Adjusting Accounts
Chapter and Preparing
Financial Statements
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2005
Learning objective
1. Periodic reporting / Time period principle
2. Accrual Accounting and Cash Accounting
3. Account Adjustment




Prepaid expense
Unearned revenue
Accrued expense
Accrued revenue
4. Adjusted Trial Balance (ATB)
5. Preparation of Financial statement from ATB
6. Decision Analysis: Profit Margin
•
McGraw-Hill/Irwin
Case: Intel & AMD
© The McGraw-Hill Companies, Inc., 2005
1. Periodic reporting
The Accounting Period
Annual
1
2
Semiannual
1
2
3
4
Quarterly
1
Jan
2
3
4
Feb
Mar
Apr
5
6
7
May Jun Jul
8
9
10
Aug Sep Oct
11
12
Nov Dec
Monthly
McGraw-Hill/Irwin
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The 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).
McGraw-Hill/Irwin
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2. Accrual Basis vs. Cash Basis
Accrual Basis
Cash Basis
Revenues are
recognized when
earned and expenses
are recognized when
incurred.
Revenues are
recognized when
cash is received and
expenses recorded
when cash is paid.
Not GAAP
Accounting
McGraw-Hill/Irwin
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Accrual Basis vs. Cash Basis
Example:
FastForward paid $2,400 for a 24-month insurance
policy beginning December 1, 2004.
Insurance Expense 2004
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 2004. No
insurance expense from this policy would be recognized
in 2005 or 2006, periods covered by the policy.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2005
Accrual Basis vs. Cash Basis
Insurance Expense 2004
Jan
Feb
Mar
Apr
$
May
$
Jun
$
Jul
$
Aug
$
Sep
$
Oct
$
Nov
$
Dec
$
-
$
-
$
-
$
100
Insurance Expense 2005
Jan
Feb
Mar
Apr
$
100
May
$
100
Jun
$
100
Jul
$
100
Aug
$
100
Sep
$
100
Oct
$
100
Nov
$
100
Dec
$
100
$
100
$
100
$
100
Insurance Expense 2006
Jan
Feb
Mar
Apr
$
100
May
$
100
Jun
$
100
Jul
$
100
Aug
$
100
Sep
$
100
Oct
$
100
Nov
$
100
Dec
McGraw-Hill/Irwin
$
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.
© The McGraw-Hill Companies, Inc., 2005
Recognizing Revenues and Expenses
 Revenue Recognition
We have delivered the
product to our customer,
so I think we should record
the revenue earned.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2005
Recognizing Revenues and Expenses
 Revenue Recognition
 Matching Principle
Summary
of Expenses
Rent
Gasoline
Advertising
Salaries
Utilities
and . . . .
McGraw-Hill/Irwin
$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.
© The McGraw-Hill Companies, Inc., 2005
Recognizing Revenues and Expenses
 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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2005
3. 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
expense (or revenue) recognized
Prepaid
(Deferred)
expenses*
McGraw-Hill/Irwin
Unearned
(Deferred)
revenues
*including depreciation
Paid (or received) cash after
expense (or revenue) recognized
Accrued
expense
Accrued
revenues
© The McGraw-Hill Companies, Inc., 2005
Adjusting Accounts – Prepaid expenses
Actually used
Paid Cash
Accounting
Period 1
Accounting
Period 2
Accounting
Period 4
Accounting
Period 3
E.g. Paid
4 years
rental fee
$ 4 million
At the beginning of period 1 recognize all cash payment as prepaid
expense (asset account):

Dr. Prepaid Rent Expense
Cr. Cash
4 million
4 million
At the end of each accounting period recognize the portion that is
used

Dr. Rent Expense
Cr. Prepaid Rent Expense
McGraw-Hill/Irwin
1 million
1 million
© The McGraw-Hill Companies, Inc., 2005
Adjusting Accounts – Unearned revenue
Received 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
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
Cr. Revenue
McGraw-Hill/Irwin
10 million
10 million
© The McGraw-Hill Companies, Inc., 2005
Adjusting Accounts – Accrued expenses
Received Cash
Accounting
Period 1

Interest expense incurred
Accounting
Period 2
Accounting
Period 3
When borrowing money:
Paid Cash
Accounting
Period 4
E.g. Borrow 40
million from bank.
Annual interest
rate is 10%.
Interest and
principal are paid
at the end of 4th
year.
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
McGraw-Hill/Irwin
56 million
© The McGraw-Hill Companies, Inc., 2005
Adjusting Accounts – Accrued revenues
Revenue Earned
Received Cash
Long-term
Contract:
Received $40
million after
building one ship
Accounting
Period 1
Accounting
Period 2
Accounting
Period 3
Accounting
Period 4
 At the end of each accounting period (1 to 4) recognize the portion of
revenue that is earned but not received:
Dr. Accounts Receivable
Cr. Revenue
10 million
10 million
 At the end of period 4:
Dr. Cash
40 million
Cr. Accounts receivable
40 million
McGraw-Hill/Irwin
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Prepaid expense
Resources paid
for prior to
receiving the
actual benefits.
Asset
Unadjusted
Balance
McGraw-Hill/Irwin
Credit
Adjustment
Here is the check
for my first
6 months’ rent.
Expense
Debit
Adjustment
© The McGraw-Hill Companies, Inc., 2005
Prepaid 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?
Dec. 31 Dr. Insurance Expense
Cr. Prepaid Insurance
100
100
To record first month's expired insurance
Prepaid Insurance
Dec. 1
2,400 Dec. 31
Bal.
2,300
McGraw-Hill/Irwin
128
100
Insurance Expense
Dec. 31
100
637
© The McGraw-Hill Companies, Inc., 2005
Prepaid 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?
Dec. 31 Dr. Supplies Expense
Cr. Supplies
1,050
1,050
To record supplies used during 2004
126
Supplies
Bought 9,720 Dec. 31 1,050
Bal.
8,670
McGraw-Hill/Irwin
Supplies Expense
Dec. 31 1,050
652
© The McGraw-Hill Companies, Inc., 2005
Prepaid expense 3
Depreciation
Depreciation is the process of allocating the cost of plant
and equipment over their expected useful lives.
Straight-Line
Asset Cost - Salvage Value
Depreciation =
Useful Life
Expense
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2005
Adjusting 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.
2004
Depreciation
Expense
=
$26,000 - $8,000
=
48
$375
Dec. 31 Dr. Depreciation Expense
375
Cr. Accumulated Depreciation - Equipment
375
To record equipment depreciation
Accumulated depreciation is
a contra asset account.
McGraw-Hill/Irwin
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contra 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.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2005
Adjusting for Depreciation
Dec. 31 Dr. Depreciation Expense
Cr. Accumulated Depreciation - Equipment
375
375
To record equipment depreciation
Equipment
Depreciation Expense
1/1 26,000
12/31
375
Accumulated Depreciation
12/31
McGraw-Hill/Irwin
375
© The McGraw-Hill Companies, Inc., 2005
Adjusting for Depreciation
Fastforward
Partial Balance Sheet
At December 31, 2004
Assets
Cash
.
Equipment
Less: accumulated deprec.
.
.
Total Assets
McGraw-Hill/Irwin
$
$ 26,000
(375)
25,625
Equipment is
shown net of
accumulated
depreciation.
© The McGraw-Hill Companies, Inc., 2005
Unearned (Deferred) Revenues
Cash received in
advance of
providing
products or
services.
Liability
Debit
Adjustment
McGraw-Hill/Irwin
Unadjusted
Balance
E.g. The New York Times
Company: Subscriptionsunearned revenue.
Revenue
Credit
Adjustment
© The McGraw-Hill Companies, Inc., 2005
Adjusting 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
Unearned Revenue
Dec 26
3,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2005
Adjusting 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.
Unearned Revenue
Dec. 31 250
Dec. 26 3000
Bal. 2,750
McGraw-Hill/Irwin
Consulting Revenue
Dec.5
4,200
Dec. 12
1,600
Dec. 31
250
Balance 6,050
© The McGraw-Hill Companies, Inc., 2005
Accrued Expenses
Costs incurred in a
period that are
both unpaid and
unrecorded.
Expense
Debit
Adjustment
McGraw-Hill/Irwin
We’re about one-half
done with this job and
want to be paid for
our work!
Liability
Credit
Adjustment
© The McGraw-Hill Companies, Inc., 2005
Adjusting 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.
Last pay
date
12/26/04
12/1/04
McGraw-Hill/Irwin
Next pay
date
1/2/05
12/31/04
Year end
Record adjusting
journal entry.
© The McGraw-Hill Companies, Inc., 2005
Adjusting 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.
Dec. 31 Dr. Salaries Expense
Cr. Salaries Payable
210
210
To accrue 3-days' salary
Salaries Expense
Dec.12
700
Dec. 26
700
Dec. 31
210
Bal.
1,610
McGraw-Hill/Irwin
Salaries Payable
Dec. 31 210
© The McGraw-Hill Companies, Inc., 2005
Accrued Revenues
Revenues earned
in a period that
are both
unrecorded and
not yet received.
Asset
Debit
Adjustment
McGraw-Hill/Irwin
Yes, I’ve completed your
tax return, but have not had
time to bill you yet.
Revenue
Credit
Adjustment
© The McGraw-Hill Companies, Inc., 2005
Adjusting 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.
Dec. 31 Dr. Accounts Receivable 31,200
Cr. Service Revenue
31,200
To accrue revenue earned
Accounts Receivable
Other receivables
1,325,268
Dec. 31
31,200
Bal.
1,356,468
McGraw-Hill/Irwin
Service Revenue
Other revenues
6,589,500
Dec. 31
31,200
Bal .
6,620,700
© The McGraw-Hill Companies, Inc., 2005
Adjusting 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
Cr. Consulting Revenue
1,800
1,800
To accrue revenue earned
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2005
Adjusting Accrued Revenues
Accounts Receivable
Dec.12 1,900 Dec. 22 1,900
Dec.31
1,800
Bal.
1,800
McGraw-Hill/Irwin
Consulting Revenue
Dec.5
4,200
Dec. 12
1,600
Dec. 31
250
Dec. 31
1,800
Balance 7,850
© The McGraw-Hill Companies, Inc., 2005
Future 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
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2005
Links to Financial Statements
Summary of Adjustments and Financial Statement Links
Before Adjustment
Income
Balance
Statement
Sheet Account
Account
Type
Adjusting Entry
Prepaid
Asset
Expense
Dr. Expense
Expenses
Overstated
Understated
Cr. Asset
Unearned
Liability
Revenue
Dr. Liability
Revenues
Overstated
Understated
Cr. Revenue
Accrued
Liability
Expense
Dr. Expense
Expenses
Understated
Understated
Cr. Liability
Accrued
Asset
Revenue
Dr. Asset
Revenues
Understated
Understated
Cr. Revenue
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2005
4. Adjusted Trial Balance
 Explain and prepare an adjusted trial balance.
 Prepare financial statements from an adjusted
trial balance.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2005
FastForward
Trial Balance
December 31, 2004
$
Cash
Accounts receivable
Supplies
Prepaid insurance
Equipment
Accum. depr. - Equip.
Accounts payable
Salaries payable
Unearned revenue
Chuck Taylor, Capital
Chuck Taylor, Withdrawals
Consulting revenue
Rental revenue
Depr. expense
Salaries expense
Insurance expense
Rent expense
Supplies expense
Utilities expense
Totals
McGraw-Hill/Irwin
Unadjusted
Trial Balance
Dr.
Cr.
3,950
9,720
2,400
26,000
$
Adjustments
Dr.
Cr.
6,200
3,000
30,000
600
5,800
300
$
1,400
1,000
230
45,300
$
Adjusted
Trial Balance
Dr.
Cr.
First, the
initial
unadjusted
amounts are
added to the
worksheet.
45,300
© The McGraw-Hill Companies, Inc., 2005
FastForward
Trial Balance
December 31, 2004
$
Cash
Accounts receivable
Supplies
Prepaid insurance
Equipment
Accum. depr. - Equip.
Accounts payable
Salaries payable
Unearned revenue
Chuck Taylor, Capital
Chuck Taylor, Withdrawals
Consulting revenue
Rental revenue
Depr. expense
Salaries expense
Insurance expense
Rent expense
Supplies expense
Utilities expense
Totals
McGraw-Hill/Irwin
Unadjusted
Trial Balance
Dr.
Cr.
3,950
9,720
2,400
26,000
$
Adjusted
TrialNext,
Balance
Dr.
Cr.
FastForward’s
Adjustments
Dr.
Cr.
f $
1,800
b
a
6,200
3,000 d
30,000
$
1,050
100
c
375
e
210
d
f
250
1,800
3,785 $
3,785
adjustments
are added.
250
600
5,800
300
$
1,400
1,000
230
45,300
$
c
e
a
375
210
100
b
1,050
45,300 $
© The McGraw-Hill Companies, Inc., 2005
Finally, the totals are
determined.
Cash
$
Accounts receivable
Supplies
Prepaid insurance
Equipment
Accum. depr. - Equip.
Accounts payable
Salaries payable
Unearned revenue
Chuck Taylor, Capital
Chuck Taylor, Withdrawals
Consulting revenue
Rental revenue
Depr. expense
Salaries expense
Insurance expense
Rent expense
Supplies expense
Utilities expense
Totals
McGraw-Hill/Irwin
FastForward
Trial Balance
December 31, 2004
Unadjusted
Trial Balance
Dr.
Cr.
3,950
9,720
2,400
26,000
$
Adjustments
Dr.
Cr.
$
f $
1,800
b
a
6,200
3,000 d
30,000
$
1,050
100
c
375
e
210
Adjusted
Trial Balance
Dr.
Cr.
3,950
1,800
8,670
2,300
26,000
$
250
600
600
5,800
d
f
250
1,800
7,850
300
$
1,400
1,000
230
45,300
$
375
6,200
210
2,750
30,000
300
c
e
a
375
210
100
b
1,050
45,300 $
3,785 $
3,785 $
375
1,610
100
1,000
1,050
230
47,685 $
47,685
© The McGraw-Hill Companies, Inc., 2005
5. 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
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2005
Adjusted
Trial Balance
December 31, 2004
Dr.
Cr.
Cash
Accounts receivable
Supplies
Prepaid insurance
Equipment
Accum. depr. - Equip.
Accounts payable
Salaries payable
Unearned revenue
Chuck Taylor, Capital
Chuck Taylor, Withd'l.
Consulting revenue
Rental revenue
Depr. expense
Salaries expense
Insurance expense
Rent expense
Supplies expense
Utilities expense
Totals
McGraw-Hill/Irwin
$
3,950
1,800
8,670
2,300
26,000
$
375
6,200
210
2,750
30,000
600
7,850
300
375
1,610
100
1,000
$
1,050
230
47,685
$
47,685
Prepare the Income
Statement.
FastForward
Income Statement
For the Month Ended December 31,
Revenues:
Consulting revenue
$
Rental revenue
Operating expenses:
Depr. expense - Equip. $
375
Salaries expense
1,610
Insurance expense
100
Rent expense
1,000
Supplies expense
1,050
Utilities expense
230
Total expenses
Net income
$
2004
7,850
300
4,365
3,785
© The McGraw-Hill Companies, Inc., 2005
FastForward
Income Statement
For the Month Ended December 31, 2004
Revenues:
Consulting revenue
$
7,850
Rental revenue
300
Operating expenses:
Depr. expense - Equip. $
375
Salaries expense
1,610
Insurance expense
100
Rent expense
1,000
Supplies expense
1,050
Utilities expense
230
Total expenses
4,365
Net income
$
3,785
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.
FastForward
Statement of Changes in Owner's Equity
For the Month Ended December 31, 2004
C. Taylor, Capital 12/1/04
Add: Net income
$ 3,785
Investment by owner
30,000
Total
Less: Withdrawal by owner
C. Taylor, Capital 12/31/04
McGraw-Hill/Irwin
$
-0-
33,785
33,785
600
$ 33,185
© The McGraw-Hill Companies, Inc., 2005
Adjusted
Trial Balance
Dr.
Cr.
Cash
$
3,950
Accounts receivable
1,800
Supplies
8,670
Prepaid insurance
2,300
Equipment
26,000
Accum. depr. - Equip.
$
375
Accounts payable
6,200
Salaries payable
210
Unearned revenue
2,750
Chuck Taylor, Capital
30,000
FastForward
ChuckStatement
Taylor, Withd'l.
600 Equity
of Changes in Owner's
Consulting
revenue
For the
Month Ended December 31, 2004 7,850
Rental revenue
300
C. Taylor,
Capital 12/1/01
$
-0Depr.
expense
375
Add: Net income
$
3,785
Salaries expense
1,610
Investment by owner
30,000
33,785
Insurance expense
100
Total
33,785
Rent
expense
1,000
Less: Withdrawal by owner
600
Supplies
expense
1,050
C. Taylor, Capital 12/31/01
$ 33,185
Utilities expense
230
Totals
$
47,685
$ 47,685
McGraw-Hill/Irwin
FastForward
Balance Sheet
December 31, 2001
Assets
Cash
Accounts receivable
Supplies
Prepaid insurance
Equipment
Less: accum. depr.
Total assets
$
26,000
(375)
3,950
1,800
8,670
2,300
$
25,625
42,345
$
9,160
$
33,185
42,345
Liabilities
Accounts payable
$ 6,200
Salaries payable
210
Unearned consulting revenues
2,750
Total liabilities
Owner's Equity
Chuck Taylor, Capital
Total liabilities and equity
Prepare the
Balance Sheet.
© The McGraw-Hill Companies, Inc., 2005
Homework for Chap 1, 2



Homework sheet: Q.
Please submit hard copy.
Please submit on time for me to keep your
homework record.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2005