Chapter 4: Adjustments, Trial Balance, and Financial Statements

1. Chapter 4: Adjustments, Trial Balance, and Financial Statements Acct 2301 Fall 2009 Cox School of Business, SMU Professor Zining Li

2. 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

3. Accounting Cycle • Identify recordable financial transactions • Record the journal entries • Post journal entry amounts to T-accounts • Prepare the unadjusted trial balance • Record adjusting journal entries • Prepare the adjusted trial balance • Prepare the financial statements • Record the closing entries

4. Adjusting Entries • Under accounting, revenues (expenses) are recorded when they are earned (incurred) • Some 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

5. Timetable of the Adjustment Process Transactions are recorded all during the period 1/1/04 12/31/04 Adjustments are made at the end of the period, but before the financial statements are prepared

6. What need to be adjusted • Accruals • Accrued revenues • Accrued expenses • Deferrals • Deferred revenues • Deferred expenses

7. 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

8. Interest Receivable Interest Revenue 12/31 150 12/31 150 Bal. 150 Bal. 150 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.

9. 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

10. 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.

11. Wages Expense Wages Payable As of 12/27 $1,900,000 12/31 50,000 12/31 50,000 Bal. 50,000 Bal. $1,950,000 After we post the entry to the T-accounts, the account balances look like this:

12. 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

13. 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

14. Unearned Rent Revenue Rent Revenue 12/31 750 12/1 3000 12/31 750 Bal. 2,250 Bal. 750 After we post the entry to the T-accounts, the account balances look like this:

15. 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

16. 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 Expense account to reflect that 1 year of the policy has expired. $3,600 X 1/3 = $1,200

17. Prepaid Insurance Insurance Expense 1/1 3,600 12/31 1,200 12/31 1,200 Bal. 2,400 Bal. 1,200 After we post the entry to the T-accounts, the account balances look like this:

18. Journal Entry for Depreciation Expense is different • Accumulated Depreciation is a contra-asset account; it carries a credit balance Dr. Deprecation Expense Cr. Accumulated Depreciation

19. 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 account to reflect that 1 year use of the equipment $8,000 X 1/5 = $1,600

20. Accumulated Depreciation -- Equipment Equipment Depreciation Expense 1/1 8,000 12/31 2,000 12/31 2,000 Bal. 8,000 Bal. 2,000 Bal. 2,000 Net Book Value of Equipment: • Equipment • Accumulated Depreciation • = Equipment (net)

21. 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

22. 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. • June 1 Paid $700 cash for insurance policy through December 31, 2004. • June 1 Purchased store equipment for $5,000 by signing a note. 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. Record all journal entries, including the adjusting entries, that must be made at June 30 in order for the company to prepare its financial statements.

23. Exercise: Complete the accounting cycle College Caps, Inc. Trial Balance – unadjusted as of June 30, 2004 AccountDRCR 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 38,00038,000 • 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. • Prepare the income statement, statement of retained earnings, and balance sheet.

24. 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