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Chapter 4: Preparing Financial Statements

Chapter 4: Preparing Financial Statements. Chapter 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:

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Chapter 4: Preparing Financial Statements

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  1. Chapter 4:Preparing Financial Statements

  2. Chapter 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 Preparing Financial Statements

  3. 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). Why Use Adjusting Entries?

  4. 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). Adjusting Journal Entries (AJEs)

  5. The “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. Accrual System vs. Accrual AJEs

  6. 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). The Revenue Recognition Principle

  7. 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. The Matching Principle

  8. 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. Types of AJEs

  9. 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. 1. Accrual of Expenses

  10. 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, 2008 before financial statements are prepared? Calc: Principal x rate x time P x R x T AJE: 1. Accrual of Expenses - Example 1 10,000 x .05 x 3/12 of a year = $125 Interest Expense 125 Interest Payable 125

  11. For revenues that have not yet been recorded at the end of the period. Ex: accrue interest revenue: Interest Receivable xx Interest Revenue xx Another example of receivable/revenue accruals relates to rent revenue, where the rental payment has not yet been received. 2. Accrual of Revenues

  12. 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: 2. Accrual of Revenues - Example 2 Rent Receivable 2,000 Rent Revenue 2,000

  13. 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). 3.Prepaid (Deferred) Expenses

  14. Example: Purchase 1-year insurance policy. General JEat time of purchase: Prepaid Insurance xx Cash xx AJEat end of the period (for the portion that has been used): Insurance Expense xx Prepaid Insurance xx 3. Prepaid Expenses

  15. Raider Company purchased a 1-year insurance policy on April 1, 2008 at a cost of $2,400 General JEat 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: 3.Prepaid Expenses - Example 3 2,400 /12 = 200 per month x 9 months= $1,800 AJE: Insurance Expense 1,800 Prepaid Insurance 1,800

  16. Example: purchase of equipment. General JEat time of purchase: Equipment xx Cash xx AJEat end of the period (for the portion that has been used): Depreciation Expense xx Accumulated Depreciation xx Note: Accumulated Depreciation is a contraasset account and is presented as an offset to Equipment on the balance sheet (expanded coverage in Chapter 8). 3.Prepaid Expenses

  17. Raider 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. 3.Prepaid Expenses - Example 4 30,000/10 = 3,000 per year AJE: Depreciation Expense 3,000 Accumulated Depr. 3,000

  18. 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 AJEat end of the period (for portion earned): Unearned Revenues xx Subscription Revenues xx 4.Unearned (Deferred) Revenues

  19. 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 AJEat end of the period (for portion earned): 4.Unearned Revenues - Example 5 6,000 / 12 = 500 per month, so 1 month earned. Unearned Revenues 500 Subscription Revenues 500

  20. The trial balance of Mega Company, Inc. at the end of its annual accounting period is as follows: Mega Company Trial Balance December 31, 2008 Cash $ 3,000 Prepaid Insurance 1,600 Supplies 2,100 Equipment 20,000 Accumulated depreciation $ 2,000 Common Stock 10,000 Retained Earnings 7,000 Dividends 1,000 Revenue 33,000 Salaries Expense 18,300 Rent Expense 6,000 ______ Totals $52,000$52,000 Class Problem – Prepare Adjusting Entries

  21. 1. Unexpired insurance at December 31 was $1,000. Adjusting Entries (So expired insurance is $600) AJE: Insurance Expense 600 Prepaid Insurance 600

  22. 2. Unused supplies, per inventory, $800 at December 31. Adjusting Entries So used supplies = 2,100 - 800 = 1,300 Supplies Expense 1,300 Supplies 1,300

  23. 3. Estimated Depreciation for 2008 is $1,000 Adjusting Entries Depreciation Expense 1,000 Accumulated Depr. 1,000

  24. 4. Earned but unpaid salaries at December 31, $700. Adjusting Entries Salaries Expense 700 Salaries Payable 700

  25. The 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, Income Statement, and Statement of Retained Earnings. The adjusted trial balance for Mega Company (after posting AJEs) is shown on the next slide. Adjusted Trial Balance

  26. Mega Company, Adjusted Trial Balance, 12/31/08 Cash $ 3,000 Prepaid Insurance 1,000 Supplies 800 Equipment 20,000 Accumulated depreciation $ 3,000 Salaries Payable 700 Common Stock 10,000 Retained Earnings 7,000 Dividends 1,000 Revenue 33,000 Salaries Expense 19,000 Rent Expense 6,000 Insurance Expense 600 Supplies Expense 1,300 Depreciation Expense 1,000 ______ Totals $53,700$53,700 Class Problem – Adjusted Trial Balance

  27. 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 beginningbalance; while the revenues, expenses, and dividends are displayed in the Trial Balance, they have not yet been included in (closed to) Retained Earnings. Preparation of Financial Statementsfrom the Adjusted Trial Balance

  28. 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. Financial Statements

  29. 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. Financial Statements

  30. 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. Closing Journal Entries (CJEs)

  31. 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. Closing Journal Entries (CJEs)

  32. 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 Closing Journal Entries (CJEs) - Example Retained Earnings 5,100

  33. Refer to Mega Company. Now close the balance in the Dividends account to Retained Earnings. Closing Journal Entries (CJEs) - Example Retained Earnings 1,000 Dividends 1,000

  34. Closing Journal entries Now post the effects of retained earnings to the RE general ledger account. Retained Earnings 7,000 Beginning Dividends 1,000 5,100 Net Income 11,100 Ending 34

  35. 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. Post-closing Trial Balance

  36. Mega Company, 12/31/08, Postclosing Trial Balance Cash $ 3,000 Prepaid Insurance 1,000 Supplies 800 Equipment 20,000 Accumulated depreciation $ 3,000 Salaries Payable 700 Common Stock 10,000 Retained Earnings ______ 11,100 Totals $24,800$24,800 Class Problem – Postclosing Trial Balance

  37. Analyze transactions. Prepare general journal entries, and post to general ledger. Prepare unadjusted trial balance. Prepare adjusting journal entries, and post to general ledger. Prepare adjusted trial balance. Prepare financial statements. Prepare closing journal entries, and post to general ledger. Prepare post-closing trial balance. Review – Accounting Cycle

  38. Exercise 4-32 7/1 Cash 50,000 Notes Payable 50,000 7/31 Calc: 50,000 x .12 x 1/12 = $500 AJE Int. Expense 500 Int. Payable 500 8/31 Owe? 50,000 + 50,000 x .12 x 2/12 = $51,000 Notes Pay. 50,000 Int. Payable 500 Int. Expense 500 Cash 51,000

  39. Problem 4-3 a. Calc: (15,000 - 250)/5 = 2,950 per yr. Depreciation Exp. 2,950 Accum. Depr. 2,950 b. Calc.: Begin. 3,600 + Purch 17,600 - Unused (1,850) =Used 19,350 Supplies Expense 19,350 Office Supplies 19,350

  40. Problem 4-3 c. Earned? 24,000/6 = 4,000 per mo. x 5 mos. = $20,000 Customer Deposits 20,000 Revenue 20,000 d. Calc: 2,700 per mo. x 2 mos = 5,400 used Rent Expense 5,400 Prepaid Rent 5,400

  41. Problem 4-3 e. Calc: 200,000 x .09 x 2/12 = $3,000 (use months unless otherwise instructed) Interest Expense 3,000 Interest Payable 3,000 f. If paid on Thursday (Dec. 30), and Friday is Dec. 31, then owe for 1 day: Salaries Expense 500 Salaries Payable 500

  42. Problem 4-3 Part 2: effect on I/S if not recorded? Depr. Exp. not recorded +2,950 Supplies Exp. not recorded +19,350 Revenues not recorded -20,000 Rent Exp. not recorded +5,400 Interest Exp. not recorded +3,000 Salaries Exp. not recorded + 500 Net effect: Net Inc. Over by 11,200

  43. Exercise 4-23 Close revenues & expenses to Ret. Earn.: Ad. Fee Earned 58,500 Int. Revenue 2,700 Wage & Sal. Exp. 14,300 Util. Exp. 12,500 Ins. Exp. 7,300 Depr. Exp. 16,250 Int. Exp. 2,600 Inc. Tax Exp. 3,300 Retained Earnings (plug) 4,950 Now close Dividends to Retained Earn.: Retained Earnings 2,000 Dividends 2,000

  44. Exercise 4-18 Ignore AJE? Effect on Net Income? O =Overstate U=Understate NE=no effect 1. no depr. exp.? O 2. no revenues? U 3. no ins. exp? O 4. no int. exp? O 5. no commission exp.? O 6. no rent revenue? U

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