slide 3-1. slide 3-2 adjusting the accounts financial accounting, seventh edition accounting 201,...

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Adjusting theAdjusting the

AccountsAccounts

Financial Accounting, Seventh Edition

Accounting 201, Instructor: Judith Paquette

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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.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

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Types of adjusting Types of adjusting entriesentries

Adjusting entries for Adjusting entries for deferralsdeferrals

Adjusting entries for Adjusting entries for accrualsaccruals

Summary of Summary of journalizing and journalizing and postingposting

Timing IssuesTiming IssuesTiming IssuesTiming Issues

Fiscal and calendar Fiscal and calendar yearsyears

Accrual- vs. cash-Accrual- vs. cash-basis accountingbasis accounting

Recognizing Recognizing revenues and revenues and expensesexpenses

Preparing the Preparing the adjusted trial balanceadjusted trial balance

Preparing financial Preparing financial statementsstatements

The Basics of The Basics of Adjusting EntriesAdjusting Entries

The Basics of The Basics of Adjusting EntriesAdjusting Entries

The Adjusted Trial The Adjusted Trial Balance and Balance and

Financial StatementsFinancial Statements

The Adjusted Trial The Adjusted Trial Balance and Balance and

Financial StatementsFinancial Statements

Adjusting the AccountsAdjusting the AccountsAdjusting the AccountsAdjusting the Accounts

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Generally a month, a quarter, or a yearFiscal year vs. calendar yearAlso known as the “Periodicity Assumption”


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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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


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

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.

Solution on notes page

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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.

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Cash-Basis Accounting

Revenues are recognized when cash is

received.

Expenses are recognized when cash is paid.

Cash-basis accounting is not in accordance with

generally accepted accounting principles

(GAAP).


Accrual- vs. Cash-Basis Accounting


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Revenue Recognition Principle


Recognizing Revenues and Expenses


Companies 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.

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Expense Recognition Principle – (Matching 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.”

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GAAP relationships in revenue and expense recognition

Illustration 3-1

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Here’s an example of Accrual Here’s an example of Accrual vs. Cash Accounting vs. Cash Accounting

A man, Jaewan, starts a company. The company paints A man, Jaewan, starts a company. The company paints buildings, called buildings, called Sky High PaintingSky High Painting

Jaewan invests $60,000 of his own money Jaewan invests $60,000 of his own money in Sky High in Sky High Painting Painting.Painting Painting.

The company is started on December 1, 2010.The company is started on December 1, 2010. He gets the job to paint a BIG Building in downtown He gets the job to paint a BIG Building in downtown

Bellevue.Bellevue. He hires employees and buys paint. He hires employees and buys paint. They paint the building.They paint the building. He pays all his expenses of $50,000 in cash.He pays all his expenses of $50,000 in cash. He bills the customer for $80,000 and goes home on He bills the customer for $80,000 and goes home on

December 31December 31stst, 2010., 2010. He gets hit by a car on the way home and dies.He gets hit by a car on the way home and dies.

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Year 1 Year 2

Purchased paint, painted building , paid employees

Received payment for work done in year one

Activity

Accrualbasis

Cashbasis

Revenue $80,000

Expense 50,000

Net Income $30,000

Revenue $ 0

Expense 50,000

Net Loss ( $50,000)

Revenue $80,000

Expense 0

Net Income $80,000

Revenue $ 0

Expense 0

Net Income $ 0

Illustration 4-2

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Adjusting entries make it possible to report

correct amounts on the balance sheet and

on the income statement.

A company must make adjusting entries

every time it prepares financial statements.

The Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting Entries

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

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Here’s an example of why we need Here’s an example of why we need adjusting entries…adjusting entries…

A company buys supplies for $900 on A company buys supplies for $900 on October 3October 3rdrd..

JE? T Account?JE? T Account? On October 31On October 31stst a physical inventory shows a physical inventory shows

that there are only $250 supplies on hand.that there are only $250 supplies on hand. How do we adjust the Supplies Account?How do we adjust the Supplies Account?

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RevenuesRevenues - recorded in the period in which - recorded in the period in which

they are earnedthey are earned.

Expenses Expenses - recognized in the period in which - recognized in the period in which

they are incurredthey are incurred.

Adjusting entriesAdjusting entries - needed to ensure that - needed to ensure that

the the revenue recognitionrevenue recognition and and matching matching

principlesprinciples are followed. are followed.



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Types of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting Entries

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. Revenues received in cash and recorded as liabilities before they are earned.

Accruals

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

Illustration 3-2Categories of adjusting entries

Types of Adjusting Entries

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Trial BalanceTrial Balance – Illustrations are based on the October 31, trial balance of Pioneer Advertising Agency Inc.

Illustration 3-3


SO 4 Identify the major types of adjusting entries.SO 4 Identify the major 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 Payment of cash that is recorded as an asset because service or benefit will be received in the future.service or benefit will be received in the future.

Adjusting Entries for “Prepaid Adjusting Entries for “Prepaid Expenses”Expenses”Adjusting Entries for “Prepaid Adjusting Entries for “Prepaid Expenses”Expenses”

insuranceinsurance

suppliessupplies

advertisingadvertising

Cash PaymentCash Payment Expense RecordedExpense RecordedBEFORE


rentrent

maintenance on maintenance on equipmentequipment

fixed assets fixed assets (depreciation)(depreciation)

Prepayments often occur in regard to:Prepayments often occur in regard to:

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Prepaid Expenses

Costs that expire either with the passage of time or through use.

Adjusting entries (1) to record the expenses that apply to the current accounting period, and (2) to show the unexpired costs in the asset accounts.



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Adjusting entries for prepaid expenses

Increases (debits) an expense account and

Decreases (credits) an asset account.

Illustration 3-4

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#1 Illustration: Pioneer Advertising Agency purchased advertising supplies costing $2,500 on October 5. Pioneer recorded the payment by increasing (debiting) the asset Advertising 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.

Advertising supplies 1,500

Advertising supplies expense

1,500Oct. 31

Illustration 3-5



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#2 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 theOctober 31 trial balance. Insurance of $50 ($600 / 12) expires each month.

Prepaid insurance 50

Insurance expense 50Oct. 31

Illustration 3-6



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Depreciation

Buildings, equipment, and vehicles (long-lived

assets) are recorded as assets, rather than an

expense, in the year acquired.

Companies report a portion of the cost of a long-

lived asset as an expense (depreciation) during

each period of the asset’s useful life (Matching

Principle).



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#3 Illustration: Pioneer Advertising estimates depreciation on the office equipment to be $480 a year, or $40 per month.

Accumulated depreciation

40

Depreciation expense 40Oct. 31

Illustration 3-7



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Depreciation (Statement Presentation)

Accumulated Depreciation is a contra asset account.

Appears just after the account it offsets (Equipment) on the balance sheet. Illustration 3-8



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SummaryIllustration 3-9



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

Adjusting Entries for “Unearned Adjusting Entries for “Unearned Revenues”Revenues”Adjusting Entries for “Unearned Adjusting Entries for “Unearned Revenues”Revenues”

rentrent

airline ticketsairline tickets

school tuitionschool tuition

Cash ReceiptCash Receipt Revenue RecordedRevenue RecordedBEFORE

magazine subscriptionsmagazine subscriptions

customer depositscustomer deposits

Unearned revenues often occur in regard to:Unearned revenues often occur in regard to:


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Unearned Revenues

Company makes an adjusting entry to record the

revenue that has been earned and to show the

liability that remains.

The adjusting entry for unearned revenues results

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

increase (a credit) to a revenue account.



31 SO 5 Prepare adjusting entries for deferrals.SO 5 Prepare adjusting entries for deferrals.

Adjusting entries for unearned revenues

Decrease (a debit) to a liability account and

Increase (a credit) to a revenue account.


Illustration 3-10

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#4 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

Illustration 3-11


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Summary


Illustration 3-12


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Made to record:

Revenues earned and

OR

Expenses incurred

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

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


Adjusting Entries for Accruals

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Revenues earned but not yet received in cash or Revenues earned but not yet received in cash or recorded.recorded.

Adjusting Entries for “Accrued Adjusting Entries for “Accrued Revenues”Revenues”Adjusting Entries for “Accrued Adjusting Entries for “Accrued Revenues”Revenues”

rentrent

interestinterest

services performedservices performed

BEFORE

Accrued revenues often occur in regard to:Accrued revenues often occur in regard to:

Cash ReceiptCash ReceiptRevenue RecordedRevenue Recorded

Adjusting entry results in:Adjusting entry results in:


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Accrued Revenues

An adjusting entry serves two purposes:

(1) It shows the receivable that exists, and

(2) It records the revenues earned.



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Adjusting entries for accrued revenues

Increases (debits) an asset account and

Increases (credits) a revenue account.



Illustration 3-13

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#5 Illustration: In October Pioneer Advertising Agency earned $200 for advertising services that had not been recorded.

Service Revenue 200

Accounts Receivable 200Oct. 31

Illustration 3-14



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Expenses incurred but not yet paid in cash or Expenses incurred but not yet paid in cash or recorded.recorded.

Adjusting Entries for “Accrued Adjusting Entries for “Accrued Expenses”Expenses”Adjusting Entries for “Accrued Adjusting Entries for “Accrued Expenses”Expenses”

rentrent

interestinterest

BEFORE

Accrued expenses often occur in regard to:Accrued expenses often occur in regard to:

Cash PaymentCash PaymentExpense RecordedExpense Recorded

taxestaxes

salariessalaries

Adjusting entry results in:Adjusting entry results in:


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Accrued Expenses

An adjusting entry serves two purposes:

(1) It records the obligations, and

(2) It recognizes the expenses.



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Adjusting entries for accrued expenses

Increases (debits) an expense account and

Increases (credits) a liability account.



Illustration 3-16

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

#6 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

Illustration 3-18

Illustration 3-17



#7 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



#7 (con’t) 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).

Salaries payable 1,200

Salaries expense 1,200Oct. 31

Illustration 3-20


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After all adjusting entries are journalized and posted

the company prepares another trial balance from the

ledger accounts (Adjusted Trial Balance).

Its purpose is to prove the equality of debit balances

and credit balances in the ledger.

The Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial Balance

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

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SO 7SO 7

Illustration 3-24Adjusted 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 Statemen

t

Retained Earnings Statemen

t

Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements


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Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements

Illustration 3-25 Preparation of the incomestatement and retained earnings statement from the adjusted trial balance

SO 7SO 7

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Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsIllustration 3-26

SO 7SO 7

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End of Chapter 3End of Chapter 3

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California adds $6 to $10 of sales tax to the cost of computers and televisions to fund recycling programs.

Each cathode ray tube (CRT) monitor contains 4–6 pounds of lead. Consumer electronic products account for about 40% of the lead found in landfills.

Environmental groups put a resolution on a recent Apple Computer’s shareholder meeting agenda requiring the company to study how it can increase recycling.

The average household has two to three old computers in its garage or storage area.

Is Your Old Computer a Liability?

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Should companies accrue for environmental cleanup costs as liabilities on their financial statements?

YES: As more states impose laws holding companies responsible, and as more courts levy pollution-related fines, it becomes increasingly likely that companies will have to pay large amounts in the future.

NO: The amounts still are too difficult to estimate. Putting inaccurate estimates on the financial statements reduces their usefulness. Instead, why not charge the costs later, when the actual environmental cleanup or disposal occurs, at which time the company knows the actual cost?

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Some companies use an alternative treatment

for prepaid expenses and unearned revenues.

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 Alternative Treatment of Prepaid Expenses and Unearned RevenuesExpenses and Unearned RevenuesAlternative Treatment of Prepaid Alternative Treatment of Prepaid Expenses and Unearned RevenuesExpenses and Unearned Revenues

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

APPENDIX

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Illustration: Pioneer Advertising purchased supplies on October 5 for $2,500 and debited AdvertisingSupplies Expense for the full amount. What if an inventoryof $1,000 of advertising supplies remains on October 31?

Alternative Treatment for “Prepaid Alternative Treatment for “Prepaid Expenses”Expenses”Alternative Treatment for “Prepaid Alternative Treatment for “Prepaid Expenses”Expenses”


Advertising supplies expense

1,000

Advertising supplies 1,000Oct. 31

Illustration 3A-1

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Alternative Treatment for “Prepaid Alternative Treatment for “Prepaid Expenses”Expenses”Alternative Treatment for “Prepaid Alternative Treatment for “Prepaid Expenses”Expenses”


Adjustment approaches—a comparisonIllustration 3A-2

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Illustration: Assume that Pioneer Advertising received $1,200 for future services on October 2 and credited the entire amount to Service Revenue. If at the statement date Pioneer has not performed $800 of the services, it would make an adjusting entry.

Alternative Treatment for “Unearned Alternative Treatment for “Unearned Revenues”Revenues”Alternative Treatment for “Unearned Alternative Treatment for “Unearned Revenues”Revenues”


Unearned service revenue 800

Service revenue 800Oct. 31

Illustration 3A-4

60 SO 8 Prepare adjusting entries for the alternative treatment of SO 8 Prepare adjusting entries for the alternative treatment of

deferrals.deferrals.

Adjustment approaches—a comparisonIllustration 3A-5

Alternative Treatment for “Unearned Alternative Treatment for “Unearned Revenues”Revenues”Alternative Treatment for “Unearned Alternative Treatment for “Unearned Revenues”Revenues”

61 SO 8 Prepare adjusting entries for the alternative treatment of SO 8 Prepare adjusting entries for the alternative treatment of

deferrals.deferrals.

Summary of Additional Adjustment Summary of Additional Adjustment RelationshipsRelationshipsSummary of Additional Adjustment Summary of Additional Adjustment RelationshipsRelationships

Illustration 3A-7

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CopyrightCopyrightCopyrightCopyright

63 SO 2SO 2

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Match the description of the concept to the concept.

Solution on notes page



gfcb

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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


SO 2 Explain the accrual basis of accounting.SO 2 Explain the accrual basis of accounting.Solution on notes page

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.

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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.

ReviewReview



67 SO 5SO 5

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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.

Review Review QuestionQuestion



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.

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