Download Chapter 3 - Bellevue College

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Adjusting the
Accounts
Accounting 201, Instructor: Judith Paquette
Financial Accounting, Seventh Edition
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Study Objectives
1.
Explain the time period assumption.
2. Explain the accrual basis of accounting.
3. Explain the reasons for adjusting entries.
4. Identify the major types of adjusting entries.
5. Prepare adjusting entries for deferrals.
6. Prepare adjusting entries for accruals.
7. Describe the nature and purpose of an adjusted
trial balance.
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Adjusting the Accounts
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The Adjusted Trial
Balance and
Financial Statements
Timing Issues
The Basics of
Adjusting Entries
Fiscal and calendar
years
Types of adjusting
entries
Preparing the
adjusted trial balance
Accrual- vs. cashbasis accounting
Adjusting entries for
deferrals
Preparing financial
statements
Recognizing
revenues and
expenses
Adjusting entries for
accruals
Summary of
journalizing and
posting
Timing Issues
Accountants divide the economic life of a business
into artificial time periods (Time Period Assumption).
.....
Jan.
Feb.
Mar.
Apr.
Dec.
Generally a month, a quarter, or a year
Fiscal year vs. calendar year
Also known as the “Periodicity Assumption”
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SO 1 Explain the time period assumption.
Timing Issues
Review
The time period assumption states that:
a. revenue should be recognized in the accounting
period in which it is earned.
b. expenses should be matched with revenues.
c.
the economic life of a business can be divided
into artificial time periods.
d. the fiscal year should correspond with the
calendar year.
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Solution on
notes page
SO 1 Explain the time period assumption.
Timing Issues
Accrual- vs. Cash-Basis Accounting
Accrual-Basis Accounting
Transactions recorded in the periods in which the
events occur.
Revenues are recognized when earned, rather than
when cash is received.
Expenses are recognized when incurred, rather
than when paid.
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SO 2 Explain the accrual basis of accounting.
Timing Issues
Accrual- vs. Cash-Basis Accounting
Cash-Basis Accounting
Revenues are recognized when cash is received.
Expenses are recognized when cash is paid.
Cash-basis accounting is not in accordance with
generally accepted accounting principles (GAAP).
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SO 2 Explain the accrual basis of accounting.
Timing Issues
Recognizing Revenues and Expenses
Revenue Recognition Principle
Companies recognize
revenue in the accounting
period in which it is earned.
In a service enterprise,
revenue is considered to be
earned at the time the
service is performed.
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SO 2 Explain the accrual basis of accounting.
Timing Issues
Recognizing Revenues and Expenses
Expense Recognition Principle – (Matching Principle)
Match expenses with
revenues in the period when
the company makes efforts
to generate those revenues.
“Let the expenses follow
the revenues.”
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SO 2 Explain the accrual basis of accounting.
Timing Issues
GAAP relationships in
revenue and expense
recognition
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Illustration 3-1
SO 2 Explain the accrual basis of accounting.
Here’s an example of Accrual vs.
Cash Accounting
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A man, Jaewan, starts a company. The company
paints buildings, called Sky High Painting
Jaewan invests $60,000 of his own money in Sky
High Painting Painting.
The company is started on December 1, 2010.
He gets the job to paint a BIG Building in
downtown Bellevue.
He hires employees and buys paint.
They paint the building.
He pays all his expenses of $50,000 in cash.
He bills the customer for $80,000 and goes home
on December 31st, 2010.
He gets hit by a car on the way home and dies.
Illustration 4-2
Year 1
Year 2
Activity
Purchased paint, painted building ,
paid employees
Accrual
basis
Cash
basis
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Received payment for work
done in year one
Revenue
$80,000
Revenue
Expense
50,000
Expense
$
0
0
Net Income
$30,000
Net Income
$
Revenue
$
0
Revenue
$80,000
Expense
50,000
Expense
0
Net Loss
( $50,000)
Net Income
0
$80,000
The Basics of Adjusting Entries
Adjusting entries make it possible to report
correct amounts on the balance sheet and on
the income statement.
A company must make adjusting entries every
time it prepares financial statements.
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SO 3 Explain the reasons for adjusting entries.
Here’s an example of why we need
adjusting entries…
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A company buys supplies for $900 on
October 3rd.
JE? T Account?
On October 31st a physical inventory shows
that there are only $250 supplies on hand.
How do we adjust the Supplies Account?
The Basics of Adjusting Entries
Revenues - recorded in the period in which they
are earned.
Expenses - recognized in the period in which they
are incurred.
Adjusting entries - needed to ensure that the
revenue recognition and matching principles are
followed.
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SO 3 Explain the reasons for adjusting entries.
Types of Adjusting Entries
Types of Adjusting Entries
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Illustration 3-2
Categories of adjusting entries
Deferrals
Accruals
1. Prepaid Expenses.
Expenses paid in cash and
recorded as assets before
they are used or consumed.
3. Accrued Revenues.
Revenues earned but not
yet received in cash or
recorded.
2. Unearned Revenues.
Revenues received in cash
and recorded as liabilities
before they are earned.
4. Accrued Expenses.
Expenses incurred but not
yet paid in cash or
recorded.
SO 4 Identify the major types of adjusting entries.
Types of Adjusting Entries
Illustration 3-3
Trial Balance –
Illustrations
are based on
the October 31,
trial balance of
Pioneer
Advertising
Agency Inc.
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SO 4 Identify the major types of adjusting entries.
Types of Adjusting Entries
Adjusting Entries for Deferrals
Deferrals are either:
Prepaid expenses
OR
Unearned revenues.
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SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
Payment of cash that is recorded as an asset because
service or benefit will be received in the future.
Cash Payment
BEFORE
Expense Recorded
Prepayments often occur in regard to:
insurance
supplies
advertising
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rent
maintenance on equipment
fixed assets (depreciation)
SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
Prepaid Expenses
Costs that expire either with the passage of time
or through use.
Adjusting entries (1) to record the expenses that
apply to the current accounting period, and (2) to
show the unexpired costs in the asset accounts.
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SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
Adjusting entries for prepaid expenses
Illustration 3-4
Increases (debits) an expense account and
Decreases (credits) an asset account.
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SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
#1 Illustration: Pioneer Advertising Agency purchased
advertising supplies costing $2,500 on October 5. Pioneer
recorded the payment by increasing (debiting) the asset
Advertising Supplies. This account shows a balance of $2,500 in
the October 31 trial balance. An inventory count at the close of
business on October 31 reveals that $1,000 of supplies are still on
hand.
Oct. 31
Advertising supplies expense
1,500
Advertising supplies
1,500
Illustration 3-5
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SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
#2 Illustration: On October 4, Pioneer Advertising Agency paid
$600 for a one-year fire insurance policy. Coverage began on
October 1. Pioneer recorded the payment by increasing (debiting)
Prepaid Insurance. This account shows a balance of $600 in the
October 31 trial balance. Insurance of $50 ($600 / 12) expires
each month.
Oct. 31
Insurance expense
Prepaid insurance
50
50
Illustration 3-6
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SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
Depreciation
Buildings, equipment, and vehicles (long-lived assets)
are recorded as assets, rather than an expense, in
the year acquired.
Companies report a portion of the cost of a longlived asset as an expense (depreciation) during each
period of the asset’s useful life (Matching Principle).
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SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
#3 Illustration: Pioneer Advertising estimates depreciation on
the office equipment to be $480 a year, or $40 per month.
Oct. 31
Depreciation expense
Accumulated depreciation
40
40
Illustration 3-7
1
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SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
Depreciation (Statement Presentation)
Accumulated Depreciation is a contra asset account.
Appears just after the account it offsets
(Equipment) on the balance sheet.
Illustration 3-8
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SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
Summary
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Illustration 3-9
SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Unearned Revenues”
Receipt of cash that is recorded as a liability because
the revenue has not been earned.
Cash Receipt
BEFORE
Revenue Recorded
Unearned revenues often occur in regard to:
rent
airline tickets
school tuition
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magazine subscriptions
customer deposits
SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Unearned Revenues”
Unearned Revenues
Company makes an adjusting entry to record the
revenue that has been earned and to show the liability
that remains.
The adjusting entry for unearned revenues results in a
decrease (a debit) to a liability account and an increase
(a credit) to a revenue account.
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SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Unearned Revenues”
Adjusting entries for unearned revenues
Illustration 3-10
Decrease (a debit) to a liability account and
Increase (a credit) to a revenue account.
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SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Unearned Revenues”
#4 Illustration: Pioneer Advertising Agency received $1,200 on
October 2 from R. Knox for advertising services expected to be
completed by December 31. Unearned Service Revenue shows a
balance of $1,200 in the October 31 trial balance. Analysis reveals
that the company earned $400 of those fees in October.
Oct. 31
Unearned service revenue
Service revenue
400
400
Illustration 3-11
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SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Unearned Revenues”
Summary
Illustration 3-12
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SO 5 Prepare adjusting entries for deferrals.
Types of Adjusting Entries
Adjusting Entries for Accruals
Made to record:
Revenues earned and
OR
Expenses incurred
in the current accounting period that have not been
recognized through daily entries.
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SO 6 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Revenues”
Revenues earned but not yet received in cash or
recorded.
Adjusting entry results in:
Revenue Recorded
BEFORE
Cash Receipt
Accrued revenues often occur in regard to:
rent
interest
services performed
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SO 6 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Revenues”
Accrued Revenues
An adjusting entry serves two purposes:
(1) It shows the receivable that exists, and
(2) It records the revenues earned.
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SO 6 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Revenues”
Adjusting entries for accrued revenues
Illustration 3-13
Increases (debits) an asset account and
Increases (credits) a revenue account.
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SO 6 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Revenues”
#5 Illustration: In October Pioneer Advertising Agency
earned $200 for advertising services that had not been
recorded.
Oct. 31
Accounts Receivable
Service Revenue
200
200
Illustration 3-14
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SO 6 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Revenues”
Summary
Illustration 3-15
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SO 6 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Expenses”
Expenses incurred but not yet paid in cash or
recorded.
Adjusting entry results in:
Expense Recorded
BEFORE
Cash Payment
Accrued expenses often occur in regard to:
rent
interest
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taxes
salaries
SO 6 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Expenses”
Accrued Expenses
An adjusting entry serves two purposes:
(1) It records the obligations, and
(2) It recognizes the expenses.
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SO 6 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Expenses”
Adjusting entries for accrued expenses
Illustration 3-16
Increases (debits) an expense account and
Increases (credits) a liability account.
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SO 6 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Expenses”
#6 Illustration: Pioneer Advertising Agency signed a threemonth note payable in the amount of $5,000 on October 1. The
note requires Pioneer to pay interest at an annual rate of 12%.
Illustration 3-17
Oct. 31
Interest expense
Interest payable
50
50
Illustration 3-18
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SO 6 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Expenses”
#7 Illustration: Pioneer Advertising Agency last paid salaries on
October 26; the next payment of salaries will not occur until
November 9. The employees receive total salaries of $2,000 for a
five-day work week, or $400 per day. Thus, accrued salaries at
October 31 are $1,200 ($400 x 3 days).
Illustration 3-19
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SO 6 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Expenses”
#7 (con’t) Illustration: Pioneer Advertising Agency last paid
salaries on October 26; the next payment of salaries will not
occur until November 9. The employees receive total salaries of
$2,000 for a five-day work week, or $400 per day. Thus, accrued
salaries at October 31 are $1,200 ($400 x 3 days).
Oct. 31
Salaries expense
1,200
Salaries payable
1,200
Illustration 3-20
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SO 6 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Expenses”
Summary
Illustration 3-21
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SO 6 Prepare adjusting entries for accruals.
The Adjusted Trial Balance
After all adjusting entries are journalized and posted the
company prepares another trial balance from the ledger
accounts (Adjusted Trial Balance).
Its purpose is to prove the equality of debit balances and
credit balances in the ledger.
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SO 7 Describe the nature and purpose of an adjusted trial balance.
The Adjusted Trial Balance
Illustration 3-24
Adjusted trial balance
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SO 7
Preparing Financial Statements
Financial Statements are prepared directly from the
Adjusted Trial Balance.
Balance
Sheet
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Income
Statement
Retained
Earnings
Statement
SO 7 Describe the nature and purpose of an adjusted trial balance.
Preparing Financial Statements
Illustration 3-25
Preparation of
the income
statement and
retained earnings
statement from
the adjusted trial
balance
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SO 7
Preparing Financial Statements
Illustration 3-26
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SO 7
End of Chapter 3
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Is Your Old Computer a Liability?
 California adds $6 to $10 of sales tax to the cost of computers
and televisions to fund recycling programs.
 Each cathode ray tube (CRT) monitor contains 4–6 pounds of lead.
Consumer electronic products account for about 40% of the lead
found in landfills.
 Environmental groups put a resolution on a recent Apple
Computer’s shareholder meeting agenda requiring the company to
study how it can increase recycling.
 The average household has two to three old computers in its
garage or storage area.
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Should companies accrue for environmental cleanup costs as
liabilities on their financial statements?
YES: As more states impose laws holding companies responsible,
and as more courts levy pollution-related fines, it becomes
increasingly likely that companies will have to pay large amounts
in the future.
NO: The amounts still are too difficult to estimate. Putting
inaccurate estimates on the financial statements reduces their
usefulness. Instead, why not charge the costs later, when the
actual environmental cleanup or disposal occurs, at which time the
company knows the actual cost?
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Alternative Treatment of Prepaid Expenses
and Unearned Revenues
APPENDIX
Some companies use an alternative treatment for
prepaid expenses and unearned revenues.
When a company prepays an expense, it debits that
amount to an expense account.
When a company receives payment for future
services, it credits the amount to a revenue account.
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SO 8 Prepare adjusting entries for the alternative treatment of deferrals.
Alternative Treatment for “Prepaid Expenses”
Illustration: Pioneer Advertising purchased supplies on
October 5 for $2,500 and debited Advertising
Supplies Expense for the full amount. What if an inventory
of $1,000 of advertising supplies remains on October 31?
Oct. 31
Advertising supplies
1,000
Advertising supplies expense
1,000
Illustration 3A-1
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SO 8 Prepare adjusting entries for the alternative treatment of deferrals.
Alternative Treatment for “Prepaid Expenses”
Adjustment approaches—a comparison
Illustration 3A-2
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SO 8 Prepare adjusting entries for the alternative treatment of deferrals.
Alternative Treatment for “Unearned Revenues”
Illustration: Assume that Pioneer Advertising received
$1,200 for future services on October 2 and credited the
entire amount to Service Revenue. If at the statement
date Pioneer has not performed $800 of the services, it
would make an adjusting entry.
Oct. 31
Service revenue
Unearned service revenue
800
800
Illustration 3A-4
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SO 8 Prepare adjusting entries for the alternative treatment of deferrals.
Alternative Treatment for “Unearned Revenues”
Adjustment approaches—a comparison
Illustration 3A-5
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SO 8 Prepare adjusting entries for the alternative treatment of deferrals.
Summary of Additional Adjustment Relationships
Illustration 3A-7
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SO 8 Prepare adjusting entries for the alternative treatment of deferrals.
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SO 2
Timing Issues
Match the description of the concept to the
concept.
g
f
c
b
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Solution on
notes page
SO 2 Explain the accrual basis of accounting.
Timing Issues
Review
One of the following statements about the accrual basis of
accounting is false. That statement is:
a. Events that change a company’s financial statements are
recorded in the periods in which the events occur.
b. Revenue is recognized in the period in which it is earned.
c. The accrual basis of accounting is in accord with
generally accepted accounting principles.
d. Revenue is recorded only when cash is received, and
expenses are recorded only when cash is paid.
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Solution on
notes page
SO 2 Explain the accrual basis of accounting.
The Basics of Adjusting Entries
Review
Adjusting entries are made to ensure that:
a. expenses are recognized in the period in which
they are incurred.
b. revenues are recorded in the period in which
they are earned.
c. balance sheet and income statement accounts
have correct balances at the end of an
accounting period.
d. all of the above.
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SO 3 Explain the reasons for adjusting entries.
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SO 5
The Adjusted Trial Balance
Review Question
Which of the following statements is incorrect concerning
the adjusted trial balance?
a. An adjusted trial balance proves the equality of the
total debit balances and the total credit balances in
the ledger after all adjustments are made.
b. The adjusted trial balance provides the primary basis
for the preparation of financial statements.
c. The adjusted trial balance lists the account balances
segregated by assets and liabilities.
d. The adjusted trial balance is prepared after the
adjusting entries have been journalized and posted.
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SO 7 Describe the nature and purpose of an adjusted trial balance.