Financial and Managerial Accounting Wild, Shaw, and Chiappetta Fifth Edition McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. 1

Adjusting Accounts and Preparing Financial Statements Chapter 3 Adjusting Accounts and Preparing Financial Statements

Conceptual Chapter Objectives C1: Explain the importance of periodic reporting and the time period assumption. C2: Explain accrual accounting and how it improves financial statements. C3: Identify steps in the accounting cycle. C4: Explain and prepare a classified balance sheet. 3-3

Analytical Chapter Objectives A1: Explain how accounting adjustments link to financial statements. A2: Compute profit margin and describe its use in analyzing company performance. A3: Compute the current ratio and describe what it reveals about a company’s financial condition. 3-4

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: Describe and prepare closing entries. P5: Explain and prepare a post-closing trial balance. 3-5

Procedural Chapter Objectives (Continued) P6: Appendix 3A – Explain the alternatives in accounting for prepaids (see text for details). P7: Appendix 3B – Prepare a work sheet and explain its usefulness (see text for details). P8: Appendix 3C – Prepare reversing entries and explain their purpose (see text for details). 3-6

The Accounting Period Annually Semiannually Quarterly Monthly 1 2 1 2 3 4 Quarterly 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 3-7

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. When should we recognize revenues and expenses? Not GAAP 3-8

Accrual Basis vs. Cash Basis Using the cash basis, the entire $2,400 would be recognized as insurance expense in 2013. No insurance expense from this policy would be recognized in 2014 or 2015, periods covered by the policy. 3-9

Accrual Basis vs. Cash Basis On the accrual basis, $100 of insurance expense is recognized in 2013, $1,200 in 2014, and $1,100 in 2015. The expense is matched with the periods benefited by the insurance coverage. 3-10

Framework for Adjustments Adjusting Accounts C2, P1 An adjusting entry is recorded to bring an asset or liability account balance to its proper amount as well as update any related revenue or expense account. Framework for Adjustments Adjustments 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 expenses Accrued revenues *including depreciation 3-11

Prepaid (Deferred) Expenses Here is the check for my first 24-months’ insurance. Resources paid for prior to receiving the actual benefits. Asset Expense Unadjusted Balance $2,400 Credit Adjustment $100 Debit Adjustment $100 3-12

What adjustment is required? Supplies P1 During 2013, Scott Company purchased $9,720 of supplies. Scott recorded the expenditures as Supplies. On December 31, a count of the supplies indicated $8,670 on hand. What adjustment is required? Dec 31 Supplies Expense 1,050 Supplies 1,050 (To record supplies used for the year) 126 652 3-13

Asset Cost - Salvage Value Depreciation P1 Depreciation is the process of allocating the costs of plant assets over their expected useful lives. Straight-Line Depreciation Expense = Asset Cost - Salvage Value Useful Life 3-14

Depreciation P1 On January 1, 2013, 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, 2013. 2013 Depreciation expense = $62,000 - $2,000 5 $12,000 3-15

Accumulated depreciation is On January 1, 2013, 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, 2013. Accumulated depreciation is a contra asset account. 3-16

Depreciation P1 Equipment is shown net of accumulated depreciation. This amount is referred to as the asset’s book value. $ 3-17

Unearned (Deferred) Revenues P1 Cash received in advance of providing products or services. Buy your season tickets for all home basketball games NOW! “Go Big Blue” Liability Revenue Debit Adjustment Unadjusted Balance Credit Adjustment 3-18

Unearned (Deferred) Revenues P1 On October 1, 2013, Ox University sold 1,000 season tickets to its 20 home basketball games for $100 each. Ox University makes the following entry: Unearned Revenue is a liability account 3-19

Unearned (Deferred) Revenues P1 On December 31, Ox University has played 10 of its regular home games, winning 2 and losing 8. 3-20

want to be paid for our work! Accrued Expenses P1 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. Expense Liability Debit Adjustment Credit Adjustment 3-21

Accrued Expenses P1 Barton, Inc. pays its employees every Friday. Year-end, 12/31/13, falls on a Thursday. As of 12/31/13, the employees have earned salaries of $47,250 for Monday through Thursday. 12/1/13 12/31/13 Year-end Last pay date 12/25/13 Next pay Jan 1, 2014 Record adjusting journal entry. 3-22

Accrued Expenses P1 Barton, Inc. pays its employees every Friday. Year-end, 12/31/13, falls on a Thursday. As of 12/31/13, the employees have earned salaries of $47,250 for Monday through Thursday. 3-23

Accrued Revenues P1 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, 2013, the end of the firm’s fiscal year. 3-24

Links to Financial Statements 3-25

First, the initial unadjusted amounts are added to the work sheet. FastForward – Trial Balance - December 31, 2013 P2 First, the initial unadjusted amounts are added to the work sheet. 3-26

FastForward – Recording Adjustments Trial Balance - December 31, 2013 P2 FastForward – Recording Adjustments Trial Balance - December 31, 2013 Next, FastForward’s adjustments are added. Key each adjustment with a letter. The letter c was used here. 3-27

FastForward - Computing the Adjusted Trial Balance - December 31, 2013 The adjusted trial balance combines the unadjusted trial balance account balances with the adjustments we make. 3-28

Prepare Income Statement 3-29

Prepare Statement of Retained Earnings Note that net income from the Income Statement carries to the Statement of Retained Earnings. 3-30

P3 Prepare Balance Sheet 3-31

The Closing Process: Temporary and Permanent Accounts C3, P4 The Closing Process: Temporary and Permanent Accounts Temporary (nominal) accounts accumulate data related to one accounting period. They include all income statement accounts, the dividends account, and the Income Summary account. These accounts are “closed” at the end of the period to get ready for the next accounting period. Permanent (real) accounts report activities related to one or more future accounting periods. They carry ending balances to the next accounting period and are not “closed.” 3-32

Recording Closing Entries P4 Close revenue accounts. Close expense accounts. Close income summary account. Close dividends account. 3-33

Examine the accounts presented. Recording Closing Entries P4 Salaries Expense Consulting Revenue 18,100 Examine the accounts presented. 25,000 Income Summary Retained Earnings 7,000 3-34

Recording Closing Entries P4 Salaries Expense Consulting Revenue 18,100 25,000 $ 25,000 25,000 Income Summary Close revenues with a debit to each revenue account and a credit to Income Summary for the total. 3-35

Recording Closing Entries P4 Salaries Expense Consulting Revenue 18,100 18,100 25,000 25,000 Close expense accounts with a credit to each expense account and a debit to Income Summary for the total. Income Summary 25,000 3-36

Determine the balance in the Income Summary account. Recording Closing Entries P4 Salaries Expense Consulting Revenue 18,100 18,100 25,000 25,000 Income Summary Determine the balance in the Income Summary account. 18,100 25,000 6,900 3-37

Close the Income Summary to Retained Earnings. Recording Closing Entries P4 Salaries Expense Close the Income Summary to Retained Earnings. 18,100 18,100 Income Summary Retained Earnings 18,100 25,000 7,000 6,900 6,900 3-38

The dividends account is closed to Retained Earnings. Recording Closing Entries P4 The dividends account is closed to Retained Earnings. Retained Earnings Dividends 2,000 2,000 7,000 6,900 3-39

Determine the ending balance in Retained Earnings. Recording Closing Entries P4 After closing, the Retained Earnings account will have a new ending balance… Retained Earnings 2,000 7,000 6,900 Determine the ending balance in Retained Earnings. 11,900 3-40

Post-Closing Trial Balance The trial balance is prepared after the closing entries have been posted. The purpose is to ensure that all nominal or temporary accounts have been closed. The only accounts on this trial balance should be assets, liabilities, and equity accounts. 3-41

The Accounting Cycle 9. Prepare post-closing trial balance 10. Reverse Start 10. Reverse (optional) 1. Analyze transactions 8. Close 2. Journalize 7. Prepare statements 3. Post 4. Prepare unadjusted trial balance 6. Prepare adjusted trial balance 5. Adjust 3-42

Classified Balance Sheet Current items are those expected to come due (either collected or owed) within one year or the company’s operating cycle, whichever is longer. 3-43

Classified Balance Sheet Plant Assets Tangible assets that are both long-lived and used to produce or sell products or services. Examples include equipment, machinery, buildings, and land that are used to produce or sell products and services. Intangible Assets Long-term resources that benefit business operations. They usually lack physical form and have uncertain benefits. Examples include patents, trademarks, copyrights, franchises, and goodwill. 3-44

Long-Term Liabilities C4 Current Liabilities Obligations due to be paid or settled within one year or the operating cycle, whichever is longer. Long-Term Liabilities Obligations not due within one year or the operating cycle, whichever is longer. 3-45

Classified Balance Sheet 3-46

Profit Margin A2 The profit margin ratio measures the company’s net income to net sales. Profit margin Net income Net sales = 3-47

Current Ratio A3 This ratio is an important measure of a company’s ability to pay its short-term obligations. Current ratio Current assets Current liabilities = 3-48

End of Chapter 3 3-49