PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 03 ADJUSTING ACCOUNTS AND

PREPARING FINANCIAL STATEMENTS

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THE ACCOUNTING PERIOD C 1

Accrual accounting

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Accounting

ACCRUAL BASIS VERSUS 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 are recorded when cash is paid.

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CALENDAR YEAR FISCAL YEAR NATURAL FISCAL YEAR ends when business Activities at low point INTERIM STATEMENTS

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Cash Basis

Revenues are recognized when cash is received and expenses are recorded when cash is paid.

Accounting

ACCRUAL BASIS VERSUS CASH BASIS

Non-GAAP

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Accrual Basis

Revenues are recognized when earned and expenses are recognized when incurred. ExpenseRecognition principle or matching prinnciple

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ACCRUAL BASIS VERSUS CASH BASIS

On the cash basis, the entire $2,400 would be recognized as insurance expense in 2011. No insurance expense from this policy would be recognized in 2012

or 2013, periods covered by the policy.

Jan Feb Mar Apr

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

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

-$ -$ -$ 2,400$

Insurance Expense 2009

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ACCRUAL BASIS VERSUS CASH BASIS

Jan Feb Mar Apr

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

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

-$ -$ -$ 100$

Jan Feb Mar Apr100$ 100$ 100$ 100$

May Jun Jul Aug100$ 100$ 100$ 100$

Sep Oct Nov Dec100$ 100$ 100$ 100$

Jan Feb Mar Apr100$ 100$ 100$ 100$

May Jun Jul Aug100$ 100$ 100$ 100$

Sep Oct Nov Dec100$ 100$ 100$ -$

Insurance Expense 2009

Insurance Expense 2010

Insurance Expense 2011

On the accrual basis, $100 of insurance

expense is recognized in 2011, $1,200 in 2012,

and $1,100 in 2013. The expense is matched with the periods benefited by the insurance coverage.

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We have delivered the product to our customer,

so I think we should record the revenue earned.

RECOGNIZING REVENUES & EXPENSES

Revenue Recognition Principle

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RECOGNIZING REVENUES & EXPENSES

Revenue Recognition Principle Matching Principle

Summary of Expenses

Rent Gasoline Advertising Salaries Utilities and . . . .

$1,000 500

2,000 3,000

450 . . . .

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

we incurred to generate that revenue.

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

ADJUSTING ACCOUNTS

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

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Here is the check for my 24-month insurance policy.

PREPAID (DEFERRED) EXPENSES

Resources paid for prior to

receiving the actual benefits.

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PREPAID INSURANCE (a) On 12/1/11, FastForward paid $2,400 for insurance for

2-years (24-months, December 2011 through November 2013). FastForward recorded the expenditure as Prepaid

Insurance on 12/31/11. What adjustment is required?

Dec. 31 Insurance Expense 100 Prepaid Insurance 100

To record first month's expired insurance

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

Prepaid Insurance 637 Dec. 31 100

Insurance Expense 128

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SUPPLIES (b) During 2011, FastForward purchased $9,720 of supplies.

FastForward recorded the expenditures in the asset account, “Supplies.” On December 31, 2011, a count of the supplies indicated $8,670 on hand, so $1,050 of supplies were used

during December. What adjustment is required?

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

To record supplies used during 2011

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

Supplies 126 Dec. 31 1,050

Supplies Expense 652

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OTHER PREPAID EXPENSES 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.

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Straight-Line Depreciation Expense

= Asset Cost - Salvage Value

Useful Life

DEPRECIATION Depreciation is the process of allocating the

cost of a plant asset over its useful life in a systematic and rational manner.

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DEPRECIATION On December 1, 2011, 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. (c) Let’s record depreciation expense for the

month ended December 31, 2011.

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Equipment Depreciation Expense

12/1 26,000 12/31 375

Accumulated Depreciation 12/31 375

Dec. 31 Depreciation Expense 375 Accumulated Depreciation - Equipment 375

To record monthly equipment depreciation

DEPRECIATION P 1

Contra asset account

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Equipment is shown net of accumulated depreciation.

$

DEPRECIATION P 1

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UNEARNED (DEFERRED) REVENUES

We will apply this cash you gave us towards

your total consulting fees. Cash received in

advance of providing products or services.

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UNEARNED (DEFERRED) REVENUES

On December 26, 2011, 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:

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

Consulting fees received in advance

Dec. 26 3,000Unearned Revenue

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UNEARNED (DEFERRED) REVENUES

(d) On December 31, FastForward earns 5-days of consulting fees. Each day that passes results in

consulting fees of $50 ($3,000 ÷ 60), so FastForward earned ($50 × 5 days) $250.

Dec. 31 Unearned Revenue 250 Consulting Revenue 250

To recognize 5-days of consulting fees

Dec 31 250 Dec 26 3,000Bal 2,750

Unearned RevenueDec. 31 250

Consulting Revenue

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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.

ACCRUED EXPENSES P 1

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FastForward’s employee earns $70 per day and is paid every two weeks on Friday. Year-end, 12/31/11, falls on a Wednesday. The last payday of 2011, is Friday, 12/26/11.

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 P 1

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Dec. 31 Salaries Expense 210 Salaries Payable 210

To accrue 3 days' salary (3 x $70)

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

Salaries ExpenseDec. 31 210

Salaries Payable

(e) FastForward’s employee has earned but not been paid on December 31, 2011, $210.

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ACCRUED SALARIES EXPENSES

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FUTURE PAYMENT OF ACCRUED EXPENSES

On January 9, 2012, FastForward will pay the payroll for the two weeks from December 26, 2011 through January

9, 2012. Here is the journal entry for the payroll:

Jan 9 Salaries Payable (3 days @ $70) 210 Salaries Expense (7 days @ $70) 490

Cash (10 days @ $70) 700 Paid two-week salary

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Dec. 31 Interest Expense 30 Interest Payable 30

To accrue interest ($6,000 × 6% × 30/360)

Dec. 31 30Interest Expense

Dec. 31 30Interest Payable

ACCRUED INTEREST EXPENSES

FastForward borrowed $6,000 from First National Bank on December 1, 2011. 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 12/31/11.

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Yes, I’ve completed your consulting job, but have not

had time to bill you yet.

ACCRUED REVENUES Revenues earned

in a period that are both

unrecorded and not yet received.

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ACCRUED SERVICE REVENUE

(f) On December 12, 2011, 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, 2012, when the client will pay in full.

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

To accrue revenue (20-days @ $90 per day)

Other receivables1,900 Receipts 1,900

Dec. 31 1,800Bal. 1,800

Accounts ReceivableOther revenues

6,050 Dec. 31 1,800Bal . 7,850

Consulting Revenue

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FUTURE RECEIPT OF SERVICE REVENUES

On January 10, 2012, FastForward completed its obligation under the consulting contract. The client was billed $2,700 and FastForward received $2,700 in cash.

Jan 10 Cash 2,700 Accounts Receivable 1,800 Consulting Revenue 900

To record completion of contract and cash collection

Revenue in January 10 days @ $90 = $900

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LINKS TO FINANCIAL STATEMENTS A 1

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FastForward - Trial Balance - December 31, 2011

First, the initial

unadjusted amounts are added to the worksheet.

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Next, FastForward’s adjustments are added.

P 2 FastForward - Trial Balance - December 31, 2011

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P 2 FastForward – Adjusted Trial Balance - December 31, 2011

Finally, the totals are

determined.

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PREPARING FINANCIAL STATEMENTS Let’s use FastForward’s adjusted trial balance to

prepare the company’s financial statements.

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P 3 1. PREPARE THE INCOME STATEMENT

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Note: Net Income from the Income Statement carries to the Statement of Changes in Owner’s Equity.

P 3 2. PREPARE THE STATEMENT OF OWNER’S EQUITY

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3. PREPARE THE BALANCE SHEET P 3

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GLOBAL VIEW Both U.S. GAAP and IFRS include broad and similar guidance for adjusting accounts. Although some variations exist in revenue and expense recognition.

Both U.S. GAAP and IFRS include similar guidance for adjusting accounts. Although some variations exist in revenue and expense

recognition.

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PROFIT MARGIN The profit margin ratio measures the company’s

net income to net sales. Profit Margin

Net Income Net Sales =

$ in millions 2009 2008 2007 2006

Net income $ 220 $ 718 $ 676 $ 683

Net sales 9,043

10,134

10,671 9,699

Profit margin 2.4% 7.1% 6.3% 7.0%

Industry profit margin 0.3% 1.1% 1.6% 1.5%

A 2

Limited Brands, Inc.

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APPENDIX 3A: ALTERNATIVE ACCOUNTING FOR PREPAYMENTS

P4

An alternative method is to record all prepaid expenses with debits to expense accounts.

The adjusting entry depends on how the original payment was recorded.

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END OF CHAPTER 03