Preparing Financial Statements: © The Mcgraw-Hill Companies, Inc., 2007 Mcgraw-Hill/Irwin

Chapter 3
Preparing Financial Statements
McGraw-Hill/Irwin
The McGraw-Hill Companies, Inc., 2007
C1
Accrual Basis vs. Cash Basis

Accrual Basis
Cash Basis
Revenues are
recognized when
earned and expenses
are recognized when
incurred.
Revenues are
recognized when
cash is received and
expenses recorded
when cash is paid.
Not GAAP
Accounting
McGraw-Hill/Irwin
C1
On the cash basis the entire $2,400 would be

recognized as insurance expense in 2007. No insurance
expense from this policy would be recognized in 2008 or
2009, periods covered by the policy.

McGraw-Hill/Irwin
C1

On the accrual basis
$100 of insurance
expense is recognized in
2007, $1,200 in 2008,
and $1,100 in 2009. The
expense is matched with
the periods benefited by
the insurance coverage.
McGraw-Hill/Irwin
Recognizing Revenues
C1
Revenue Recognition
We have delivered the
product to our customer,
so I think we should record
the revenue earned.
McGraw-Hill/Irwin
Recognizing Expenses
C1
Revenue Recognition
Now that we have
Matching
Summary
of Expenses
Rent
Gasoline
Advertising
Salaries
Utilities
and . . . .
McGraw-Hill/Irwin
$1,000
500
2,000
3,000
450
....
recognized the revenue,

lets see what expenses
we incurred to
generate that revenue.
C3
Adjusting Accounts
An adjusting entry is recorded to bring an asset or
liability account balance to its proper amount.
Framework for Adjustments

Adjustments
Paid
Paid (or
(or received)
received) cash
cash before
before
expense
expense (or
(or revenue)
revenue) recognized
recognized
Prepaid
Unearned
Prepaid
Unearned
(Deferred)
(Deferred)
(Deferred)
(Deferred)
expenses*
revenues
expenses*
revenues
*including
depreciation
McGraw-Hill/Irwin
Paid
Paid (or
(or received)
received) cash
cash after
after
expense
expense (or
(or revenue)
revenue) recognized
recognized
Accrued
Accrued
expense
expense
Accrued
Accrued
revenues
revenues
P1
Prepaid (Deferred) Expenses

Resources paid
for prior to
receiving the
actual benefits.
Asset
Unadjusted
Balance
McGraw-Hill/Irwin
Credit
Adjustment
Here is the check

for my first
6 months rent.
Expense
Debit
Adjustment
P1
Prepaid Insurance
On December 1, 2007, Scott Company paid $12,000 to

cover rent for December 2007 through May 2008.
Scott recorded the expenditure as Prepaid Insurance
on December 1.
What adjustment is required?
637
McGraw-Hill/Irwin
128
Supplies
P1
During 2007, Scott Company purchased $15,500 of

supplies. Scott recorded the expenditures as
Supplies. On December 31, a count of the supplies
indicated $2,655 on hand.
What adjustment is required?
126
McGraw-Hill/Irwin
652
Depreciation
P1
Depreciation is the process of computing

expense from allocating the cost of plant
and equipment over their expected useful
lives.
Straight-Line
Asset Cost - Salvage Value
Depreciation =
Useful Life
Expense
McGraw-Hill/Irwin
Depreciation
P1
On January 1, 2007, Barton, Inc. purchased

equipment for $62,000 cash. The equipment
has an estimated useful life of 5 years and
Barton expects to sell the equipment at the end
of its life for $2,000 cash.
Lets record depreciation expense for the year
ended December 31, 2007.
2007
$62,000 - $2,000
Depreciation =
=
Expense
5
McGraw-Hill/Irwin
$12,000
Depreciation
P1
On January 1, 2007, Barton, Inc. purchased

equipment for $62,000 cash. The equipment has
an estimated useful life of 5 years and Barton
expects to sell the equipment at the end of its life
for $2,000 cash.
Lets record depreciation expense for the year ended
December 31, 2007.
McGraw-Hill/Irwin
Accumulated
Accumulated depreciation
depreciation is
is
aa contra
contra asset
asset account.
account.
Depreciation
P1
Equipment
1/1 62,000
Depreciation Expense
12/31 12,000
Accumulated Depreciation
12/31 12,000
McGraw-Hill/Irwin
Depreciation
P1
McGraw-Hill/Irwin
Equipment is
shown net of
accumulated
depreciation.
P1
Unearned (Deferred) Revenues

Cash
Cash received
received in
in
advance
advance of
of
providing
providing
products
products or
or
services.
services.
Liability
Debit
Adjustment
McGraw-Hill/Irwin
Unadjusted
Balance
Buy your season tickets for

all home basketball games NOW!
Go Big Blue
Revenue
Credit
Adjustment
P1

On October 1, 2007, Ox University sold 1,000 season
tickets to its 20 home basketball games for $100
each. Ox University makes the following entry:
McGraw-Hill/Irwin
P1

On December 31, Ox University has played 10 of
its regular home games, winning 2 and losing 8.
McGraw-Hill/Irwin
Accrued Expenses
P1
Costs
Costs incurred
incurred in
in aa
period
period that
that are
are
both
both unpaid
unpaid and
and
unrecorded.
unrecorded.
Expense
Liability
Credit
Adjustment
Debit
Adjustment
McGraw-Hill/Irwin
Were about one-half

done with this job and
want to be paid for
our work!
Accrued Expenses
P1
Barton,
Barton, Inc.
Inc. pays
pays its
its employees
employees every
every Friday.
Friday. Year-end,
Year-end,
12/31/07,
12/31/07, falls
falls on
on aa Wednesday.
Wednesday. As
As of
of 12/31/07,
12/31/07, the
the
employees
employees have
have earned
earned salaries
salaries of
of $47,250
$47,250 for
for Monday
Monday
through
through Wednesday
Wednesday of
of the
the week
week ended
ended 1/02/08.
1/02/08.
Last pay
date
12/26/07
12/1/07
McGraw-Hill/Irwin
Next pay
date
1/2/08
12/31/07
Year end
Record
Record adjusting
adjusting
journal
journal entry.
entry.
Accrued Expenses
P1
Barton,
Barton, Inc.
Inc. pays
pays its
its employees
employees every
every Friday.
Friday. Year-end,
Year-end,
12/31/07,
12/31/07, falls
falls on
on aa Wednesday.
Wednesday. As
As of
of 12/31/07,
12/31/07, the
the
employees
employees have
have earned
earned salaries
salaries of
of $47,250
$47,250 for
for Monday
Monday
through
through Wednesday
Wednesday of
of the
the week
week ended
ended 1/02/08.
1/02/08.
McGraw-Hill/Irwin
Accrued Revenues
P1
Revenues earned
in a period that
are both
unrecorded and
not yet received.
Asset
Debit
Adjustment
McGraw-Hill/Irwin
Yes, Ive completed your

tax return, but have not had
time to bill you yet.
Revenue
Credit
Adjustment
Accrued Revenues
P1
Smith
Smith &
& Jones,
Jones, CPAs,
CPAs, had
had $31,200
$31,200 of
of work
work
completed
completed but
but not
not yet
yet billed
billed to
to clients.
clients. Lets
Lets make
make
the
the adjusting
adjusting entry
entry necessary
necessary on
on December
December 31,
31, 2007,
2007,
the
the end
end of
of the
the companys
companys fiscal
fiscal year.
year.
McGraw-Hill/Irwin
C4
Temporary and Permanent

Accounts
Temporary (nominal) accounts accumulate data related to

one accounting period. They include all income statement
accounts, the dividends account, and the Income Summary
account. These accounts are closed at the end of the period
to get ready for the next accounting period.
Permanent (real) accounts report activities related to one or

more future accounting periods. They carry ending balances
to the next accounting period and are not closed.

McGraw-Hill/Irwin
The Accounting Cycle
C5
Start
Reverse
(optional)
Analyze
transactions
Prepare
post-closing
trial balance
Close
Journalize
Post
Prepare
statements
Prepare
unadjusted
trial balance
Prepare
adjusted
trial balance
McGraw-Hill/Irwin
Adjust
Classified Balance Sheet
C6
Current items are those expected to come due

(either collected or owed) within one year or the
companys operating cycle, whichever is longer.
McGraw-Hill/Irwin
C6
Current Assets
1. Cash,
2. Short-term investments,
3. Accounts receivable,
4. Short-term notes receivable,
5. Inventory for sale, and
6. Prepaid expenses.
McGraw-Hill/Irwin
C6
Long-Term Investments
Notes receivable and investments in stocks and
bonds of other companies that will be held for
the longer of one year or the operating cycle.
Land held for future expansion is also a longterm investment.
McGraw-Hill/Irwin
C6
Plant Assets
Plant assets are tangible assets that are both
long lived and used to produce or sell products
or services. Examples include equipment,
machinery, buildings, and land that are used to
produce or sell products and services.
McGraw-Hill/Irwin
C6
Intangible Assets
Long-term resources that benefit business
operations. They usually lack physical form and
have uncertain benefits. Examples include patents,
trademarks, copyrights, franchises, and goodwill.
McGraw-Hill/Irwin
C6
Current Liabilities
Obligations due to be paid or settled within one year or
the operating cycle, whichever is longer. Current
liabilities include:
1. Accounts payable,
2. Notes payable,
3. Taxes payable,
4. Interest payable,
5. Unearned revenues,
6. Wages payable.
McGraw-Hill/Irwin
Long-Term Liabilities
C6
Obligations not due within one year or the

operating cycle, whichever is longer. Long-term
liabilities include:
1. Notes payable,
2. Mortgages payable,
3. Bonds payable, and
4. Lease obligations.
McGraw-Hill/Irwin
Profit Margin
A2
The profit margin ratio measures the

companys net income to net sales.
Profit
Net Income
=
Margin
Net Sales
McGraw-Hill/Irwin
A3
Current Ratio
This ratio is an important measure of a companys ability to

pay its short-term obligations.
Current
Current assets
=
ratio
Current liabilities
McGraw-Hill/Irwin

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Chapter 3

Preparing Financial Statements

The McGraw-Hill Companies, Inc., 2007

Accrual Basis vs. Cash Basis

The McGraw-Hill Companies, Inc., 2007

Accrual Basis vs. Cash Basis

On the cash basis the entire $2,400 would be

The McGraw-Hill Companies, Inc., 2007

Accrual Basis vs. Cash Basis

The McGraw-Hill Companies, Inc., 2007

The McGraw-Hill Companies, Inc., 2007

recognized the revenue,

The McGraw-Hill Companies, Inc., 2007

Framework for Adjustments

The McGraw-Hill Companies, Inc., 2007

Prepaid (Deferred) Expenses

Here is the check

The McGraw-Hill Companies, Inc., 2007

On December 1, 2007, Scott Company paid $12,000 to

The McGraw-Hill Companies, Inc., 2007

During 2007, Scott Company purchased $15,500 of

The McGraw-Hill Companies, Inc., 2007

Depreciation is the process of computing

The McGraw-Hill Companies, Inc., 2007

On January 1, 2007, Barton, Inc. purchased

The McGraw-Hill Companies, Inc., 2007

On January 1, 2007, Barton, Inc. purchased

The McGraw-Hill Companies, Inc., 2007

The McGraw-Hill Companies, Inc., 2007

The McGraw-Hill Companies, Inc., 2007

Unearned (Deferred) Revenues

Buy your season tickets for

The McGraw-Hill Companies, Inc., 2007

Unearned (Deferred) Revenues

The McGraw-Hill Companies, Inc., 2007

Unearned (Deferred) Revenues

The McGraw-Hill Companies, Inc., 2007

Were about one-half

The McGraw-Hill Companies, Inc., 2007

The McGraw-Hill Companies, Inc., 2007

The McGraw-Hill Companies, Inc., 2007

Yes, Ive completed your

The McGraw-Hill Companies, Inc., 2007

The McGraw-Hill Companies, Inc., 2007

Temporary and Permanent

Temporary (nominal) accounts accumulate data related to

Permanent (real) accounts report activities related to one or

The McGraw-Hill Companies, Inc., 2007

The Accounting Cycle

The McGraw-Hill Companies, Inc., 2007

Classified Balance Sheet

Current items are those expected to come due

The McGraw-Hill Companies, Inc., 2007

Classified Balance Sheet

The McGraw-Hill Companies, Inc., 2007

Classified Balance Sheet

The McGraw-Hill Companies, Inc., 2007

Classified Balance Sheet

The McGraw-Hill Companies, Inc., 2007