Chapter Three Page 90
Adjusting Accounts and Preparing Financial Statements
Objective: To have students demonstrate their knowledge in preparing adjusting entries on a timely basis using the Accrual Accounting System. They will be able to prepare F/S from the adjusted trial balance and calculate the Gross Profit Margin.
Topics to be covered:
Adjusting Accounts and F/S
- Timing and Reporting
o Accounting periods
o Accrual vs, Cash accounting methods
o Benefits of Accrual Accounting
o Revenue Recognition with expenses
- Adjusting Accounts and J/E’s
o Prepaid Expenses
o Unearned Revenue
o Accrued Expenses
o Accrued Revenues
o Adjusted Trial Balance
- Preparing the F/S from the Adjusted Trial Balance
Accounting Period Assumption
- Information must be Timely
- Interim F/S cover periods: monthly, quarterly, semi-annual, three quarters
- Fiscal Year – any 12 month period
- Calendar Year – January thru December
Two types of Accounting Methods
- Cash Basis – Recognizes revenues and expenses when the cash is received or paid out.
- Not consistent with GAAP
- Does not use prepaid, unearned, or accrual accounts
- Tough for comparisons
- Mainly used by professionals: Dr., Lawyers, Dentist, ect.
- Accrual Basis – Uses adjustments to recognize revenue when it is earned and not paid and expenses when the are incurred in generating revenue. This better reflects a businesses performance and it is better for year to year and period to period comparisons.
- Supports Revenue Recognition and the Matching Concept
Adjusting Entries and Accounts
- Each adjusting entry will affect one income statement account (temporary account) and one balance sheet account (permanent account)
- Adjusting entries NEVER affect cash
- Used to comply with the Matching Concept
- There is a three step process:
1. Determine the current account balance
2. Determine what the adjusted current balance should be, do the math
3. Record the adjusting J/E to get to the new balance
Accounts that are used:
1. Prepaid Expenses – Items paid for in advance of you receiving their benefit. The adjustment records the using up of the asset. The total of the expense plus the total of the remaining prepaid should equal the original total. Examples include Prepaid Rent, Prepaid Advertising, ect.
J/E: Dr. To Expense
Cr. To PrePaid (Asset)
Prepaid Insurance is used to record the expiration of insurance policies, NOT CLAIMS.
Purchase of Insurance: Dr. Prepaid Insurance, Cr. Cash
Adjustment: Dr. Insurance Expense, Cr. Prepaid Ins
2. Supplies – Supplies are acquired and not used right away. Then as they are used they will be expensed. You can also compare ending balances to arrive at the adjustment.
Purchase of Supplies : Dr. Supplies (asset), Cr. Cash
Adjustment: Dr. Supply Expense, Cr. Supplies (asset)
3. Depreciation – Process of allocating costs of assets over their useful lives.
-Plant assets – Long term (lasting more than one year) tangible asset used to produce a product . These provide benefits for more than one accounting period. Examples include: Buildings, machinery, automobiles, furniture, ect.
To calculate depreciation you must get a base or net original cost:
Purchase price + Tax – Salvage Value (remaining estimated cost after its useful life, not what you can get for it).= Net Asset Value
EXAMPLE: COST 30,000-SALVAGE 3,000 = 27,000
Useful Life – Amount of time (in months or years) you expect it to last and be productive. EXAMPLE: 3 YEARS
Calculation: Net Asset value/Useful Life= Annual Depreciation
EXAMPLE: 27,000 / 3 YEARS= 9,000 PER YEAR
This depreciation is called Straight Line.
The J/E that is always used is: Dr. Depreciation Expense- (Type)
Cr. Accumulated Depreciation (Type)(contra asset)
Accumulated Depreciation is a contra asset account. This is and asset account that has a natural credit balance and all the rules of a liability even though it is an asset account. The accumulated account is tied to the asset account ot get the book value. It would look like this:
(asset account) Automobile 30,000
(contra asset) Accumulated depreciation 9,000 (one year’s worth of depreciation)
Net BV of Automobiles 27,000
4. Unearned Revenue (deferred) – This is cash received in advance of providing a service or product. This is treated as a liability until you satisfy the agreement.
Receipt of cash in advance: Dr. Cash, Cr. Unearned Revenue (Liability)
Adjustment for providing the service: Dr Unearned Revenue, Cr Sales
5. Accrued Expenses are cost that are incurred in a revenue period that we have not been billed for or recorded yet. We can estimate the cost:
Dr. Expense, Cr Acrrued Liability
If we know the cost but have not been billed yet the entry is:
Dr. Expense, Cr. Accounts Payable
When we receive the bill the entry is:
Dr. Accounts Payable, Cr. Cash
6. Accrued Revenue is the setting up of a receivable for services provided or product delivered that has not been paid for yet. A bill has been generated.
The entry is : Dr. Accounts Receivable, Cr. Revenue (sales)
When we get paid: Dr. Cash, Cr. Accounts Receivable
(Summary of effects of adjustments pg 103)
Adjusted Trial Balance
The summary of accounts after adjustments have been made. The T/B Dr. and Cr. Columns will always equal for each classification on the top.-T/B, Adjustments, Adjusted T/B. The Adjustment columns will have reference makings for each entry to keep track of them (letters or numbers). You take the original T/B add or subtract the adjustments, or just carry over the original amount if there is no adjustment, and put the new amount in the Adjusted T/B column. If it equals you would go ahead and prepare the F/S.
Profit Margin – The percentage of profit made to each dollar of sales, this is also known as Return on Sales. Net income/ Net Sales
The higher the better. Compare year to year and to the industry average.
Demonstration Problem page 106-108
Quick Study, Exercises, and Problems
1. Do QS: 3-1 – Cash and Accrual Methods pg 115
Ex. 3-7 – Cash vs. Accrual pg 118
Ex. 3-2 – Adjusting J/E pg 117
Ex. 3-3 - Adjusting J/E pg 117
2. Do QS: 3-2 – Account Adjustments pg 115
3-3 – Account Adjusting J/E pg 115
Ex. 3- 8 – Adjusting J/Es from I/S pg 119
3. Do QS: 3-4 – Prepaid Ins. pg 115
3-5 – Depreciation pg 115
Ex. 3-1 – Classify adjusting J/e pg 117
Problem 3-1 Identify Adj. Entries pg 12076
4. Do QS: 3-6 – Accrued Salary pg 115
3-7 – Adj J/E Unearned Rev. pg 115
Ex. 3-4 Accrued Salary pg 118
3-6 Accrued Expenses pg 118
5. Do problem 3-2 – Adj. J/E pg 120 & 121
6. Do problem 3-3 – Adj. J/E pg 124
Profit Margin QS 3-11 pg 116
EX 3-9 pg 119
Backup: Problem 3-4 Adj T/B and Adj J/E pg 122