© 2009 The McGraw-Hill Companies, Inc., All Rights Reserved ADJUSTING ACCOUNTS AND PREPARING FINANCIAL STATEMENTS Chapter 3

McGraw-Hill/Irwin Slide 2 McGraw-Hill/Irwin Slide 2 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 C2

McGraw-Hill/Irwin Slide 3 McGraw-Hill/Irwin Slide 3 A CCRUAL B ASIS VS. C ASH B ASIS 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. C2

McGraw-Hill/Irwin Slide 4 McGraw-Hill/Irwin Slide 4 A CCRUAL B ASIS VS. C ASH B ASIS On the accrual basis $100 of insurance expense is recognized in 2009, $1,200 in 2010, and $1,100 in The expense is matched with the periods benefited by the insurance coverage. C2

McGraw-Hill/Irwin Slide 5 McGraw-Hill/Irwin Slide 5 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. R ECOGNIZING R EVENUES & E XPENSES Revenue Recognition Principle C2

McGraw-Hill/Irwin Slide 6 McGraw-Hill/Irwin Slide 6 R ECOGNIZING R EVENUES & E XPENSES Revenue Recognition Principle Matching Principle Summary of Expenses Rent Gasoline Advertisin g 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. C2

McGraw-Hill/Irwin Slide 7 McGraw-Hill/Irwin Slide 7 An adjusting entry is recorded to bring an asset or liability account balance to its proper amount. A DJUSTING A CCOUNTS Prepaid (Deferred) expenses* Unearned (Deferred) revenues Accrued expense Accrued revenues Framework for Adjustments * including depreciation Paid (or received) cash before expense (or revenue) recognized Paid (or received) cash after expense (or revenue) recognized Adjustments C3

McGraw-Hill/Irwin Slide 8 McGraw-Hill/Irwin Slide 8 Here is the check for my 24-month insurance policy. Here is the check for my 24-month insurance policy. P REPAID (D EFERRED ) E XPENSES Resources paid for prior to receiving the actual benefits. Asset Expense Unadjusted Balance Credit Adjustment Debit Adjustment P1

McGraw-Hill/Irwin Slide 9 McGraw-Hill/Irwin Slide 9 P REPAID I NSURANCE On 12/1/09, FastForward paid $2,400 for insurance for 2- years (24-months, December 2009 through November 2011). FastForward recorded the expenditure as Prepaid Insurance on 12/31/09. What adjustment is required? On 12/1/09, FastForward paid $2,400 for insurance for 2- years (24-months, December 2009 through November 2011). FastForward recorded the expenditure as Prepaid Insurance on 12/31/09. What adjustment is required? P1

McGraw-Hill/Irwin Slide 10 McGraw-Hill/Irwin Slide 10 S UPPLIES During 2009, FastForward purchased $9,720 of supplies. FastForward recorded the expenditures in the asset account, “Supplies.” On December 31, 2009, a count of the supplies indicated $8,670 on hand, so $1,050 of supplies were used during December. What adjustment is required? During 2009, FastForward purchased $9,720 of supplies. FastForward recorded the expenditures in the asset account, “Supplies.” On December 31, 2009, a count of the supplies indicated $8,670 on hand, so $1,050 of supplies were used during December. What adjustment is required? P1

McGraw-Hill/Irwin Slide 11 McGraw-Hill/Irwin Slide 11 O THER P REPAID E XPENSES 1.Other prepaid expenses, such as Prepaid Rent, are accounted for exactly as Insurance and Supplies. 2.We should note that some prepaid expenses are both paid for and fully used up within a single period. 3.For example, a company may pay monthly rent on the first day of each month. This payment creates a prepaid expense on the first day of the month that fully expires by the end of the month. 4.In these special cases, we can record the cash paid with a debit to the expense account instead of an asset account. 1.Other prepaid expenses, such as Prepaid Rent, are accounted for exactly as Insurance and Supplies. 2.We should note that some prepaid expenses are both paid for and fully used up within a single period. 3.For example, a company may pay monthly rent on the first day of each month. This payment creates a prepaid expense on the first day of the month that fully expires by the end of the month. 4.In these special cases, we can record the cash paid with a debit to the expense account instead of an asset account. P1

McGraw-Hill/Irwin Slide 12 McGraw-Hill/Irwin Slide 12 Straight-Line Depreciation Expense = Asset Cost - Salvage Value Useful Life D EPRECIATION Depreciation is the process of allocating the cost of a plant asset over its useful life in a systematic and rational manner. P1

McGraw-Hill/Irwin Slide 13 McGraw-Hill/Irwin Slide 13 D EPRECIATION On December 1, 2009, FastForward purchased equipment for $26,000 cash. The equipment has an estimated useful life of four years (48 months) and FastForward expects to sell the equipment at the end of its life for $8,000 cash. Let’s record depreciation expense for the month ended December 31, Dec Depreciation Expense = $26,000 - $8, months =$375 per month P1

McGraw-Hill/Irwin Slide 14 McGraw-Hill/Irwin Slide 14 Accumulated depreciation is a contra asset account. Accumulated depreciation is a contra asset account. D EPRECIATION On December 1, 2009, FastForward purchased equipment for $26,000 cash. The equipment has an estimated useful life of four years (48 months) and FastForward expects to sell the equipment at the end of its life for $8,000 cash. Let’s record depreciation expense for the month ended December 31, P1

McGraw-Hill/Irwin Slide 15 McGraw-Hill/Irwin Slide 15 Equipment Depreciation Expense 1/1 26,000 12/ Accumulated Depreciation 12/ D EPRECIATION P1

McGraw-Hill/Irwin Slide 16 McGraw-Hill/Irwin Slide 16 Equipment is shown net of accumulated depreciation. $ D EPRECIATION P1

McGraw-Hill/Irwin Slide 17 McGraw-Hill/Irwin Slide 17 U NEARNED (D EFERRED ) R EVENUES Liability Revenue Unadjusted Balance Credit Adjustment Debit Adjustment We will apply this cash you gave us towards your total consulting fees. We will apply this cash you gave us towards your total consulting fees. Cash received in advance of providing products or services. P1

McGraw-Hill/Irwin Slide 18 McGraw-Hill/Irwin Slide 18 U NEARNED (D EFERRED ) R EVENUES On December 26, 2009, FastForward agrees to provide consulting services to a client for a fixed fee of $3,000 for 60 days. On this date, the client pays the entire consulting fee in advance. FastForward makes the following entry: P1

McGraw-Hill/Irwin Slide 19 McGraw-Hill/Irwin Slide 19 On December 31, earns some of the 60-days of consulting fees. Each day that passes results in consulting fees of $50 ($3,000 ÷ 60). U NEARNED (D EFERRED ) R EVENUES P1

McGraw-Hill/Irwin Slide 20 McGraw-Hill/Irwin Slide 20 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. A CCRUED E XPENSES ExpenseLiability Credit Adjustment Debit Adjustment P1

McGraw-Hill/Irwin Slide 21 McGraw-Hill/Irwin Slide 21 12/31/09 Year end Last pay date 12/26/09 Next pay date 1/9/10 Record adjusting journal entry. Record adjusting journal entry. FastForward’s employee earns $70 per day and is paid every two weeks on Friday. Year-end, 12/31/09, falls on a Wednesday. The last payday of 2009, is Friday, 12/26/09. From 12/26 until year-end is three working days. The employee has earned salaries of $210 for Monday through Wednesday. They will not be paid until the next Friday. ACCRUED SALARIES EXPENSES P1

McGraw-Hill/Irwin Slide 22 McGraw-Hill/Irwin Slide 22 ACCRUED SALARIES EXPENSES FastForward’s employee earns $70 per day and is paid every two weeks on Friday. Year-end, 12/31/09, the employee has earned salaries of $210. P1

McGraw-Hill/Irwin Slide 23 McGraw-Hill/Irwin Slide 23 F UTURE P AYMENT OF A CCRUED E XPENSES On January 9, 2010, FastForward will pay the payroll for the two weeks from December 26, 2009 through January 9, Here is the journal entry for the payroll: P1

McGraw-Hill/Irwin Slide 24 McGraw-Hill/Irwin Slide 24 ACCRUED INTEREST EXPENSE FastForward borrowed $6,000 from First National Bank on December 1, The note bears interest at the annual rate of 6% and is due to be repaid in one year. Let’s accrue interest for the month ended 12/31/09. P1

McGraw-Hill/Irwin Slide 25 McGraw-Hill/Irwin Slide 25 Yes, I’ve completed your consulting job, but have not had time to bill you yet. Yes, I’ve completed your consulting job, but have not had time to bill you yet. A CCRUED R EVENUES 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 P1

McGraw-Hill/Irwin Slide 26 McGraw-Hill/Irwin Slide 26 ACCRUED SERVICE REVENUES On December 12, 2009, FastForward agrees to render consulting services under a 30-day fixed fee contract for $2,700 ($90 per day). All services are to be completed by January 10, 2010, when the client will pay in full. P1

McGraw-Hill/Irwin Slide 27 McGraw-Hill/Irwin Slide 27 P ROFIT M ARGIN The profit margin ratio measures the company’s net income to net sales. Profit Margin Net Income Net Sales = $ in millions Net income $ 676 $ 683 $ 705 $ 717 Net sales 10,671 9,699 9,408 8,934 Profit margin6.3%7.0%7.5%8.0% Industry profit margin1.6%1.5%1.4%1.5% A2