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Adjusting Accounts & Financial Statements
- 1. Chapter 5 Adjusting Accounts and Preparing Financial Statements Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
- 2. Learning Objective 1 Explain accrual accounting and how it improves financial statements. LO1 5-
- 3. Accrual Basis verses Cash Basis Accrual basis accounting uses the adjusting process to recognize revenues when earned and expenses when incurred. Cash basis accounting recognizes revenue when cash is received and records expenses when cash is paid. It is commonly held that accrual accounting better reflects business performance than cash basis accounting. LO1 5-
- 4. Recognizing Revenues and Expenses Time period assumption assumes a business’ activities can be divided into specific periods, such as a month or year. Reports that cover a period of one year are called annual financial statements. Interim financial statements cover one, three, or six months of activity. LO1 5-
- 5. Learning Objective 2 Identify the types of accounting adjustments and their purpose. LO2 5-
- 6. Types of Adjustments Adjustments are necessary for transactions that extend over more than one accounting period. Adjustments Cash before work (Deferrals) Work before cash (Accruals) Unearned (Deferred) revenues Prepaid (deferred) expenses Accrued revenues Accrued expenses LO2 5-
- 7. Learning Objective 3 Prepare and explain adjusting entries. LO3 5-
- 9. Prepaid Expenses Here is the check for my first six months’ rent. Resources paid for prior to receiving the actual benefits. LO3 5- Asset Expense Unadjusted Balance Credit Adjustment Debit Adjustment
- 12. Depreciation Depreciation is the process of spreading the costs of plant and equipment over their expected useful lives. LO3 5- Straight-Line Depreciation Expense = Asset Cost - Salvage Value Useful Life
- 14. Depreciation FastForward purchased equipment for $26,000 in early December. The equipment is expected to have a useful life of four years and a salvage value of $8,000. LO3 5- Accumulated depreciation is a contra asset account.
- 15. Depreciation LO3 5- Equipment Depreciation Expense 12/1 26,000 12/31 375 Accumulated Depreciation 12/31 375
- 16. Depreciation Equipment is shown net of accumulated depreciation. $ LO3 5-
- 17. Accrued Expenses We’re about one-half done with this job and want to be paid for our work! Costs incurred in a period that are both unpaid and unrecorded. LO3 5- Expense Liability Credit Adjustment Debit Adjustment
- 18. Accrued Salaries Expense FastForward’s employee earns $70 per day, or $350 for a five-day workweek beginning on Monday and ending on Friday. This employee is paid every two weeks on Friday. On December 12 and 26, the wages are paid, recorded in the journal, and posted to the ledger. At December 31, the employee has worked for three days for FastForward and will be paid on January 9, 2011. LO3 5- 12/31/10 Year end Last pay date 12/26/10 Next pay date 1/9/11 Record adjusting journal entry.
- 19. Accrued Salaries Expense LO3 5-
- 20. Learning Objective 4 Explain and prepare an adjusted trial balance. LO4 5-
- 21. Trial Balance LO4 5- An unadjusted trial balance is a list of accounts and balances prepared before adjustments are recorded. An adjusted trial balance is a list of accounts and balances prepared after adjusting entries have been recorded and posted to the ledger.
- 22. Adjusted Trial Balance LO4 5-
- 23. Learning Objective 5 Prepare financial statements from an adjusted trial balance. LO5 5-
- 24. Preparing Financial Statements LO5 5-
- 25. Preparing Financial Statements Note: Investment by owner and withdrawals by owner come from the adjusted trial balance. LO5 5-
- 26. Preparing Financial Statements LO5 5-
- 27. End of Chapter 5
Hinweis der Redaktion
- Chapter 5: Adjusting Accounts and Preparing Financial Statements
- Learning objective number 1 is to explain accrual accounting and how it improves financial statements.
- Accrual basis accounting uses the adjusting process to recognize revenues when earned and expenses when incurred. Sometimes cash is received before the revenue is earned. Likewise, sometimes cash is paid before an expense is incurred. Cash basis accounting recognizes revenue when cash is received and records expenses when cash is paid. This means that cash basis net income is the difference between cash receipts and cash payments.
- We use the time period assumption to divide a company’s activities into specific time periods, but not all activates are complete when financial statements are prepared. Therefore adjustments are required to correct the account balances.
- Learning objective number 2 is to identify the types of accounting adjustments and their purpose.
- The right side of this exhibit shows accrued revenues and accrued expenses, which reflect transactions when cash is paid or received after a related expense or revenue is recognized. The left side shows unearned revenues and prepaid expenses (including prepaid rent and depreciation). This reflects the transactions when cash is paid or received before a related expense (or revenue) is deferred until after the related cash is paid (or received).
- Learning objective number 3 is to prepare and explain adjusting entries.
- Part I The process of adjusting accounts involves analyzing each account balance and the transactions that affect it to determine any needed adjustments. Adjustments are considered internal transactions because they do not involve outside parties. An adjusting entry is recorded to bring an asset or liability account balance to its proper amount. This entry also updates a related expense or revenue account. Part II Making adjusting entries is three-step process: 1. Determine the current account balance. 2. Determine what the current account balance should be. Record the adjusting journal entry to get from step 1 to step 2.
- Part I Let’s start by looking at how to adjust prepaid expenses. Remember that a prepaid expense is an asset that results from the payment of cash before the expense is recognized. An example we talked about in an earlier chapter was prepaid insurance on your car. Another example might be prepaid rent. Part II For all adjustments involving prepaid expenses, we increase, or debit, an expense account and reduce, or credit, an asset account. Now, let’s look at an example.
- Part I On December 1, 2010, FastForward paid $2,400 to cover its insurance for 24 months. When FastForward made the payment, it debited prepaid insurance and credited cash. Let’s look at the adjusting entry we would make on December 31, 2010. So, step one in our adjustment process indicates that the current account balance in prepaid insurance is $2,400. Step two asks what should the current balance be in the account. In other words, does FastForward still have $2,400 of prepaid insurance to use? The answer is no. It has used one month of insurance. Part II Step three is to determine how much has been used. FastForward has used $100 ($2,400 divided by 24 months) of insurance in December. So, our adjusting entry would be a debit to insurance expense and credit to prepaid insurance for $100. Now we have recorded the insurance expense for December, 2010. Let’s post the adjusting entry and see what the ledger account looks like on December 31. Part III The prepaid insurance account is reduced from $2,400 to $2,300 showing that FastForward used $100 of the prepaid insurance. The $2,300 represents the prepaid insurance for the next 23 months. The insurance expense account now has a $100 balance, which represents the amount of the insurance used for December 2010.
- Part I In our second transaction, FastForward is focusing on the supplies account. During December, FastForward purchased supplies of $9,720. When FastForward purchased the supplies, it debited supplies. On December 31, a count of the supplies indicated $8,670 on hand. Let’s look at the adjusting entry we would make on December 31, 2010. Step one in our adjustment process indicates that the current account balance in supplies is $9,720. Step two asks what should the current balance be in the account. In other words, does FastForward still have $9,720 of supplies to use? The answer is no. The count of supplies indicated that it only had $8,670 on hand to use. Part II Step three is to determine how much has been used. FastForward has used $1,050 of supplies in December. We determine this by taking the beginning balance of $9,720 and subtracting $8,670. So, our adjusting entry would be a debit to supplies expense and a credit to supplies for $1,050. Now we have recorded the amount of supplies FastForward used in December, 2010. Let’s post the adjusting entry and see what the ledger account looks like on December 31. Part III The supplies account is reduced from $9,720 to $8,670 showing that FastForward used $1,050 of supplies. The $8,670 represents the supplies on hand for future use. The supplies expense account now has a $1,050 balance, which represents the amount of the supplies used in December 2007.
- A special category of prepaid expenses is plant assets, which refers to long-term tangible assets used to produce and sell products and services. Depreciation is the process of allocating the cost of a plant asset over its useful life in a systematic and rational manner. At this point in the accounting process, we want to introduce you to a depreciation method known as straight-line depreciation. Straight-line depreciation is the most popular method used by companies. Companies determine the amount of annual depreciation by taking the cost of the plant assets, subtracting the estimated salvage value, and dividing that amount by the useful life of the asset. The salvage value is the amount we expect to receive for the asset when we dispose of it at the end of its useful life. In a later chapter, we will discuss other acceptable methods of depreciation. For now, let’s look at the adjusting entry to record depreciation expense.
- Part I FastForward purchased equipment for $26,000 in early December. The equipment is expected to have a useful life of four years and a salvage value of $8,000. What is the amount of the depreciation expense for December 2010? Part II How did you do? The numerator of the equation is cost of $26,000 minus salvage value of $8,000, and the denominator is 48 months. So our monthly depreciation expense is $375. Now, let’s record the adjusting journal entry.
- Part I On December 31, 2010, FastForward will debit depreciation expense and credit a new account called accumulated depreciation equipment for $375. Part II Accumulated depreciation is a contra asset account. A contra-account means that the amount in the account reduces the related asset account. In our case, accumulated depreciation will reduce the asset account, equipment. Because this is a relatively new type of account, let’s look at the treatment of the contra and related asset account.
- On this slide, you can see the affect on the accounts when we post the adjusting entry to record depreciation expense. We have also shown you the balance in the equipment account, even though the account balance does not change. Just like all other expenses, the depreciation expense account will appear on our income statement for the year ended December 31, 2010. Let’s see how we will deal with the other two accounts.
- The contra-account, accumulated depreciation, will be shown as a reduction in the cost of the asset, equipment. Cost of a plant asset less accumulated depreciation is known as book value. So the asset, equipment, will be shown on the balance sheet at its net amount, or book value, of $25,625. Because the contra account appears on the balance sheet it will not be closed at the end of the period. It will be carried forward to 2011 and used to accumulate the depreciation related to the equipment. Now let’s move on to the second category of adjusting entries, accrued expenses.
- Part I An accrued expense is defined as a cost incurred in the current period that is both unpaid and unrecorded. When you use your credit card, often you do not record the transaction until you pay your monthly invoice; even though you have incurred the cost. Part II For all accrued expense adjusting entries, we debit an expense account and credit a liability account. Let’s look at a specific example of an accrued expense.
- FastForward’s employee earns $70 per day, or $350 for a five-day workweek beginning on Monday and ending on Friday. This employee is paid every two weeks on Friday. On December 12 and 26, the wages are paid, recorded in the journal, and posted to the ledger. At December 31, the employee has worked for three days for FastForward and will be paid on January 9, 2011. So, on December 31, 2010 FastForward owes its employee for three days of work. If we work through our adjusting process, step one is to determine the current balance in salaries expense and salaries payable. Salaries expense has a current balance of $1,400 determined as $70 per day times 20 workdays days in December. And, salaries payable has a 0 balance. Step two is to determine what the current balances should be. For salaries expense, FastForward has incurred an additional expense of $210 (3 days times $70) that has not been recorded. So, the salaries expense balance should be $1,610. Similarly, FastForward owes $210 to the employee so the balance in salaries payable should be $210 not 0. Step three identifies that $210 is the amount needed to get the account balances properly updated. Let’s look at the adjusting entry.
- Part I In our adjusting journal entry we will debit salaries expense and credit salaries payable for $210. Let’s look at the posting to the ledger accounts. Part II After posting this entry, the accounts are properly stated. Salaries expense recorded during December amounted to $1,610. The salaries payable account has a balance of $210, which will be eliminated when the employee is paid on January 9, 2011. Now let’s move on and look at accrued interest expense.
- Learning objective number 4 is to explain and prepare an adjusted trial balance.
- Notice that an unadjusted trial balance is a list of accounts and balances prepared before adjustments are recorded, where an adjusted trial balance is a list of accounts and balances prepared after adjusting entries have been recorded and posted to the ledger.
- We have now included the adjustments for FastForward that we completed in this chapter and extended the updated balances to the adjusted trial balance columns of the work sheet. An adjusted trial balance is a list of accounts and balances prepared after adjusting entries have been recorded and posted to the ledger. Be careful when determining the balances for the adjusted trial balance columns. For example, look at entry b for Supplies. It is the entry to adjust the supplies account for the physical inventory taken at year-end. The supplies account on the unadjusted trial balance is $9,720. Our adjustment reduced the supplies on hand, so the adjusted trial balance account is $8,670. But, if you look at entry d for salaries expense, you will notice that the adjustment increased salaries expense instead of reducing it like the adjusting entry for supplies.
- Learning objective number 5 is to prepare financial statements from an adjusted trial balance.
- You can see how we took the information directly from the work sheet and prepared the income statement for the month ended December 31, 2010. Net income reported by FastForward for the month is $1,735. We will see this amount again on the Statement of Owner's Equity.
- The Statement of Owner’s Equity adds together the net income and the owner’s investment of $30,000 and subtracts the owner’s withdrawal of $200. C. Taylor’s ending capital balance is $31,535.
- After we have completed the Income Statement and the Statement of Owner’s Equity, we are ready to prepare our last financial statement, which is called the Balance Sheet. Asset and liability balances are transferred over from the adjusted trial balance to the Balance Sheet. The ending capital balance was determined on the Statement of Owner’s Equity shown in the previous slide. The ending balance is transferred from that statement to the Balance Sheet. The Balance Sheet proves that the fundamental accounting equation is in balance and you can see that the total assets of $40,945 is equivalent to the sum of the total liabilities and owner’s equity.
- End of Chapter 5.