1. Adjusting Accounts and Preparing Financial Statements
Chapter 3
Adjusting Accounts and Preparing Financial Statements
In chapter three, we will take a close look at the process of preparing adjusting journal entries at the end of the accounting period. 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.
Toward the end of the chapter we will review the preparation of our basic financial statements.

2. Conceptual Chapter Objectives
C1: Explain the importance of periodic reporting and the time period principle
C2: Explain accrual accounting and how it improves financial statements
C3: Identify the types of adjustments and their purpose
In this chapter, you will learn the following conceptual objectives:
C1: Explain the importance of periodic reporting and the time period principle
C2: Explain accrual accounting and how it improves financial statements
C3: Identify the types of adjustments and their purpose

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
In this chapter, you will learn the following analytical objectives:
A1: Explain how accounting adjustments link to financial statements
A2: Compute profit margin and describe its use in analyzing company performance

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: Appendix A: Identify and explain alternatives in accounting for prepaids
In this chapter, you will learn the following procedural 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: Appendix A: Identify and explain alternatives in accounting for prepaids

5. The Accounting Period Annually Semiannually Quarterly Monthly 1 2 1 23 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 5 5

6. 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 One
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 Two
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 9 9

7. Accrual Basis vs. Cash Basis
In our first transaction, on December first, 2007, 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 2007 even though the policy provides protection for 2007, 2008 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 2008 or 2009, periods covered by the policy. 9 9

8. Accrual Basis vs. Cash Basis
On the accrual basis $100 of insurance expense is recognized in 2007, $1,200 in 2008, and $1,100 in 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, 2007, one hundred dollars for each month in 2008, 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. 9 9

9. Recognizing Revenues & Expenses
Revenue Recognition
We have delivered the
product to our customer,
so I think we should record
the revenue earned.
With accrual basis, we recognize revenue when the product or service is delivered to our customer. 7 7

10. Recognizing Revenues & Expenses
Revenue Recognition
Matching
Now that we have
recognized the revenue,
let’s see what expenses
we incurred to
generate that revenue.
Summary
of Expenses
Rent
Gasoline
Advertising
Salaries
Utilities
and
$1,000
500
2,000
3,000
450
The adjusting process helps us match the expenses incurred to generate the revenue recorded from the sales transaction. 7 7

11. Adjusting Accounts
C 3
An adjusting entry is recorded to bring an asset or liability account balance to its proper amount.
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 expense
Accrued revenues
*including depreciation 12 12

12. Adjusting Prepaid (Deferred) Expenses
Here is the check
for my first
six months’ rent.
Resources paid for prior to receiving the actual benefits.
Asset
Expense
Unadjusted
Balance
Credit
Adjustment
Debit
Part One
Let’s start with the first type of adjusting entries that we showed you on the previous screen, the payment or receipt of cash before the expense or revenue is recognized.
Part Two
We will start with a prepaid expense. For all adjustments involving prepaid expenses, we increase, or debit, an expense account and reduce, or credit, an asset account. Now, let’s look at an example. 14 14

13. What adjustment is required?
Prepaid Insurance P1
On December 1, 2007, Scott Company paid $12,000 for insurance for December 2007 through May Scott recorded the expenditure as Prepaid Insurance on December 1.
What adjustment is required?
Part One
On December first, 2007, Scott Company paid twelve thousand dollars to cover its insurance for six months, December 2007 through May When Scott made the payment, it debited prepaid insurance and credited cash. Let’s look at the adjusting entry we would make on December thirty first, 2007.
Part Two
We would debit, or increase, the insurance expense account for two thousand dollars (one sixth of twelve thousand dollars) and credit, or reduce, the asset “prepaid insurance.” Now we have recorded the rent expense for December, Let’s post the adjusting entry and see what the ledger account looks like on December thirty first.
Part Three
The prepaid insurance account is reduced from twelve thousand to ten thousand dollars. The ten thousand dollars represents the prepaid insurance for the five months in The insurance expense account now has a two thousand dollar balance, the amount of the rent for December 2007.
637
128 16 16

14. What adjustment is required?
Supplies P1
During 2007, 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?
Part One
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 thirty first, 2007, 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 thirty first, 2007, to get the balance in the supplies account stated properly.
Part Two
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 Three
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 16 16

15. Adjusting for Depreciation
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
As we have seen, 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. 19 19

16. Adjusting for Depreciation
On January 1, 2007, Barton, Inc. purchased equipment for $62,000 cash. The equipment has an estimated useful life of five 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, 2007.
Part One
On January first, 2007, 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 2007?
Part Two
How did you do? The numerator of the equation is sixty thousand dollars, cost less salvage value, and the denominator is five, so our annual depreciation expense is twelve thousand dollars. Now, let’s record the adjusting journal entry.
2007
Depreciation
Expense =
$62, $2,000 5
$12,000 20 20

17. Adjusting for Depreciation
On January 1, 2007, Barton, Inc. purchased equipment for $62,000 cash. The equipment has an estimated useful life of five 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, 2007.
Part One
On December thirty first, 2007, we will debit, or increase, depreciation expense for twelve thousand dollars and credit a new account called accumulated depreciation (dash) equipment.
Part Two
Accumulated depreciation is a contra asset account. This is a contra-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 relatively new type of account, let’s look at the treatment of the contra and related asset account.
Accumulated depreciation is
a contra asset account. 22 22

18. Adjusting for Depreciation
Equipment
Depreciation Expense
1/1 62,000
12/31 12,000
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 thirty first, Let’s see how we will deal with the other two accounts.
Accumulated Depreciation
12/31 12,000 23 23

19. Adjusting for Depreciation
Equipment is shown net of accumulated depreciation. $
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 2008 and used to accumulate the depreciation related to the equipment.
Now let’s move on to the second category of adjusting entries, deferred revenues. 24 24

20. Adjusting Unearned (Deferred) RevenuesP1
Adjusting Unearned (Deferred) Revenues
Cash received in advance of providing products or services.
Buy your season tickets for
all home basketball games NOW!
“Go Big Blue”
Liability
Revenue
Part One
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 Two
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
Unadjusted
Balance
Credit
Adjustment 25 25

21. Adjusting Unearned (Deferred) RevenuesP1
Adjusting Unearned (Deferred) Revenues
On October 1, 2007, Ox University sold 1,000 season tickets to its 20 home basketball games for $100 each. Ox University makes the following entry:
Part One
On October first, 2007, Ox University sold one thousand season tickets to its twenty 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 Two
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 thirty first, 2007, the end of the accounting period. 27 27

22. Adjusting Unearned (Deferred) RevenuesP1
Adjusting Unearned (Deferred) Revenues
On December 31, Ox University has played 10 of its regular home games, winning two and losing eight.
Part One
As of December thirty first, 2007, the University had played ten home games and compiled a record of two wins and eight losses. Let’s make the adjusting entry.
Part Two
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 Three
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 thirty first, 2007.
Now let’s change the subject and look at adjustments for accrued expenses. 28 28

23. Adjusting for Accrued Expenses
Costs incurred in a period that are
both unpaid and unrecorded.
We’re about one-half
done with this job and
want to be paid for our work!
Expense
Liability
Credit
Adjustment
Debit
Part One
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 Two
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. 31 31

24. Adjusting for Accrued Expenses
Barton, Inc. pays its employees every Friday. Year-end, 12/31/07, falls on a Wednesday. As of 12/31/07, the employees have earned salaries of $47,250 for Monday through Wednesday. They will not be paid until the next Friday, 1/02/08.
12/31/07
Year end
Last pay
date
12/26/07
Next pay
1/2/08
Record adjusting
journal entry.
Part One
Barton, Incorporated pays its employees every Friday. The current year-end, December thirty first, 2007, falls on a Wednesday. As of December thirty first, 2007, the employees have earned salaries of forty-seven thousand, two hundred fifty dollars that will not be paid until the following Friday, January second, 2008.
Part Two
Here is a schematic of the dates. We need to record an adjusting entry on December thirty first, 2007, to recognize the salaries earned by employees but not paid. Let’s look at the adjusting entry. 33 33

25. Adjusting for Accrued Expenses
Barton, Inc. pays its employees every Friday. Year-end, 12/31/07, falls on a Wednesday. As of 12/31/07, the employees have earned salaries of $47,250 for Monday through Wednesday of the week ended 1/02/08.
Part One
In our adjusting journal entry we will debit, or increase, salaries expense and credit, or increase, salaries payable. After the adjustment, salaries expense for 2007 is stated properly. Let’s look at the posting to the ledger accounts.
Part Two
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 second, Now let’s move on and look at accrued revenue. 34 34

26. Adjusting for Accrued RevenuesP1
Revenues earned in a period that
are both unrecorded and not yet received.
Yes, I’ve completed your tax return, but have not had time to bill you yet.
Asset
Revenue
Part One
The adjusting entry to accrue revenues 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 Two
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.
Debit
Adjustment
Credit
Adjustment 36 36

27. Adjusting for Accrued RevenuesP1
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, 2007, the end of the company’s fiscal year.
Part One
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.
Part Two
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 Three
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. 38

28. 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. 41

29. First, the initial unadjusted amounts are added to the worksheet.P2
FastForward - Trial Balance - December 31, 2007
First, the initial unadjusted amounts are added to the worksheet.
We prepared this worksheet using Excel but you could use an electronic spreadsheet. We begin with the unadjusted trial balance, that is, the trial balance before we make our adjusting entries. On the next slide, we will post our adjusting entries for FastForward. 43

30. FastForward - Trial Balances - December 31, 2007P2
FastForward - Trial Balances - December 31, 2007
Next, FastForward’s adjustments are added.
Look at adjusting journal entry c. This is the entry to record depreciation expense for the period ended December thirty first, We debit, or increase, depreciation expense and credit, or increase, accumulated depreciation-equipment. Do you recall this type of adjusting entry from our previous discussion? The total debits and credits are equal on the unadjusted trial balance and on the adjustments set of columns. Let’s move on to the adjusted trial balance. 44

31. FastForward - Trial Balance - December 31, 2007P2
FastForward - Trial Balance - December 31, 2007
The adjusted trial balance combines the unadjusted trial balance account balances with the adjustments we make. Be careful when doing the arithmetic. For example, look at entry b. It is the entry to adjust the supplies account for the physical inventory taken at year-end. The supplies account on the unadjusted trial balance is nine thousand, seven hundred twenty dollars. Our adjustment reduced the supplies on hand, so the adjusted trial balance account is eight thousand, six hundred seventy dollars.
Finally, the totals are determined. 45

32. Preparing Financial Statements
Let’s use FastForward’s adjusted trial balance to prepare the company’s financial statements.
Once we have completed the worksheet, we can move on to the preparation of the company’s financial statements. We always begin with the income statement.

33. 1. Prepare the Income Statement
You can see how we took the information directly from the worksheet and prepared the income statement for the month ended December thirty first, 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 Owner's Equity.

34. 2. 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 statement of owner’s equity adds together the net income and the owner’s investment of thirty thousand dollars. The owner’s withdrawal of six hundred dollars reduces owner’s equity to thirty-three thousand one hundred eighty-five dollars.

35. Preparation of Balance Sheet
The last step in preparing the financial statements is the preparation of the Balance Sheet. After we have completed the Income Statement and the Statement of Owner’s Equity, we are ready to prepare our last financial statement, which is called the Balance Sheet. Asset and liability balances are transferred over from the adjusted trial balance to the Balance Sheet. The ending capital balance was determined on the Statement of Owner’s Equity shown in the previous slide. The ending balance is transferred from that statement to the Balance Sheet. The Balance Sheet proves that the fundamental accounting equation is in balance and you can see that the Total Assets of forty two thousand, three hundred, forty five is equivalent to the sum of the total liabilities and owner’s equity.

36. 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. You can see the profit margin at Limited Brands has increased slightly from 2002 to 2005.

37. 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.