© the mcgraw-hill companies, inc., 2006 mcgraw-hill/irwin1 adjusting accounts and preparing...
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© The McGraw-Hill Companies, Inc., 2006McGraw-Hill/Irwin1
Adjusting Accounts and Preparing Financial Statements
Chapter
33
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Learning objectiveLearning objective Explain the importance of periodic reporting and the
time period principle. Explain accrual accounting and how it makes financial
statements more useful. Identify the types of adjustments and their purpose. Explain how accounting adjustments link to financial
statements. Explain and prepare an adjusted trial balance. Prepare financial statements from an adjusted trial
balance. Use adjusted trial balance to prepare the company’s
financial statements.
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Learning objectiveLearning objective
Explain the importance of periodic reporting and the time period principle.
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1 2 3 4 5 6 7 8 9 10 11 12
1 2 3 4
Annual
1 2
Monthly
Quarterly
Semiannual
The Accounting PeriodThe Accounting Period
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
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The Time Period PrincipleThe Time Period Principle
The time period principle assumes that an organization’s activities can be divided into specific time periods such as a month, a quarter, a six-month interval, or a year.
Fiscal year versus calendar year (Jan. 1 ~ Dec. 31).
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Learning objectiveLearning objective
Explain accrual accounting and how it makes financial statements more useful.
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Accounting
Accrual Basis vs. Cash BasisAccrual Basis vs. Cash Basis
Accrual Basis
Revenues are recognized when
earned and expenses are recognized when
incurred.
Cash Basis
Revenues are recognized when
cash is received and expenses recorded when cash is paid.
Not GAAPNot GAAPNot GAAPNot GAAP
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Accrual Basis vs. Cash BasisAccrual Basis vs. Cash Basis
On the cash basis the entire $2,400 would be recognized as insurance expense in 2004. No insurance expense from this policy would be recognized in 2005 or
2006, periods covered by the policy.
On the cash basis the entire $2,400 would be recognized as insurance expense in 2004. No insurance expense from this policy would be recognized in 2005 or
2006, periods covered by the policy.
Jan Feb Mar Apr
-$ -$ -$ -$ May Jun Jul Aug
-$ -$ -$ -$ Sep Oct Nov Dec
-$ -$ -$ 2,400$
Insurance Expense 2004
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Accrual Basis vs. Cash BasisAccrual Basis vs. Cash BasisJan Feb Mar Apr
-$ -$ -$ -$ May Jun Jul Aug
-$ -$ -$ -$ Sep Oct Nov Dec
-$ -$ -$ 100$
Jan Feb Mar Apr
100$ 100$ 100$ 100$ May Jun Jul Aug
100$ 100$ 100$ 100$ Sep Oct Nov Dec
100$ 100$ 100$ 100$
Jan Feb Mar Apr
100$ 100$ 100$ 100$ May Jun Jul Aug
100$ 100$ 100$ 100$ Sep Oct Nov Dec
100$ 100$ 100$ -$
Insurance Expense 2004
Insurance Expense 2005
Insurance Expense 2006
On the accrual basis $100 of insurance
expense is recognized in 2004, $1,200 in 2005,
and $1,100 in 2006. The expense is matched with the periods benefited by the insurance coverage.
On the accrual basis $100 of insurance
expense is recognized in 2004, $1,200 in 2005,
and $1,100 in 2006. The expense is matched with the periods benefited by the insurance coverage.
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We have delivered theproduct to our customer,
so I think we should recordthe revenue earned.
We have delivered theproduct to our customer,
so I think we should recordthe revenue earned.
Recognizing Revenues and ExpensesRecognizing Revenues and Expenses
Revenue Recognition
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Recognizing Revenues and ExpensesRecognizing Revenues and Expenses
Revenue Recognition Matching
Summaryof Expenses
Rent
Gasoline
Advertising
Salaries
Utilities
and . . . .
$1,000
500
2,000
3,000
450
. . . .
Now that we haverecognized the revenue,let’s see what expenses
we incurred togenerate that revenue.
Now that we haverecognized the revenue,let’s see what expenses
we incurred togenerate that revenue.
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Recognizing Revenues and ExpensesRecognizing Revenues and Expenses
Revenue recognition principle requires that revenue be recorded when earned, not before or after.
Matching principle intends to record expenses in the same accounting period as the revenues that are earned as a result of these expenses.
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Revenues and ExpensesRevenues and Expenses
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Revenues and ExpensesRevenues and Expenses
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Revenues and ExpensesRevenues and Expenses
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Revenues and ExpensesRevenues and Expenses
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Recognizing Revenues and ExpensesRecognizing Revenues and Expenses
Can revenue and expense recognition be used to manipulate earnings?
Accelerate revenue recognition Postpone expense recognition
Postpone revenue recognition Accelerate expense recognition
Are they all?
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Recognizing Revenues and ExpensesRecognizing Revenues and Expenses
What are the usual intentions to manipulate earnings?
Executive compensationMeet certain targets Changes of CEOPolitical motivationsTaxation reasons Initial Public Offering
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Learning objectiveLearning objective
Identify the types of adjustments and their purpose.
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AdjustmentsAdjustments
An adjusting entry is recorded to bring an asset or liability account balance to its proper amount.
Adjusting AccountsAdjusting Accounts
Paid (or received) cash before expense (or revenue) recognizedPaid (or received) cash before
expense (or revenue) recognizedPaid (or received) cash after
expense (or revenue) recognizedPaid (or received) cash after
expense (or revenue) recognized
Prepaid (Deferred) expenses*
Prepaid (Deferred) expenses*
Unearned (Deferred) revenues
Unearned (Deferred) revenues
AccruedexpenseAccruedexpense
AccruedrevenuesAccruedrevenues
Framework for Adjustments
*including depreciation
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Adjusting Accounts – Prepaid expensesAdjusting Accounts – Prepaid expenses
Paid Cash Actually used
Accounting Period 1
Accounting Period 2
Accounting Period 3
Accounting Period 4
When should expenses be recognized?
Cash basis: At the beginning of period 1 recognize all cash payment as expense.
Dr. Rent Expense 4 million
Cr. Cash 4 million
No entry at later periods.
E.g. Paid 4 years rental fee $ 4 million
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Paid Cash Actually used
Accounting Period 1
Accounting Period 2
Accounting Period 3
Accounting Period 4
Accrual basis: At the beginning of period 1 recognize all cash payment as prepaid expense (asset account):
Dr. Prepaid Rent Expense 4 million
Cr. Cash 4 million
At the end of each accounting period recognize the portion that is used
Dr. Rent Expense 1 million
Cr. Prepaid Rent Expense 1 million
Adjusting Accounts – Prepaid expensesAdjusting Accounts – Prepaid expensesE.g. Paid 4 years
rental fee $ 4 million
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Adjusting Accounts – Unearned revenueAdjusting Accounts – Unearned revenue
Received Cash Revenue Earned
Accounting Period 1
Accounting Period 2
Accounting Period 3
Accounting Period 4
When should revenues be recognized?
E.g. Long-term contract: Received $40m in
advance to build a ship
Cash basis: At the beginning of period 1 recognize all cash receipt as revenue.
Dr. Cash 40 million
Cr. Revenue 40 million
No entry at later periods.
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Received Cash Revenue Earned
Accounting Period 1
Accounting Period 2
Accounting Period 3
Accounting Period 4
Accrual basis: At the beginning of period 1 recognize all cash receipt as unearned revenue (liability account).
Dr. Cash 40 million
Cr. Unearned revenue 40 million
At the end of each accounting period recognize the portion that is earned:
Dr. Unearned revenue 10 million
Cr. Revenue 10 million
Adjusting Accounts – Unearned revenueAdjusting Accounts – Unearned revenueE.g. Long-term contract:
Received $40m in
advance to build a ship
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Adjusting Accounts – Accrued expensesAdjusting Accounts – Accrued expenses
Paid CashActually used
Accounting Period 1
Accounting Period 2
Accounting Period 3
Accounting Period 4
When should expenses be recognized?
Cash basis: When borrowing money:
Dr. Cash 40 million
Cr. Bank loan 40 million
At the end of period 4:
Dr. Interest Expense 16 million
Dr. Bank loan 40 million
Cr. Cash 56 million
E.g. Borrow 40 million from bank.
Annual interest rate
is 10%. Interest and principal are paid at the end of 4th
year.
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Adjusting Accounts – Accrued expensesAdjusting Accounts – Accrued expenses
Paid CashActually used
Accounting Period 1
Accounting Period 2
Accounting Period 3
Accounting Period 4
Accrual basis: At the end of each period (1 to 4) recognize the portion that is due but not paid:
Dr. Interest Expense 4 million
Cr. interest payable 4 million
At the end of the period 4:
Dr. Interest payable 16 million
Dr. Bank loan 40 million
Cr. Cash 56 million
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Adjusting Accounts – Accrued revenuesAdjusting Accounts – Accrued revenues
Received Cash
Accounting Period 1
Accounting Period 2
Accounting Period 3
Accounting Period 4
When should revenues be recognized?
Revenue Earned
Cash basis: No entry from accounting period 1 to 3
At the end of period 4:
Dr. Cash 40 million
Cr. Revenue 40 million
Long-term
Contract: Received $40 million after building one
ship
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Adjusting Accounts – Accrued revenuesAdjusting Accounts – Accrued revenues
Received Cash
Accounting Period 1
Accounting Period 2
Accounting Period 3
Accounting Period 4
Revenue Earned
Accrual basis: At the end of each accounting period (1 to 4) recognize the portion of revenue that is earned but not received:
Dr. Accounts Receivable 10 million
Cr. Revenue 10 million
At the end of period 4:
Dr. Cash 40 million
Cr. Accounts receivable 40 million
Long-term
Contract
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Here is the checkfor my first
6 months’ rent.
Here is the checkfor my first
6 months’ rent.
Adjusting Prepaid (Deferred) ExpensesAdjusting Prepaid (Deferred) Expenses
Resources paid for prior to
receiving the actual benefits.
Resources paid for prior to
receiving the actual benefits.
Asset Expense
UnadjustedBalance
CreditAdjustment
DebitAdjustment
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Prepaid InsurancePrepaid Insurance
On December 1, 2004, Scott Company paid $12,000 to cover rent for December 2004 through May 2005.
Scott recorded the expenditure as Prepaid Insurance on December 1. What adjustment is required at
Dec.31, 2004?
On December 1, 2004, Scott Company paid $12,000 to cover rent for December 2004 through May 2005.
Scott recorded the expenditure as Prepaid Insurance on December 1. What adjustment is required at
Dec.31, 2004?
Dec. 31 Insurance Expense 2,000 Prepaid Insurance 2,000
To record first month's expired insurance
Dec. 1 12,000 Dec. 31 2,000Bal. 10,000
Prepaid Insurance 637
Dec. 31 2,000Insurance Expense 128
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SuppliesSupplies
During 2004, Scott Company purchase $15,500 of supplies. Scott recorded the expenditures as Supplies.
At December 31, a count of the supplies indicated $2,655 on hand. What adjustment is required?
During 2004, Scott Company purchase $15,500 of supplies. Scott recorded the expenditures as Supplies.
At December 31, a count of the supplies indicated $2,655 on hand. What adjustment is required?
Dec. 31 Supplies Expense 12,845 Supplies 12,845
To record supplies used during 2004
Bought 15,500 Dec. 31 12,845Bal. 2,655
Supplies 126Dec. 31 12,845
Supplies Expense 652
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Straight-LineDepreciationExpense
= Asset Cost - Salvage Value
Useful Life
Adjusting for DepreciationAdjusting for Depreciation
Depreciation is the process of computing expense from allocating the cost of plant and equipment over their
expected useful lives.
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Adjusting for DepreciationAdjusting for Depreciation
On January 1, 2004, Barton, Inc. purchased equipment for $62,000 cash. The equipment has an estimated useful life of 5 years and Barton expects to sell the
equipment at the end of its life for $2,000 cash.
Let’s record depreciation expense for the year ended December 31, 2004.
2004Depreciation
Expense= $62,000 - $2,000
5= $12,000
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Adjusting for DepreciationAdjusting for Depreciation
On January 1, 2004, Barton, Inc. purchased equipment for $62,000 cash. The equipment has an estimated useful life of 5 years and Barton expects to sell the
equipment at the end of its life for $2,000 cash.
Let’s record depreciation expense for the year ended December 31, 2004.
Dec. 31 Depreciation Expense 12,000 Accumulated Depreciation - Equipment 12,000
To record equipment depreciation
Accumulated depreciation isa contra asset account.
Accumulated depreciation isa contra asset account.
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contra accountcontra account
A contra account is an account linked with another account, it has an opposite normal balance, and it is reported as a subtraction from that other account’s balance.
A contra account allow information users to know both the full costs of assets and the total amount of depreciation.
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Equipment Depreciation Expense
1/1 62,000 12/31 12,000
Accumulated Depreciation12/31 12,000
Adjusting for DepreciationAdjusting for DepreciationDec. 31 Depreciation Expense 12,000
Accumulated Depreciation - Equipment 12,000 To record equipment depreciation
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Adjusting for DepreciationAdjusting for Depreciation
Equipment is shown net of accumulated depreciation.
$
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Adjusting for DepreciationAdjusting for Depreciation
A company spent 42 million to buy a machine, which can produce 50 million units of LCD monitor. The useful life is estimated to be 2 years and the salvage value is estimated to be 2 million. The depreciation for each year is 20 million.
When the company bought the machine: Dr. Machinery 42 million Cr. Cash 42 million
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Adjusting for DepreciationAdjusting for Depreciation
At the end of first year:
Dr. Depreciation expense 20 m
Cr. Machinery 20 m
Dr. Depreciation expense 20 m
Cr. Accumulated depreciation-machinery 20 m
Correct
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Adjusting for DepreciationAdjusting for Depreciation
With the contra account, balance sheet indicates: …… Machinery 42 million Less accumulated depreciation (20 million) 22 million
If not: …… Machinery 22 million Such information would be misleading, since it could not indicate
the correct production capacity of the company.
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Buy your season tickets forall home basketball games NOW!
““Go Big Blue”Go Big Blue”
Adjusting Unearned (Deferred) RevenuesAdjusting Unearned (Deferred) Revenues
Cash received in advance of providing
products or services.
Cash received in advance of providing
products or services.
Liability RevenueUnadjusted
BalanceCredit
AdjustmentDebit
Adjustment
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Adjusting Unearned (Deferred) RevenuesAdjusting Unearned (Deferred) Revenues
On October 1, 2004, Ox University sold 1,000 season tickets to its 20 home basketball games for $100 each. Ox University makes the following entry:
Oct. 1 Cash 100,000 Unearned Revenue 100,000
Basketball revenue received in advance
Oct. 1 100,000Unearned Revenue
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Adjusting Unearned (Deferred) RevenuesAdjusting Unearned (Deferred) Revenues
On December 31, Ox University has played 10 of its regular home games, winning 2 and losing 8.
Dec. 31 Unearned Revenue 50,000 Basketball Revenue 50,000
To recognized 10-game basketball revenue
Dec. 31 50,000 Oct. 1 100,000Bal. 50,000
Unearned RevenueDec. 31 50,000
Basketball Revenue
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We’re about one-halfdone with this job and
want to be paid forour work!
We’re about one-halfdone with this job and
want to be paid forour work!
Costs incurred in a period that are
both unpaid and unrecorded.
Costs incurred in a period that are
both unpaid and unrecorded.
Adjusting for Accrued ExpensesAdjusting for Accrued Expenses
Expense LiabilityCredit
AdjustmentDebit
Adjustment
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12/1/04 12/31/04Year end
Last paydate
12/26/04
Next paydate
1/2/05
Record adjustingjournal entry.
Record adjustingjournal entry.
Adjusting for Accrued ExpensesAdjusting for Accrued Expenses
Barton, Inc. pays its employees every Friday. Year-end, 12/31/04, falls on a Wednesday. As of 12/31/04, the employees have earned salaries of $47,250 for Monday
through Wednesday of the week ended 1/02/05.
Barton, Inc. pays its employees every Friday. Year-end, 12/31/04, falls on a Wednesday. As of 12/31/04, the employees have earned salaries of $47,250 for Monday
through Wednesday of the week ended 1/02/05.
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Adjusting for Accrued ExpensesAdjusting for Accrued Expenses
Barton, Inc. pays its employees every Friday. Year-end, 12/31/04, falls on a Wednesday. As of 12/31/04, the employees have earned salaries of $47,250 for Monday
through Wednesday of the week ended 1/02/05.
Barton, Inc. pays its employees every Friday. Year-end, 12/31/04, falls on a Wednesday. As of 12/31/04, the employees have earned salaries of $47,250 for Monday
through Wednesday of the week ended 1/02/05.
Dec. 31 Salaries Expense 47,250 Salaries Payable 47,250
To accrue 3-days' salary
Other salaries657,500
Dec. 31 47,250Bal. 704,750
Salaries Expense
Dec. 31 47,250Salaries Payable
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Yes, I’ve completed yourtax return, but have not had
time to bill you yet.
Yes, I’ve completed yourtax return, but have not had
time to bill you yet.
Adjusting Accrued RevenuesAdjusting Accrued Revenues
Revenues earned in a period that
are both unrecorded and not yet received.
Revenues earned in a period that
are both unrecorded and not yet received.
Asset Revenue
CreditAdjustment
DebitAdjustment
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Adjusting for Accrued RevenuesAdjusting for Accrued Revenues
Smith & Jones, CPAs, had $31,200 of work completed but not yet billed to clients. Let’s make
the adjusting entry necessary on December 31, 2004, the end of the company’s fiscal year.
Smith & Jones, CPAs, had $31,200 of work completed but not yet billed to clients. Let’s make
the adjusting entry necessary on December 31, 2004, the end of the company’s fiscal year.
Dec. 31 Accounts Receivable 31,200 Service Revenue 31,200
To accrue revenue earned
Other receivables1,325,268
Dec. 31 31,200Bal. 1,356,468
Accounts ReceivableOther revenues
6,589,500 Dec. 31 31,200Bal . 6,620,700
Service Revenue
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Adjusting Accrued RevenuesAdjusting Accrued Revenues
In the 2nd week of Dec, FastForward agreed to provide 30 days of consulting services to a local sports club for a fixed fee of $2700, beginning from Dec 12. The club agrees to pay FastForward on Jan 10, 2005.
Dec. 31 Dr. Accounts Receivable 1,800 Cr. Consulting Revenue 1,800
To accrue revenue earned
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Adjusting Accrued RevenuesAdjusting Accrued Revenues
Dec.12 1,900 Dec. 22 1,900Dec.31 1,800
Bal. 1,800
Accounts Receivable
Dec.5 4,200Dec. 12 1,600Dec. 31 250Dec. 31 1,800Balance 7,850
Consulting Revenue
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Future receipts of accrued revenuesFuture receipts of accrued revenues
FastForward received $2,700 cash on Jan 10 for the entire contract amount.
Jan 10: Dr. Cash 2,700
Cr. Accounts Receivable 1,800
Cr. Consulting Revenue 900
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Learning objectiveLearning objective
Explain how accounting adjustments link to financial statements.
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Type
Balance Sheet Account
Income Statement Account Adjusting Entry
Prepaid Asset Expense Dr. ExpenseExpenses Overstated Understated Cr. Asset
Unearned Liability Revenue Dr. LiabilityRevenues Overstated Understated Cr. Revenue
Accrued Liability Expense Dr. ExpenseExpenses Understated Understated Cr. Liability
Accrued Asset Revenue Dr. AssetRevenues Understated Understated Cr. Revenue
Before Adjustment
Summary of Adjustments and Financial Statement Links
Links to Financial StatementsLinks to Financial Statements
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Learning objectiveLearning objective
Explain and prepare an adjusted trial balance. Prepare financial statements from an adjusted
trial balance.
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FastForwardTrial Balance
December 31, 2004
First, the initial
unadjusted amounts are added to the worksheet.
First, the initial
unadjusted amounts are added to the worksheet.
$
$
$$
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Next, FastForward’s adjustments are added.
Next, FastForward’s adjustments are added.
FastForwardTrial Balance
December 31, 2004
$
$
$$
$$
$$
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FastForwardTrial Balance
December 31, 2004Finally, the totals are determined.
Finally, the totals are determined.
$
$
$$
$$
$$
$
$
$$
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Preparing Financial StatementsPreparing Financial Statements
Let’s use FastForward’s adjusted trial balance to prepare the company’s financial statements.
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Prepare the IncomeStatement.
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Prepare the Statement of Changes in Owner’s Equity.Note: Net Income from the Income Statement carries to the Statement of Changes in Owner’s Equity.
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Prepare the Balance Sheet.
FastForwardBalance Sheet
December 31, 2001
AssetsCash 4,400$ Accounts receivable 1,800 Supplies 8,220 Prepaid insurance 2,300 Equipment 26,000 Less: accum. depr. (375) 25,625 Total assets 42,345$
LiabilitiesAccounts payable 6,200$ Salaries payable 210 Unearned consulting revenues 2,750 Total liabilities 9,160$
Owner's EquityChuck Taylor, Capital 33,185 Total liabilities and equity 42,345$
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The profit margin ratio measures the company’s net income to sales.
ProfitMargin
Net Income Net Sales
=
Profit MarginProfit Margin
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Profit MarginProfit Margin
SmarTone: 13.85% Hutchison Telecom: 0.48% City Telecom: 4.24% Sunday: 0.48% Peoples: 14.96%
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Homework for chapter 3Homework for chapter 3
Ex 3-1, 3-2, 3-9 Problem 3-2A Due on June 19,2006 (Monday)
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End of Chapter 3End of Chapter 3