Study guide: Adjusting Accounts for Financial Statements

📋 Course Outline

1. Periodic Reporting and Accrual Accounting
2. Adjustment Framework and Prepaid Expenses
3. Deferred Revenue Adjustments
4. Accrued Expense Adjustments
5. Accrued Revenue Adjustments
6. Financial Statements and Closing Process
7. Automation and Classified Balance Sheets
8. Classified Balance Sheet Structure
9. Asset and Liability Categories
10. Equity and Financial Ratios
11. Alternative Prepayment Accounting
12. Work Sheet Preparation
13. Reversing Entries

📖 1. Periodic Reporting and Accrual Accounting

🔑 Key Concepts & Definitions

• Time period assumption: presumes that an organization’s activities can be divided into specific periods such as a month, quarter, six-month interval, or year

★ Must-know

📌 Accrual-basis accounting records revenues when products or services are delivered and expenses when incurred, whereas cash-basis accounting records revenues when cash is received and expenses when cash is paid.

• For a $2,400 insurance policy covering 24 months beginning December 1, accrual accounting recognizes $100 of expense in December 2027, $1,200 in 2028, and $1,100 in 2029, whereas cash accounting recognizes the entire $2,400 in 2027.

📌 The revenue recognition principle requires revenue to be recorded when goods or services are provided to customers and at the amount expected to be received.

📌 The expense recognition or matching principle requires expenses to be recorded in the same accounting period as the revenues resulting from those expenses.

Further detail

• A fiscal year consists of any 12 consecutive months or 52 weeks, and a natural business year end occurs when sales are at their lowest level for the year.

💡 Memory Hook

Accrual basis records when earned or incurred; cash basis records when cash moves.

📖 2. Adjustment Framework and Prepaid Expenses

🔑 Key Concepts & Definitions

• Adjusting entry: recorded at the end of an accounting period to reflect a transaction or event that has not yet been recorded
• Prepaid expenses: assets paid for in advance of receiving their benefits, such as prepaid insurance, prepaid rent, and supplies

★ Must-know

• Adjusting entries are prepared by determining what the current account balance equals, determining what the balance should equal, and recording an entry to move from the current balance to the required balance.

📌 Each adjusting entry affects at least one income statement account and one balance sheet account, but never the Cash account.

📌 Adjusting a prepaid expense debits an expense account and credits the related asset account.

📐 Formula - Straight-line depreciation is calculated as $\text{Depreciation} = \frac{\text{Asset Cost} - \text{Salvage Value}}{\text{Useful Life}}$.

Further detail

• For equipment costing $26,000 with an $8,000 salvage value and a 5-year useful life, monthly straight-line depreciation is $300.

💡 Memory Hook

Current balance → required balance → adjusting entry.

📖 3. Deferred Revenue Adjustments

🔑 Key Concepts & Definitions

• Unearned revenue: cash received in advance of providing products or services and is reported as a liability

📝 Essential Points

📌 Adjusting unearned revenue debits the liability account and credits the revenue account for the portion earned.

• When $3,000 is received for 60 days of consulting and 5 days are earned by December 31, the adjustment recognizes $250 of consulting revenue and leaves $2,750 as unearned revenue.

💡 Memory Hook

Cash received first → service delivered later → liability becomes revenue.

📖 4. Accrued Expense Adjustments

🔑 Key Concepts & Definitions

• Accrued expenses: costs incurred in the current period that are both unpaid and unrecorded, including salaries, rent, taxes, and interest

★ Must-know

📌 An accrued expense adjustment debits an expense account and credits a liability account.

• If employees earn $70 per day and three days are unpaid at year-end, the accrued salaries adjustment debits Salaries Expense and credits Salaries Payable for $210.

Further detail

• A future payment of an accrued expense reduces the accrued liability, records the new-period expense, and credits Cash for the total payment.

💡 Memory Hook

Expense incurred unpaid → liability and expense recognized → cash settles the liability.

📖 5. Accrued Revenue Adjustments

🔑 Key Concepts & Definitions

• Accrued revenues: revenues earned in a period that are both unrecorded and not yet received in cash or other assets

★ Must-know

📌 An accrued revenue adjustment debits an asset account and credits a revenue account.

• When $2,700 is due for 30 days of service and 20 days are completed by December 31, the adjustment recognizes $1,800 of Accounts Receivable and Consulting Revenue.

Further detail

• The adjustment types are:
  • Prepaid expenses
  • Unearned revenues
  • Accrued expenses
  • Accrued revenues

💡 Memory Hook

Revenue earned uncollected → receivable and revenue recognized → cash is collected later.

📖 6. Financial Statements and Closing Process

🔑 Key Concepts & Definitions

• Temporary accounts: accumulate data for one accounting period and include income statement accounts, Dividends, and Income Summary
• Permanent accounts: report activities affecting future periods and include assets, liabilities, common stock, and retained earnings
• Post-closing trial balance: lists permanent accounts and their balances after closing entries have been journalized and posted

★ Must-know

📌 An unadjusted trial balance is prepared before adjustments, whereas an adjusted trial balance is prepared after adjusting entries have been recorded and posted.

• 🔄 The statements are prepared in this order:

  1. Prepare the income statement
  2. Prepare the statement of retained earnings
  3. Prepare the balance sheet
  4. Prepare the statement of cash flows

• 🔄 Closing entries follow four steps:

  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

Further detail

• The accounting cycle includes:
  • Analyze transactions
  • Journalize
  • Post
  • Prepare the unadjusted trial balance
  • Adjust and post
  • Prepare the adjusted trial balance
  • Prepare financial statements
  • Close accounts
  • Prepare the post-closing trial balance
  • Optionally reverse and post

💡 Memory Hook

Adjusted trial balance → statements → closing entries → post-closing trial balance.

📖 7. Automation and Classified Balance Sheets

🔑 Key Concepts & Definitions

• Current assets: cash and other resources expected to be sold, collected, or used within one year or the company’s normal operating cycle, whichever is longer
• Operating cycle: the time required to acquire inventory, sell the inventory, and collect cash from the sale of goods and services
• Robotic process automation: the use of software bots to automate repetitive and routine tasks usually performed by human workers

📝 Essential Points

• Examples of current assets include:
  • Cash
  • Short-term investments
  • Accounts receivable
  • Short-term notes receivable
  • Merchandise inventory
  • Prepaid expenses

📌 Current assets and current liabilities are listed in order of how quickly they will be converted to or paid in cash.

• RPA can be used to:
  • Extract data from invoices
  • Enter data into an accounting system
  • Process transaction data
  • Generate weekly sales reports

💡 Memory Hook

Current items meet the operating-cycle test; noncurrent items extend beyond it.

📖 8. Classified Balance Sheet Structure

🔑 Key Concepts & Definitions

• Classified balance sheet: organizes assets and liabilities into subgroups that provide more information to decision makers
• Current item: expected to be collected, sold, used, or paid within the longer of one year or the company’s normal operating cycle

📝 Essential Points

📌 Current assets and current liabilities are listed according to how quickly assets are converted to cash or liabilities are paid in cash.

💡 Memory Hook

Current items turn into or are paid in cash soon; noncurrent items remain longer.

📖 9. Asset and Liability Categories

🔑 Key Concepts & Definitions

• Long-term investments: notes receivable and investments in stocks and bonds expected to be held for more than the longer of one year or the operating cycle
• Plant assets: tangible, long-lived assets used to produce or sell products and services and are also called property, plant, and equipment or fixed assets
• Intangible assets: long-term assets that benefit business operations, lack physical form, and derive their value from privileges or rights held by the owner
• Current liabilities: obligations due to be paid or settled within the longer of one year or the company’s operating cycle, including the current portion of a long-term liability
• Long-term liabilities: obligations not due within the longer of one year or the company’s operating cycle, such as notes payable, mortgages payable, bonds payable, and lease obligations

📝 Essential Points

• Examples of plant assets are:

  • equipment
  • machinery
  • buildings
  • land

• Examples of intangible assets are:

  • patents
  • trademarks
  • copyrights
  • franchises
  • goodwill

• Examples of current liabilities are:

  • accounts payable
  • wages payable
  • taxes payable
  • interest payable
  • unearned revenues

💡 Memory Hook

C-L-I: Current, Long-term investments, Plant assets, Intangibles.

📖 10. Equity and Financial Ratios

🔑 Key Concepts & Definitions

• Equity: the owner’s claim on assets; for a corporation, it is reported as common stock and retained earnings and is not divided into current and noncurrent categories

★ Must-know

📐 Formula - Profit margin equals $\text{Profit margin}=\frac{\text{Net income}}{\text{Net sales}}$.

📐 Formula - Current ratio equals $\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}$ and helps assess the ability to pay debts in the near future.

Further detail

• Profit margin measures the relationship between net income and net sales and can improve when expenses decrease or revenues increase by more than expenses.

📌 A current ratio above 1.0 means that current assets can cover current obligations with some buffer.

💡 Memory Hook

Profit margin measures profitability, whereas current ratio measures short-term solvency.

📖 11. Alternative Prepayment Accounting

📝 Essential Points

• Under the alternative prepayment method, prepaid expenses are initially debited to expense accounts, and unused or unexpired portions are later transferred from expense accounts to prepaid accounts.

• For FastForward’s $2,400 payment for 24 months of insurance, one month of coverage expires in December, creating $100 of insurance expense and leaving $2,300 of prepaid insurance.

📌 The asset and expense methods for recording prepayments produce identical adjusted financial statements but require different adjusting entries.

• Under the alternative revenue method, receipts are initially credited to revenue accounts, and unearned portions are later transferred from revenue accounts to unearned revenue liabilities.

• For FastForward’s $3,000 receipt, $250 is earned by December 31, leaving $2,750 as unearned consulting revenue under either method.

💡 Memory Hook

The initial debit or credit differs, but the adjusted financial statements are identical.

📖 12. Work Sheet Preparation

🔑 Key Concepts & Definitions

• Work sheet: an internal document used to help prepare adjusting and closing entries and financial statements, but it does not substitute for financial statements

★ Must-know

• 🔄 The five work sheet steps are:

  1. Enter the unadjusted trial balance
  2. Enter adjustments
  3. Prepare the adjusted trial balance
  4. Sort adjusted balances into financial statement columns
  5. Total the statement columns and compute income or loss

• Work sheet column classifications are: expenses in the Income Statement Debit column, revenues in the Income Statement Credit column, assets and dividends in the Balance Sheet and Statement of Retained Earnings Debit column, liabilities, common stock, and retained earnings in the corresponding Credit column

Further detail

• A work sheet: reduces errors, links accounts and adjustments to financial statements, helps prepare financial statements, shows proposed what-if transactions

📌 If the Income Statement Credit total exceeds the Debit total, the difference is net income; if the Debit total exceeds the Credit total, the difference is net loss.

💡 Memory Hook

Unadjusted trial balance → adjustments → adjusted trial balance → statement columns → totals.

📖 13. Reversing Entries

🔑 Key Concepts & Definitions

• Reversing entries: optional entries dated the first day of the next accounting period that reverse the debits and credits of adjusting entries involving accrued revenues and accrued expenses

★ Must-know

📌 A reversing entry uses the same accounts and amounts as the original adjusting entry but reverses its debits and credits.

• The purpose of reversing entries is to simplify recordkeeping when accrued revenues or accrued expenses are subsequently settled.

Further detail

• For FastForward’s payroll accrual, the December 31 adjusting entry records three days of unpaid salary of $210, and the January 1 reversing entry debits Salaries Payable and credits Salaries Expense for $210.

• With a reversing entry, FastForward records the January 9 payment by debiting Salaries Expense and crediting Cash for the full $700, leaving a $490 salary expense balance for seven days at $70 per day.

💡 Memory Hook

Reverse the accrual on the first day → simplify the next payment entry.

📊 Synthesis Tables

Accrual Adjustment Types

Balance Sheet Classifications