The University of Papua New Guinea

P. O. Box 1078
Goroka
E.H.P

School of Humanities - Division of Business Studies

Bachelor of Business Accounting - BBA

The Basics of Accounting (Module 3)

CHAPTER 4 Adjusting the accounts and preparing financial statements

Learning outcomes

By the end of this semester the student should be able to:

1. Describe the difference between the cash basis and accrual basis of measuring profits
2. Explain the Accounting cycle and the need for end of account period adjusting entries
3. Identify the different types of adjusting entries
4. Prepare adjusting entries for prepared or recollected items
5. Prepare adjusting entries for accruals or un recorded items
6. Prepare and explain the purpose of an adjusted trial balance
7. Prepare financial statements from an adjusted trial balance
8. Describe the difference between current and non-current assets and liabilities
9. Use a worksheet to prepare the financial statements
10. Explain how financial statements are used in decision making

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3.0 Adjusting the accounts and preparing financial statements
3.1 Cash basis
Cash basis, strictly speaking, under the cash basis accounting, income (including revenue) is
recorded in the period in which cash is received and expenses are recorded in the period in
which cash is paid. Profit is the excess of cash inflows from income over cash outflows from
expenses. This method does not recognize income when goods are sold or services are
performed on credit. Note, the cost of goods and services consumed during the current
period, but not paid for, are recognized as expenses in the subsequent period when cash is
paid.

3.2 Accrual basis

Under the accrual basis of accounting, basis of accounting income (including revenue) is
recognized in the period in which the expected inflow of economic benefits can be measured
in a faithful and verifiable manner. That is, normally in a period in which a business sells
goods or performs a service under a contractual agreement. Expenses are recognized when
the consumption of good or service is also capable of such measurement. Accrual basis profit
for an accounting period is determined by subtracting expenses recognized during the period
from income recognized in the period. We will study more detail on the accrual basis of
accounting later in the course.

3.3 Income - Including revenue

What are income and expenses? Income includes revenue; income represents increase in
economic benefits during the period in the form of inflows or enhancement of assets or of
decrease liabilities that result in increases in equity, other than those resulting from
contributions by owner. Revenue is the major part of income – that part which results in the
ordinary activities of an entity, such as the performance of services or the sale of
merchandise. Revenue is recognizing at the fair value of assets received, if capable of
verifiable measurement. Therefore, for a given accounting period, revenue is recognize as the
sum of cash, accounts receivable and the fair value of other assets received from customers
for the sale of goods or the performance of services during that particular period.

To illustrate the accrual concept of revenue, assume that an entity begun operation in 2012
and received K100, 000 in cash for services rendered before the end of year. Assume also
that its clients were charged K20, 000 for services rendered in 2012 for which cash is to be
received in 2013. Revenue recognized in 2012 is K120, 000, which is the sum of cash
received (100, 000) and accounts receivable (K20, 000 – yet to be received or collected) from
customers for services rendered in 2012. The transaction effect is that when services are for
customer on credit, both accounts receivable and revenue are increased. Note in 2013, the
cash collection of K20, 000 is not revenue but recorded as an increase in assets (cash at
bank), and a decrease asset (accounts receivable). Thus revenue is recognized when is
capable of verifiable measurement, regardless of the period in which the resulting cash is
collected.

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 You will notice that many titles are used to describe major categories of revenue, some
examples are: Service provider - Management Services Fees Revenue or Tax services Fees
Revenue, Retailers/Merchandising - Sales Revenue.

Note; A company’s revenue is the total amount of money it receives from sales over a set
time period. Income is how much of that revenue is left after you deduct the business’s
expenses. Subtract income from revenue and you’ll get the company’s cost of doing
business over the time period measured.

 Revenue is the total money generated by selling a company’s goods or services.

 Income can be deduced by subtracting the total expenses from the total revenue generated by
the company.

They can be found in the same financial statement, i.e., the income statement. But the income
is a subset of the revenue, whereas the revenue is the superset of the income.

3.4 Expenses
It is important to understand that costs are incurred as a necessary part of the revenue –
generating process. The portion of a cost that is expected to provide economic benefits in a
future period represents an unexpired cost and is reported as an asset in the balance sheet
(called the (statement of financial position) at the end of the period. The costs of assets that
have been consumed during the current period are reported in the income statement as
expenses (sometimes called expired costs) and are deducted from income (revenues) in the
calculation of profit. Under accrual basis of accounting, expenses are recognized in the
period which the consumption of costs can be verified and reasonably measured.

Despite when the expenses are recognized, financial statement are prepared on the
assumption that the entity will continue to operate in the future (the going concern
assumption), unless there is evidence to the contrary. Note going concern is the basis for
accrual accounting. If it was not for the going concern assumption, the cash basis would be
satisfactory.

3.5 Temporary (nominal) and permanent (real) accounts)

Income statements are prepared for periods of equal lengths to enable information users to
make meaningful comparisons of current period results with those of past periods. To
facilitate the preparation of next periods income statement‟ all income and expense accounts
are reduced to a zero balance at the end of the accounting period, they are called temporary or
(nominal accounts). Accounts reported in the balance sheet are not closed: their ending
balances of one period are carried forward to the next period and become the beginning
balances of the next period. These accounts are called (permanent or (real accounts).

3.6 The accounting cycle – expansion to include adjusting entries.

In the section of the module we are going to learn about the recording of end of period
adjustments at the end of the accounting period. End of period adjustments are very important
to recognize the accruals needed at the end of the accounting period. These adjusting entries

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are recorded in the general journal, and then posted to the general ledger, and an
adjusted trial balance is prepared to proof the general ledger is in balance after the adjusting
entries have been posted to the relevant accounts. The use of an optional worksheet enables
the recording of adjustments outside the accounting records and to prepare financial
statements.

The work is particularly helpful when managers wish to prepare end of month financial
statements during the yearly accounting period. Whether or not use the worksheet is entirely
up to individual accountants.

The accounting cycle in module 2, figure (3.1) is expanded on figure 3.1 to accommodate the
additional steps in module 3, note the cycle is repeated each accounting period. As shown
below is the accounting cycle expanded to include adjusting entries.

Steps in the cycle Accounting records

1 Recognise and record transactions Source documents

2 Journalise transactions General Journal

Figure 3.1

3 Post to ledger accounts General ledger

Start of new 4 Prepare unadjusted trial balance Trial Balance (unadjusted)

Period
5 Determine adjusting entries - General Journal
journalise adjusting entries

6 Post adjusting entries to ledger accounts General ledger - Accounts adjusted

7 Prepare adjusted trial balance of Trial balance adjusted

adjusted general ledger
Worksheet
8 Prepare financial statements (optional) Financial statements

3.7 The need for adjusting entries

In most cases, the payment or receipt of cash coincides with the accounting period in which
the expense or income is recognized. However, some transactions affect the entity‟s profit
and financial position for two more accounting periods. In these cases, the period in which
the cash is paid or received does not coincide with the period in which the expense and
income is recognized. As a result, some of the accounts must be adjusted as for the last day of
the accounting period to provide for the correct recognition of income and expenses (inflows

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and outflows of economic benefits not recorded in cash receipts or cash payments during the
period in order to assess the entity‟s performance. The other reason for adjusting the accounts
in the last day of the accounting period is, the adjusting entries are necessary to achieve and
accurate reporting of asset and liability balances on the last day of the accounting period in
order to assess the entity‟s financial position.

The adjusting process involves an analysis of accounts and supporting documents to

determine whether entries are needed to adjust account balances to their proper amounts for
financial statement purposes. Once this analysis is completed, adjusting entries are entered,
if necessary in the general journal and posted to the respective accounts.

During the accounting, for example, if management requires interim (end of month) financial
statements, the adjusting entries are usually not recorded in the entity‟s journal but shown on
a worksheet – an illustration of a worksheet will be shown later in the course. Normally,
adjusting entries are record in the general journal on the last day of the entity‟s accounting
period.

3.8 Classification of adjusting entries

There are two categories of adjusting entries, deferrals and accruals. Deferrals are expenses
paid in advance (called prepaid expenses) or revenues received in advanced called (unearned
revenues) which needed to be allocated over future accounting periods. Accrual are the
recognition of expenses incurred but not yet paid for (accrued expenses) or the recognition of
revenue earned but for which cash has not yet been received called (accrued revenues).The
adjusting entries are made so that all income (revenues) and expenses are recognized in the
appropriate accounting period. Adjusting entries both size of the entity‟s profit and its
financial position. Figure 3.2 below.

Types of adjustments

Deferrals Prepaid expenses Unearned revenue

(Prepayments) Costs or expenses paid for before they Revenues that have been collected or
are consumed,e.g. rent paid in received in advance but not yet earned,
advance, insurance premium paid for e.g. magine subcriptions fees received
protection in the future (initially in advance, rent received inadvance
as assets and charged to expenses in from a tenant (intitially recorded as Figure 3.2
subsequence periods as they are liabilities and recognised as revenue
consumed) in subsequence periods as the revenue
is earned.

Accruals Accrued expenses Accrued revenues

(unrecorded expenses Expenses incurred but not yet paid for Revenue earned but not yet received in
and revenues) or entered in the records , e.g. wages cash or entered in the records, e.g. sales
earned by employees but not yet paid, commissions earned but not yet paid, interest
accumulated on a receivable but not yet
received.

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There are two rules for adjusting entries

1) One side of the entry affects an account reported in the income statement (expense or
income (revenue)), and the other side of the entry affects an account reported in the
balance sheet (Asset or liabilities).
2) The cash amount is never adjusted as the cash flow occurs either before or after the
end of the reporting period.

To demonstrate each of these adjusting entries, the illustration of Intellectual

Management Services developed in module is continued. The trial balance figure 2.16 on
page 76 is show again below. This trial balance is called an Unadjusted Trial Balance
because at this stage no adjustments have been made. For illustrative purposes we shall
assume that the financial year for Intellectual Management Services ends on 30 June.
Adjusting entries prepared in the general journal for June, i.e. one month only.

Where an entity has operated for the whole 12 months of the financial year, formal
adjusting entries are made in general journal usually only at year‟s end, more on this will
be covered in the later part of the course. Figure 3.3

Figure 3.3

3.9 Adjusting entries for deferrals prepaid expenses

Prepaid expenses

An entity often pays for certain items (such as rent, insurance and supplies) in advance their
use. Under the accrual basis of accounting, the payment of cash does not necessarily result in
the recognition of expense. Goods and services that are paid for in advance and are expected

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to provide benefit beyond the current period are normally recorded as assets at the time of
payment. At the end of the accounting period, the portion of the cost that is associated with
the good that has been consumed or with services that have been received is transferred to an
expense account. The remaining unexpired or unused portion is reported as an asset in the
balance sheet, since it represents future economic benefits to be received in the future
periods. Thus, before the financial statements are prepared, the balance in the assets account
is analyzed and is apportioned between an asset and an expense. Below shows adjusting
entries for prepaid expenses (The asset is initially recorded).

Prepaid expense (costs/expenses paid for before they are consumed)

ASSET ACCOUNT
Prepaid Expense EXPENSE ACCOUNT
Intitial cost Adjusting entry Adjusting entry
Debit Credit Debit

Costs consumed or expired

Prepaid insurance

On 3 June, a 24 month fire and business liability insurance policy was purchased by
Intellectual Management Services for k1, 920 plus VAT of K192, as evidenced by a tax
invoice of K2, 112, insurance coverage begun on 1 June. The transaction was initially
recorded as follows.

Jun-03 Prepaid Insurance 110 1, 920

VAT Outlays 120 192
Cash at Bank 100 2, 112
(Purchase of 24 - months fire & business
liability insurance policy)

Recall that the account numbers are added to the posting reference column in the journal
when postings are made to the ledger. The balance in the prepared insurance (asset) remains
the same until the end of the month, at which time the cost of the insurance protection for the
month of June is calculated. The cost of the insurance protection per month is K80 (K1,
920/24 months). The following adjusting entry is made on 30 June to record insurance
expense and to reduce the Prepaid Insurance account. The VAT has no effect on the internal
transaction. The adjusting entries are identified by letters in this illustration for reference
purposes only.

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 Jun-30 Insurance Expense 521 80
Prepaid Insurance 110 80
(Adjusting entry to record expiration of
1 month insurance)

After the adjusting entry is posted, the account appears as follows.

110 521
3-Jun Cash at Bank 1, 920 30-Jun Insurance 30-Jun Prepaid Insuarnce
Expense 80 insurance 80

The adjusting entry reduces the Prepaid Insurance account balance to K1, 840 (1, 920 –K80),
which is the unexpired portion of cost applicable to future periods, and is reported as an asset.
The portion of the cost that is consumed in this period is K80 is properly shown as an
expense for the month of June. If the adjusting entries were not made, profit, assets and
equity would all be overstated.

In future periods, the K1, 840 balance is reduced by K80 each month as insurance protection
is received by the entry, i.e. insurance expense is incurred. The cost of additional policies
purchased are debited to the Prepared Insurance account and allocated to expense following
the same procedures.

3.10 Prepare Insurance recorded initially in an expense account

In the previous discussion, the insurance premium paid in advance was originally debited to
an asset account. It is possible, however to record prepaid items in more than one way. Some
entities find it more convenient to record all payments for goods and services initially in
expense accounts, irrespective of whether the cost benefit the current period only or is
expected to benefit several accounting periods. If this method is used, the accounts must be
adjusted at the end of the period to determine properly the expense of the period and
recognize an asset for the prepaid portion of the payment.

To illustrate, assume that Intellectual Management services recorded the payment for the
insurance policy as flows on 3 June:

Jun-03 Insurance Expense 521 1, 920

VAT Outlays 120 192
Cash at Bank 100 2, 112
(Purchase of 24 - months fire & business
liability insurance policy)

At the end of the period, an adjusting entry is needed to remove the unexpired portion of the
insurance coverage from the expense account.

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 Jun-30 Prepaid insurance 110 1, 840
Insurance Expense 521 1, 840
(Adjusting entry to record portion of
insurance policy unexpired,
23 months x K80 per month)

After these entries are posted, the accounts appear as follows:

Insurance Expense 152 Prepaid iNsurance 110
3-Jun Cash at Bank 1, 920 30-Jun Prepaid 30-Jun Insurance
Insurance 1, 840 Expense 1, 840

Note that the 30 June balances are the same (Prepaid insurance), K 1, 840; Insurance expense
K80, i.e. K1,920 – K1,840 as when he insurance premium was made initially to the Prepaid
Insurance (asset) account.

When this method is used to record prepayments, a journal entry is commonly made on the
first day of the new accounting period (1 July)to restore the prepaid portion of the premiums
of K1,840 to the insurance expense account. The entry is referred to as reversing entry, is as
follows:

Jul-01 Insurance Expense 521 1, 840

Prepaid Insurance 110 1, 840
(Reversing entry)

Additional payments from insurance premium are than added to the balance in the Insurance
Expense account. At the end of the next reporting period, the account is analyzed and the
prepaid portion is removed again as we have done previously. We will used the commonly
used method, i.e. to debit the Prepaid Insurance asset when the premium is paid, because this
approach correctly recognizes an existing asset at the time and means that you do not have to
make a reversing entry later.

Prepaid expense (costs/expenses paid for before they are consumed)

ASSET ACCOUNT
Expense Account Prepaid Expense
Intitial cost Adjusting entry Adjusting entry
Debit Credit Debit

Costs unused or unexpired

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3.11 Office Supplies

Jun-05 Office Supplies 111 1, 240

VAT Outlays 120 124
Accounts Payable 200 1, 364
(Office supplies purchased on credit)

The cost of unused supplies is reported as an asset in the balance sheet. As the office supplies
are consumed, their cost is transferred to an expense account. Normally, the recognition of
the expense occurs at the end of the accounting period. Before financial statements are
prepared, an adjusting entry is made to remove the cost of the supplies consumed from the
asset account and to recognize the cost of supplies consumed as an expense.

For Intellectual Management Services, assume that the cost of supplies on hand at the end of
June was determined to be K1, 080. The cost of supplies used this period is assumed to be
K160, since a total of K1, 240 was available for use during the period. The following
adjusting entry is made to record the supplies used:

Jun-30 Office Supplies Expense 530 160

Office Supplies 111 160
(Adjusting entry to record supplies used)

VAT is not affected by the consumption of office supplies as this is an internal transaction,
after the entry is posted, the account appear as follows:

Office Supplies 111 Office Supplies Expense

5-Jun Accouunts Payable 1, 420 30-Jun Office 30-Jun Office Supplies
Supplies 160 160
Expense

The K1,080 balance left in the Office Supplies account is the cost of supplies available for
use in future periods (an assets). The K160 balance in the office Supplies Expense is the cost
of supplies consumed during June, which is charged against income for this period in the
income statement. In the future periods the cost of additional purchased will be debited to
office Supplies account.

3.12 Depreciation of equipment and buildings

Included in Intellectual Management Service, was the acquisition of a building for K180,
000and office Equipment for K19, 200. These assets were acquired and held by the entity to
carry out its activities. In order to determine profit, the cost of its assets less its expected sales
value at the end of its useful life is allocated to expense in the current and future periods as

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the assets are consumed in producing income. Use life is the estimated amount of time over
which over which the asset is estimated to be consumed by the entity. The proportion of the
asset‟s cost assigned to expense is called (depreciation). The adjusting entry to record
depreciation is that an expense account is debited for the portion of the cost allocated to the
current period and an asset is decreased.

Unlike other assets equipment and buildings, are used for longer period of time, sometimes
up to 30 years or longer. It is impossible for the accountant to know the useful life and
expected sales value at the end of the asset‟s useful life. This expected sales value is called
(residual value). Amounts calculated for Depreciation are by necessity based on estimates of
the assets useful life; hence depreciation expense is an estimate only. Depreciation is an
internal transaction, therefore there is no VAT.

In making the adjusting entry for depreciation, a separate account entitled (Accumulated
Depreciation) is credited for cost associated with the period rather than making a direct credit
to the asset account. The balance in the accumulated depreciation account reflects the portion
of the cost that has been assigned to the expense and accumulated since the item was
purchased. The accumulated depreciation account is called (a contra account). The contra
account is reported as an off set to or a deduction from a related account. Thus in the balance
sheet, the Accumulated Depreciation account is reported as a deduction from the original cost
as shown in the related asset account. Reporting both the original cost of the asset and the
accumulated depreciation can provide useful information about the age of the asset to
information users. Adjusting for depreciation is summarized in in figure …….

To illustrate, assume the building has a useful life of 25 years, at which time it is expected to
have a residual value K30, 000. The office equipment has an 8 year useful life and a zero
residual value at the end of 8 years. The depreciation for each asset is calculated as follows:

Office Equipment Building

K19, 200 K180, 000 – K30, 000

= K200 per month = K500 per month
96 months 300 months

For Adjusting entries for prepaid expenses (non-Current assets – Depreciation)

Prepaid expense (costs/expenses paid for before they are consumed)

ASSET ACCOUNT
Initial cost
Debit

CONTRA ASSET ACCOUNT

Accumulated Depreciation EXPENSE ACCOUNT
Adjusting entry Adjusting entry
Credit Debit

Costs consumed and allocated

to current period

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The adjusting entries to record depreciation expense for the month of June are:

Jun-30 Depreciation Expense - Office Equipment 540 200

Accumulated Depreciation - Office Equipment 171 200
(Adjusting entries to record depreciation of Equipment)

Jume 30 Depreciation Expense - Building 541 500

Accumulated Depreciation - Building 171 50
(Adjusting entries to record depreciation of building)

The accounts for depreciation of equipment after posting appear as follows.

Office Equipment 170
5-Jun Cash at Bank/ 1, 920
Mortgage Payable

Accumulated Depreciation - Office Equipment 171 Depreciation Expense-Office Equip. 540

30-Jun Depr. Exp. - 30-Jun Acc, Depr. -
Office Equip. 200 Office Equip. 200

Depreciation is reported as an expense in the income statement. The buildings and office
equipment accounts will be shown in the balance sheet at the end of the first month as
follows.

Building K180, 000

Less: Accumulated depreciation – building 500 K179, 500
Office equipment 19, 200
Less: Accumulated depreciation – office equipment 200 19, 000

The difference between the original cost of the asset and its accumulated depreciation is
called the carrying amount (or book value) of the asset and represents the unexpired cost of
the asset. As long as the assets are used, the same adjusting entries are made until the cost
less expected sales value is fully assigned to expense. Thus, in successive balance sheets the
Accumulated Depreciation – Office Equipment account increases K200 each month and the
accumulated Depreciation - building account increases K500 each month. The original cost
of the two assets remains in the Office Equipment and building accounts and does not
change.

3.13 Pre - collected or unearned revenue

An entity may receive cash in advance for services that are to be performed in the future.
Until the service is performed, a liability equal to the advance amount payment is reported in
the balance sheet to reflect the obligation of the entity to perform future services. That is,

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recognition of the income (revenue) is postponed until the services are performed, at which
time entities obligations are reduced.

To illustrate, recall that Intellectual Management Services issued a tax invoice and received
K560 in advance payment plus VAT of K56 on 29 June for a valuation appraisal to be
completed on2 July. The following entry was made to record the receipt of cash.

Jun-29 Cash at Bank 100 616

Unearned Appraisal Fees 220 560
VAT Collections 250 56
(Cash reveived for appraisal to be performed in July)

Adjusting entries for pre-collected for unearned revenues.

Precollected or unearned revenues ( revenues received before they are earned
LIABILITY ACCOUNT INCOME ACCOUNT
Uearned Revenue Revenue
Adjusting entry Cash receipt Adjusting entry
Debit Credit

Revenue earned during the current period

Since the appraisal will not be performed by June 30, the credit is made to unearned revenue
account (a liability) at the time the cash is received. The income revenue of K560 will be
recognized in July when the appraisal is performed for the client, thus reducing the entity‟s
liabilities. Once the appraisal is completed on 2 July, an entry is made either at the time the
obligation is reduced or at the end of the period as an adjusting entry when the account s are
reviewed to transfer the appropriate portion of the advance payment to revenue as follow:

Jul-02 Unearned Appraisal Fees 220 560

Appraisal Fees Revenue 401 560
(Apraisal fees earned in July)

Now that the revenue is recognized in July, when obligation is reduced, rather in June when
the cash was received. The receipt of cash for services to be performed in the future may have
been recorded originally in a revenue account rather than a liability account. If so an
adjusting entry is needed at the end of the period to reduce the balance in the revenue account
and to record a liability for the remaining portion representing services yet to be performed.

3.14 Adjusting entries for Accruals – Accrued or Unrecorded Expenses

During the period, most expenses are recorded when they are paid. At the end of the
accounting period there usually some expenses that has been consumed but has not been
recorded because payment has not been made. An adjusting entry is needed to recognize the
expense in the period in which it is consumed rather than in the period of payment. Another
offsetting credit is made to a liability account to record the entity‟s obligation to pay for the
goods or services that have been received. These items are called accrued expenses or
accrued liabilities.

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Adjusting entries for accrued and unrecorded expenses
Accrued expenses (expenses incurred but not yet paid)
LIABILITY ACCOUNT
Expense Payable EXPENSE ACCOUNT
Adjusting entry Adjusting entry
Credit Debit

Expense incurred

Accrued salaries (liability)

Intellectual Management Services follows the practice of paying employees every 2 weeks.
On Friday, 22 June, the employees were paid K7, 600 for the preceding two weeks of service.
Below is a diagram of the salaries earned between this payment and 30 June is presented as
shown, Figure 3.4

Date employees Pay day End of accounting Pay day

started work Period

June July Figure 3.4

F S S M T W T F S S M T W T F
22 23 24 25 26 27 28 29 30 1 2 3 4 5 6

Salary expense and payments Accrued salary expense K3,980 Salary Expense K3,420

Payment K7, 400

Note: The total salaries vary in each pay period because some employees work part time

There was on particular encountered on 22 June when salaries were paid for the period of 8
June to 22 June because both the payment and the expense occurred in the same period. The
following entry was made to record that payment both the payment and expense occurred in
the same period. Note that items like salaries and wages are exempted from VAT:

Jun-22 Salaries Expense 500 7 ,600

Cash at Bank 100 7, 600
(Salaries paid to employees)
[Deductions from the employees salaries are
ignored for now]

Because the end of the period, 30 June, occurred before the next salary payment date, 6 July,
an adjusting entry is required to provide a correct determination of expenses consumed in
June to provide a record of liabilities at the end of June. Even though the employees are not
paid until 6 July, a portion of K7, 400 payment (some employees work part time and the

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office is open 7 days a week) is for employees services that were received in June. The entry
to accrue the unpaid salaries up to 30 June is:

Jun-30 Salaries Expense 500 3, 980

Salaries Payable 210 3, 980
( Adjusting entries to record salaries payable from
23 Juneto 30 June)

The accounts after the adjusting entry are posted is as follows:

And

Salaries Payable 210 Salaries Expense 500

30-Jun Salary Expense 22-Jun Cash at Bank 7, 600
3, 980 30-Jun Salaries Payable 3, 980

The adjusting entry records an expense (K3, 980) for the services received in June and
reported in the June income statement along with salaries previously paid (K7, 600). The
Credit (K3, 980) in the salaries payable account reflects the amount owed to the employees
for services performed during the period 23 June to 30 June and is reported as a liability in
the balance sheet. Failure to make the 30 June adjusting entry results in an understatement of
expense and an overstatement of profit for June, and in the balance sheet, liabilities would be
understated and equity would be over stated

The liability of K3, 980, is eliminated on 6 July, when the payment of K7, 400 is made to the
employees. The K3, 420 earned by the employees in July is recorded as an expense as shown
in the entry below:

Jul-06 Salaries Payable 210 3, 980

Salaries expense 500 3, 420
Cash at Bank 100 7, 400
(Payment for salaries earned from 23 June to 6 July )

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Figure 3.5, Intellectual Management Services Trial Balance for June 2013

INTELLECTUAL MANAGEMENT SERVICES

Adjusted Trial Balance
as at 30 June 2013
Account Account balance
Account No. Debit (K) Credit (K)
Cash at bank 100 135,770
Accounts receivable 104 12,680
Prepaid insurance 110 1,840
Office supplies 111 1,080 Figure 3.5
VAT outlays 120 32,276
Land 150 120,000
Building 160 180,000
Accumulated depreciation - building 161 500
Office Equipment 170 19,200
Accumulated depreciation - Office equipment 171 200
Accounts payable 200 9,200
Salaries payable 210 3,980
Interest payable 215 1,600
Electricity account payable 216 420
Unearned appraisal fees 220 560
VAT collections 250 2,026
Mortgage payable 26 240,000
M.Mooney, Capital 300 240,000
M.Mooney, Drawings 310 1,200
Management services revenue 400 19,200
Appraisal fees revenue 401 500
Marketing services revenues 402 800
Salaries expense 500 11,580
Telephone expense 510 160
Advertising expense 520 240
Insurance expense 521 80
Office supplies expense 530 160
Depreciation expense- building 540 200
Depreciation expense- office equipment 541 500
Interest expense 560 1,600
Electricity expense 570 420

K518, 986 K518, 986

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3.15 Preparation of Financial Statements
After the adjusting process is completed, the adjusted trial balance may be used to prepare
financial statements. We will learn to prepare financial statements; Income statement, balance
sheet and Cash flow statement.

Income statement

Will prepare an income statement of Intellectual Management Services from the adjust trial
balance, figure 3.6, page 97. Note that the heading shows the name of the entity, the type of
financial statement, and the length of time to generate the reported profit or loss.

Intellectual Management Services

Figure 3.6
Income Statement
for the month ended 30 June 2013

INCOME K K
Revenues:
Management service fees 19,200
Appraisal fees 500
Markting services fees 800
K20, 500
EXPENSES
Salaries expense 11, 580
Telephone expense 160
Advertising expense 240
Insurance expense 80
Office supplies expense 160
Depreciation expense - Building 500
Depreciation expense - Office Equipment 200
Interest expense 1, 600
Electricity expense 420 K14, 940
K5, 560

The income statement is normally prepared before the statement changes in equity and the
balance sheet because the profit or loss is needed to complete the equity section. For
example, in this illustration a profit K5, 560is derived. This means the sum of the credit
balances in the income accounts (20, 500 exceed the sum of debit balances in the expense
accounts (K14, 940) by K5, 560. The profit must be added to equity to equalize the total
liabilities and equity with the total assets. That real means that there was an increase in net
assets from earning a profit. This increase in net (asset) minus liabilities)belongs to the owner
and should be added to the capital account in the balance sheet. Details of changes in equity
are shown in the statement of changes in equity.

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Statement of change in equity

Figure 3…… presents the income statement of Intellectual Management Services, showing a
profit of K5, 560. The statement of changes in equity shows this profit is added to the equity
of the owner and any withdrawals of profits made by the owner to shoe the balance of equity
at the end of the period. The equity balance of K244, 360; must then equal the net (assets)
minus liabilities as reported in the balance sheet, figure 3.7.

Intellectual Management Services

Statement of change in Equity Figure 3.7

for the month ended June 30 2013

M. Mooney, Beginning Capital K240, 000

Add: Profits for the month of June 5, 560
Less: Drawings (1, 200)
M. Mooney, Ending Capital K244, 360

The Balance Sheet

The accounts shown in a balance sheet are in three major categories: assets, liabilities
and owner’s equity. When a number of accounts are reported, statement users find the
information useful if the information is further classified into several important
categories:

Assets Liabilities

Current assets Current liabilities

Non-Current Assets: Non-Current liabilities

These categories facilitate the evaluation of financial data and are arranged in the statement
so that important relationships between two subcategories are shown. For example, the
liquidity of a business entity, its ability to satisfy short term obligations as they fall due is of
primary concern to most statement readers and users. To help readers evaluate an entity‟s
liquidity assets, and liabilities are classified as current (short term) and non-current (long
term). The access of current assets over current liabilities is called working capital. The use
of these categories to analysis an entity‟s liquidity and to make relevant economic decisions
will be discussed later in the chapter. Figure 3.8 is Intellectual Management Services balance
sheet shown narrative account format.

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 Intellectual Management Services
Balance sheet Figure 3.8
as at 30 June 2013
ASSETS K K K
Current assets:
Cash at bank 135,770
Accounts receivable 12,680
Prpepaid insurance 960
Office supplies 1,080
VAT Receivable 30,250 180,740

Non Current assets:

Land 120, 000
Building 180,000
Less: Accumulated Depreciation 500 179,500
Office equipment 19,200
Less accumulated depreciation 200 19,000
Prepaid insurance 800 319,380
TOTAL ASSETS 500,120

LIABILITIES
Current liabilities
Accounts payable 9,200
Salaries payable 3,980
Interest payable 1,600
Electricity account payable 420
Unearned appraisal fees 500 27,760
Current portion of mortgage payable 12,000

Non current liabilities

Mortgage payable 228,000
Total Liabilities 255,760
NET ASSETS 244,360

EQUITY
M,Mooney, Capital 244,360
TOTAL EQUITY K244,360

We will study statement of cash flows in another chapter later in the course.

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3.17 Preparing Financial Statements from a worksheet

Figure 3.9

Figure 3.9 above, shows adjusting entries have been made directly in the journal and then
post to the ledger, after which an unadjusted trail balance and financial statement are
prepared from the adjusted accounts. In real practice, formal recording of adjusting entries
does not occur accept on the last day of the accounting period or the end of the financial year.
The worksheet is usually used whenever interim financial reports are required by
management. The worksheet may still be used at the end of the year. The worksheet has a
number of important functions:

 It assembles in one place all the information needed to adjust the accounts and prepare
the financial statements.
 It aids in the preparation of interim financial statements for internal use when the
adjusting and closing entries are not required in the formal accounting records.

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  It contains the information needed to close off the income and expenses accounts
(temporary accounts), at the end of the period. Note closing entries is covered in the
next module.

The worksheet does not replace the financial statements, it is simply a tool to gather and
organize information these steps of the account cycle. It is a convenient way of preparing
interim financial statements for management and owners when adjusting and closing entries
are made.

Preparation of the worksheet

The basic format of a work sheet is show below, figure 3.10. The heading contains the name
of entity, the title of the document, that is a „worksheet’ and the period it covers. The first
column is used for the account titles. This column is followed by five sets of money columns
for (1) the unadjusted trial balance, (2) adjusting entries, (3 the adjusted trial balance, (4) the
income statement, and (5) the balance sheet.. Each set consists of a debit and a credit
column, making a total of ten columns for entering Kina amounts. The steps for in preparing
a worksheet are illustrated and described by using the information for Intellectual
Management Services.

Step (1) Enter the ledger account titles and balances in the account title and unadjusted trial
balance column. After all the transactions that occurred during the period re posted, a trial
balance is prepared from the general ledger to verify the equality of debit and credit account
balances, because it is taken before any adjusting entries is have been posted to the ledger.

Step (2) Enter the necessary adjusting entries in the adjustments columns. The adjusting
entries are entered in the worksheet in the adjustments columns. After the worksheet is
completed the adjusting entries are recorded in the journal if financial statements are to be
prepaid for the period. To aid in journalizing the entries and locating errors, each adjusting
entry is identified by a separate letter so that the debit part of the entry can be crossed
referenced to credit part of the entry.
Adjusting entries were required for the following items:

Entry
a) Prepaid insurance expired, K80
b) Office supplies used, K160
c) Depreciation on Building, K500
d) Depreciation Office equipment, K400
e) Salaries earned but not yet paid, K3, 980
f) accrued interest on mortgage paid, K1, 600

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 Figure 3.10

Entry
(g) Electricity use but not paid for, K420
(h) Revenue not received from marketing service, K800.

When entering the adjustments, if an account already has a balance in adjusted trial balance
columns, the adjusted amount is entered on the same line. The account titles required by
adjusting entries that were not listed in the unadjusted trial balance columns are added on
lines immediately below the trial balance account titles.

For example, in adjusting entry (a) the insurance expense account is debited and the prepaid
insurance is credited for K80. To enter the debit amount of this entry, it is necessary to add an
insurance Expense account on the line below the trial balance because the account had a zero
balance before the adjusting entry and consequently was not included in the unadjusted trial
balance. The K80 credit is entered in the adjustments credit column on the same lone as the
Prepaid Insurance account balance of K1, 920. Thus, in this entry it is to only necessary to
add only one new account. However, in adjusting entry (f) (interest on mortgage, observe
both accounts affected by the entry must be entered below the unadjusted trial balance. The
appropriate account titles were selected from the chart of accounts. After all the entries are

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entered, the two adjusting entries are totaled to prove that the total debit is equal to the total
credit adjustments.

Step (3) Prepare an adjusted trial balance

In this step, each account in the unadjusted trial balance is combined with the cross ponding
adjustments, if any, in the adjustments column as shown in figure 3….. . The combined
amounts entered in this two column will be the same as ledger account balances after the
adjusting entries are recorded in the journal and posted to the ledger. Combining the amount
entered on each line, that is adding or subtracting across the worksheet horizontally is called
cross adding. The cross adding must be done very carefully because it is easy to make an
error.

For those accounts unaffected by the adjustments, such as Cash at Bank account, Accounts
Payable and Management Services Revenue, the balance is simply extended directly to the
appropriate debit and credit column in the adjusted trial balance columns. If an account has
debit balance in the unadjusted trial balance column, a debit adjustment will increase the
balance, for example, Salaries Expense account, whereas a credit adjustment will decrease
the, for example, Prepaid Insurance. An account with a credit balance I increased by a credit
adjustment and decrease by a debit adjustment. In some cases, an account may not have a
balance in the unadjusted trial balance columns, but an adjustment is made to the account. In
such cases, the amount of adjustment is extended directly to the adjusted trial balance
column. Examples of those accounts are added below the unadjusted trial balance. After all
adjusted balances have been determined; the equality of debit and credits is verified by totally
the two columns.

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 Figure 3.1.1

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Step (4) Extend every account balance listed in the adjusted trial balance columns to its
proper financial statement columns

Every account balance listed in the adjusted trial balance columns is extended to either the
income statement columns or the balance sheet columns as shown below, figure 3.1.2.

INTELLECTUAL MANAGEMENT SERVICES

Worksheet
for the month ended 30 June 2016 Figure 3.1.2

Unadjusted Adjusted Income Balancet

trial balance Adjustments trial balance Statement sheet
Accounts Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit
Cash at bank 135,770 135,770 135,770
Accounts receivable 11,880 (h) 800 12,680 12,680
Prepaid Insurance 1,920 (a) 80 1, 840 1, 840
Office Supplies 1,240 (b) 160 1,080 1,080
VAT/GST Outlays 32,276 32,276 32,276
Land 120, 000 120, 000 120, 000
Building 180,000 180, 000 180, 000
Accumulated Depreciation ( d) 500 500 500
Office equipment 19,200 19, 200 19, 200
Accumulated Depreciation (c ) 200 200 200
Accounts Payable 9,200 9,200 9,200
Unearned appraisal fees 560 560 560
VAT/GST collections 2,026 2,026 2,026
Mortgage payable 240,000 240,000 240,000
M. Mooney, Capital 240,000 240,000 240,000
M, Mooney, Drawings 1,200 1,200 1,200
Management services revenue 19,200 19,200 19,200
Appraisal fees revenue 500 500 500
Salary expense 7,600 (e ) 3, 980 11, 580 11, 580
Telephone expense 160 160 160
Advertising expense 240 240 240
K511, 486 K511, 486
Insurance Expense (a) 80 80 80
Office Supplies Expense (b) 160 160 160
Depreciation - Building ( c) 500 500 500
Depreciation - Office Equipment (d) 200 200 200
Electricity Expense ( g) 420 420 420
Salaries Payable ( e) 3, 980 3, 980 3, 980
Interest Expense (f) 1, 600 1, 600 1, 600
Interest Payable (f) 1, 600 1, 600 1, 600
Electricity Account Payable (d) 420 420 420
Marketing Services Revenue (h) 800 800 800
7,740 7, 740 518, 986 518, 986 14,940 20, 500
Profit for the period 5, 560 498, 486
20, 500 20,500 5, 560
20, 500 20, 500 504, 046 540, 046

Income (revenue) accounts are extended to the income statement credit column and expense
accounts are extended to the income statement debit column. Assets, liabilities sand equity
accounts are extended to the proper balance debit or credit column. In other words accounts
are sorted on their basis of their financial statement classification in this part of the process.
As for VAT Outlays, it is shown on the debit column and VAT Collects is shown on the
credit side of the column. Note that drawings, is extended to the debited column of the
balance sheet, i.e.it decreases equity. Accumulated depreciation is extended to the credit
column of the balance is that it decreases the asset accounts.

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Step (5)
Total the two income statement columns and the two balance sheet columns. Calculate the
difference between the total of the two income statement columns and enter this as the
balancing amount in both the income and the balance sheet columns. Calculate the four
column totals again with the balancing amount included. After all the amounts have been
extended to ether the income statement or he balance sheet columns, the four columns are
tolled and their amounts entered at the bottom of each column. The profit or loss of the period
is determined by taking the difference between the totals of the two income statement
columns as shown in figure 3….. .

The calculation in our illustration is:

Total of the credit column K20, 500

Total of the debit column 14, 940
Difference = Profit K 5, 560

In this illustration, the income (revenues) K20, 500 exceeded the expense K14, 940, resulting
in a profit of K5, 560. The amount is entered in the income debit column to balance the two
columns and is also entered on the same line in the balance sheet credit column because profit
for the period is an increase in equity. Extending the profit of K5, 560 to the balance sheet
credit column updates the equity in the business to the end of the period. On the same line the
account title column, a caption “profit” for the period is entered to identify the nature of the
item being entered in the two set of columns.

The four columns are totaled again with the profit of K5, 560 included. If the debit and credit
columns under the balance sheet heading are not equal, there is an error in the extending
amounts from the adjusted trial balance column.

If the income debit column has exceeded the credit column, a loss for the period would be
indicated. In this case, the difference between the two columns would be captioned‟ loss” for
the period, and that difference entered in the income statement credit column and balance
sheet debit column.

Totaling the debit and credit columns as work proceeds across the worksheet does not ensure
that an error has not been made. That is because not all errors in the accounts are uncovered
by the trial balance. What it means is needed adjustments may have been omitted entirely or
wrong amounts may have been entered in the worksheet. An amount may have been entered
in the wrong column, for example, extending the credit balance in the unearned Appraisals
Fees account (liability) to the income statement credit column. This will not destroy the
equality of debits and credits, but it will result in an overstatement in revenue, and
understatement in liabilities, and an overstatement in equity.
Note, financial statements (income statement, balance sheet and statement of equity) can be
prepared from the information in the worksheet – of which the account balances have all been
sorted out into their respective categories.

End of Chapter 4 – Module - 3

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