Chapter 4: Adjustments, Trial Balance, and Financial Statements

Acct 2301 Fall 2009 Cox School of Business, SMU

Professor Zining Li

What do We Hope to Learn?

• Accounting Cycle• Adjusting entries

– What, why, when, and how to adjust?

• Unadjusted and adjusted trial balance• Preparing financial statements• Closing process

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Accounting Cycle

1. Identify recordable financial transactions2. Record the journal entries3. Post journal entry amounts to T-accounts4. Prepare the unadjusted trial balance5. Record adjusting journal entries6. Prepare the adjusted trial balance7. Prepare the financial statements8. Record the closing entries

1. Identify recordable financial transactions2. Record the journal entries3. Post journal entry amounts to T-accounts4. Prepare the unadjusted trial balance5. Record adjusting journal entries6. Prepare the adjusted trial balance7. Prepare the financial statements8. Record the closing entries

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Adjusting Entries• Under accounting, revenues (expenses) are

recorded when they are earned (incurred)• Sometimes revenues (expenses) are earned

(incurred) without any external transaction• Adjusting entries are needed to record such

revenues and expenses in the correct period• Adjustments are made at the end of a reporting

period

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Timetable of the Adjustment Process

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1/1/04 12/31/04

Adjustments are made at the end of the period, but before the financial statements are prepared

Adjustments are made at the end of the period, but before the financial statements are prepared

Transactions are recorded all during the period

Transactions are recorded all during the period

What need to be adjusted• Accruals

– Accrued revenues– Accrued expenses

• Deferrals

– Deferred revenues – Deferred expenses

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What need to be adjusted (1)

• Accrued revenues– Those are revenues that are already earned,

although cash haven’t been collected– Revenues need to be recorded, at the same

time, assets are increased

• Example: interest revenue

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On October 1, 2006, Webb, Inc. invests $10,000 for 6 months in a certificate of deposit that pays 6% interest per year. Webb will not receive the interest until the CD matures on March 31, 2007. On December 31, 2006, Webb, Inc. must make an entry for the interest earned so far.

Interest Receivable

12/31 150

Bal. 150

Interest Revenue

12/31 150

Bal. 150

What need to be adjusted (2)• Accrued expenses

– Those are expenses that are already incurred through out the accounting period, although cash haven’t been paid

– Expense need to be recorded, at the same time, liabilities are increased

• Examples:– Salary expense– Interest expense– Tax expense

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• As of 12/27/06, Denton, Inc. had already paid $1,900,000 in wages for the year. Denton pays its employees every Friday. Year-end, 12/31/06, falls on a Wednesday. The employees have earned total wages of $50,000 for Monday through Wednesday of the week ending 1/02/07.

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Wages Payable

12/31 50,000

Bal. 50,000

Wages Expense

$1,900,000

Bal. $1,950,000

As of 12/27

12/31 50,000

After we post the entry to the T-accounts, the After we post the entry to the T-accounts, the account balances look like this:account balances look like this:After we post the entry to the T-accounts, the After we post the entry to the T-accounts, the account balances look like this:account balances look like this:

What need to be adjusted (3)• Deferred revenues

– Previously recorded as liabilities when cash were received before goods were delivered or services were rendered

– At the end of reporting period, if the earning process is complete, these liability accounts need to be reduced, and revenues are recorded

• Examples– Unearned rent revenue --> rent revenue– Unearned franchise revenue --> franchise revenue– Unearned subscription revenue --> subscription revenue– Unearned ticket revenue --> ticket revenue

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On December 1, 2006, Tom’s Rentals received a check for $3,000, for

the first four months’ rent from a new tenant.

On December 1, 2006, Tom’s Rentals received a check for $3,000, for

the first four months’ rent from a new tenant.

On December 31, 2006, Tom’s Rentals must adjust the Unearned Rent Revenue account to reflect that one month of rent revenue has been earned. $3,000 × 1/4 = $750

On December 31, 2006, Tom’s Rentals must adjust the Unearned Rent Revenue account to reflect that one month of rent revenue has been earned. $3,000 × 1/4 = $750

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Unearned Rent Revenue

12/31 750 12/1 3000

Bal. 2,250

Rent Revenue

12/31 750

Bal. 750

After we post the entry to the T-accounts, the After we post the entry to the T-accounts, the account balances look like this:account balances look like this:

After we post the entry to the T-accounts, the After we post the entry to the T-accounts, the account balances look like this:account balances look like this:

What need to be adjusted (4)• Deferred expenses

– Previously recorded as assets when cash were paid before these assets are being used

– At the end of reporting period, the “used-up” amount of these assets need to be reduced, and expenses are recorded

• Examples– Buildings and Equipment (PP&E) --> Depreciation expenses– Supplies --> Supplies expense– Prepaid rent --> Rent expense– Prepaid insurance --> Insurance expense

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On January 1, 2006, Matrix, Inc. paid $3,600 for a 3-year fire insurance

policy. On January 1, 2006, Matrix, Inc. paid $3,600 for a 3-year fire insurance

policy.

On December 31, 2006, Matrix, Inc. adjust the Prepaid Insurance adjust the Prepaid Insurance Expense account to reflect that 1 year of the policy has expired. Expense account to reflect that 1 year of the policy has expired. $3,600 X 1/3 = $1,200

On December 31, 2006, Matrix, Inc. adjust the Prepaid Insurance adjust the Prepaid Insurance Expense account to reflect that 1 year of the policy has expired. Expense account to reflect that 1 year of the policy has expired. $3,600 X 1/3 = $1,200

PrepaidInsurance

1/1 3,600 12/31 1,200

Bal. 2,400

Insurance Expense

12/31 1,200

Bal. 1,200

After we post the entry to the T-accounts, the After we post the entry to the T-accounts, the account balances look like this:account balances look like this:

After we post the entry to the T-accounts, the After we post the entry to the T-accounts, the account balances look like this:account balances look like this:

Journal Entry for Depreciation Expense is different

• Accumulated Depreciation is a contra-asset account; it carries a credit balance

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Dr. Deprecation Expense

Cr. Accumulative Depreciation

On January 1, 2006, Matrix, Inc. paid $8,000 for equipment, which is expected to last 5 years

On January 1, 2006, Matrix, Inc. paid $8,000 for equipment, which is expected to last 5 years

On December 31, 2006, Matrix, Inc. adjust the Equipment adjust the Equipment account to reflect that 1 year use of the equipmentaccount to reflect that 1 year use of the equipment

$8,000 X 1/5 = $1,600

On December 31, 2006, Matrix, Inc. adjust the Equipment adjust the Equipment account to reflect that 1 year use of the equipmentaccount to reflect that 1 year use of the equipment

$8,000 X 1/5 = $1,600

Depreciation Expense

12/31 1,600

Bal. 1,600

Equipment

1/1 8,000

Bal. 8,000

Accumulated Depreciation-- Equipment

12/31 1,600

Bal. 1,600

Equipment - Accumulated Depreciation= Equipment (net)

(Net) Book Value of Equipment= 8,000- 1600

(Net) Book Value of Equipment

Adjusting Entries: Summary• Done at the end of reporting period• No cash account in an adjusting entry• Revenues and expenses are recorded• Non-cash asset accounts or liability accounts

are increased or decreased• Adjusting entries affect income statement,

balance sheet, statement of retained earnings; but NOT cash flow statement

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Exercise: Recording transactions with journal entries College Caps, Inc. operates a small retail store in the mall that sells baseball

caps. The following transactions occurred during June 2004.

Record all journal entries and the adjusting entries that must be made at June 30 before the company prepare its financial statements.

•June 1 Paid $700 cash for insurance policy through December 31, 2004.

•June 1 Purchased store equipment for $5,000 and paid cash. The company estimates annual depreciation of $1,200.

•June 5 Purchased supplies worth $500 with cash.

•June 15 Loaned $10,000 to the manager of the store (as a personal loan) for one year. The annual rate of interest on the loan is 12%. The loan is supported by a note and interest is due upon repayment.

•June 28 Earned revenue of $1,400 with delivery of custom cap order for SMU football team. SMU must pay the bill by July 31. Cost of the caps sold was $500.

•June 30 Amount of supplies on hand is $300. The balance in the Supplies account was $150 on June 1.

Transactional Journal Entries

Debits Credits June 1 Prepaid Insurance $700 Cash $700 June 1 Equipment $5,000 Cash $5,000 June 5 Supplies $500 Cash $500 June 15 Notes receivable $10,000 Cash $10,000 June 28 Accounts receivable $1,400 Sales revenue $1,400 Cost of goods sold $500 Inventory $500

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Adjusting Journal Entries

Debits Credits June 30 Supplies expense $350 Supplies $350 June 30 Insurance expense $100 Prepaid insurance $100 June 30 Depreciation expense $100 Accumulated depreciation $100 June 30 Interest receivable $50 Interest revenue $50

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Exercise: Complete the accounting cycleCollege Caps, Inc. Trial Balance – unadjusted

as of June 30, 2004

Account DR CR

Cash 8,150 Accounts Receivable 7,500 Supplies 650 Inventory 5,500 Prepaid Insurance 700 Notes Receivable 10,000 Equipment 5,000 Accounts Payable 6,050 Contributed Capital 30,000 Retained Earnings

550 Sales Revenue 1,400 Cost of Sales 500

TOTALS 38,000 38,000

1. Based on the information provided in previous example, post the adjusting entries for the period ended June 30, 2004 and prepare an adjusted trial balance. Income tax expense should be recorded at 30% of pretax net income.

2. Prepare the income statement, statement of retained earnings, and balance sheet.

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College Caps, Inc. Adjusted Trial Balance as of

June 30, 2004

Account DR CRCash 8,150 Accounts Receivable 7,500 Supplies 300 Inventory 5,500 Prepaid Insurance 600Interest Receivable 50Notes Receivable 10,000 Equipment 5,000 Accumulated Depreciation 100Accounts Payable 6,050Income tax payable 120 Contributed Capital 30,000 Retained Earnings 550 Sales Revenue 1,400 Cost of Sales 500Depreciate expense 100Supplies expense 350Insurance expense 100Income tax expense 120Interest revenue 50

TOTALS 38,270 38,2702

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College Caps, Inc. The Income Statement

For the month ended June 30, 2004

Sales Revenue 1,400 Cost of Sales ( 500) Gross Profit 900Depreciate expense (100)Supplies expense ( 350)Insurance expense (100)Operating Income 350Other revenues (expenses)Interest revenue 50Pre-tax Income 400 Income tax expense (120)Net Income 280

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College Caps, Inc. Statement of Retained Earnings

For the month ended June 30, 2004

Retained Earnings (beg.) 550 Net Income 280Dividend (0)Retained Earnings (ending) 830

College Caps, Inc. Balance Sheet

as of June 30, 2004

AssetsCash 8,150 Accounts Receivable 7,500 Supplies 300 Inventory 5,500 Prepaid Insurance 600 Interest Receivable 50Notes Receivable 10,000Current Assets 32,100Equipment 5,000 Accumulated Depreciation (100)Total Assets 37,000LiabilitiesAccounts Payable 6,050 Income Tax Payable 120Total Liabilities 6,050Stockholders’ EquityContributed Capital 30,000 Retained Earnings 830 Total stockholders’ equity 30,950Total liabilities and stockholders’ equity 37,000

Closing• When: After all four financial statements are

prepared• What: all income statement accounts• Closing means to bring the balances of all the

income statement accounts to zero• Key Terms

– Permanent accounts– Temporary accounts

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Closing Journal Entry

Dr. Sales revenue $1,400Dr. Interest revenue 50 Cr. Cost of sale $500 Cr. Depreciation exp. 100 Cr. Supplies expense 350 Cr. Insurance expense 100

Cr. Retained Earnings $400

Accounting Cycle

1. Identify recordable financial transactions2. Record the journal entries3. Post journal entry amounts to T-accounts4. Prepare the unadjusted trial balance5. Record adjusting journal entries6. Prepare the adjusted trial balance7. Prepare the financial statements8. Record the closing entries

1. Identify recordable financial transactions2. Record the journal entries3. Post journal entry amounts to T-accounts4. Prepare the unadjusted trial balance5. Record adjusting journal entries6. Prepare the adjusted trial balance7. Prepare the financial statements8. Record the closing entries

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