Corporate Financial Reporting

Session 4 & 5 : IIMC-PGP 2020-21

Accounting Mechanics

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 Learning Goals

– Adjustment Entries
• Deferrals and Accruals
 Preparing an Adjusted Trial Balance
– Preparing Financial Statements
– Closing Entries
 Preparing a Post-Closing Trial Balance
– Assignment Problems

2
Trial Balance
– Each
account is
analyzed to
determine
whether it is
complete and
up-to-date.

3
 Accrual Concept
• Problem:
– Revenues can be earned in a period other than the one in which
cash is received
– Expenses can be incurred in a period other than the one in
which cash is paid

• Solution:
Transactions recorded in the periods in which the events occur
• Recognize revenues in the accounting period in which the
goods are sold or services are rendered (even if cash was not
received
• Recognize expenses in the accounting period in which they
are used to generate revenues (even if cash was not paid)

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 Revenue Recognition and Expense Recognition
Revenue Recognition Principle:
• Companies recognize revenue in the accounting period in which the
performance obligation is satisfied

Expense Recognition :
• Expenses need to be matched with the revenue in the period when
the company makes efforts to generate those revenues
“Let the expenses follow the revenues”
• Also referred to as Matching Principle

• Accrual basis of accounting helps to apply the matching principle

– The difficulty of assigning revenues and expenses to the
appropriate accounting period is addressed so that net income
is measured accurately

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 Assumptions and Matching Rule
Going Concern,
Accruals Basis

Matching
Principle
“Let the expenses
follow the revenues.”

Realisation convention:
Amounts reasonably certain
to be realized,
Unrealised gain should not
Some transactions span more than one accounting period be recorded 6
 Adjusting Entries
Adjusting entries needed to ensure that
• Transactions that span more than one period are adjusted at the end of
an accounting period – Applying Accrual Basis
• Revenue recognition & Expense recognition principles are followed

Adjusting entries make it possible to report

• correct amounts on the balance sheet and income statement.

A company must make adjusting entries

• every time it prepares financial statements at the end of a period

Adjustment Entry must:

• Include at least one income statement A/c
• Include at least one balance sheet A/c
• Do not affect cash flows in current period, never affect Cash A/c

Involves Judgment: Potential for abuse (Ethics)

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 Types of Adjusting Entries
Deferrals: Cash Exchanged in Advance of a future Revenue or Expense
1. Prepaid expenses: Recognition of Expense is Deferred
Expenses already paid in cash and recorded as assets
before they are used or consumed.
Recognition of Revenue is Deferred
3. Unearned revenues: (Pre-received/ Received in advance)
Cash received in advance and reported as liabilities
before revenue is earned.

Accruals: Cash to be Exchanged Later for a current Revenue or Expense

2. Accrued expenses:
Expenses incurred Expenses arisen, not yet recorded
but not yet paid in cash or recorded.
4. Accrued revenues: Revenue arisen, not yet recorded
Revenues earned
but not yet received in cash or recorded
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 Four Types of Adjustments
Cash exchanged BALANCE SHEET
BEFORE recognition
Assets Liabilities

1. Recorded costs are 2. Expenses are

Expense allocated between incurred but not yet
Note: Each
two or more recorded adjusting entry
INCOME STATEMENT

accounting periods involves one

(Accrued Expenses) balance sheet
(Deferred Expenses) account & one
income statement
4. Revenues are 3. Recorded unearned account
Revenue earned but not yet revenues are
recorded allocated between
two or more
accounting periods
(Accrued Revenues)
(Deferred Revenues)
Cash to be exchanged
AFTER recognition

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 DEFERRALS
(Type 1 and 3)

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 Adjustment Entries – Deferrals: Prepaid Expense (Type 1)
Prepaid Expense : Expenses paid in advance that have not yet expired
– Cash Payment Before Expenses are recorded (Supplies, Prepaid Rent, Plant)
– Recorded costs to be allocated between two or more accounting periods
– At the time of Payment : Service or benefit is yet to be received
• Debited to an Asset a/c Recognition of Expense is Deferred
– At the end of Accounting Period: A certain portion Expires (with passage of
time or Use)
• Expired portion to be transferred to an Expense A/c  Adjustment Entry
– Adjusting entry to record the EXPENSE that has been incurred and to the
ASSET that remains. Results in
• an increase to an expense account (Dr.) and
• a decrease to an asset account (Cr.)

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 Prepaid Expense

– When payment was made

• Recognition of expense was postponed and asset recorded
– If adjustment entry is not passed at the end of the accounting period,
even though the asset has been used/consumed
• Assets will be overstated
• Expenses will be understated
• Net income will be overstated
• Stockholders’ equity will be overstated
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 Adjustment Entry (Type 1) : Prepaid Insurance

Illustration: On October 4, Sierra Corporation paid $600 for a one-year fire

insurance policy. Coverage began on October 1. Sierra recorded the
payment by increasing (debiting) Prepaid Insurance. This account shows a
balance of $600 in the October 31 trial balance (if not adjusted).
Insurance of $50 ($600 ÷ 12) expires each month.

Oct. 31 Insurance Expense 50

Prepaid Insurance 50

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 Adjustment Entry (Type 1) : Supplies

Illustration: Sierra Corporation purchased supplies costing $2,500 on

October 5. Sierra recorded the purchase by increasing (debiting) the asset
Supplies. This account shows a balance of $2,500 in the October 31 trial
balance (if not adjusted).
An inventory count at the close of business on October 31 reveals that
$1,000 of supplies are still on hand.

Oct. 31 Supplies Expense 1,500

Supplies 1,500
($2,500 – 1,000 = $1,500)

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 Plant, Depreciation Expense, Accumulated Depreciation
Purchase of a long term asset is a deferral of an expense
– The cost of the asset must be allocated over its estimated useful life.
• The amount allocated to any one period is called depreciation.

Depreciation expense
– Incurred during an accounting period to produce revenue, must be estimated
– Based on: Cost of the asset, its estimated useful life (number of methods)

• Depreciation expense does not reduce the asset account directly, but is recorded
in a Contra Account, called Accumulated Depreciation
– A separate account, shown as a deduction from the related asset account
• Contra account is used to
– Recognize that depreciation is an estimate, Preserves original cost of the asset
• In combination with the asset account, it shows
– How much of the asset has been allocated as an expense
– The balance left to be depreciated
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 Adjusting Entry (Type 1): Prepaid Expense (Asset, Depreciation)
Depreciation is the process of allocating cost of an asset to expense over its useful life
- Depreciation doesn’t attempt to report actual change in the value of the asset
For Sierra Corporation, assume that depreciation on the office equipment is $480
a year, or $40 per month.
Oct. 31 Depreciation Expense 40
Accumulated Depreciation - Equipment 40

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 Prepaid Expense and Unearned Revenue
Mr. A records Mr. B records
Prepaid Rent (A) Cash (A) (Dr.)
Cash (A) (Cr.) Unearned Revenue (L)
Advance payment today

Mr. A (Tenant) Mr. B (Landlord)

Service Tomorrow

Mr. A records: Mr. B records

Rent Expense (E) (Dr.), Unearned Revenue (L) (Dr.),
Prepaid Rent (A) (Cr.) Rent Revenue ( R ) (Cr.)

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 Adjustment Entries – Deferred or Unearned Revenue (Type 3)
Unearned Revenue (Pre-received/ Received in advance)
— Cash Receipt Before Revenue earned or recognized
(Airline Tickets, Magazine Subscription, Rent, Customer deposits)
— Recorded unearned revenue to be allocated between two or more
accounting periods
— At the time of cash receipt: Service (goods) yet to be rendered (delivered)
— Credited to a Liability A/c Recognition of Revenue is Deferred
— At the end of the accounting period: Service Rendered (or Goods delivered)
— Amount Earned is transferred to a Revenue A/c  Adjustment Entry
— Adjusting entry to record the REVENUE that has been earned and to show
the LIABILITY that remains. Results in :
— a decrease to a liability account (Dr.) and
— an increase to a revenue account (Cr.)

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 Unearned Revenue

– When payment was received

• Recognition of revenue was postponed and LIABILITY recorded
– If adjustment entry is not passed at the end of the accounting period,
even though the REVENUE has been Earned
• LIABIITIES will be overstated
• REVENUES will be understated
• Net income will be Understated
• Stockholders’ equity will be Understated
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 Adjustment Entries (Type 3) –Unearned Revenue

Illustration: Sierra Corporation received $1,200 on October 2 from R. Knox

for guide services for multi-day trips expected to be completed by
December 31. Unearned Service Revenue shows a balance of $1,200 in the
October 31 trial balance.
From an evaluation of the service Sierra performed for Knox during
October, the company determines that it has earned $400 in October.

Oct. 31 Unearned Service Revenue 400

Service Revenue 400

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 ACCRUALS
(Type 2 and 4)

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 Adjustment Entries – Accrued Expense (Type 2)

Accrued Expenses or Outstanding Expenses

• Expenses Incurred during the period, but not yet recorded – no cash paid yet
(Rent, Interest, Wages, Taxes, Utilities) Expenses arisen, not yet recorded

• At the end of the Accounting Period: Amount that has been incurred is
– Recognized as an Expense, and Adjustment Entry
– Recorded as a Liability.  As the expense accumulates,
it is said to accrue
• Adjustment Entry results in
– Increases an expense account (Dr.) and
– Increases a liability account (Cr.)

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 Adjustment Entry (Type 2 ): Accrued Wages
Illustration: Sierra Corporation last paid salaries on October 26; the next payment of
salaries will not occur until November 9. The employees receive total salaries of $2,000
for a five-day work week, or $400 per day.
Thus, accrued salaries at October 31 are $1,200 ($400 x 3 days).

Hired : 9th Oct,

Work started :15th Oct,
Wages payable:
Every 2 weeks
First Wage Paid: 26th Oct

Oct. 31 Salaries and Wages Expense 1,200

Salaries and Wages Payable 1,200

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 Adjustment Entry (Type 2 ): Accrued Interest

Illustration: Sierra Corporation signed a three-month note

payable in the amount of $5,000 on October 1. The note
requires Sierra to pay interest at an annual rate of 12%.

Oct. 31 Interest Expense 50

Interest Payable 50

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 Adjustment Entries – Accrued Revenue (Type 4)
Accrued Revenue or Receivables
• Revenue earned during the period, but not yet recorded: no cash receipts
yet Revenue arisen, not yet recorded
(Rent, Interest, Service performed, Revenues earned on operations)
• At the end of the Accounting Period: Amount that has been Earned is
– Recognized as an REVENUE, and Adjustment Entry
– Recorded as an ASSET (Accounts Receivable) – amount due to the
company for services performed (or goods delivered)
 As the revenue accumulates,
• Adjustment Entry results in it is said to accrue
– Increases an asset account (debits) and
– Increases a revenue account (credits)

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 Adjustment Entries – Accrued Revenue (Type 4)

Illustration: In October, Sierra Corporation performed guide services

for $200 that were not billed to clients before October 31.

Oct. 31 Accounts Receivable 200

Service Revenue 200

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 Adjusting Entries - Accruals

• Without Adjustment for Accrued Expenses - Expenses and Liabilities will

be understated: NI, Shareholders’ Equity will be Overstated
• Without Adjustment for Accrued Revenues – Revenues and Assets will be
understated: NI, Shareholders’ Equity will be Understated
• Balance Sheet and Income Statement would be incorrect
• Mr X’s Accrued Expenses (A/P) would be Mr. Y’s Accrued Revenue (A/R)
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 Preparing an Adjusted Trial Balance

• After all adjusting entries are recorded (journalized) and posted

– the Ledger Account balances are recalculated

 Some accounts will have the same balance they had on the trial balance
 Others will be different because adjusting entries changed the balances

• After that another Trial balance is prepared from the ledger accounts
(Adjusted Trial Balance)

• The adjusted trial balance’s purpose is

– to prove the equality of debit balances and credit balances in the
ledger.
• The adjusted trial balance is
– the primary basis for the preparation of the financial statements.
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The Adjusted Trial Balance

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 Preparing Financial Statements : Sequence

1 Income Statement
Revenue accounts
– Expense accounts
Net income
Adjusted Trial Balance 2 Statement of Retained Earnings
Asset accounts Beginning retained earnings
Liability accounts
+ Net Income
Common Stock
Retained Earnings – Dividends
Dividends Ending retained earnings
Revenue accounts
Expense accounts Balance Sheet
3 Assets
Asset accounts

Liabilities
Liability accounts

Stockholders’ Equity
Common stock
Retained earnings
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Preparing Financial Statements

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Preparing Financial Statements

From
Balance Sheet
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 Closing the Books

Temporary accounts Permanent accounts

(or nominal accounts) (or real accounts)
All Revenue accounts, All Assets accounts,
All Expense accounts, All Liabilities accounts,
Dividends accounts All Shareholders’ Equity accounts
i.e. all Balance sheet accounts

Are closed at the end of each period Are not closed at the end of each
period

Begin each period with a zero Carry their end-of-period balances to

balance next period

At the end of the accounting period, companies transfer the temporary account
balances to : Retained Earnings (stockholders’ equity account- permanent)
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 Closing Entries
CLOSING ENTRY: Required at the end of any period for which financial
statements are prepared
• Summarizes a period’s revenues and expenses by transferring balances to
the Income Summary account
– Updates Retained Earnings to its correct ending balance
• Produces a zero balance in each temporary account
– Set the stage for the next period by clearing revenue, expense, and
dividends accounts of their balances

• Does not appear on financial statements Income Summary

• Only used in the closing process
• Balance of account equals the net income or loss reported on the income statement
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 The Closing Process

Expense Accounts Revenue Accounts

xxx xxx

Step 2: Close Step 1: Close

expense accounts Income Summary revenue accounts
xxx xxx
xx

Step 3: Close
Income Summary

Dividends Retained Earnings

xx Step 4: xx xx
Close
Dividends

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 Closing the Books

2012

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 Closing the Books

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 Preparing a Post-Closing Trial Balance

• Trial balance is prepared again after the closing entries

– All temporary accounts will have zero balances.
– It would show balances of ONLY Permanent (Balance Sheet)
accounts

• The purpose of the post-closing trial balance is

– To check that total debits equal total credits in the ledger after
closing entries have been posted
– To prove the equality of the permanent account balances that
the company carries forward into the next accounting period
– Hence prove equality of the two sides of balance sheet

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Below are the adjusted accounts of Century Realtors, Inc., for the month ended
October 31, 20x7, listed in alphabetical order:
Accounts Payable $ 520 Dividends $ 750
Accounts Receivable 2,400 Income Taxes Expense 80
Accumulated Depreciation– Income Taxes Payable 80
Office Equipment 3,000 Office Equipment 7,500
Cash 1,200 Prepaid Rent 1,100
Commissions Revenue 5,400 Retained Earnings 4,000
Common Stock 2,000 Salaries Expense 1,720
Depreciation Expense– Utilities Expense 100
Office Equipment 150

Prepare a post-closing trial balance

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 Below are the adjusted accounts of Century Realtors, Inc., for the month ended
October 31, 20x7, listed in alphabetical order:
Accounts Payable $ 520 Dividends $ 750
Accounts Receivable 2,400 Income Taxes Expense 80
Accumulated Depreciation– Income Taxes Payable 80
Office Equipment 3,000 Office Equipment 7,500
Cash 1,200 Prepaid Rent 1,100
Commissions Revenue 5,400 Retained Earnings 4,000
Common Stock 2,000 Salaries Expense 1,720
Depreciation Expense– Utilities Expense 100
Office Equipment 150

Prepare a post-closing trial balance Commissions Revenue 5,400

Century Realtors, Inc. Depreciation Expense 150
Post-Closing Trial Balance Income Taxes Expense 80
October 31, 20x7 Salaries Expense 1,720
Utilities Expense 100 2,050
Cash $ 1,200 Net Income 3,350
Accounts Receivable 2,400
Prepaid Rent 1,100 Which accounts will have a zero
Office Equipment 7,500 balance after closing entries?
Accumulated Depreciation–Office Equipment $ 3,000
• Revenues (Commissions Revenue)
Accounts Payable 520 • Expenses (Depreciation Expense, Income
Income Taxes Payable 80 Taxes Expense, Salaries Expense, Utilities
Expense)
Common Stock 2,000 • Dividends
Retained Earnings 6,600*
$12,200 $12,200
*$4,000 + $3,350 net income – $750 dividends = $6,600.
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 Summary of the Accounting Cycle

1. Analyze business transactions

9. Prepare a post-closing trial

2. Journalize the transactions
balance

8. Journalize and post closing

3. Post to ledger accounts
entries

7. Prepare financial statements 4. Prepare a trial balance

6. Prepare an adjusted trial 5. Journalize and post

balance adjusting entries:
Deferrals/Accruals

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 Deferrals Accruals
Prepaid Expense Unearned Accrued Expense Accrued
Revenue Revenue
Examples Insurance, Rent, Customer Interest, Revenue earned
Supplies, Plant deposits Salaries, Tax not collected
Cash exchange Assets ... Dr. Cash ..… Dr.
(in advance) Cash … Cr. Liability … Cr.
Reason for Prepaid Unearned Expenses Revenues
Adjustment expenses Revenue incurred but not earned but not
recorded in recorded in yet paid in cash yet received in
asset have been liability have or recorded cash or recorded
used been earned
Adjustment Expense … Dr. Liability … Dr. Expense … Dr. Asset… Dr.
Entry Assets ….Cr. Revenue … Cr. Liability .Cr. Revenue … Cr.
Without Adjustment Entry:
Overstated Assets, Profit, Liability Profit, Equity
Equity
Understated Expenses Revenue, Profit, Expenses, Revenue, Assets,
Equity Liability Profit, Equity
Cash exchange Liability … Dr. Cash .… Dr.
(later) Cash … Cr. Asset… Cr.
 Summary of Basic Relationship

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 I.For each of the following oversights, state whether Total assets, Total liabilities, Net income,
Owner’s equity will be understated, overstated, or not affected (NA).
Also, state the amount of increase/decrease in A, L, NI, OE to correct the effect of these oversights
______ a. Failure to record revenue of Rs12,000 earned but not yet received
A, NI, OE: Understated  Increase by 12,000; L: NA
______ b. Failure to record expired rent Rs 4000 (Prepaid Rent 8000)
A, NI, OE: Overstated  Decrease by 4,000; L: NA
______ c. Failure to record accrued interest income of Rs 3000 at the bank
A, NI, OE: Understated  Increase by 3,000; L: NA
______ d. Failure to record depreciation of Rs 2000
A, NI, OE: Overstated  Decrease by 2,000; L: NA
______ e. Failure to record accrued wages of Rs700
L : Understated Increase by 700; NI, OE: Overstated  Decrease by 700; A: NA
______ f. Failure to convert unearned revenue to earned revenue of Rs 200
L : Overstated Decrease by 200; NI, OE: Understated  Increase by 200; A: NA
II. Jamal Company began the year with $84,000 in its Common Stock account and a debit balance in
Retained Earnings of $36,000. During the year, the company earned net income of $18,000 and declared
and paid $6,000 of dividends. In addition, the company sold additional common stock amounting to
$22,000. Based on this information, what should the transaction analysis show for the ending total of all
stockholders' equity accounts?
a. $154,000
b. $166,000
c. $82,000
d. $110,000
Solution: $84,000 + ($36,000) + $18,000  $6,000 + $22,000  $82,000 44
 Determining Cash Flows: Applying the General Rule
Note: The general rule
General Rule Potential cash payments or receipts
does not apply to
– Amount not paid or received
depreciation
Cash flows for expenses or from revenues
Application of the general rule varies with the type of asset or liability account
• For accruals
 Accrued expenses
• Beginning Balance + Expense for the Period – Ending Balance
 Accrued revenues
• Beginning Balance + Revenue for the Period – Ending Balance
Cash Receipts (Payments) for Revenue (or Expense) for - Increase in Accrual
Revenue (Expense) = the period (Receivables / Payables)
• For deferrals
 Prepaid expenses
• Ending Balance + Expense for the Period – Beginning Balance
 Unearned revenues
• Ending Balance + Revenue for the Period – Beginning Balance
Cash Receipts (Payments) Revenue (or Expense) for + Increase in Deferral
for Revenue (Expense) = the period (Prepaid/ Unearned)

Cash Receipts (Payments) for Revenue (or Expense) for + Increase in Deferral - Increase in Accrual
Revenue (Expense) = the period (Prepaid/ Unearned) (Receivables / Payables)
 Cash Payments for Insurance
Cash Prepaid Insurance Insurance Expense
310 May 31 480 120 120
310

Jun 30 670
General Rule:
Ending balance + Expense for period – Beginning Balance = Cash payments

Prepaid Insurance at June 30 $670

Insurance Expense during June 120
Potential cash payments for insurance 790
Less Prepaid Insurance at May 31 480
Cash payments for insurance during June $310
The beginning balance is deducted
because it was paid in a prior period
Practice

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Journalize: On December 12, Roger Kent, a painter, was paid $1,800 in advance for performing a
service that would extend into the following calendar year.
By December 31, he still had three-fourths of the service remaining to perform.
In the journal provided, prepare the December 12 entry, the December 31 end-of-period adjustment,
as well as the entry on January 29 when the job was completed. Omit explanations.

a. Equipment is purchased for $48,000, to be used for eight years. Assuming zero value at the end of
eight years, what is the equipment's carrying value after two years and three months?
a. $34,500 [$48,000 - ($48,000 ÷ 8 = $6,000 ÷ 12 = $500 * 27 months = $13,500)]

b. Prepaid Insurance has an $800 balance prior to adjustment. By year end, one-fourth has expired. What
will be the balance in Prepaid Insurance after the adjusting entry has been made?
b. $600 [$800 - ($800 ÷ 4)]
c. A company purchased $210 in supplies during the year, recorded $120 in Supplies Expense, and ended
with $350 of supplies. What was the beginning balance of Supplies? 48
c. $260 ($350 + $120 = $470 - $210)
Journalize: On December 12, Roger Kent, a painter, was paid $1,800 in advance for performing a
service that would extend into the following calendar year.
By December 31, he still had three-fourths of the service remaining to perform.
In the journal provided, prepare the December 12 entry, the December 31 end-of-period adjustment,
as well as the entry on January 29 when the job was completed. Omit explanations.

a. Equipment is purchased for $48,000, to be used for eight years. Assuming zero value at the end of
eight years, what is the equipment's carrying value after two years and three months?
a. $34,500 [$48,000 - ($48,000 ÷ 8 = $6,000 ÷ 12 = $500 * 27 months = $13,500)]

b. Prepaid Insurance has an $800 balance prior to adjustment. By year end, one-fourth has expired. What
will be the balance in Prepaid Insurance after the adjusting entry has been made?
b. $600 [$800 - ($800 ÷ 4)]
c. A company purchased $210 in supplies during the year, recorded $120 in Supplies Expense, and ended
with $350 of supplies. What was the beginning balance of Supplies? 49
c. $260 ($350 + $120 = $470 - $210)
In the journal provided, prepare adjusting entries for the following items. Omit explanations.

a. Depreciation on machinery is $940 for the accounting period.

b. Interest incurred on a loan but not paid or recorded is $635.
c. Office supplies of $600 were on hand at the beginning of the period. Purchases of office supplies during
the period totaled $200. At the end of the period, $140 in office supplies remained.
d. Commissions amounting to $540 were earned but not recorded or collected by year end.
e. Prepaid Rent had an $8,000 normal balance prior to adjustment. By year end, 50 percent had expired.
f. Income taxes for the year are estimated to be $3,250.
What is the effect of the adjustment entry on Income statement and Balance Sheet ?
In the journal provided, prepare adjusting entries for the following items. Omit explanations.

a. Depreciation on machinery is $940 for the accounting period.

b. Interest incurred on a loan but not paid or recorded is $635.
c. Office supplies of $600 were on hand at the beginning of the period. Purchases of office supplies during
the period totaled $200. At the end of the period, $140 in office supplies remained.
d. Commissions amounting to $540 were earned but not recorded or collected by year end.
e. Prepaid Rent had an $8,000 normal balance prior to adjustment. By year end, 50 percent had expired.
f. Income taxes for the year are estimated to be $3,250.
What is the effect of the adjustment entry on Income statement and Balance Sheet ?
Indicate with an X in the appropriate column the type of entry to be made to close the
following accounts:

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Thank You

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