Chapter 3

The Adjusting ProcessUnit 4

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Accrual versus CashBasis of Accounting p100

Under the accrual basis of accounting, revenues are reported in the income statement in the period in which they are earned.

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Under the cash basis of accounting, revenues and expenses are reported in the income statement in the period in which cash is received or paid.

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The Adjusting Process

The analysis and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process.

-- Making the records as correct as we can.

The Adjusting Process

Under the accrual basis, at the end of the accounting period some of the accounts need updating for the following reasons:1. Some expenses are not recorded daily.2. Some revenues and expenses are incurred

as time passes rather than as separate transactions.

3. Some revenues and expenses may be unrecorded.

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Indicate with a Yes or No whether or not each of the following accounts normally requires an adjusting entry.

a. Cash d. Office Equipmentb. Prepaid Rent e. Accounts Receivablec. Wages Expense f. Unearned Rent

Example Exercise 3-1 p101

Accounts Requiring Adjustment

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a. Cash d. Office Equipmentb. Prepaid Rent e. Accounts Receivablec. Wages Expense f. Unearned Rent

NoYes

Yes

NoYes

Yes

Example Exercise 3-1 (continued)

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Prepaid expenses are the advance payment of future expenses and are recorded as assets when cash is paid.

Ex. Prepaid Insurance

Types of Accounts Requiring Adjustment

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Unearned revenues are the advance receipt of future revenues and are recorded as liabilities when cash is received.

Ex. Unearned Rent

Types of Accounts Requiring Adjustment

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Accrued revenues are unrecorded revenues that have been earned and for which cash has yet to be received.

Ex. Fees earned but not yet billed.

Types of Accounts Requiring Adjustment

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Accrued expenses are unrecorded expenses that have been incurred and for which cash has not been paid.

Ex. Wages earned but not yet paid.

Types of Accounts Requiring Adjustment

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Type of Adjustment

Example Exercise 3-2 p104

Classify the following items as (1) prepaid expense, (2) unearned revenue, (3) accrued expense, or (4) accrued revenue.

a. Wages owed but not yet paid.

b. Supplies on hand.

c. Fees received but not yet earned.

d. Fees earned but not yet received.

a. Accrued expense

b. Prepaid expense

c. Unearned revenue

d. Accrued revenue

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Journalize entries for accounts requiring

adjustment.

Objective 2

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NetSolutions’ Supplies account has a balance of $2,000 in the unadjusted trial balance. Some of these supplies have been used. On December 31, a count reveals that $760 of supplies are on hand. Think of a supply cabinet here.

Prepaid Expenses

Supplies (balance on trial balance – from ledger card) $2,000Supplies on hand, December 31 (looked in cabinet) – 760Supplies used (so these are gone) $1,240

Here’s the problem with this. Our accounting records show we still have $2000 in supplies but we really only have $760 left. So we need to adjust or correct the supplies account.

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Dec. 31 1,240Dec. 31 1,240

Supplies Supplies ExpenseBal. 800

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2,040760

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Bal. 2000

The prepaid insurance account had a beginning balance of $6,400 and was debited for $3,600 of premiums paid during the year. Journalize the adjusting entry required at the end of the year assuming the amount of unexpired (what wasn’t used up) insurance related to future periods is $3,250.

So we started with $6400 in that account and during the year paid $3600 more in premiums for a total balance in the account of? $10,000. We only want what wasn’t used in the account so…

Adjustment for Prepaid Expenses

Example Exercise 3-3 p107

Insurance Expense……………………… 6,750Prepaid Insurance…………………… 6,750

Insurance expired ($6,400 +$3,600 – $3,250).

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The December 31 unadjusted trial balance of NetSolutions indicates a balance in the unearned rent account of $360.

This was 3 months of rent received from a renter for the months of Dec, Jan and Feb. So on Dec. 31st one month has been earned and two months are still unearned. We need to move one month out of the unearned account.

Unearned Revenues

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Adjustment for Unearned Revenue

Example Exercise 3-4 p108

The balance in the unearned fees account, before adjustment at the end of the year, is $44,900. Journalize the adjusting entry required if the amount of unearned fees at the end of the year is really $22,300 (so we earned the difference).

Unearned Fees……………………………. 22,600Fees Earned………………………….. 22,600

Fees earned ($44,900 – $22,300).

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NetSolutions signed an agreement with Danker Co. on December 15 to provide services at $20 per hour. As of December 31, NetSolutions had provided 25 hours of assistance. So we need to record the money owed to us for the work that we completed.

$20 times 25 hours = $500

Accrued Revenues

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At the end of the current year, $13,680 of fees have been earned but have not been billed to clients. Journalize the adjusting entry to record the accrued fees.

Example Exercise 3-5 p109

Follow My Example 3-5

Accounts Receivable……………………. 13,680Fees Earned………………………….. 13,680 Accrued fees.

Adjustment for Accrued Fees

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NetSolutions pays it employees biweekly. During December, NetSolutions paid wages of $950 on December 13 and $1,200 on December 27. As of December 31, NetSolutions owes $250 of wages to employees for Monday and Tuesday. (Assume that the 27th is a Friday, no one worked on the 28th and 29th so we owe for Monday the 30th and Tuesday the 31st).

Accrued Expenses

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Note:

• Make sure you read page 110 to see how to record the payment of wages after recording this adjusting entry.

Sanregret Realty Co. pays weekly salaries of $12,500 on Friday for a five-day week ending on that day. Journalize the necessary adjusting entry at the end of the accounting period, assuming that the period ends on Thursday.

Example Exercise 3-6 p111

Adjustment for Accrued Expenses

Salaries Expense……………………….. 10,000Salaries Payable…………………….. 10,000

Accrued salaries [($12,500 ÷ 5 days) × 4 days].

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Fixed assets, or plant assets, are physical resources that are owned and used by a business and are permanent or have a long life.

Fixed Assets (getting into the depreciation expense on this one p111)

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As time passes, a fixed asset loses its ability to provide useful services. This decrease in usefulness is called depreciation.

Depreciation

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Normal titles for fixed asset accounts and their related contra asset accounts are as follows:

Fixed Asset Contra Asset

Land None—Land is not depreciatedBuildings Accumulated Depreciation—BuildingsStore Equipment Accumulated Depreciation—Store EquipmentOffice Equipment Accumulated Depreciation—Office Equipment

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NetSolutions estimates the depreciation on its office equipment to be $50 for the month of December.

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NetSolutions’ balance sheet would show office equipment at cost, less accumulated depreciation.

Office equipment $1,800 Less accumulated depreciation 50 $1,750

Book value

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Example Exercise 3-8 p113

For the year ending December 31, 2010, Mann Medical Co. mistakenly omitted adjusting entries for (1) $8,600 of unearned revenue that was earned, (2) earned revenue of $12,500 that was not billed, and (3) accrued wages of $2,900. Indicate the combined effect of the errors on (a) revenues, (b) expenses, and (c) net income for 2010.

Let’s work through it - next slide.

Effect of Omitting Adjustments

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• 1. $8,600 of unearned rent was earned. So this should have been moved to rent revenue. Therefore, revenue is short by $8600.

• 2. Earned revenue of $12,500 was not billed. So we did the work but didn’t get the $12,500 into our books. Again, revenue is short but by $12,500 this time.

• 3. Accrued wages means wages were earned but not yet paid – accrued. So our expenses are going to be short by $2900 for this one.

• Finally, remember that net income is revenues minus expenses = net income.

Example Exercise 3-8 (continued)

a. Revenues were understated by $21,100 ($8,600 + $12,500). For number 1 and 2.

c. Net income was understated by $18,200 ($8,600 +12,500 – $2,900). The revenue figure is short by $21,100 so net income is smaller than it should be for A. The expense figure is short by $2900 so net income is bigger than it should be for B.

Revenue (missing $21,100) makes NI too little- Expense (missing $2,900) makes NI too big

= Net income would be short $18,200.

b. Expenses were understated by $2,900. For #3.

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Adjusted Trial Balance p 118The purpose of the adjusted trial balance is to verify the equality of the total debit and credit balances before the financial statements are prepared. Better to do it before you pass out the information than to find errors after the statements have gone to the boss and others.

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Questions??Textbook Exercises for this unit are:

Exercise 3-1(use Example Exercise 3-2)Exercise 3-2 (use Example Exercises 3-1 & 3-2)

Exercise 3-23 (use Example Exercise 3-9)Exercise 3-26 (example exercises 3-3 to 3-7 and page 116)

Problem 3-5A (Problem 3-5B)

Don’t forget to work on the B problems before tackling these. The solutions for the Bs are in Doc Sharing.

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