The Adjusting Process Chapter 3 3-1Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall

The Adjusting Process

Chapter 3

3-1Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall

Learning Objectives

1. Differentiate between cash basis accounting and accrual basis accounting

2. Define and apply the time period concept, revenue recognition, and matching principles

3. Explain the purpose of and journalize and post adjusting entries

4. Explain the purpose of and prepare an adjusted trial balance


Learning Objectives

5. Identify the impact of adjusting entries on the financial statements

6. Explain the purpose of a worksheet and use it to prepare adjusting entries and the adjusted trial balance

7. Understand the alternative treatments of recording prepaid expenses and unearned revenues (Appendix 3A)


Learning Objective 1

Differentiate between cash basis accounting

and accrual basis accounting


What is the Difference between Cash Basis Accounting & Accrual Basis Accounting?

CASH BASIS• Revenue is recorded

when Cash is received

• Expenses are recorded when Cash is paid

• Not allowed under GAAP

ACCRUAL BASIS• Revenue is recorded

when it is earned• Expenses are

recorded when incurred

• Generally used by larger businesses



Define and apply the time period concept, revenue recognition,

and matching principles


The Time Period Concept

• Assumes that a business’s activities can be sliced into small segments and that financial statements can be prepared for specific time periods, such as a month, quarter, or year.

• Any twelve month period is referred to as a fiscal year.


Su Mo Tu We Th Fr Sa

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14 15 16 17 18 19 20

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OCTOBER 2012

The Revenue Recognition Principle


Revenue should be recorded when it is

EARNED.

A good has been delivered

or a service has been

performed.

The earnings

process is complete.

The amount of revenues must represent the

actually selling price.

If a $200 item is discounted to $100, then the

revenue is $100.

The Matching Principle


Expenses are recorded when

they are incurred during

the period.

Expenses are matched at the end of the period

against the revenues for that period.

For example, rent expense for January should be

matched against January revenues, even if was

actually paid in December.


Explain the purpose of and journalize and post

adjusting entries



The initial trial balance that comes from the

General Ledger is referred to as an Unadjusted Trial

Balance.

Because of the Time Period Concept,

Revenue Recognition Principle, and Matching

Principle some adjustments are

needed.

Smart Touch Learning

Trial Balance

December 31, 2014

Debit Credit

Cash 12,200$

Accounts Receivable 1,000

Office Supplies 500

Prepaid Rent 3,000

Furniture 18,000

Building 60,000

Land 20,000

Accounts Payable 200

Utilities Payable 100

Unearned Revenue 600

Notes Payable 60,000

Common Stock 48,000

Dividends 5,000

Service Revenue 16,500

Rent Expense 2,000

Salaries Expense 3,600

Utilities Expense 100

125,400$ 125,400$

Smart Touch Learning

Trial Balance

December 31, 2014

Debit Credit

Cash 12,200$

Accounts Receivable 1,000

Office Supplies 500

Prepaid Rent 3,000

Furniture 18,000

Building 60,000

Land 20,000

Accounts Payable 200

Utilities Payable 100

Unearned Revenue 600

Notes Payable 60,000

Common Stock 48,000

Dividends 5,000 -

Service Revenue 16,500

Rent Expense 2,000

Salaries Expense 3,600

Utilities Expense 100

125,400$ 125,400$


For example, the Office Supplies

account shows $500 at the end of December.

If a count of the actual supplies on hand shows that some

supplies have been used, we will need to adjust the account.

Adjusting Journal Entries

• Adjustments to the Trial Balance are made by recording actual Adjusting Journal Entries.


Date Accounts and Explanation Debit Credit

Dec. 31 Account $$$ Account $$$


• Each Adjusting Journal Entry will adjust a balance sheet account and an income statement account.



Dec. 31 Supplies Expense $$$ Office Supplies $$$To record office supplies used.


Adjusting Journal Entries (AJE’s) can be divided into two basic categories:


Prepaids1.Prepaid Expenses2.Unearned Revenues

Accruals1.Accrued revenues2.Accrued expenses

Prepaid Rent Example

In Transaction #10 (see Chapter 2), on December 1, Smart Touch Learning prepaid 3 months rent of

$3,000 ($1,000 x 3 months).



Dec. 1 Prepaid Rent 3,000 Cash 3,000 Paid rent in advance.

Dec. 1 3,000 Prepaid Rent


Paying rent in advance gives us the right to use the property for 3 months (in this case). By the end

of December, 1/3 of that right has been used.



Dec. 1 Prepaid Rent 3,000 Cash 3,000 Paid rent in advance.

Dec. 1 3,000 Prepaid Rent


To adjust the Prepaid Rent account, we need to reduce it by 1/3, and we need to show the rent expense related to the December revenues.



Dec. 31 Rent Expense 1,000 Prepaid Rent 1,000 To record rent expense.

Dec. 1 3,000 1,000 Dec. 31Prepaid Rent

Depreciation

• Long-lived, tangible assets used to generate revenue are referred to as plant assets.

• Plant assets act like Prepaid Expenses

3-19Copyright ©2014 Pearson Education, Inc. Publishing as Prentice Hall

Paid for when

acquired

Used to produce revenues

Used up over time

Depreciation

• The process of systematically recording the periodic usage of plant assets to generate revenues is called Depreciation.

• The accounts used are:– Depreciation Expense– Accumulated

Depreciation


Land is never depreciated.

Accumulated Depreciation is a

contra-asset. - Has a credit balance- Appears in the Asset section of the Balance

Sheet

Depreciation Example

Assume that, on December 2, Smart Touch Learning received a contribution of furniture with a

market value of $18,000 from a stockholder.

At the end of December, Smart Touch Learning will need to record depreciation for the use of the furniture, assuming it has a 5 year useful life.



Dec. 2 Furniture 18,000 Common Stock 18,000 Contribution of furniture in exchange for common stock


Using the straight-line method of computing depreciation, Smart Touch Learning will need to

record $300 of depreciation for December.


Straight-Line Depreciation = ( Cost - Residual Value ) ÷ Useful Life = ( $18,000 - $0 ) ÷ 5 Years = $3,600 per year

Monthly Amount = $3,600 ÷ 12 months = $300


Recording the entry requires the use of two accounts: Depreciation Expense and

Accumulated Depreciation.



Dec. 31 Depreciation Expense—Furniture 300 Accumulated Depreciation—Furniture 300 To record depreciation on furniture.

Unearned Revenue Example

On December 21, a law firm engages Smart Touch Learning to provide e-learning services for the next

30 days, paying $600 in advance.



Dec. 21 Cash 600 Unearned Revenue 600 Collected cash for future services.

600 Dec. 21Unearned Revenue

Dec. 31 200 600 Dec. 21Unearned Revenue


Dec. 31 Unearned Revenue 200 Service Revenue 200 To record service revenue earned that was collected in advance.

Unearned Revenue Example

Smart Touch Learning is obligated to perform the services. During the last 10 days of the month, 1/3

of the services are performed.


Accrued Expenses Example

Smart Touch Learning pays its employee a monthly salary of $2,400, half on the 15th and half

on the first day of the next month.


Accrued Expenses Example

On December 31, Smart Touch Learning still owes the employee $1,200, which won’t be paid until

January 1.



Dec. 31 Salaries Expense 1,200 Salaries Payable 1,200 To accrue salaries expense.

Dec. 31 1,200 1,200 Dec. 31

Salaries Expense Salaries Payable

Accrued Revenue Example

Accrued revenues arise when the company recognizes that it has performed a service, or

delivered a product, but has not yet recorded that they have “earned” the revenue.



Dec. 31 Accounts Receivable xxxx Service Revenue xxxxTo accrue service revenue.

Accrued Revenue Example

On December 15, Smart Touch Learning agrees to perform e-learning services for $1,600 per month. By the end of December, they have earned ½ of

the monthly fee for December.



Dec. 31 Accounts Receivable 800 Service Revenue 800 To accrue service revenue.


Explain the purpose of and prepare an

adjusted trial balance


The Adjusted Trial Balance

• After journalizing and posting all the adjusting journal entries at the end of the fiscal period, a new adjusted trial balance is prepared.– List all accounts– List debit balances in the debit column– List credit balance in the credit column

• If it balances, financial statements can be prepared.


• The adjusted trial balance includes accounts that did not appear on the original unadjusted trial balance.

• The financial statements are prepared directly from the adjusted trial balance.



Identify the impact of adjusting entries on

the financial statements

3-33Copyright ©2014 Pearson Education, Inc. Publishing as Prentice Hall



Explain the purpose of a worksheet and use it

to prepare adjusting entries and the

adjusted trial balance



Account Names Debit Credit Debit Credit Debit CreditCash 6,500 Accounts Receivable 800 Offi ce Supplies 250 Prepaid Rent 1,000 Delivery Van 23,000 Accumulated Depreciation - Delivery VanEquipment 15,000 Accumulated Depreciation - EquipmentAccounts Payable 800 Utilities Payable 230 Salaries PayableUnearned Revenue 400 Common Stock 37,800 Dividends 8,000 Delivery Revenue 23,000 Rent Expense 3,000 Salaries Expense 4,500 Supplies ExpenseUtilities Expense 180 Depreciation Expense - Delivery VanDepreciation Expense - EquipmentTotal 62,230 62,230

Unadjusted Trial Balance Adjustments

Adjusted Trial Balance

First, enter the information from the unadjusted

trial balance into the first two

columns of the worksheet.


Account Names Debit Credit Debit Credit Debit CreditCash 6,500 Accounts Receivable 800 225 Offi ce Supplies 250 80 Prepaid Rent 1,000 800 Delivery Van 23,000 Accumulated Depreciation - Delivery Van 750 Equipment 15,000 Accumulated Depreciation - Equipment 300 Accounts Payable 800 Utilities Payable 230 Salaries Payable 875 Unearned Revenue 400 130 Common Stock 37,800 Dividends 8,000 Delivery Revenue 23,000 355 Rent Expense 3,000 800 Salaries Expense 4,500 875 Supplies Expense 80 Utilities Expense 180 Depreciation Expense - Delivery Van 750 Depreciation Expense - Equipment 300 Total 62,230 62,230 3,160 3,160



Second, enter the information

for the adjusting journal entries

into the Adjustments

columns.


Account Names Debit Credit Debit Credit Debit CreditCash 6,500 6,500 Accounts Receivable 800 225 1,025 Offi ce Supplies 250 80 170 Prepaid Rent 1,000 800 200 Delviery Van 23,000 23,000 Accumulated Depreciation - Delivery Van 750 750 Equipment 15,000 15,000 Accumulated Depreciation - Equipment 300 300 Accounts Payable 800 800 Utilities Payable 230 230 Salaries Payable 875 875 Unearned Revenue 400 130 270 Common Stock 37,800 37,800 Dividends 8,000 8,000 Delivery Revenue 23,000 355 23,355 Rent Expense 3,000 800 3,800 Salaries Expense 4,500 875 5,375 Supplies Expense 80 80 Utilities Expense 180 180 Depreciation Expense - Delivery Van 750 750 Depreciation Expense - Equipment 300 300 Total 62,230 62,230 3,160 3,160 64,380 64,380



Third, cross-foot the numbers across the

spreadsheet to the Adjusted Trial Balance

columns.


Understand the alternative treatments of recording prepaid

expenses and unearned revenues

(Appendix 3A)


Alternative Treatment of Prepaid Expenses

Rather than record the prepayment of an expense as a current asset, record the prepayment as an

expense on the date of payment.



Dec. 1 Rent Expense 3,000 Cash 3,000 Paid rent in advance.

Alternative Treatment of Prepaid Expenses

At the end of the period, if any of the expense remains “unused,” then adjust some of it INTO the

prepaid asset account.

The results are the same as the

traditional approach.3-41Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall


Dec. 31 Prepaid Rent 2,000 Rent Expense 2,000 To record prepaid rent.

Alternative Treatment of Unearned Revenues

Rather than record the early cash receipt from a customer as a current liability, record the cash

receipt as a revenue on the date of receipt.



Dec. 1 Cash 600 Service Revenue 600 Collected cash for future services.

Alternative Treatment of Unearned Revenues

At the end of the period, if any of the revenue remains “unearned,” then adjust some of it INTO

the unearned revenue account.

The results are the same as the

traditional approach.3-43Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall


Dec. 31 Service Revenue 400 Unearned Revenue 400 To record unearned revenue.

End of Chapter 3


Documents

The Adjusting Process Chapter 3 3-1Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall