Chapter 3 Adjusting Accounts and Preparing Financial Statements Timing and Reporting Time period assumption presumes that an organization s activities can be divided into specific time periods such as a month 3 month quarter or six month interval Accounting periods aka reporting periods annually semiannually monthly quarterly Annual financial statements reports covering a 1 year period Interim financial statements reports covering one three or six months of activity The annual reporting period is not always a calendar year ending on December 31st o Fiscal year any 12 consecutive months Natural business year companies experiencing seasonal variation in sales often choose this for their reporting period when sales activities are at their lowest level for the year Accrual basis accounting uses the adjusting process to recognize revenues when earned and expenses when incurred o Increases the comparability of financial statements from one period to another Cash basis accounting recognizes revenues when cash is received and records expenses when cash is paid not consistent with GAAP Not all activities are complete when financial statements are prepared therefore we need adjustments Two principles in the adjusting process o Revenue recognition revenue be recorded when earned o Expense recognition matching principle record expenses in the same accounting period as the revenues that are earned as a result of those expenses Adjusting Accounts Step 1 determine what the current account balance equals Step 2 determine what the current account balance should be Step 3 record an adjusting entry to get from step 1 to step 2 Adjusting entry made at the end of an accounting period to reflect a transaction or even that is not yet recorded Prepaid expenses include depreciation and unearned revenues o Reflect transactions when cash is paid or received before a related expense or revenue is recognized o Aka deferrals o Prepaid expenses refer to items paid for in advance of receiving their benefits are assets when these assets are used they become expenses o Plant assets long term tangible assets used to produce and sell products and services expected to provide benefits for more than one period buildings machines vehicles eventually wear out o Depreciation is the process of allocating the costs of these assets over their expected useful lives equipment cost 26 000 will cost 8 000 in 4 years do 26 000 8 000 18 000 18 000 divided by 48 months 4 years 375 depreciation o Contra account is an account linked with another account contra account has a normal balance opposite of the account it is linked with o Book value aka net amount asset s cost minus its accumulated o Unearned revenues cash received in advance of providing products depreciation and services Accrued expenses and accrued revenues o Reflect transactions when cash is paid or received after a related expense or revenue is recognized o Accrued expenses refer to costs that are incurred in a period but are both unpaid and unrecorded must be reported on the income statement of the period when incurred salaries interest o Formula for computing accrued interest Principle amount owed annual interest rate fraction of year since last payment date o Accrued revenue refers to revenues earned in a period that are both unrecorded and not yet received in cash or other assets Each adjusting entry affects one or more income statement accounts and one or more balance sheet accounts but never cash BEFORE ADJUSTING Category Balance sheet Prepaid expenses Unearned revenue Accrued expenses Accrued revenue Asset Income statement Expense understated Revenue understated Expense understated Revenue understated Adjusting entry Debit expense Credit asset Debit liability Credit revenue Debit expense Credit liability Debit assets Credit revenue Asset overstated Equity overstated Liability overstated Equity understated Liability understated Equity overstated understated Equity understated Unadjusted trial balance is a list of accounts and balances prepared before adjustments are recorded Adjusted trial balance is a list of accounts and balances prepared after adjusting entries have been recorded and posted to the ledger Preparing Financial Statements Step 1 prepare income statement using revenue and expense accounts from trial balance Step 2 prepare statement of retained earnings using retained earnings and dividends from trial balance and pull net income from step 1 Step 3 prepare balance sheet using asset and liability accounts and common stock from trial balance and pull updated retained earnings from step 2 Step 4 prepare statement of cash flows from changes in cash flows for the period Closing Process Closing process is an important step at the end of an accounting period after financial statements have been completed it prepares accounts for recording the transactions and the events of the next period we must identify accounts for closing record post the closing entries and prepare a post closing trial balance o Purpose resets revenue expense and dividends account balances at 0 and helps in summarizing a period s revenues and expenses Temporary nominal accounts accumulate data related to one accounting period revenues expenses dividends income summary closing process only applies to temporary accounts Permanent real accounts report on activities related to one or more future accounting periods assets liabilities common stock retained earnings Closing entries record and post closing entries by transferring the end of period balances in revenue expenses and dividends accounts to the permanent retained earnings account Income summary is a temporary account only used for the closing process that contains a credit for the sum of all revenues and a debit for the sum of all losses its balance equals net income or net loss and is then transferred to retained earnings Then the dividends account balance is transferred to retained earnings After these closing entries are posted the revenue expense dividends and income summary are at 0 Step 1 close income statement credit balances Step 2 close income statement debit balances Step 3 use data from step 1 and 2 to credit income summary account and then close it Step 4 close dividends account When closing income summary account that balance goes to retained earnings when closing dividends account it also goes to retained earnings and gets deducted from the income summary account balance Post closing trial balance is a list of
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