Chapter 3

Adjusting Accounts and

Preparing Financial
Statements

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 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

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

 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

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

 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

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

 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

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

 3-6
C1
The Accounting Period

Annually

1 2
Semiannually
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
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-7
C1
Accrual Basis vs. Cash Basis
Accrual Basis Cash Basis
Revenues are Revenues are
recognized when recognized when
earned and expenses cash is received and
are recognized when expenses recorded
incurred. when cash is paid.

Not GAAP
Accounting

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 3-8
C1
Accrual Basis vs. Cash Basis

FastForward paid $2,400 for a 24-month insurance

Example: policy beginning December 1, 2007.
Insurance Expense 2007
Jan Feb Mar Apr

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

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

$ - $ - $ - $ 2,400

On the cash basis the entire $2,400 would be

recognized as insurance expense in 2007. No
insurance expense from this policy would be recognized
in 2008 or 2009, periods covered by the policy.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-9
C1
Accrual Basis vs. Cash Basis
Insurance Expense 2007
Jan Feb Mar Apr

$ - $ - $ - $ -
May Jun Jul Aug On the accrual basis
$ - $ - $ - $ -
Sep Oct Nov Dec $100 of insurance
$ - $ - $ - $ 100 expense is recognized in
Jan
Insurance Expense 2008
Feb Mar Apr
2007, $1,200 in 2008,
$ 100
May
$ 100
Jun
$ 100
Jul
$ 100
Aug
and $1,100 in 2009. The
$ 100 $ 100 $ 100 $ 100 expense is matched with
Sep Oct Nov Dec
$ 100 $ 100 $ 100 $ 100 the periods benefited by
Jan
Insurance Expense 2009
Feb Mar Apr
the insurance coverage.
$ 100 $ 100 $ 100 $ 100
May Jun Jul Aug
$ 100 $ 100 $ 100 $ 100
Sep Oct Nov Dec
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
$ 100 $ 100 $ 100 $ -
 3-10
C1
Recognizing Revenues

 Revenue Recognition
We have delivered the
product to our customer,
so I think we should record
the revenue earned.

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 3-11
C1
Recognizing Expenses

 Revenue Recognition
 Matching Now that we have
Summary
recognized the revenue,
of Expenses let’s see what expenses
Rent $1,000 we incurred to
Gasoline 500 generate that revenue.
Advertising 2,000
Salaries 3,000
Utilities 450
and . . . . ....

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

 3-12
C3
Adjusting Accounts
An adjusting entry is recorded to bring an asset or
liability account balance to its proper amount.

Framework for Adjustments

Adjustments

Paid (or received) cash before Paid (or received) cash after
expense (or revenue) recognized expense (or revenue) recognized

Prepaid Unearned Accrued Accrued

(Deferred) (Deferred) expense revenues
expenses* revenues
*including depreciation © The McGraw-Hill Companies, Inc., 2008
McGraw-Hill/Irwin
 3-13
P1
Prepaid (Deferred) Expenses
Here is the check
for my first
Resources paid 6 months’ insurance.
for prior to
receiving the
actual benefits.

Asset Expense
Unadjusted Credit Debit
Balance Adjustment Adjustment

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

 3-14
P1
Prepaid Insurance
On December 1, 2007, Scott Company paid
$12,000 to cover insurance for December 2007
through May 2008. Scott recorded the
expenditure as Prepaid Insurance on December 1.
What adjustment is required?
Dec. 31 Insurance Expense 2,000
Prepaid Insurance 2,000
To record first month's expired insurance

Prepaid Insurance 637 Insurance Expense 128

Dec. 1 12,000 Dec. 31 2,000 Dec. 31 2,000
Bal. 10,000

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 3-15
P1
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?
Dec. 31 Supplies Expense 12,845
Supplies 12,845
To record supplies used during 2007
Supplies 126 Supplies Expense 652
Bought 15,500 Dec. 31 12,845 Dec. 31 12,845
Bal. 2,655

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 3-16
P1
Depreciation

Depreciation is the process of computing

expense from allocating the cost of plant
and equipment over their expected useful
lives.
Straight-Line Asset Cost - Salvage Value
Depreciation =
Expense Useful Life

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 3-17
P1
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, 2007.

2007 $62,000 - $2,000

Depreciation = = $12,000
Expense 5
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-18
P1
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, 2007.
Dec. 31 Depreciation Expense 12,000
Accumulated Depreciation - Equipment 12,000
To record equipment depreciation

Accumulated depreciation is
a contra asset account.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-19
P1
Depreciation

Dec. 31 Depreciation Expense 12,000

Accumulated Depreciation - Equipment 12,000
To record equipment depreciation

Equipment Depreciation Expense

1/1 62,000 12/31 12,000

Accumulated Depreciation
12/31 12,000

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

 3-20
P1
Depreciation

Barton, Inc.
Partial Balance Sheet
At December 31, 2007 Equipment is
Assets $ shown net of
Cash accumulated
.
Equipment $ 62,000
depreciation.
Less: accumulated deprec. (12,000) 50,000
.
.
Total Assets

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

 3-21
P1
Unearned (Deferred) Revenues

Cash received in
advance of
Buy your season tickets for
providing all home basketball games NOW!
products or
services. “Go Big Blue”

Liability Revenue
Debit Unadjusted Credit
Adjustment Balance Adjustment

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

 3-22
P1 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:
Oct. 1 Cash 100,000
Unearned Revenue 100,000
Basketball revenue received in advance

Unearned Revenue
Oct.1 100,000

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 3-23
P1
Unearned (Deferred) Revenues

On December 31, Ox University has played

10 of its regular home games, winning 2 and
losing 8.

Dec. 31 Unearned Revenue 50,000

Basketball Revenue 50,000
To recognize 10-games of revenue
Unearned Revenue Basketball Revenue
Dec. 31 50,000 Oct. 1 100,000 Dec. 31 50,000
Bal. 50,000

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

 3-24
P1
Accrued Expenses
Costs incurred in a We’re about one-half
done with this job and
period that are
want to be paid for
both unpaid and our work!
unrecorded.

Expense Liability
Debit Credit
Adjustment Adjustment

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 3-25
P1
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.

Last pay Next pay

date date
12/26/07

12/1/07 12/31/07 Record adjusting

Year end journal entry.

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 3-26
P1
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.

Dec. 31 Salaries Expense 47,250

Salaries Payable 47,250
To accrue 3-days' salary
Salaries Expense Salaries Payable
Other salaries Dec. 31 47,250
657,500
Dec. 31 47,250
Bal. 704,750

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

 3-27
P1 Accrued Revenues

Revenues earned Yes, I’ve completed your

in a period that tax return, but have not had
time to bill you yet.
are both
unrecorded and
not yet received.

Asset Revenue
Debit Credit
Adjustment Adjustment

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 3-28
P1 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.

Dec. 31 Accounts Receivable 31,200

Service Revenue 31,200
To accrue revenue earned
Accounts Receivable Service Revenue
Other receivables Other revenues
1,325,268 6,589,500
Dec. 31 31,200 Dec. 31 31,200
Bal. 1,356,468 Bal . 6,620,700

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

 3-29
A1
Links to Financial Statements

Summary of Adjustments and Financial Statement Links

Before Adjustment
Income
Balance Sheet Statement
Type Account Account Adjusting Entry
Prepaid Asset Overstated Expense Dr. Expense
Expenses Equity Overstated Understated Cr. Asset
Unearned Liability Overstated Revenue Dr. Liability
Revenues Equity Understated Understated Cr. Revenue
Accrued Liability Understated Expense Dr. Expense
Expenses Equity Overstated Understated Cr. Liability
Accrued Asset Understated Revenue Dr. Asset
Revenues Equity Understated Understated Cr. Revenue

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 3-30
P2
FastForward - Trial Balance - December 31, 2007
Adjusted
Trial Balance Adjustments Trial Balance
Dr. Cr. Dr. Cr. Dr. Cr.
Cash 3,950
Accounts receivable -
Supplies 9,720
Prepaid insurance 2,400
Equipment 26,000
Accum. depr. - Equip. -
Accounts payable $ 6,200
Salaries payable - First, the
Unearned revenue 3,000
Common Stock 30,000 initial
Retained Earnings 0
Dividends 600 unadjusted
Consulting revenue 5,800
amounts are
Rental revenue 300
Depr. expense
Salaries expense
-
1,400
added to the
Insurance expense
Rent expense
-
1,000
work sheet.
Supplies expense -
Utilities expense 230
Totals 45,300 45,300

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 3-31
P2
FastForward - Trial Balance - December 31, 2007

Unadjusted Adjusted
Trial Balance Adjustments Trial Balance
Dr. Cr. Dr. Cr. Dr. Cr.
Cash 3,950
Accounts receivable - f 1,800
Supplies 9,720 b 1,050
Prepaid insurance 2,400 a 100
Equipment 26,000 Next,
Accum. depr. - Equip.
Accounts payable
-
6,200
c 375
FastForward’s
Salaries payable - e 210 adjustments
Unearned revenue 3,000 d 250
Common Stock 30,000 are added.
Retained Earnings 0
Dividends 600
Consulting revenue 5,800 d 250
f 1,800
Rental revenue 300
Depr. expense - c 375
Salaries expense 1,400 e 210
Insurance expense - a 100
Rent expense 1,000
Supplies expense - b 1,050
Utilities expense 230
Totals $45,300 $45,300 $3,785
McGraw-Hill/Irwin © $3,785
The McGraw-Hill Companies, Inc., 2008
 3-32
P2
FastForward - Trial Balance - December 31, 2007
Unadjusted Adjusted
Trial Balance Adjustments Trial Balance
Dr. Cr. Dr. Cr. Dr. Cr.
Cash 3,950 3,950
Accounts receivable - f 1,800 1,800
Supplies 9,720 b 1,050 8,670
Prepaid insurance 2,400 a 100 2,300
Equipment 26,000 26,000
Accum. depr. - Equip. - c 375 375
Accounts payable 6,200 6,200
Salaries payable - e 210 210
Unearned revenue 3,000 d 250 2,750
Common Stock 30,000 - 30,000
Retained Earnings - -
Dividends 600 600
Consulting revenue 5,800 d 250 7,850
f 1,800
Rental revenue 300 300
Depr. expense - c 375 375
Salaries expense 1,400 e 210
Finally, the 1,610
Insurance expense - a 100 totals are 100
Rent expense 1,000 determined. 1,000
Supplies expense - b 1,050 1,050
Utilities expense 230 230
Totals $45,300 $45,300 $3,785 $3,785 $47,685 $47,685
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-33
P3 Preparing Financial
Statements

Let’s use FastForward’s adjusted trial

balance to prepare the company’s
financial statements.

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

 3-34
P3 1. Prepare the Income
Statement

Adjusted
Trial Balance
December 31, 2007
Dr. Cr.
FastForward
Cash $ 3,950 Income Statement
Accounts receivable 1,800
For the Month Ended December 31, 2007
Supplies 8,670
Prepaid insurance 2,300 Revenues:
Equipment 26,000 Consulting revenue $ 7,850
Accum. depr. - Equip. $ 375
Accounts payable 6,200 Rental revenue 300
Salaries payable 210 Operating expenses:
Unearned revenue 2,750
Common Stock 30,000
Depr. expense - Equip. $ 375
Retained Earnings - Salaries expense 1,610
Dividends 600
Insurance expense 100
Consulting revenue 7,850
Rental revenue 300 Rent expense 1,000
Depr. expense 375 Supplies expense 1,050
Salaries expense 1,610
Insurance expense 100
Utilities expense 230
Rent expense 1,000 Total expenses 4,365
Supplies expense 1,050
Utilities expense 230
Net income $ 3,785
Totals $ 47,685 $ 47,685
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-35
P3 2. Prepare Statement of Retained Earnings

Note: Net Income from the Income

Statement carries to the Statement
of Retained Earnings.
FastForward
Income Statement
For the Month Ended December 31, 2007
Revenues:
Consulting revenue $ 7,850 FastForward
Rental revenue 300 Statement of Retained Earnings
Operating expenses:
Depr. expense - Equip. $ 375
For the Month Ended December 31, 2007
Salaries expense 1,610
Insurance expense 100
Rent expense 1,000
Retained earnings, 12/1/07 $ -0-
Supplies expense 1,050 Add: Net income 3,785
Utilities expense 230
Less: Dividends 600
Total expenses 4,365
Net income $ 3,785 Retained earnings 12/31/07 $ 3,185
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-36
P3
3. Prepare Balance Sheet

Adjusted FastForward
Trial Balance Balance Sheet
December 31, 2007
Dr. Cr.
Cash $ 3,950 Assets
Accounts receivable 1,800 Cash $ 3,950
Supplies 8,670 Accounts receivable 1,800
Prepaid insurance 2,300 Supplies 8,670
Equipment 26,000 Prepaid insurance 2,300
Accum. depr. - Equip. $ 375 Equipment 26,000
Accounts payable 6,200 Less: accum. depr. (375) 25,625
Salaries payable 210 Total assets $ 42,345
FastForward
Unearned revenue 2,750 Liabilities
Statement of Retained Earnings
Chuck Taylor, Capital 30,000 Accounts payable $ 6,200
ChuckForTaylor,
the Month
Withd'l.Ended December
600 31, 2007 Salaries payable 210
Consulting revenue 7,850 Unearned revenue 2,750
Rental revenue
Retained earnings, 12/1/07 $ 300 -0- Total liabilities $ 9,160
Depr. expense 375 Equity
Add: Net
Salaries income
expense 1,610 3,785
Common stock 30,000
Less: Dividends
Insurance expense 100 600 Retained earnings 3,185
Rent expenseearnings 12/31/07
Retained 1,000 $ 3,185 Total liabilities and equity $ 42,345
Supplies expense 1,050
Utilities expense 230
Totals $ 47,685 $ 47,685
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-37
C4
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.”
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 3-38
P4
Recording Closing Entries

1. Close revenue accounts.

2. Close expense accounts.
3. Close the income summary account.
4. Close dividends account.

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 3-39
P4
Recording Closing Entries

Salaries Expenses Consulting Revenues

$ 18,100 $ 25,000
Examine the
accounts
presented.
Income Summary Retained Earnings

$ 7,000

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 3-40
P4
Recording Closing Entries

Salaries Expenses Consulting Revenues

$ 18,100 $ 25,000 $ 25,000

Income Summary Close revenues

$ 25,000 with a debit to the
revenue account
and a credit to
Income Summary.
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 3-41
P4
Recording Closing Entries

Salaries Expenses Consulting Revenues

$ 18,100 $ 18,100 $ 25,000 $ 25,000

Income Summary Close expense

accounts with a
$ 18,100 $ 25,000
credit to expenses
and a debit to
Income Summary.

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 3-42
P4
Recording Closing Entries

Salaries Expenses Consulting Revenues

$ 18,100 $ 18,100 $ 25,000 $ 25,000

Income Summary
Determine the
$ 18,100 $ 25,000 balance in the
$ 6,900 Income Summary
account.

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 3-43
P4
Recording Closing Entries

Salaries Expenses Close the Income

$ 18,100 $ 18,100 Summary to
Retained Earnings.

Income Summary Retained Earnings

$ 18,100 $ 25,000 $ 7,000

$ 6,900
$ 6,900 $ 6,900

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 3-44
P4
Recording Closing Entries

The dividends account is closed to

Retained Earnings.
Dividends Retained Earnings
$ 2,000 $ 2,000 $ 2,000 $ 7,000
6,900

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 3-45
P4
Recording Closing Entries

The dividends account is closed to

Retained Earnings.
Dividends Retained Earnings
$ 2,000 $ 2,000 $ 2,000 $ 7,000
6,900
$ 11,900
Determine the
ending balance in
Retained Earnings.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 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.

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 3-47
C5
The Accounting Cycle
Start Prepare
Reverse
post-closing
(optional)
Analyze trial balance
transactions
Close
Journalize
Prepare
Post statements

Prepare Prepare
unadjusted Adjust adjusted
trial balance trial balance
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-48
C6
Classified Balance Sheet

Assets Liabilities and Equity

Current assets Current liabilities
Noncurrent assets: Noncurrent liabilities
Long-term investments Equity
Plant assets
Intangible assets

Current items are those expected to come due

(either collected or owed) within one year or the
company’s operating cycle, whichever is longer.

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 3-49
C6
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.

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 3-50
C6
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.

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 3-51
C6
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.

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 3-52
C6
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.

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 3-53
C6
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.

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 3-54
C6
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.

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 3-55
FastForward
Balance Sheet
December 31, 2007
Assets
Current Assets
Cash $ 3,950 Classified
Accounts receivable 1,800
Supplies 8,670 Balance
Prepaid insurance 2,300
Total Current Assets 16,720 Sheet
Plant Assets
Equipm ent 26,000
Less: accum . depr. (375) 25,625
Total assets $ 42,345
Liabilities
Current Liabilities
Accounts payable $ 6,200
Salaries payable 210
Unearned revenue 2,750
Total liabilities $ 9,160
Equity
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008
 3-56
A2
Profit Margin

The profit margin ratio measures the

company’s net income to net sales.

Year Profit Margin

2005 7.50%
2004Limited Brands,
8.00% Inc.
9.00%
2003 5.90%
8.00% 2002 6.20%
Profit Net Income 7.00%
= 6.00%
Profit Margin

Margin Net Sales 5.00%

4.00%
3.00%
2.00%
1.00%
0.00%
2005 2004 2003 2002
Year

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 3-57
A3
Current Ratio
This ratio is an important measure of a company’s ability to
pay its short-term obligations.
Current Current assets
=
ratio Current liabilities

Current Ratio

4.0
3.0
Limited Brands, Inc.
2.0
Industry average
1.0
-
2005 2004 2003 2002

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 3-58

End of Chapter 3

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