, copyrights, trademarks, and goodwill. In general, it is very difficult to properly value intangible assets. In summary, we have current assets, and noncurrent assets that are divided among long-term investments, plant assets, and 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

Current Liabilities Long Term Liabilities
Obligations due to be paid or settled within one year or the operating cycle, whichever is longer. Long Term Liabilities Obligations not due within one year or the operating cycle, whichever is longer. Current liabilities normally include accounts payable, wages payable, short-term notes payable, and the current portion of long-term liabilities. Other examples of current liabilities are interest payable and unearned revenues. Long-term liabilities include long-term notes payable (net of current amounts due), mortgages payable, and bonds payable. We will look at the accounting for long-term liabilities later in the text. 3-51

Let’s take a look at how these accounts would appear on a balance sheet. A classified Balance Sheet separates the assets into current and long term assets. It also separates the liabilities into current and long-term liabilities. When the data is presented in a classified format, it makes the calculation of key ratios easier. 3-52

Profit Margin A2 The profit margin ratio measures the company’s net income to net sales. Profit Margin Net Income Net Sales = Profit margin is an important measure in business. It tells us about the relationship between sales and profits or net income. We calculate the ratio by dividing net income for the period by sales revenue. A high profit margin is an indicator of future growth. 3-53

Current Ratio A3 This ratio is an important measure of a company’s ability to pay its short-term obligations. Current ratio Current assets Current liabilities = The current ratio of a company gives us a good indication of the company’s ability to pay its debts when they fall due. The current ratio is calculated by dividing current assets by current liabilities. Let’s look at a quick example. Suppose we have a company that has two hundred thousand dollars in current assets and one hundred thousand dollars in current liabilities. The current ratio is two to one, that is, two hundred thousand divided by one hundred thousand. A two to one current ratio means that for each dollar of current liabilities falling due in the next year, we expect to have two dollars of current assets to pay the liabilities. 3-54

End of Chapter 3 This completes our discussion of chapter three.
The process of preparing adjusting entries and closing a company’s books may seem very difficult at first. If adjusting entries or closing entries seem unclear to you, why not review the slides one more time. Of course, you will get to reinforce what we have discussed when doing your homework. Good luck. 3-55

Adjusting Accounts and Preparing Financial Statements

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