© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Adjusting Accounts and Preparing Financial Statements Chapter 3 3

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Learning objective 1.Periodic reporting / Time period principle 2.Accrual Accounting and Cash Accounting 3.Account Adjustment  Prepaid expense  Unearned revenue  Accrued expense  Accrued revenue 4.Adjusted Trial Balance (ATB) 5.Preparation of Financial statement from ATB 6.Decision Analysis: Profit Margin Case: Intel & AMD

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Annual 12 Monthly Quarterly Semiannual 1. Periodic reporting The Accounting Period Jan FebMar Apr MayJunJulAugSepOctNovDec

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin The Time Period Principle  The time period principle assumes that an organization’s activities can be divided into specific time periods such as a month, a quarter, a six-month interval, or a year.  Fiscal year VS. calendar year (Jan. 1 ~ Dec. 31).

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Accounting 2. 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

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 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 2005 or 2006, periods covered by the policy.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Accrual Basis vs. Cash Basis On the accrual basis $100 of insurance expense is recognized in 2004, $1,200 in 2005, and $1,100 in The expense is matched with the periods benefited by the insurance coverage.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 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 and Expenses  Revenue Recognition

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Recognizing Revenues and Expenses  Revenue Recognition  Matching Principle Summary of Expenses Rent Gasoline Advertising Salaries Utilities and.... $1, ,000 3, 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.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Recognizing Revenues and Expenses  Revenue recognition principle requires that revenue be recorded when earned, not before or after.  Matching principle intends to record expenses in the same accounting period as the revenues that are earned as a result of these expenses.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Adjustments An adjusting entry is recorded to bring an asset or liability account balance to its proper amount. 3. 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 expense Accrued revenues Framework for Adjustments * including depreciation

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin At the beginning of period 1 recognize all cash payment as prepaid expense (asset account): Dr. Prepaid Rent Expense 4 million Cr. Cash 4 million At the end of each accounting period recognize the portion that is used Dr. Rent Expense 1 million Cr. Prepaid Rent Expense 1 million Adjusting Accounts – Prepaid expenses Paid Cash Actually used Accounting Period 1 Accounting Period 2 Accounting Period 3 Accounting Period 4 E.g. Paid 4 years rental fee $ 4 million

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin At the beginning of period 1 recognize all cash receipt as unearned revenue (liability account). Dr. Cash 40 million Cr. Unearned revenue 40 million At the end of each accounting period recognize the portion that is earned: Dr. Unearned revenue 10 million Cr. Revenue 10 million Adjusting Accounts – Unearned revenue Received CashRevenue Earned Accounting Period 1 Accounting Period 2 Accounting Period 3 Accounting Period 4 E.g. Long-term contract: Received $40m in advance to build a ship

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Adjusting Accounts – Accrued expenses Paid CashInterest expense incurred Accounting Period 1 Accounting Period 2 Accounting Period 3 Accounting Period 4 When borrowing money: Dr. Cash 40 million Cr. Bank loan 40 million At the end of each period (1 to 4) recognize the portion of interest expense that is due but not paid: Dr. Interest Expense 4 million Cr. interest payable 4 million At the end of the period 4: Dr. Interest payable 16 million Dr. Bank loan 40 million Cr. Cash 56 million E.g. Borrow 40 million from bank. Annual interest rate is 10%. Interest and principal are paid at the end of 4 th year. Received Cash

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Adjusting Accounts – Accrued revenues  At the end of each accounting period (1 to 4) recognize the portion of revenue that is earned but not received: Dr. Accounts Receivable 10 million Cr. Revenue 10 million  At the end of period 4: Dr. Cash 40 million Cr. Accounts receivable 40 million Received Cash Accounting Period 1 Accounting Period 2 Accounting Period 3 Accounting Period 4 Revenue Earned Long-term Contract: Received $40 million after building one ship

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Here is the check for my first 6 months’ rent. Here is the check for my first 6 months’ rent. Prepaid expense Resources paid for prior to receiving the actual benefits. Asset Expense Unadjusted Balance Credit Adjustment Debit Adjustment

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Prepaid expense 1 Prepaid Insurance On December 1, 2004, Fastforward paid $2,400 for 24 months of insurance benefits beginning on December 1, Fastforward recorded the expenditure as Prepaid Insurance on December 1. What adjustment is required?

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Prepaid expense 2 Supplies During 2004, Fastforward purchase $9,720 of supplies. Fastforward recorded the expenditures as Supplies. At December 31, a count of the supplies indicated $8,670 on hand. What adjustment is required?

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Straight-Line Depreciation Expense = Asset Cost - Salvage Value Useful Life Prepaid expense 3 Depreciation Depreciation is the process of allocating the cost of plant and equipment over their expected useful lives.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Adjusting for Depreciation Dec 1, 2004, Fastforward purchased equipment for $26,000 cash. The equipment has an estimated useful life of 4 years Fastforward expects to sell the equipment at the end of its life for $8,000 cash Depreciation Expense = $26,000 - $8, = $375 Accumulated depreciation is a contra asset account. Accumulated depreciation is a contra asset account.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin contra account  A contra account is an account linked with another account, it has an opposite normal balance, and it is reported as a subtraction from that other account’s balance.  A contra account allow information users to know both the full costs of assets and the total amount of depreciation.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Equipment Depreciation Expense 1/1 26,000 12/ Accumulated Depreciation 12/ Adjusting for Depreciation

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Adjusting for Depreciation Equipment is shown net of accumulated depreciation. $

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Unearned (Deferred) Revenues Cash received in advance of providing products or services. Liability Revenue Unadjusted Balance Credit Adjustment Debit Adjustment E.g. The New York Times Company: Subscriptions- unearned revenue.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Adjusting Unearned (Deferred) Revenues Dec 26, 2004,  Fastforward agreed to provide consulting services to a client for a fixed fee of $3,000 for 60 days.  On the same day, the client paid the 60-day fee in advance, covering the period from Dec 27 to Feb 24.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Adjusting Unearned (Deferred) Revenues December 31, Fastforward has provided 5 days’ service and earned 5/60 of $3000.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 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

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 12/1/04 12/31/04 Year end Last pay date 12/26/04 Next pay date 1/2/05 Record adjusting journal entry. Record adjusting journal entry. Adjusting for Accrued Expenses Fastforward pays its employee $700 every two weeks on Friday. Year-end, 12/31/04, falls on a Wednesday. As of 12/31/04, the employees have earned salaries of 3 days for Monday through Wednesday of the week ended 1/02/05.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Adjusting for Accrued Expenses Fastforward pays its employee $700 every two weeks on Friday. Year-end, 12/31/04, falls on a Wednesday. As of 12/31/04, the employees have earned salaries of 3 days for Monday through Wednesday of the week ended 1/02/05.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Yes, I’ve completed your tax return, 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. Asset Revenue Credit Adjustment Debit Adjustment

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Adjusting for 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, 2004, the end of the company’s fiscal year.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Adjusting Accrued Revenues Dec 12, 2004  FastForward agreed to provide 30 days of consulting services to a local sports club for a fixed fee of $2700, beginning from Dec 12.  The club agrees to pay FastForward on Jan 10, 2005.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Adjusting Accrued Revenues

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Future receipts of accrued revenues Jan 10, 2005 FastForward received $2,700 cash for the entire contract amount. Jan 10 Dr. Cash 2,700 Cr. Accounts Receivable 1,800 Cr. Consulting Revenue 900 To record cash collection

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Links to Financial Statements

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 4. Adjusted Trial Balance  Explain and prepare an adjusted trial balance.  Prepare financial statements from an adjusted trial balance.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin FastForward Trial Balance December 31, 2004 First, the initial unadjusted amounts are added to the worksheet. $ $ $ $

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Next, FastForward’s adjustments are added. FastForward Trial Balance December 31, 2004 $ $ $ $ $ $ $$

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin FastForward Trial Balance December 31, 2004 Finally, the totals are determined. $ $ $ $ $ $ $$ $ $ $ $

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 5. Preparing Financial Statements Let’s use FastForward’s adjusted trial balance to prepare the company’s financial statements. Remember order: Income Statement, Statement of Owner’s Equity, Balance Sheet, Statement of Cash Flow

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin  Prepare the Income Statement.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin  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.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin  Prepare the Balance Sheet.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin  Profit margin ratio measures the company’s profitability  Comparison technique with competitors with prior period Profit Margin Net Income Net Sales = 6. Decision Analysis - Profit Margin

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 1.Industry Characteristics  Highly technology intensive  Cyclical with economic cycle 2.Key success factors:  Technology innovation 3.Companies for analysis  Intel  AMD Profit Margin - Semiconductor Industry

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 6. Profit Margin - Intel & AMD PM Intel22.31%21.97%18.72%11.65%4.86%31.24%24.89%23.10%27.70%24.74% AMD2.83%1.82%-7.80%-48.31%-1.56% Industry 14.85%14.07%13.16%

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin ROA - Intel & AMD ROA Intel17.93%15.61%11.97%7.05%2.91%21.97%16.68%19.28%24.05%21.73% AMD2.27%1.16%-3.89%-22.88%-1.07% Industry 9.22%8.06%7.41%

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Homework for Chap 1, 2, 3  Chap 1: Problem 1-8 A  Chap 2: Problem 2-3 B  Chap 3: Problem 3-3 A  Due on June,16,2006 (Friday) in class.  Please submit hard copy.  Please submit on time for me to keep your homework record.