Chapter 4

Adjusting the accounts and preparing financial

statements

PowerPoint presentation by Anne AbrahamUniversity of Wollongong

©2009 John Wiley & Sons Australia, Ltd

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MEASUREMENT OF PROFIT

• Cash basis– Income recorded when received

– Expenses recorded when paid

• 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

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MEASUREMENT OF PROFIT continued

• Temporary (nominal) accounts– Income statement accounts

• Income

• Expenses

• Permanent (real) accounts– Balance sheet accounts

• Assets

• Liabilities

• Equity

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THE ACCOUNTING CYCLE – FURTHER EXPANSION

1. Recognise and record transactions

1. Recognise and record transactions

2. Journalise transactions2. Journalise transactions

3. Post to ledger accounts3. Post to ledger accounts

4. Prepare unadjusted trial balance of GL

4. Prepare unadjusted trial balance of GL

Source documentsSource documents

General journalGeneral journal

General ledgerGeneral ledger

Trial balance (unadjusted)

Trial balance (unadjusted)

Continued next slide

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THE ACCOUNTING CYCLE – FURTHER EXPANSION continued

5. Determine adjusting entries and/or journalise

5. Determine adjusting entries and/or journalise

6. Post adjusting entries to general ledger

6. Post adjusting entries to general ledger

7. Prepare adjusted trial balance of GL (adjusted)

7. Prepare adjusted trial balance of GL (adjusted)

8. Prepare financial statements

8. Prepare financial statements

General journal

General journal

General ledger(accounts adjusted)

General ledger(accounts adjusted)

Trial balance(adjusted)

Trial balance(adjusted)

Financial statementsFinancial statementsworksheet

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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

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CLASSIFICATION OF ADJUSTING ENTRIES

Deferrals Accruals

• Prepaid expenses

• Unearned revenues

• Accrued expenses

• Accrued revenues

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Prepaid expenses

• Amounts paid before the benefit is consumed• Initially recorded as assets and charged to

expenses in subsequent periods as consumed

ASSET ACCOUNTPrepaid Expenses

Initial costDebit

EXPENSE ACCOUNT

Adjusting entryCredit

Adjusting entryDebit

cost used up,incurred or expired

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Prepaid expenses continued

Prepaid insurance• On 3 June a 24 month insurance policy

purchased for $960. Initially recorded as:

Jun 3 Prepaid Insurance 960 GST Outlays 96

Cash at Bank 1 056

(Purchase of a 25 mth fire and business liability insurance policy)

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Prepaid expenses continued

• By 30 June, the period end, we need to adjust prepaid insurance account to reflect the consumption

Jun 30 Insurance Expense 40 Prepaid Insurance

40(Adjusting entry to record expiration of 1 mth’s insurance)

Prepaid Insurance

Initial cost960

Insurance Expense

Adjusting entry40

Adjusting entry40

cost used up,incurred or expired

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Prepaid expenses continued

Office supplies• On 5 June an entry was made to record a

tax invoice covering purchase of office supplies:

Jun 5 Office Supplies 620 GST Outlays 62

Accounts Payable 682

(Office supplies purchased on credit)

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Prepaid expenses continued

• By 30 June, the period end, we need to adjust office supplies account to reflect the remaining supplies of $540 (or $80 consumed)

Jun 30 Office Supplies Expense 80 Office Supplies

80(Adjusting entry to record supplies consumed in June)

Office Supplies

Initial cost620

Office Supplies Expense

Adjusting entry80

Adjusting entry80

cost used up,incurred or expired

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Prepaid expenses continued

Depreciation of equipment and buildings

CONTRA ASSET ACCOUNTAccumulated Depreciation EXPENSE ACCOUNT

Adjusting entryCredit

Adjusting entryDebit

cost used up &allocated to current

period

Initial costDebit

ASSET ACCOUNT

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Precollected or unearned revenue

• Amounts received before service is performed

LIABILITY ACCOUNTUnearned Revenue

INCOME ACCOUNTRevenue

Cash receipt Adjusting entryCredit

Adjusting entryDebit

revenue earned during the current period

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Accrued or unrecorded expenses

• Expenses consumed but not yet paid for

LIABILITY ACCOUNTExpense Payable EXPENSE ACCOUNT

Adjusting entryCredit

Adjusting entryDebit

expenses incurred

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Accrued or unrecorded expenses continued

Accrued salaries (liability)

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Accrued or unrecorded expenses continued

• On 22 June salaries were paid for the period of 8 June to 22 June:

Jun 22 Salary Expense 3 800 Cash at Bank 3 800

(Salaries paid to employees)

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Accrued or unrecorded expenses continued

• By 30 June, the period end, we need to adjust records to provide for liability since last pay day

Jun 30 Salaries Expense 1 990 Salaries Payable 1

990(Adjusting entry to record salaries payable from 23 June to 30 June)

Adjusting entry1 990

Adjusting entry1 990

earned, but notyet paid

Salaries Payable Salary Expense

Initial salaries

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Accrued or unrecorded expenses continued

• The liability is eliminated on 6 July when the next payment is made to employees

Jul 6 Salaries Payable 1 990Salary Expense 1 710

Cash at Bank 3 700

(Salaries paid to employees)

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Accrued or unrecorded expenses continued

Accrued interest (liability)• On 2 June, company took on a 20 year

$120,000 8% mortgage requiring an annual payment of $6000 plus accrued interest

• On 30 June, adjusting entry is made to record interest expense incurred in June:

Jun 30 Interest Expense 800 Interest Payable 800

(Adjusting entry to record interest payable on mortgage for June)

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Accrued or unrecorded expenses continued

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:

Jun 30 Electricity Expense 210 Electricity Account Payable 210

(Adjusting entry to record electricity consumed in June)

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Unrecorded or accrued revenue

• Amounts due for services performed but not yet received

ASSET ACCOUNTAccounts receivable

INCOME ACCOUNTRevenue

Adjusting entryCredit

Adjusting entryDebit

revenue earned but not yet received

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ADJUSTED TRIAL BALANCE

• Reflects balances in ledger accounts after end-of-period adjusting entries

• Debits must still equal credits!

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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

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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

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Balance sheet continued

ASSETS• Current assets• Non-current assets

– Investments

– Property, plant and equipment

– Intangible assets

– Other assets

LIABILITIES• Current liabilities• Non-current or

long-term liabilities

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Balance sheet continued

The operating cycle

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PREPARING FINANCIAL STATEMENTS FROM THE WORKSHEET

• 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

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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

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Preparation of financial statements

• Use worksheet columns for:– Income statement

– Balance sheet

• To prepare:– Income statement

– Statement of changes in equity

– Balance sheet

Preparing financial statements

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FINANCIAL STATEMENTS AND 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?

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