© the mcgraw-hill companies, inc., 2005 mcgraw-hill/irwin adjusting accounts and preparing...

© The McGraw-Hill Companies, Inc., 2005McGraw-Hill/Irwin

Adjusting Accounts and Preparing Financial Statements

Chapter

33


Learning objectiveLearning objective

1. Periodic reporting / Time period principle2. Accrual Accounting and Cash Accounting3. Account Adjustment

Prepaid expense Unearned revenue Accrued expense Accrued revenue

4. Adjusted Trial Balance (ATB)5. Preparation of Financial statement from ATB6. Decision Analysis: Profit Margin

• Case: Intel & AMD


1 2 3 4 5 6 7 8 9 10 11 12

1 2 3 4

Annual

1 2

Monthly

Quarterly

Semiannual

1. Periodic reportingThe Accounting Period1. Periodic reportingThe Accounting Period

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec


The Time Period PrincipleThe Time Period Principle

The time period principle assumes that an organization’s activities can be divided into specific time periods such as a month, a quarter, a six-month interval, or a year.

Fiscal year VS. calendar year (Jan. 1 ~ Dec. 31).


Accounting

2. Accrual Basis vs. Cash Basis2. 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 GAAPNot GAAPNot GAAPNot GAAP


Accrual Basis vs. Cash BasisAccrual Basis vs. Cash Basis

On the cash basis the entire $2,400 would be recognized as insurance expense in 2004. No insurance expense from this policy would be recognized in 2005 or

2006, periods covered by the policy.

On the cash basis the entire $2,400 would be recognized as insurance expense in 2004. No insurance expense from this policy would be recognized in 2005 or

2006, periods covered by the policy.

Jan Feb Mar Apr

-$ -$ -$ -$ May Jun Jul Aug

-$ -$ -$ -$ Sep Oct Nov Dec

-$ -$ -$ 2,400$

Insurance Expense 2004


Accrual Basis vs. Cash BasisAccrual Basis vs. Cash BasisJan Feb Mar Apr

-$ -$ -$ -$ May Jun Jul Aug

-$ -$ -$ -$ Sep Oct Nov Dec

-$ -$ -$ 100$

Jan Feb Mar Apr

100$ 100$ 100$ 100$ May Jun Jul Aug

100$ 100$ 100$ 100$ Sep Oct Nov Dec

100$ 100$ 100$ 100$

Jan Feb Mar Apr

100$ 100$ 100$ 100$ May Jun Jul Aug

100$ 100$ 100$ 100$ Sep Oct Nov Dec

100$ 100$ 100$ -$




On the accrual basis $100 of insurance

expense is recognized in 2004, $1,200 in 2005,

and $1,100 in 2006. The expense is matched with the periods benefited by the insurance coverage.

On the accrual basis $100 of insurance

expense is recognized in 2004, $1,200 in 2005,

and $1,100 in 2006. The expense is matched with the periods benefited by the insurance coverage.


We have delivered theproduct to our customer,

so I think we should recordthe revenue earned.

We have delivered theproduct to our customer,

so I think we should recordthe revenue earned.

Recognizing Revenues and ExpensesRecognizing Revenues and Expenses

Revenue Recognition



Revenue Recognition Matching Principle

Summaryof Expenses

Rent

Gasoline

Advertising

Salaries

Utilities

and . . . .

$1,000

500

2,000

3,000

450

. . . .

Now that we haverecognized the revenue,let’s see what expenses

we incurred togenerate that revenue.

Now that we haverecognized the revenue,let’s see what expenses

we incurred togenerate that revenue.



Revenue recognition principle requires that revenue be recorded when earned, not before or after.

Matching principle intends to record expenses in the same accounting period as the revenues that are earned as a result of these expenses.


AdjustmentsAdjustments

An adjusting entry is recorded to bring an asset or liability account balance to its proper amount.

3. Adjusting Accounts3. Adjusting Accounts

Paid (or received) cash before expense (or revenue) recognizedPaid (or received) cash before

expense (or revenue) recognizedPaid (or received) cash after

expense (or revenue) recognizedPaid (or received) cash after

expense (or revenue) recognized

Prepaid (Deferred) expenses*

Prepaid (Deferred) expenses*

Unearned (Deferred) revenues

Unearned (Deferred) revenues

AccruedexpenseAccruedexpense

AccruedrevenuesAccruedrevenues

Framework for Adjustments

*including depreciation


At the beginning of period 1 recognize all cash payment as prepaid expense (asset account):

Dr. Prepaid Rent Expense 4 million

Cr. Cash 4 million

At the end of each accounting period recognize the portion that is used

Dr. Rent Expense 1 million

Cr. Prepaid Rent Expense 1 million

Adjusting Accounts – Prepaid expensesAdjusting Accounts – Prepaid expensesPaid Cash Actually used

Accounting Period 1

Accounting Period 2

Accounting Period 3

Accounting Period 4

E.g. Paid 4 years

rental fee $ 4 million


At the beginning of period 1 recognize all cash receipt as unearned revenue (liability account).

Dr. Cash 40 million

Cr. Unearned revenue 40 million

At the end of each accounting period recognize the portion that is earned:

Dr. Unearned revenue 10 million

Cr. Revenue 10 million

Adjusting Accounts – Unearned revenueAdjusting Accounts – Unearned revenueReceived Cash Revenue Earned

Accounting Period 1

Accounting Period 2

Accounting Period 3

Accounting Period 4

E.g. Long-term contract:

Received $40m in advance to build a ship


Adjusting Accounts – Accrued expensesAdjusting Accounts – Accrued expensesPaid CashInterest expense incurred

Accounting Period 1

Accounting Period 2

Accounting Period 3

Accounting Period 4

When borrowing money:Dr. Cash 40 million Cr. Bank loan 40 million

At the end of each period (1 to 4) recognize the portion of interest expense that is due but not paid:

Dr. Interest Expense 4 million

Cr. interest payable 4 million

At the end of the period 4:

Dr. Interest payable 16 million

Dr. Bank loan 40 million

Cr. Cash 56 million

E.g. Borrow 40 million from bank.

Annual interest rate is 10%. Interest and

principal are paid at the end of 4th

year.

Received Cash


Adjusting Accounts – Accrued revenuesAdjusting Accounts – Accrued revenues

At the end of each accounting period (1 to 4) recognize the portion of revenue that is earned but not received:

Dr. Accounts Receivable 10 million Cr. Revenue 10 million

At the end of period 4:Dr. Cash 40 million Cr. Accounts receivable 40 million

Received Cash

Accounting Period 1

Accounting Period 2

Accounting Period 3

Accounting Period 4

Revenue Earned Long-term

Contract: Received $40 million after

building one ship


Here is the checkfor my first

6 months’ rent.

Here is the checkfor my first

6 months’ rent.

Prepaid expensePrepaid expense

Resources paid for prior to

receiving the actual benefits.

Resources paid for prior to

receiving the actual benefits.

Asset Expense

UnadjustedBalance

CreditAdjustment

DebitAdjustment


Prepaid expense 1 Prepaid InsurancePrepaid expense 1 Prepaid Insurance

On December 1, 2004, Fastforward paid $2,400 for 24 months of insurance benefits beginning on December

1, 2004. Fastforward recorded the expenditure as Prepaid Insurance on December 1. What adjustment

is required?

On December 1, 2004, Fastforward paid $2,400 for 24 months of insurance benefits beginning on December

1, 2004. Fastforward recorded the expenditure as Prepaid Insurance on December 1. What adjustment

is required?

Dec. 31 Dr. Insurance Expense 100 Cr. Prepaid Insurance 100

To record first month's expired insurance

Dec. 1 2,400 Dec. 31 100Bal. 2,300

Prepaid Insurance 128Dec. 31 100



Prepaid expense 2 SuppliesPrepaid expense 2 Supplies

During 2004, Fastforward purchase $9,720 of supplies. Fastforward recorded the expenditures as Supplies. At December 31, a count of the supplies indicated $8,670

on hand. What adjustment is required?

During 2004, Fastforward purchase $9,720 of supplies. Fastforward recorded the expenditures as Supplies. At December 31, a count of the supplies indicated $8,670

on hand. What adjustment is required?

Dec. 31 Dr. Supplies Expense 1,050 Cr. Supplies 1,050

To record supplies used during 2004

Bought 9,720 Dec. 31 1,050Bal. 8,670

Supplies 126Dec. 31 1,050

Supplies Expense 652


Straight-LineDepreciationExpense

= Asset Cost - Salvage Value

Useful Life

Prepaid expense 3 DepreciationPrepaid expense 3 Depreciation

Depreciation is the process of allocating the cost of plant and equipment over their expected useful lives.


Adjusting for DepreciationAdjusting for Depreciation

Dec 1, 2004,• Fastforward purchased equipment for $26,000 cash. • The equipment has an estimated useful life of 4 years• Fastforward expects to sell the equipment at the end of its life for

$8,000 cash.

2004Depreciation

Expense=

$26,000 - $8,000 48 = $375

Dec. 31 Dr. Depreciation Expense 375 Cr. Accumulated Depreciation - Equipment 375

To record equipment depreciation

Accumulated depreciation isa contra asset account.

Accumulated depreciation isa contra asset account.


contra accountcontra account

A contra account is an account linked with another account, it has an opposite normal balance, and it is reported as a subtraction from that other account’s balance.

A contra account allow information users to know both the full costs of assets and the total amount of depreciation.


Equipment Depreciation Expense

1/1 26,000 12/31 375

Accumulated Depreciation12/31 375

Adjusting for DepreciationAdjusting for DepreciationDec. 31 Dr. Depreciation Expense 375

Cr. Accumulated Depreciation - Equipment 375 To record equipment depreciation


Adjusting for DepreciationAdjusting for Depreciation

Equipment is shown net of accumulated depreciation.

$


Unearned (Deferred) RevenuesUnearned (Deferred) Revenues

Cash received in advance of providing

products or services.

Cash received in advance of providing

products or services.

Liability RevenueUnadjusted

BalanceCredit

AdjustmentDebit

Adjustment

E.g. The New York Times Company: Subscriptions- unearned revenue.


Adjusting Unearned (Deferred) RevenuesAdjusting Unearned (Deferred) Revenues

Dec 26, 2004, Fastforward agreed to provide consulting services to a client for a

fixed fee of $3,000 for 60 days. On the same day, the client paid the 60-day fee in advance,

covering the period from Dec 27 to Feb 24.

Dec. 26 Dr. Cash 3,000 Cr. Unearned Revenue 3,000

Received advance payment for services over next 60 days

Dec 26 3,000Unearned Revenue


Adjusting Unearned (Deferred) RevenuesAdjusting Unearned (Deferred) Revenues

December 31, Fastforward has provided 5 days’ service and earned 5/60 of $3000.

Dec. 31 Dr. Unearned Revenue 250

Cr. Consulting Revenue 250

To record earned revenue.

Dec. 31 250 Dec. 26 3000Bal. 2,750

Unearned Revenue

Dec.5 4,200Dec. 12 1,600Dec. 31 250Balance 6,050

Consulting Revenue


We’re about one-halfdone with this job and

want to be paid forour work!

We’re about one-halfdone with this job and

want to be paid forour work!

Costs incurred in a period that are

both unpaid and unrecorded.

Costs incurred in a period that are

both unpaid and unrecorded.

Accrued ExpensesAccrued Expenses

Expense LiabilityCredit

AdjustmentDebit

Adjustment


12/1/04 12/31/04Year end

Last paydate

12/26/04

Next paydate

1/2/05

Record adjustingjournal entry.

Record adjustingjournal entry.

Adjusting for Accrued ExpensesAdjusting for Accrued Expenses

Fastforward pays its employee $700 every two weeks on Friday. Year-end, 12/31/04, falls on a Wednesday. As of

12/31/04, the employees have earned salaries of 3 days for Monday through Wednesday of the week ended 1/02/05.




Adjusting for Accrued ExpensesAdjusting for Accrued Expenses





Dec. 31 Dr. Salaries Expense 210 Cr. Salaries Payable 210

To accrue 3-days' salary

Dec.12 700 Dec. 26 700 Dec. 31 210Bal. 1,610

Salaries ExpenseDec. 31 210

Salaries Payable


Yes, I’ve completed yourtax return, but have not had

time to bill you yet.

Yes, I’ve completed yourtax return, but have not had

time to bill you yet.

Accrued RevenuesAccrued 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

CreditAdjustment

DebitAdjustment


Adjusting for Accrued RevenuesAdjusting for 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, 2004, the end of the company’s fiscal year.

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, 2004, the end of the company’s fiscal year.

Dec. 31 Dr. Accounts Receivable 31,200 Cr. Service Revenue 31,200

To accrue revenue earned

Other receivables1,325,268

Dec. 31 31,200Bal. 1,356,468

Accounts ReceivableOther revenues

6,589,500 Dec. 31 31,200Bal . 6,620,700

Service Revenue


Adjusting Accrued RevenuesAdjusting Accrued Revenues

Dec 12, 2004 FastForward agreed to provide 30 days of consulting services

to a local sports club for a fixed fee of $2700, beginning from Dec 12.

The club agrees to pay FastForward on Jan 10, 2005.

Dec. 31 Dr. Accounts Receivable 1,800 Cr. Consulting Revenue 1,800

To accrue revenue earned


Adjusting Accrued RevenuesAdjusting Accrued Revenues

Dec.12 1,900 Dec. 22 1,900Dec.31 1,800

Bal. 1,800

Accounts Receivable

Dec.5 4,200Dec. 12 1,600Dec. 31 250Dec. 31 1,800Balance 7,850

Consulting Revenue


Future receipts of accrued revenuesFuture receipts of accrued revenues

Jan 10, 2005• FastForward received $2,700 cash for the entire

contract amount.

Jan 10 Dr. Cash 2,700

Cr. Accounts Receivable 1,800

Cr. Consulting Revenue 900 To record cash collection


Type

Balance Sheet Account

Income Statement Account Adjusting Entry

Prepaid Asset Expense Dr. ExpenseExpenses Overstated Understated Cr. Asset

Unearned Liability Revenue Dr. LiabilityRevenues Overstated Understated Cr. Revenue

Accrued Liability Expense Dr. ExpenseExpenses Understated Understated Cr. Liability

Accrued Asset Revenue Dr. AssetRevenues Understated Understated Cr. Revenue

Before Adjustment

Summary of Adjustments and Financial Statement Links

Links to Financial StatementsLinks to Financial Statements


4. Adjusted Trial Balance4. Adjusted Trial Balance

Explain and prepare an adjusted trial balance. Prepare financial statements from an adjusted

trial balance.


FastForwardTrial Balance

December 31, 2004

First, the initial

unadjusted amounts are added to the worksheet.

First, the initial

unadjusted amounts are added to the worksheet.

$

$

$$


Next, FastForward’s adjustments are added.

Next, FastForward’s adjustments are added.


December 31, 2004

$

$

$$

$$

$$



December 31, 2004Finally, the totals are determined.

Finally, the totals are determined.

$

$

$$

$$

$$

$

$

$$


5. Preparing Financial Statements5. Preparing Financial Statements

Let’s use FastForward’s adjusted trial balance to prepare the company’s financial statements.

Remember order: • Income Statement,

• Statement of Owner’s Equity,

• Balance Sheet,

• Statement of Cash Flow


Prepare the IncomeStatement.


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.


Prepare the Balance Sheet.

FastForwardBalance Sheet

December 31, 2001

AssetsCash 3,950$ Accounts receivable 1,800 Supplies 8,670 Prepaid insurance 2,300 Equipment 26,000 Less: accum. depr. (375) 25,625 Total assets 42,345$

LiabilitiesAccounts payable 6,200$ Salaries payable 210 Unearned consulting revenues 2,750 Total liabilities 9,160$

Owner's EquityChuck Taylor, Capital 33,185 Total liabilities and equity 42,345$


Profit margin ratio measures the company’s profitability Comparison technique

• with competitors• with prior period

ProfitMargin

Net Income Net Sales=

6. Decision Analysis - Profit Margin6. Decision Analysis - Profit Margin


1. Industry Characteristics

Highly technology intensive

Cyclical with economic cycle

2. Key success factors:

Technology innovation

3. Companies for analysis

Intel

AMD

Profit Margin - Semiconductor Industry Profit Margin - Semiconductor Industry


6. Profit Margin - Intel & AMD 6. Profit Margin - Intel & AMD

Profit Margin

-60.00%

-50.00%

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Year

Pro

fit

Mar

gin

Intel AMD

PM 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996

Intel 22.31% 21.97% 18.72% 11.65% 4.86% 31.24% 24.89% 23.10% 27.70% 24.74%

AMD 2.83% 1.82% -7.80% -48.31% -1.56%

Industry 14.85% 14.07% 13.16%


ROA - Intel & AMD ROA - Intel & AMD

ROA

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Year

RO

A

Intel AMD

ROA 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996

Intel 17.93% 15.61% 11.97% 7.05% 2.91% 21.97% 16.68% 19.28% 24.05% 21.73%

AMD 2.27% 1.16% -3.89% -22.88% -1.07%

Industry 9.22% 8.06% 7.41%


Homework for Chap 1, 2, 3Homework for Chap 1, 2, 3

Chap 1: Problem 1-8 A Chap 2: Problem 2-3 B Chap 3: Problem 3-3 A

Due on June,16,2006 (Friday) in class. Please submit hard copy. Please submit on time for me to keep your

homework record.

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