Chapter 4:
Preparing Financial Statements
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Preparing Financial Statements



Chapter 4 is a continuation of Chapter 3.
Once the general journal entries have been
posted and totaled, and a Trial Balance
prepared, additional activities must be
considered before preparing financials.
The remaining steps in the process are:
- Adjusting journal entries
- Adjusted Trial Balance
- Preparation of financial statements
- Closing journal entries
- Post-closing Trial Balance
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Why Use Adjusting Entries?

Accrual Basis
– recognize revenues in the period they are
earned
– recognize expenses in the period they are
incurred
– basis of the matching principle
 Adjusting
Journal Entries (AJEs) align
revenues and expenses at the end of
the accounting period (month, quarter,
year).
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Adjusting Journal Entries (AJEs)
Prepared at the end of the accounting
period to align revenues and expenses
(matching).
 Usually NO document flow to trigger
recording (internal transaction).
 Based on the accrual system of
accounting which records revenues as
earned and expenses as incurred (rather
than based on cash flows).

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Accrual System vs. Accrual AJEs



The “accrual system of accounting” and
“accrual of revenues and expenses” are both
discussed in this chapter.
Note that the “accrual of revenues and
expenses” is a subset of the AJEs discussed
in this chapter.
In comparison, the “accrual system of
accounting” refers to the entire process of
revenue and expense recognition, and relates
to the definitions of matching and revenue
recognition discussed in this chapter.
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The Revenue Recognition Principle

This principle determines when revenues
can be recognized.
 Revenue recognized when realized (or
realizable) and earned.
 This principle triggers the matching principle,
which is necessary for determining the
measure of performance.
 The most common point of revenue
recognition is when goods or services are
transferred or provided to the buyer (at
delivery).
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The Matching Principle

Matching focuses on the timing of recognition of
expenses after revenue recognition has been
determined.
 This principle states that the efforts of a given
period (expenses) should be matched against the
benefits (revenues) they generate.
 For example, the cost of inventory is initially
capitalized as an asset on the balance sheet; it is
not recorded in Cost of Goods Sold (expense) until
the sale is recognized.
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Types of AJEs
1. Accrual of expenses
2. Accrual of revenues
3. Prepaid (deferred) expenses
4. Unearned (deferred) revenues
Most AJEs fit into one of these four
categories.
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1. Accrual of Expenses

Probably the most common type of AJE.
Ex: accrue interest at the end of the period:
Interest Expense
xx
Interest Payable
xx
 Note: this is a “skeletal” journal entry, where the
“xx” simply indicates values to be calculated
later. The focus here is on the account and
direction.
 Other examples of expense/payable include
wages, rent, taxes, insurance.
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1. Accrual of Expenses - Example 1
Raider Company borrowed $10,000 on October
1, 2008. The note included a 5 percent annual
interest rate, payable each September 30,
starting Sept. 30, 2009. How much interest must
Raider accrue at Dec. 31, before financial
statements are prepared?
Calc: Principal x rate x time
P
x R x T
AJE:
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2. Accrual of Revenues
For revenues that have not yet been
recorded at the end of the period.
 Ex: accrue interest revenue:
Interest Receivable
xx
Interest Revenue
xx
 Another example of receivable/revenue
accruals relates to rent revenue, where
the rental payment has not yet been
received.

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2. Accrual of Revenues - Example 2
Raider Company leases out part of its
office building to Tu Company for $2,000
per month. At the end of the year, Tu
owes Raider for December’s rent.
Prepare the AJE for Raider Company:
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3.Prepaid (Deferred) Expenses

This category of AJE relates to the concept of
asset capitalization and the matching principle.
 Asset capitalization occurs when a cost (with
future economic benefit) is incurred. An asset is
recognized at that time. Examples include
supplies, prepaid Insurance, inventory, and long
term assets like equipment.
 As the asset is “used up” in the generation of
revenue, the related cost is recognized as an
expense (matching).
 Some expenses are deferred for a short period of
time (supplies expense), and some expenses are
deferred and allocated over many years
(depreciation expense).
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3. Prepaid Expenses

Example: Purchase 1-year insurance policy.
General JE at time of purchase:
Prepaid Insurance
xx
Cash
xx
AJE at end of the period (for the portion that
has been used):
Insurance Expense
xx
Prepaid Insurance
xx
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3.Prepaid Expenses - Example 3
Raider Company purchased a 1-year insurance
policy on April 1, 2008 at a cost of $2,400
General JE at time of purchase:
Prepaid Insurance
2,400
Cash
2,400
Calculation for AJE at December 31 to
recognize the portion that has been used up:
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3.Prepaid Expenses


Example: purchase of equipment.
General JE at time of purchase:
Equipment
xx
Cash
xx
AJE at end of the period (for the portion that
has been used):
Depreciation Expense
xx
Accumulated Depreciation
xx
Note: Accumulated Depreciation is a contra
asset account and is presented as an offset
to Equipment on the balance sheet (expanded
coverage in Chapter 8).
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3.Prepaid Expenses - Example 4
Raider Company purchased equipment in 2006
at a cost of $30,000. The equipment has a
useful life of 10 years and no salvage value.
Calculation for AJE at December 31, 2008 for
the current year’s depreciation.
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4.Unearned (Deferred) Revenues

Cash is received from customer before
goods/services are delivered (before revenue
can be recognized).
Ex: Received subscription in advance (other
examples include rent received in advance, and
advance collections for gift cards).
General JE at time cash received:
Cash
xx
Unearned Revenues
xx
AJE at end of the period (for portion earned):
Unearned Revenues
xx
Subscription Revenues
xx
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4.Unearned Revenues - Example 5
Raider Company received $6,000 on November
30, 2008 for subscriptions to be delivered over
the next 12 months, starting in December of
2008.
General JE at time cash received:
Cash
6,000
Unearned Revenues
6,000
AJE at end of the period (for portion earned):
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Class Problem – Prepare Adjusting Entries
The trial balance of Mega Company, Inc. at the end of its
annual accounting period is as follows:
Mega Company
Unadjusted Trial Balance
December 31, 2008
Cash
$ 3,000
Prepaid Insurance
1,600
Supplies
2,100
Equipment
20,000
Accumulated depreciation
$ 2,000
Common Stock
10,000
Retained Earnings
7,000
Dividends
1,000
Revenue
33,000
Salaries Expense
18,300
Rent Expense
6,000
______
Totals
$52,000
$52,000
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Adjusting Entries
1. Unexpired insurance at December 31 was
$1,000.
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Adjusting Entries
2. Unused supplies, per inventory, $800 at
December 31.
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Adjusting Entries
3. Estimated Depreciation for 2008 is $1,000
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Adjusting Entries
4. Earned but unpaid salaries at December
31, $700.
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Adjusted Trial Balance
The Adjusted Trial Balance reflects totals
after the AJEs are posted to the General
Ledger.
 The balance sheet accounts reflect the endof-year balances, and the income statement
accounts reflect the proper revenues and
expenses to be recognized for the year.
 This list of accounts and amounts is used to
prepare the Balance Sheet and Income
Statement.
 The adjusted trial balance for Mega
Company (after posting AJEs) is shown on
the next slide.

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Class Problem – Adjusted Trial Balance
Mega Company, Adjusted Trial Balance, 12/31/08
Cash
$ 3,000
Prepaid Insurance
1,000
Supplies
800
Equipment
20,000
Accumulated depreciation
$ 3,000
Salaries Payable
700
Common Stock
10,000
Retained Earnings
7,000
Dividends
1,000
Revenue
33,000
Salaries Expense
19,000
Rent Expense
6,000
Insurance Expense
600
Supplies Expense
1,300
Depreciation Expense
1,000
______
Totals
$53,700
$53,700
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Preparation of Financial Statements
from the Adjusted Trial Balance
The amounts in the Adjusted Trial Balance
are used to prepare the Balance Sheet and
the Income Statement.
 Retained Earnings has a unique treatment
in this process.
 The Retained Earnings on the Adjusted
Trial Balance is a beginning balance; while
the revenues, expenses, and dividends are
displayed in the Trial Balance, they have
not yet been included in (closed to)
Retained Earnings.

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Financial Statements

The Adjusted Trial Balance is used to prepare the
financial statements.
 The financial statements are prepared in the
following order:
– Income Statement (I/S)
– Statement of Retained Earnings (SRE)
– Balance Sheet (B/S)
 Note: The Statement of Cash Flow (SCF) is not
prepared from the Adjusted Trial Balance but from
a detailed analysis of the cash flow activities of
the company.
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Financial Statements

Comments on the preparation of financial
statements from Adjusted Trial Balance (ATB):
– revenue and expense balances from the ATB
are carried to the Income Statement.
– net income is carried to the Statement of
Retained Earnings.
– dividends are carried to the Statement of
Retained Earnings.
– the ending balance in the Statement of
Retained Earnings is carried to the
stockholders’ equity section of the Balance
Sheet.
– asset and liability balances from the ATB are
carried to the Balance Sheet.
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Closing Journal Entries (CJEs)
Prepared after the financial statements
have been completed.
 Close temporary (nominal) accounts to
Retained Earnings so that the balances in
those accounts at the start of the next
accounting period will be zero.
 Temporary accounts include revenues,
expenses, and dividends.

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Closing Journal Entries (CJEs)




First, close all revenues and expenses to
retained earnings (your text does this in 3
entries, and uses an Income Summary account
to break out the components). (Note that the
adjustment to RE in this entry carries the effect
of net income to retained earnings.)
Second, close dividends to retained earnings.
After these entries are posted, the temporary
accounts are now at zero, and the company is
ready to start the next period.
Note that the post-closing trial balance will
include only the permanent, balance sheet
accounts, and the retained earnings account is
finally the ENDING retained earnings.
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Closing Journal Entries (CJEs) - Example
Refer to Mega Company Adjusted Trial Balance.
Close revenues and expense to retained earnings:
Revenue
33,000
Salaries Expense
19,000
Rent Expense
6,000
Insurance Expense
600
Supplies Expense
1,300
Depreciation Expense
1,000
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Closing Journal Entries (CJEs) - Example
Refer to Mega Company. Now close the
balance in the Dividends account to
Retained Earnings.
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Closing Journal entries
Now post the effects of retained earnings to
the RE general ledger account.
Retained Earnings
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Post-closing Trial Balance
The final Trial Balance after closing will
display only permanent, balance sheet
accounts.
 The Retained Earnings in this Trial Balance
is the ENDING retained earnings for the
period and includes the effects of all the
revenues, expenses, and dividends for the
period.

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Class Problem – Postclosing Trial Balance
Mega Company, 12/31/08, Postclosing Trial Balance
Cash
$ 3,000
Prepaid Insurance
1,000
Supplies
800
Equipment
20,000
Accumulated depreciation
Salaries Payable
Common Stock
Retained Earnings
______
Totals
$24,800
$ 3,000
700
10,000
11,100
$24,800
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Review – Accounting Cycle
1.
2.
3.
4.
5.
6.
7.
8.
Analyze transactions.
Prepare general journal entries, and post
to general ledger.
Prepare unadjusted trial balance.
Prepare adjusting journal entries, and
post to general ledger.
Prepare adjusted trial balance.
Prepare financial statements.
Prepare closing journal entries, and post
to general ledger.
Prepare post-closing trial balance.
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