© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 3 Adjusting Accounts and Preparing Financial Statements

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-2 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 C4: Explain why temporary accounts are closed each period C5: Identify steps in the accounting cycle C6: Explain and prepare a classified balance sheet

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-5 Procedural Chapter Objectives (Continued) P6: Appendix A: Explain alternatives in accounting for prepaids P7: Appendix B: Prepare a work sheet and explain its usefulness P8: Appendix C: Prepare reversing entries and explain their purpose

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Annually 12 Monthly Quarterly Semiannually The Accounting Period Jan FebMar Apr MayJunJulAugSepOctNovDec C 1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-7 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 C 1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-8 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 2008 or 2009, periods covered by the policy. C 1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-9 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. C 1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-10 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 Revenue Recognition C 1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-11 Recognizing 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. C 1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-12 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 C 3

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-13 Here is the check for my first 6 months’ insurance. Here is the check for my first 6 months’ insurance. Prepaid (Deferred) Expenses Resources paid for prior to receiving the actual benefits. Asset Expense Unadjusted Balance Credit Adjustment Debit Adjustment P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-14 Prepaid Insurance On December 1, 2007, Scott Company paid $12,000 to cover insurance for December 2007 through May Scott recorded the expenditure as Prepaid Insurance on December 1. What adjustment is required? On December 1, 2007, Scott Company paid $12,000 to cover insurance for December 2007 through May Scott recorded the expenditure as Prepaid Insurance on December 1. What adjustment is required? P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-15 Supplies 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? 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? P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-16 Straight-Line Depreciation Expense = Asset Cost - Salvage Value Useful Life Depreciation Depreciation is the process of computing expense from allocating the cost of plant and equipment over their expected useful lives. P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-17 Depreciation On January 1, 2007, 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, On January 1, 2007, 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 P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-18 Depreciation On January 1, 2007, 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, On January 1, 2007, 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. P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-19 Equipment Depreciation Expense 1/1 62,000 12/31 12,000 Accumulated Depreciation 12/31 12,000 Depreciation P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-20 Depreciation Equipment is shown net of accumulated depreciation. $ P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-21 Buy your season tickets for all home basketball games NOW! “Go Big Blue” Unearned (Deferred) Revenues Cash received in advance of providing products or services. Liability Revenue Unadjusted Balance Credit Adjustment Debit Adjustment P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-22 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: P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-23 Unearned (Deferred) Revenues On December 31, Ox University has played 10 of its regular home games, winning 2 and losing 8. P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-24 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. Accrued Expenses ExpenseLiability Credit Adjustment Debit Adjustment P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin /1/07 12/31/07 Year end Last pay date 12/26/07 Next pay date Record adjusting journal entry. Record adjusting journal entry. 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. P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-26 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. P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-27 Yes, I’ve completed your tax return, but have not had time to bill you yet. 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 P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-28 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, 2007, the end of the company’s fiscal year. P1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-29 Links to Financial Statements A1

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-30 FastForward - Trial Balance - December 31, 2007 First, the initial unadjusted amounts are added to the work sheet. $ P2

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-31 Next, FastForward’s adjustments are added. FastForward - Trial Balance - December 31, 2007 P2

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-32 Finally, the totals are determined. FastForward - Trial Balance - December 31, 2007 P2

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-33 Preparing Financial Statements Let’s use FastForward’s adjusted trial balance to prepare the company’s financial statements. P3

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Prepare the Income Statement P3

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Prepare Statement of Retained Earnings Note: Net Income from the Income Statement carries to the Statement of Retained Earnings. P3

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Prepare Balance Sheet P3

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-37 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.” C 4

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-38 Recording Closing Entries 1. Close revenue accounts. 2. Close expense accounts. 3. Close the income summary account. 4. Close dividends account. P4

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-39 Recording Closing Entries Income Summary Salaries ExpensesConsulting Revenues $ 18,100 $ 25,000 Retained Earnings $ 7,000 Examine the accounts presented. P4

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-40 $ 25,000 Close revenues with a debit to the revenue account and a credit to Income Summary. Recording Closing Entries $ 18,100 Salaries ExpensesConsulting Revenues Income Summary $ 25,000 P4

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-41 $ 25,000 Close expense accounts with a credit to expenses and a debit to Income Summary. $ 25,000 Recording Closing Entries $ 18,100 Salaries ExpensesConsulting Revenues Income Summary $ 18,100 P4

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-42 $ 18,100 $ 25,000 $ 18,100 $ 25,000 $ 18,100 Determine the balance in the Income Summary account. Recording Closing Entries Salaries ExpensesConsulting Revenues Income Summary $ 6,900 P4

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-43 $ 18,100 $ 25,000 $ 18,100 $ 7,000 Close the Income Summary to Retained Earnings. Recording Closing Entries $ 6,900 Salaries Expenses Income Summary Retained Earnings $ 6,900 P4

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-44 Recording Closing Entries Dividends $ 2,000 $ 7,000 6,900 Retained Earnings The dividends account is closed to Retained Earnings. $ 2,000 P4

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-45 Recording Closing Entries Dividends $ 2,000 Determine the ending balance in Retained Earnings. $ 11,900 $ 7,000 6,900 Retained Earnings The dividends account is closed to Retained Earnings. P4

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-46 Post Closing Trial Balance Trial Balance prepared after the closing entries have been posted. The purpose is to insure that all nominal or temporary accounts have been closed. The only accounts on this trial balance should be assets, liabilities, and equity accounts.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-47 The Accounting Cycle Start Analyze transactions Journalize Post Prepare unadjusted trial balance Adjust Prepare adjusted trial balance Prepare statements Close Prepare post-closing trial balance Reverse (optional) C5

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-48 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. C 6

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-49 Classified Balance Sheet Current Assets 1.Cash, 2.Short-term investments, 3.Accounts receivable, 4.Short-term notes receivable, 5.Inventory for sale, and 6.Prepaid expenses. 1.Cash, 2.Short-term investments, 3.Accounts receivable, 4.Short-term notes receivable, 5.Inventory for sale, and 6.Prepaid expenses. C 6

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-50 Classified Balance Sheet Long-Term Investments Notes receivable and investments in stocks and bonds of other companies that will be held for the longer of one year or the operating cycle. Land held for future expansion is also a long- term investment. C 6

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-51 Classified Balance Sheet Plant Assets Plant assets are 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. C 6

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-52 Classified Balance Sheet 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. C 6

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-53 Current Liabilities Obligations due to be paid or settled within one year or the operating cycle, whichever is longer. Current liabilities include: 1.Accounts payable, 2.Notes payable, 3.Taxes payable, 4.Interest payable, 5.Unearned revenues, 6.Wages payable. Obligations due to be paid or settled within one year or the operating cycle, whichever is longer. Current liabilities include: 1.Accounts payable, 2.Notes payable, 3.Taxes payable, 4.Interest payable, 5.Unearned revenues, 6.Wages payable. C 6

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-54 Long-Term Liabilities Obligations not due within one year or the operating cycle, whichever is longer. Long-term liabilities include: 1.Notes payable, 2.Mortgages payable, 3.Bonds payable, and 4.Lease obligations. Obligations not due within one year or the operating cycle, whichever is longer. Long-term liabilities include: 1.Notes payable, 2.Mortgages payable, 3.Bonds payable, and 4.Lease obligations. C 6

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-55 Classified Balance Sheet

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-56 Profit Margin The profit margin ratio measures the company’s net income to net sales. Profit Margin Net Income Net Sales = A2

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-57 Current Ratio Current ratio Current assets Current liabilities = This ratio is an important measure of a company’s ability to pay its short-term obligations. A3

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 3-58 End of Chapter 3