Chapter 3-1 CHAPTER 3 ADJUSTING THE ACCOUNTS. Chapter 3-2 1. 1.Explain the time period assumption. 2. 2.Explain the accrual basis of accounting. 3. 3.Explain

Chapter 3-1

CHAPTER CHAPTER 33

ADJUSTING THE ADJUSTING THE ACCOUNTSACCOUNTS

Chapter 3-2

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 3-3

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 The Adjusted

Trial Balance and Trial Balance and

Financial Financial

StatementsStatements

The Adjusted The Adjusted

Trial Balance and Trial 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 3-4

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).

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

Chapter 3-5

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


Chapter 3-6

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

Chapter 3-7

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 3-8

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 3-9

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 3-10


GAAP relationships in revenue and expense recognition

GAAP relationships in revenue and expense recognition

Illustration 3-1Illustration 3-1

Chapter 3-11

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.

ReviewReview


Chapter 3-12

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

Chapter 3-13

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 3-14

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 3-15

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

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

Deferrals

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

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

2. Unearned Revenues. Revenues received in cash and recorded as liabilities before they are earned.

Accruals

Chapter 3-16

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

Phoenix Consulting - J an. 31st (before adjusting entries)Acct. No. Account Debit Credit

100 Cash 50,000$ 105 Accounts receivable 35,000 110 Prepaid insurance 12,000 120 Equipment 24,000 130 I nvestments 300,000 200 Accounts payable 20,000$ 210 Unearned revenue 24,000 220 Note payable 200,000 300 Austin, capital 40,000 400 Sales 137,000

421,000$ 421,000$

Trial BalanceTrial BalanceTrial BalanceTrial Balance

Chapter 3-17

Deferrals are either:

Prepaid expenses

OR

Unearned revenues.

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

Chapter 3-18

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

Cash PaymentCash Payment Expense RecordedExpense RecordedBEFORE

rentrent

maintenance on maintenance on equipmentequipment

fixed assets fixed assets (depreciation)(depreciation)

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

Chapter 3-19

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 3-20


Adjusting entries for prepaid expenses

Increases (debits) an expense account and

Decreases (credits) an asset account.


Chapter 3-21

Example Example (Insurance)(Insurance):: On Jan. 1On Jan. 1stst, Phoenix , Phoenix Consulting paid $12,000 for 12 months of insurance Consulting paid $12,000 for 12 months of insurance coverage. Show the journal entry to record the coverage. Show the journal entry to record the payment on Jan. 1payment on Jan. 1stst. .

Cash 12,000

Prepaid Insurance 12,000

Jan. 1

Debit Credit

Prepaid Insurance

12,00012,000 12,00012,000

Debit Credit

Cash


Chapter 3-22

Example Example (Insurance)(Insurance):: On Jan. 1On Jan. 1stst, Phoenix , Phoenix Consulting paid $12,000 for 12 months of insurance Consulting paid $12,000 for 12 months of insurance coverage. Show the coverage. Show the adjusting journal entryadjusting journal entry required at required at Jan. 31Jan. 31stst. .


Insurance Expense 1,000Jan. 31

Debit Credit

Prepaid Insurance

12,00012,000 1,0001,000

Debit Credit

Insurance Expense

1,0001,000

11,00011,000


Chapter 3-23

DepreciationCompanies record long-term assets (buildings, equipments, vehicles) at cost, as required by the cost principle (Chapter 1).

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).

As time passes these assets wear out and their usefulness reduces, which leads to its value getting decreased.

Companies report an estimated portion of the cost of an asset, which has been reduced with time, as an expense (depreciation expense) during each period of the asset’s useful life.


Chapter 3-24

The basics of Adjusting EntriesThe basics of Adjusting Entries

DepreciationDepreciation Purchasing long-term assets is essentially a Purchasing long-term assets is essentially a

long-term prepayment of services offered by the long-term prepayment of services offered by the asset.asset.

Recording depreciation expense periodically in Recording depreciation expense periodically in the journal is recognizing that a portion of that the journal is recognizing that a portion of that prepayment has been used.prepayment has been used.

Thus entries of Depreciation expense are Thus entries of Depreciation expense are adjustment entriesadjustment entries

Instead of writing off depreciation directly from Instead of writing off depreciation directly from the asset account, a contra-asset account called the asset account, a contra-asset account called Accumulated Depreciation is made.Accumulated Depreciation is made.

Chapter 3-25

Example Example (Depreciation)(Depreciation):: On Jan. 1On Jan. 1stst, Phoenix , Phoenix Consulting paid $24,000 for equipment that has an Consulting paid $24,000 for equipment that has an estimated useful life of 20 years. Show the journal estimated useful life of 20 years. Show the journal entry to record the purchase of the equipment on Jan. entry to record the purchase of the equipment on Jan. 11stst. .

Cash 24,000

Equipment 24,000

Jan. 1

Debit Credit

Equipment

24,00024,000 24,00024,000

Debit Credit

Cash


Chapter 3-26

Example Example (Depreciation)(Depreciation):: On Jan. 1On Jan. 1stst, Phoenix , Phoenix Consulting paid $24,000 for equipment that has an Consulting paid $24,000 for equipment that has an estimated useful life of 20 years. Show the estimated useful life of 20 years. Show the adjusting adjusting journal entryjournal entry required at Jan. 31 required at Jan. 31stst. . ($24,000 / 20 ($24,000 / 20 yrs. / 12 months = $100)yrs. / 12 months = $100)

Accumulated Depreciation 100

Depreciation Expense 100Jan. 31

Debit Credit

Depreciation Expense

100100 100100

Debit Credit

Accumulated Depreciation


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.


Balance Sheet J an. 31

Assets

Equipment 24,000 Accumulated Depreciation (100) Net Equipment 23,900

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

airline ticketsairline tickets

school tuitionschool tuition

Cash ReceiptCash Receipt Revenue RecordedRevenue RecordedBEFORE

magazine subscriptionsmagazine subscriptions

customer depositscustomer deposits

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

Adjusting 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 Jan. 1On Jan. 1stst, Phoenix Consulting received , Phoenix Consulting received $24,000 from Arcadia High School for 3 months rent in $24,000 from Arcadia High School for 3 months rent in advance. Show the journal entry to record the receipt advance. Show the journal entry to record the receipt on Jan. 1on Jan. 1stst. .

Unearned Rent Revenue

24,000

Cash 24,000

Jan. 1

Debit Credit

Cash

24,00024,000 24,00024,000

Debit Credit



Chapter 3-32

Example:Example: On Jan. 1On Jan. 1stst, Phoenix Consulting received , Phoenix Consulting received $24,000 from Arcadia High School for 3 months rent in $24,000 from Arcadia High School for 3 months rent in advance. Show the advance. Show the adjusting journal entryadjusting journal entry required on required on Jan. 31Jan. 31stst. .

Rent Revenue 8,000


8,000Jan. 31

Debit Credit

Rent Revenue

8,0008,000 24,00024,000

Debit Credit


8,0008,000

16,00016,000


Chapter 3-33

Made to record:

Revenues earned and

OR

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

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”

rentrent

interestinterest

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

Adjusting entries for accrued revenues

Increases (debits) an asset account and

Increases (credits) a revenue account.

Adjusting Entries for “Accrued Adjusting Entries for “Accrued Revenues”Revenues”Adjusting Entries for “Accrued Adjusting Entries for “Accrued Revenues”Revenues”Illustration 3-13Illustration 3-13

Chapter 3-37

Example:Example: On Jan. 1On Jan. 1stst, Phoenix Consulting invested , Phoenix Consulting invested $300,000 in securities that return 5% interest per year. $300,000 in securities that return 5% interest per year. Show the journal entry to record the investment on Jan. Show the journal entry to record the investment on Jan. 11stst. .

Cash 300,000

Investments 300,000

Jan. 1

Debit Credit

Investments

300,000300,000 300,000300,000

Debit Credit

Cash


Chapter 3-38

Example:Example: On Jan. 1On Jan. 1stst, Phoenix Consulting invested , Phoenix Consulting invested $300,000 in securities that return 5% interest per year. $300,000 in securities that return 5% interest per year. Show the Show the adjusting journal entryadjusting journal entry required on Jan. 31 required on Jan. 31stst. . ($300,000 x 5% / 12 months = $1,250)($300,000 x 5% / 12 months = $1,250)

Interest Revenue 1,250

Interest Receivable 1,250Jan. 31

Debit Credit

Interest Receivable

1,2501,250 1,2501,250

Debit Credit

Interest Revenue


Chapter 3-39

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”

rentrent

interestinterest

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 3-40

Accrued Expenses


(1) It records the obligations, and

(2) It recognizes the expenses.


Chapter 3-41

Adjusting entries for accrued expenses

Increases (debits) an expense account and

Increases (credits) a liability account.

Adjusting Entries for “Accrued Adjusting Entries for “Accrued Expenses”Expenses”Adjusting Entries for “Accrued Adjusting Entries for “Accrued Expenses”Expenses”Illustration 3-16Illustration 3-16

Chapter 3-42

Notes Payable 200,000

Cash 200,000

Jan. 2

Debit Credit

Cash

200,000200,000 200,000200,000

Debit Credit

Notes Payable

Example:Example: On Jan. 2On Jan. 2ndnd, Phoenix Consulting borrowed , Phoenix Consulting borrowed $200,000 at a rate of 9% per year. Interest is due on first $200,000 at a rate of 9% per year. Interest is due on first of each month. Show the journal entry to record the of each month. Show the journal entry to record the borrowing on Jan. 2borrowing on Jan. 2ndnd..


Chapter 3-43

Example:Example: On Jan. 2On Jan. 2ndnd, Phoenix Consulting borrowed , Phoenix Consulting borrowed $200,000 at a rate of 9% per year. Interest is due on first $200,000 at a rate of 9% per year. Interest is due on first of each month. Show the of each month. Show the adjusting journal entryadjusting journal entry required required on Jan. 31on Jan. 31stst. . ($200,000 x 9% / 12 months = $1,500)($200,000 x 9% / 12 months = $1,500)

Interest Payable 1,500

Interest Expense 1,500Jan. 31

Debit Credit

Interest Expense

1,5001,500 1,5001,500

Debit Credit

Interest Payable


Chapter 3-44

Accrued Expenses


(1) It records the obligations, and

(2) it recognizes the expenses.


Chapter 3-45

• 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.

• Is the primary basis for the preparation of financial statements.

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

Chapter 3-46

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 3-47

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

Owner’s Equity

Statement

Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements

Chapter 3-48

I ncome Statement

For the Month Ended J an. 31, 2008

Revenues:

S ales 137,000$

I nterest revenue 1,250

Rent revenue 8,000

T otal revenue 146,250

Expenses:

I nterest expense 1,500

Depreciation expense 100

I nsurance expense 1,000

T otal expenses 2,600

Net income 143,650$

Income Statement


Adjusted Trial Balance Debit Credit

Cash 50,000$ Accounts receivable 35,000 I nterest receivable 1,250 Prepaid insurance 11,000 Equipment 24,000 Accumulated depreciation 100$ I nvestments 300,000 Accounts payable 20,000 I nterest payable 1,500 Unearned revenue 16,000 Note payable 200,000 Austin, capital 40,000 Sales 137,000 I nterest revenue 1,250 Rent revenue 8,000 I nterest expense 1,500 Depreciation expense 100 I nsurance expense 1,000

423,850$ 423,850$

Chapter 3-49

Statement of Owner' s Equity

For the Month Ended J an. 31, 2008

Austin, Capital, J an. 1 40,000$

+ N et income 143,650

- Drawings 0

Austin, Capital, J an. 31 183,650$

Statement of Owner’s Equity




423,850$ 423,850$

Chapter 3-50



423,850$ 423,850$

Balance Sheet J an. 31, 2008

Assets

Cash 50,000$

Accounts receivable 35,000

I nterest receivable 1,250

Prepaid insurance 11,000

Equipment 24,000

Accum. Depreciation (100)

I nvestments 300,000

T otal assets 421,150$

Liabilities & Owner' s Equity

Accounts payable 20,000$

I nter st payable 1,500

Unearned revenue 16,000

N ote payable 200,000

Austin, capital 183,650

T otal liab. & equity 421,150$


Chapter 3-51

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.

Alternative Treatment of Prepaid Expenses and Unearned Revenues

Chapter 3-52

Example Example (Insurance)(Insurance):: On Dec. 1On Dec. 1stst, Phoenix , Phoenix Consulting paid $12,000 for 12 months of insurance Consulting paid $12,000 for 12 months of insurance coverage. Show the journal entry to record the coverage. Show the journal entry to record the payment on Dec. 1payment on Dec. 1stst. .

Cash 12,000

Insurance Expense 12,000

Dec. 1

Debit Credit

Insurance Expense

12,00012,000 12,00012,000

Debit Credit

Cash

Alternative Treatment for “Prepaid Expenses”

Chapter 3-53

Example Example (Insurance)(Insurance):: On Dec. 1On Dec. 1stst, Phoenix , Phoenix Consulting paid $12,000 for 12 months of insurance Consulting paid $12,000 for 12 months of insurance coverage. Show the coverage. Show the adjusting journal entryadjusting journal entry required at required at Dec. 31Dec. 31stst. .

Insurance Expense 11,000


Dec. 31

Debit Credit

Insurance Expense

12,000 11,000

Debit Credit

Prepaid Insurance

Alternative Treatment for “Prepaid Expenses”

11,00011,000

1,000

Chapter 3-54

Example:Example: On Dec. 1On Dec. 1stst, Phoenix Consulting received , Phoenix Consulting received $24,000 from Arcadia High School for 3 months rent in $24,000 from Arcadia High School for 3 months rent in advance. Show the journal entry to record the receipt advance. Show the journal entry to record the receipt on Dec. 1on Dec. 1stst. .

Rent Revenue 24,000

Cash 24,000

Dec. 1

Debit Credit

Cash

24,00024,000 24,00024,000

Debit Credit

Rent Revenue

Alternative Alternative Treatment for “Unearned Treatment for “Unearned Revenues”Revenues”Alternative Alternative Treatment for “Unearned Treatment for “Unearned Revenues”Revenues”

Chapter 3-55

Example:Example: On Dec. 1On Dec. 1stst, Phoenix Consulting received , Phoenix Consulting received $24,000 from Arcadia High School for 3 months rent in $24,000 from Arcadia High School for 3 months rent in advance. Show the advance. Show the adjusting journal entryadjusting journal entry required on required on Dec. 31Dec. 31stst. .


16,000

Rent Revenue 16,000

Dec. 31

Debit Credit


16,00016,000 24,00024,000

Debit Credit

Rent Revenue

16,00016,000

8,0008,000

Alternative Treatment for “Unearned Alternative Treatment for “Unearned Revenues”Revenues”Alternative Treatment for “Unearned Alternative Treatment for “Unearned Revenues”Revenues”

Chapter 3-56

Summary of Basic Relationships for Deferrals

Illustration 3A-7Illustration 3A-7

Documents

Chapter 3-1 CHAPTER 3 ADJUSTING THE ACCOUNTS. Chapter 3-2 1. 1.Explain the time period assumption. 2. 2.Explain the accrual basis of accounting. 3. 3.Explain