Adjusting the Accounts

STUDY OBJECTIVES

After studying this chapter, you should understand:

Time period assumption Adjusting entries for prepayments

Accrual basis of accounting Adjusting entries for accruals

Why adjusting entries are necessary

Purpose of an adjusted

trial balance

Major types of adjusting entries

ADJUSTING THE ACCOUNTSADJUSTING THE ACCOUNTS

• The time period assumption assumes that the economic life of a business can be divided into artificial time periods.

• Accounting time periods are generally a month, a quarter, or a year (fiscal year)

STUDY OBJECTIVE 1

TIME PERIOD ASSUMPTION

STUDY OBJECTIVE 1

TIME PERIOD ASSUMPTION

STUDY OBJECTIVE 2

ACCRUAL vs. CASH-BASIS ACCOUNTING

STUDY OBJECTIVE 2

ACCRUAL vs. CASH-BASIS ACCOUNTING

Accrual BasisRevenue recognized when earned

Expenses are matched against revenuesRequired by GAAP

Accrual BasisRevenue recognized when earned

Expenses are matched against revenuesRequired by GAAP

Cash-Basis Revenues and expenses

recorded when cash is paid or received Not GAAP

Cash-Basis Revenues and expenses

recorded when cash is paid or received Not GAAP

• The revenue recognition principle dictates that revenue be recognized in the accounting period in which it is earned.

• In a service business, revenue is considered to be earned when the service is performed.

REVENUE RECOGNITION PRINCIPLEREVENUE RECOGNITION PRINCIPLE

• The practice of expense recognition is referred to as the matching principle.

• The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues).

Revenues earned

this monthare offset against....

expensesincurred inearning the

revenue

MATCHING PRINCIPLEMATCHING PRINCIPLE

Time-Period Assumption

Economic life of businesscan be divided into

artificial time periods

Revenue-Recognition Principle

Revenue recognized in the accounting period in

which it is earned

Matching Principle

Expenses matched with revenuesin the same period when efforts

are expended to generate revenues

GAAP RELATIONSHIPS IN

REVENUE & EXPENSE RECOGNITION

GAAP RELATIONSHIPS IN

REVENUE & EXPENSE RECOGNITION

Adjusting entries are needed to ensure that revenue recognition and matching principles are followed

1 Revenues are recorded in the period earned, and...... 2 Expenses are recognized in the period incurred.

STUDY OBJECTIVE 3

WHY ADJUSTING ENTRIES ARE NECESSARY

STUDY OBJECTIVE 3

WHY ADJUSTING ENTRIES ARE NECESSARY

STUDY OBJECTIVE 4

TYPES OF ADJUSTING ENTRIES

STUDY OBJECTIVE 4

TYPES OF ADJUSTING ENTRIES

Adjusting entries are required each time financial statements are prepared.

Two main categories of adjustments are: Adjusting entries are required each time financial statements are prepared.

Two main categories of adjustments are:

PREPAYMENTS ACCRUALS

ADJUSTING ENTRIES:

PREPAYMENTS

ADJUSTING ENTRIES:

PREPAYMENTS

Prepaid Expenses Expenses are paid

and recorded as assets

before they are

used or consumed

Example: Prepaid Insurance

Prepaid Expenses Expenses are paid

and recorded as assets

before they are

used or consumed

Example: Prepaid Insurance

Unearned Revenues Cash received and

recorded as liabilities

before revenue is earned

Example: Cash received for

services provided in future

Unearned Revenues Cash received and

recorded as liabilities

before revenue is earned

Example: Cash received for

services provided in future

ADJUSTING ENTRIES:

ACCRUALS

ADJUSTING ENTRIES:

ACCRUALS

Accrued RevenuesRevenues earned but

Not yet received

In cash or recorded

Example: Sales of merchandise

On account

Accrued RevenuesRevenues earned but

Not yet received

In cash or recorded

Example: Sales of merchandise

On account

Accrued Expenses Expenses incurred

but not yet paid

in cash or recorded

Example: Utilities used but not yet paid for

Accrued Expenses Expenses incurred

but not yet paid

in cash or recorded

Example: Utilities used but not yet paid for

PIONEER ADVERTISING AGENCY Trial Balance October 31, 2006 Debit Credit Cash $ 15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable $ 5,000 Accounts Payable 2,500 Unearned Revenue 1,200 Common Stock

Retained Earnings 10,000

0 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 $ 28,700 $ 28,700

The Trial Balance is the starting place

for adjusting entries.

The Trial Balance is the starting place

for adjusting entries.

TRIAL BALANCETRIAL BALANCE

Adjusting entries for prepayments are required to

record the portion of the prepayment representing:

1 the expense incurred, or

2 the revenue earned in the current period.

STUDY OBJECTIVE 5

ADJUSTING ENTRIES FOR PREPAYMENTS

STUDY OBJECTIVE 5


Adjusting Entries

Asset

Unadjusted Balance

Credit Adjusting Entry (-)

Expense

Debit Adjusting Entry (+)

Prepaid Expenses

Liability

Unadjusted Balance

Debit Adjusting Entry (-)

Revenue

Credit Adjusting Entry (+)

Unearned Revenues

ADJUSTING ENTRIES

FOR PREPAYMENTS

ADJUSTING ENTRIES

FOR PREPAYMENTS

Advertising Supplies ExpenseOct. 31 1,500

Advertising Supplies Oct. 5 2,500 Oct. 31 1,500 31 1,000

Date Account Titles and Explanation Debit Credit Oct. 31 Advertising Supplies Expense 1,500 Advertising Supplies 1,500 (To record supplies used)

JOURNAL ENTRYJOURNAL ENTRY

POSTINGPOSTING

ADJUSTMENTADJUSTMENT October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand.


SUPPLIES


SUPPLIES

Insurance Expense 63Oct. 31 50

Prepaid Insurance 10 Oct. 4 600 Oct. 31 50 31 550

Date Account Titles and Explanation Debit Credit Oct. 31 Insurance Expense 50

Prepaid Insurance 50 (To record insurance expired)


POSTINGPOSTING

ADJUSTMENTADJUSTMENT October 31, an analysis of the policy reveals that $50 of insurance expires each month.


INSURANCE


INSURANCE

REVIEW QUESTION

ADJUSTING ENTRY-SUPPLIES

REVIEW QUESTION

ADJUSTING ENTRY-SUPPLIES

The trial balance shows supplies of $1,350 and supplies expense of $0. If $750 of supplies are on hand at

the end of the period, what is the adjusting entry?

$600 Supplies

$600Supplies Expense

CreditDebit Account

The balance in supplies after adjustment is $750, the amount remaining unused.

The amount used is transferred to expense.

• Depreciation is the allocation of the cost of an asset to expense over its useful life.

• Depreciation is an estimate of expired cost.• Depreciation Expense is debited and a contra-asset account, Accumulated

Depreciation, is credited • Cost – accumulated depreciation = Book value

Depreciation ExpenseXXX

Accumulated DepreciationXXX


DEPRECIATION


DEPRECIATION

Accumulated Depreciation -Office Equipment

Oct. 31 40

Date Account Titles and Explanation Debit Credit Oct. 31 Depreciation Expense 40

Accumulated Depreciation - Office Equipment 40 (To record monthly depreciation)


POSTINGPOSTING

ADJUSTMENTADJUSTMENT October 31, depreciation on the office equipment is estimated to be $480 a year, or $40 per month.

Depreciation ExpenseOct. 31 40


DEPRECIATION


DEPRECIATION

Service RevenueOct. 31 10,000 31 400

Unearned RevenueOct. 31 400 Oct. 2 1,200

31 800


POSTINGPOSTING

ADJUSTMENTADJUSTMENTOctober 31, analysis reveals that, of $1,200 in fees received in advance of performance, $400 has been earned in October.

Date Account Titles and Explanation Debit Credit Oct. 31 Unearned Revenue 400

Service Revenue 400 (To record revenue for services provided)


UNEARNED REVENUES


UNEARNED REVENUES

• Adjusting entries for accruals are required to record revenues earned and expenses incurred in the current period.

• The adjusting entry for accruals will increase both a balance sheet and an income statement account.

STUDY OBJECTIVE 6

ADJUSTING ENTRIES FOR ACCRUALS

STUDY OBJECTIVE 6


Adjusting Entries

Asset


Accrued Revenues

Revenue


Accrued Expenses

Expense


Liability


ADJUSTING ENTRIES

FOR ACCRUALS

ADJUSTING ENTRIES

FOR ACCRUALS

Service RevenueOct. 31 10,000 31 400 31 200 31 10,600

Accounts ReceivableOct. 31 200

Date Account Titles and Explanation Debit Credit Oct. 31 Accounts Receivable 200

Service Revenue 200 (To accrue revenue for services provided)

October 31, the agency earned $200 for advertising services that were not billed to clients before October 31.


POSTINGPOSTING

ADJUSTMENTADJUSTMENT


ACCRUED REVENUE


ACCRUED REVENUE

Interest PayableOct. 31 50

Interest ExpenseOct. 31 50

Date Account Titles and Explanation Debit Credit Oct. 31 Interest Expense 50

Interest Payable 50 (To accrue interest on notes payable)


POSTINGPOSTING

ADJUSTMENTADJUSTMENT October 31, the portion of the interest to be accrued on a 3-month note payable is calculated to be $50.


ACCRUED INTEREST


ACCRUED INTEREST

Salaries PayableOct. 31 1,200

Date Account Titles and Explanation Debit Credit Oct. 31 Salaries Expense 1,200

Salaries Payable 1,200 (To record accrued salaries)


POSTINGPOSTING

ADJUSTMENTADJUSTMENT October 31, accrued salaries are calculated to be $1,200.

Salaries ExpenseOct. 26 4,000 31 1,200 31 5,200


ACCRUED SALARIES


ACCRUED SALARIES

REVIEW QUESTION

ADJUSTING ENTRY-SALARIES

REVIEW QUESTION

ADJUSTING ENTRY-SALARIES

$400 Salaries Payable

$400Salaries Expense

CreditDebit Account

This entry recognizes an expense for the salaryearned by Kathy in the last week of September, and a

liability for the amount due to Kathy at September 30th.

Kathy Siska earned a salary of $400 for the last week of September. She will be paid on October 1.

What is the required adjusting entry?

• An Adjusted Trial Balance is prepared after all adjusting entries have been journalized and posted.

• Its purpose is to prove the equality of the total debit and credit balances in the ledger after all adjustments have been made.

• Financial statements can be prepared directly from the adjusted trial balance.

STUDY OBJECTIVE 7

ADJUSTED TRIAL BALANCE

STUDY OBJECTIVE 7

ADJUSTED TRIAL BALANCE

PIONEER ADVERTISING AGENCY Adjusted Trial Balance October 31, 2006

Debit Credit Cash $ 15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Depreciation - Office Equpment $ 40 Notes Payable 5,000 Accounts Payable 2,500 Interest Payable 50 Unearned Revenue 800 Salaries Payable 1,200 Common Stock


0 Dividends 500 Service Revenue 10,600 Salaries Expense 5,200 Advertising Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 $ 30,190 $ 30,190

PREPARING THE INCOME STATEMENT FROM

THE ADJUSTED TRIAL BALANCE

PREPARING THE INCOME STATEMENT FROM

THE ADJUSTED TRIAL BALANCE

INCOMESTATEMENTACCOUNTS

INCOMESTATEMENTACCOUNTS

PIONEER ADVERTISING AGENCY Income Statement For the Month Ended October 31, 200 6 Revenues Fees earned $ 10,600 Expenses Salaries expense $ 5,200 Advertising supplies expense 1,500 Rent expense 900 Insurance expense 50 Interest expense 50 Depreciation expense 40 Total expenses 7,740 Net income $ 2,860

The income statement is prepared from the revenue and expense accounts.The income statement is prepared from the revenue and expense accounts.

INCOME STATEMENTINCOME STATEMENT

PIONEER ADVERTISING AGENCY Adjusted Trial Balance October 31, 2006

Debit Credit Cash $ 15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Depreciation - Office Equpt. $ 40 Notes Payable 5,000 Accounts Payable 2,500 Interest Payable 50 Unearned Revenue 800 Salaries Payable 1,200 C.ommon Stock


0 Dividends 500 Service Revenue 10,600 Salaries Expense 5,200 Advertising Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 $ 30,190 $ 30,190

PREPARING THE RETAINED EARNINGS STATEMENT

FROM THE ADJUSTED TRIAL BALANCE

PREPARING THE RETAINED EARNINGS STATEMENT

FROM THE ADJUSTED TRIAL BALANCE

RETAINEDEARNINGS

STATEMENTACCOUNTS

BALANCESHEET

ACCOUNTS

PIONEER ADVERTISING AGENCY Retained Earnings Statement For the Month Ended October 31, 2006 Retained earnings, October 1 $ -0- Add: Net income 2,860 2,860 2,860 Less: Dividends 500 Retained earnings, October 31 $ 2,360

The retained earnings statement is prepared from the revenue, expense, dividends, and retained earnings accounts.

The retained earnings statement is prepared from the revenue, expense, dividends, and retained earnings accounts.

RETAINED EARNINGS STATEMENTRETAINED EARNINGS STATEMENT

PIONEER ADVERTISING AGENCY Balance Sheet October 31, 2006 Assets Liabilities and Stockholders’ Equity Cash $ 15,200 Liabilities Accounts receivable 200 Notes payable $ 5,000 Advertising supplies 1,000 Accounts payable 2,500 Prepaid insurance 550 Interest payable 50 Office equipment $ 5,000 Unearned fees 800 Less: Accumulated Salaries payable 1,200 depreciation 40 4,960 Total liabilities 9,550 Stockholders’ Equity

Common Stock

10,000 Retained Earnings 2,360 Total liabilities and owner’s Total assets $ 21,910 equity $ 21,910

The balance sheet is prepared from asset and liability and stockholders equity accounts. The balance sheet is prepared from asset and liability and stockholders equity accounts.

BALANCE SHEETBALANCE SHEET

Documents

Adjusting the Accounts