Chapter 3

Adjusting Accounts
and Preparing Financial Statements
 Conceptual Chapter Objectives

CH 3 QUIZ: Concepts 1 – 4:

C1: Explain the importance of periodic

reporting and the time period
principle.
C2: Explain accrual accounting and how
it improves financial statements.
C3: Identify steps in the accounting cycle.
C4: Explain and prepare a classified
balance sheet.

3-2
 Analytical Chapter Objectives
A1: Explain how accounting adjustments
link to financial statements.
A2: Compute profit margin and describe its
use in analyzing company performance.
SELF STUDY
A3: Compute the current ratio and describe
what it reveals about a company’s
financial condition.
SELF STUDY

3-3
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: Describe and prepare closing entries.
P5: Explain and prepare a post-closing trial
balance.

3-4
Procedural Chapter Objectives
(Continued)

P6: Appendix 3A: Explain the

alternatives in accounting for
prepaids. NOT COVERED
P7: Appendix 3B: Prepare a work sheet
and explain its usefulness.
NOT COVERED

3-5
C3 The Accounting Cycle
Prepare
Start post-closing
trial balance

Analyze POST
transactions
Closing
Entries
Journalize
Prepare
Post statements

Prepare Prepare
Adjusting
unadjusted POST adjusted
Entries
trial balance trial balance
3-6
 The Accounting Period
To provide timely information, accounting
systems prepare periodic reports at regular
intervals.

1. Time-period principle assumes that an

organization’s activities can be divided into
specific time periods such as a month, a three-
month quarter, a six-month interval, or a year.
Reports covering a one-year period are known as
annual financial statements.
Interim financial statements cover one, three, or
six months of activity.
 The Accounting Period
2. Annual reporting period:

a. Calendar year —January 1 to December 31.

b. Fiscal year —Any twelve consecutive months

used to base annual financial reports on.

c. Natural business year —a fiscal year that ends

when a company's sales activities are at their
lowest level for the year.
C1
The Accounting Period

Annually

1 2
Semiannually
1 2 3 4
Quarterly
1 2 3 4 5 6 7 8 9 10 11 12
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Monthly
3-9
 The Adjustment Process
Accounts are adjusted at the end of a period to
record internal transactions and events that are
not yet recorded.

Two basic principles for recognizing Revenues

and Expenses:
1. The revenue recognition principle requires
revenue be recorded when earned, not before
and not after.
2. The matching principle requires expenses be
recorded in the same period as the revenues
earned as a result of these expenses.
Accrual Basis versus Cash Basis
Accrual basis accounting —uses the adjusting
process to recognize revenue when earned and to
match expenses with revenues. This means the
economic effects of revenues and expenses are
recorded when earned or incurred, not when cash is
received or paid. Accrual basis is consistent with
GAAP.
Cash basis accounting —revenues are recognized
when cash is received and expenses are recognized
when cash paid. Cash basis is not consistent with
GAAP.
Accrual accounting also increases the comparability
of financial statements from one period to another.
C1
Accrual Basis vs. Cash Basis

Accrual Basis Cash Basis

Revenues are Revenues are
recognized when recognized when
earned and expenses cash is received and
are recognized when expenses recorded
incurred. when cash is paid.

Not GAAP
Accounting

3-12
C1
Accrual Basis vs. Cash Basis

Insurance Expense 2009

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 2009.
No insurance expense from this policy would be
recognized in 2010 or 2011, periods covered by the
3-13
C2
Accrual Basis vs. Cash Basis
On the accrual basis,
Insurance Expense 2009
Jan Feb Mar Apr Insurance expense is
$ -
May
$ -
Jun
$ -
Jul
$ -
Aug recognized as follows:
$ -
Sep
$ -
Oct
$ -
Nov
$ -
Dec
$100 in 2009,
$ - $ - $ - $ 100 $1,200 in 2010, and
Jan
Insurance Expense 2010
Feb Mar Apr
$1,100 in 2011.
$ 100 $ 100 $ 100 $ 100

$
May
100 $
Jun
100 $
Jul
100 $
Aug
100
The expense is matched
$
Sep
100 $
Oct
100 $
Nov
100 $
Dec
100
with the periods benefited
Jan
Insurance Expense 2011
Feb Mar Apr
by the insurance coverage.
$ 100 $ 100 $ 100 $ 100
May Jun Jul Aug
$ 100 $ 100 $ 100 $ 100
Sep Oct Nov Dec
$ 100 $ 100 $ 100 $ -
3-14
 Adjusting Accounts
An adjusting entry is recorded to bring an asset
or liability account balance to its proper amount.

The adjusting process is based on ACCRUAL

ACCOUNTING of Revenue Recognition and
Matching Principle.

Adjusting accounts is a 3-step process:

(1) Determine the current account balance,
(2) Determine what the current account balance
should be, and
(3) Record adjusting entry to get from step 1
to step 2.
P1
Supplies

During 2009, Scott Company purchased $15,500 of

supplies. Scott recorded the expenditures as
Supplies (Asset). On December 31, a count of the
supplies indicated $2,655 on hand.
What adjustment is required?
Dec. 31 Supplies Expense 12,845
Supplies 12,845
To record supplies used during 2009
Supplies 126 Supplies Expense 652
Bought 15,500 Dec. 31 12,845 Dec. 31 12,845
Bal. 2,655

3-16
C2, P1
Adjusting Accounts
Framework for
Adjustments
Adjustments

Paid
Paid (or
(or received) cash before
received) cash before Paid
Paid (or
(or received) cash after
received) cash after
expense
expense (or(or revenue)
revenue) recognized
recognized expense
expense (or
(or revenue)
revenue) recognized
recognized

Prepaid
Prepaid Unearned
Unearned Accrued
Accrued Accrued
Accrued
(Deferred)
(Deferred) (Deferred)
(Deferred) expenses
expenses revenues
revenues
expenses*
expenses* revenues
revenues
*including depreciation
3-17
 Prepaid (Deferred) Expenses
P1

Supplies
During 2009, 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 12,845
Supplies 12,845
To record supplies used during 2009
Supplies 126 Supplies Expense 652
Bought 15,500 Dec. 31 12,845 Dec. 31 12,845
Bal. 2,655

3-18
P1
Depreciation

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 =
Expense Useful Life

3-19
P1
Depreciation
On January 1, 2009, Barton, Inc. purchased
equipment for $62,000 cash. The equipment
has an estimated useful life of 5 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, 2009.

2009 $62,000 - $2,000

Depreciation = = $12,000
Expense 5
3-20
P1
Depreciation

On January 1, 2009, Barton, Inc. purchased

equipment for $62,000 cash. The equipment
has an estimated useful life of 5 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, 2009.
Dec. 31 Depreciation Expense 12,000
Accumulated Depreciation - Equipment 12,000
To record equipment depreciation

Accumulated
Accumulated depreciation
depreciation is
is
aa contra
contra asset
asset account.
account. 3-21
P1
Depreciation

Equipment is
shown net of
$ accumulated
depreciation.
This amount is
referred to as the
asset’s book
value

3-22
P1
Unearned (Deferred) Revenues

Cash
Cash received
received in
in
advance
advance ofof Buy your season tickets for
providing
providing all home basketball games NOW!
products
products or
or
services. “Go Big Blue”
services.

Revenue
Liability
Debit Unadjusted Credit
Adjustment Balance Adjustment

3-23
P1 Unearned (Deferred) Revenues

On October 1, 2009, 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

3-24
P1
Unearned (Deferred) Revenues

On December 31, Ox University has

played 10 of its regular home games,
winning 2 and losing 8.

Dec. 31 Unearned Revenue 50,000

Basketball Revenue 50,000
To recognize 10-games of revenue
Unearned Revenue Basketball Revenue
Dec. 31 50,000 Oct. 1 100,000 Dec. 31 50,000
Bal. 50,000

3-25
P1
Accrued Expenses
We’re about one-half
done with this job and
Costs
Costs incurred
incurred in
in aa want to be paid for
period
period that
that are
are our work!
both
both unpaid
unpaid and
and
unrecorded.
unrecorded.

Expense Liability
Debit Credit
Adjustment Adjustment

3-26
P1
Accrued Expenses

Barton,
Barton, Inc.
Inc. pays
pays its
its employees
employees every
every Friday.
Friday. Year-
Year-
end,
end, 12/31/09,
12/31/09, falls
falls on
on aa Wednesday.
Wednesday. As As of
of 12/31/09,
12/31/09, the
the
employees
employees have
have earned
earned salaries
salaries of
of $47,250
$47,250 for
for Monday
Monday
through
through Wednesday.
Wednesday.

Last pay Next pay

date date
12/26/09

12/1/09 12/31/09 Record

Record adjusting
adjusting
Year end journal
journal entry.
entry.

3-27
P1
Accrued Expenses

Barton,
Barton, Inc.
Inc. pays
pays its
its employees
employees every
every Friday.
Friday. Year-
Year-
end,
end, 12/31/09,
12/31/09, falls
falls on
on aa Wednesday.
Wednesday. As As of
of 12/31/09,
12/31/09, the
the
employees
employees have
have earned
earned salaries
salaries of
of $47,250
$47,250 for
for Monday
Monday
through
through Wednesday.
Wednesday.
Dec. 31 Salaries Expense 47,250
Salaries Payable 47,250
To accrue 3-days' salary
Salaries Expense Salaries Payable
Other salaries Dec. 31 47,250
657,500
Dec. 31 47,250
Bal. 704,750

3-28
P1 Accrued Revenues
Smith
Smith && Jones,
Jones, CPAs,
CPAs, had
had $31,200
$31,200 ofof work
work
completed
completed but
but not
not yet
yet billed
billed to
to clients.
clients.
Let’s
Let’s make
make the
the adjusting
adjusting entry
entry necessary
necessary on
on
December
December 31,
31, 2009,
2009, the
the end
end of
of the
the company’s
company’s fiscal
fiscal
year.
year.

Dec. 31 Accounts Receivable 31,200

Service Revenue 31,200
To accrue revenue earned
Accounts Receivable Service Revenue
Other receivables Other revenues
1,325,268 6,589,500
Dec. 31 31,200 Dec. 31 31,200
Bal. 1,356,468 Bal . 6,620,700

3-29
Quick Study 2, 3, 4, 5
Exercise 2, 3
A1
Links to Financial Statements

Summary of Adjustments and Financial Statement Links

Before Adjustment
Income
Balance Sheet Statement
Type Account Account 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

3-31
C3 The Accounting Cycle
Prepare
Start post-closing
trial balance

Analyze POST
transactions
Closing
Entries
Journalize
Prepare
Post statements

Prepare Prepare
Adjusting
unadjusted POST adjusted
Entries
trial balance trial balance
3-32
P3
1. Prepare the Income
Statement

3-33
P3 2. Prepare Statement of Retained
Earnings
Note: Net Income from the Income
Statement carries to the Statement
of Retained Earnings.

3-34
P3
3. Prepare Balance Sheet

FastForward
Balance Sheet
December 31, 2009
Assets
Cash $ 3,950
Accounts receivable 1,800
Supplies 8,670
Prepaid insurance 2,300
Equipment 26,000
Less: accum. depr. (375) 25,625
Total assets $ 42,345
Liabilities
Accounts payable $ 6,200
Salaries payable 210
Unearned revenue 2,750
Total liabilities $ 9,160
Equity
Common stock 30,000
Retained earnings 3,185
Total liabilities and equity $ 42,345

3-35
C3 The Closing Process: Temporary and
Permanent Accounts

Temporary (nominal) accounts accumulate data related to

one accounting period. They include all income statement
accounts, the dividends account, and the Income Summary
account. These accounts are “closed” at the end of the period
to get ready for the next accounting period.

Permanent (real) accounts report activities related to one or

more future accounting periods. They carry ending balances
to the next accounting period and are not “closed.”
3-36
C3 The Accounting Cycle
Prepare
Start post-closing
trial balance

Analyze POST
transactions
Closing
Entries
Journalize
Prepare
Post statements

Prepare Prepare
Adjusting
unadjusted POST adjusted
Entries
trial balance trial balance
3-37
P4
Recording Closing Entries

1. Close revenue accounts to Inc. Summary;

2. Close expense accounts to Inc. Summary;
3. Close the income summary to RE;
4. Close dividends account to RE.

3-38
P4
Recording Closing Entries

Salaries Expenses Consulting Revenues

$ 18,100 $ 25,000
Examine the
accounts
presented.
Income Summary Retained Earnings

$ 7,000

3-39
P4
Recording Closing Entries

Salaries Expenses Consulting Revenues

$ 18,100 $ 25,000 $ 25,000

Income Summary Close revenues

$ 25,000 with a debit to the
revenue account
and a credit to
Income Summary.

3-40
P4
Recording Closing Entries

Salaries Expenses Consulting Revenues

$ 18,100 $ 18,100 $ 25,000 $ 25,000

Income Summary Close expense

accounts with a
$ 18,100 $ 25,000
credit to expenses
and a debit to
Income Summary.

3-41
P4
Recording Closing Entries

Salaries Expenses Consulting Revenues

$ 18,100 $ 18,100 $ 25,000 $ 25,000

Income Summary
Determine the
$ 18,100 $ 25,000 balance in the
$ 6,900 Income Summary
account.

3-42
P4
Recording Closing Entries

Salaries Expenses Close the Income

$ 18,100 $ 18,100 Summary to
Retained Earnings.

Income Summary Retained Earnings

$ 18,100 $ 25,000 $ 7,000

$ 6,900
$ 6,900 $ 6,900

3-43
P4
Recording Closing Entries

The dividends account is closed to

Retained Earnings.

Dividends Retained Earnings

$ 2,000 $ 2,000 $ 2,000 $ 7,000
6,900

3-44
P4
Recording Closing Entries

The dividends account is closed to

Retained Earnings.

Dividends Retained Earnings

$ 2,000 $ 2,000 $ 2,000 $ 7,000
6,900
$ 11,900
Determine the ending
balance in Retained
Earnings.
3-45
C3 The Accounting Cycle
Prepare
Start post-closing
trial balance

Analyze POST
transactions
Closing
Entries
Journalize
Prepare
Post statements

Prepare Prepare
Adjusting
unadjusted POST adjusted
Entries
trial balance trial balance
3-46
Quick Study 10, 14, 15
Exercise 11
P5 Post Closing Trial Balance
 Trial Balance prepared after the
closing entries have been posted.
 The purpose is to insure that all
nominal or temporary accounts
have been closed.
 The only accounts on this trial
balance should be assets,
liabilities, and equity accounts.

3-48
C4
Classified Balance Sheet

Assets Liabilities and Equity

Current assets Current liabilities
Noncurrent assets: Noncurrent liabilities
Long-term investments Equity
Plant assets
Intangible assets

Current items are those expected to come due

(either collected or owed) within one year or the
company’s operating cycle, whichever is
longer.

3-49
C4 Classified Balance Sheet
Plant Assets
Plant assets are tangible assets that are both long
lived and used to produce or sell products or
services. Examples include equipment, machinery,
buildings, and land that are used to produce or
sell products and services.

Intangible Assets
Long-term resources that benefit business
operations. They usually lack physical form and
have uncertain benefits. Examples include
patents, trademarks, copyrights, franchises, and
goodwill. 3-50
C4
Current Liabilities

Obligations due to be paid or settled within one year

or the operating cycle, whichever is longer.

Long Term Liabilities

Obligations not due within one year or the
operating cycle, whichever is longer.

3-51
Classified Balance Sheet
FastForw ard
Balance She et
Decem ber 31, 2009
Assets
Current Assets
Cash $ 3,950
Accounts receivable 1,800
Supplies 8,670
Prepaid insurance 2,300
Total Current Asse ts 16,720
Plant Assets
Equipm ent 26,000
Less: accum . depr. (375) 25,625
Total assets $ 42,345
Liabilities
Current Liabilities
Accounts payable $ 6,200
Salaries payable 210
Unearned revenue 2,750
Total liabilities $ 9,160
Equity
Com m on stock 30,000
Retained earnings 3,185
Total liabilities and equity $ 42,345

3-52
A2
Profit Margin
The profit margin ratio measures the
company’s net income to net sales.
Profit Net Income
=
Margin Net Sales

3-53
A3
Current Ratio
This ratio is an important measure of a company’s
ability to pay its short-term obligations.
Current Current assets
=
ratio Current liabilities
Current Ratio

4.0
3.0 Limited Brands,
Inc.
2.0
Industry
1.0
average
-
11

10

09

08
20

20
20

20

3-54
End of Chapter 3

3-55