ACCT 101 – Fundamentals of Accounting

Chapter 3 – Adjusting Accounts and

Preparing Financial Statements

Overview: Much of this chapter should be a review for you. However, there may be
some new terminology related to adjustments. In addition, the Statement of Retained
Earnings will be new to you.

Accounting Periods – important to determine because users need information

frequently and promptly. Regular intervals for information are necessary. Annual
financial statements are needed, but more frequent interim statements are also usually
necessary.

Cash Basis Accrual Basis

Recognizes revenues when cash is received Recognizes revenues when the revenues
are earned, not when received
Recognizes expenses when cash is paid Recognizes expenses when they are
incurred, regardless of when paid
Not GAAP Required by GAAP
Net Income = Cash Receipts – Cash Paid Net Income = Revenues Earned – Expenses
incurred. Does not match cash balance.
Comparability questionable over periods Comparability is increased
Cash basis accounting may be useful for Profitability determined by accrual basis
business decisions, so that’s why we now accounting is required by GAAP. The
have a statement of cash flows income statement, in addition to a
statement of cash flows tells investors and
other users much information about a
company.

Adjusting Accounts
 Is necessary under accrual basis of accounting.
 Necessary for transactions that extend over more than one account period.
 Affect an income statement account and a balance sheet account.
 Process is to determine what the current balance is, decide what balance should be,
and make an adjustment for the difference.
 All adjustments can be categorized as deferrals or accruals.
 Key question to ask is “Has the Cash Changed Hands?” If so, it’s a deferral, if not,
it’s an accrual.
 Overview of Framework

Adjustments

Has the CASH changed hands?

YES NO

DEFERRALS ACCRUALS

Prepaid or deferred Unearned or deferred Accrued Expenses Accrued Revenues

expenses revenues

Prepaid or deferred expenses – Items paid for in advance or things you pay for
ahead of time and receive benefits later. Examples are insurance, advertising, supplies,
and even depreciation. If you pay for season tickets to sporting events to entertain clients,
this is a prepaid asset until the game is played.

Unearned or deferred revenues – Cash received in advance of providing products

or services. When cash is received ahead a time, an obligation or liability is received to
provide something later. If you receive money for the season tickets, then you have an
obligation to provide a game. In this respect, it’s the flipside of a prepaid. The amount
received is a liability until the game is played.

Accrued Expenses - Costs that are incurred in one period but are unpaid and
unrecorded. Accrued expenses must be reported in the period incurred. Examples of
accrued expenses are salaries, interest, taxes.

Accrued Revenues – Revenues earned in a period that are unrecorded and for which no
cash has yet been received. Accrued revenues usually arise from services and products
that have been performed/delivered but not yet billed. Also arises from interest that you
have earned but not yet received.
Prepaid or Unearned or Accrued Accrued
deferred deferred Expenses Revenues
expenses revenues
What Is it?
Paid for something Cash received in Costs incurred in Revenues earned in
in advance of benefit advance of providing one period but not one period but cash
goods or services paid for until not received until
another another
Accounts Affected:
One asset and one A revenue and a One expense and a An asset and a
expense are affected liability are affected liability account revenue account
Types of AJE’s
Prepaid Insurance Subscriptions Salary Accruals Unbilled amounts
Supplies Tickets Interest on amounts Partially completed
owed work
Depreciation Anything else where Taxes owed Interest earned but
cash is received ahead not paid on
of time investments
JE’s:
Insurance Used: Subscriptions Earned Wage Accrual Unbilled Items
Dr. Insurance Exp. Dr. Unearned Subs. Dr. Salary Exp. Dr. A/R
Cr. Prepaid Ins Cr. Subsc Income Cr. Salaries Pybl Cr. Fees Earned
Supplies Used: Tickets – Games Interest on Debt
Dr. Supplies Exp Played Dr. Interest Exp.
Cr. Supplies Dr. Unearned Tkt Inc Cr. Interest Pybl
Cr. Ticker Income
Assets Used Up: Taxes owed
Dr. Depn Exp. Dr. Tax Expense
Cr. Accum Depn Cr. Taxes Pybl

Closing Entries:
You learned how to do these in Acct 100.
Why: (1) to get certain accounts ready for the next accounting period
(2) to update the Retained earnings account for net income and dividends

How: (1) close revenues to income summary

(2) close expenses to income summary
(3) close income summary to retained earnings
(4) close dividends to retained earnings

After: Prepare a post closing trial balance. The only accounts that should have balances
are assets, liability, and equity accounts.
Classified Balance Sheet
 Assets should be classified into Current Assets, Long Term investments, and Plan
Assets.
 Liabilities should be classified into current liabilities and long-term liabilities.
 Equity is classified into two main subsections, Common Stock (contributed capital)
and Retained earnings.

Ratios
Profit Margin – return on sales – very common. It represents the percentage of profit for
each dollar in sales.
Profit Margin = Net Income
Net Sales