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CHAPTER 3
PREPARING FINANCIAL STATEMENTS
Key Terms and Concepts to Know
Accounting Period: Time Period Principle Calendar vs. Fiscal Year
Accounting Cycle: Know the steps in order. Use the steps as a reference to insure that journal entries, trial balances and financial statements are prepared in the proper order.
Accrual Basis Accounting: Accrual vs. Cash Basis Accounting Revenue Recognition Principle requires that revenues are reported in the period in which they are earned, regardless of when payment is received. Matching Principle requires that all expenses incurred (whether paid or not) are recorded in the same accounting period as the revenues earned as a result of these expenses.
Adjusting Entries: Accrued revenues and accrued expenses Deferred revenues and deferred expenses Unbilled vs. unearned revenues
Closing Process: Records the current year’s net income and dividends in retained earnings and zeros-out the balance in all revenue, expense and dividend accounts at year-end. Revenue and expense account balances are transferred into the Income Summary account. The balance in the income summary represents net income (revenues minus expenses) which is then transferred into retained earnings. Dividends are transferred directly into retained earnings, bypassing the income summary because dividends are not part of the calculation of net income and do not appear on the income statement.
Profit Margin ratio and Current ratio
Key Topics to Know
Adjusting Entries
Adjusting entries are required to record internal transactions and to bring assets and liability accounts to their proper balances and record expenses or revenues in the proper accounting period.
Therefore adjusting entries always affect one income statement account (revenue or expense) and one balance sheet account (asset or liability).
There are two basic types of adjusting entries: Deferrals and Accruals
Deferred Revenue and Expense
Deferrals occur when cash changes hands prior to when the revenue is earned or expense is incurred. Recording the revenue or expense is postponed or deferred until a subsequent economic event has occurred which causes revenue to be earned or expense to be incurred.
Deferred Revenues (also referred to as unearned revenue) are initially recorded as a liability and adjusted at the end of the period for the portion that has been earned. This occurs when payment is received in advance of performing the service.
Any Date Cash (Cash received in advance)
Unearned Revenue
Dec. 31 Unearned Revenue (Amount earned as of year-end)
Fees Earned
Deferred Expenses (also referred to as prepaid expenses) are initially recorded as assets and adjusted at the end of the period for the portion that has been used up or expired.
Any Date Prepaid Insurance (Cost of insurance policy)
Cash
Example #1: Journalize the adjusting entries and label them as accruals or deferrals, adding accounts as needed.
a. Unexpired insurance at December 31 $1, b. Supplies on hand at December 31 $ c. Depreciation of building for the year $1, d. Depreciation of equipment for the year $5, e. Revenue unearned at December 31 $2, f. Accrued salaries and wages at December 31 $2, g. Fees earned but unbilled on December 31 $4,
Forever Green Lawn Care, Inc. Trial Balance December 31, 20-- Cash 8, Accounts Receivable 20, Prepaid Insurance 4, Supplies 1, Land 45, Building 134, Accumulated Depreciation-Bldg
Equipment 80, Accumulated Depreciation-Equip.
Accounts Payable 7, Unearned Revenue 6, Capital Stock 15, Retained Earnings 54, Dividends 8, Fees Earned 199, Salaries and Wages Expense
Utilities Expense 23, Advertising Expense 18, Repairs Expense 11, Miscellaneous Expense 4, Totals 430,200 430,
Solution #
a) Deferred Expense Insurance Expense 2, Prepaid Insurance 2,
b) Deferred Expense Supplies Expense 1, Supplies 1,
c) Deferred Expense Depreciation Expense-Bldg 1, Accum. Depr.- Bldg 1,
d) Deferred Expense Depreciation Expense-Equip 5, Accum. Depr.-Equipment 5,
e) Deferred Revenue Unearned Revenue 4, Fees Earned 4,
f) Accrued Expense Wages Expense 2, Wages Payable 2,
g) Accrued Revenue Accounts Receivable 4, Fees Earned 4,
Example #2:
Using the data in Example #1, determine the adjusted balances of the accounts and prepare an adjusted trial balance.
Practice Problem #1:
- Journalize the adjusting entries and label them as accruals or deferrals.
- Update the account balances of the selected accounts given below.
a) Supplies on hand on August 31 $ b) Depreciation of equipment during the year $3, c) Rent expired during the year $11, d) Wages accrued, but not paid at August 31 $2, e) Unearned fees at August 31 $1, f) Unbilled fees at August 31 $5, g) Supplies on hand on August 31 $
Selected Account Balances
Current Balance
Adjust. Entry
Adjusted Balance
Debit Credit (+ / - ) Debit Credit
Accounts Receivable 12, Supplies 1, Prepaid Rent 20, Equipment 73, Accumulated Depreciation- Equipment
Capital Stock 20, Dividends 2, Unearned Fees 7, Fees Earned 99, Wages Expense 42, Rent Expense Depreciation Expense Supplies Expense
Adjusting Entries and Errors
Failure to journalize and post adjusting entries at the end of the period will cause multiple financial statement items to be misstated.
Company A failed to record accrued wages of $5,000 at the end of the period.
The adjusting entry should have been:
Wages Expense 5, Wages Payable 5,
This entry should have increased wages expense with a debit and increased wages payable with a credit. Failing to record this entry caused the following errors:
a) Wages Expense will be understated by $5,000, so b) Total Expenses will be understated by $5,000, so c) Net Income will be overstated by $5,000, and when closed to RE d) Retained Earnings will be overstated by $5, e) Wages Payable will be understated by $5,000, so f) Total Liabilities will be understated by $5,
Example #2: At the end of October, the first month of operations, the following selected data were taken from the financial statements of Crisp Cleaners:
Net Income for October $102, Total Assets at October 31 228, Total Liabilities at October 31 60, Total Stockholders’ Equity at October 31 168,
The following adjusting entries were omitted at the end of the month:
a) Supplies used during October $ b) Depreciation of equipment for October $3, c) Unbilled fees earned at October 31 $1, d) Accrued wages at October 31 $
Required:
- Journalize the entries to record the omitted adjustments.
- Determine the correct amounts for Net Income, Total Assets, Total Liabilities and Total Stockholders’ Equity as of October 31.
Solution #
a. Supplies Expense 800 Supplies 800 b. Depreciation Exp.-Equip. 3, Accum. Depr.- Equip. 3, c. Accounts Receivable^ 1, Fees Earned 1, d. Wages Expense 500 Wages Payable 500
Temporary accounts are the revenue, expense and dividend accounts which measure activity for a specific time period. Temporary accounts are closed at the end of the year.
Income Summary is a special temporary account used only during the closing process to summarize net income.
The closing process involves four entries:
- Zeroing-out the balance in each revenue account and transferring the total revenues to the Income Summary account as a credit.
- Zeroing-out the balance in each expense account and transferring the total revenues to the Income Summary account as a debit.
- Zeroing-out the balance in Income Summary, the net income (credit) or net loss (debit) for the period, to the Retained Earnings account.
- Zeroing-out the balance in each dividend account and transferring the total dividends directly into retained earnings as a debit. Income Summary is not used because dividends are not used to determine Net Income.
After closing, only asset, liability and permanent stockholders’ equity accounts should have balances.
The following closing entries are based on the previous worksheet. There are four closing entries that are numbered below.
- Fees Revenue 190, Rent Revenue 2, Income Summary 192,
- Income Summary 201, Salaries and Wages Expense 102, Advertising Expense 58, Utilities Expense 19, Repairs Expense 11, Miscellaneous Expense 4, Insurance Expense 800 Supplies Expense 700 Depreciation Expense-Bldg 1, Depreciation Expense-Equipment 3,
Balance in Income Summary account = Net Income
- Retained Earnings 9, Income Summary 9,
- Retained Earnings 10, Dividends 10,
Practice Problem # For each of the following accounts indicate whether it is: (IS) – Closed to Income Summary (RE) – Closed to Retained Earnings (P) – A permanent account and not closed
- Accounts Payable 7. Prepaid Advertising
- Accounts Receivable 8. Wages Payable
- Fees Earned 9. Unearned Fees
- Dividends 10. Supplies
- Insurance Expense 11. Prepaid Insurance
- Accumulated Depreciation-Bldg 12. Salary Expense
Trial Balance
A Trial Balance is a summary of all account balances in the general ledger. Each account and its balance (debit or credit) is listed on the trial balance. Total of all debit account balances must equal the total of all credit debit balances.
A trial balance is useful in determining whether the general ledger is in balance (total debits equal total credits). It will not identify errors in the general ledger or in preparing the trial balance for which debits equal credits or if an entry is not posted to the general ledger at all.
Trial balances are typically prepared three times during the accounting cycle: Unadjusted which is prepared prior to adjusting entries Adjusted which is prepared after adjusting entries and is the basis for preparing financial statements Post-closing which is prepared after closing entries.
Practice Problem # Using the completed worksheet from Practice Problem #1, prepare closing entries and the Post-Closing Trial Balance.
Sample True / False Questions
- Accrual-basis accounting involves recording revenues when earned and recording expenses with their related revenues. True False
- Adjusting entries should be prepared after financial statements are prepared. True False
- Prepaid expenses involve payment of cash (or an obligation to pay cash) for the purchase of an asset before the expense is incurred. True False
- Unearned revenues occur when cash is received after the revenue is earned. True False
- Accrued expenses involve the payment of cash before recording an expense and a liability. True False
- Accrued revenues involve the receipt of cash after the revenue has been earned and an asset has been recorded. True False
- The adjusting entry for an accrued expense always includes a debit to an expense account and a credit to a liability account. True False
- Adjusting entries for accrued revenues always includes a debit to a liability account and a credit to a revenue account. True False
- Adjusting entries are not necessary when cash is paid at the same time expenses are incurred. True False
- A post-closing trial balance is a list of all accounts and their balances after we have updated account balances for adjusting entries. True False
- A classified balance sheet separates assets into current and long- term, and separates liabilities into current and long-term. True False
- Closing entries transfer the balances of all temporary accounts (revenues, expenses, and dividends) to the balance of the Common Stock account. True False
- The closing entry for expense accounts includes a debit to Retained Earnings and a credit to all expense accounts. True False
- The closing entry for dividends includes a debit to the Dividends account and a credit to Retained Earnings. True False
- After closing entries are prepared, the balance of Retained Earnings is updated to reflect the activity in the revenue, expense, and dividend accounts for the period. True False
- The post-closing trial balance is a list of all accounts and their balances at a particular date after the account balances have been updated for closing entries. True False
- According to the revenue recognition principle, if a company provides services to a customer in the current year but does not collect cash until the following year, the company should report the revenue in the current year. True False
- The matching principle states that we recognize expenses in the same period as the revenues they help to generate. True False
Sample Multiple Choice Questions
- The revenue recognition concept a) Determines when revenue is credited to a revenue account. b) States that revenue is not recorded until the cash is received. c) Controls all revenue reporting for the cash basis of accounting. d) Is in conflict with accrual accounting.
- The matching principle: a) Addresses the relationship between the journal and the ledger. b) Determines the normal balance of an account. c) Requires that expenses related to revenue and revenue be reported at the same time. d) Requires that the dollar amount of debits equal the dollar amount of credits in a journal entry.
- Using accrual accounting, expenses are recorded only: a) When they are incurred and paid at the same time b) If they are paid before they are incurred c) If they are paid after they are incurred d) When they are incurred, whether or not cash is paid
- The primary difference between deferred and accrued expenses is that deferred expenses have: a) Been recorded and accrued expenses have not been incurred b) Been incurred and accrued expenses have not c) Not been incurred and accrued expenses have been incurred d) Not been recorded and accrued expenses have been incurred
- Adjusting entries affect at least one: a) Revenue and one expense account b) Asset and one liability account c) Revenue and one stockholders’ equity account d) Income statement account and one balance sheet account
- The year-end balance in the prepaid rent account before adjustment is $18,000, representing three months’ rent paid on December 1. The adjusting entry required on December 31 is: a) Debit Rent Expense, $6,000; credit Prepaid Rent, $6, b) Debit Prepaid Rent, $6,000; credit Rent Expense, $6, c) Debit Rent expense, $12,000; credit Prepaid Rent, $12, d) Debit Prepaid Rent, $12,000; credit Rent expense, $12,
- At the end of the fiscal year, the usual adjusting entry for accrued salaries owed to employees was omitted. Which of the following statements is true? a) Stockholders’ equity at the end of the year was overstated b) Salary Expense for the year was overstated c) The total of the liabilities at the end of the year was overstated d) Net Income for the year was understated
- What is the proper adjusting entry at June 30, the end of the fiscal year, based on a supplies account balance before adjustment, $7,200, and supplies inventory on June 30, $1,200? a) Debit Supplies, $1,200; credit Supplies Expense, $1, b) Debit Supplies Expense, $1,200; credit Supplies, $1, c) Debit Supplies Expense, $6,000; credit Supplies, $6, d) Debit Supplies, $6,000; credit Supplies Expense, $6,
- A business enterprise pays weekly salaries of $45,000 on Friday for a five-day week ending on that day. The adjusting entry necessary at the end of the fiscal period ending on Thursday is: a) Debit Salaries Payable, $36,000; credit Cash, $36, b) Debit Salary Expense, $36,000; credit Dividends, $36, c) Debit Salary Expense, $36,000; credit Salaries Payable, $36, d) Debit Dividends, $36,000; credit Cash, $36,
- At the end of the fiscal year, May Company omitted the usual adjusting entry for depreciation on equipment. Which of the following statements is true? a) Total assets will be understated at the end of the current year. b) The balance sheet, income statement, and retained earnings statement will be misstated for the current year. c) Expenses will be overstated at the end of the current year. d) Net income will be understated for the current year.
- Data for an adjusting entry described as “accrued wages, $800” means to debit: a) Capital Stock and credit Wages Payable b) Wages Expense and credit Wages Payable c) Wages Payable and credit Wages Expense d) Accounts Receivable and credit Wages Expense
- Notes Receivable due in 60 days appears on the: a) Balance Sheet in the Current Assets section b) Balance Sheet in the Fixed Asset section c) Balance Sheet in the Current Liabilities section d) Income Statement as Revenue
- Adjusting entries are dated in the journal as of: a) The last day of the accounting period, although they are actually journalized after the end of the accounting period. b) The date they are actually journalized, although this date is generally after the end of the accounting period. c) The first day of the accounting period, although they are actually journalized after the end of the accounting period. d) The first day of the subsequent accounting period.
- Closing entries: a) Need not be journalized since they appear on the worksheet b) Need not be posted if the financial statements are prepared from the worksheet c) Must be journalized and posted d) Are not needed if adjusting entries are prepared
- Which of the following accounts should be closed to Income Summary? a) Accumulated Depreciation b) Supplies Expense c) Prepaid Expenses d) Dividends
- Which of the following accounts ordinarily appears in the post- closing trial balance? a) Salaries Expense b) Supplies Expense c) Accumulated Depreciation d) Fees Earned
- The entry to close the income summary account when there is net income at the end of the accounting period is: a) Debit Retained Earnings; credit Income Summary b) Debit Income Summary; credit Retained Earnings c) Debit Income Summary; credit Dividends d) Debit Dividends; credit Income Summary
- In the normal manual accounting cycle the: a) Financial statements are prepared after the adjusting entries are posted b) Financial statements are prepared after the closing entries are posted c) Adjusting and closing entries are journalized before financial statements are prepared d) Post-closing trial balance is prepared before the closing entries are posted
- The ability of a company to pay its debts is called a) Solvency b) Working capital c) Current ratio d) Net worth
- A current ratio of 5.6 means that a) There is $5.60 in current assets available to pay each dollar of current liabilities b) The company cannot pay its debts as they come due c) There is $5 in current assets for every $6 in current liabilities d) There is $6 in current assets for every $5 in current liabilities
- Receipt of an unearned revenue a) Increases an asset; increases a liability. b) Increases an asset; increases a revenue. c) Decreases a liability; increases stockholders’ equity. d) Decreases a revenue; increases stockholders’ equity.
- If revenues are recognized only when a customer pays, what method of accounting is being used? a) Accrual basis b) Recognition basis c) Cash basis d) Matching basis
- Which of the following is not a typical example of a prepaid expense? a) Supplies b) Insurance c) Rent d) Wages
