ACCT 101

LECTURE NOTES – CH. 3: Adjusting Accounts and Preparing Financial Statements

ACCOUNTING PERIODS

Financial statements are to be produced based on regular, predictable time periods. In most businesses, the time period is monthly. At a minimum, it must be annually. Publicly-traded companies must submit their financial statements to the Securities and Exchange Commission, and the public, quarterly.

ACCRUAL BASIS VS CASH BASIS OF ACCOUNTING

GAAP requires use of accrual basis accounting. The accrual basis records revenues as they are earned, and expenses are recorded as incurred.

Many small businesses do not follow GAAP, but instead use the cash basis of accounting. The cash basis of accounting records revenues as cash from customers is received. Expenses are not recorded until paid.

The following table summarizes the differences between these two accounting systems.

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 business decisions, so that’s why we now have a statement of cash flows / Profitability determined by accrual basis accounting is required by GAAP. The income statement, in addition to a statement of cash flows tells investors and other users much information about a company.

Overview of Framework

YES NO

Prepaid or deferred expenses – Items paid for in advance. These items are assets when acquired, but will become expense later. Examples are prepaid insurance, prepaid advertising, and supplies. Here is a guided example of accounting for prepaid expenses:

Unearned or deferred revenues – Cash received in advance of providing products or services. Unearned revenues are classified as liabilities, as the firm has an obligation to provide services or products later. Revenues will be recognized as the goods or services are delivered. Here is a guided example of how to account for unearned revenues:

Accrued Expenses - Costs that are incurred in one period but will be paid later. A good example of an accrued expense is wages earned in one accounting period but paid in a later accounting period. Watch the link below to see a guided example of preparation of adjusting entries in one period, followed by actual payment in the next.

Accrued Revenues – Revenues earned in a period for which no cash has yet been received. Accrued revenues usually arise from services and products that have been performed or delivered but have not been billed. See the link below for a guided example:

We will work several exercises and problems practicing adjusting entries in class.

CLASSIFIED BALANCE SHEET

The following table summarizes classification criteria in a classified balance sheet.

Account Category / Classifications / Definition / Examples of Accounts Included

Assets

/ Current Assets / Assets that will be converted to cash, or "used up," within one year from the date of the balance sheet. / Cash, Accounts Receivable, Merchandise Inventory, Prepaid Insurance, Prepaid Rent, Supplies

Property and Equipment

/ Assets that (1) are tangible, (2) have long useful lives, usually exceeding 3 years,
and (3) are used in business operations. / Land, Equipment, Building,
Machinery, Furniture and
Fixtures. Also includes the
Accumulated Depreciation
accounts as contra-assets
(except Land, which is not
depreciated).
Long-term investments / Investments expected to be held for more than one year. / Notes Receivable, Investments in Stocks.
Intangible assets / Long-term assets that benefit business operations but lack physical form. / Copyrights, patents, trademarks.
Liabilities / Current liabilities / Liabilities that are expected to be paid, or otherwise terminated, within one year
from the date of the balance sheet. / Accounts Payable, Wages
Payable, Unearned Revenue, and Notes
Payable—current portion
Long-term liabilities / Liabilities that are expected
to be paid, or otherwise
terminated, after one
year from the date of
the balance sheet / Notes Payable, due after one year.
Equity / The owners’ claim on assets. / Common stock and retained earnings.

CLOSING ENTRIES FOR CORPORATIONS

As in ACCT 100, temporary accounts—revenues, expenses, income summary, and dividends---are closed. Permanent accounts—assets, liabilities, common stock, and retained earnings---are not closed.

The four closing entries are summarized, as follows:

(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 closing entries are journalized and posted, a post-closing trial balance should be prepared. The only accounts that should have balances are assets, liabilities, common stock, and retained earnings.

The following guided example shows how to prepare closing entries for corporations:

RATIOS

Profit Margin: represents the percentage of profit for each dollar in sales. The formula is:

Net Income

Net Sales

Current Ratio:one measure of a company’s ability to pay its short-term obligations. The formula is:

Current Assets

Current Liabilities

Debt Ratio: measures risk associated with company’s use of debt:

Total Liabilities

Total Assets

1