Chapter 3: The Adjusting Process Objectives 1: Distinguish accrual accounting from cash-basis accounting Accrual Basis Vs. Cash Basis

The Accounting Period: Time period principle: assumes that an entity’s life can be divided into specific time periods. Accounting divides the economic life of a business into artificial time periods (arbitrary time periods). Why? To provide immediate feedback to evaluate performance. Annual financial statements: cover a one-year period. Interim financial statements: cover less than one year (Monthly, quarterly, and semiannually). Objective 2: Apply the revenue and matching principles Recognizing Revenues and Expenses: Three new basic accounting principles Revenue Recognition Matching Time Period

The Revenue Principle: When is revenue recognized? When it is earned. The revenue recognition principle states that revenues be recorded in the accounting records when they are earned. In most cases, revenue is earned when the business has delivered a completed good or service to the customer. Not necessarily when cash is received. How much revenue should be recognized? - Cash value of item transferred to customer. When should revenue be recorded? When the magazines are mailed to customers. How much revenue should be recorded? As of March, three month’s revenue should be recognized. The Matching Principle: Measure all expenses incurred during the accounting period. When are expenses recognized? - Match the expenses against the revenues earned during the period. The Time Period Concept: - Requires that accounting information be reported at regular intervals.

Adjusting the Accounts (Adjusting Entries): Adjusting entries are needed whenever revenue or expenses affect more than one accounting period. At the end of an accounting period, ask yourself these questions: - Have I recorded or recognized all revenues earned during this accounting period? - Have I recorded or recognized all expenses incurred during this accounting period? - If the answer is “No”, you need to prepare an adjusting entry. Prepared at end of an accounting period. Recorded to bring an asset or liability account balance to its proper amount. - Recognize all revenues when earned. - Recognize all expenses incurred. Every adjusting entry involves a change in either a revenue or expense and an asset or liability.

Adjusting Entries: Adjusting entries fall into five categories: Prepaid expenses. Depreciation. Accrued revenues. Accrued expenses. Unearned revenues.

Example: The trial balance of Cookie Lapp Travel Design at April 30, 2008, and the data needed for the month-end adjustments as follow.

Adjustment data at April 30, 2008: Cookie Lapp Travel Design prepays three months’ office rent on April 1, 2008 (rent for the month, $1,000). Supplies costing $600 remain at April 30. Depreciation expense has that not been recorded on the furniture for the 2008 fiscal year. The furniture has a useful life of 5 years. Cookie Lapp pays her employee a monthly salary of $1,800, half on the 15th and half on the last day of the month. Cookie Lapp Travel is hired on April 15 to perform travel services for San Jacinto College; Lapp will earn $800 monthly. Suppose a law firm engages Cookie Lapp Travel to provide travel services, agreeing to pay her $600 monthly, beginning immediately. Lapp collects the first amount on April 20. Requirements: Open the ledger T-accounts with their unadjusted balances. Journalize COOKIE Lapp’s adjusting entries at April 30, Post the entries to T-accounts. Prepare the trial balance after adjusting entries using the work sheet. Prepare the income statement, the statement of retained earnings, and the balance sheet. Draw arrows linking the three financial statements.

The Solution

2- Depreciation: Depreciation, for accounting purposes, is not an attempt to assign a market value to assets. It is merely a systematic way of allocating some of the cost of the asset to each period that asset helps the company earn revenue. Accumulated Depreciation: - A contra asset account. - Represents the amount of depreciation that has been taken over the life of the asset to date. - Land is the exception. There is no record depreciation for land.

Book Value: Reported on balance sheet. Cost minus accumulated depreciation. Depreciable assets are physical objects that retain their size and shape but lose their economic usefulness over time. The balance sheet reports both Furniture and Accumulated Depreciation. Because it’s a contra account, Accumulated Depreciation is subtracted from Furniture. The resulting net amount (cost minus accumulating depreciation) of a plant asset is called its book value, as follows for Furniture:

4- Accrued Revenues: Revenues earned in a period that are both unrecorded and not yet received. During the period (April), Lapp will earn half a month’s fee, $400, for work April 16 through April 30. On April 30, Lapp makes the following adjusting entry to accrue the revenue earned during April 16 through 30: