Corporate Financial Reporting

Session- 4 IIMC-PGP-2013: Prof. Arpita Ghosh

Learning Goals
Limitations of Trial Balance Rectification Entries Adjustment Entries Deferrals and Accruals Preparing an Adjusted Trial Balance Preparing Financial Statements Closing Entries Preparing a Post-Closing Trial Balance

Limitations of a Trial Balance

The trial balance may balance even when there are 1. Errors of Omission : A transaction is not journalized, a correct journal entry is not posted
Rs 1000 paid to Mr X is unrecorded

2. 3. 4. 5.

Double Recording or Posting : Credit sales of Rs 5000 recorded in journal or posted from journal twice Compensating Errors Salary extra debit, Sales extra credit- Rs 100 Errors of Principle Repairs to building Recording wrong amounts on the correct sides of right A/cs Stationery purchased on credit for Rs 175, is recorded as Rs 751 in journal and posted to stationery and A/P for Rs 751 Recording the right amount on the correct side of wrong account:
Rs 1000 cash paid to Shyam is wrongly debited to Shyamal A/c
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6.

Rectification Entries
Stationery purchased for Rs 500 is recorded in the cash book for Rs 50 1. What should have happened ? - Correct Entry Stationery A/c Dr. 500 Cash A/c......Cr. 500 What has happened ? - Entry as passed Stationery A/c Dr. 50 Cash A/c......Cr. 50 What action will correct the error ? - Rectification Entry Stationery A/c Dr. 450 Cash A/c......Cr. 450

2.

3.

So for errors of omission Record it

Lets Check
Which of the following transactions a) Are incorrect b) Will make the trial balance tally ? c) Which side Dr./ Cr. Will be higher ? 1. 2. 3. 4. A debit record of Rs 4000 cash dividends was posted to the Salaries Expense A/c Payment of the accounting periods rent of Rs 5000 was debited to Rent Expense and credited to Cash Cash received from Mr A of Rs 540 was recorded as debit to cash but posted to the credit of A/R for Rs 450 Supplies purchased Rs120 was posted to the credit to Supplies

Timing, Assumptions and Matching Rule

Going Concern, Accruals Basis

Matching Principle

Let the expenses follow the revenues.

Some transactions span more than one accounting period

Revenue Recognition Principle

1.Persuasive Evidence of an arrangement between buyer and seller Contract with the buyer : Simple delivery of the product just before the year end, without evidence of a prior order not a revenue 2. Product has been delivered/ service has been rendered A Ltd received advance payment of Rs50,000 for delivery of goods not yet produced It should recognize the amount as unearned revenue (CL) till the goods are delivered 3. Price is determined or determinable 4. Collectability is reasonable certain The buyer has not become insolvent : Has the ability to pay The buyer is not deliberately escaping payment by fleeing : Has the intention to pay Uncertainty till embargo imposed on remittance to the sellers country not lifted

Matching Principle
Addresses the difficulty of assigning revenues and expenses to the appropriate accounting period so that net income is measured accurately 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: The matching rule Assign revenues to the accounting period in which the goods are sold or services are rendered Assign expenses to the accounting period in which they are used to produce income
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Timing Issues : Accrual Vs. Cash Basis of Accounting

Illustration: Suppose that Fresh Colors paints a large building in 2011. In 2011, it incurs and pays total expenses (salaries and paint costs) of $50,000. It bills the customer $80,000, but does not receive payment until 2012.
Accrual Basis: Revenues and Expenses are recorded when they occur

Cash Basis: Revenues and Expenses are recorded when cash is exchanged
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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
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Involves Judgment: Potential for abuse (Ethics)

Types of Adjusting Entries

Deferrals: Cash Exchanged in Advance of a future Revenue or Expense
Recognition of Expense is Deferred 1. Prepaid expenses: 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 arisen, not yet recorded Expenses incurred 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 BEFORE recognition BALANCE SHEET
Assets 1. Recorded costs are allocated between two or more accounting periods
(Deferred Expenses)

Liabilities 2. Expenses are incurred but not yet recorded

(Accrued Expenses)

Expense
INCOME STATEMENT

Revenue

4. Revenues are earned but not yet recorded

(Accrued Revenues)

3. Recorded unearned revenues are allocated between two or more accounting periods
(Deferred Revenues)

Note: Each adjusting entry involves one balance sheet account & one income statement account

Deferral postponement of recognition of an expense already paid or of revenue received in advance (Type 1, 3)

Accrual recognition of a revenue or expense that has arisen but is unrecorded (Type 2, 4)

Cash to be exchanged AFTER recognition

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DEFERRALS (Type 1 and 3 : of the Book)

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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 Expense 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 during the accounting period 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 Stockholders equity will be overstated Net income will be overstated
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Adjustment Entry (Type 1) : Prepaid Rent Adjustment

On July 3, Creative Design, Inc paid two months rent in advance for $3,200. The amount was recorded in the Prepaid Rent account.
July 3 Prepaid Rent Cash Dr. 3,200 Cr. 3,200

By July 31, half of the prepaid rent has expired and should be treated Dr. Cr. as an expense July 31 Rent Expense 1,600
Prepaid Rent

1,600

Adjustment July 31: Prepaid rent of $1,600 has expired for July. Adjust account by allocating the amount to the Rent Expense account.
Prepaid Rent Rent Expense

July 3 Bal.

3,200 1,600

1,600 July 31

July 31

1,600

The account now reflects the prepaid August amount

The account now reflects the July rent expense amount

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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): Deferred Expense (Asset, Depreciation)

Depreciation is the process of allocating cost of an asset to expense over its useful life - Depreciation doesnt attempt to report actual change in the value of the asset For ABC Corporation, assume that depreciation on the office equipment is $480 a year, or $40 per month.

Oct. 31

Depreciation Expense Accumulated Depreciation - Equipment

40 40

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Prepaid Expense and Unearned Revenue

Mr. A records Prepaid Expense (A) Cash (A) (Cr.) Mr. B records Cash (A) (Dr.) Unearned Revenue (L)

Advance payment today

Mr. A (Tenant)

Mr. B (Landlord)

Service Tomorrow
Mr. A records: Mr. B records Unearned Revenue (L) (Dr.),

Rent Expense (E) (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 during the accounting period 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 Stockholders equity will be Understated Net income will be Understated
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Adjustment Entries (Type 3) Unearned Revenue

On July 19, Creative Designs, Inc. received $1,400 as an advance payment for brochures to be prepared for a client. By the end of the month, $800 of the brochures were completed and accepted by the client. When the payment was originally received, it was recorded as a liability.
July 19 Cash Unearned Design Revenue 1400
Dr. Dr. Cr.

1400
Cr.

$800 of the advance payment has been earned in July July 31 Unearned Design Revenue Design Revenue

800 800

Adjustment July 31: Recognize $800 of the unearned revenue as earned in July. Assets July 31 800 = Liabilities + July 19 1,400 Bal. 600 Stockholders Equity
Design Revenue Unearned Design Revenue

July 10 2,800 July 15 9,600 July 31 800

The account now reflects the total revenue applicable to July
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The account now reflects a balance that is unearned revenue

ACCRUALS (Type 2 and 4 : of the Book)

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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. Adjustment Entry results in Increases an expense account (Dr.) and Increases a liability account (Cr.)
As the expense accumulates, it is said to accrue

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Adjustment Entry (Type 2 ): Accrued Wages

Creative Designs pays its employees every two week: On 12th and 26th of every month. The last pay period ended on July 26. The secretary worked July 29 31, but will not be paid until the regular payday in August (12th). The unrecorded wages for July 29 31 are an expense of July even though they will not be paid until August. July 31 Wages Expense Wages Payable Dr. 720 Cr. 720

Adjustment July 31: Accrue the unrecorded wages. The secretary earns $2,400 every two weeks. ($2,400/ 10 working days = $240/day x 3 days = $720) Wages Payable Wages Expense

July 31

720

July 26 4,800 July 31 720 Bal. 5,520

The account now reflects the total July wages expense
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The account now reflects the liability applicable to July

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) Adjustment Entry results in Increases an asset account (debits) and Increases a revenue account (credits)
As the revenue accumulates, it is said to accrue

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Adjustment Entries Accrued Revenue (Type 4)

In July, Creative Designs agreed to design a website for Marsh Tire Company with the first section operational by July 31. The fee for this section is $400. The fee has been earned by the end of the month, but has not been recorded July 31 Accounts Receivable Design Revenue 400 400

Adjustment July 31: Recognize $400 as revenue earned in July

Accounts Receivable Design Revenues

July 15 9,600 July 31 400 Bal. 5,000

July 22 5,000

July 10 2,800 July 16 9,600 July 31 800 July 31 400

The account now reflects the total revenue applicable to July

The account now reflects all receivables for July

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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 Xs Accrued Expenses (A/P) would be Mr. Ys 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 balances 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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Preparing Financial Statements : Sequence

1

Income Statement Revenue accounts Expense accounts Net income

Adjusted Trial Balance Asset accounts Liability accounts Common Stock Retained Earnings Dividends Revenue accounts Expense accounts

Statement of Retained Earnings Beginning retained earnings + Net Income Dividends Ending retained earnings

Balance Sheet Assets Asset accounts Liabilities Liability accounts Stockholders Equity Common stock Retained earnings

Check the preparation in Page 153 of text book

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Closing the Books

Temporary accounts
(or nominal accounts) All Revenue accounts, All Expense accounts, Dividends accounts Are closed at the end of each period Begin each period with a zero balance

Permanent accounts
(or real accounts) All Assets accounts, All Liabilities accounts, All Shareholders Equity accounts i.e. all Balance sheet accounts Are not closed at the end of each period Carry their end-of-period balances to 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 periods 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

Income Summary Does not appear on financial statements Only used in the closing process Its balance equals the net income or loss reported on the income statement

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The Closing Process

Expense Accounts xxx Step 2: Close expense accounts Revenue Accounts xxx Step 1: Close revenue accounts

Income Summary xxx xx Step 3: Close Income Summary xxx

Dividends xx Step 4: Close Dividends

Retained Earnings xx xx

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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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Summary of the Accounting Cycle

1. Analyze business transactions

9. Prepare a post-closing trial balance 8. Journalize and post closing entries

2. Journalize the transactions

3. Post to ledger accounts

7. Prepare financial statements

4. Prepare a trial balance 5. Journalize and post adjusting entries: Deferrals/Accruals

6. Prepare an adjusted trial balance

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Determining Cash Flows from Accrual-Based Information

Each revenue and expense account has one or more related accounts on the balance sheet, joined through adjusting entries

Balance Sheet
Supplies Wages Payable Unearned Revenue Prepaid Insurance

Income Statement
Supplies Expense Wages Expense Earned Revenue Insurance Expense

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Determining Cash Flows

For deferrals
Prepaid Expense Ending Balance + Expense for the Period Beginning Balance + Unearned Revenue Ending Balance Revenue for the Period Beginning Balance

For Accruals
Accrued Payable Beg. Balance + Expense for the Period Ending Balance Accrued Receivable Beg. Balance + Revenue for the Period Ending Balance

Cash Payments for Expenses

Cash Receipts from Revenues

Cash Payments for Expenses

Cash Receipts from Revenues

Determining Cash Flows from Accrual-Based Information

Cash
310

Prepaid Insurance
May 31 480 310 June 30 670 120

Insurance Expense
120

Actual cash paid for insurance in June

Prepaid Expense Ending Balance (on 30 June) + Expense for the Period (during June) Beginning Balance ( on May 31) Cash Payments for Expenses during June

Prepaid Expense $ 670 + 120 480 $ 310

SE 11 (p165)

The beginning balance is deducted because it was paid in a prior period

E12 (p168)

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Thank You

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