Finance: Chapter 3

Chapter 3Adjustments, Financial Statements, and Completing the Accounting Cycle

This chapter discusses the procedures that are necessary to prepare financial statements at the end of an accounting period. The end-of-period procedures are necessary because many revenue and expense transactions extend beyond one accounting period. As a result, we must adjust the accounts so that they are correct for the preparation of the financial statements for the period. Accounting apportions the effects of multi-period transactions among accounting periods based on the fundamental elements of financial accounting, most of which were introduced previously. In this chapter, we also discuss the additional end-of-period procedures that are necessary to complete the accounting cycle. These procedures involve the closing of revenue and expense accounts to begin the accounting cycle for the next accounting period.

ANING OBJECTIVES

1. Explain the concepts, assumptions, and principles underlying the accrual basis of accounting.2. Prepare adjusting entries at the end of an accounting period.3. Prepare financial statements using an adjusted trial balance.4. Explain the closing process and prepare closing entries.5. Prepare a post-closing trial balance.6. Describe the various steps in the accounting cycle.7. Calculate and interpret a business’s profit margin.

Copyright © 2000, Robert G. May Page 1

LEARNING OBJECTIVES

LO 1 ACCRUAL CONCEPTS, ASSUMPTIONS, AND PRINCIPLES

In previous chapters, we introduced the fundamental elements that compose the foundations of financial accounting. Several of those elements are essential to understanding the role of the accrual basis of accounting and the adjustment of accounts for preparation of financial statements. We review these key elements in this chapter to provide the basis for the discussion of the adjustment process. The elements that we review are: accounting period concept, realization principle, and matching principle. In addition to reviewing these elements, we introduce a new element—the going-concern assumption.

Accounting Period Concept

The previous discussion of accounting net income referred to the business’s net income for a period. The period of time for which we determine net income is called the accounting period. The accounting period commonly is a year, but we may measure and report income for periods as short as a month. The development of a year as the accounting period may be traced to the requirement for businesses to file income tax returns with federal and state governments on an annual basis. Also, federal and state regulatory agencies require many businesses to file financial statements on an annual basis. In any event, the annual accounting period for businesses is an established practice. When we determine net income for a period of less than a year, the process is usually less formal than that for an annual determination and involves more estimates and assumptions. We present financial information such as net income for a period shorter than a year in reports called interim financial reports.

Various Business Fiscal Periods A fiscal year is the specific twelve-month accounting period a business adopts. Most businesses adopt the calendar year, January 1 to December 31, as their fiscal year. Some businesses, however, use so-called “natural” fiscal years that end in their most slack seasons.

The preparation of annual financial statements and annual tax returns requires many procedures and significant effort by the employees. For example, in this chapter, we describe how a business must undertake additional accounting procedures to adjust its accounts to prepare formal financial statements. Therefore, if the end of the fiscal year comes during the business’s slack season, the required additional efforts to prepare its annual financial statements can be accommodated more conveniently. During a period of four years, from 1995 through 1998, a sample of 600 U.S. companies averaged the following percentages of fiscal year ends. These percentages appear to be relatively stable, but there is a slight trend toward December year-ends and away from the other months.

Month PercentJanuary 3.8%February 1.8%March 2.5%April 1.5%May 2.5%


Source: Accounting Trends and Techniques (New York: AICPA, 1992), p. 41.

June 9.5%July 2.1%August 2.5%September 6.0%October 3.8%November 2.6%December 61.5%

Income Determination and Multi-period Transactions. Determining net income for the accounting period, whether it is the annual period or an interim period, is one of the most difficult problems accountants face. Many transactions extend beyond one accounting period. That is, the transaction begins in one accounting period and concludes in a subsequent accounting period. Some transactions may conclude in the next accounting period; other transactions may span several accounting periods.

To determine net income for a period, the accountant must apportion to the appropriate periods the effects of transactions that extend beyond one period. For example, PhotoCopy, Inc. purchased a delivery van costing $13,000 in February 20X1 that will benefit the business for several years—the estimated time period that the business can use the van. Since PhotoCopy will use the van to earn revenues over several years, we allocate the cost of the van to the years that the business benefits from the expenditure.

We accomplish the required apportionment of the cost of the van by the adjustment process illustrated later in this chapter. After the adjustment process, the accounts should reflect the revenues earned and the expenses incurred during the period. To accomplish this objective, however, the accountant makes certain critical assumptions.

Going-Concern Assumption

The going-concern assumption states that, in the absence of evidence to the contrary, we assume that the enterprise will continue to operate as a viable business. The going-concern assumption is the basis of the adjustment process. To apportion the effects of multi-period transactions to current and future periods, the accountant assumes that the enterprise is a going-concern, even though thousands of businesses fail each year. Of course, the going-concern assumption is not appropriate if evidence is available that the enterprise is about to go out of business.

Accounting for the van PhotoCopy, Inc. purchased provides an excellent example of the application of the going-concern assumption. At the date of purchase, we record the van as an asset. As PhotoCopy uses the van, a portion of the asset expires and becomes an expense. If we estimate that the van can be used for 6 years, we apportion the cost of the van through the adjustment process to the 6-year period as an expense called depreciation expense. For example, we might recognize one-sixth of the total cost as an expense in each of the 6 years. But, the process of spreading the cost of the van over 6 years is appropriate only if the accountant can reasonably assume that the business will continue and, thereby, utilize the van to earn revenues in all 6 years.


Realization Principle and Revenue Apportionment

Some revenue transactions extend beyond one accounting period. Earlier we discussed that according to the realization principle, we recognize revenue in the period it is earned. Accountants apportion the effects of multi-period revenue transactions to current and future periods by recognizing revenues in the period they are earned from delivering goods or providing services.

Matching Principle and Expense Apportionment

Some expense transactions, like some revenue transactions, extend beyond one accounting period. Accountants apportion the effects of multi-period expense transactions to current and future periods by recognizing expenses in the period they are incurred. An expense is incurred in the period that the business uses up its assets or incurs liabilities from delivering goods or providing services in connection with its normal operations.

According to the matching principle, we should recognize expenses in the same period as the related revenues. Some expenses, such as sales commissions, are related directly to the revenues of a period. We recognize expenses that are related directly to revenues in the same period we recognize those revenues. Other expenses are only indirectly related to revenues, and their recognition involves much approximation. We allocate these expenses such as rent and insurance to the periods in which the business benefits from occupancy and insurance coverage.

LO 2 ADJUSTING ENTRIES

The adjustment process requires the accountant to make adjusting entries at the end of an accounting period. Adjusting entries are those necessary to adjust the accounts to their proper balances to conform with GAAP for purposes of preparing appropriate financial statements. The adjustment process involves apportioning multi-period revenues and expenses to the periods in which they are earned and incurred. The need for adjusting entries does not mean that the account balances are in error. All general journal entries to date may be correct, and all transactions may have been posted correctly to T-accounts. We need adjusting entries because some revenues may have been earned but not yet recorded, and some expenses may have been incurred but not yet recorded. Also, some cash receipts may initially be recorded as revenues, but they are not yet earned; and some cash payments may initially be recorded as expenses, but the expenditures may not be expenses of the current period.

The adjusting entries needed at the end of an accounting period are for the following items:

Expiration of Prepaid ExpensesRecognition of Depreciation ExpenseAccrual of Unpaid ExpensesRecognition of Revenues Previously UnearnedAccrual of Revenues Earned

Using PhotoCopy, Inc. from previous chapters, we discuss and illustrate adjusting entries for these items. Illustration 3-1 reproduces the trial balance at the end of February 20X1. The account balances reflect the transactions analyzed and recorded previously, but they do not reflect the adjusting


entries. A trial balance prepared before posting the adjusting entries is an unadjusted trial balance.

Expiration of Prepaid Expenses

Prepaid expenses are those that have been paid but not yet incurred. Examples of prepaid expenses include insurance and rent. When prepaid expenses are for periods beyond one accounting period, we need adjusting entries to apportion the expenses to the periods they are incurred.

Prepaid Insurance. Insurance policies cover a future period of time and usually require that the amount of the premium be paid in advance. The payment of the premium creates an asset—insurance coverage for the period of the policy—and we record the asset in Prepaid Insurance. As time passes, a portion of the asset expires and becomes insurance expense. At the end of an accounting period, we make an adjusting entry to record the expiration of the prepaid insurance. On February 3, 20X1, PhotoCopy paid for an insurance policy that provides coverage from the beginning of February 20X1 to the end of January 20X2. The transaction created an asset that we record in Prepaid Insurance in the amount of $900. On February 28, 20X1, we need an adjusting entry to recognize the expiration of one month’s prepaid insurance. The amount of the expired insurance is $75 ($900 x 1/12). The adjusting entry is:

Feb. 28 Insurance Expense 75Prepaid Insurance 75To record the expiration of prepaid insurance.

Illustration 3-1 Unadjusted Trial Balance

PhotoCopy, Inc.Trial Balance

February 28, 20X1

Debits Credits

Cash $ 3,400

Copying Supplies 2,400

Prepaid Insurance 900

Delivery Equipment 13,000

Office Equipment 1,200

Accounts Payable $ 2,400

Unearned Revenue 600

Notes Payable - Noncurrent 10,000

Capital Stock 6,000

Revenue 11,200

Advertising Expense

100

Copying Supplies Expense 800

Rent Expense 2,000

Wages and Salaries Expense 6,400

Total $30,200 $30,200


Posting the adjusting entry to T-accounts affects the accounts as follows:

Prepaid Insurance Insurance ExpenseFeb. 3 900 Feb 28 75Bal. 825

The entry reduces (credits) the asset account, Prepaid Insurance, by the amount of the insurance expense ($75) - which we debit to Insurance Expense.

Copying Supplies. On February 8, PhotoCopy purchased copying supplies costing $2,400. PhotoCopy recorded the copying supplies as an asset at their cost of $2,400. On February 28, the owners of PhotoCopy counted the remaining copying supplies and determined that supplies originally costing $1,500 were still on hand. This means that PhotoCopy had used $900 ($2,400 – $1,500) of the supplies during the month of February. Using the copying supplies is an expense since an asset was used up in the process of generating revenues. To recognize the expense, PhotoCopy records an adjusting entry at the end of February that debits Copying Supplies Expense for the $900 cost of the supplies used during the month and reduces the asset account, Copying Supplies, by the $900.

Feb. 28 Copying Supplies Expense 900 Copying Supplies 900To record the cost of copying supplies used during February.

As shown in the T-accounts below, this entry leaves a balance in Copying Supplies of $1,500, which is the cost of the supplies that remain on hand at the end of February. The balance in Copying Supplies Expense is the total cost of copying supplies used during January and February.

Copying Supplies Copying Supplies ExpenseFeb 8 2,400 Feb 28 900 Jan 31 800Bal. 1,500 Feb 28 900

Bal. 1,700


Depreciation

We recognize an expense, called depreciation expense, for expiration of portions of the total lifetime usefulness of certain assets such as equipment and buildings. As time passes, a portion of the usefulness of such an asset expires, due to physical wear and such other forces as eventual obsolescence. Generally, it is not possible to observe the diminishing usefulness of assets on a day-to-day basis. However, management knows that a significant amount will expire during the estimated time that the business will use the assets. The matching principle requires that we apportion the cost of the assets to the accounting periods during the assets’ useful lives. Apportioning the cost of an asset involves much estimation. Management must estimate both the useful life of the asset and the pattern of the expiration of the asset’s usefulness during its useful life.

At the end of an accounting period, we make an adjusting entry to record the portion of the asset’s cost that has expired during the period. The entry is a debit to Depreciation Expense. However, the credit is not made directly to the asset account, as you might have expected. Instead, a credit is made to an account called Accumulated Depreciation. Accumulated Depreciation represents the cumulative depreciation of the asset since it was acquired. Accumulated depreciation is a valuation (or contra-asset) account that reduces the asset to its correct balance for presentation in the balance sheet. The balance sheet presentation of these accounts is shown in Illustration 3-2.

Illustration 3-2 Undepreciated Cost of an Asset

Asset Account Original Cost of Asset

Less: Accumulated Depreciation Cumulative Depreciation

Carrying Amount Undepreciated Cost of Asset

We credit Accumulated Depreciation for the amount of current depreciation expense so that the asset’s original purchase cost will be preserved in the asset account. The balance in the asset account retains the cost of the total service potential purchased when the asset was new. The balance of Accumulated Depreciation represents the cost of the estimated service potential used up as of the end of the fiscal period. The net amount, the difference between the asset account balance and Accumulated Depreciation balance, represents the cost of the asset’s estimated remaining service potential. You should note that the net amount is not the current price of similar service potential. Rather, it is the original cost of the asset’s unused service potential. The net amount is the asset’s undepreciated cost and is called the carrying amount, carrying value, or the net book value. We record each category of assets that last multiple periods in separate accounts, and we maintain separate accumulated depreciation accounts for them. This separate identity is maintained because each asset conceivably depreciates over a different number of periods according to a different pattern. We discuss the varying patterns of depreciation in a subsequent chapter.

Office Equipment. PhotoCopy purchased a computer on January 31 at a cost of $1,200. Assume PhotoCopy estimates that the computer can be used for 4 years. The useful life of an asset is the period of time the business estimates it can use the asset in its operations. The expense of using the


computer for 1 year is one-fourth of $1,200, or $300. The expense of using the computer for 1 month is one-twelfth of $300, or $25.

Depreciation Expense—Office Equipment. PhotoCopy, Inc. classifies the computer as office equipment. Note that there is no depreciation expense for January because PhotoCopy purchased the computer on the last day of the month and any usage of the asset would have been insignificant. The depreciation expense for office equipment for February as calculated above is $25. At the end of February, PhotoCopy should record depreciation expense by making the following adjusting entry:

Feb. 28 Depreciation Expense—Office Equipment 25 Accumulated Depreciation—Office Equipment 25 To record February depreciation.

After we post the adjusting entry to the T-accounts, they will appear as follows:

Office EquipmentJan 31 1200

Accumulated Depreciation-- Depreciation Expense-Office Equipment Office Equipment

Feb 28 25 Feb 28 25

We include Depreciation Expense—Office Equipment in the income statement that we prepare at the end of February. Office Equipment and the contra-asset account, Accumulated Depreciation—Office Equipment, are shown in the February 28 balance sheet as follows:

Office Equipment $1,200

Less: Accumulated depreciation 25 $1,175

The balance sheet presentation informs the reader that the cost of the service potential of the computer when purchased is $1,200. This amount gives the users of the financial statements some idea of the computer’s total service capacity. The cost of the service potential used up is $25, and the cost of the remaining service potential is $1,175. The latter figure gives the users of the financial statements some idea of the computer’s remaining capacity to provide service to the business. In subsequent months, the periodic depreciation continues to accumulate in Accumulated Depreciation—Office Equipment at the rate of $25 per month. Therefore, the carrying amount of the asset declines each month by $25.

Delivery Equipment. On February 3, PhotoCopy purchased a van to use in the business at a cost of $13,000. PhotoCopy’s owners estimate that the van can be used in the business for 6 years. At the end of the van’s estimated useful life, the owners estimate it will be worth $4,000 as a trade-in on a new van. We call an asset’s estimated value at the end of its estimated useful life the estimated residual value. In this case, the cost of the van to apportion to the years that the business benefits from its services is $9,000 ($13,000 – $4,000). We call the asset’s original cost less its estimated residual value the depreciable cost. For the van, annual depreciation is $1,500 ($9,000 ÷ 6) and monthly depreciation is $125 ($1,500 ÷ 12). The adjusting entry for February depreciation for the van is:


Feb. 28 Depreciation Expense—Delivery Equipment 125 Accumulated Depreciation—Delivery Equipment 125 To record depreciation for February.

The presentation of Delivery Equipment and Accumulated Depreciation—Delivery Equipment would be similar to the presentation of the computer. The accounts appear as follows after posting:

Delivery EquipmentFeb 3 13,000

Accumulated Depreciation Depreciation Expense—Delivery Equipment Delivery Equipment

Feb 28 125 Feb 28 125

Accrued Expenses

As previously discussed, the transactions processing methods in most accounting systems are designed to record expenses at the time they are paid. At the end of an accounting period, some expenses may have been incurred but not recorded because they have not been paid. Incurred but unpaid expenses are called accrued expenses. Common examples of accrued expenses include wages and salaries, interest, and utilities.

Wages and Salaries Expense. On February 21, PhotoCopy paid its employee $400 for her services through February 21. Assume that for the period February 22 through February 28 the employee earned an additional $200. Since these wages are unpaid, they are unrecorded. To prepare financial statements at the end of February, however, we must record the employee’s wages that have been incurred since she was last paid. We record the earned but unpaid wages with the following adjusting entry:

Feb. 28 Wages and Salaries Expense 200 Wages and Salaries Payable 200 To record earned but unpaid wages.

After we post the adjusting entry to the T-accounts, the accounts appear as follows:

Wages and Salaries Expense Wages and Salaries PayableJan 31 3,000 Feb 28 200Feb 21 400Feb 28 3,000Feb 28 200

The effect of the adjusting entry is to increase Wages and Salaries Expense to $6,600, which is the amount of wages and salaries expense PhotoCopy actually incurred during January and February. Also, we record Wages and Salaries Payable of $200. PhotoCopy is obligated to pay this amount as of the end of February because the employee has worked during February after the date she was last paid.

Interest expense. On February 1, PhotoCopy borrowed $10,000 from the bank to purchase the van. Recall that the interest rate on the loan is 7.2% per year. As of the end of February, PhotoCopy has incurred one month’s interest. Even though the interest is not due to be paid until March 1,


PhotoCopy incurs the interest expense in February. The amount of interest expense for February is $60 ($10,000 x 7.2% x 1/12). We record the interest expense for February with the following adjusting entry:

Feb. 28 Interest Expense 60 Interest Payable 60To record interest expense for February.

After posting the entry to the T-accounts, the accounts appear as follows:

Interest Expense Interest PayableFeb 28 60 Feb 28 60

The adjusting entry records the interest expense for February and the liability (interest payable) to pay the interest to the bank.

Unearned Revenue

When a business receives a cash payment for goods or services before it delivers the goods or performs the services, we record unearned revenue. For example, if you subscribe to a magazine at a cost of $36 per year for 12 monthly issues, you pay the subscription price in advance. The magazine company records your payment as unearned revenue. The revenue is unearned until the magazines are delivered to you. Each month, the company earns one-twelfth of the subscription price when it delivers an issue of the magazine to you. Therefore, each month the company decreases unearned revenue and increases revenues by $3 (1/12 of $36).

PhotoCopy entered into an agreement with the Student Government Association to provide copying services to its members. The Association paid $600 in advance for the copying. We record the receipt of the payment on February 15 as a debit to Cash and a credit to Unearned Revenue. Remember: Unearned Revenue is a liability account because PhotoCopy is obligated to provide the copying services or else refund the advance payment to the customer. As of the end of February, however, PhotoCopy has earned a portion of the revenue because the members of the Association have made copies that used $400 of the advance payment. Therefore, PhotoCopy recognizes the revenue with the following adjusting entry:

Feb. 28 Unearned Revenue 400 Revenue 400To record revenue earned.

The $400 is classified properly as revenue because net assets have increased (due to a decrease in liabilities) from the business’s revenue-producing activities. After we post the adjusting entry to the T-accounts, they appear as follows:

Unearned Revenue RevenueFeb 28 400 Feb 15 600 Jan 31 5,000

Bal. 200 Feb 28 6,200Feb 28 400Bal. 11,600

The adjusting entry decreases Unearned Revenue to reflect the partial satisfaction of the obligation to provide copying services and increases Revenue by the amount that has been earned under the agreement.


Accrued Revenue

A business sometimes earns revenue before receiving payment from the customer. Under the accrual basis of accounting, we record the revenue because it is earned. At the end of the accounting period, we record an adjusting entry for accrued revenue—revenue that the business has earned but not yet received. Also, as part of the adjusting entry, we record an account receivable representing the business’s right to receive payment from the customer for the services performed. Examples of accrued revenues include interest earned, rent earned, and many types of revenues for services.

On February 23, the Chairperson of the Microbiology Department at the University entered into an agreement for PhotoCopy to make numerous copies of research grant applications for faculty and graduate students. It is expected that the copies will be needed over the next two weeks. The Chairperson agreed to make payment for the copies by March 15. As of February 28, PhotoCopy has made copies in the amount of $300. To record the revenue, we make the following adjusting entry:

Feb. 28 Accounts Receivable 300 Revenue 300To record revenue earned.

After the adjusting entry is posted, the T-accounts appear as follows:

Accounts Receivable RevenueJan 31 1,000 Feb 5 1,000 Jan 31 5,000Feb 28 300 Feb 28 6,200Bal. 300 Feb 28 400

Feb 28 300Bal. 11,900

The adjusting entry increases Accounts Receivable and Revenue by the $300 that PhotoCopy has earned in February under the agreement with the Microbiology Department.

Accrued Income Tax Expense

After all the other adjusting entries have been prepared, the final adjusting entry is for income tax expense. This adjusting entry is actually an accrued expense of the type discussed earlier. However, the amount of the entry cannot be determined until the amount of income is known, which depends on the other adjusting entries. PhotoCopy’s owners determine that the amount of income taxes for the first two months of operation are $200. This amount is an expense that we debit to Income Tax Expense and credit to the liability account, Income Taxes Payable, for the same amount.

Feb. 28 Income Tax Expense 200 Income Taxes Payable 200To record income taxes for Jan. and Feb.

After we post the adjusting entry to the T-accounts, they appear as follows:

Income Tax Expense Income Taxes PayableFeb 28 200 Feb 28 200


Summary of Adjustments

One way to think of adjusting entries is: Without them, the business’s accounts would be misstated. A summary of the adjustment process reflecting this view is seen in Illustration 3-3.

Illustration 3-3 Summary of Adjustments

Account BalancesType Accounts Without Adjustment Adjusting Entry

1. Expiration of prepaid Expenses

Expenses and Assets Expenses understatedAssets overstated

Dr. Expenses Cr. Assets

2. Depreciation expense Expenses and Assets Expenses understatedAssets overstated

Dr. Expenses Cr. Accum. Depr.

3. Accrued Expenses Expenses and Liabilities Expenses understatedLiabilities understated

Dr. Expenses Cr. Liabilities

4. Previously unearned Revenue

Liabilities and Revenues Liabilities overstatedRevenues understated

Dr. Liabilities Cr. Revenues

5. Accrued Revenue Assets and Revenues Assets understatedRevenues understated

Dr. Assets Cr. Revenues

THE ADJUSTED TRIAL BALANCE

A trial balance prepared after posting the adjusting entries is an adjusted trial balance. Illustration 3-4 shows the adjusted trial balance for PhotoCopy, Inc. If we have correctly posted the adjusting entries, the debits and credits will be equal in the trial balance. Illustration 3-4 shows they are equal.

LO 3 PREPARING FINANCIAL STATEMENTS FROM THE ADJUSTED TRIAL BALANCE

The account balances in the adjusted trial balance conform with GAAP and, therefore, are appropriate for the preparation of financial statements. We can prepare the income statement as shown in Illustration 3-5, by extracting the revenue and expense accounts from the adjusted trial balance. We prepare the retained earnings statement as shown in Illustration 3-6 using the net income figure from the income statement. Finally, we prepare the balance sheet, as shown in Illustration 3-7, by extracting the balance sheet accounts from the adjusted trial balance and the ending balance for retained earnings from the retained earnings statement.


Illustration 3-4 Adjusted Trial Balance


February 28, 20X1Debits Credits

Cash $3,400

Accounts Receivable 300




Accumulated Depreciation --Delivery Equipment $125


Accumulated Depreciation --Office Equipment 25

Accounts Payable 2,400

Income Tax Payable 200

Interest Payable 60


Wages and Salaries Payable 200

Notes Payable – Noncurrent 10,000

Capital Stock 6,000

Revenue 11,900

Advertising Expense 100

Copying Supplies Expense 1,700

Depreciation Expense-- Delivery Equipment 125

Depreciation Expense-- Office Equipment 25

Income Tax Expense 200

Insurance Expense 75

Interest Expense 60

Rent Expense 2,000


Totals $ 31,110 $ 31,110

LO 4 CLOSING THE TEMPORARY ACCOUNTS

After we have journalized and posted the adjusting entries and have prepared the financial statements, the final step in the accounting cycle is to close the revenue and expense accounts. This section discusses the need for closing entries, describes the closing process, and shows the closing entries for PhotoCopy, Inc.

The Need for Closing Entries

Revenues and expenses could be recorded directly as increases and decreases in stockholders’ equity. In practice, however, the detailed amounts and types of the business’s individual revenues and expenses must be conveniently available to the accountant to facilitate calculating and presenting net income. To satisfy this requirement, we use a separate account for each type of revenue and expense.



Illustration 3-5 Preparation of the Income Statement



Cash $ 3,400





Accumulated Depreciation –Delivery Equipment $ 125


Accumulated Depreciation – Office Equipment 25



Interest Payable 60




Capital Stock 6,000

Revenue 11,900

Advertising Expense 100

Copying Supplies Expense 1,700




insurance Expense 75

Interest Expense 60

Rent Expense 2,000


Totals $ 31,110 $ 31,110


PhotoCopy, IncIncome Statement

For the Two Months Ended February 28, 20X1

Revenue $11,900

Expenses:

Advertising Expense $100

Copying Expense 1,700





Interest Expense 60

Rent Expense 2,000


Total Expenses 10,885

Net Income $1,015

Illustration 3-6 Preparation of the Retained Earnings Statement

PhotoCopy, IncIncome Statement

For the Two Months Ended February 28, 20X1

Revenue $11,900

Expenses:

Advertising Expense $100

Copying Expense 1,700





Interest Expense 60

Rent Expense 2,000


10,885

1,015

PhotoCopy, Inc.Retained Earning Statement

For the Two Months Ended Feb. 28, 20X1

Beginning Balance $0

Add: Net Income 1015

Ending Balance $ 1,015

The revenue and expense accounts are temporary accounts. During an accounting period, we record revenues and expenses in the appropriate accounts, which always begin the period with zero balances. The net income measured in the revenue and expense accounts is for that period only. At the


end of the period, we transfer the temporary account balances to stockholders’ equity to state correctly the business’s financial position as of the end of the period. Retained Earnings is the stockholders’ equity account to which revenues and expenses are transferred. Therefore, at both the beginning and the end of an accounting period, temporary accounts have zero balances. We simply use temporary accounts in the interim to accumulate information in convenient form for the preparation of the financial statements. We call the process of transferring temporary account balances to stockholders’ equity closing temporary accounts, or simply closing the accounts.


Illustration 3-7 Preparation of the Balance SheetPhotoCopy, Inc.Trial Balance


Cash $3,400Accounts Receivable 300Copying Supplies 1,500Prepaid Insurance 825Delivery Equipment 13,000Accumulated Depreciation –Delivery Equipment $125Office Equipment 1,200Accumulated Depreciation – Office Equipment 25Accounts Payable 2,400Income Tax Payable 200Interest Payable 60Unearned Revenue 200Wages and Salaries Payable 200Notes Payable – Noncurrent 10,000Capital Stock 6,000Revenue 11,900Advertising Expense 100Copying Supplies Expense 1,700Depreciation Expense-- Delivery Equipment 125Depreciation Expense-- Office Equipment 25Income Tax Expense 200Insurance Expense 75Interest Expense 60Rent Expense 2,000Wages and Salaries Expense 6,600

Totals $ 31,110 $ 31,110


PhotoCopy, Inc.Balance Sheet

February 28, 20X1

AssetsCash 3400





Accumulated Depreciation -125 12,875


Accumulated Depreciation -25 1,175

Total Assets $ 20,075

Liabilities and Stockholders' EquityLiabilities

Accounts Payable $ 2,400

Income Taxes Payable 200

Interest Payable 60



notes Payable – noncurrent 10,000

Total Liabilities $ 13,060Stockholders' equity

Capital Stock 6,000

Retained earnings 1,015

Total stockholders' equity 7,015

Total Liabilities and Stockholders' equity 20,075

The Closing Process

The closing process for a corporation involves transferring net income and dividends to the retained earnings account. The revenue and expense accounts contain the information about net income. We could close (transfer) the revenue and expense accounts directly to Retained Earnings, but this would result in too much detailed information in Retained Earnings. For this reason, we close the revenue and expense accounts first to an account called Income Summary. After we close the revenue and expense account balances to Income Summary, the balance of Income Summary is equal to the net income or net loss for the period.

The closing process for a corporation is shown in Illustration 3-8. The process consists of four entries that we journalize in the general journal and post to the T-accounts. The four entries are:

1. Close the revenue accounts by debiting each revenue account with the amount of its credit balance and crediting Income Summary with an amount equal to the sum of the debits. After posting this entry, the revenue accounts have zero balances.

2. Close the expense accounts by crediting each expense account with the amount of its debit balance and debiting Income Summary with an amount equal to the sum of the credits. After posting this entry, the expense accounts have zero balances. After the first two entries, the balance of Income Summary is equal to the net income (credit balance) or net loss (debit balance) for the period.


From the Statement of Retained Earnings—see Illustration 3-6

3. Close Income Summary to Retained Earnings. For net income (assumed in Illustration 3-8), the entry is a debit to Income Summary in an amount equal to its credit balance and a credit to Retained Earnings for the same amount. For a net loss, the entry is a credit to Income Summary and a debit to Retained Earnings in the amount of the debit balance in Income Summary. After this closing entry, Income Summary has a zero balance and the net income (loss) has been added to (subtracted from) Retained Earnings.

4. Close Dividends to Retained Earnings. This closing entry is illustrated here even though PhotoCopy has not declared dividends. The entry is a credit to Dividends and a debit to Retained Earnings in an amount equal to the debit balance in Dividends. After this entry, Dividends has a zero balance.

Illustration 3-8 Closing Process

Dividends Expenses RevenuesBal. Closing Bal. Closing Closing Bal.

Entry Entry Entry

Income SummaryExpenses RevenuesClosing Bal.Entry

Retained Earnings

Bal.- Dividends + Net Income

Bal.

Closing Entries for PhotoCopy, Inc.

You may find the information necessary to prepare closing entries in the T-accounts or in the adjusted trial balance. We base the closing entries for PhotoCopy, Inc. on the information in the adjusted trial balance in Illustration 3-4.

Closing the Revenue Account. PhotoCopy only has one revenue account and the closing entry is:

Feb. 28 Revenue 11,900 Income Summary 11,900To close revenue account to Income Summary

The effect of the closing entry for revenue is shown below:


3

1

2

4

Income Summary Revenue11,900 11,900 Bal. 11,900

Closing the Expense Accounts. The Closing entry for PhotoCopy’s expense account is:

Feb. 28 Income Summary 10,885 Advertising Expense 100 Copying Supplies Expense 1,700 Depreciation Expense–Delivery Equipment 125 Depreciation Expense–Office Equipment 25 Income Tax Expense 200 Insurance Expense 75 Interest Expense 60 Rent Expense 2,000 Wages and Salaries Expense 6,600To close expense accounts to Income Summary.

The effects of the closing entry for expenses may be illustrated as follows:

Advertising ExpenseBal. 100 100

Copying Supplies ExpenseBal. 1,700 1,700

Depr. Expense- Delivery EqtBal. 125 125

Depr. Expense- Office Eqt.Bal. 25 25

Income Tax Expense Income SummaryBal. 200 200 10,855 11,900

Bal. 1,015Insurance Expense

Bal. 75 75

Interest ExpenseBal. 60 60

Rent ExpenseBal. 2,200 2,000

Wages and Salary ExpenseBal. 6,600 6,600

Closing the Income Summary Account. After the first two closing entries above, the balance of $1,015 in Income Summary is equal to the net income for the period. The closing entry for Income Summary is:

Feb. 28 Income Summary 1,015 Retained Earnings 1,015To close Income Summary.


1

2

The effect of closing Income Summary may be illustrated as follows:

Retained Earnings Income Summary1,015 10,885 11,900

1,015Bal. 0

LO 5 The Post-Closing Trial Balance

A post-closing trial balance is a trial balance prepared after we have posted the closing entries to the T-accounts. A post-closing trial balance for PhotoCopy, Inc. is presented in Illustration 3-9. Since revenue and expense accounts have zero balances after closing, the post-closing trial balance lists only the balance sheet accounts––asset, liability, and stockholders’ equity. The purpose of the post-closing trial balance is to serve as a check that no errors occurred in preparing and posting the closing entries.

Illustration 3-9 Post-Closing Trial Balance



Cash $3,400





Accumulated Depreciation –Delivery Equipment $125


Accumulated Depreciation – Office Equipment 25



Interest Payable 60




Capital Stock 6,000

Revenue 1,015

Totals $ 20,225 $ 20,225


3

LO 6 THE ACCOUNTING CYCLE

You have seen the six steps in the accounting cycle. These steps are summarized in Illustration 3-10. Not all of the steps are performed at equal time intervals. On a daily basis, we perform the first three steps. That is, we analyze transactions, enter them in the general journal, and post them to the T-accounts. We adjust the accounts whenever the business prepares financial statements. Most businesses prepare statements for interim periods such as monthly or quarterly; and we adjust the accounts to prepare the financial statements for those time intervals. We generally close the temporary accounts annually, so that the accumulation of revenue and expense information is for the annual accounting period. In this chapter, we closed the temporary accounts at the end of the second month of operations for discussion purposes only.

LO 7 PROFITABILITY OF PHOTOCOPY, INC.

Now that the owners of PhotoCopy, Inc. have prepared financial statements, just how profitable was the business during January and February? The income statement for the two months shows net income of $1,015. But how does this amount compare to the profitability of other service businesses? One measure of profitability is the profit margin. Profit margin is the amount of net income as a percent of revenues, or:

Profit Margin = Net Income ÷ Revenues

The profit margin is an indication of the business’s ability to generate revenues that are profitable. For the two-month period, PhotoCopy’s profit margin is 8.5% ($1,015 ÷ $11,900). How does an 8.5% profit margin compare to those of other service businesses?

Generally it pays to compare financial statistics across companies in similar lines of business. For example, from 1992 to 1998, TRM Corporation, the largest self-serve copy company in the U.S., specializing in self-serve copy machines in retail stores, had an average profit margin of 5.6%. Mail Boxes Etc., the world's largest franchiser of postal/shipping, business, and communications services, on the other hand, averaged 13.7% for the period


(1)Analyze

Transactions

(2)JournalizeTransactio

ns

(3)Post to

T-accounts

(6)Close theAccounts

(5)Prepare

Statements

(4)Adjust

Accounts

1996 to 1998. While these businesses are obviously many times larger than PhotoCopy in scale, they do provide some industry benchmarks. Compared to other service businesses, PhotoCopy appears to be reasonably profitable.

However, since no two businesses are alike, it is also useful to compare a company’s performance to it’s own performance in previous periods (not possible in this case). And is important to ask questions about what will be different in the future. For example, is January—February a typical period? Will the same level of business continue throughout the year? Also, other investors may open copying centers in the area and take away some of PhotoCopy’s business.

SUMMARY

Explain the concepts, assumptions, and principles underlying the accrual basis of accounting. The accrual basis of accounting relies on the principles of revenue realization and expense recognition. Costs that are associated directly with revenues are recognized as expenses in the period that the related revenues are recognized. Costs that are not directly associated with revenues are recognized as expenses in the period that the business benefits from the costs. The accountant relies on the going-concern assumption as well as on assumptions about the useful lives of specific assets in apportioning the effects of multi-period transactions.

Prepare adjusting entries at the end of the accounting period. Accountants use adjusting entries to prepare financial statements. Adjusting entries apportion the effects of multi-period transactions to the proper periods. Adjusting entries are entered in the general journal and posted to T- accounts.

Prepare financial statements using an adjusted trial balance. An adjusted trial balance reflects the debit and credit effects of the adjusting entries; and the resulting adjusted account balances are appropriate for preparing the financial statements. Financial statements may be prepared directly from the adjusted trial balance. The income statement is prepared by using the adjusted revenue and expense accounts. The retained earnings statement is prepared by using the net income from the income statement. The balance sheet uses adjusted asset, liability, and capital stock accounts from the adjusted trial balance and retained earnings from the retained earnings statement.

Explain the closing process and prepare closing entries. The final step in the accounting cycle is to close the temporary accounts to Retained Earnings. The temporary accounts are the income statement accounts––revenue and expense accounts––and the dividends account. The temporary accounts begin each annual accounting period with zero balances and are used to accumulate information about net income and dividends for the year. At the end of the year, the temporary accounts are returned to zero balances by transferring (closing) their balances to Retained Earnings. After closing, the temporary accounts are ready to accumulate the applicable information for the next year.

Prepare a post-closing trial balance. An optional procedure after closing is to check the equality of the permanent (balance sheet) accounts by preparing a post-closing trial balance.


Describe the timing of the various steps in the accounting cycle. We perform the steps in the accounting cycle at varying time intervals. We daily analyze transactions, enter them in the general journal, and post them to the T-accounts. We adjust the accounts whenever the business prepares financial statements. We close the accounts annually so that the accumulation of net income information is for the annual accounting period.Calculate and interpret a business’s profit margin. A business’s profit margin is the ratio of net income to revenues. The profit margin is an indication of the business’s ability to generate revenues that are profitable.

REVIEW PROBLEM: ADJUSTING ENTRIES, TRIAL BALANCE, FINANCIAL STATEMENTS, CLOSING ENTRIES, AND PROFIT MARGINS

Jack Ford organized Wildwater Expeditions, Inc. several years ago to provide raft trips down the Big South Fork of the Cumberland River. Wildwater has an annual accounting period based on the calendar year. Jack Ford provides the unadjusted trial balance and additional information shown below.

Wildwater Expeditions, Inc.Trial Balance

December 31, 20X3Debits Credits

Cash $ 6,500

Accounts Receivable 4,500

Prepaid Insurance 2,400

Office Supplies 500

Equipment 50,000

Accumulated Depreciation –Equipment $ 20,000


Unearned Fees 80,000

Capital Stock 10,000

Retained Earnings 4,400

Dividends 25,000

Fee Revenue 32,000

Miscellaneous Expense 4,000

Rent Expense 15,000

Utilities 1,500


Totals $ 149,400 $ 149,400

Additional Information:1. The balance in Prepaid Insurance is the result of a comprehensive river liability

policy that was purchased on April 1, 20X3. The policy cost $2,400 and covers the period of April 1, 20X3, through March 31, 20X4.

2. The equipment, purchased on January 1, 20X1, consists of 25 River Supply Scout Rafts at a cost of $2,000 each. These rafts have an estimated useful life of 5 years and are estimated to be worthless at the end of the 5-year period.

3. Wildwater records walk-in trip ticket sales (which result from customers purchasing trip tickets on the days of the trip) by crediting Fee Revenue. Most of its business, however, consists of trips booked and paid for in advance. Advance bookings are recorded with a credit to Unearned Fees. Unearned Fees is adjusted


at the end of theaccounting year based on the amount of advance booking customers that have completed the raft trip. On December 31, $65,000 of the $80,000 advance booking revenue is earned.

4. Wildwater rents paddles, helmets, and wetsuits from Whitewater Sales and Service. The bill for December rentals is $1,500 and is due January 31, 20X4.

5. Office supplies on hand on December 31 total $200.

REQUIRED:

a.Prepare and post the necessary adjusting entries.b.Prepare an adjusted trial balance.c.Prepare an income statement, a retained earnings statement, and a balance sheet

for Wildwater as of December 31, 20X3.d.Prepare and post closing entries.e.Prepare a post-closing trial balance.f.Calculate the profit margin for the 20X3 operations and comment on what it tells us

about Wildwater’s operations.

SOLUTION:

Planning and Organizing Your Work1. Analyze the information in the problem to determine which accounts require adjustment.2. Journalize the adjusting entries.3. Post the adjusting entries to the T-accounts.4. Prepare an adjusted trial balance. Make sure the debits equal the credits.5. Prepare the financial statements.6. Journalize the closing entries.7. Post the closing entries to the T-accounts.8. Prepare a post-closing trial balance. Make sure the debits equal the credits.9. Use the appropriate figures to determine the profit margin from 20X3 operations.

(a) Prepare and post adjusting entries.Dec. 31 Insurance Expense 1,800

Prepaid Insurance 1,800To record expired insurance.($2,400 x 9/12 = $1,800)

31 Depreciation Expense—Equipment 10,000 Accumulated Depreciation–Equipment 10,000To record 20X3 depreciation.((25 x $2,000)/5 = $10,000)

31 Unearned Fees 65,000 Fee Revenue 65,000To record advance booking revenuesthat have been earned.

31 Rent Expense 1,500 Accounts Payable 1,500To accrue rental expense.

31 Office Supplies Expense 300 Office Supplies 300To record office supplies used.

Note: Two approaches are possible from working from an unadjusted trial balance to an adjusted trial balance: (1) Use T-accounts and place the balance from the trial balance in the accounts and then post the adjusting entries to the accounts and prepare an adjusted trial balance from the resulting account balances. (2) Use an “eyeball” approach, increasing and decreasing the account balances in the trial balance as required by the adjustments and adding account balances as required. The T-account approach is illustrated.


TB = Trial balance; Bal. = Balance; ( ) = Adjustment; keyed to “Additional Information”

Cash Accounts PayableTB 6,500 TB 4,500Bal. 6,500 Bal. 4,500

Prepaid Insurance Office SuppliesTB 2,400 (1) 1,800 TB 500 (5) 300Bal. 600 Bal. 200

Equipment Accumulated Depreciation- EquipmentTB 50,000 TB 20,000Bal. 50,000 (2) 10,000

Bal. 30,000

Accounts Payable Unearned FeesTB 3,000 (3) 65,000 TB 80,000(4) 1,500 Bal. 15,000Bal. 4,500


Capital Stock Retained Earnings TB 10,000 TB 4,400Bal. 10,000 Bal. 4,400

Dividends Fee RevenueTB 25,000 TB 32,000Bal. 25,000 (3) 65,000

Bal. 97,000

Depreciation Expense- Eqt. Insurance Expense(2) 10,000 (1) 1,800Bal. 10,000 Bal. 1,800

Miscellaneous Expense Rent ExpenseTB 4,000 TB 15,000Bal. 4,000 (4) 1,500

Bal. 16,500

Office Supplies Expense Wages and Salaries Expense(5) 300 TB 40,000Bal. 300 Bal. 40,000

UtilitiesTB 1,500Bal. 1,500

b) Prepare an adjusted trial balance.


December 31, 20X3

Debits Credits

Cash $ 6,500



Office Supplies 200

Equipment 50,000






Dividends 25,000

Fee Revenue 97,000

Depreciation Expense- Equipment 10,000

Insurance Expense 1,800

Miscellaneous Expense 4,000

Office Supplies Expense 300

Rent Expense 16,500

Utilities Expense 1,500


Totals $ 160,900 $ 160,900


(c) Prepare Financial Statements

Wildwater Expedition, Inc.Income StatementFor the Year Ended

Fee Revenue $ 97,000Expenses:

Depreciation-Equipment $10,000Insurance 1,800Miscellaneous 4,000Rent 16,500Office supplies 300Utilities 1,500Wages and Salaries 40,000

Total Expenses 74,100Net Income $ 22,900

Wildwater Expedition, Inc.Retained Earnings Statement

For the Year Ended December 31, 20X3Beginning balance, 1-1-X3 $ 4,400Add: Net Income 22,900Less: Dividends (25,000)Ending Balance, 12-31-X3 $ 2,300

Wildwater Expeditions, Inc.Balance Sheet

December 31, 20X3Assets

Cash $ 6,500Accounts Receivable 4,500Prepaid Insurance 600Office Supplies 200Equipment $ 50,000Accumulated depreciation - equipment (30,000) 20,000

Total Assets $ 31,800

Liabilities and Stockholders’ EquityLiabilities:

Accounts Payable $ 4,500Unearned Fees 15,000

Total Liabilities $ 19,500Stockholders’ Equity

Capital Stock $ 10,000Retained Earnings 2,300 Total stockholder’s Equity 12,300

Total liabilities and stockholders’ equity $31,800

(d) Prepare and post the closing entries.

Dec. 31 Fee Revenue 97,000 Income Summary 97,000To record the closing of the revenue accounts.


31 Income Summary 74,100 Depreciation Expense—Equipment 10,000 Insurance Expense 1,800 Miscellaneous Expense 4,000 Rent Expense 16,500 Office Supplies Expense 300 Utilities Expense 1,500 Wages and Salaries Expense 40,000To record the closing of the expense accounts.

31 Income Summary 22,900 Retained Earnings 22,900To record the closing of Income Summary.

31 Retained Earnings 25,000 Dividends 25,000To record the closing of Dividends.

Cash Accounts PayableTB 6,500 TB 4,500Bal. 6,500 Bal. 4,500

Prepaid Insurance Office SuppliesTB 2,400 (1) 1,800 TB 500 (5) 300Bal. 600 Bal. 200

Equipment Accumulated Depreciation- EquipmentTB 50,000 TB 20,000Bal. 50,000 (2) 10,000

Bal. 30,000

Accounts Payable Unearned FeesTB 3,000 (3) 65,000 TB 80,000(4) 1,500 Bal. 15,000Bal. 4,500

Capital Stock Retained Earnings TB 10,000 TB 4,400Bal. 10,000 (C) 25,000 (C) 22,900

Bal. 2,300

Dividends Income SummaryTB 25,000 (C) 25,000 (C) 97,000Bal. 0 (C) 74,100

(C) 22,900Bal. 0

Depreciation Expense- Eqt. Insurance Expense(2) 10,000 (C) 10,000 (1) 1,800 (C) 1,800Bal. 0 Bal. 0

Miscellaneous Expense Rent ExpenseTB 4,000 (C) 4,000 TB 15,000Bal. 0 (4) 1,500 (C) 16,500

Bal. 0

Office Supplies Expense Wages and Salaries Expense(5) 300 (C) 300 TB 40,000 (C) 40,000Bal. 0 Bal. 0

Utilities Fee RevenueTB 1,500 (C) 1,500 TB 32,000Bal. 0 (C) 97,000 (3) 65,000

Bal. 0


(e) Prepare a post-closing trial balance.


December 31, 20X3Debits Credits

Cash $ 6,500



Office Supplies 200

Equipment 50,000






Totals $ 160,900 $ 160,900

(f) Calculate profit margin.

Profit Margin = Net Income ÷ RevenuesProfit Margin = $22,900 ÷ $97,000Profit Margin = 23.61%

Comments: The profit margin indicates that nearly 24 cents of each dollar of revenue is profit. Conversely, we can conclude that 76 cents ($1 – 24 cents) of each dollar of revenue go to cover the expenses of the business. This seems to indicate good profit potential for Wildwater. Better information about the business’s operating performance could be obtained by: (1) comparing the margin with past years to identify any trends that may appear and (2) obtaining industry profit margin data from a source such as Robert Morris Associates to learn how Wildwater compares with other businesses providing guided outdoor activities.

KEY TERMS

accounting periodaccrued expensesaccrued revenueAccumulated Depreciationadjusted trial balanceadjusting entriescarrying amountcarrying value

closing temporary accounts (closing the accounts)depreciable costdepreciation expenseestimated residual valuefiscal yeargoing-concern assumptionIncome Summaryinterim financial reports

net book valuepost-closing trial balanceprofit margintemporary accountsunadjusted trial balanceunearned revenueuseful life of an assetvaluation (contra-asset account)
