Chapter 4: Preparing Financial Statements

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Chapter 4Preparing Financial Statements

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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
• - Adjusting journal entries
• - Adjusted Trial Balance
• - Preparation of financial statements
• - Closing journal entries
• - Post-closing Trial Balance

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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).

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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).

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Accrual System vs. Accrual AJEs

• 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.

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The 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).

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The 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.

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Types 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.

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1. 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.

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1. 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

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2. 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 xx
• Another example of receivable/revenue accruals
  relates to rent revenue, where the rental payment
  has not yet been received.

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2. 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
  Decembers rent. Prepare the AJE for Raider
  Company

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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).

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3. Prepaid Expenses

• Example 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

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3.Prepaid Expenses - Example 3

• Raider 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

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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).

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3.Prepaid Expenses - Example 4

• 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 years depreciation.

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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 xx
• Subscription Revenues xx

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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)

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Class 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 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

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Adjusting Entries

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

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Adjusting Entries

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

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Adjusting Entries

• 3. Estimated Depreciation for 2008 is 1,000

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Adjusting Entries

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

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Adjusted Trial Balance

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

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Class Problem Adjusted Trial Balance

• 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

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Preparation of Financial Statementsfrom 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.

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Financial 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.

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Financial 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.

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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.

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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.

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Closing 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

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Closing Journal Entries (CJEs) - Example

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

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Closing Journal entries
Now post the effects of retained earnings to the
RE general ledger account.
Retained Earnings


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Post-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.

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Class Problem Postclosing Trial Balance

• 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

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Review Accounting Cycle

1. 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.