Financial Accounting and Accounting Standards 2 Explain the accrual basis of accounting. Timing Issues . 3-7 ... Ensure that the revenue recognition and expense recognition principles

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Chapter 3 Adjusting the Accounts

Learning Objectives

After studying this chapter, you should be able to:

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.

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Financial Accounting

IFRS Edition, 2e

Weygandt Kimmel Kieso

Preview of Chapter 3

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Generally a month, a quarter, or a year.

Also known as the “Periodicity Assumption”

Timing Issues

Accountants divide the economic life of a business into

artificial time periods (Time Period Assumption).

LO 1 Explain the time period assumption.

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

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Monthly and quarterly time periods are called interim

periods.

Most large companies must prepare both quarterly and

annual financial statements.

Fiscal Year = Accounting time period that is one year in

length.

Calendar Year = January 1 to December 31.

Timing Issues

LO 1 Explain the time period assumption.

Fiscal and Calendar Years

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Accrual-Basis Accounting

Transactions recorded in the periods in which the

events occur.

Revenues are recognized when the services are

performed, 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.

Timing Issues

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Cash-Basis Accounting

Revenues recognized when cash is received.

Expenses recognized when cash is paid.

Cash-basis accounting is not in accordance with

International Financial Reporting Standards (IFRS).

Accrual- vs. Cash-Basis Accounting


Timing Issues

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Revenue Recognition Principle

Recognizing Revenues and Expenses


Recognize revenue in the

accounting period in which the

performance obligation is

satisfied.

In a service enterprise,

revenue is considered to be

earned at the time the service

is performed.

Timing Issues

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Expense Recognition 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.”

Timing Issues

3-10 LO 2 Explain the accrual basis of accounting.

Timing Issues

Illustration 3-1

IFRS relationships in revenue

and expense recognition

3-11 LO 2 Explain the accrual basis of accounting.

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A list of concepts is provided in the left column below, with a

description of the concept in the right column below. There are more

descriptions provided than concepts. Match the description of the

concept to the concept.

LO 2

f

e

c

b

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Adjusting Entries

Ensure that the revenue recognition and expense

recognition principles are followed.

Necessary because the trial balance may not contain

up-to-date and complete data.

Required every time a company prepares financial

statements.

Will include one income statement account and one

statement of financial position account.

LO 3 Explain the reasons for adjusting entries.

The Basics of Adjusting Entries

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1. Prepaid Expenses.

Expenses paid in cash before

they are used or consumed.

Deferrals

3. Accrued Revenues.

Revenues for services

performed but not yet

received in cash or recorded.

4. Accrued Expenses.

Expenses incurred but not yet

paid in cash or recorded.

2. Unearned Revenues.

Cash received before services

are performed.

Accruals

Illustration 3-2

Categories of adjusting entries


LO 4 Identify the major types of adjusting entries.

Types of Adjusting Entries

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Trial Balance –

Each account is

analyzed to

determine whether

it is complete and

up-to-date.

Illustration 3-3


LO 4 Identify the major types of adjusting entries.

Types of Adjusting Entries

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Deferrals are either:

Prepaid expenses

OR

Unearned revenues.

LO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for Deferrals


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Payment of cash, that is recorded as an asset because

service or benefit will be received in the future.

insurance

supplies

advertising

Cash Payment Expense Recorded BEFORE

rent

equipment

buildings

Prepayments often occur in regard to:



Prepaid Expenses

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Expire either with the passage of time or through use.

Adjusting entry:

► Increase (debit) to an expense account and

► Decrease (credit) to an asset account.



Prepaid Expenses

Illustration 3-4

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Illustration: Pioneer Advertising Agency

purchased supplies costing $2,500 on

October 5. Pioneer recorded the payment

by increasing (debiting) the asset

Supplies. This account shows a balance

of $2,500 in the October 31 trial balance.

An inventory count at the close of

business on October 31 reveals that

$1,000 of supplies are still on hand.

Supplies 1,500

Supplies expense 1,500 Oct. 31



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Illustration 3-5

LO 5

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Illustration: On October 4, Pioneer

Advertising paid $600 for a one-year fire

insurance policy. Coverage began on

October 1. Pioneer recorded the payment

by increasing (debiting) Prepaid

Insurance. This account shows a balance

of $600 in the October 31 trial balance.

Insurance of $50 ($600 ÷ 12) expires each

month.

Prepaid insurance 50

Insurance expense 50 Oct. 31



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Illustration 3-6

LO 5

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Depreciation

Buildings, equipment, and vehicles (assets with long

lives) are recorded as assets, rather than an expense,

in the year acquired.

Depreciation allocates a portion of the asset’s cost as

an expense during each period of the asset’s useful life.

Depreciation does not attempt to report the actual

change in the value of the asset.



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40

Illustration: For Pioneer Advertising, assume

that depreciation on the equipment is $480 a

year, or $40 per month.

Accumulated depreciation 40

Depreciation expense

Oct. 31



Accumulated Depreciation is called a contra

asset account.

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LO 5

Illustration 3-7

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Statement Presentation

Accumulated Depreciation is a contra asset account

(credit).

Appears just after the account it offsets (Equipment) on

the statement of financial position.

Book value is the difference between the cost of any

depreciable asset and its accumulated depreciation.



Illustration 3-8

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Illustration 3-9



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Receipt of cash that is recorded as a liability because service

has not be performed.

Rent

Airline tickets

Cash Receipt Revenue Recorded BEFORE

Magazine subscriptions

Customer deposits

Unearned revenues often occur in regard to:



Unearned Revenues

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Adjusting entry is made to record the revenue for

services performed and to show the liability that remains.

Results in a decrease (debit) to a liability account and

an increase (credit) to a revenue account.



Unearned Revenues

Illustration 3-10

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Illustration: Pioneer Advertising received $1,200 on October 2 from

R. Knox for advertising services expected to be completed by

December 31. Unearned Service Revenue shows a balance of

$1,200 in the October 31 trial balance. Analysis reveals that the

company earned $ 400 of those fees in October.

Service revenue 400

Unearned service revenue 400 Oct. 31



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LO 5

Illustration 3-11

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Illustration 3-12



3-33 LO 5

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Accruals are made to record

Revenues for services performed

OR

Expenses incurred

in the current accounting period that have not been

recognized through daily entries.

Adjusting Entries for Accruals


LO 6 Prepare adjusting entries for accruals.

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Revenues for services performed but not yet received in cash

or recorded.

Interest

Services performed

Rent

Accrued revenues often occur in regard to:


Accrued Revenues


BEFORE Cash Receipt Revenue Recorded

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Adjusting entry shows the receivable that exists and

records the revenues for services performed.

Adjusting entry:

► Increases (debits) an asset account and

► Increases (credits) a revenue account.


Illustration 3-13

LO 6

Accrued Revenues

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Illustration: In October Pioneer Advertising

Agency recognized $200 for advertising

services performed but not recorded.

Accounts receivable 200

Cash 200 Nov. 10



200

Service revenue 200

Accounts receivable

Oct. 31

On November 10, Pioneer receives cash of $ 200 for the services performed.

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Illustration 3-14

LO 6

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Illustration 3-15



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Expenses incurred but not yet paid in cash or recorded.

Rent

Interest

Taxes

Salaries

Accrued expenses often occur in regard to:


Accrued Expenses

BEFORE Cash Payment Expense Recorded


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Adjusting entry records the obligation and recognizes the

expense.

Adjusting entry:

► Increase (debit) an expense account and

► Increase (credit) a liability account.

LO 6


Accrued Expenses

Illustration 3-16

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Illustration: Pioneer Advertising signed a three-month note

payable in the amount of $5,000 on October 1. The note requires

Pioneer to pay interest at an annual rate of 12%.

Interest payable 50

Interest expense 50 Oct. 31



Illustration 3-17

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Illustration 3-18

LO 6

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Illustration: Pioneer Advertising last paid salaries on October 26;

the next payment of salaries will not occur until November 9. The

employees receive total salaries of $2,000 for a five-day work

week, or $400 per day. Thus, accrued salaries at October 31 are

$1,200 ($ 400 x 3 days).



Illustration 3-19

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Illustration 3-20

LO 6

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Illustration 3-21



3-47 LO 6 Prepare adjusting entries for accruals.

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Micro Computer Services Inc. began operations on August 1,

2014. At the end of August 2014, management attempted to

prepare monthly financial statements. The following information

relates to August. Prepare the adjusting journal entries needed at

August 31, 2014. (Amounts are in Chinese yuan.)

1. At August 31, the company owed its employees ¥8,000 in

salaries and wages that will be paid on September 1.

LO 6

Salaries and wages expense 8,000

Salaries and wages payable 8,000

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Interest expense (¥ 300,000 x 10% x 1/12) 2,500

Interest payable 2,500






2. At August 1, the company borrowed ¥300,000 from a local

bank on a 15-year mortgage. The annual interest rate is 10%.

3-50 LO 6

Accounts receivable 11,000

Service revenue 11,000






3. Revenue for services performed but unrecorded for August

totaled ¥11,000.

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Summary of Basic Relationships Illustration 3-22

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Prepared after all adjusting entries are journalized and

posted.

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.

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

The Adjusted Trial Balance

Adjusted Trial Balance

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Illustration 3-25

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Financial Statements are prepared directly from the

Adjusted Trial Balance.

Statement

of Financial

Position

Income

Statement

Retained

Earnings

Statement

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

Preparing Financial Statements

3-55 LO 7

Illustration 3-26

3-56 LO 7

Illustration 3-27

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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

LO 8 Prepare adjusting entries for the alternative treatment of deferrals.

APPENDIX 3A

3-58 LO 8 Prepare adjusting entries for the alternative treatment of deferrals.

Illustration 3A-2

Prepaid Expenses

Company may choose to debit (increase) an expense account

rather than an asset account. This alternative treatment is simply

more convenient.

APPENDIX 3A


Illustration 3A-5

Company may credit (increase) a revenue account when they

receive cash for future services.

APPENDIX 3A

Unearned Revenues


Illustration 3A-7

APPENDIX 3A

Summary of Additional Adjustment Relationships

3-61 LO 9 Discuss financial reporting concepts.

APPENDIX 3B CONCEPTS IN ACTION

Qualities of Useful Information Illustration 3B-1



Enhancing Qualities

Comparability

Consistency

Verifiability

Timeliness

Understandability

3-63 LO 9


Assumptions

in Financial

Reporting

Illustration 3B-2

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Assumptions

in Financial

Reporting

Illustration 3B-2



Principles of Financial Reporting

Measurement Principles

► Historical Cost Principle

► Fair Value Principle

Revenue Recognition Principle

Expense Recognition Principle

Full Disclosure Principle

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Principles of Financial Reporting

Constraints in Financial Reporting

Accounting standard-setters weigh the cost that companies

will incur to provide the information against the benefit that

financial statement users will gain from having the information

available.

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Key Points

Like IFRS, companies applying GAAP use accrual-basis accounting to

ensure that they record transactions that change a company’s financial

statements in the period in which events occur.

Similar to IFRS, cash-basis accounting is not in accordance with GAAP.

GAAP also divides the economic life of companies into artificial time

periods. Under both GAAP and IFRS, this is referred to as the time

period assumption.

GAAP has more than 100 rules dealing with revenue recognition. Many

of these rules are industry specific. Revenue recognition under IFRS is

determined primarily by a single standard, IAS 18. Despite this large

disparity in the detailed guidance devoted to revenue recognition, the

general revenue recognition principles required by IFRS that are used in

this textbook are similar to those under GAAP.

Another Perspective

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Key Points

Internal controls are a system of checks and balances designed to

detect and prevent fraud and errors. The Sarbanes-Oxley Act requires

U.S. companies to enhance their systems of internal control. However,

many foreign companies do not have this requirement.

Under IFRS, revaluation to fair value of items such as land and buildings

is permitted. This is not permitted under GAAP.

The form and content of financial statements are very similar under

GAAP and IFRS. Any significant differences will be discussed in those

chapters that address specific financial statements.

Revenue recognition fraud is a major issue in U.S. financial reporting.

The same situation exists for most other countries as well.

Another Perspective

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Key Points

As indicated above, both the IASB and FASB are working together on a

common conceptual framework. Some of the major issues that are being

addressed are:

► What are the qualitative characteristics that make accounting

information useful?

► What is the primary objective of financial reporting?

► What basis should be used to measure and report, that is, should a

historical cost or fair value approach be used?

► What criteria should be used to determine when revenue should be

recognized and when expenses have been incurred?

► What guidelines should be established for disclosing financial

information?

Another Perspective

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Key Points

Income includes both revenues, which arise during the normal course of

operating activities, and gains, which arise from activities outside of the

normal sales of goods and services. The term income is not used this

way under GAAP. Instead, under GAAP income refers to the net

difference between revenues and expenses. Expenses under IFRS

include both those costs incurred in the normal course of operations, as

well as losses that are not part of normal operations. This is in contrast

to GAAP, which defines each separately.

Another Perspective

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Looking to the Future

As this textbook is being written, the IASB and FASB are close to completing

a joint project on revenue recognition. The purpose of this project is to

develop comprehensive guidance on when to recognize revenue. This

approach focuses on changes in assets and liabilities as the basis for

revenue recognition. It is hoped that this approach will lead to more

consistent accounting in this area. For more on this topic, see

www.fasb.org/project/revenue_recognition.shtml.

Another Perspective

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Financial Accounting and Accounting Standards 2 Explain the accrual basis of accounting. Timing Issues . 3-7 ... Ensure that the revenue recognition and expense recognition principles