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Learning objectives

Chapter 4 After studying this presentation, you should be able to:

4.1 describe the difference between the cash basis
Adjusting the accounts and and the accrual basis of measuring profit
preparing financial statements 4.2 explain the accounting cycle and the need for
end-of-accounting-period adjusting entries
4.3 identify and prepare the different types of
adjusting entries
4.4 prepare an adjusted trial balance and financial
©2018 John Wiley & Sons Australia Ltd
statements

Learning objectives Measurement of profit

4.5 use a worksheet to prepare the financial • Cash basis:

statements – Income is recorded when cash is received.
4.7 explain how financial statements are used in – Expenses are recorded when cash is paid.
decision making. – It does not recognise income when goods are sold or
services are performed on credit.
– It is simple to operate.

Measurement of profit Measurement of profit

• Accrual basis: • Accrual basis:

– Income is recognised in the period in which the – Income (including revenue):
expected inflow of economic benefit can be reliably • Accounting definition:
measured. –Increases in economic benefits during the
– Expenses recognised when the consumption of period in the form of inflows or enhancements
benefits can be reliably measured. of assets or decreases in liabilities.
–Result in increases in equity.
–Not contribution by the owners.

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Measurement of profit Measurement of profit

• Accrual basis: • Accrual basis:

– Income (including revenue): – Expenses:
• Income = Revenue + Gains • Accounting definition:
• Recognised at the fair value of assets received. –Decreases in economic benefits during the
period in the form of outflows or depletions of
assets or incurrences of liabilities.
–Result in decreases in equity.
–Not distributions to the owners.

Measurement of profit Measurement of profit

• Accrual basis: • Accrual basis:

– Expenses: – Temporary (nominal) accounts:
• Expenses are recognised in the period in which • Income and expense accounts are reduced to a
the consumption of costs can be measured. zero balance at the end of the accounting
period.

The accounting cycle — expansion to include

Measurement of profit
adjusting entries

• Accrual basis: • Accounting has adopted the accrual basis assumption in

– Permanent (real) accounts: the Conceptual Framework end‐of‐period adjustments.
• accounts in the balance sheet are not closed • Adjusting entries are recorded in the general journal.
• ending balances of one period are carried
forward and become the beginning balances of
the next period.

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The accounting cycle — expansion to include The accounting cycle — expansion to include
adjusting entries adjusting entries

• The accounting cycle – expanded to include adjusting • The need for adjusting entries:
entries: – Period in which cash is paid or received does not
coincide with period in which expense and income
are recognised.
– Some accounts must be adjusted on the last day of
the accounting period to correctly recognise
income and expenses not reflected in cash receipts
or payments.

Classification of adjusting entries Classification of adjusting entries

• Adjusting entries are classified into two major • Types of adjustments:

categories:
– Deferrals:
• the expenses paid in advance (called ‘prepaid
expenses’) or revenues received in advance (called
‘unearned revenues’).
– Accruals:
• the recognition of expenses incurred but not yet
paid for (called ‘accrued expenses’).

Classification of adjusting entries Classification of adjusting entries

• Rules for adjusting entries: • Adjusting entries for deferrals:

– One side of the entry affects an income statement – Prepaid expenses:
account: • cash paid before benefits are consumed/expire
• that is revenue or expense. • initially recorded as an asset when paid
– The other side of the entry affects an account • at the end of the period the amount
reported in the balance sheet, That is asset or consumed/expired is expensed.
liability.
– The cash account is never adjusted as the cash flow
occurs either before or after the end of the
reporting period.

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Classification of adjusting entries Classification of adjusting entries

• Adjusting entries for prepaid expenses (asset initially • Adjusting entries for prepaid expenses (expense
recorded): initially recorded):

Classification of adjusting entries Classification of adjusting entries

• Adjusting entries for prepaid expenses (non-current • Adjusting entries for precollected or unearned
assets) – depreciation: revenues:

Classification of adjusting entries Classification of adjusting entries

• Adjusting entries for accruals: • Adjusting entries for accrued and unrecorded
– Accrued or unrecorded expenses: expenses:
• Expenses that have been consumed but have not
been recorded because payment has not yet been
made.
• An adjusting entry is needed to recognise the
expense in the period in which it is incurred
rather than in the period of payment.

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Classification of adjusting entries Classification of adjusting entries

• Diagram of salaries paid and accrued: • Adjusting entries for accruals:

– Unrecorded or accrued revenue:
• Usually recorded when service is performed.
–No adjusting entry would be necessary.
• Revenue that is unrecorded at the end of the
period must be included in the accounting records
by debiting a receivable and crediting a revenue
account.

Classification of adjusting entries Classification of adjusting entries

• Adjusting entries for accrued revenues: • Summary of end-of-period adjustments:

Adjusted trial balance Adjusted trial balance

• Same accounting process applied. • Preparation of financial statements:

• Unadjusted trial balance used as starting point. – Income statement:
• Adjusting entries are posted to the general ledger. • Prepared first to determine profit or loss.
• An adjusted trial balance can then be prepared. • Reflects entity’s performance for the period.
• Debits must still equal credits.
• Adjusting entries always affect an income statement
and a balance sheet account.

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Adjusted trial balance Adjusted trial balance

• Preparation of financial statements: • Preparation of financial statements:

– Statement of changes in equity: – Balance sheet:
• Profit (loss) must be added to (subtracted from) • Reflects entity’s financial position as at the end of
equity. the period.
• Three major categories of accounts:
• Capital contributions and Drawings/Dividends – assets
also recorded. – liabilities
• Shows details of movements in equity. – equity.
• Equity balance is reported in balance sheet. • Statement users find it useful if assets and
liabilities are further classified.

Distinguishing current and non‐current assets

Adjusted trial balance
and liabilities

• Subcategories for assets and liabilities: • Current assets:

– Cash and other types of assets that are held
primarily for the purpose of sale or trading.
– Will be used up/paid off within a single operating
cycle (usually 12 months).
– The operating cycle is the average length of time it
takes to acquire inventory.

Distinguishing current and non‐current assets Distinguishing current and non‐current assets
and liabilities and liabilities

• The operating cycle: • Non‐current assets:

– Will not be used up/paid off within a single operating
cycle (usually 12 months).
– Property, plant and equipment are expected to be
used by the business entity for a number of years
and are not held for resale.
– An intangible asset is one that usually does not have
a physical substance.

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Distinguishing current and non‐current assets Distinguishing current and non‐current assets
and liabilities and liabilities

• Current liabilities: • Non‐current or long‐term liabilities:

– Entity that are reasonably expected to be settled in – Entity that do not require payment within the
the entity’s normal operating cycle. entity’s operating cycle or within 12 months.
– It will require payment in the short term accounts – Long-term debt is that portion of the mortgage due
payable (trade creditors), interest payable and other after 1 year.
accrued liabilities. – The interest accrued on both the long‐term and
short‐term portion of the debt is reported as a
current liability.

Preparing financial statements Preparing financial statements

from a worksheet from a worksheet

• Assembles all information needed to adjust the • Preparation of the worksheet:

accounts and prepare financial statements. 1. Enter ledger account titles and balances in the
• Aids in the preparation of interim financial statements account title and unadjusted trial balance columns.
when adjusting and closing entries are not required. 2. Enter the necessary adjusting entries in the
• Contains information needed to close off profit and adjustment columns.
loss accounts for the period if required. 3. Prepare an adjusted trial balance.
4. Extend every account balance listed in the adjusted
trial balance columns to its proper financial
statement column.

Preparing financial statements Preparing financial statements

from a worksheet from a worksheet

• Preparation of the worksheet: • Preparation of financial statements:

5. Steps below: – Completed worksheet is:
• Total the two income statement columns and the • used to prepare the financial statements.
two balance sheet columns. • can be used as a basis for journalising adjusting
• Calculate the difference between the totals of and closing entries.
the two income statement columns and enter – Income statement is:
this as a balancing amount in both the income
• prepared from account balances listed in the
statement and balance sheet columns.
two income statement columns.
• Calculate the four column totals again with the
balancing amount included.

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Preparing financial statements

Financial statements and decision making
from a worksheet

• Preparation of financial statements: • Financial statements are the final output of the
– Statement of changes in equity and the balance accounting cycle.
sheet are: – Not an ends in themselves.
• prepared from items contained in the balance – Allow users to make decisions.
sheet columns. • Questions might include:
– Has the business been profitable?
– Does the profit made compare with what I
expected?
– And so on.

Summary Summary

• Difference between the cash basis and the accrual • Using the worksheet.
basis. • Use of financial statements in decision making.
• The accounting cycle and end‐of‐accounting‐period
adjusting entries.
• Identifying and preparing the different types of
adjusting entries.
• Preparing adjusted trial balance and financial
statements.
• Difference between current and non‐current assets and
liabilities.

Concepts of Capital

• Financial capital
– Capital is synonymous with the net assets (equity) of the entity
– Profit exists only after the entity has maintained its capital, measured as
the dollar value (or purchasing power) of equity at the beginning of the
period

• Physical capital
– Capital is viewed as the operating capability of the entity’s assets
– Profit exists only after the entity has set aside enough capital to maintain
the operating capability of its assets