HI5001

TOPIC 4
Preparing Financial Statements
 Introduction
•In this session we look at the process involved
with the preparation of financial statements
• Measurement of profit
•Adjusting entries
•The steps in the final preparation of the various
statements.
 Measurement of Profit
•Cash basis
Income recorded when received
Expenses recorded when paid
This method more applicable to small cash-only
businesses
•Accrual basis
Income recognised when the anticipated inflow of
economic benefit can be reliably measured
Expenses when the consumption of benefits can be
reliably measured
This method used by the corporate sector
 Measurement of Profit (cont.)
•Temporary (nominal) accounts
• Income statement accounts
• Income
• Expenses
•Permanent (real) accounts
• Balance sheet accounts
• Assets
• Liabilities
• Equity
 Temporary Accounts
•These are accounts are those that apply for
one accounting period only and are closed
off.

•These are the revenue/income and expense

accounts which are closed off to P/L
 Permanent Accounts
•These are accounts that remain open from
one accounting period to the next such as
asset accounts, liability accounts and equity
accounts.
•The relate to the Balance Sheet and include
negative-asset accounts such as
Accumulated Depreciation.
 The Accounting Cycle – Further Expansion

1. Recognise and record Source documents

transactions

2. Journalise transactions General journal

3. Post to ledger accounts General ledger

4. Prepare unadjusted trial Trial balance

balance of GL (unadjusted)

Continued next slide

 The Accounting Cycle – Further Expansion (cont.)

5. Determine adjusting entries General

and/or journalise journal

6. Post adjusting entries to General ledger

general ledger
(accounts adjusted)

7. Prepare adjusted trial balance Trial balance

of GL (adjusted)
(adjusted)

8. Prepare financial statements worksheet Financial statements

 The Need for Adjusting Entries

•In some cases the period in which cash is paid or

received does not coincide with period in which
expense and income are recognised
•Therefore, some accounts must be adjusted on
the last day of the accounting period to correct
recognition of income and expenses not reflected
in cash receipts or payments.
•Whilst can add to the timeliness of completion of
the various statements, they are still important
and for correctness, must occur!
 Classification of Adjusting Entries

Deferrals Accruals

• Prepaid expenses • Accrued expenses

• Unearned revenues • Accrued revenues
 Prepaid Expenses
•Amounts paid before the benefit is consumed
•Initially recorded as assets and charged to expenses in
subsequent periods as consumed
ASSET ACCOUNT
Prepaid Expenses Expense Account
Initial cost Adjusting entry Adjusting entry
Debit Credit Debit

Cost used up,

incurred or expired
 Prepaid Expenses (cont.)

Prepaid insurance
On 3 June a 24 month insurance policy
purchased for $1,920. Initially recorded as:

June 3 Prepaid Insurance 1,920

GST Outlays 192
Cash at Bank 2,112
Purchase of a 24 month fire and business
liability insurance policy
 Prepaid Expenses (cont.)
By 30 June, the period end, we need to adjust prepaid
insurance account to reflect the consumption
June 30 Insurance expense 80
Prepaid insurance 80
Adjusting entry to record expiration of 1 month’s insurance

Prepaid insurance Insurance expense

Initial cost Adjusting entry Adjusting entry

1,920 80 80
Cost used up,
incurred or expired
 Prepaid Expenses (cont.)
Office supplies
On 5 June an entry was made to record a tax
invoice covering purchase of office supplies:

June 5 Office Supplies 1,240

GST Outlays 124
Accounts Payable 1,364
Office supplies purchased on credit
 Prepaid Expenses (cont.)
By 30 June, the period end, we need to adjust
office supplies account to reflect the remaining
supplies of $1,080 (or $160 consumed)
Jun 30 Office Supplies Expense 160
Office Supplies 160
Adjusting entry to record supplies consumed in June

Office supplies Office supplies expense

Initial cost Adjusting entry Adjusting entry

1,240 160 160
Cost used up,
incurred or expired
 Prepaid Expenses (cont.)
Depreciation of Equipment & Buildings
ASSET ACCOUNT

Initial cost
Debit

CONTRA- ASSET ACCOUNT

Accumulated Depreciation EXPENSE ACCOUNT

Adjusting entry Adjusting entry

Credit Debit

Cost used up &

allocated to current
period
 Precollected or Unearned Revenue

Amounts received before service is performed

LIABILITY ACCOUNT INCOME ACCOUNT

Unearned revenue Revenue

Adjusting entry Cash receipt Adjusting entry

Debit Credit

Revenue earned during the current

period
 Accrued or Unrecorded Expenses

Expenses consumed but not yet paid for

LIABILITY ACCOUNT
EXPENSE ACCOUNT
Expense Payable
Adjusting entry Adjusting entry
Credit Debit

expenses incurred
 Accrued or Unrecorded Expenses (cont.)

Accrued salaries (liability)

 Accrued or unrecorded expenses (cont.)

On 22 June salaries were paid for the period of

8 June to 22 June:

June 22 Salary expense 3,800

Cash at bank 3,800
Salaries paid to employees
 Accrued or Unrecorded Expenses (cont.)

By 30 June, the period end, we need to adjust

records to provide for liability since last pay day
June 30 Salaries expense 1,990
Salaries payable 1,990
Adjusting entry to record salaries payable from 23 to 30 June

Salaries payable Salary expense

Initial salaries
Adjusting entry Adjusting entry
1,990 1,990
Earned, but not
yet paid
 Accrued or Unrecorded Expenses (cont.)

The liability is eliminated on 6 July when the next

payment is made to employees

July 6 Salaries payable 1,990

Salary expense 1,710
Cash at Bank 3,700
Salaries paid to employees
 Accrued or Unrecorded Expenses (cont.)

Accrued interest (liability)

•On 2 June, company took on a 20 year
$240,000 8% mortgage requiring an annual
payment of $12,000 plus accrued interest
•On 30 June, adjusting entry is made to record
interest expense incurred in June:

June 30 Interest expense 1,600

Interest payable 1,600
Adjusting entry to record interest payable on mortgage
for June
 Accrued or Unrecorded Expenses (cont.)

Accrued electricity (liability)

•The electricity provider invoices customers after
the service has been provided
•On 30 June, adjusting entry is made to record the
estimated electricity used in June:

June 30 Electricity expense 420

Electricity account payable 420
Adjusting entry to record electricity consumed in June
 Unrecorded or Accrued Revenue

Amounts due for services performed but not

yet received

ASSET ACCOUNT INCOME ACCOUNT

Accounts receivable Revenue
Adjusting entry Adjusting entry
Debit Credit

Revenue earned but not yet

received
 Adjusted Trial Balance

•Reflects balances in ledger accounts after

end-of-period adjusting entries
•Debits must still equal credits!
 Preparation of Financial Statements

•Income statement
Prepared first to determine profit or loss
Reflects entity’s performance
•Statement of changes in equity
Profit (loss) must be added to (subtracted from)
equity
Shows details of movements in equity
Equity balance is reported in balance sheet
 Balance Sheet
•Reflects entity’s financial position
•Three major categories of accounts
Assets
Liabilities
Equity
•Statement users find it useful if assets and
liabilities are further categorised
 Balance Sheet (cont.)
ASSETS
LIABILITIES
•Current assets
• Current liabilities
•Non-current assets
• Non-current or
Investments long-term liabilities
Property, plant and equipment
Intangible assets
Other assets
Balance Sheet (cont.)
The Operating Cycle
 The Worksheet
• Assembles all information needed to adjust the
accounts and prepare financial statements

• Aids in the preparation of interim financial

statements when adjusting and closing entries are
not required

• Contains information needed to close off profit

and loss accounts for the period
 Preparation of the Worksheet
1. Enter ledger account titles and balances in
the account title and unadjusted trial balance
columns
2. Enter the adjustments in the adjustment
column
3. Prepare an adjusted trial balance
4. Extend adjusted balances to the financial
statements columns
 Preparation of Financial Statements

•Use worksheet columns for:

Income statement
Balance sheet
•To prepare:
Income statement
Statement of changes in equity
Balance sheet
 Financial Statements & Decision Making

•Has the business been profitable?

•Is the profit satisfactory?
•Is the business solvent?
•Is there enough cash for the day-to-day running
of the business?
•Is a bank overdraft facility needed?
•Should more capital be invested?
•Has the business been financed with too much
long-term debt?
 ABC Learning
https://www.youtube.com/watch?v=YYF6JW9vJK
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35
 Tutorial
Topic 4
Preparing Financial Statements

Reading:
Hoggett & Edwards Chapter Four

Questions:
Hoggett & Edwards Chapter Four
Problems 4.1, 4.2, 4.3, 4.4, 4.5, 4.7, 4.7, 4.8, 4.9
Critical Thinking Case
Ethical Issues
The END