3-1. 3-2 chapter3 adjusting the accounts 3-3 3-4 generally a month, a quarter, or a year. also...

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CHAPTER3Adjusting the

Accounts

3-4

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).

SO 1 Explain the time period assumption.SO 1 Explain the time period assumption.

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

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Monthly and quarterly time periods are called interim

periods.

Public 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


Fiscal and Calendar Years

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The time period assumption states that:

a. revenue should be recognized in the accounting

period in which it is earned.

b. expenses should be matched with revenues.

c. the economic life of a business can be divided into

artificial time periods.

d. the fiscal year should correspond with the calendar

year.

ReviewReview


Timing Issues

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Accrual-Basis Accounting

Transactions recorded in the periods in which the

events occur.

Revenues are recognized when earned, rather than

when cash is received.

Expenses are recognized when incurred, rather

than when paid.

Accrual- vs. Cash-Basis Accounting

SO 2 Explain the accrual basis of accounting.SO 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

generally accepted accounting principles (GAAP).

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 it

is earned.

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

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

Timing Issues

Illustration 3-1 GAAP relationships in revenue and expense recognition

3-12 SO 2 Explain the accrual basis of accounting.SO 2 Explain the accrual basis of accounting.

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One of the following statements about the accrual basis of accounting is false. That statement is:

a. Events that change a company’s financial statements are recorded in the periods in which the events occur.

b. Revenue is recognized in the period in which it is earned.

c. The accrual basis of accounting is in accord with generally accepted accounting principles.

d. Revenue is recorded only when cash is received, and expenses are recorded only when cash is paid.

ReviewReview


Timing Issues

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Adjusting entries are necessary because the trial

balance may not contain up-to-date and complete

data.

Ensure that the revenue recognition and expense

recognition principles are followed.

Required every time a company prepares financial

statements.

Will include one income statement account and

one balance sheet account.

SO 3 Explain the reasons for adjusting entries.SO 3 Explain the reasons for adjusting entries.

The Basics of Adjusting Entries

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Adjusting entries are made to ensure that:

a. expenses are recognized in the period in which they are incurred.

b. revenues are recorded in the period in which they are earned.

c. balance sheet and income statement accounts have correct balances at the end of an accounting period.

d. all of the above.

SO 3 Explain the reasons for adjusting entries.SO 3 Explain the reasons for adjusting entries.

ReviewReview


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1. Prepaid Expenses. Expenses paid in cash and recorded as assets before they are used or consumed.

Deferrals

3. Accrued Revenues. Revenues earned 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 and recorded as liabilities before revenue is earned.

Accruals

Illustration 3-2Categories of adjusting entries


SO 4 Identify the major types of adjusting entries.SO 4 Identify the major types of adjusting entries.

Types of Adjusting Entries

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Trial BalanceTrial Balance –

Each account is

analyzed to

determine

whether it is

complete and up-

to-date.

Illustration 3-3


SO 4 Identify the major types of adjusting entries.SO 4 Identify the major types of adjusting entries.

Types of Adjusting Entries

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Deferrals are either:

Prepaid expenses

OR

Unearned revenues.

SO 5 Prepare adjusting entries for deferrals.SO 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 PaymentCash Payment Expense RecordedExpense RecordedBEFORE

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 1,500Oct. 31



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Illustration 3-5

SO 5SO 5

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Illustration: On October 4, Pioneer

Advertising Agency 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 50Oct. 31



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Illustration 3-6

SO 5SO 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.

Companies report a portion of the cost of the asset as

an expense (depreciation 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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SO 5SO 5

Illustration 3-7

3-28

Statement Presentation

Accumulated Depreciation is a contra asset account.

Appears just after the account it offsets (Equipment)

on the balance sheet.

Normal balance of a contra asset account is a credit.



Illustration 3-8

3-29

Illustration 3-9



3-30

Receipt of cash that is recorded as a liability because the revenue has not been earned.

Rent

Airline tickets

Cash ReceiptCash Receipt Revenue RecordedRevenue RecordedBEFORE

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 that

has been earned 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

3-32

Illustration: Pioneer Advertising Agency 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 400Oct. 31



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SO 5SO 5

Illustration 3-11

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Illustration 3-12



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Accruals are made to record

Revenues earned

OR

Expenses incurred

in the current accounting period that have not been recognized through daily entries.

Adjusting Entries for Accruals


SO 6 Prepare adjusting entries for accruals.SO 6 Prepare adjusting entries for accruals.

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Revenues earned but not yet received in cash or recorded.

Rent

Interest

Services performed

Accrued revenues often occur in regard to:


Accrued Revenues


BEFORE Cash ReceiptCash ReceiptRevenue RecordedRevenue Recorded

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Adjusting entry shows the receivable that exists and

records the revenues earned.

Adjusting entry:

► Increases (debits) an asset account and

► Increases (credits) a revenue account.


Illustration 3-13

SO 6SO 6

Accrued Revenues

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Illustration: In October Pioneer Advertising

Agency earned $200 for advertising services

that had not been recorded.

Accounts receivable 200

Cash 200Nov. 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

SO 6SO 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 PaymentCash PaymentExpense RecordedExpense 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.

SO 6SO 6


Accrued Expenses

Illustration 3-16

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Illustration: Pioneer Advertising Agency 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 50Oct. 31



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Illustration 3-18

SO 6SO 6

3-47

Illustration: Pioneer Advertising Agency 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

SO 6SO 6

3-49

Illustration 3-21



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Summary of Basic RelationshipsIllustration 3-22

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Adjusted Trial Balance

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.

SO 7 Describe the nature and purpose of the adjusted trial balance.SO 7 Describe the nature and purpose of the adjusted trial balance.

The Adjusted Trial Balance

3-52

Illustration 3-25

3-53

Which of the following statements is incorrect concerning the adjusted trial balance?

a. An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made.

b. The adjusted trial balance provides the primary basis for the preparation of financial statements.

c. The adjusted trial balance lists the account balances segregated by assets and liabilities.

d. The adjusted trial balance is prepared after the adjusting entries have been journalized and posted.

ReviewReview


The Adjusted Trial Balance

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Financial Statements are prepared directly from the Adjusted Trial Balance.

Financial Statements are prepared directly from the Adjusted Trial Balance.

Balance Sheet

Income Statement

Owner’s Equity

Statement


The Financial Statements

3-55 SO 7SO 7

Illustration 3-26

3-56

Illustration 3-27

SO 7SO 7

3-57

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

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

APPENDIX3A

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

Illustration 3A-2

Prepaid Expenses

APPENDIX3A

Company may choose to debit (increase) an expense

account rather than an asset account. This alternative

treatment is simply more convenient.


Illustration 3A-5

Unearned Revenues

APPENDIX3A

Company may credit (increase) a revenue account when

they receive cash for future services.


Illustration 3A-7

Summary of Additional Adjustment Relationships

APPENDIX3A

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Key Points

Companies applying IFRS also 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 GAAP, cash-basis accounting is not in accordance with IFRS.

IFRS 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.

IFRS requires that companies present a complete set of financial statements, including comparative information annually.

IFRS A Look at IFRS

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Key Points

GAAP has more than 100 rules dealing with revenue recognition. Many of these rules are industry specific. In contrast, revenue recognition under IFRS is determined primarily by a single standard. Despite this large disparity in the amount of detailed guidance devoted to revenue recognition, the general revenue recognition principles required by GAAP that are used in this textbook are similar to those under IFRS.

As the Feature Story illustrates, revenue recognition fraud is a major issue in U.S. financial reporting. The same situation occurs in other countries, as evidenced by revenue recognition breakdowns at Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch grocer AHold NV.

IFRS A Look at IFRS

3-63

Key Points

A specific standard exists for revenue recognition under IFRS (IAS 18). In general, the standard is based on the probability that the economic benefits associated with the transaction will flow to the company selling the goods, providing the service, or receiving investment income. In addition, the revenues and costs must be capable of being measured reliably. GAAP uses concepts such as realized, realizable (that is, it is received, or expected to be received), and earned as a basis for revenue recognition.

Under IFRS, revaluation of items such as land and buildings is permitted. IFRS allows depreciation based on revaluation of assets, which is not permitted under GAAP.

IFRS A Look at IFRS

3-64

Key Points

The terminology used for revenues and gains, and expenses and losses, differs somewhat between IFRS and GAAP. For example, income is defined as:

Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from shareholders.

Expenses are defined as:

Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity other than those r elating to distributions to shareholders.

IFRS A Look at IFRS

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Looking into the Future

IFRS A Look at IFRS

The IASB and FASB are now involved in a joint project on

revenue recognition. The purpose of this project is to develop

comprehensive guidance on when to recognize revenue.

Presently, the Boards are considering an approach that focuses

on changes in assets and liabilities (rather than on earned and

realized) as the basis for revenue recognition.

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GAAP:

a. provides very detailed, industry-specific guidance on

revenue recognition, compared to the general

guidance provided by IFRS.

b. provides only general guidance on revenue

recognition, compared to the detailed guidance

provided by IFRS.

c. allows revenue to be recognized when a customer

makes an order.

d. requires that revenue not be recognized until cash is

received.

IFRS A Look at IFRS

3-67

Which of the following statements is false?

a. IFRS employs the periodicity assumption.

b. IFRS employs accrual accounting.

c. IFRS requires that revenues and costs must be

capable of being measured reliably.

d. IFRS uses the cash basis of accounting.

IFRS A Look at IFRS

3-68

As a result of the revenue recognition project being

undertaken by the FASB and IASB:

a. revenue recognition will place more emphasis on

when revenue is earned.

b. revenue recognition will place more emphasis on

when revenue is realized.

c. revenue recognition will place more emphasis on

when changes occur in assets and liabilities.

d. revenue will no longer be recorded unless cash has

been received

IFRS A Look at IFRS

3-69

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