c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. The Adjusting Process Chapter 3

Learning Objectives 1. Describe the nature of the adjusting process. 2. Journalize entries for accounts requiring adjustment. 3. Summarize the adjustment process. 4. Prepare an adjusted trial balance. 5. Describe and illustrate the use of vertical analysis in evaluating a company’s performance and financial condition.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe the nature of the adjusting process. 1

Nature of the Adjusting Process o The accounting period concept requires that revenues and expenses be reported in the proper period.

Nature of the Adjusting Process o Under the accrual basis of accounting, revenues are reported on the income statement in the period in which they are earned.

Nature of the Adjusting Process o The accounting concept supporting the reporting of revenues when they are earned regardless of when cash is received is called the revenue recognition concept.

Nature of the Adjusting Process o The accounting concept supporting reporting revenues and related expenses in the same period is called the matching concept, or matching principle.

Nature of the Adjusting Process o Under the cash basis of accounting, revenues and expenses are reported on the income statement in the period in which cash is received or paid.

The Adjusting Process o Under the accrual basis, some of the accounts need updating at the end of the accounting period for the following reasons:  Some expenses are not recorded daily.  Some revenues and expenses are incurred as time passes rather than as separate transactions.  Some revenues and expenses may be unrecorded.

The Adjusting Process o The analysis and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process.

The Adjusting Process o The analysis and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process. o The journal entries that bring the accounts up to date at the end of the accounting period are called adjusting entries.

Types of Accounts Requiring Adjustment o Prepaid expenses are the advance payment of future expenses and are recorded as assets when cash is paid.

P REPAID E XPENSES (continued)

P REPAID E XPENSES (concluded)

Types of Accounts Requiring Adjustment o Unearned revenues are the advance receipt of future revenues and are recorded as liabilities when cash is received.

U NEARNED R EVENUES (continued)

U NEARNED R EVENUES (concluded)

Types of Accounts Requiring Adjustment o Accrued revenues are unrecorded revenues that have been earned and for which cash has yet to be received.

A CCRUED R EVENUES (continued)

(concluded) A CCRUED R EVENUES

Types of Accounts Requiring Adjustment o Accrued expenses are unrecorded expenses that have been incurred and for which cash has yet to be paid.

A CCRUED E XPENSES (continued)

A CCRUED E XPENSES (concluded)

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Journalize entries for accounts requiring adjustment. 2

A DJUSTING E NTRIES

Prepaid Expenses o NetSolutions’ supplies account has a balance of $2,000 on the unadjusted trial balance. Some of these supplies have been used. On December 31, a count reveals that the amount of supplies on hand is $760. Supplies (balance on trial balance) $2,000 Supplies on hand, December 31 – 760 Supplies used $1,240

P REPAID E XPENSES Assets = Liabilities + Owner’s Equity (Expense) Accounting Equation Impact decrease increase

Prepaid Insurance o The debit balance of $2,400 in NetSolutions’ prepaid insurance account represents the December 1 prepayment of insurance for 12 months.

Assets = Liabilities + Owner’s Equity (Expense) Accounting Equation Impact decrease increase P REPAID I NSURANCE

Impact of Omitting Adjusting Entries

Unearned Revenues o The credit balance of $360 in NetSolutions’ unearned rent account represents the receipt of three months’ rent on December 1 for December, January, and February. At the end of December, one month’s rent has been earned.

U NEARNED R EVENUES Assets = Liabilities + Owner’s Equity (Revenue) Accounting Equation Impact decrease increase

Impact of Omitting Adjusting Entry

Accrued Revenues o NetSolutions signed an agreement with Danker Co. on December 15 to provide services at a rate of $20 per hour. As of December 31, NetSolutions had provided 25 hours of services. The revenue will be billed on January 15.

U NEARNED R EVENUES Assets = Liabilities + Owner’s Equity (Revenue) Accounting Equation Impact increase

Impact of Omitting Adjusting Entry

Accrued Expenses: Accrued Wages

Accrued Wages o NetSolutions pays it employees biweekly. During December, NetSolutions paid wages of $950 on December 13 and $1,200 on December 27. As of December 31, NetSolutions owes $250 of wages to employees for Monday and Tuesday, December 30 and 31.

A CCRUED W AGES Assets = Liabilities + Owner’s Equity (Expense) Accounting Equation Impact increase

Accrued Wages o NetSolutions paid wages of $1,275 on January 10. This payment includes the $250 of accrued wages recorded on December 31.

I MPACT OF O MITTING A DJUSTING E NTRY

Depreciation Expense o Fixed assets, or plant assets, are physical resources that are owned and used by a business and are permanent or have a long life. o As time passes, a fixed asset loses its ability to provide useful services. This decrease in usefulness is called depreciation.

Depreciation Expense o All fixed assets, except land, lose their usefulness and, thus, are said to depreciate. o As a fixed asset depreciates, a portion of its cost should be recorded as an expense. This periodic expense is called depreciation expense.

Depreciation Expense o The fixed asset account is not decreased (credited) when making the related adjusting entry. This is because both the original cost of a fixed asset and the depreciation recorded since its purchase are reported on the balance sheet. Instead, an account entitled Accumulated Depreciation is increased (credited). o Accumulated depreciation accounts are called contra accounts, or contra asset accounts.

Depreciation Expense o Normal titles for fixed asset accounts and their related contra asset accounts are as follows:

Depreciation Expense o NetSolutions estimates the depreciation on its office equipment to be $50 for the month of December.

D EPRECIATION E XPENSE Assets = Liabilities + Owner’s Equity (Expense) Accounting Equation Impact increase

Depreciation Expense o The difference between the original cost of the office equipment and the balance in the accumulated depreciation—office equipment account is called the book value of the asset (or net book value). It is computed as shown below. Book Value of Asset= Cost of the Asset – Accumulated Depreciation of Asset Book Value of Off. Equip. = Cost of Off. Equip. – Acc. Deprec. of Office Equip. Book Value of Off. Equip.= $1,800 – $50 Book Value of Off. Equip.= $1,750

I MPACT OF O MITTING A DJUSTING E NTRY

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Summarize the adjustment process. 3

S UMMARY OF A DJUSTMENT P ROCESS (continued)

S UMMARY OF A DJUSTMENT P ROCESS

(continued) S UMMARY OF A DJUSTMENT P ROCESS

(continued) S UMMARY OF A DJUSTMENT P ROCESS

(concluded) S UMMARY OF A DJUSTMENT P ROCESS

A DJUSTING E NTRIES

(continued) L EDGER WITH A DJUSTING E NTRIES

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Prepare an adjusted trial balance. 4

Adjusted Trial Balance o The purpose of the adjusted trial balance is to verify the equality of the total debit and credit balances before the financial statements are prepared.

A DJUSTED T RIAL B ALANCE

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe and illustrate the use of vertical analysis in evaluating a company’s performance and financial condition 5

Vertical Analysis o Comparing each item in a financial statement with a total amount from the same statement is referred to as vertical analysis.

Vertical Analysis $12,500 =.067 or 6.7% $187,500

Vertical Analysis $3,000 =.02 or 2% $150,000

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. The Adjusting Process The End