ACC 201-CFinancial Accounting

Professor Kiefer

Chapter 3

The Adjusting Process

ACC 201-CFinancial Accounting

Professor Kiefer

Chapter 3

The Adjusting Process

Learning ObjectivesLearning Objectives

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Differentiate between accrual and cash-basis accounting

Define and apply the accounting periodconcept, revenue recognition and matchingprinciples, and time period concept

Explain why adjusting entries are needed

Journalize and post adjusting entries

Learning ObjectivesLearning Objectives

4

Explain the purpose of and prepare an adjusted trial balance

Prepare the financial statements from theadjusted trial balance

Understand the alternate treatment of unearned revenues and prepaid expenses(see Appendix 3A, located at myaccountinglab.com)

Differentiate between accrual and cash-basis accounting

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Accrual Accounting Versus Accrual Accounting Versus Cash-Basis AccountingCash-Basis Accounting

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Accrual Basis

Revenues recognized when earned

Expenses recognized when incurred

Cash Basis

Revenues recognized when cash received

Expensesrecorded when cash paid

Not GAAPNot GAAP

Accrual vs. Cash-Basis: Accrual vs. Cash-Basis: RevenueRevenue

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Accrual vs. Cash-Basis: Accrual vs. Cash-Basis: RevenueRevenue

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Cash-basis revenue transactions

Accrual basis revenue transactions

Accrual vs. Cash-Basis: Accrual vs. Cash-Basis: ExpensesExpenses

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S3-2: COMPARING ACCRUAL AND CASH-BASIS ACCOUNTING

The Johnny Flowers Law Firm uses a client database. Suppose Johnny Flowers paid $2,900 for a computer.Requirements:1. Describe how the business should account for the $2,900 expenditure under

a. the cash basis.

b. the accrual basis.

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Record expense $2,900

Record asset $2,900

2. State why the accrual basis is more realistic for this situation.

The accrual basis is more realistic because the computer is an asset and it will benefit the business for more than one year. To record the cost of the computer as an expense is unrealistic.

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S3-2: COMPARING ACCRUAL AND CASH-BASIS ACCOUNTING

Define and apply the accounting period concept, revenue, and matching principles

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Accounting Period ConceptAccounting Period Concept• Businesses prepare financial statements for

specific periods to evaluate performance• Basic accounting period = one year

– Calendar year– Fiscal year

• Interim periods– Financial statements of less than one year

• Monthly• Quarterly• Semi-annually

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Revenue Recognition Revenue Recognition PrinciplePrinciple

• When to record revenue?– When it is earned

• When service is provided

• When the product delivered

• When the earnings process is complete

– Not when cash is received, cash method

• The amount of revenue to record?– Value of item or service transferred to customer

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Recording Revenue: The Recording Revenue: The Revenue Recognition Revenue Recognition

PrinciplePrinciple

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The Matching PrincipleThe Matching Principle• Measure all expenses incurred during

the period

• Match the expenses against the revenues earned during the same period

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The Time-Period ConceptThe Time-Period Concept• Requires that accounting information be

reported at regular intervals

• Accounts are updated at the end of each accounting period

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Time-Period ConceptTime-Period Concept

On May 31, Smart Touch recorded salary expense of $900 that is owed to an employee at the end of the month.

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Explain why adjusting entries are needed

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Adjusting Entries

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Adjusting EntriesAdjusting Entries• Prepared at end of an accounting period• Assigns:

– Revenues to the period when earned– Expenses to the period when incurred

• Update asset and liability accounts• Need to properly match revenues and

expenses to measure:– Net income– Assets and Liabilities

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Adjusting Entry RulesAdjusting Entry Rules

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Journalize and post adjusting entries

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Types of Adjusting EntriesTypes of Adjusting Entries

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Prepaid ExpensesPrepaid Expenses• Advance payments of expenses• Examples:

– Rent– Insurance– Supplies

• Recorded as an asset• Adjusting entry records amount used as an expense

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Prepaid Expense: RentPrepaid Expense: Rent

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At May 31st, this amount is too high. One month has been used.

DepreciationDepreciation• Plant assets

– Long-lived tangible assets used in business operations

– Examples:• Land, buildings, equipment, and furniture

• Depreciation– Allocation of a plant asset’s cost to expense over

its useful life• Land is not depreciated

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Depreciation EntryDepreciation Entry

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Amount calculated based on

depreciation method

Contra asset account

Accumulated DepreciationAccumulated Depreciation• Contra asset

– Normal credit balance

– Always paired with related account

• Holds sum of all depreciation recorded on a plant asset• Book value:

– Cost minus accumulated depreciation

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Depreciation PostingDepreciation Posting

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Accrued ExpensesAccrued Expenses• Expenses incurred before payment is made

– Results in a liability

• Opposite of a prepaid expense– Examples:

• Salaries

• Interest

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Accrued Expense EntriesAccrued Expense Entries

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Accrued RevenuesAccrued Revenues• Revenue earned before cash is received

• Results in a receivable

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Unearned RevenueUnearned Revenue• Cash is collected before revenue is earned

– Results in a liability – Owes a product or service or refund

• Also called deferred revenue

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BEFORE

Unearned Revenue EntriesUnearned Revenue Entries

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S3-5: IDENTIFYING TYPES OF ADJUSTING ENTRIES

• A select list of transactions for Anuradha’s Goals follows:

Apr 1 Paid six months of rent, $4,800.

10 Received $1,200 from customer for six-month service contract that began April 1.

15 Purchased computer for $1,000.

Requirement:

1. For each transaction, identify what type of adjusting entry would be needed.

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Prepaid expense

Unearned revenues

Depreciation

S3-5: IDENTIFYING TYPES OF ADJUSTING ENTRIES

• A select list of transactions for Anuradha’s Goals follows:

Apr 18 Purchased $300 of office supplies on account.

30 Work performed but not yet billed to customer, $500.

30 Employees earned $600 in salary that will be paid May 2.

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Prepaid expense

Accrued revenues

Accrued expenses

E3-22: JOURNALIZING ADJUSTING ENTRIES AND ANALYZING THEIR EFFECT ON THE

INCOME STATEMENT

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The following data at January 31, 2012 is given for EBM, Inc.

a. Depreciation, $500

b. Prepaid rent expired, $600

c. Interest expense accrued, $300

d. Employee salaries owed for Monday through Thursday of a five-day workweek; weekly payroll, $13,000

e. Unearned service revenue earned, $1,300

Requirement:

1. Journalize the adjusting entries needed on January 31, 2012.

E3-22: JOURNALIZING ADJUSTING ENTRIES AND ANALYZING THEIR EFFECT ON THE INCOME

STATEMENTJournal

DATEACCOUNTS AND EXPLANATIONS

POST.

REF. DEBIT CREDIT2013 Adjusting Entries

Jan 31 Depreciation expense 500a. Accumulated depreciation 500

b. 31 Rent expense 600Prepaid rent 600

c. 31 Interest expense 300Interest payable 300

d. 31 Salary expense 10,400Salary payable 10,400

e. 31 Unearned service revenue 1,300Service revenue 1,300

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E3-22: JOURNALIZING ADJUSTING ENTRIES AND ANALYZING THEIR EFFECT ON THE

INCOME STATEMENT

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2. Suppose the adjustments made in Requirement 1 were not made. Compute the overall overstatement or understatement of net income as a result of the omission of these adjustments.

Net income would be overstated by $10,500.

Summary of Adjusting Summary of Adjusting EntriesEntries

• To properly measure net income for the period– The entry affects a revenue or an expense

• To update the balance sheet– The entry affects an asset or a liability

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Adjusted Trial BalanceAdjusted Trial Balance

• Prepared after adjusting entries are posted

• Useful step in preparing financial statements

• Often appears on a work sheet– Tool accountants use at end of period

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S3-10: PREPARING AN ADJUSTED TRIAL BALANCE

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a) 600

a) 600

b)1,000

b)1,000

c) 600

c) 600

$2,200 $2,200

$ 800 300 19,100 $ 2,000 200 600 2,500 7,400 14,800 4,500 600 1,000 1,200 ______

$27,500 $27,500

Prepare the financial statements from the adjusted trial balance

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Income Statement is prepared first.

Revenue - Expenses

Statement of Owner’s Equity is second

The Balance Sheet is prepared last.

A = L + E

Income Statement

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Statement of Retained Earnings

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Balance Sheet

S3-10: PREPARING AN INCOME STATEMENT

Refer to the data in Short Exercise 3-10.

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Famous Cut Hair StylistsIncome Statement

Year Ended December 31, 2012Revenue: Service revenue $ 14,800Expenses: Rent expense $ 4,500 Interest expense 1,200 Depreciation expense 1,000 Supplies expense 600

Total expenses 7,300Net income $ 7,500

FOR 3-27: PREPARING A STATEMENT OF OWNER’S EQUITY (ADDITIONAL STEP)

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Famous Cut Hair Stylists

Statement of Owner’s Equity

Year Ended December 31, 2012

Fabio, capital, December 31, 2011 $ 7,400

Net income 7,500

14,900

Drawing 0

Fabio, capital, December 31, 2012 $ 14,900

S3-12: PREPARING A BALANCE SHEET

Compute Famous Cut’s total assets at December 31, 2012.

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Famous Cut Hair StylistsBalance Sheet

December 31, 2012ASSETS LIABILITIES

Cash $ 800 Accounts payable $ 200Supplies 300 Interest payable 600Equipment $19,100 Notes payable 2,500Accu. Depr. (2,000) 17,100 Total liabilities 3,300

OWNER’ S EQUITY Fabio, capital $ 14,900

Total assets $18,200Total liabilities and owner’s equity

$18,200

Understand the alternate treatment of unearned

revenues and prepaid expenses(see Appendix 3A, located at

myaccountinglab.com)

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Alternative Treatment of Alternative Treatment of PrepaidPrepaid

ExpensesExpenses• Prepaid Expenses (normally)

– Advance payments of expenses– Debit an asset account– Adjust at end of period

• Alternative– Debit an expense account– Adjust at end of period

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Prepaid ExpensePrepaid Expense

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Initially debit and expense account

Adjust at end of period for unused amount

Unearned (Deferred) Unearned (Deferred) RevenuesRevenues

• Unearned Revenues (normally)– Advance receipt of revenues–creates liability– Credit a liability account– Adjust at end of period

• Alternative– Credit a revenue account– Adjust at end of period

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Unearned (Deferred) Unearned (Deferred) RevenuesRevenues

• Initially credit a revenue account

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Adjust at end of period for unearned amount

Chapter 3 SummaryChapter 3 Summary• Cash-basis accounting and accrual

accounting are different. Accrual accounting records revenues and expenses when they are earned/incurred. Cash-basis accounting records revenues and expenses when cash is received or paid.

• The principles guide us as to when (the time period and accounting period concepts) and how (the revenue recognition and matching principles) to record revenues and expenses.

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Chapter 3 SummaryChapter 3 Summary• We adjust accounts to make sure the balance

sheet shows the value of what we own (assets) and what we owe (liabilities) on a specific date. We also adjust to make sure all revenues and expenses are recorded in the period they are earned or incurred. Adjusting journal entries either credit a revenue account or debit an expense account, but they NEVER affect the Cash account.

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Chapter 3 SummaryChapter 3 Summary• The adjusted trial balance includes all the

transactions captured during the period on the trial balance plus/minus any adjusting journal entries made at the end of the period. The adjusted trial balance gives us the final adjusted values that we use to prepare the financial statements.

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Chapter 3 SummaryChapter 3 Summary• The financial statements must be prepared in

order: 1. income statement2. statement of retained earnings3. balance sheet, third.

• It is important for accountants to prepare accurate and complete financial statements as other people rely on the data to make decisions.

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