© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin1 Adjusting Accounts and Preparing Financial Statements Chapter 3 3

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin2 Learning objective  Explain the importance of periodic reporting and the time period principle.  Explain accrual accounting and how it makes financial statements more useful.  Identify the types of adjustments and their purpose.  Explain how accounting adjustments link to financial statements.  Explain and prepare an adjusted trial balance.  Prepare financial statements from an adjusted trial balance.  Use adjusted trial balance to prepare the company’s financial statements.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin3 Learning objective  Explain the importance of periodic reporting and the time period principle.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin Annual 12 Monthly Quarterly Semiannual The Accounting Period Jan FebMar Apr MayJunJulAugSepOctNovDec

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin5 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 versus calendar year (Jan. 1 ~ Dec. 31).

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin6 Learning objective  Explain accrual accounting and how it makes financial statements more useful.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin7 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

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin8 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., 2006 McGraw-Hill/Irwin9 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., 2006 McGraw-Hill/Irwin10 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., 2006 McGraw-Hill/Irwin11 Recognizing Revenues and Expenses  Revenue Recognition  Matching 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., 2006 McGraw-Hill/Irwin12 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., 2006 McGraw-Hill/Irwin13 Revenues and Expenses

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin14 Revenues and Expenses

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin15 Revenues and Expenses

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin16 Revenues and Expenses

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin17 Recognizing Revenues and Expenses  Can revenue and expense recognition be used to manipulate earnings?  Accelerate revenue recognition  Postpone expense recognition  Postpone revenue recognition  Accelerate expense recognition Are they all?

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin18 Recognizing Revenues and Expenses  What are the usual intentions to manipulate earnings? Executive compensation Meet certain targets Changes of CEO Political motivations Taxation reasons Initial Public Offering

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin19 Learning objective  Identify the types of adjustments and their purpose.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin20 Adjustments An adjusting entry is recorded to bring an asset or liability account balance to its proper amount. 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., 2006 McGraw-Hill/Irwin21 Adjusting Accounts – Prepaid expenses Paid Cash Actually used Accounting Period 1 Accounting Period 2 Accounting Period 3 Accounting Period 4 When should expenses be recognized? Cash basis: At the beginning of period 1 recognize all cash payment as expense. Dr. Rent Expense 4 million Cr. Cash 4 million No entry at later periods. E.g. Paid 4 years rental fee $ 4 million

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin22 Paid Cash Actually used Accounting Period 1 Accounting Period 2 Accounting Period 3 Accounting Period 4 Accrual basis: 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 E.g. Paid 4 years rental fee $ 4 million

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin23 Adjusting Accounts – Unearned revenue Received CashRevenue Earned Accounting Period 1 Accounting Period 2 Accounting Period 3 Accounting Period 4 When should revenues be recognized? E.g. Long-term contract: Received $40m in advance to build a ship Cash basis: At the beginning of period 1 recognize all cash receipt as revenue. Dr. Cash 40 million Cr. Revenue 40 million No entry at later periods.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin24 Received CashRevenue Earned Accounting Period 1 Accounting Period 2 Accounting Period 3 Accounting Period 4 Accrual basis: 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 E.g. Long-term contract: Received $40m in advance to build a ship

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin25 Adjusting Accounts – Accrued expenses Paid CashActually used Accounting Period 1 Accounting Period 2 Accounting Period 3 Accounting Period 4 When should expenses be recognized? Cash basis: When borrowing money: Dr. Cash 40 million Cr. Bank loan 40 million At the end of period 4: Dr. Interest Expense 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.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin26 Adjusting Accounts – Accrued expenses Paid CashActually used Accounting Period 1 Accounting Period 2 Accounting Period 3 Accounting Period 4 Accrual basis: At the end of each period (1 to 4) recognize the portion 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

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin27 Adjusting Accounts – Accrued revenues Received Cash Accounting Period 1 Accounting Period 2 Accounting Period 3 Accounting Period 4 When should revenues be recognized? Revenue Earned Cash basis: No entry from accounting period 1 to 3 At the end of period 4: Dr. Cash 40 million Cr. Revenue 40 million Long-term Contract: Received $40 million after building one ship

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin28 Adjusting Accounts – Accrued revenues Received Cash Accounting Period 1 Accounting Period 2 Accounting Period 3 Accounting Period 4 Revenue Earned Accrual basis: 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 Long-term Contract

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin29 Here is the check for my first 6 months’ rent. Here is the check for my first 6 months’ rent. Adjusting Prepaid (Deferred) Expenses Resources paid for prior to receiving the actual benefits. Asset Expense Unadjusted Balance Credit Adjustment Debit Adjustment

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin30 Prepaid Insurance On December 1, 2004, Scott Company paid $12,000 to cover rent for December 2004 through May Scott recorded the expenditure as Prepaid Insurance on December 1. What adjustment is required at Dec.31, 2004?

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin31 Supplies During 2004, Scott Company purchase $15,500 of supplies. Scott recorded the expenditures as Supplies. At December 31, a count of the supplies indicated $2,655 on hand. What adjustment is required?

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin32 Straight-Line Depreciation Expense = Asset Cost - Salvage Value Useful Life Adjusting for Depreciation Depreciation is the process of computing expense from allocating the cost of plant and equipment over their expected useful lives.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin33 Adjusting for Depreciation On January 1, 2004, 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

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin34 Adjusting for Depreciation On January 1, 2004, 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.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin35 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., 2006 McGraw-Hill/Irwin36 Equipment Depreciation Expense 1/1 62,000 12/31 12,000 Accumulated Depreciation 12/31 12,000 Adjusting for Depreciation

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin37 Adjusting for Depreciation Equipment is shown net of accumulated depreciation. $

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin38 Adjusting for Depreciation  A company spent 42 million to buy a machine, which can produce 50 million units of LCD monitor. The useful life is estimated to be 2 years and the salvage value is estimated to be 2 million. The depreciation for each year is 20 million.  When the company bought the machine:  Dr. Machinery 42 million  Cr. Cash 42 million

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin39 Adjusting for Depreciation  At the end of first year: Dr. Depreciation expense 20 m Cr. Machinery 20 m Dr. Depreciation expense 20 m Cr. Accumulated depreciation-machinery 20 m Correct

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin40 Adjusting for Depreciation  With the contra account, balance sheet indicates: …… Machinery 42 million Less accumulated depreciation (20 million) 22 million  If not: …… Machinery 22 million Such information would be misleading, since it could not indicate the correct production capacity of the company.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin41 Buy your season tickets for all home basketball games NOW! “Go Big Blue” Adjusting Unearned (Deferred) Revenues Cash received in advance of providing products or services. Liability Revenue Unadjusted Balance Credit Adjustment Debit Adjustment

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin42 Adjusting Unearned (Deferred) Revenues On October 1, 2004, Ox University sold 1,000 season tickets to its 20 home basketball games for $100 each. Ox University makes the following entry:

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin43 Adjusting Unearned (Deferred) Revenues On December 31, Ox University has played 10 of its regular home games, winning 2 and losing 8.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin44 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. Adjusting for Accrued Expenses ExpenseLiability Credit Adjustment Debit Adjustment

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin45 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 Barton, Inc. pays its employees every Friday. Year-end, 12/31/04, falls on a Wednesday. As of 12/31/04, the employees have earned salaries of $47,250 for Monday through Wednesday of the week ended 1/02/05.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin46 Adjusting for Accrued Expenses Barton, Inc. pays its employees every Friday. Year-end, 12/31/04, falls on a Wednesday. As of 12/31/04, the employees have earned salaries of $47,250 for Monday through Wednesday of the week ended 1/02/05.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin47 Yes, I’ve completed your tax return, but have not had time to bill you yet. Adjusting 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., 2006 McGraw-Hill/Irwin48 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., 2006 McGraw-Hill/Irwin49 Adjusting Accrued Revenues  In the 2 nd week of Dec, 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., 2006 McGraw-Hill/Irwin50 Adjusting Accrued Revenues

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin51 Future receipts of accrued revenues  FastForward received $2,700 cash on Jan 10 for the entire contract amount. Jan 10: Dr. Cash 2,700 Cr. Accounts Receivable 1,800 Cr. Consulting Revenue 900

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin52 Learning objective  Explain how accounting adjustments link to financial statements.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin53 Links to Financial Statements

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin54 Learning objective  Explain and prepare an adjusted trial balance.  Prepare financial statements from an adjusted trial balance.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin55 FastForward Trial Balance December 31, 2004 First, the initial unadjusted amounts are added to the worksheet. $ $ $ $

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin56 Next, FastForward’s adjustments are added. FastForward Trial Balance December 31, 2004 $ $ $ $ $ $ $$

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin57 FastForward Trial Balance December 31, 2004 Finally, the totals are determined. $ $ $ $ $ $ $$ $ $ $ $

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin58 Preparing Financial Statements Let’s use FastForward’s adjusted trial balance to prepare the company’s financial statements.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin59  Prepare the Income Statement.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin60  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., 2006 McGraw-Hill/Irwin61  Prepare the Balance Sheet.

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin62 The profit margin ratio measures the company’s net income to sales. Profit Margin Net Income Net Sales = Profit Margin

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin63 Profit Margin  SmarTone: 13.85%  Hutchison Telecom: 0.48%  City Telecom: 4.24%  Sunday: 0.48%  Peoples: 14.96%

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin64 Homework for chapter 3  Ex 3-1, 3-2, 3-9  Problem 3-2A  Due on June 19,2006 (Monday)

© The McGraw-Hill Companies, Inc., 2006 McGraw-Hill/Irwin65 End of Chapter 3