Adjustments, Financial Statements and the Quality of Earnings

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1 Adjustments, Financial Statements and the Quality of Earnings Chapter 4 Accounting Cycle 4-2 1

2 Unadjusted Trial Balance Listing of all the balance sheet and income statement accounts, usually in financial statement order. Ending debit or credit balances are listed in two separate columns. Total debit account balance should equal total credit account balance. XYZ Company Unadjusted Trial Balance 31-Dec-09 $ $ Cash 11,900 Prepaid Insurance 3,000 Accounts receivable 2,000 Inventory 1,000 Supplies 100 Furniture and fixtures 1,000 Equipment 10,000 Accounts payable 100 Unearned revenue 5,000 Loans payable 10,000 Contributed Capital 15,000 Retained earnings 1,000 Sales Revenue 11,000 Cost of goods sold 4,000 Salaries expense 5,000 Utilities expense 3,000 Gain on sale of furniture 900 Total 42,000 42,000 Note that total debits = total credits 2

3 Adjusting Entries Types of Adjustments Revenues 1. Unearned or Deferred Revenues 2. Accrued Revenues Expenses 3. Prepaid or Deferred Expenses 4. Accrued Expenses Unearned/Deferred Revenues End of accounting period. Cash received. Revenues earned. Arise when a company receives cash advance from a customer. The amount should be recorded as a liability because the amount has not been earned yet. Over time, as the cash advance is earned, revenue should be recognized. 3

4 Unearned Revenue On Dec 1, 2013, the company received a check for $5,000, for two months of service beginning Dec 1, 2013 from a new customer. What is the journal entry recorded on Dec 1, 2013? Dr Cash 5,000 Cr Unearned Revenue 5,000 The adjustment on December 31, 2013, to reduce the liability and record the revenue earned would be: Dec 31 Unearned Revenue (-L) 2,500 Revenue (+R, +SE) 2,500 $5,000 1/2 = $2,500 Accrued Revenues End of accounting period. Revenues earned Cash received Arise when revenue has been earned but customer has not paid. 4

5 Accrued Revenue Accounts Receivable On December 31 st, a customer informed the company that they will make the payment of $15,000 in January 2014 for services rendered in December Dec 31 Accounts Receivable (+A) 15,000 Revenue (+R, +SE) 15,000 Accrued Revenue Accounts Receivable A customer pays at the end of every other month for services received worth $100/month. The last payment made by the customer was on Nov. 30, Prepare the adjusting entry at the end of 2013 (Dec. 31, 2013) and the first related entry in 2010 (Jan. 31, 2014). Dec 31 Accounts Receivable 100 Revenue 100 Jan 31 Cash 200 Accounts Receivable 100 Revenue 100 5

6 Accrued Revenue Interest Receivable At December 31 st, the company earned, but has not received, interest on its money market account. The company deposited $6,000 in the money market account on December 1 st. The account pays 2 percent interest per year. Dec 31 Interest Receivable (+A) 10 Interest Income (+R, +SE) 10 Prepaid Expenses End of accounting period. Cash paid. Expense incurred. Arise when an expense is paid for in advance. This creates a resource or benefit that is purchased but not consumed immediately, thereby creating an asset. Over time, this asset is used and the balance needs to be updated to recognize its consumption. 6

7 Prepaid Insurance Expense On January 1, 2013, the company paid $3,000 for a 3-year fire insurance policy. They are paying in advance for a resource they will use over a 3-year period. What is the journal entry on January 1, 2013? Dr Prepaid insurance expense 3,000 Cr Cash 3,000 At December 31 st, the company must recognize the portion of the insurance that has been consumed and becomes an expense. Dec 31 Insurance Expense (+E, -SE) 1,000 Prepaid Insurance (-A) 1,000 $3,000 1/3 = $1,000 per year. Depreciation Expense Allocation of an asset s cost over all periods for which it provides a benefit. Straight-line depreciation One method of calculating depreciation. This assumes that the asset is used equally every year. Annual Depreciation = (Cost Salvage Value) / Useful life 7

8 Depreciation Expense On January 1, 2013, the company paid $10,000 for equipment that has a 5-year life and is expected to have a salvage value of $1,000 at the end of its useful life. They are paying in advance for a resource they will use over a 5-year period. At December 31 st, the company must recognize the portion of the equipment that has been consumed and becomes an expense. Dec 31 Depreciation Expense (+E, -SE) 1,800 Acc Depreciation (+XA, -A) 1,800 ($10,000 -$1000) 1/5 = $1,800 per year. Depreciation Expense BALANCE SHEET: Equipment $10,000 Less: Accumulated depreciation 1,800 Net cost of equipment $8,200 Accumulated depreciation is a contra-asset account. Used to accumulate the amount of historical cost allocated to prior periods. Directly related to the plant, property and equipment account but has the opposite balance(a credit balance). 8

9 Accrued Expenses End of accounting period. Expense incurred. Expense paid. Arise when expenses are incurred but no cash payment has been made yet. Accrued Expenses Salaries Payable The company pays employees $500/week at the end of a 5- day work week starting every Monday. Assume that December 31, 2013 ends on a Tuesday. Prepare the adjusting entry at the end of 2013 (Dec. 31, 2013) and the first related entry in year Dec 31 Salaries expense 200 Salaries payable 200 Jan 1 Salaries expense 300 Salaries payable 200 Cash 500 9

10 Accrued Expenses Interest Payable The company has a loan outstanding of $10,000 that pays interest of 5% per year with both principal and interest payable at the end of year Assume that the interest rate is 5% per year. What is the adjusting entry required? Dec 31 Interest Expense 500 Interest Payable 500 XYZ Company Adjusted Trial Balance 31-Dec-09 Unadjusted Adjustments Adjusted $ $ $ $ Cash 11,900 11,900 Prepaid Insurance 3,000 1,000 2,000 Accounts receivable 2,000 15,100 17,100 Interest receivable Inventory 1,000 1,000 Supplies Furniture and fixtures 1,000 1,000 Equipment 10,000 10,000 Accumulated depreciation 1,800 1,800 Accounts payable Salaries payable Interest payable Unearned revenue 5,000 2,500 2,500 Loans payable 10,000 10,000 Contributed Capital 15,000 15,000 Retained earnings 1,000 1,000 Sales Revenue 11,000 17,600 28,600 Cost of goods sold 4,000 4,000 Salaries expense 5, ,400 Utilities expense 3,000 3,000 Interest expense Depreciation expense 1,800 1,800 Insurance expense 1,000 1,000 Interest income Gain on sale of furniture Total 42,000 42,000 21,310 21,310 59,810 59,810 10

11 P4-2 Adjusting Entries a. On September 1, 2014, Zimmerman collected six months' rent of $8,400 on storage space. At that date, Zimmerman debited Cash and credited Unearned Rent Revenue for $8,400. b. On October 1, 2014, the company borrowed $18,000 from a local bank and signed a 12 percent note for that amount. The principal and interest are payable on the maturity date, September 30, c. Depreciation of $2,500 must be recognized on a service truck purchased on July 1, 2014, at a cost of $15,000. d. Cash of $3,000 was collected on November 1, 2014, for services to be rendered evenly over the next year beginning on November 1, Unearned Service Revenue was credited when the cash was received. e. On November 1, 2014, Zimmerman paid a one-year premium for property insurance, $9,000, for coverage starting on that date. Cash was credited and Prepaid Insurance was debited for this amount. f. The company earned service revenue of $4,000 on a special job that was completed December 29, Collection will be made during January No entry has been recorded. g. At December 31, 2014, wages earned by employees totaled $14,000. The employees will be paid on the next payroll date, January 15, h. On December 31, 2014, the company estimated it owed $500 for 2014 property taxes on land. The tax will be paid when the bill is received in January Preparing Financial Statements The next step in the accounting cycle is to prepare the financial statements... Income statement, Statement of stockholders equity, Balance sheet, and Statement of cash flows. 11

12 Preparing Income Statement XYZ Company Income Statement For the year ended December 31, 2009 $ $ Revenues: Sales Revenue 28,600 Expenses: Cost of goods sold 4,000 Salaries expense 5,400 Utilities expense 3,000 Depreciation expense 1,800 Insurance expense 1,000 15,200 Operating income 13,400 Interest income 10 Interest expense -500 Gain on sale of furniture 900 Net income 13,810 Earnings per share (13,810/50,000) $0.28 *Assume that the company has 50,000 average number of shares of stock outstanding. EPS = Net income available to common stockholders Average number of common stock outstanding during the period Preparing Statement of Stockholders Equity XYZ Company Consolidated Statement of Stockholders' Equity For the Year Ended December 31, 2009 Contributed Capital Retained Earnings Stockholders' Equity Beginning balance $ 15,000 $ - $ 15,000 Stock Issuance Net income 13,810 13,810 Dividends (1,000) (1,000) Ending balance $ 15,000 $ 12,810 $ 27,810 From the Income Statement 12

13 Closing the Books Even though the balance sheet account balances carry forward from period to period, the income statement accounts do not. Closing entries: 1. Transfer net income (or loss) to Retained Earnings. 2. Establish a zero balance in each of the temporary accounts to start the next accounting period. Closing the Books Here is an example of the closing process using an illustration with just a few accounts. 13

14 Post-Closing Trial Balance After all temporary accounts have been closed, we prepare a post-closing trial balance. Only assets, liabilities, and stockholders equity accounts will appear. All revenue, expense, gain and loss accounts will have a zero balance. Preparing Closing Entries XYZ Company Income Statement For the year ended December 31, 2009 $ $ Revenues: Sales Revenue 28,600 Interest income 10 Gain on sale of furniture 900 Cost of goods sold 4000 Salaries expense 5400 Utilities expense 3000 Interest expense 500 Depreciation expense 1,800 Insurance expense 1,000 Retained Earnings (13,810-1,000 Dividends) = 12,800 14

15 Post-closing Trial Balance XYZ Company Post-closing Trial Balance 31-Dec-09 $ $ Cash 11,900 Prepaid Insurance 2,000 Accounts receivable 17,100 Interest receivable 10 Inventory 1,000 Supplies 100 Furniture and fixtures 1,000 Equipment 10,000 Accumulated depreciation 1,800 Accounts payable 100 Salaries payable 400 Interest payable 500 Unearned revenue 2,500 Loans payable 10,000 Contributed Capital 15,000 Retained earnings 12,810 Total 43,110 43,110 From closing the books Preparing Balance Sheet XYZ Company Balance Sheet 31-Dec-09 $ $ Current assets: Cash 11,900 Prepaid Insurance 2,000 Accounts receivable 17,100 Interest receivable 10 Inventory 1,000 Supplies 100 Total current assets 32,110 Furniture and fixtures 1,000 Equipment 10,000 Less: accumulated depreciation 1,800 8,200 Total assets 41,310 Accounts payable 100 Salaries payable 400 Interest payable 500 Unearned revenue 2,500 Total current liabilities 3,500 Loans payable 10,000 Total liabilities 13,500 A=L+SE Stockholders' Equity: Contributed Capital 15,000 Retained earnings 12,810 Total stockholders' equity 27,810 Total liabilities and stockholders' equity 41,310 15

16 Total asset turnover Ratio The ratio helps us determine how efficient management is in using assets (its resources) to generate sales P4-7 Tunstall, Inc., a small service company, prepared an unadjusted trial balance as of the end of the annual accounting period, December 31, (See your book for the unadjusted TB) Data not yet recorded at December 31, 2014, included: a. The supplies count on December 31, 2014, reflected $300 remaining supplies on hand to be used in There are 900 in the TB as of 12/31/14. b. Insurance expired during 2014, $800. c. Depreciation expense for 2014, $3,700. d. Wages earned by employees not yet paid on December 31, 2014, $640. e. Income tax expense, $5,540. Required: 1) Record the 2014 adjusting entries. 2) Prepare an income statement and a classified balance sheet that include the effects of the preceding five transactions. 3) Record the 2014 closing entry. 16

17 End of Chapter

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