Chapter 3

Adjusting the Accounts

The Year

• Calendar Year is January 1 through December 31

• Fiscal year is any 12-month period– I.E. ATA’s year is July 1 through June 30

Cash Basis vs. Accrual

• Cash Basis is when a company only records when cash has been received or paid out.

• Accrual Basis records events as they happen

• **Cash accounting is not in accordance with GAAP***

Revenue Recognition

• Revenue is recognized only when the services have been performed.

• However, if we receive money ahead of time, we increase the liability account—”Unearned Revenue”

Matching Principle

• We always need to match the expenses that were needed to produce the revenue

Adjusting Entries

• Certain accounts are not the same at the end of an accounting period.– Deferrals , accounts recorded as assets and have

been used up.• Pre-Paid Insurance• Supplies• Large assets that have depreciated (or lost some of

their value)

Pre-Paid Insurance

• We paid insurance for a period of time and recorded the entire amount as the asset, Pre-Paid Insurance.

• If we paid for insurance for $600 for 12 months, then we use up $50 each month

• At the end of the month we record the used up part like this:– Insurance Expense $50.00 (Debit)

• Pre-Paid Insurance $50.00 (Credit)

You Try

• Leo Jewelers purchased Insurance on January 1 for $1500/yr. On April 1, he is adjusting his account.

• How many months have been used ___?____• Figure the amount used up_____?________• What is the entry ______?__________• How much insurance is left ______?____

Supplies

• When you buy supplies for your business, you add it to the asset account, supplies.

• However, as you go through the year, your supplies as used, so you don’t have as many at the end of a month, year or quarter.

So What Now

• You take an inventory of your supplies• You determine that you have $100 of pencils left.• You bought $250.00 of supplies in the beginning.• How many pencils did you use?• The adjusting entry is:– Supplies Expense ? (Debit)• Supplies ? (Credit)

This poor computer isn’t worth what it used to be!!!

Many large assets lose their valueExamples are: Furniture, Cars, TechnologyThese assets have depreciated in value

First, we need to know two things:A contra asset account is an account that offsets an

asset but is still noted on the balance sheet. Accumulated Depreciation is a contra-asset account.

Second

• The book value of any depreciable asset is calculated by taking the original value – depreciation.

• If you bought office equipment for $5,000 and it has depreciated $1,000, then the book value is $4,000 (5,000-1,000).

Adjusting Entry

• On the previous example, Smith Bros bought office equipment for $5,000 and it has depreciated $1,000 in the past year. We do adjusting entries at the end of the year (important note)

• Entry– Depreciation Expense-Office Equip $1,000 (Dr)• Accumulated Depreciation-Office Equipment

$1,000(Cr)

Unearned Revenue

• Examples: Magazine Subscriptions, Airline Tickets, Consulting Projects, Architectural contracts.

• Unearned Revenue is a liability account.• It is adjusted when the service is performed or

completed. The adjusting entry can be for the entire amount of a partial part.

Pioneer Advertising Agency

• Pioneer Advertising Agency received $1,200 on October 2 from R. Knox for advertising services expected to be completed by December 31.

• The first entry:– Cash $1,200 (Dr)• Unearned Revenue $1,200 (Cr).

Adjusting Entry

• At the end of March Pioneer completed one month’s worth of the services.

• We want to take one-month of the liability away so…– Unearned Revenue $400 (Dr)• Service Revenue $400(cr)

– ? How much is in Unearned Revenue Now?

You do it!

• Buhl Company has Unearned Revenue of $10,000.

• At the end of the month, Buhl has performed 2/5 of the services.

• What is the amount of revenue earned?• What is the entry?• How much is still unearned?

Accruals

• To account for revenue and expenses that should be put into an accounting period but because of timing they have not been recorded.

Revenue not yet recorded

• Might have happened on the day the financial statements are being prepared so we record it with an adjusting entry

• Accounts Receivable (Dr.)– Service Revenue (Cr)

Accrued Expenses

• Examples are interest that has accrued but doesn’t need to be paid yet.

• Salaries that have been earned but do not need to be paid yet.

Accrued Interest

• Let’s say we went to the bank to get money for your business and you signed a note for $5,000 at 12% annual interest.

• How do we record this money when received?

At the End of the Month

• We have accrued 1 month of interest of 1/12.• We would then take $5,000 x 12% x 1/12.• We should come out with ?• The adjusting entry is– Interest Expense ? (Dr.)• Interest Payable ?(Cr)

You Do It!

• Calvin and Hobbes borrowed $30,000 from a local bank on a 15 year note. The annual interest rate is 10%.

• What is the interest for a year?• What is the interest for ½ year?• What is entry to record the interest for 6

months?

Accrued Salaries

• Many companies pay every other week. The accounting period may end in between pay periods. We must account for the days that were performed but not yet paid.

Example

• Carter just paid everyone on October 26 and the next payday is November 9.

• They are preparing statements at the end of October. Therefore 3 days of work were performed after October 26.

• If their total payroll for 5 days of work is $2,000, how much was performed in 3 days?

Next, the Adjusting Entry

• Salaries Expense1,200 (Dr)Salaries Payable 1,200 (Cr)

Then when the entire amount is paid on Nov 9Salaries Payable $1,200 (Dr)

Salaries Expense $ 800 (Dr) Cash 2,000 (Cr.)

Finally!!!

• The adjusted trial balance• Take each account in the ledger• Write their balance• Debits in total should equal credits in total.

Examples

• Page 112• Page 113• E3-6 Page 128• E3-9 Page 129

Test Review

• Define– Accrual– Book Value– Depreciation– Contra-Asset– Deferrals– Fiscal Year– Prepaid Expenses– Unearned Revenue– Adjusting Entries

Analyze

• Amount of adjusting entries.• Accounts to enter adjusting entries.• Problem similar to P3-1A