Chapter 3 Notes: Adjusting Accounts for Financial Statements (McGraw-Hill, 9th Edition)

The Accounting Period

• Fiscal year: Think of it like a school year, but for a business. It's any 12 months in a row or 52 weeks that a company uses to add up all its money stuff.

• If a business's "school year" ends on December 31, it's just called a calendar year.

• Some businesses pick a "natural business year" for their fiscal year. This is usually when they're super chill and sales are at their lowest, kind of like how a summer break might be a natural end for a school year.

Accrual Basis versus Cash Basis

• Accrual Basis: Imagine you deliver pizzas. You record the money you earned from those pizzas the moment you hand them over, even if the customer hasn't paid you yet. Same for expenses – if your delivery car needs gas, you record that cost when you used the gas, not when you actually pay for it later.

• Cash Basis: This is simpler. You only record money when you actually get the cash in your hand, and you only record expenses when you actually pay out the cash.

Accrual Basis Example: Insurance (FastForward)

• FastForward paid $2,400$ for a 2-year insurance policy on Dec 1, 2021. That's like paying for your streaming service subscription way in advance.

• Accrual Basis says you've only "used up" a little bit of that insurance each month. So, for 2021, only $100$ is an expense (like how only one month of your subscription is "used"). The rest of the $2,400$ gets spread out to 2022 and 2023 as it's "used."

• Cash Basis would say, "Whoa, they paid $2,400$ in 2021, so that's the whole expense for 2021!" No expense recorded for the next two years, even though the insurance is still protecting them.

Recognizing Revenues

• Revenue recognition principle: You record that you earned money when you actually give the customer what they paid for (like the pizza being delivered), and you expect to get the cash for it.

Recognizing Expenses

• Expense recognition (matching) principle: This is like saying, "If you're going to claim you earned money from selling those pizzas, you also have to record the cost of the ingredients for those pizzas in the same time period." It's about matching the costs with the sales they helped create.

Framework for Adjustments

• Sometimes, money stuff doesn't neatly fit into one period. These are adjustments.

  • Deferrals: When you pay cash before you use something (like prepaid phone credit).

  • Accruals: When you use something or earn money before any cash changes hands (like working a job but getting paid next week).

• How to make an adjustment (3 steps):

1. Find out what the account balance is right now.

2. Figure out what the balance should be (the correct amount after considering what's been used or earned).

3. Make an "adjusting entry" (like a little tweak) to fix it.

• These tweaks always affect one account that shows up on your budget (income statement) and one account that shows what you own/owe (balance sheet). But never the actual cash account!

Prepare Adjusting Entries for Deferral of Expenses (P1)

Prepaid (Deferred) Expenses

• These are things you paid for in advance before you actually get the good stuff. Like paying for a year of gym membership upfront.

• Examples: Prepaid Insurance, Prepaid Rent, Supplies (like school supplies).

Adjusting for Prepaid Insurance

• You bought 24 months of insurance for $2,400$ on Dec 1. That's $100$ per month ($2,400 / 24$ months).

• By Dec 31, one month has passed, so $100$ of that insurance is "used up" (it's expired!).

• You need to show that you now have $2,300$ left of "Prepaid Insurance" (an asset), and you've used $100$ worth of "Insurance Expense." It's like your gym membership: after one month, you have less prepaid time left, and you've incurred the expense of one month's worth of gym access.

Adjusting for Supplies

• Imagine you buy $9,720$ worth of art supplies. At the end of the month, you still have $8,670$ left.

• The difference (what you used) is $9,720 - 8,670 = 1,050$. This $1,050$ is your "Supplies Expense" for the month. The leftovers are still your "Supplies" asset.

Straight-Line Depreciation

• Depreciation: When you buy something big like a computer, it doesn't stay new forever; it loses value over time. Depreciation is how businesses slowly count that loss of value as an expense over the item's "useful life."

• Instead of saying your computer is worthless the day after you buy it, you spread out its cost over, say, 5 years. This is your depreciation expense.

• Formula (straight-line): Think of it as dividing the cost that can be depreciated by the number of years you expect to use it.
  $\text{Depreciation per period} = \frac{\text{Depreciable Cost}}{\text{Useful Life in periods}}$

• This expense reduces the value of the asset on the books (through "Accumulated Depreciation").

Adjusting for Depreciation – Step 1

• FastForward bought equipment for $26,000$. They think it'll be useful for 5 years and be worth $8,000$ as "salvage" (like its trade-in value) at the end.

• So, the value they need to depreciate is $26,000 - 8,000 = 18,000$.

• Over 5 years (60 months), that's $18,000 / 60 = 300$ per month. That's your monthly depreciation "wear and tear" cost.

Deferral of Revenue (P2)

Unearned Revenue

• This is when a customer gives you cash before you've actually done the work or delivered the product. Like getting paid for a tutoring session before you've tutored.

• It's a liability because you owe them something (the service) until you actually perform it. Only then does it become real "revenue."

Adjusting for Unearned Revenues – Example

• A client pays you $3,000$ upfront for 60 days of consulting. You record that $3,000$ as "Unearned Consulting Revenue" (a liability).

• By Dec 31, if 5 days have passed, you've now earned 5/60 of $3,000$, which is $250$.

• You adjust by reducing the "Unearned Consulting Revenue" (you owe them less now) and increasing your "Consulting Revenue" (you actually earned this $250$!).

Accrued Expenses (P3)

Accrued expenses are costs incurred that are both unpaid and unrecorded.

• These are expenses you've used but haven't paid for yet, and you haven't even written them down. Like working hours in the last few days of the month when payday is next month.

• Examples: Salaries you owe, rent you haven't paid, taxes you owe, interest on a loan.

Adjusting for Accrued Salaries

• Say FastForward pays its team $70$ a day. Dec 31 is a Wednesday, meaning people worked Monday, Tuesday, Wednesday and are owed $70 \times 3 = 210$. But payday isn't until next week!

• You need to show that the company owes $210$ for salaries ("Salaries Payable" - a liability) and that it incurred a "Salaries Expense" of $210$ for the work done in December.

Accrued Revenues (P4)

Accrued Revenues

• This is money you've earned for work you've already done, but you haven't billed the customer yet, and you definitely haven't received the cash.

Adjusting for Accrued Services Revenue

• You agree to do a 30-day service for $2,700$, starting Dec 12, with payment due Jan 10.

• By Dec 31, you've done 20 days of work. So, you've earned 20/30 of $2,700$, which is $1,800$.

• You adjust by increasing "Accounts Receivable" (the customer owes you $1,800$ - an asset) and increasing your "Consulting Revenue" (you earned that $1,800$!).

Preparing Financial Statements from an Adjusted Trial Balance (P5)

• After all those adjustments, you use the final numbers to create your major financial reports.

1. Income Statement: Shows if you made a profit (like your report card for how much money you made vs. spent).

2. Statement of Retained Earnings: Shows how much profit the company kept or paid out as dividends.

3. Balance Sheet: A snapshot of what the company owns (assets), owes (liabilities), and the owner's stake (equity) at a specific moment in time.

4. Statement of Cash Flows: Shows where the cash came from and where it went (we'll cover that later).

Closing Entries and a Post-Closing Trial Balance (P6)

• Closing Process: At the end of the "school year," you reset certain accounts to zero to start fresh for the next year. It's like clearing your desk.

  • Temporary Accounts: These are like your weekly allowance or spending money; they get reset to zero at the end of the period (revenue, expenses, dividends).

  • Permanent Accounts: These are like your savings account balance; they just carry over to the next period (assets, liabilities, and the main equity account).

• The main goal of closing is to update the "Retained Earnings" (the accumulated profit kept in the business) with the net income and dividends from the year.

Classified Balance Sheet (C2)

• A classified balance sheet is like organizing your stuff into two main piles: "Current" and "Long-Term."

• Current items: Things that will turn into cash, be used up, or be paid off within one year (or the business's normal operating cycle, typically a year).

• Long-Term items: Things that will stick around or be paid off over more than one year.

Current Assets

• Things you own that you expect to use up, sell, or collect as cash within a year. Like the cash in your wallet, money friends owe you, or your stash of snacks that you'll eat soon.

• Examples: cash, short-term investments, accounts receivable (money owed to you), supplies, prepaid expenses.

Long-Term Investments

• Assets you plan to hold for more than a year. Like stocks you're saving for college.

Plant Assets (PP&E)

• These are the big, physical things a business owns and uses for a long time to make stuff or run the show. Think of a school building, computers in the lab, or the school bus.

• Also called property, plant, and equipment (PP&E).

Intangible Assets

• These are valuable things a company owns that you can't touch. Like a secret recipe, a brand name, or a song's copyright. They benefit the business for a long time but have no physical form.

• Examples: patents, trademarks, copyrights, goodwill.

Current Liabilities

• Money the company owes that needs to be paid off within one year. Like your phone bill or a small loan you need to repay soon.

• Examples: accounts payable (money you owe suppliers), wages payable (salaries to pay), unearned revenues (money customers paid you but you haven't earned yet).

Long-Term Liabilities

• Money the company owes that won't be due for more than a year. Like your family's mortgage or a long-term car loan.

Equity

• This is the owner's share or claim on the business's assets. For a big company, it's called "Retained Earnings" (profits kept in the business) and "Common Stock" (what owners originally put in).

Profit Margin and Current Ratio (A1)

• Profit Margin: This tells you how much profit a company makes for every dollar of sales. If your lemonade stand has a high profit margin, it means you're doing great at turning sales into actual money in your pocket.

  • Formula: $\text{Profit Margin} = \frac{\text{Net Income}}{\text{Net Sales}}$

• Current Ratio: This is like checking if you have enough quick money (current assets) to pay off your immediate bills (current liabilities). A higher number means you're in a better cash position.

  • Formula: $\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$

End of Chapter 3