1

Chapter 4:Chapter 4:Preparing Financial StatementsPreparing Financial Statements

2

Preparing Financial StatementsPreparing Financial StatementsChapter 4 is a continuation of Chapter 3.Once the general journal entries have been

posted and totaled, and a Trial Balance prepared, additional activities must be considered before preparing financials.

The remaining steps in the process are:- Adjusting journal entries- Adjusted Trial Balance- Preparation of financial statements- Closing journal entries- Post-closing Trial Balance

3

Why Use Adjusting Entries?Why Use Adjusting Entries?

Accrual Basis– recognize revenues in the period they are

earned– recognize expenses in the period they are

incurred– basis of the matching principle

Adjusting Journal Entries (AJEs) align revenues and expenses at the end of the accounting period (month, quarter, year).

4

Adjusting Journal Entries (AJEs)Adjusting Journal Entries (AJEs)

Prepared at the end of the accounting period to align revenues and expenses (matching).

Usually NO document flow to trigger recording (internal transaction).

Based on the accrual system of accounting which records revenues as earned and expenses as incurred (rather than based on cash flows).

5

Accrual System vs. Accrual AJEsAccrual System vs. Accrual AJEsThe “accrual system of accounting” and

“accrual of revenues and expenses” are both discussed in this chapter.

Note that the “accrual of revenues and expenses” is a subset of the AJEs discussed in this chapter.

In comparison, the “accrual system of accounting” refers to the entire process of revenue and expense recognition, and relates to the definitions of matching and revenue recognition discussed in this chapter.

6

The Revenue Recognition PrincipleThe Revenue Recognition Principle This principle determines when revenues can

be recognized. Revenue recognized when realized (or

realizable) and earned. This principle triggers the matching principle,

which is necessary for determining the measure of performance.

The most common point of revenue recognition is when goods or services are transferred or provided to the buyer (at delivery).

7

The Matching PrincipleThe Matching Principle Matching focuses on the timing of recognition of

expenses after revenue recognition has been determined.

This principle states that the efforts of a given period (expenses) should be matched against the benefits (revenues) they generate.

For example, the cost of inventory is initially capitalized as an asset on the balance sheet; it is not recorded in Cost of Goods Sold (expense) until the sale is recognized.

8

Types of AJEsTypes of AJEs

1. Accrual of expenses

2. Accrual of revenues

3. Prepaid (deferred) expenses

4. Unearned (deferred) revenues

Most AJEs fit into one of these four categories.

9

1. Accrual of Expenses1. Accrual of Expenses Probably the most common type of AJE.

Ex: accrue interest at the end of the period:

Interest Expense xx

Interest Payable xx Note: this is a “skeletal” journal entry, where the

“xx” simply indicates values to be calculated later. The focus here is on the account and direction.

Other examples of expense/payable include wages, rent, taxes, insurance.

10

1. Accrual of Expenses - Example 11. Accrual of Expenses - Example 1 Raider Company borrowed $10,000 on October

1, 2008. The note included a 5 percent annual interest rate, payable each September 30, starting Sept. 30, 2009. How much interest must Raider accrue at Dec. 31, before financial statements are prepared?Calc: Principal x rate x time

P x R x T

AJE:

11

2. Accrual of Revenues2. Accrual of Revenues

For revenues that have not yet been recorded at the end of the period.

Ex: accrue interest revenue:

Interest Receivable xx

Interest Revenue xxAnother example of receivable/revenue

accruals relates to rent revenue, where the rental payment has not yet been received.

12

2. Accrual of Revenues - Example 22. Accrual of Revenues - Example 2

Raider Company leases out part of its office building to Tu Company for $2,000 per month. At the end of the year, Tu owes Raider for December’s rent. Prepare the AJE for Raider Company:

13

3.Prepaid (Deferred) Expenses 3.Prepaid (Deferred) Expenses This category of AJE relates to the concept of

asset capitalization and the matching principle. Asset capitalization occurs when a cost (with

future economic benefit) is incurred. An asset is recognized at that time. Examples include supplies, prepaid Insurance, inventory, and long term assets like equipment.

As the asset is “used up” in the generation of revenue, the related cost is recognized as an expense (matching).

Some expenses are deferred for a short period of time (supplies expense), and some expenses are deferred and allocated over many years (depreciation expense).

14

3. Prepaid Expenses3. Prepaid ExpensesExample: Purchase 1-year insurance policy.

General JE at time of purchase:

Prepaid Insurance xx

Cash xx

AJE at end of the period (for the portion that has been used):

Insurance Expense xx

Prepaid Insurance xx

15

3.Prepaid Expenses - Example 33.Prepaid Expenses - Example 3Raider Company purchased a 1-year insurance

policy on April 1, 2008 at a cost of $2,400

General JE at time of purchase:

Prepaid Insurance 2,400

Cash 2,400

Calculation for AJE at December 31 to recognize the portion that has been used up:

16

3.Prepaid Expenses 3.Prepaid Expenses Example: purchase of equipment.

General JE at time of purchase:Equipment xx

Cash xx AJE at end of the period (for the portion that

has been used):Depreciation Expense xx

Accumulated Depreciation xx Note: Accumulated Depreciation is a contra

asset account and is presented as an offset to Equipment on the balance sheet (expanded coverage in Chapter 8).

17

3.Prepaid Expenses - Example 43.Prepaid Expenses - Example 4Raider Company purchased equipment in 2006

at a cost of $30,000. The equipment has a useful life of 10 years and no salvage value.

Calculation for AJE at December 31, 2008 for the current year’s depreciation.

18

4.Unearned (Deferred) Revenues 4.Unearned (Deferred) Revenues Cash is received from customer before

goods/services are delivered (before revenue can be recognized).

Ex: Received subscription in advance (other examples include rent received in advance, and advance collections for gift cards).

General JE at time cash received:Cash xx

Unearned Revenues xx AJE at end of the period (for portion earned):

Unearned Revenues xxSubscription Revenues xx

19

4.Unearned Revenues - Example 5 4.Unearned Revenues - Example 5 Raider Company received $6,000 on November

30, 2008 for subscriptions to be delivered over the next 12 months, starting in December of 2008.

General JE at time cash received:Cash 6,000

Unearned Revenues 6,000 AJE at end of the period (for portion earned):

20

Class Problem – Prepare Adjusting EntriesClass Problem – Prepare Adjusting Entries The trial balance of Mega Company, Inc. at the end of its

annual accounting period is as follows:Mega Company

Unadjusted Trial BalanceDecember 31, 2008

Cash $ 3,000Prepaid Insurance 1,600Supplies 2,100Equipment 20,000Accumulated depreciation $ 2,000Common Stock 10,000Retained Earnings 7,000Dividends 1,000Revenue 33,000Salaries Expense 18,300Rent Expense 6,000 ______Totals $52,000 $52,000

21

Adjusting EntriesAdjusting Entries

1. Unexpired insurance at December 31 was $1,000.

22

Adjusting EntriesAdjusting Entries

2. Unused supplies, per inventory, $800 at December 31.

23

Adjusting EntriesAdjusting Entries

3. Estimated Depreciation for 2008 is $1,000

24

Adjusting EntriesAdjusting Entries

4. Earned but unpaid salaries at December 31, $700.

25

Adjusted Trial BalanceAdjusted Trial BalanceThe Adjusted Trial Balance reflects totals

after the AJEs are posted to the General Ledger.

The balance sheet accounts reflect the end-of-year balances, and the income statement accounts reflect the proper revenues and expenses to be recognized for the year.

This list of accounts and amounts is used to prepare the Balance Sheet and Income Statement.

The adjusted trial balance for Mega Company (after posting AJEs) is shown on the next slide.

26

Class Problem – Adjusted Trial BalanceClass Problem – Adjusted Trial BalanceMega Company, Adjusted Trial Balance, 12/31/08

Cash $ 3,000Prepaid Insurance 1,000Supplies 800Equipment 20,000Accumulated depreciation $ 3,000Salaries Payable 700Common Stock 10,000Retained Earnings 7,000Dividends 1,000Revenue 33,000Salaries Expense 19,000Rent Expense 6,000Insurance Expense 600Supplies Expense 1,300Depreciation Expense 1,000 ______Totals $53,700 $53,700

27

Preparation of Financial StatementsPreparation of Financial Statementsfrom the Adjusted Trial Balancefrom the Adjusted Trial Balance

The amounts in the Adjusted Trial Balance are used to prepare the Balance Sheet and the Income Statement.

Retained Earnings has a unique treatment in this process.

The Retained Earnings on the Adjusted Trial Balance is a beginning balance; while the revenues, expenses, and dividends are displayed in the Trial Balance, they have not yet been included in (closed to) Retained Earnings.

28

Financial StatementsFinancial Statements

The Adjusted Trial Balance is used to prepare the financial statements.

The financial statements are prepared in the following order:– Income Statement (I/S)– Statement of Retained Earnings (SRE)– Balance Sheet (B/S)

Note: The Statement of Cash Flow (SCF) is not prepared from the Adjusted Trial Balance but from a detailed analysis of the cash flow activities of the company.

29

Financial StatementsFinancial Statements Comments on the preparation of financial

statements from Adjusted Trial Balance (ATB):– revenue and expense balances from the ATB

are carried to the Income Statement.– net income is carried to the Statement of

Retained Earnings.– dividends are carried to the Statement of

Retained Earnings.– the ending balance in the Statement of

Retained Earnings is carried to the stockholders’ equity section of the Balance Sheet.

– asset and liability balances from the ATB are carried to the Balance Sheet.

30

Closing Journal Entries (CJEs)Closing Journal Entries (CJEs)Prepared after the financial statements

have been completed.Close temporary (nominal) accounts to

Retained Earnings so that the balances in those accounts at the start of the next accounting period will be zero.

Temporary accounts include revenues, expenses, and dividends.

31

Closing Journal Entries (CJEs)Closing Journal Entries (CJEs)First, close all revenues and expenses to

retained earnings (your text does this in 3 entries, and uses an Income Summary account to break out the components). (Note that the adjustment to RE in this entry carries the effect of net income to retained earnings.)

Second, close dividends to retained earnings. After these entries are posted, the temporary

accounts are now at zero, and the company is ready to start the next period.

Note that the post-closing trial balance will include only the permanent, balance sheet accounts, and the retained earnings account is finally the ENDING retained earnings.

32

Closing Journal Entries (CJEs) - ExampleClosing Journal Entries (CJEs) - Example

Refer to Mega Company Adjusted Trial Balance.Close revenues and expense to retained earnings:Revenue 33,000

Salaries Expense 19,000 Rent Expense 6,000 Insurance Expense 600 Supplies Expense 1,300 Depreciation Expense 1,000

33

Closing Journal Entries (CJEs) - ExampleClosing Journal Entries (CJEs) - Example

Refer to Mega Company. Now close the balance in the Dividends account to Retained Earnings.

3434

Closing Journal entriesClosing Journal entries

Retained Earnings

Now post the effects of retained earnings to the RE general ledger account.

35

Post-closing Trial BalancePost-closing Trial Balance

The final Trial Balance after closing will display only permanent, balance sheet accounts.

The Retained Earnings in this Trial Balance is the ENDING retained earnings for the period and includes the effects of all the revenues, expenses, and dividends for the period.

36

Class Problem – Postclosing Trial BalanceClass Problem – Postclosing Trial Balance

Mega Company, 12/31/08, Postclosing Trial Balance

Cash $ 3,000Prepaid Insurance 1,000Supplies 800Equipment 20,000Accumulated depreciation $ 3,000Salaries Payable 700Common Stock 10,000Retained Earnings ______ 11,100 Totals $24,800 $24,800

37

Review – Accounting CycleReview – Accounting Cycle1. Analyze transactions.2. Prepare general journal entries, and post

to general ledger.3. Prepare unadjusted trial balance.4. Prepare adjusting journal entries, and

post to general ledger.5. Prepare adjusted trial balance.6. Prepare financial statements.7. Prepare closing journal entries, and post

to general ledger.8. Prepare post-closing trial balance.