Chapter 3
Adjusting Accounts and
Preparing Financial
Statements
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2007
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
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2007
Analytical Chapter Objectives
A1: Explain how accounting adjustments
link to financial statements
A2: Compute profit margin and describe
its use in analyzing company
performance
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2007
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: Appendix A: Identify and explain
alternatives in accounting for prepaids
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2007
C1
The Accounting Period
Annually
1
2
Semiannually
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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C2
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
© The McGraw-Hill Companies, Inc., 2007
C2
Accrual Basis vs. Cash Basis
Example:
FastForward paid $2,400 for a 24-month insurance
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., 2007
Accrual Basis vs. Cash Basis
C2
Insurance Expense 2007
Jan
Feb
Mar
Apr
$
May
$
Jun
$
Jul
$
Aug
$
Sep
$
Oct
$
Nov
$
Dec
$
-
$
-
$
-
$
100
Insurance Expense 2008
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 2009
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
2007, $1,200 in 2008,
and $1,100 in 2009. The
expense is matched with
the periods benefited by
the insurance coverage.
© The McGraw-Hill Companies, Inc., 2007
Recognizing Revenues &
Expenses
C2

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., 2007
Recognizing Revenues &
Expenses
C1


Revenue Recognition
Now that we have
Matching
Summary
of Expenses
Rent
Gasoline
Advertising
Salaries
Utilities
and . . . .
McGraw-Hill/Irwin
$1,000
500
2,000
3,000
450
....
recognized the revenue,
let’s see what expenses
we incurred to
generate that revenue.
© The McGraw-Hill Companies, Inc., 2007
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
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., 2007
Adjusting Prepaid (Deferred)
Expenses
P1
Resources paid
for prior to
receiving the
actual benefits.
Asset
Unadjusted
Balance
McGraw-Hill/Irwin
Credit
Adjustment
Here is the check
for my first
six months’ rent.
Expense
Debit
Adjustment
© The McGraw-Hill Companies, Inc., 2007
P1
Prepaid Insurance
On December 1, 2007, Scott Company paid
$12,000 for 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
Prepaid Insurance
2,000
2,000
To record first month's expired insurance
Prepaid Insurance
Dec. 1 12,000 Dec. 31
Bal.
10,000
McGraw-Hill/Irwin
637
2,000
Insurance Expense
Dec. 31 2,000
128
© The McGraw-Hill Companies, Inc., 2007
Supplies
P1
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
Supplies
12,845
12,845
To record supplies used during 2007
126
Supplies
Bought 15,500 Dec. 31 12,845
Bal.
2,655
McGraw-Hill/Irwin
Supplies Expense
Dec. 31 12,845
652
© The McGraw-Hill Companies, Inc., 2007
Adjusting for Depreciation
P1
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 =
Useful Life
Expense
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2007
P1
Adjusting for Depreciation
On January 1, 2007, Barton, Inc. purchased
equipment for $62,000 cash. The equipment has
an estimated useful life of five 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 =
=
Expense
5
McGraw-Hill/Irwin
$12,000
© The McGraw-Hill Companies, Inc., 2007
P1
Adjusting for Depreciation
On January 1, 2007, Barton, Inc. purchased
equipment for $62,000 cash. The equipment has an
estimated useful life of five 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
Accumulated Depreciation - Equipment
12,000
12,000
To record equipment depreciation
Accumulated depreciation is
a contra asset account.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2007
P1
Adjusting for Depreciation
Dec. 31 Depreciation Expense
Accumulated Depreciation - Equipment
12,000
12,000
To record equipment depreciation
Equipment
1/1 62,000
Depreciation Expense
12/31 12,000
Accumulated
Depreciation 12/31 12,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2007
P1
Adjusting for Depreciation
Barton, Inc.
Partial Balance Sheet
At December 31, 2007
$
Assets
Cash
.
Equipment
Less: accumulated deprec.
.
.
Total Assets
McGraw-Hill/Irwin
$ 62,000
(12,000)
Equipment is
shown net of
accumulated
depreciation.
50,000
© The McGraw-Hill Companies, Inc., 2007
P1
Adjusting Unearned (Deferred)
Revenues
Cash received in
advance of
providing
products or
services.
Liability
Debit
Adjustment
McGraw-Hill/Irwin
Unadjusted
Balance
Buy your season tickets for
all home basketball games NOW!
“Go Big Blue”
Revenue
Credit
Adjustment
© The McGraw-Hill Companies, Inc., 2007
P1
Adjusting 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
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2007
P1
Adjusting Unearned (Deferred)
Revenues
On December 31, Ox University has played 10
of its regular home games, winning two and
losing eight.
Dec. 31 Unearned Revenue
50,000
Basketball Revenue
50,000
To recognize 10-games played
Unearned Revenue
Dec 31 50,000
Oct 1 100,000
Bal
50,000
McGraw-Hill/Irwin
Basketball Revenue
Dec. 31 50,000
© The McGraw-Hill Companies, Inc., 2007
P1
Adjusting for 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., 2007
P1
Adjusting for 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. They will not be paid until the next
Friday, 1/02/08.
Last pay
date
12/26/07
Next pay
date
1/2/08
12/31/07
Year end
McGraw-Hill/Irwin
Record adjusting
journal entry.
© The McGraw-Hill Companies, Inc., 2007
P1
Adjusting for 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 of the week ended 1/02/08.
Dec. 31 Salaries Expense
Salaries Payable
47,250
47,250
To accrue three days' salary
Salaries Expense
Other salaries
657,500
Dec. 31 47,250
Bal.
704,750
McGraw-Hill/Irwin
Salaries Payable
Dec. 31 47,250
© The McGraw-Hill Companies, Inc., 2007
P1
Adjusting for 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., 2007
P1
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, 2007, the
end of the company’s fiscal year.
Dec. 31 Accounts Receivable
Service Revenue
31,200
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., 2007
A1
Links to Financial Statements
Summary of Adjustments and Financial Statement Links
Before Adjustment
Income
Balance Sheet
Statement
Account
Account
Type
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
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2007
P2
FastForward - Trial Balance - December 31, 2007
Cash
Accounts receivable
Supplies
Prepaid insurance
Equipment
Accum. depr. - Equip.
Accounts payable
Salaries payable
Unearned revenue
Capital
Withdrawals
Consulting revenue
Rental revenue
Depr. expense
Salaries expense
Insurance expense
Rent expense
Supplies expense
Utilities expense
Totals
McGraw-Hill/Irwin
Trial Balance
Dr.
Cr.
3,950
9,720
2,400
26,000
Adjustments
Dr.
6,200
3,000
30,000
600
5,800
300
1,400
1,000
230
45,300
Cr.
Adjusted Trial Balance
Dr.
Cr.
First, the
initial
unadjusted
amounts are
added to the
worksheet.
45,300
© The McGraw-Hill Companies, Inc., 2007
P2
FastForward - Trial Balances - December 31, 2007
Cash
Accounts receivable
Supplies
Prepaid insurance
Equipment
Accum. depr. - Equip.
Accounts payable
Salaries payable
Unearned revenue
Capital
Withdrawals
Consulting revenue
Rental revenue
Depr. expense
Salaries expense
Insurance expense
Rent expense
Supplies expense
Utilities expense
McGraw-Hill/Irwin
Totals
Unadjusted
Trial Balance
Dr.
Cr.
3,950
9,720
2,400
26,000
Adjustments
Dr.
f
6,200
3,000 d
30,000
Adjusted
Trial Balance
Dr.
Cr.
Cr.
1,800
b
a
1,050
100
c
375
e
210
d
f
250
1,800
250
Next,
FastForward’s
adjustments
are added.
600
5,800
300
1,400
1,000
230
$45,300
$45,300
c
e
a
375
210
100
b
1,050
$3,785
©$3,785
The McGraw-Hill Companies, Inc., 2007
P2
FastForward - Trial Balance - December 31, 2007
Cash
Accounts receivable
Supplies
Prepaid insurance
Equipment
Accum. depr. - Equip.
Accounts payable
Salaries payable
Unearned revenue
Capital
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.
f
6,200
3,000
30,000
d
Cr.
1,800
b
a
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
$45,300
375
6,200
210
2,750
30,000
300
c
e
a
375
210
100
b
1,050
$3,785
Finally, the
totals are
determined.
$3,785
375
1,610
100
1,000
1,050
230
$47,685
$47,685
© The McGraw-Hill Companies, Inc., 2007
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., 2007
P3
1. Prepare the Income Statement
Adjusted
Trial Balance
December 31, 2007
Dr.
Cr.
Cash
Accounts receivable
Supplies
Prepaid insurance
Equipment
Accum. depr. - Equip.
Accounts payable
Salaries payable
Unearned revenue
Capital
Withdrawals
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
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
$
2007
7,850
300
4,365
3,785
© The McGraw-Hill Companies, Inc., 2007
FastForward
Income Statement
For the Month Ended December 31, 2007
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
2. 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, 2007
C. Taylor, Capital 12/1/07
Add: Net income
$
Investment by owner
Total
Less: Withdrawal by owner
C. Taylor, Capital 12/31/07
McGraw-Hill/Irwin
$
3,785
30,000
-0-
33,785
33,785
600
$ 33,185
© The McGraw-Hill Companies, Inc., 2007
Preparation of Balance Sheet
FastForward
Balance Sheet
12/31/07
Assets
Cash
Accounts Receivable
Supplies
Prepaid Insurance
Equipment
$
Accumulated Depreciation
Total assets
$
26,000
375
$
3,950
1,800
8,670
2,300
25,625
42,345
Liabilities
Accounts Payable
Salaries Payable
Unearned Revenue
Total Liabilities
6,200
210
2,750
9,160
Equity
McGraw-Hill/Irwin
C Taylor, Capital
Total liabilities and Equity
$
33,185
© The
McGraw-Hill Companies, Inc., 2007
42,345
Profit Margin
A2
The profit margin ratio measures the
company’s net income to net sales.
Year
Profit Margin
2005Limited Brands,
7.50% Inc.
2004
8.00%
2003
5.90%
2002
6.20%
9.00%
8.00%
Profit
Net Income
=
Margin
Net Sales
Profit Margin
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
2005
2004
2003
2002
Year
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2007
End of Chapter 3
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2007