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Lecture #3: Adjusting the Accounts and Preparing the Statements

  • The life of a business often spans many years, but investors and managers can’t wait until the business ends to determine if it was profitable. Instead the business provides financial reports periodically.
  • The activities of a business occur during specific time periods, such as a month, three-month period, or one year. Then financial reports are prepared for each period. Usually most businesses use an one year period and prepare annual financial statements.

Need for Adjustments at the End of an Accounting Period

At the end of an accounting period, several accounts do not show proper end-of-period balances, because internal economic events occurred, but were not recorded.

For all examples, we will use a 1-month accounting period.

1. Prepaid Expenses - Prepaid expense is an economic benefit that has been paid for in advance. With the passage of time, this economic benefit is used up.

For example, Jerry Dow law practice paid $2,400 for liability insurance that would last two years. The policy went into effect on Dec. 1.

Dec. 31 Insurance Expense $100
Prepaid Insurance $100
To record the expired insurance.

Another example, the Dow law practice purchased some office supplies for $120. Some of these supplies were used up, so it must be written off as an expense. Jerry Dow took inventory of the remaining supplies and determined that $75 of unused supplies remained. So in Dec., $45 of supplies were used

Dec. 31 Office Supplies Expense $45
Office Supplies $45
To record the supplies used.


2. Depreciation.

Tangible, long-lived assets that are held for use in the production or sale of other assets or services are called plant and equipment. They include assets such as land, buildings, machines, professional libraries, and cars. All items, except for land, will eventually wear out or lose their usefulness. The cost of these assets must be charged off to expense accounts over their useful lives. This process of allocating the cost of these items to expense accounts is called depreciation.

For example, Jerry Dow law practice owns a library that costs $2,880.Jerry will use these books for 3 years, and after 3 years, he will get rid of them and buy new ones.


Dec. 31 Depreciation Expense, Law Library $80
Accumulated Depreciation, Law Library $80
To record the depreciation of law library


For depreciation, do not directly credit the account, where the asset is recorded. Depreciation entries are not supported by objective evidence as most other entries. Depreciation is only an estimate. Readers of a balance sheet can see both the original cost and the estimated amount of depreciation.

Another example, the office equipment of Dow’ law practice is another type of plant and equipment that must be depreciated. Jerry thinks that this office equipment will be used for 4 years and at the end of 4 years, he thinks he can sell them for $880.

Dec. 31 Depreciation Expense, Office Equipment $125
Accumulated Depreciation, Office Equipment $125
To record the depreciation of office equipment


3. Accrued Expenses.

Most expenses are recorded at the time they are paid. However, some expenses were incurred, but may remain unrecorded because payment is not due.

For example, the Dow law practice has a secretary who earns $70 per day or $350 per week that begins on Monday and ends on Friday. The secretary’s wages are due and payable every two weeks on Friday. During December, these wages were paid on the 12 and 26 of the month.

The secretary worked on December 29, 30, and 31. The secretary has earned three days’ wages that were not paid. This is still an expense for Dec., so Jerry Dow should record this in his accounts.

Dec. 31 Salaries Expense $210
Salaries Payable $210
To record the accrued wages.


4. Unearned Revenues.

An unearned revenue results when payment is received for goods or services in advance of their delivery.

For example, Jerry Dow entered into an agreement with Chemical Supply (firm) to do its legal work on a fixed-fee basis of $500 per month, beginning Dec. 15. The fee was recorded with this entry.

Dec. 26 Cash $3,000
Unearned Legal Fees $3,000
Received a legal fee in advance.

One half of a month transpired, so Jerry Dow earned part of this revenue, which must be reflected in the income statement.

Dec. 31 Unearned Legal Fees $250
Legal Fees Earned $250
Earned legal fees that had been received in advance.


5. Accrued Revenues.

Many revenues are recorded when cash is received. Others are recorded at the time the goods or services are sold on credit and a bill is given to the customer. Some revenues may remain unrecorded even though they have been earned. This revenue has to be recorded on the income statement.

For example, Jerry Dow agreed to do the legal work for Guaranty Bank for a fixed fee of $600 a month. He entered this agreement on Dec. 20. On Dec. 31, he earned 1/3 of a month’s fee, which is $200.

Dec. 31 Accounts Receivable $200
Legal Fees Earned $200
To record accrued legal fees.


The Adjusted Trial Balance

An adjusted trial balance shows the proper balance sheet and income statement amounts. Therefore you can use it to prepare the financial statements. The income statement is prepared first, because you need to know the net income before you complete the statement of changes in owner’s equity.

Account Unadjusted Trial
Balance
Adjustments Adjusted Trial
Balance
Debit Credit Debit Credit Debit Credit
Cash 650 650
Prepaid Insurance 2,400 100 2,300
Office Supplies 120 45 75
Law Library 2,880 2,880
Office Equipment 6,880 6,880
Accounts Payable 760 760
Unearned Legal Fees 3,000 250 2,750
Jerry Dow, Capital 9,000 9,000
Jerry Dow, Withdrawals 1,100 1,100
Legal Fees Earned 3,900 250 4,350
Rent Expense 1,000 1,000
Salaries Expense 1,400 210 1,610
Utilities Expense 230 230
Total 16,660 16,660
Insurance Expense 100 100
Office Supplies Expense 45 45
Depreciation Expense, Law Library 80 80
Accumulated Depreciation, Law Library 80 80
Depreciation Expense, Office Equipment 125 125
Accumulated Depreciation, Office Equipment 125 125
Salaries Payable 210 210
Accounts Receivable 200 200
Totals 1,010 1,010 17,275 17,275


Jerry Dow, Attorney
Income Statement
For the Month Ended December 31,1990
Revenues
Legal Fees Earned $4,350
Operating Expense
Rent Expense $1,000
Salaries Expense 1,610
Utilities Expense 230
Insurance Expense 100
Office Supplies Expense 45
Depreciation Expense, Law Library 80
Depreciation Expense, Office Equipment 125
Total Operating Expense 3,190
Net Income $1,160


Jerry Dow, Attorney
Statement of Changes in Owner’s Equity
For the Month Ended December 31, 1990
Jerry Dow, Capital November 30, 1990 $0
Plus:
Investments by Owner $9,000
Net Income 1,160
Less :
Withdrawals by Owner 1,100
Jerry Dow, Capital, December 31, 1990 $9,060


Jerry Dow, Attorney
Balance Sheet
December 31, 1990
Assets
Cash $650
Accounts Receivable 200
Prepaid Insurance 2,300
Office Supplies 75
Law Library $2,880 2,880
Less Accumulated Depreciation 80
Office Equipment $6,880 6,755
Less Accumulated Depreciation 125
Total Assets $12,780
Liabilities
Accounts Payable $760
Unearned Legal Fees 2,750
Salaries Payable 210
Owner's Equity
Jerry Dow, Capital, December 31, 1990 9,060
Total Liabilities and Owner's Equity $12,780


The Adjustment Process.

The adjustment process is based on two accounting principles.

1. The Realization Principle.

This requires that revenue be reported in the income statement when it is earned, not before and not after. For most firms, the revenue is earned at the time a service is rendered or the product is sold to the customer.

2. The Matching Principle.

This requires that expenses be reported on the income statement in the same accounting period as are the revenues that were earned as a result of the expenses.

F This provides a better indication of enterprise performance.

There is another accounting system called the cash basis of accounting. Revenues are reported when cash is received and expenses are reported when cash is paid. No adjustments are made for prepaid, unearned, and accrued items. This is not a good system.

Disposing of Accrued Items.

1. Accrued Expenses.

Dec. 31 Salaries Expense $210
Salaries Payable $210
To record the accrued wages

When these wages are paid on Friday, January 9, you make the following entry:

Jan. 9 Salaries Payable $210
Salaries Expense $490
Cash $700
Paid two weeks' wages


2. Accrued Revenues.

Dec. 31 Accounts Receivable $200
Legal Fees Earned $200
To record the legal fees


When payment of the first month’s fee is received on Jan. 20, you make the following entry:
Jan. 20 Cash $600
Accounts Receivable $200
Legal Fees Earned $400
Received cash for accrued and earned legal fees.


Classification of Balance Sheet Items

A balance sheet becomes more useful when you classify its assets and liabilities into meaningful groups. You can better judge the adequacy of the different kinds of assets used on the business.

  1. Current Assets - It is defined as cash and other assets that are reasonably expected to be realized in cash or consumed within one year. Current assets are ranked and listed in terms of liquidity. Liquidity is the ease of transferring assets into money with a known value and little transaction costs.
  2. Investments - This includes stocks, bonds, and promissory notes that will be held for more than one year. Investment also includes land held for future expansion, but it is not being used in current business operations.
  3. Plant and Equipment - They are tangible, long-lived assets that are held for the use in the production or sale of goods and services, which include equipment, buildings, and land. In this case, land is being used in current business operations.
  4. Intangible Assets - They do not have a physical substance, such as goodwill, patents, trademarks, copyrights, and franchises.
  5. Current Liabilities - Obligations that are due to be paid within one year.
  6. Long-Term Liabilities - Liabilities that are not due and payable in one year, which includes notes payable and bonds payable (i.e. the business issued bonds from itself)
  7. Owner’s Equity.

(i) Single Proprietorships.

Jerry Dow, capital, December 31, 1990 $9,000

(ii) Partnership - You have separate capital and withdrawal accounts for each partner.

Partner’s Equities
Rebecca Mathews, capital $17,300
Amy Searcy, capital $24,800
Total equities of the partners $42,100

(iii) Corporations

State laws require corporations to have two accounts for corporation equity.

  • The first is called contributed capital. When stockholders purchase corporate stock, then it is listed under contributed capital. When a corporation issues one type of stock, it is called common stock.
  • The second account is called retained earnings. This includes the changes in net income of the corporation. This also includes dividends. Each share of stock can receive a fixed proportion of the corporation’s profits (i.e. net income). A dividend is equivalent to a withdrawal for a proprietorship.
Stockholder’s Equity
Contributed Capital, Common Stock $400,00
Retained Earnings $124,400
Total Stockholder’s Equity $524,400


National Electrical Supply
Balance Sheet
December 31, 1990
Assets
Current Assets:
Cash
Temporary investments
Accounts receivable
Notes receivable
Merchandise inventory
Prepaid expenses
$1,050
2,145
3,961
600
10,248
405
Total current assets $18,409
Investments:
Chrysler Corporation common stock
Land held for future expansion
$2,400
8,000
Total investments 10,400
Plant and equipment:
Store equipment
Less accumulated depreciation
Buildings
Less accumulated depreciation
Land
$3,200
800
$70,000
18,400

$2,400

51,600
24,200
Total plant and equipment 78,200
Intangible assets:
Franchise 10,000
Total assets $117,009
Liabilities
Current liabilities:
Accounts payable
Wages payable
Notes payable
Current portion of long-term liabilities
$2,715
480
3,000
1,200
Total current liabilities $7,395
Long-Term liabilities
Notes Payable $48,800
Stockholder's Equity
Contributed Capital, Common Stock $50,000
Retained Earnings $10,814
Total liabilities and stockholder’s equity $117,009
 

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