Chapter 3-1. Chapter 3-2 CHAPTER 3 ADJUSTING THE ACCOUNTS Financial Accounting, Sixth Edition

Chapter 3-1

Chapter 3-2

CHAPTER CHAPTER 33

ADJUSTING THE ADJUSTING THE ACCOUNTSACCOUNTS

Financial Accounting, Sixth Edition

Chapter 3-3

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.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

Chapter 3-4

Adjusting the AccountsAdjusting the AccountsAdjusting the AccountsAdjusting the Accounts

Timing IssuesTiming IssuesTiming IssuesTiming IssuesThe Basics of The Basics of

Adjusting Adjusting

EntriesEntries

The Basics of The Basics of

Adjusting Adjusting

EntriesEntries

The Adjusted Trial The Adjusted Trial

Balance and Balance and

Financial Financial

StatementsStatements

The Adjusted Trial The Adjusted Trial

Balance and Balance and

Financial Financial

StatementsStatements

Time period Time period assumptionassumption

Fiscal and Fiscal and calendar yearscalendar years

Accrual- vs. cash-Accrual- vs. cash-basis accountingbasis accounting

Recognizing Recognizing revenues and revenues and expensesexpenses

Types of Types of adjusting entriesadjusting entries

Adjusting entries Adjusting entries for deferralsfor deferrals

Adjusting entries Adjusting entries for accrualsfor accruals

Summary of Summary of journalizing and journalizing and postingposting

Preparing the Preparing the adjusted trial adjusted trial balancebalance

Preparing Preparing financial financial statementsstatements

Chapter 3-5

Generally a month, a quarter, or a year.Fiscal year vs. calendar yearAlso known as the “Periodicity Assumption”

Timing IssuesTiming IssuesTiming IssuesTiming Issues

Accountants divide the economic life of a business into artificial time periods (Time Period Assumption).

LO 1 Explain the time period assumption.LO 1 Explain the time period assumption.

Jan. Feb. Mar. Apr. Dec.. . . . .

Chapter 3-6

The time period assumption states that:The time period assumption states that:

a.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.

ReviewReview


LO 1 Explain the time period assumption.LO 1 Explain the time period assumption.

Chapter 3-7

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.


Accrual- vs. Cash-Basis Accounting

LO 2 Explain the accrual basis of accounting.LO 2 Explain the accrual basis of accounting.

Chapter 3-8

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).


Accrual- vs. Cash-Basis Accounting


Chapter 3-9

Revenue Recognition Principle


Recognizing Revenues and Expenses


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.

Chapter 3-10

Matching Principle


Recognizing Revenues and Expenses


Match expenses with revenues in the period when the company makes efforts to generate those revenues.

“Let the expenses follow the revenues.”

Chapter 3-11



GAAP relationships in revenue and expense recognition

GAAP relationships in revenue and expense recognition

Illustration 3-1Illustration 3-1

Chapter 3-12

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 is in accord with generally accepted accounting principles.

d. Revenue is recorded only when cash is received, and expense is recorded only when cash is paid.

ReviewReview



Chapter 3-13

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.

The Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting Entries

LO 3 Explain the reasons for adjusting entries.LO 3 Explain the reasons for adjusting entries.

Chapter 3-14

RevenuesRevenues - recorded in the period in - recorded in the period in which they are earnedwhich they are earned.

Expenses Expenses - recognized in the period in - recognized in the period in which they are incurredwhich they are incurred.

Adjusting entriesAdjusting entries - needed to ensure - needed to ensure that the that the revenue recognitionrevenue recognition and and matching principlesmatching principles are followed. are followed.

The Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting Entries


Chapter 3-15

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.

ReviewReview



Chapter 3-16

Types of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting Entries

Deferrals

1. Prepaid Expenses. Expenses paid in cash and recorded as assets before they are used or consumed.

2. Unearned Revenues. Cash received and recorded as liabilities before revenue is earned.

Accruals

1. Accrued Revenues. Revenues earned but not yet received in cash or recorded.

2. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded.

LO 4 Identify the major types of adjusting entries.LO 4 Identify the major types of adjusting entries.

Chapter 3-17

Trial BalanceTrial Balance – Each account is analyzed to determine whether it is complete and up-to-date.

Trial BalanceTrial BalanceTrial BalanceTrial Balance

LO 4 Identify the major types of adjusting entries.LO 4 Identify the major types of adjusting entries.

PIONEER ADVERTISING AGENCY INC.Trial Balance

October 31, 2008Account Debit CreditCash $ 15,200Advertising Supplies 2,500Prepaid Insurance 600Office Equipment 5,000Notes Payable $ 5,000Accounts Payable 2,500Unearned Revenue 1,200Common Stock 10,000Retained Earnings 0Dividends 500Service Revenue 10,000Salaries Expense 4,000Rent Expense 900

$28,700 $ 28,700

Chapter 3-18

Deferrals are either:

Prepaid expenses or

Unearned revenues.

Adjusting Entries for DeferralsAdjusting Entries for DeferralsAdjusting Entries for DeferralsAdjusting Entries for Deferrals

LO 5 LO 5 Prepare adjusting entries for deferrals.Prepare adjusting entries for deferrals.

Chapter 3-19

Payment of cash, that is recorded as an asset because Payment of cash, that is recorded as an asset because service or benefit will be received in the future.service or benefit will be received in the future.

Adjusting Entries for “Prepaid Adjusting Entries for “Prepaid Expenses”Expenses”Adjusting Entries for “Prepaid Adjusting Entries for “Prepaid Expenses”Expenses”

insuranceinsurance

suppliessupplies

AdvertisingAdvertising

rentrent

Cash PaymentCash Payment Expense RecordedExpense RecordedBEFORE


Prepayments often occur in regard to:Prepayments often occur in regard to:

building building purchasespurchases

equipment equipment purchasespurchases

Chapter 3-20

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.



Chapter 3-21



Illustration 3-4Adjusting entries for prepaid expenses

Increases (debits) an expense account and

Decreases (credits) an asset account.

Chapter 3-22

Example Example (Insurance)(Insurance):: On Oct. 4On Oct. 4thth, Pioneer , Pioneer Advertising paid $600 for a one-year fire insurance Advertising paid $600 for a one-year fire insurance policy. Show the journal entry to record the payment policy. Show the journal entry to record the payment on Oct 4on Oct 4thth. .

Cash 600

Prepaid insurance 600Oct. 4

Debit Credit

Prepaid Insurance

600600 600600

Debit Credit

Cash



Chapter 3-23

Example Example (Insurance)(Insurance):: On Oct. 4th, Pioneer Advertising On Oct. 4th, Pioneer Advertising paid $600 for a one-year fire insurance policy. paid $600 for a one-year fire insurance policy. Show the Show the adjusting journal entryadjusting journal entry required at Oct. 31 required at Oct. 31stst. .

Prepaid insurance 50

Insurance expense 50Oct. 31

Debit Credit

Prepaid Insurance

600600 5050

Debit Credit

Insurance Expense

5050

550550



Chapter 3-24

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 long-lived asset as an expense (depreciation) during each period of the asset’s useful life (Matching Principle).



Chapter 3-25

Example Example (Depreciation)(Depreciation):: On Oct. 2On Oct. 2ndnd, Pioneer , Pioneer Advertising paid $5,000 for office equipment that has Advertising paid $5,000 for office equipment that has an expected useful life of 10 years. Show the journal an expected useful life of 10 years. Show the journal entry to record the purchase of the equipment on Oct. entry to record the purchase of the equipment on Oct. 22ndnd. .

Cash 5,000

Equipment 5,000Oct. 2

Debit Credit

Equipment

5,0005,000 5,0005,000

Debit Credit

Cash



Chapter 3-26

Example Example (Depreciation)(Depreciation):: On Oct. 2On Oct. 2ndnd, Pioneer , Pioneer Advertising paid $5,000 for office equipment that has an Advertising paid $5,000 for office equipment that has an expected useful life of 10 years. Show the expected useful life of 10 years. Show the adjusting adjusting journal entryjournal entry required at Oct. 31 required at Oct. 31stst. The equipment has a . The equipment has a $200 salvage value.$200 salvage value.([$5,000- $200 salvage value] / 5 yrs / 12 months = $40)([$5,000- $200 salvage value] / 5 yrs / 12 months = $40)

Accumulated depreciation 40

Depreciation expense 40Jan. 31

Debit Credit

Depreciation Expense

4040 4040

Debit Credit

Accumulated Depreciation

4040



Chapter 3-27

Depreciation (Statement Presentation)

Accumulated Depreciation—is a contra asset account.

Appears just after the account it offsets (Equipment) on the balance sheet.



Office equipment $5,000

Less: Accumulated depreciation-Office Equipment 40 $4,960

Chapter 3-28

Receipt of cash that is recorded as a liability Receipt of cash that is recorded as a liability because the revenue has not been earned.because the revenue has not been earned.

Adjusting Entries for “Unearned Adjusting Entries for “Unearned Revenues”Revenues”Adjusting Entries for “Unearned Adjusting Entries for “Unearned Revenues”Revenues”

rentrent

magazine subscriptionsmagazine subscriptions

customer deposits for customer deposits for future servicefuture service

Cash ReceiptCash Receipt Revenue RecordedRevenue RecordedBEFORE

sale of airline ticketssale of airline tickets

school tuitionschool tuition

Unearned revenues often occur in regard to:Unearned revenues often occur in regard to:


Chapter 3-29

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.



Chapter 3-30 LO 5 LO 5 Prepare adjusting entries for deferrals.Prepare adjusting entries for deferrals.

Illustration 3-10Adjusting entries for unearned revenues

Decrease (a debit) to a liability account and

Increase (a credit) to a revenue account.


Chapter 3-31

Example:Example: On Oct. 2On Oct. 2ndnd, Pioneer Advertising received , Pioneer Advertising received $1,200 from R. Knox for services to be completed by $1,200 from R. Knox for services to be completed by December 31. Show the journal entry to record the December 31. Show the journal entry to record the receipt on Oct 2receipt on Oct 2ndnd. .

Unearned Revenue 1,200

Cash 1,200Oct. 2

Debit Credit

Cash

1,2001,200 1,2001,200

Debit Credit

Unearned Rent Revenue



Chapter 3-32

Example:Example: On Oct. 2nd, Pioneer Advertising received $1,200 On Oct. 2nd, Pioneer Advertising received $1,200 from R. Knox for services to be completed by December 31.from R. Knox for services to be completed by December 31. Show the Show the adjusting journal entryadjusting journal entry required on Oct. 31 required on Oct. 31stst. .

Service Revenue 400

Unearned Revenue 400Oct. 31

Debit Credit

Service Revenue

400400 1,2001,200

Debit Credit

Unearned Revenue

400400

800800



Chapter 3-33

Made to record:

Revenues earned and

Expenses incurred

in the current accounting period that have not been recognized through daily entries.

Adjusting Entries for AccrualsAdjusting Entries for AccrualsAdjusting Entries for AccrualsAdjusting Entries for Accruals

LO 6 LO 6 Prepare adjusting entries for accruals.Prepare adjusting entries for accruals.

Chapter 3-34

Revenues earned but not yet received in cash or Revenues earned but not yet received in cash or recorded.recorded.

Adjusting Entries for “Accrued Adjusting Entries for “Accrued Revenues”Revenues”Adjusting Entries for “Accrued Adjusting Entries for “Accrued Revenues”Revenues”

interestinterest

rentrent

services performedservices performed

BEFORE

Accrued revenues often occur in regard to:Accrued revenues often occur in regard to:

Cash ReceiptCash ReceiptRevenue RecordedRevenue Recorded

Adjusting entry results in:Adjusting entry results in:


Chapter 3-35

Accrued Revenues

An adjusting entry serves two purposes:

(1) It shows the receivable that exists, and

(2) It records the revenues earned.



Chapter 3-36

Illustration 3-13Adjusting entries for accrued revenues

Increases (debits) an asset account and

Increases (credits) a revenue account.



Chapter 3-37

Example:Example: In October Pioneer Advertising earned $200 October Pioneer Advertising earned $200 for advertising services that have not been recorded. for advertising services that have not been recorded. Show the journal entry to record the accrued revenues Show the journal entry to record the accrued revenues in October. in October.

Service Revenue 200

Accounts Receivable 200Oct. 31


Debit Credit

Accounts Receivable

200200 200200

Debit Credit

Service Revenue


Chapter 3-38

Expenses incurred but not yet paid in cash or Expenses incurred but not yet paid in cash or recorded.recorded.

Adjusting Entries for “Accrued Adjusting Entries for “Accrued Expenses”Expenses”Adjusting Entries for “Accrued Adjusting Entries for “Accrued Expenses”Expenses”

interestinterest

rentrent

BEFORE

Accrued expenses often occur in regard to:Accrued expenses often occur in regard to:

Cash PaymentCash PaymentExpense RecordedExpense Recorded

taxestaxes

salariessalaries

Adjusting entry results in:Adjusting entry results in:


Chapter 3-39

Accrued Expenses


(1) It records the obligations, and

(2) It recognizes the expenses.



Chapter 3-40

Illustration 3-16Adjusting entries for accrued expenses

Increases (debits) an expense account and

Increases (credits) a liability account.



Chapter 3-41

Notes payable 5,000

Cash 5,000Oct. 1

Debit Credit

Cash

5,0005,000 5,0005,000

Debit Credit

Notes Payable

Example:Example: On Oct 1On Oct 1stst, Pioneer Advertising signed a , Pioneer Advertising signed a $,5000, 3-month note payable at a rate of 12% per year. $,5000, 3-month note payable at a rate of 12% per year. The total interest due on the note at its due date is $150 The total interest due on the note at its due date is $150 ($5,000 X 12% X 3/12). Show the journal entry to record ($5,000 X 12% X 3/12). Show the journal entry to record the borrowing on Oct. 1the borrowing on Oct. 1stst..



Chapter 3-42

Example:Example: On Oct 1st, Pioneer Advertising signed a $,5000, 3-On Oct 1st, Pioneer Advertising signed a $,5000, 3-month note payable at a rate of 12% per year. The total interest month note payable at a rate of 12% per year. The total interest due on the note at its due date is due on the note at its due date is $150 ([$5,000 x 12%] / 12 $150 ([$5,000 x 12%] / 12

months)months). . Show the Show the adjusting journal entryadjusting journal entry required on required on Oct. 31Oct. 31stst. .

Interest payable 50

Interest expense 50Oct. 31

Debit Credit

Interest Expense

5050 5050

Debit Credit

Interest Payable



Chapter 3-43

Accrued Expenses


(1) It records the obligations, and

(2) it recognizes the expenses.



Chapter 3-44

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.

The Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial Balance

LO 7 LO 7 Describe the nature and purpose of an adjusted trial Describe the nature and purpose of an adjusted trial balance.balance.

Chapter 3-45

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.

ReviewReview



Chapter 3-46

Financial Statements are prepared directly from the Adjusted Trial Balance. Financial Statements are prepared directly from the Adjusted Trial Balance.

Balance Sheet

Income Statemen

t

Statement of Cash

Flows

Retained Earnings Statemen

t

Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements


Chapter 3-47

Income Statement



Account Debit CreditCash $ 15,200Accounts Receivable 200Advertising Supplies 1,000Prepaid Insurance 550Office Equipment 5,000Accumulated Depreciation-Off Equip $40Notes Payable 5,000Accounts Payable 2,500Unearned Revenue 800Salaries Payable 1,200Interest Payable 50Common Stock 10,000Retained Earnings 0Dividends 500Service Revenue 10,600Salaries Expense 5,200Advertising Supplies Expense 1,500Rent Expense 900Insurance Expense 50Interest Expense 50Depreciation Expense 40

$ 30,190 $ 30,190

PIONEER ADVERTISING AGENCY INC.Income Statement

For the Month Ended October 31, 2008RevenuesService Revenue 10,600

ExpensesSalaries Expense 5,200Advertising Supplies Expense1,500Rent Expense 900Insurance Expense 50Interest Expense 50Depreciation Expense 40Total expenses 7,740

Net income $ 2,860

Chapter 3-48

Retained Earnings

Statement




$ 30,190 $ 30,190

PIONEER ADVERTISING AGENCY INC.Retained Earnings Statement

For the Month Ended October 31, 2008Retained earnings, October 1 $ 0Add: Net income 2,860

2,860Less: Dividends 500Retained Earnings, October 31 2,360

Chapter 3-49

Balance SheetPreparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements



$ 30,190 $ 30,190

PIONEER ADVERTISING AGENCY INC.Balance Sheet

October 31, 2008Assets

Cash $ 15,200Accounts Receivable 200Advertising Supplies 1,000Prepaid Insurance 550Office Equipment $5,000Accumulated Depreciation-Off Equip 40 4,960

Total Assets $ 21,910Liabilities and Stockholders’ Equity

LiabilitiesNotes Payable $ 5,000Accounts Payable 2,500Unearned Revenue 800Salaries Payable 1,200Interest Payable 50

Total liabilities 9,550Stockholders’ EquityCommon Stock 10,000Retained Earnings 2,360Total liabilities and stockholders’ equity $ 21,910

Chapter 3-50

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Chapter 3-1. Chapter 3-2 CHAPTER 3 ADJUSTING THE ACCOUNTS Financial Accounting, Sixth Edition