1. Chapter 4: Adjustments, Trial Balance, and Financial Statements Acct 2301 Fall 2009 Cox School of Business, SMU Professor Zining Li

2. What do We Hope to Learn? Accounting Cycle Adjusting entries – What, why, when, and how to adjust? Unadjusted and adjusted trial balance Preparing financial statements Closing process 2

3. Accounting Cycle 1.Identify recordable financial transactions 2.Record the journal entries 3.Post journal entry amounts to T-accounts 4.Prepare the unadjusted trial balance 5.Record adjusting journal entries 6.Prepare the adjusted trial balance 7.Prepare the financial statements 8.Record the closing entries 1.Identify recordable financial transactions 2.Record the journal entries 3.Post journal entry amounts to T-accounts 4.Prepare the unadjusted trial balance 5.Record adjusting journal entries 6.Prepare the adjusted trial balance 7.Prepare the financial statements 8.Record the closing entries 3

4. Adjusting Entries Under accounting, revenues (expenses) are recorded when they are earned (incurred) Sometimes revenues (expenses) are earned (incurred) without any external transaction Adjusting entries are needed to record such revenues and expenses in the correct period Adjustments are made at the end of a reporting period 4

5. Timetable of the Adjustment Process 5 1/1/0412/31/04 Adjustments are made at the end of the period, but before the financial statements are prepared Transactions are recorded all during the period

6. What need to be adjusted Accruals – Accrued revenues – Accrued expenses Deferrals – Deferred revenues – Deferred expenses 6

7. What need to be adjusted (1) Accrued revenues – Those are revenues that are already earned, although cash haven’t been collected – Revenues need to be recorded, at the same time, assets are increased Example: interest revenue 7

8. On October 1, 2006, Webb, Inc. invests $10,000 for 6 months in a certificate of deposit that pays 6% interest per year. Webb will not receive the interest until the CD matures on March 31, 2007. On December 31, 2006, Webb, Inc. must make an entry for the interest earned so far. Interest Receivable 12/31 150 Bal. 150 Interest Revenue 12/31 150 Bal. 150

9. What need to be adjusted (2) Accrued expenses – Those are expenses that are already incurred through out the accounting period, although cash haven’t been paid – Expense need to be recorded, at the same time, liabilities are increased Examples: – Salary expense – Interest expense – Tax expense 9

10. As of 12/27/06, Denton, Inc. had already paid $1,900,000 in wages for the year. Denton pays its employees every Friday. Year-end, 12/31/06, falls on a Wednesday. The employees have earned total wages of $50,000 for Monday through Wednesday of the week ending 1/02/07. 10

11. Wages Payable 12/31 50,000 Bal. 50,000 Wages Expense $1,900,000 Bal. $1,950,000 As of 12/27 12/31 50,000 After we post the entry to the T-accounts, the account balances look like this:

12. What need to be adjusted (3) Deferred revenues – Previously recorded as liabilities when cash were received before goods were delivered or services were rendered – At the end of reporting period, if the earning process is complete, these liability accounts need to be reduced, and revenues are recorded Examples – Unearned rent revenue --> rent revenue – Unearned franchise revenue --> franchise revenue – Unearned subscription revenue --> subscription revenue – Unearned ticket revenue --> ticket revenue 12

13. 13 On December 1, 2006, Tom’s Rentals received a check for $3,000, for the first four months’ rent from a new tenant. On December 1, 2006, Tom’s Rentals received a check for $3,000, for the first four months’ rent from a new tenant. On December 31, 2006, Tom’s Rentals must adjust the Unearned Rent Revenue account to reflect that one month of rent revenue has been earned. $3,000 × 1/4 = $750

14. 14 Unearned Rent Revenue 12/31 75012/1 3000 Bal. 2,250 Rent Revenue 12/31 750 Bal. 750 After we post the entry to the T-accounts, the account balances look like this:

15. What need to be adjusted (4) Deferred expenses – Previously recorded as assets when cash were paid before these assets are being used – At the end of reporting period, the “used-up” amount of these assets need to be reduced, and expenses are recorded Examples – Buildings and Equipment (PP&E) --> Depreciation expenses – Supplies --> Supplies expense – Prepaid rent --> Rent expense – Prepaid insurance --> Insurance expense 15

16. On January 1, 2006, Matrix, Inc. paid $3,600 for a 3-year fire insurance policy. adjust the Prepaid Insurance Expense account to reflect that 1 year of the policy has expired. On December 31, 2006, Matrix, Inc. adjust the Prepaid Insurance Expense account to reflect that 1 year of the policy has expired. $3,600 X 1/3 = $1,200

17. Prepaid Insurance 1/1 3,60012/31 1,200 Bal. 2,400 Insurance Expense 12/31 1,200 Bal. 1,200 After we post the entry to the T-accounts, the account balances look like this:

18. Journal Entry for Depreciation Expense is different Accumulated Depreciation is a contra- asset account; it carries a credit balance 18 Dr. Deprecation Expense Cr. Accumulative Depreciation

19. On January 1, 2006, Matrix, Inc. paid $8,000 for equipment, which is expected to last 5 years adjust the Equipment account to reflect that 1 year use of the equipment On December 31, 2006, Matrix, Inc. adjust the Equipment account to reflect that 1 year use of the equipment $8,000 X 1/5 = $1,600 adjust the Equipment account to reflect that 1 year use of the equipment On December 31, 2006, Matrix, Inc. adjust the Equipment account to reflect that 1 year use of the equipment $8,000 X 1/5 = $1,600

20. Depreciation Expense 12/31 1,600 Bal. 1,600 Equipment 1/1 8,000 Bal. 8,000 Accumulated Depreciation -- Equipment 12/31 1,600 Bal. 1,600 Equipment - Accumulated Depreciation = Equipment (net) (Net) Book Value of Equipment = 8,000- 1600 (Net) Book Value of Equipment

21. Adjusting Entries: Summary Done at the end of reporting period No cash account in an adjusting entry Revenues and expenses are recorded Non-cash asset accounts or liability accounts are increased or decreased Adjusting entries affect income statement, balance sheet, statement of retained earnings; but NOT cash flow statement 21

22. Exercise: Recording transactions with journal entries College Caps, Inc. operates a small retail store in the mall that sells baseball caps. The following transactions occurred during June 2004. Record all journal entries and the adjusting entries that must be made at June 30 before the company prepare its financial statements. June 1Paid $700 cash for insurance policy through December 31, 2004. June 1Purchased store equipment for $5,000 and paid cash. The company estimates annual depreciation of $1,200. June 5Purchased supplies worth $500 with cash. June 15Loaned $10,000 to the manager of the store (as a personal loan) for one year. The annual rate of interest on the loan is 12%. The loan is supported by a note and interest is due upon repayment. June 28Earned revenue of $1,400 with delivery of custom cap order for SMU football team. SMU must pay the bill by July 31. Cost of the caps sold was $500. June 30Amount of supplies on hand is $300. The balance in the Supplies account was $150 on June 1.

23. Transactional Journal Entries 23

24. Adjusting Journal Entries 24

25. 25 Exercise: Complete the accounting cycle College Caps, Inc. Trial Balance – unadjusted as of June 30, 2004 Account DR CR Cash 8,150 Accounts Receivable 7,500 Supplies 650 Inventory 5,500 Prepaid Insurance 700 Notes Receivable 10,000 Equipment 5,000 Accounts Payable 6,050 Contributed Capital 30,000 Retained Earnings 550 Sales Revenue 1,400 Cost of Sales 500 TOTALS 38,000 38,000 1.Based on the information provided in previous example, post the adjusting entries for the period ended June 30, 2004 and prepare an adjusted trial balance. Income tax expense should be recorded at 30% of pretax net income. 2.Prepare the income statement, statement of retained earnings, and balance sheet.

26. 26 College Caps, Inc. Adjusted Trial Balance as of June 30, 2004 Account DR CR Cash 8,150 Accounts Receivable 7,500 Supplies 300 Inventory 5,500 Prepaid Insurance 600 Interest Receivable 50 Notes Receivable 10,000 Equipment 5,000 Accumulated Depreciation 100 Accounts Payable 6,050 Income tax payable 120 Contributed Capital 30,000 Retained Earnings 550 Sales Revenue 1,400 Cost of Sales 500 Depreciate expense 100 Supplies expense 350 Insurance expense 100 Income tax expense 120 Interest revenue 50 TOTALS 38,270 38,270 2

27. 27 College Caps, Inc. The Income Statement For the month ended June 30, 2004 Sales Revenue 1,400 Cost of Sales ( 500) Gross Profit 900 Depreciate expense (100) Supplies expense ( 350) Insurance expense (100) Operating Income 350 Other revenues (expenses) Interest revenue 50 Pre-tax Income 400 Income tax expense (120) Net Income 28 0

28. 28 College Caps, Inc. Statement of Retained Earnings For the month ended June 30, 2004 Retained Earnings (beg.) 550 Net Income 280 Dividend (0) Retained Earnings (ending) 830

29. College Caps, Inc. Balance Sheet as of June 30, 2004 Assets Cash 8,150 Accounts Receivable 7,500 Supplies 300 Inventory 5,500 Prepaid Insurance 600 Interest Receivable 50 Notes Receivable 10,000 Current Assets 32,100 Equipment 5,000 Accumulated Depreciation (100) Total Assets 37,000 Liabilities Accounts Payable 6,050 Income Tax Payable 120 Total Liabilities 6,050 Stockholders’ Equity Contributed Capital 30,000 Retained Earnings 830 Total stockholders’ equity 30,950 Total liabilities and stockholders’ equity 37,000

30. Closing When: After all four financial statements are prepared What: all income statement accounts Closing means to bring the balances of all the income statement accounts to zero Key Terms – Permanent accounts – Temporary accounts 30

31. Closing Journal Entry Dr. Sales revenue $1,400 Dr. Interest revenue 50 Cr. Cost of sale $500 Cr. Depreciation exp. 100 Cr. Supplies expense 350 Cr. Insurance expense 100 Cr. Retained Earnings $400

32. Accounting Cycle 1.Identify recordable financial transactions 2.Record the journal entries 3.Post journal entry amounts to T-accounts 4.Prepare the unadjusted trial balance 5.Record adjusting journal entries 6.Prepare the adjusted trial balance 7.Prepare the financial statements 8.Record the closing entries 1.Identify recordable financial transactions 2.Record the journal entries 3.Post journal entry amounts to T-accounts 4.Prepare the unadjusted trial balance 5.Record adjusting journal entries 6.Prepare the adjusted trial balance 7.Prepare the financial statements 8.Record the closing entries 32