Ch. 3 - Adjusting Accounts for Financial Statements

*Contra Account*

*Account linked with another account and having an opposite normal balance; reported as a subtraction from the other account's balance.*

*Cash Basis Accounting*

*Accounting system that recognizes revenues when cash is received and records expenses when cash is paid.* Recognizes revenues when cash is received and record expenses when cash is paid. -This means that cash basis income is the difference between cash receipts and cash payments. *Not* consistent with generally accepted accounting principles. Accrual accounting better reflects business performance than information about cash receipts and payments.

*Accrual basis accounting*

*Accounting system that recognizes revenues when goods or services are provided and expenses when incurred; the basis for GAAP.* Applies adjustments so that revenues are recognized when services and products are delivered, and expenses are recognized when incurred (matched with revenues). Better reflects business performance than information about cash receipts and payments. -Accrual accounting also increases the *comparability* of financial statements from period to period.

*Permanent Accounts*

*Accounts that reflect activities related to one or more future periods; balance sheet accounts whose balances are not closed; also called real accounts.* Report on activities relative to one or more future accounting periods. They include asset, liability, and equity accounts (all balance sheet accounts) -*Permanent accounts are not closed each period and carry their ending balance into future periods* -(not closed at period-end) Assets Liabilities Common Stock Retained Earnings

*Temporary Accounts*

*Accounts used to record revenues, expenses, and withdrawals (dividends for a corporation); they are closed at the end of each period; also called nominal accounts.* Relate to one accounting period. Include all income statements, the dividends account ad the Income Summary account. -Temporary because the accounts are opened at the beginning of a period, used to record transactions and events for that period, and then closed at the end of the period. -*The closing process applies only to temporary accounts. -(closed at period-end) Revenues Expenses Dividends Income Summary

*Book Value*

*Asset's acquisition costs less its accumulated depreciation (or depletion, or amortization); also sometimes used synonymously as the carrying value of an account.* *Net amount*, which equals the asset's costs less its accumulated depreciation.

*Time Period Assumption*

*Assumption that an organization's activities can be divided into specific time periods such as months, quarters, or years.*

*Unclassified balance sheet*

*Balance sheet that broadly groups assets, liabilities, and equity accounts.*

*Classified balance sheet*

*Balance sheet that presents assets and liabilities in relevant subgroups, including current and noncurrent classifications.* Organizes assets and liabilities into subgroups that provide more information to decision makers.

*Current assets*

*Cash and other assets expected to be sold, collected, or used within one year or the company's operating cycle, whichever is longer.* also called, short-term assets. -Short-term investment -Accounts receivables -Short-term notes receivables -Goods for sale (called merchandise or inventory) -Prepaid expenses

*Fiscal Year*

*Consecutive 12-month (or 52-week) period chosen as the organization's annual accounting period.*

*Accrued expenses*

*Costs incurred in a period that are both unpaid and unrecorded; adjusting entries for recording accrued expenses involve increasing expenses and increasing liabilities.* Accrued expenses must be reported on the income statement for the period when incurred. Also called Accrued Liabilities.

*Accumulated Depreciation*

*Cumulative sum of all depreciation expense recorded for an asset.* -Kept in a separate contra account. Accumulated Depreciation has a normal credit balance; it decreases the asset's reported value. -The Accumulated Depreciation contra account includes total depreciation expense for all prior periods for which the asset was used.

*Closing entries*

*Entries recorded at the end of each accounting period to transfer end-of-period balances in revenue, gain, expense, loss, and withdrawal (dividend for a corporation) accounts to the capital account (to retained earnings for a corporation).* Transfer the end-of-period balances in revenue, expense, and dividends accounts to the permanent Retained Earnings account.

*Depreciation*

*Expense created by allocating the cost of plant and equipment to periods in which they are used; represents the expense of using the asset.* Process of allocating the costs of these assets over their expected useful lives. -Depreciation expense is recorded with an adjusting entry similar to that other prepaid expenses. Depreciation does not necessarily measure decline in market value.

*Annual financial statements*

*Financial statements covering a one-year period; often based on a calendar year, but any consecutive 12-month (or 52-week) period is acceptable.*

*Interim financial statements*

*Financial statements covering periods of less than one year; usually based on one-, three-, or six-month periods.*

*Prepaid expenses*

*Items paid for in advance of receiving their benefits; classified as assets.* Assets paid for in advance of receiving their benefits. -When these assets are used, their costs become their expenses.

*Adjusting entry*

*Journal entry at the end of an accounting period to bring an asset or liability account to its proper amount and update the related expense or revenue account.* Is made at the end of an accounting period ot reflect a transaction or event that is not yet recorded. -Each adjusting entry affects one or more income statement accounts and one or more balance sheet accounts (but never the Cash account)

*Accounting Period*

*Length of time covered by financial statements; also called reporting period.*

*Unearned Revenue*

*Liability created when customers pay in advance for products or services; earned when the products or services are later delivered.*

*Unadjusted Trial Balance*

*List of accounts and balances prepared before accounting adjustments are recorded and posted.*

*Post-closing trial balance*

*List of permanent accounts and their balances from the ledger after all closing entries are journalized and posted.* A list of permanent accounts and their balances from the ledger after all closing entries have been journalized and posted. -Lists balances for all accounts not closed. 1.) Total debits equal total credits for permanent accounts 2.) All temporary accounts have zero balances. *Posting closing trial balance is usually the last step in the accounting process.*

*Long-term (or noncurrent) investments*

*Long-term assets not used in operating activities such as notes receivable and investments in stocks and bonds.* non current is also called long-term -Land held for future expansion is a long-term investment because it is not used in operations.

*Straight-line depreciation*

*Method that allocates an equal portion of the depreciable cost of plant asset (cost minus salvage) to each accounting period in its useful life.* Allocates equal amounts of the asset's net cost to depreciation udring its useful life.

*Closing Process*

*Necessary end-of-period steps to prepare the accounts for recording the transactions of the next period.* Important step at the end of an accounting period after financial statements are completed. 1.) Identify accounts for closing 2.) Record and post the closing entries 3.) Prepare a post-closing trial balance.

*Operating cycle*

*Normal time between paying cash. for merchandise or employee services and receiving cash from customers* the time span from when cash is used to acquire goods and services until cash is received from the sale of goods and services. -Time span between... 1.) Paying employees who perform the services (or paying suppliers for merchandise.) 2.) Receiving cash from customers

*Current Liabilities*

*Obligations due to be paid or settled within one year or the company's operating cycle, whichever is longer.* Usually settled by paying out cash. -Often Include Accounts Payable Notes Payables Wages Payable Taxes Payable Interest Payable Unearned Reveneus

*Long-term liabilities*

*Obligations not due to be paid within one year or the operating cycle, whichever is longer.* Notes Payable Mortgages Payable Bonds Payable Lease obligations

*Reversing entries*

*Optional entries recorded at the beginning of a period that prepare the accounts for the usual journal entries as if adjusting entries had not occurred in the prior period.* Purpose: to simplify a company's record-keeping. -Firms will use this to hope it reduces erros

*Expense recognition principle*

*Prescribes expenses to be reported in the same period as (matched with) the revenues that were earned as a result of the expenses.* Aims to record expenses in the same accounting period as the revenues that are recognized as a result of those expenses.

*Profit margin*

*Ratio of a company's net income to its net sales; the percent of income in each dollar of revenue; also called net profit margin.*

*Profit Margin*

*Ratio of a company's net income to its net sales; the percent of income in each dollar of revenue; also called net profit margin.* also called return on sales. Profit Margin = Net income / Net Sales. Ration is interpreted as reflecting the percent of profit in each dollar of sales.

*Plant asset useful life*

*Ratio that estimates the productive life of an asset; equals the plant asset cost divided by depreciation expense.* -Plant assets are tangible assets that are both long-lived and sued to produce or sell products and services. (Plant assets are also called fixed assets; property, plant, and equipment (PP&E); or long lived assets.) Long-term tangible assets used to produce and sell products and services. Expected to provide benefits for more than one period. -All plant assets, with a general exception for land, eventually wear out or decline in usefulness. Examples: Buildings, Machines, vehicles, and fixtures.

*Current ratio*

*Ratio used to evaluate a company's ability to pay its short-term obligations, calculated by dividing current assets by current liabilities.*

*Current Ratio*

*Ratio used to evaluate a company's ability to pay its short-term obligations, calculated by dividing current assets by current liabilities.* A measure to assess a company's ability to pay its short-term debts when the come due. Current Ratio = Current Assets / Current Liabilities

*Accounting cycle*

*Recurring steps performed each accounting period, starting with analyzing transactions and continuing through the post-closing trial balance (or optional reversing entries).* called a cycle because the steps are repeated each reporting period

*Accrued revenues*

*Revenues earned in a period that are both unrecorded and not yet received in cash (or other assets); adjusting entries for recording accrued revenues involve increasing assets and increasing revenues.* Also called accrued assets

*Work Sheet*

*Spreadsheet used to draft an unadjusted trial balance, adjusting entries, adjusted trial balance, and financial statements.*

*Pro forma financial statements*

*Statements that show the effects of proposed transactions and events as if they had occurred.* Because they show the statements as if the proposed transactions occured.

*Income Summary*

*Temporary account used only in the closing process to which the balances of revenue and expense accounts (including any gains or losses) are transferred; its balance is transferred to the capital account (or retained earnings for a corporation).* A temporary account only used for the closing process...that contains a credit for total revenues (and gains). Balance = net incomes or net loss and it is transferred to retained earnings.

*Revenue recognition principle*

*The principle prescribing that revenue is recognized when goods or services are delivered to customers.* Requires that revenue be recorded when goods or services are provided to customers and at an amount expected to be received from customers. -Big goal of the adjusting process is to have revenue recognized (reported) in the time period when those services and products are delivered.

*Natural Business Year*

*Twelve-month period that ends when a company's sales activities are at their lowest point.*

*Adjusted trial balance*

*a list of accounts and their balances prepared after period-end adjustments are recorded and posted*

*Intangible Assets*

*long-term assets (e.g., resources) used to produce or sell products or services; usually lack physical form and have uncertain benefits* Long-term resources that benefit business operations but lack physical form. -Examples Patents Trademarks Copyrights Franchises Goodwill

Benefits of a work sheet

-Aids the preparation of financial statements -Reduces the risk of errors when working with many accounts and adjustments -Link accounts and adjustments to their impacts in financial statements. -Helps in preparing interim (monthly and quarterly) financial statements when journalizing adjusting entries is postponed until year-end -shows the effects of proposed or "what-if" transactions.

4 Types of adjustments for transactions that extend over more than one period.

-Prepaid expenses -Unearned revenues -Accrued Expenses -Accrued Revenues

Closing entries are necessary at the ned of each period after financial statements are prepared because...

-Revenue, expense, and dividends account must begin each period with zero balances. -Retained earnings must reflect prior periods' revenues, expenses, and dividends

Steps in the Accounting Cycle

1. Prepare Journal Entries 2. Post Journal Entries to General Ledger 3. Prepare Unadjusted Trial Balance 4. Prepare Adjusting Entries 5. Post Adjusting Entries to General Ledger 6. Prepare Adjusted Trial Balance 7. Prepare Financial Statements 8. Prepare Closing Entries 9. Post Closing Entries to General Ledger 10. Prepare Post-Closing Trial Balance 11. Prepare Reversing Entries 12. Post Reversing Entries to General Ledger

3 Step Process for Adjusting Entries

1.) Determine what the current account balance equals 2.) Determine what the current account balance should equal. 3.) Record an adjusting entry to get from step 1 to step 2

Steps of a Worksheet

1.) Enter Unadjusted Trial Balance 2.) Enter Adjustments -After preparing the work sheet, *adjustments must still be entered in the journal and posted to the ledger* 3.) Prepare Adjusted Trial Balance 4.) Sort Adjusted Trial Balance Amounts to Financial Statements 5.) Total Statement Columns, Compute Income or Loss, a Balance Column. -*The ending balance of retained earnings does not appear int eh last 2 columns as a single amount, but it is computed in the statement of retained earnings* using these account balances.

Prepaid (Deferred) expenses... Paid (or received) cash *before* expense (or revenue) recognized.

Adjusting Entry Dr (increase) Expense Cr. (decrease) Asset* ------ BEFORE Adjusting Expense understated Asset overstated

Unearned (Deferred) Revenues..... Paid (or received) cash *before* expense (or revenue) recognized.

Adjusting Entry Dr. (decrease) Liability Cr. (increase) revenues ------- Before Adjusting Entry Liability overstated Revenues understated

Accrued Revenues.... Paid (or received) cash *after* expense (or revenue) recognized

Adjusting Entry Dr. (increase) Asset Cr. (increase) Revenue ----------- Before Adjusting Asset understated Revenue understated

Accrued Expenses... Paid (or received) cash *after* expense (or revenue) recognized

Adjusting Entry Dr. (increase) Expenses Cr. (increase) Liabilities --------- Before Adjusting Expenses Understated Liabilities Understated

General Rule for Adjusting Entries

Adjusting entries that create new asset or liability accounts are likely candidates for reversing

keying adjustments

An identifying letter links the debit and credit column of each adjustment

Purpose of the closing process

First, resets revenues, expenses, and dividends account balances to zero at the ned of each period (which is also updates the Retained Earnings account for inclusion on the balance sheet. This is done so that these accounts can properly measure income and dividends for the next period. Second, it helps in summarizing a period's revenues and expenses.

Banker's Rule

Interest computations assume a 360-day year

Cash basis income statement

Measures revenue when it is received and expenses when they are incurred. Reports the expense in full on the day of. Opposed to accrual (more accurate w/ rules) which reports the expense each month.

Prepaid Expense likely include

Prepaid Insurance Prepaid rent Office supplies Store supplies

Compound Accrued Interest

Principal amount owed x Annual Interest Rate x Fraction of year since last. payment date (#/360)

Depreciable basis

The net cost of equipment

Salvage Value

an asset's expected value at the end of its useful life

Use of a Worksheet

to *prepare financial statements*, it is constructed at the end of a period before the adjusting process. *does not substitute financial statements* -Includes a list of the accounts, their balances, and adjustments and their sorting into financial statement columns. -Provides 2 columns for unadj. trial balance, the adjustments, the adj. trial balance sheet.

Defer

to postpone. We postpone reporting amounts received as revenues until they are earned.