Chapter 3: Adjusting Accounts and Preparing Financial Statements
Authors and Publication Information
Authors: Susan Coomer Galbreath, Ph.D., CPA; Charles W. Caldwell, D.B.A., CMA; Jon A. Booker, Ph.D., CPA, CIA; Cynthia J. Rooney, Ph.D., CPA; Winston Kwok, Ph.D., CA
Publisher: McGraw-Hill Education (Asia), Copyright © 2015
Subject: Chapter 3: Adjusting Accounts and Preparing Financial Statements
The Accounting Period
Accounting Period Intervals: Business activities are divided into specific time periods for reporting purposes:
Annual: A 1-year accounting period covering 12 months.
Semiannual: Two 6-month reporting periods per year.
Quarterly: Four 3-month reporting periods per year (Q1, Q2, Q3, Q4).
Monthly: Twelve 1-month reporting periods per year (Jan, Feb, Mar, Apr, May, June, July, Aug, Sept, Oct, Nov, Dec).
Accrual Basis versus Cash Basis Accounting
Accrual Basis Accounting:
Revenue Recognition: Revenues are recognized when earned, regardless of when cash is received.
Expense Recognition: Expenses are recognized when incurred, regardless of when cash is paid.
Compliance: Complies with Generally Accepted Accounting Principles (GAAP).
Cash Basis Accounting:
Revenue Recognition: Revenues are recognized only when cash is received.
Expense Recognition: Expenses are recorded only when cash is paid.
Compliance: Non-GAAP.
Comparative Example (Insurance Policy):
Scenario: A 24-month insurance policy is purchased for $2,400 in 2015, covering December 2015 through November 2017.
Cash Basis: The entire is recognized as insurance expense in 2015. No insurance expense is recognized in 2016 or 2017.
Accrual Basis: The expense is matched across the periods benefited by coverage:
2015 (1 month): $100
2016 (12 months): $1,200
2017 (11 months): $1,100
Recognizing Revenues and Expenses
Revenue Recognition Principle: Requires that revenue be recognized and recorded when product delivery or service performance has occurred and revenue is earned.
Matching Principle (Expense Recognition Principle): Requires that expenses incurred to generate revenue be recorded in the same accounting period as the associated revenues.
Expense Category Summary Example: Expenses incurred to generate revenue in a given period include:
Rent: $1,000
Gasoline: $500
Advertising: $2,000
Salaries: $3,000
Utilities: $450
Framework for Accounting Adjustments
Definition of Adjusting Entry: An entry recorded at the end of an accounting period to bring an asset or liability account balance to its proper amount and ensure revenues and expenses are properly recorded.
Four Categories of Adjustments:
Prepaid (Deferred) Expenses: Cash is paid before the expense is recognized. Includes supplies, prepaid insurance, prepaid rent, and depreciation.
Unearned (Deferred) Revenues: Cash is received before the revenue is earned.
Accrued Expenses: Costs incurred in a period that are unpaid and unrecorded (cash paid after expense recognized).
Accrued Revenues: Revenues earned in a period that are unrecorded and not yet received (cash received after revenue recognized).
Comprehensive Adjustment Examples (FastForward)
Prepaid Insurance:
Transaction: On 12/1/15, FastForward paid for a 2-year (24-month) insurance policy covering December 2015 through November 2017, recorded in account 128 (Prepaid Insurance).
Monthly Calculation: \text{Monthly Insurance Expense} = \frac{\2{,}400}{24\,\text{months}} = \
Adjusting Entry (12/31/15): Debit Insurance Expense (Account 637) ; Credit Prepaid Insurance (Account 128) .
Supplies:
Transaction: During 2015, FastForward purchased of supplies, recorded in asset account 126 (Supplies).
Inventory Count (12/31/15): Physical count reveals of supplies on hand.
Supplies Used Calculation:
Adjusting Entry (12/31/15): Debit Supplies Expense (Account 652) ; Credit Supplies (Account 126) .
Other Prepaid Expenses & Special Direct Expense Charging:
Other items like Prepaid Rent follow identical procedures as Insurance and Supplies.
Special Case: Certain prepaid expenses are paid for and fully consumed within a single period (e.g., paying monthly rent on the 1st of the month that expires by month-end). In these cases, cash paid can be recorded directly with a debit to the expense account instead of an asset account.
Depreciation:
Definition: The process of allocating the cost of a plant asset over its useful life in a systematic and rational manner.
Straight-Line Depreciation Formula:
Transaction: On 12/1/15, FastForward purchased equipment for cash. Estimated useful life is 4 years (48 months); estimated residual value is
Monthly Depreciation Calculation (for Dec 2015):
Adjusting Entry (12/31/15): Debit Depreciation Expense ; Credit Accumulated Depreciation
Account Nature: Accumulated Depreciation is a contra asset account.
Statement Presentation (12/31/15):
Equipment:
Less: Accumulated Depreciation:
Net Equipment Book Value:
Unearned (Deferred) Revenues:
Transaction: On 12/26/15, FastForward agreed to provide consulting services for a fixed fee of over 60 days, receiving full payment in advance.
Daily Revenue Calculation: \text{Daily Consulting Rate} = \frac{\3{,}000}{60\,\text{days}} = \
Earned Amount Calculation (5 days through 12/31/15): \text{Earned Consulting Revenue} = 5\,\text{days} \times \50\,\text{per day} = \
Adjusting Entry (12/31/15): Debit Unearned Revenue ; Credit Consulting Revenue
Accrued Salaries Expenses:
Transaction: An employee earns and is paid biweekly on Friday. Year-end 12/31/15 falls on a Wednesday. Last payday was Friday 12/26/15.
Unpaid Work Days: Monday, Tuesday, Wednesday (3 days).
Accrued Amount Calculation: \text{Accrued Salaries} = 3\,\text{days} \times \70\,\text{per day} = \
Adjusting Entry (12/31/15): Debit Salaries Expense ; Credit Salaries Payable
Subsequent Payment Entry (1/9/16): Payment covers 2 full weeks (10 working days = total payroll):
Debit Salaries Payable: (for 2015 accrued expense)
Debit Salaries Expense: (for 7 working days in Jan 2016)
Credit Cash:
Accrued Interest Expenses:
Transaction: On 12/1/15, FastForward borrowed from First National Bank on a 1-year note at an annual interest rate of 6%.
Monthly Accrual Calculation (for month ended 12/31/15): \text{Interest Expense} = \6{,}000 \times 6\% \times \frac{1}{12} = \
Accrued Service Revenue:
Transaction: On 12/12/15, FastForward agreed to render consulting services under a 30-day fixed fee contract for (), due upon full completion on 1/10/16.
Earned Days in December: 20 days (12/12/15 through 12/31/15).
Accrued Amount Calculation: \text{Accrued Revenue} = 20\,\text{days} \times \90\,\text{per day} = \
Adjusting Entry (12/31/15): Debit Accounts Receivable ; Credit Consulting Revenue
Subsequent Receipt Entry (1/10/16): Contract completed, client billed and pays cash. January revenue component represents 10 days at :
Debit Cash:
Credit Accounts Receivable:
Credit Consulting Revenue:
Summary of Financial Statement Impact of Adjustments
Prepaid Expenses (Initially Recorded as Assets):
Before Adjusting: Asset overstated; Equity overstated; Expense understated; Revenue unaffected.
Adjusting Entry: Debit Expense; Credit Asset (or Credit Accumulated Depreciation for contra assets).
Unearned Revenues (Initially Recorded as Liabilities):
Before Adjusting: Liability overstated; Equity understated; Revenue understated; Expense unaffected.
Adjusting Entry: Debit Liability; Credit Revenue.
Accrued Expenses:
Before Adjusting: Liability understated; Equity overstated; Expense understated; Revenue unaffected.
Adjusting Entry: Debit Expense; Credit Liability.
Accrued Revenues:
Before Adjusting: Asset understated; Equity understated; Revenue understated; Expense unaffected.
Adjusting Entry: Debit Asset; Credit Revenue.
Trial Balance and Financial Statement Preparation
Worksheet Processing Steps:
Enter initial unadjusted trial balance amounts into the worksheet.
Enter FastForward's adjusting entries.
Determine adjusted trial balance totals.
FastForward Adjusted Trial Balance (December 31, 2015):
Cash: Debit
Accounts Receivable: Debit
Supplies: Debit
Prepaid Insurance: Debit
Equipment: Debit
Accumulated Depreciation - Equipment: Credit
Accounts Payable: Credit
Salaries Payable: Credit
Unearned Revenue: Credit
C. Taylor, Capital: Credit
C. Taylor, Withdrawals: Debit
Consulting Revenue: Credit
Rental Revenue: Credit
Depreciation Expense - Equipment: Debit
Salaries Expense: Debit
Insurance Expense: Debit
Rent Expense: Debit
Supplies Expense: Debit
Utilities Expense: Debit
Total Debits / Total Credits:
Step 1: Income Statement Preparation (Month Ended 12/31/15):
Revenues: Consulting Revenue () + Rental Revenue () = Total Revenues
Operating Expenses: Depreciation Expense - Equipment () + Salaries Expense () + Insurance Expense () + Rent Expense () + Supplies Expense () + Utilities Expense () = Total Expenses
Net Profit Calculation:
Step 2: Statement of Changes in Equity Preparation (Month Ended 12/31/15):
C. Taylor, Capital (12/1/15):
Add: Investment by owner:
Add: Net profit:
Subtotal:
Less: Withdrawal by owner:
C. Taylor, Capital (12/31/15):
Step 3: Statement of Financial Position Preparation (At 12/31/15):
Assets:
Cash:
Accounts Receivable:
Supplies:
Prepaid Insurance:
Equipment:
Less Accumulated Depreciation:
Net Equipment:
Total Assets:
Liabilities:
Accounts Payable:
Salaries Payable:
Unearned Revenue:
Total Liabilities:
Equity:
C. Taylor, Capital:
Total Liabilities and Equity:
Financial Analysis: Profit Margin Ratio
Definition: Measures the ratio of a company's net profit relative to its net sales.
Formula:
Application: Used in corporate financial evaluation, such as analyzing performance for entities like Adidas.
Appendix 3A: Alternative Accounting for Prepayments
Alternative Method: Prepaid expenses can initially be recorded with a debit to an expense account rather than an asset account (and unearned revenues can be recorded with a credit to a revenue account initially).
Adjustment Impact: When using this alternative, the end-of-period adjusting entry is structured based on how the original payment was recorded to ensure ending balances reflect proper asset, liability, revenue, and expense amounts.
Authors: Susan Coomer Galbreath, Ph.D., CPA; Charles W. Caldwell, D.B.A., CMA; Jon A. Booker, Ph.D., CPA, CIA; Cynthia J. Rooney, Ph.D., CPA; Winston Kwok, Ph.D., CA
Publisher: McGraw-Hill Education (Asia), Copyright © 2015
Subject: Chapter 3: Adjusting Accounts and Preparing Financial Statements
The Accounting Period
Accounting Period Intervals: Business activities are divided into specific time periods for reporting purposes:
Annual: A 1-year accounting period covering 12 months.
Semiannual: Two 6-month reporting periods per year.
Quarterly: Four 3-month reporting periods per year (Q1, Q2, Q3, Q4).
Monthly: Twelve 1-month reporting periods per year (Jan, Feb, Mar, Apr, May, June, July, Aug, Sept, Oct, Nov, Dec).
Accrual Basis versus Cash Basis Accounting
Accrual Basis Accounting:
Revenue Recognition: Revenues are recognized when earned, regardless of when cash is received.
Expense Recognition: Expenses are recognized when incurred, regardless of when cash is paid.
Compliance: Complies with Generally Accepted Accounting Principles (GAAP).
Cash Basis Accounting:
Revenue Recognition: Revenues are recognized only when cash is received.
Expense Recognition: Expenses are recorded only when cash is paid.
Compliance: Non-GAAP.
Comparative Example (Insurance Policy):
Scenario: A 24-month insurance policy is purchased for $2,400 in 2015, covering December 2015 through November 2017.
Cash Basis: The entire $2,400 is recognized as insurance expense in 2015. No insurance expense is recognized in 2016 or 2017.
Accrual Basis: The expense is matched across the periods benefited by coverage:
2015 (1 month): $100
2016 (12 months): $1,200
2017 (11 months): $1,100
Recognizing Revenues and Expenses
Revenue Recognition Principle: Requires that revenue be recognized and recorded when product delivery or service performance has occurred and revenue is earned.
Matching Principle (Expense Recognition Principle): Requires that expenses incurred to generate revenue be recorded in the same accounting period as the associated revenues.
Expense Category Summary Example: Expenses incurred to generate revenue in a given period include:
Rent: $1,000
Gasoline: $500
Advertising: $2,000
Salaries: $3,000
Utilities: $450
Framework for Accounting Adjustments
Definition of Adjusting Entry: An entry recorded at the end of an accounting period to bring an asset or liability account balance to its proper amount and ensure revenues and expenses are properly recorded.
Four Categories of Adjustments:
Prepaid (Deferred) Expenses: Cash is paid before the expense is recognized. Includes supplies, prepaid insurance, prepaid rent, and depreciation.
Unearned (Deferred) Revenues: Cash is received before the revenue is earned.
Accrued Expenses: Costs incurred in a period that are unpaid and unrecorded (cash paid after expense recognized).
Accrued Revenues: Revenues earned in a period that are unrecorded and not yet received (cash received after revenue recognized).
Comprehensive Adjustment Examples (FastForward)
Prepaid Insurance:
Transaction: On 12/1/15, FastForward paid $2,400 for a 2-year (24-month) insurance policy covering December 2015 through November 2017, recorded in account 128 (Prepaid Insurance).
Monthly Calculation: $\text{Monthly Insurance Expense} = \frac{2,400}{24\,\text{months}} = 100\,\text{per month}$
Adjusting Entry (12/31/15): Debit Insurance Expense (Account 637) $100; Credit Prepaid Insurance (Account 128) $100.
Supplies:
Transaction: During 2015, FastForward purchased $9,720 of supplies, recorded in asset account 126 (Supplies).
Inventory Count (12/31/15): Physical count reveals $8,670 of supplies on hand.
Supplies Used Calculation: $\text{Supplies Expense} = 9,720 - 8,670 = 1,050$
Adjusting Entry (12/31/15): Debit Supplies Expense (Account 652) $1,050; Credit Supplies (Account 126) $1,050.
Other Prepaid Expenses & Special Direct Expense Charging:
Other items like Prepaid Rent follow identical procedures as Insurance and Supplies.
Special Case: Certain prepaid expenses are paid for and fully consumed within a single period (e.g., paying monthly rent on the 1st of the month that expires by month-end). In these cases, cash paid can be recorded directly with a debit to the expense account instead of an asset account.
Depreciation:
Definition: The process of allocating the cost of a plant asset over its useful life in a systematic and rational manner.
Straight-Line Depreciation Formula: $\text{Straight-Line Depreciation Expense} = \frac{\text{Asset Cost} - \text{Residual Value}}{\text{Useful Life}}$
Transaction: On 12/1/15, FastForward purchased equipment for $26,000 cash. Estimated useful life is 4 years (48 months); estimated residual value is $8,000
Monthly Depreciation Calculation (for Dec 2015): $\text{Monthly Depreciation} = \frac{26,000 - 8,000}{48\,\text{months}} = 375\,\text{per month}$
Adjusting Entry (12/31/15): Debit Depreciation Expense $375; Credit Accumulated Depreciation $375
Account Nature: Accumulated Depreciation is a contra asset account.
Statement Presentation (12/31/15):
Equipment: $26,000
Less: Accumulated Depreciation:
Net Equipment Book Value: $25,625
Unearned (Deferred) Revenues:
Transaction: On 12/26/15, FastForward agreed to provide consulting services for a fixed fee of $3,000 over 60 days, receiving full payment in advance.
Daily Revenue Calculation:
Earned Amount Calculation (5 days through 12/31/15):
Adjusting Entry (12/31/15): Debit Unearned Revenue $250; Credit Consulting Revenue $250
Accrued Salaries Expenses:
Transaction: An employee earns \text{Accrued Salaries} = 3\,\text{days} \times 70\,\text{per day} = 210$
Adjusting Entry (12/31/15): Debit Salaries Expense $210; Credit Salaries Payable $210
Subsequent Payment Entry (1/9/16):** Payment covers 2 full weeks (10 working days = $700 total payroll):
Debit Salaries Payable: $210 (for 2015 accrued expense)
Debit Salaries Expense: $490 (for 7 working days in Jan 2016)
Credit Cash: $700
Accrued Interest Expenses:
Transaction: On 12/1/15, FastForward borrowed $6,000 from First National Bank on a 1-year note at an annual interest rate of 6%.
Monthly Accrual Calculation (for month ended 12/31/15):
Accrued Service Revenue:
Transaction: On 12/12/15, FastForward agreed to render consulting services under a 30-day fixed fee contract for $2,700 ($90\text{ per day}), due upon full completion on 1/10/16.
Earned Days in December: 20 days (12/12/15 through 12/31/15).
Accrued Amount Calculation:
Adjusting Entry (12/31/15): Debit Accounts Receivable $1,800; Credit Consulting Revenue $1,800
Subsequent Receipt Entry (1/10/16): Contract completed, client billed and pays $2,700 cash. January revenue component represents 10 days at $90\text{ per day} = :
Debit Cash: $2,700
Credit Accounts Receivable: $1,800
Credit Consulting Revenue: $900
Summary of Financial Statement Impact of Adjustments
Prepaid Expenses (Initially Recorded as Assets):
Before Adjusting: Asset overstated; Equity overstated; Expense understated; Revenue unaffected.
Adjusting Entry: Debit Expense; Credit Asset (or Credit Accumulated Depreciation for contra assets).
Unearned Revenues (Initially Recorded as Liabilities):
Before Adjusting: Liability overstated; Equity understated; Revenue understated; Expense unaffected.
Adjusting Entry: Debit Liability; Credit Revenue.
Accrued Expenses:
Before Adjusting: Liability understated; Equity overstated; Expense understated; Revenue unaffected.
Adjusting Entry: Debit Expense; Credit Liability.
Accrued Revenues:
Before Adjusting: Asset understated; Equity understated; Revenue understated; Expense unaffected.
Adjusting Entry: Debit Asset; Credit Revenue.
Trial Balance and Financial Statement Preparation
Worksheet Processing Steps:
Enter initial unadjusted trial balance amounts into the worksheet.
Enter FastForward's adjusting entries.
Determine adjusted trial balance totals.
FastForward Adjusted Trial Balance (December 31, 2015):
Cash: Debit $4,350
Accounts Receivable: Debit $1,800
Supplies: Debit $8,670
Prepaid Insurance: Debit $2,300
Equipment: Debit $26,000
Accumulated Depreciation - Equipment: Credit $375
Accounts Payable: Credit $6,200
Salaries Payable: Credit $210
Unearned Revenue: Credit $2,750
C. Taylor, Capital: Credit $30,000
C. Taylor, Withdrawals: Debit $200
Consulting Revenue: Credit $7,850
Rental Revenue: Credit $300
Depreciation Expense - Equipment: Debit $375
Salaries Expense: Debit $1,610
Insurance Expense: Debit $100
Rent Expense: Debit $1,000
Supplies Expense: Debit $1,050
Utilities Expense: Debit $230
Total Debits / Total Credits: $47,685
Step 1: Income Statement Preparation (Month Ended 12/31/15):
Revenues: Consulting Revenue ($7,850) + Rental Revenue ($300) = Total Revenues $8,150
Operating Expenses: Depreciation Expense - Equipment ($375) + Salaries Expense ($1,610) + Insurance Expense ($100) + Rent Expense ($1,000) + Supplies Expense ($1,050) + Utilities Expense ($230) = Total Expenses $4,365
Net Profit Calculation: $\text{Net Profit} = 8,150 - 4,365 = 3,785$
Step 2: Statement of Changes in Equity Preparation (Month Ended 12/31/15):
C. Taylor, Capital (12/1/15): $0
Add: Investment by owner: $30,000
Add: Net profit: $3,785
Subtotal: $33,785
Less: Withdrawal by owner: $(200)$
C. Taylor, Capital (12/31/15): $33,585
Step 3: Statement of Financial Position Preparation (At 12/31/15):
Assets:
Cash: $4,350
Accounts Receivable: $1,800
Supplies: $8,670
Prepaid Insurance: $2,300
Equipment: $26,000
Less Accumulated Depreciation: $(375)$
Net Equipment: $25,625
Total Assets: $42,745
Liabilities:
Accounts Payable: $6,200
Salaries Payable: $210
Unearned Revenue: $2,750
Total Liabilities: $9,160
Equity:
C. Taylor, Capital: $33,585
Total Liabilities and Equity:
Financial Analysis: Profit Margin Ratio
Definition: Measures the ratio of a company's net profit relative to its net sales.
Formula:
Application: Used in corporate financial evaluation, such as analyzing performance for entities like Adidas.
Appendix 3A: Alternative Accounting for Prepayments
Alternative Method: Prepaid expenses can initially be recorded with a debit to an expense account rather than an asset account (and unearned revenues can be recorded with a credit to a revenue