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.

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

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.

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.

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.

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.

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

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.

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.

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.

→ 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.

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

2. Accrued Revenues.

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.

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

(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.