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Lecture 05 Adjusting Entries, Financial Statement, Closing Entries 3-1 Learning Learning Objectives Objectives 3-2 1. Explain the reasons for preparing adjusting entries. 2. Prepare financial statement from the adjusted trial balance. 3. Prepare closing entries. Adjusting Adjusting Entries Entries for for Accruals Accruals Accruals are either  accrued revenues or  accrued expenses. Illustration 3-27 3-3 LO 5 Explain the reasons for preparing adjusting entries. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Revenues” Revenues” Revenues earned but not yet received in cash or recorded. Adjusting entry results in: Revenue Recorded BEFORE Cash Receipt Accrued revenues often occur in regard to: 3-4  rent  interest  services performed LO 5 Explain the reasons for preparing adjusting entries. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Revenues” Revenues” Accrued Revenues. In October Pioneer earned $2,000 for advertising services that it did not bill to clients before October 31. Thus, Pioneer makes the following adjusting entry. Oct. 31 Accounts receivable 2,000 Service revenue Accounts Receivable Debit 72,000 2,000 74,000 3-5 Credit 2,000 Service Revenue Debit Credit 100,000 4,000 2,000 106,000 LO 5 Adjusting Adjusting Entries Entries for for “Accrued “Accrued Revenues” Revenues” Illustration 3-35 Illustration 3-35 3-6 LO 5 Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” Expenses” Expenses incurred but not yet paid in cash or recorded. Adjusting entry results in: Expense Recorded BEFORE Cash Payment, if any* Accrued expenses often occur in regard to: 3-7  rent  salaries  interest  bad debts*  taxes LO 5 Explain the reasons for preparing adjusting entries. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” Expenses” Accrued Interest. Pioneer signed a three-month, 12%, note payable in the amount of $50,000 on October 1. The note requires interest at an annual rate of 12 percent. Three factors determine the amount of the interest accumulation: 1 3-8 2 3 Illustration 3-29 LO 5 Explain the reasons for preparing adjusting entries. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” Expenses” Accrued Interest. Pioneer signed a three-month, 12%, note payable in the amount of $50,000 on October 1. Prepare the adjusting entry on Oct. 31 to record the accrual of interest. Oct. 31 Interest expense 500 Interest payable Interest Expense Debit 500 3-9 Credit 500 Interest Payable Debit Credit 500 LO 5 Explain the reasons for preparing adjusting entries. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” Expenses” Illustration 3-35 Illustration 3-35 3-10 LO 5 Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” Expenses” Accrued Salaries. At October 31, the salaries for these days represent an accrued expense and a related liability to Pioneer. The employees receive total salaries of $10,000 for a five-day work week, or $2,000 per day. 3-11 LO 5 Explain the reasons for preparing adjusting entries. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” Expenses” Accrued Salaries. Employees receive total salaries of $10,000 for a five-day work week, or $2,000 per day. Prepare the adjusting entry on Oct. 31 to record accrual for salaries. Oct. 31 Salaries expense 6,000 Salaries payable Salaries Expense Debit 40,000 6,000 Credit 6,000 Salaries Payable Debit Credit 6,000 46,000 3-12 LO 5 Explain the reasons for preparing adjusting entries. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” Expenses” Accrued Salaries. On November 23, Pioneer will again pay total salaries of $40,000. Prepare the entry to record the payment of salaries on November 23. Nov. 23 Salaries payable 6,000 Salaries expense 34,000 Cash Salaries Expense Debit 34,000 3-13 Credit 40,000 Salaries Payable Debit 6,000 Credit 6,000 LO 5 Explain the reasons for preparing adjusting entries. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” Expenses” Illustration 3-35 Illustration 3-35 3-14 LO 5 Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” Expenses” Bad Debts. Assume Pioneer reasonably estimates a bad debt expense for the month of $1,600. It makes the adjusting entry for bad debts as follows. Illustration 3-32 3-15 LO 5 Explain the reasons for preparing adjusting entries. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” Expenses” Illustration 3-35 Illustration 3-35 3-16 LO 5 5. 5. Adjusted Adjusted Trial Trial Balance Balance Shows the balance of all accounts, after adjusting entries, at the end of the accounting period. 3-17 Illustration 3-33 6. 6. Preparing Preparing Financial Financial Statements Statements Financial FinancialStatements Statementsare areprepared prepareddirectly directlyfrom from the the Adjusted AdjustedTrial TrialBalance. Balance. Income Statement 3-18 Retained Earnings Statement Balance Sheet LO 6 Prepare financial statement from the adjusted trial balance. 6. 6. Preparing Preparing Financial Financial Statements Statements Illustration 3-34 3-19 LO 6 6. 6. Preparing Preparing Financial Financial Statements Statements Illustration 3-35 3-20 LO 6 7. 7. Closing Closing Entries Entries 3-21  To reduce the balance of the income statement (revenue and expense) accounts to zero.  To transfer net income or net loss to owner’s equity.  Balance sheet (asset, liability, and equity) accounts are not closed.  Dividends are closed directly to the Retained Earnings account. LO 7 Prepare closing entries. 7. 7. Closing Closing Entries Entries Illustration 3-33 Closing Journal Entries: Retained earnings Dividends 5,000 Service revenue 106,000 5,000 Salaries & wages expense 46,000 Supplies expense Rent expense 3-22 15,000 9,000 Insurance expense 500 Interest expense 500 Depreciation expense 400 Bad debt expense 1,600 Retained earnings 33,000 LO 7 Prepare closing entries. 7. 7. Closing Closing Entries Entries Illustration 3-37 Illustration 3-37 3-23 8. 8. Post-Closing Post-Closing Trial Trial Balance Balance Illustration 3-38 3-24 LO 7 9. 9. Reversing Reversing Entries Entries After preparing the financial statements and closing the books, a company may reverse some of the adjusting entries before recording the regular transactions of the next period. 3-25 LO 7 Prepare closing entries. Accounting Accounting Cycle Cycle Summarized Summarized 3-26 1. Enter the transactions of the period in appropriate journals. 2. Post from the journals to the ledger (or ledgers). 3. Take an unadjusted trial balance (trial balance). 4. Prepare adjusting journal entries and post to the ledger(s). 5. Take a trial balance after adjusting (adjusted trial balance). 6. Prepare the financial statements from the second trial balance. 7. Prepare closing journal entries and post to the ledger(s). 8. Take a trial balance after closing (post-closing trial balance). 9. Prepare reversing entries (optional) and post to the ledger(s). LO 7 Prepare closing entries. Financial Financial Statements Statements of of aa Merchandising Merchandising Company Company Illustration 3-39 3-27 LO 7 Financial Financial Statements Statements of of aa Merchandising Merchandising Company Company Illustration 3-40 3-28 LO 7 Financial Financial Statements Statements of of aa Merchandising Merchandising Company Company Illustration 3-41 3-29 LO 7 APPENDIX 3A CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING Most companies use accrual-basis accounting  recognize revenue when it is earned and  expenses in the period incurred, without regard to the time of receipt or payment of cash. Under the strict cash-basis, companies  record revenue only when they receive cash, and  record expenses only when they disperse cash. Cash basis financial statements are not in conformity with GAAP. 3-30 LO 8 Differentiate the cash basis of accounting from the accrual basis of accounting. APPENDIX 3A CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING Illustration: Quality Contractor signs an agreement to construct a garage for $22,000. In January, Quality begins construction, incurs costs of $18,000 on credit, and by the end of January delivers a finished garage to the buyer. In February, Quality collects $22,000 cash from the customer. In March, Quality pays the $18,000 due the creditors. Illustration 3A-1 3-31 LO 8 Differentiate the cash basis of accounting from the accrual basis of accounting. APPENDIX 3A CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING Illustration: Quality Contractor signs an agreement to construct a garage for $22,000. In January, Quality begins construction, incurs costs of $18,000 on credit, and by the end of January delivers a finished garage to the buyer. In February, Quality collects $22,000 cash from the customer. In March, Quality pays the $18,000 due the creditors. Illustration 3A-2 3-32 LO 8 Differentiate the cash basis of accounting from the accrual basis of accounting. APPENDIX 3A CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING Conversion From Cash Basis To Accrual Basis Illustration: Dr. Diane Windsor, like many small business owners, keeps her accounting records on a cash basis. In the year 2010, Dr. Windsor received $300,000 from her patients and paid $170,000 for operating expenses, resulting in an excess of cash receipts over disbursements of $130,000 ($300,000 - $170,000). At January 1 and December 31, 2010, she has accounts receivable, unearned service revenue, accrued liabilities, and prepaid expenses as shown in Illustration 3A-5. Illustration 3A-5 3-33 LO 8 Differentiate the cash basis of accounting from the accrual basis of accounting. APPENDIX 3A CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING Conversion From Cash Basis To Accrual Basis Illustration: Calculate service revenue on an accrual basis. Illustration 3A-8 Illustration 3A-5 3-34 LO 8 Differentiate the cash basis of accounting from the accrual basis of accounting. APPENDIX 3A CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING Conversion From Cash Basis To Accrual Basis Illustration: Calculate operating expenses on an accrual basis. Illustration 3A-11 Illustration 3A-5 3-35 LO 8 Differentiate the cash basis of accounting from the accrual basis of accounting. APPENDIX 3A CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING Conversion From Cash Basis To Accrual Basis Illustration 3A-12 3-36 LO 8 APPENDIX 3A CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING Theoretical Weaknesses of the Cash Basis Today’s economy is considerably more lubricated by credit than by cash. The accrual basis, not the cash basis, recognizes all aspects of the credit phenomenon. Investors, creditors, and other decision makers seek timely information about an enterprise’s future cash flows. 3-37 LO 8 Differentiate the cash basis of accounting from the accrual basis of accounting. APPENDIX 3B USING REVERSING ENTRIES Illustration of Reversing Entries—Accruals Illustration 3B-1 3-38 LO 9 Identifying adjusting entries that may be reversed. APPENDIX 3B USING REVERSING ENTRIES Illustration of Reversing Entries—Deferrals Illustration 3B-2 3-39 LO 9 Identifying adjusting entries that may be reversed. APPENDIX 3B USING REVERSING ENTRIES Summary of Reversing Entries 1. All accruals should be reversed. 2. All deferrals for which a company debited or credited the original cash transaction to an expense or revenue account should be reversed. 3. Adjusting entries for depreciation and bad debts are not reversed. Recognize that reversing entries do not have to be used. Therefore, some accountants avoid them entirely. 3-40 LO 9 Identifying adjusting entries that may be reversed. APPENDIX 3C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED A company prepares a worksheet either on  columnar paper or  within an electronic spreadsheet. A company uses the worksheet to adjust 3-41  account balances and  to prepare financial statements. LO 10 Prepare a 10-column worksheet. APPENDIX 3C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED Worksheet Columns A company prepares a worksheet either on 3-42  columnar paper or  within an electronic spreadsheet. LO 10 Prepare a 10-column worksheet. APPENDIX 3C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED Illustration 3C-1 Worksheet 3-43 LO 10 APPENDIX 3C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED Preparing Financial Statements from a Worksheet The Worksheet:  provides information needed for preparation of the financial statements.  Sorts data into appropriate columns, which facilitates the preparation of the statements. 3-44 LO 10 Prepare a 10-column worksheet. APPENDIX 3C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED Illustration 3-39 3-45 LO 10 APPENDIX 3C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED Illustration 3-40 3-46 LO 10 APPENDIX 3C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED Illustration 3-41 3-47 LO 10