Chapter 03 – Adjusting Accounts for Financial Statements
3-11
Chapter Outline
Notes
1. Profit margin (also called return on sales) is a useful measure
of a company’s operating results.
2. It is calculated as net income divided by net sales.
3. It is interpreted as reflecting the portion of profit in each dollar
of sales.
B. Current Ratio
1. The current ratio is an important measure of a company’s
ability to pay its short-term obligations.
2. It is calculated as total current assets divided by total current
liabilities.
VIII. Alternative Accounting for Prepayments (Appendix 3A)
A. Recording Prepayment of Expenses in Expense Accounts
Prepaid expenses may originally be recorded with debits to
expense accounts (instead of to asset accounts). If so, then
adjusting entries must transfer the cost of the unused portions from
expense accounts to prepaid expense (asset) accounts.
B. Recording Prepayment of Revenues in Revenue Accounts
Unearned revenues may originally be recorded with credits to
revenue accounts (instead of to liability accounts). If so, then
adjusting entries must transfer the unearned portions from revenue
accounts to unearned revenue (liability) accounts.
C. The financial statements are identical under either procedure, but
the adjusting entries are different.
IX. Work Sheet as a Tool (Appendix 3B)
A. Working papers are internal documents. One widely used working
paper is the work sheet, which is a useful tool for preparers in
working with accounting information. It is usually not available to
external decision makers.
B. Use of a Worksheet. Preparing a worksheet has five steps:
1. Enter the unadjusted trial balance in the first two columns.
2. Enter the adjustments in the third and fourth columns. Total
columns to verify debit adjustments equal credit adjustments.
3. Prepare the Adjusted Trial Balance. This is done by combining
the unadjusted trial balance and adjustment columns. Total
Adjusted Trial Balance columns to verify debits equal credits.
4. Sort the adjusted trial balance amounts to the appropriate
financial statement columns.
5. Total statement columns, compute net income or loss, and
balance the columns by adding net income or loss.
Chapter 03 – Adjusting Accounts for Financial Statements
3-12
Chapter Outline
Notes
X. Reversing Entries (Appendix 3C)
A. Reversing entries are optional; they are recorded in response to
accrued assets and accrued liabilities that were created by
adjusting entries at the end of a reporting period.
B. Accounting without Reversing Entries—the disadvantage of this
approach is the slightly more complex entry required when the
cash subsequently changes hands (i.e., when cash is received for
the asset that was originally accrued or when cash is paid for the
liability that was originally accrued).
C. Accounting with Reversing Entries
1. A reversing entry is the exact opposite of an adjusting entry.
2. Reversing entries are prepared after closing entries and dated
the first day of the new period.
3. Procedure is to transfer accrued asset and liability account
balances to related revenue and expense accounts creating
abnormal balances in these accounts.
4. The full subsequent cash receipts (and payments) are recorded
as increases in revenue (and expense) accounts creating a net
balance equal to the amount earned or incurred in that period.
Chapter 03 – Adjusting Accounts for Financial Statements
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VISUAL #3-1
ACCRUAL BASIS ACCOUNTING
(Follows GAAP)
requires that the
Income Statement
(for a period)
reports
ALL REVENUES EARNED in period (Collected or Not)
Minus ALL EXPENSES INCURRED in period (Paid
or Not)
Equals Net Income or Net Loss for the period
ACCOUNTS MUST BE ADJUSTED TO FOLLOW
PRINCIPLES
GAAP
Matching
Chapter 03 – Adjusting Accounts for Financial Statements
3-14
VISUAL #3-2
DEFERRALS
The converse of statements in Visual #3-1 also applies.
Revenue not earned or expense not incurred results in
Deferrals*
UNEARNED = LIABILITY *
A REVENUE not earned cannot be shown, even if collected.
An EXPENSE not incurred cannot be shown, even if paid.
PREPAID = ASSET *
*We defer or postpone the reporting of the collected revenues
(as revenues) and prepaid expenses (as expenses) until the
revenue is earned and the expense is incurred.
Chapter 03 – Adjusting Accounts for Financial Statements
3-15
VISUAL #3-3
ADJUSTMENTS
TYPE
GENERALIZED*
ENTRY
AMOUNT
1. Prepaid items or supplies
a) initially recorded as assets
Dr. _________ Expense
Cr. The Asset* acct.
Amount used, or
consumed, or expired
b) initially recorded as
expenses (alternate
treatment)
Dr. the Asset** acct.
Cr. ________ Expense
Amount left, or
not consumed, or
unexpired
2. Accrued expenses
(expenses incurred but not
yet recorded)
Dr. _________ Expense
Cr. _________ Payable
Amount accrued
3. Accrued revenues
(revenues earned but not
yet recorded)
Dr. ________ Receivable
Cr. The Revenue**
acct.
Amount accrued
4. Long-term assets that are
depreciable
Dr. Depreciation Expense
Cr. Accumulated
Depreciation
Portion of cost
allocated to this period
as depreciation
5. Unearned revenues
(received in advance)
a) record initially as liability
(unearned account)
Dr. Unearned ________
Cr. The Revenue**
acct.
Amount earned to date
b) initially recorded as a
revenue (alternate
treatment)
Dr. the Revenue** acct.
Cr. Unearned________
Amount still not
earned
* Note: (1) Each adjustment affects a Balance Sheet Account and an Income
Statement Account (2) CASH NEVER appears in an adjustment.
** Title or account name varies.
Chapter 03 – Adjusting Accounts for Financial Statements
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VISUAL #3-4
THE ACCOUNTING CYCLE
STEPS
PURPOSE
TIMING
1. Analyze
transactions
Analyze transactions to prepare for
journalizing.
During the period
2. Journalize
Record accounts, including debits and
credits, in a journal.
During the period
3. Post
Transfer debits and credits from the
journal to the ledger.
During the period
4. Prepare
unadjusted
trial balance
Summarize unadjusted ledger
accounts and amounts.
End of period
5. Adjust
Record adjustments to bring account
balances up to date; journalize and
post adjusting entries.
End of period
6. Prepared adjusted
trial balance
Summarize adjusted ledger accounts
and amounts.
End of period
7. Prepare
statements
Use adjusted trial balance to prepare
financial statements.
End of period
8. Close
Journalize and post entries to close
temporary accounts.
End of year
9. Prepare post-
closing trial
balance
Test clerical accuracy of the closing
procedures.
End of year
10. Reverse
(Optional)
Reverse certain adjustments in the
next period
Beginning of next
year
Chapter 03 – Adjusting Accounts for Financial Statements
3-17
VISUAL #3-5
MUSIC WORLD
BALANCE SHEET
DECEMBER 31, xxxx
Assets
Current Assets
Cash
$30,360
Short-Term Investments
2,000
Notes Receivable
8,000
Accounts Receivable
35,300
Merchandise Inventory
60,400
Prepaid Insurance
6,600
Supplies
1,696
Total Current Assets
$144,356
Investments
Land Held for Future Use
13,950
Property, Plant, and Equipment
Land
$ 4,500
Building
$20,650
Less Accumulated Depreciation
8,640
12,010
Office Equipment
$ 8,600
Less Accumulated Depreciation
5,000
3,600
Total Property, Plant, and Equipment
20,110
Intangible Assets
Trademark
500
Total Assets
$178,916
Liabilities
Current Liabilities
Notes Payable
$15,000
Accounts Payable
25,683
Salaries Payable
2,000
Current Portion of Mortgage Payable
10,200
Total Current Liabilities
$ 52,883
Long-Term Liabilities
Mortgage Payable
27,600
Total Liabilities
$ 80,483
Equity
Common Stock
40,000
Retained Earnings
58,433
Total Liabilities and Equity
$178,916