Chapter 03 ADJUSTING ACCOUNTS AND PREPARING FINANCIAL STATEMENTS

Chapter 03 ADJUSTING ACCOUNTS AND PREPARING FINANCIAL STATEMENTS Power. Point 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 Mc. Graw-Hill/Irwin Copyright © 2011 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

3 -2 C 1 THE ACCOUNTING PERIOD

3 -3 C 2 ACCRUAL BASIS VERSUS CASH BASIS Cash Basis Accrual Basis Revenues are recognized when earned and expenses are recognized when incurred. Revenues are recognized when cash is received and expenses are recorded when cash is paid. Accounting

3 -4 C 2 ACCRUAL BASIS VERSUS CASH BASIS Cash Basis Accrual Basis Revenues are recognized when earned and expenses are recognized when incurred. Revenues are recognized when cash is received and expenses are recorded when cash is paid. Non-GAAP Accounting

3 -5 C 2 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.

3 -6 C 2 ACCRUAL BASIS VERSUS CASH BASIS 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.

3 -7 C 2 RECOGNIZING REVENUES & EXPENSES Revenue Recognition Principle We have delivered the product to our customer, so I think we should record the revenue earned.

3 -8 C 2 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.

3 -9 C 3 ADJUSTING ACCOUNTS An adjusting entry is recorded to bring an asset or liability account balance to its proper amount. Framework for Adjustments Paid (or received) cash before expense (or revenue) recognized Prepaid (Deferred) expenses* *including depreciation Unearned (Deferred) revenues Paid (or received) cash after expense (or revenue) recognized Accrued expense Accrued revenues

3 - 10 P 1 PREPAID (DEFERRED) EXPENSES Resources paid for prior to receiving the actual benefits. Here is the check for my 24 -month insurance policy.

3 - 11 P 1 PREPAID INSURANCE (a) On 12/1/11, Fast. Forward paid $2, 400 for insurance for 2 -years (24 -months, December 2011 through November 2013). Fast. Forward recorded the expenditure as Prepaid Insurance on 12/31/11. What adjustment is required? 637 128

3 - 12 P 1 SUPPLIES (b) During 2011, Fast. Forward purchased $9, 720 of supplies. Fast. Forward 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? 126 652

3 - 13 P 1 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.

3 - 14 P 1 DEPRECIATION Depreciation is the process of allocating the cost of a plant asset over its useful life in a systematic and rational manner. Straight-Line Asset Cost - Salvage Value Depreciation = Useful Life Expense

3 - 15 P 1 DEPRECIATION On December 1, 2011, Fast. Forward purchased equipment for $26, 000 cash. The equipment has an estimated useful life of four years (48 months) and Fast. Forward 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.

3 - 16 P 1 DEPRECIATION Contra asset account Depreciation Expense Equipment 12/31 12/1 26, 000 Accumulated Depreciation 12/31 375

3 - 17 P 1 DEPRECIATION $ Equipment is shown net of accumulated depreciation.

3 - 18 P 1 UNEARNED (DEFERRED) REVENUES Cash received in advance of providing products or services. We will apply this cash you gave us towards your total consulting fees.

3 - 19 P 1 UNEARNED (DEFERRED) REVENUES On December 26, 2011, Fast. Forward 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. Fast. Forward makes the following entry:

3 - 20 P 1 UNEARNED (DEFERRED) REVENUES (d) On December 31, Fast. Forward earns 5 -days of consulting fees. Each day that passes results in consulting fees of $50 ($3, 000 ÷ 60), so Fast. Forward earned ($50 × 5 days) $250.

3 - 21 P 1 ACCRUED EXPENSES Costs incurred in a period that are both unpaid and unrecorded. We’re about one-half done with this job and want to be paid for our work!

3 - 22 P 1 ACCRUED SALARIES EXPENSES Fast. Forward’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.

3 - 23 P 1 ACCRUED SALARIES EXPENSES (e) Fast. Forward’s employee has earned but not been paid on December 31, 2011, $210.

3 - 24 P 1 FUTURE PAYMENT OF ACCRUED EXPENSES On January 9, 2012, Fast. Forward will pay the payroll for the two weeks from December 26, 2011 through January 9, 2012. Here is the journal entry for the payroll:

3 - 25 P 1 ACCRUED INTEREST EXPENSES Fast. Forward 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.

3 - 26 P 1 ACCRUED REVENUES Revenues earned in a period that are both unrecorded and not yet received. Yes, I’ve completed your consulting job, but have not had time to bill you yet.

3 - 27 P 1 ACCRUED SERVICE REVENUE (f) On December 12, 2011, Fast. Forward 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.

3 - 28 P 1 FUTURE RECEIPT OF SERVICE REVENUES On January 10, 2012, Fast. Forward completed its obligation under the consulting contract. The client was billed $2, 700 and Fast. Forward received $2, 700 in cash. Revenue in January 10 days @ $90 = $900

3 - 29 A 1 LINKS TO FINANCIAL STATEMENTS

3 - 30 P 2 Fast. Forward - Trial Balance - December 31, 2011 First, the initial unadjusted amounts are added to the worksheet.

3 - 31 P 2 Fast. Forward - Trial Balance - December 31, 2011 Next, Fast. Forward’s adjustments are added.

3 - 32 P 2 Fast. Forward – Adjusted Trial Balance - December 31, 2011 Finally, the totals are determined.

3 - 33 P 3 PREPARING FINANCIAL STATEMENTS Let’s use Fast. Forward’s adjusted trial balance to prepare the company’s financial statements.

3 - 34 P 3 1. PREPARE THE INCOME STATEMENT

3 - 35 P 3 2. PREPARE THE STATEMENT OF OWNER’S EQUITY Note: Net Income from the Income Statement carries to the Statement of Changes in Owner’s Equity.

3 - 36 P 3 3. PREPARE THE BALANCE SHEET

3 - 37 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.

3 - 38 A 2 PROFIT MARGIN The profit margin ratio measures the company’s net income to net sales. Profit Net Income = Margin Net Sales $ in millions Net income Limited Brands, Inc. 2009 $ 220 $ 2008 2007 2006 Net sales 9, 043 718 $ 676 $ 683 10, 13 10, 67 4 1 9, 699 Profit margin 2. 4% 7. 1% 6. 3% 7. 0% Industry profit margin 0. 3% 1. 1% 1. 6% 1. 5%

3 - 39 P 4 APPENDIX 3 A: ALTERNATIVE ACCOUNTING FOR PREPAYMENTS 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.

3 - 40 END OF CHAPTER 03