Chapter 4 Adjusting the Accounts

2 Describe the nature of the adjusting process.

3 Under the accrual basis of accounting, revenues are reported in the income statement in the period in which they are earned.

4-1 Guidelines to Report Revenue and Expenses Time Period Assumption Economic life of business can be divided into artificial time periods Revenue Recognition Principle Revenue recognized in the accounting period in which it is earned Matching Principle Expenses matched with revenues in the period when efforts are expended to generate revenues

5 The accounting concept that supports this approach to reporting of revenues is called the revenue recognition concept.

6 The accounting concept that supports reporting revenues and related expenses in the same period is called the matching concept, or matching principle.

7 Under the cash basis of accounting, revenues and expenses are reported in the income statement in the period in which cash is received or paid.

8 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

9 The journal entries that bring the accounts up to date at the end of the accounting period are called adjusting entries. Adjusting Entries

10 1)allow revenues and expenses to be recorded in the correct time period. 2)are dated the last day of the period. 3)always involved at least one balance sheet and at least one income statement account. 4)never involves the Cash account. Adjusting entries--

11 Prepaid expenses, sometimes referred to as deferred expenses, are items that have been initially recorded as assets but are expected to become expenses over time or through the normal operations of the business. Accounts Requiring Adjustment

12 Unearned revenues, sometimes referred to as deferred revenues, are items that have been initially recorded as liabilities but are expected to become revenues over time or through the normal operations of the business. Accounts Requiring Adjustment

13 Accrued revenues, sometimes referred to as accrued assets (accrued means unpaid), are revenues that have been earned but have not been recorded in the accounts. Accounts Requiring Adjusting

14 Accrued expenses, sometimes referred to as accrued liabilities, are expenses that have been incurred but have not been recorded in the accounts. Adjusting the Accounts

15 Journalize entries for accounts requiring adjustment.

16 Unadjusted Trial Balance for ABC Restaurant

17 ABC Restaurant’ Supplies account has a balance of $2,000 in the unadjusted trial balance. Some of these supplies have been used. On December 31, a count reveals that $760 of supplies are on hand. Adjusting Process for Prepaid Expenses

18 Supplies (balance on trial balance)$2,000 Supplies on hand, December 31 – 760 Supplies used$1,240

19 Supplies Supplies used ($2,000 – $760) Dec. 311,240 Supplies Bal.2,000 Supplies Expense Bal , Dec. 31Supplies Expense

20 The debit balance of $2,400 in ABC Restaurant’ Prepaid Insurance account represents the December 1 prepayment of insurance for 12 months.

21 Dec Prepaid Insurance Bal.2,400 Insurance Expense , Insurance Expense Prepaid Insurance Insurance expired ($2,400/12). 25

22 On December 1, the tenant prepaid three months’ rent for use of an office building owned by ABC Restaurant. As of December 31, only $120 has been earned.

23 Dec Unearned Rent Bal.360 Rent Revenue Unearned Rent Rent Revenue Rent earned ($360/3 months) Bal.

24 ABC Restaurant provided $500 in services during December for which the customer has not been billed.

25 Dec Accounts Receivable Bal.16,340 Fees Earned Bal.2,220 31Accounts Receivable Fees Earned Accrued fees (25 hrs. x $20) ,720 Bal. 16,840 Bal.

26 At the end of December, accrued wages amounted to $250. Without this adjusting entry, Wages Expense is understated.

27 Dec Wages Payable Bal.4,275 Wages Expense Wages Expense Wages Payable Accrued wages Bal.4,525

28 Dec Wages Payable Bal.4,275 Wages Expense Bal.4,525 Closing entries will be discussed in a later chapter. For now, just be aware that Wages Expense is closed after financial statements are prepared and its balance rolled back to zero.

29 The payment of January 10 wages totaling $1,275 is shown below. Jan. 10Wages Expense Wages Payable Cash Paid wages.

30 Dec Wages Payable Bal.4,275 Wages Expense 2251 Bal.4,525 Jan. 101,025 Jan An expense for wages of $1,025 is recorded in the new fiscal year. The liability is cancelled.

4-5 Types of Adjusting Entries Type of AdjustmentReason for AdjustmentAccount Balances Before Adjustment Adjusting Entry 1. Prepaid Expenses(a) Prepaid expenses originally recorded in asset accounts have been used Assets Overstated Expenses Understated Dr. Expenses Cr. Assets 2. Unearned Revenues(b) Unearned revenues initially recorded in liability accounts have been earned Liabilities Overstated Revenues Understated Dr. Liabilities Cr. Revenues 3. Accrued Revenues(c) Revenues earned but not yet received in cash or recorded Assets Understated Revenues Understated Dr. Assets Cr. Revenues 4. Accrued Expenses(d) Expenses incurred but not yet paid in cash or recorded Expenses Understated Liabilities Understated Dr. Expenses Cr. Liabilities Each adjusting entry affects a balance sheet account and an income statement account.

32 Adjusting Entries (Part 1): Prepaids (9:26) Adjusting Entries (Part 2): Supplies (4:44)

33 Physical resources that are owned and used by a business and are permanent or have a long life are called fixed assets or plant assets.

34 As time passes, a fixed asset loses its ability to provide useful services. This decrease in usefulness is called depreciation.

35 Definition of 'Depreciation' Depreciation is used in accounting to try to match the expense of an asset to the asset's income. For example, if a company buys a piece of equipment for $1 million and expects it to have a useful life of 10 years, it will be depreciated over 10 years.

36 Every accounting year, the company will expense $100,000 (assuming straight-line depreciation, $1 million/10), which will be matched with the money that the equipment helps to make each year. DDepreciation(5:45) gzeQ

37 Normal titles for fixed asset accounts and their related contra asset accounts are as follows: Fixed Asset Contra Asset LandNone—Land is not depreciated BuildingsAccumulated Depreciation—Buildings Store EquipmentAccumulate Depreciation— Store Equipment Office EquipmentAccumulated Depreciation— Office Equipment Normal Titles and Related Contra Asset Accounts

4-2 Depreciation PREPAYMENTASSETEXPENSE Cost of Truck$15,000 1/1/ Entry: Truck 15,000 Cash 15,000 Cash 15,000 DepreciationExpense 5,000 AccumulatedDepreciation 5,000 DepreciationExpense 5,000 AccumulatedDepreciation 10,000 CONTRA ASSET EXPENSE ASSET 12/31/0812/31/0912/31/10 DepreciationExpense 5,000 Statement Presentation: Balance Sheet AssetTruck$15,000 Contra AssetLess: Accum. Depr. 5,000 10,000 15,000 Book Value$10,000$ 5,000$ -0- AccumulatedDepreciation 15,000

39 ABC Restaurant estimates the depreciation on its office equipment to be $50 for the month of December.

40 Dec Depreciation Expense Dec Accum. Depr.—Office Equip Depreciation Expense50 00 Accum. Depreciation— Office Equipment

41 ABC Restaurant’ balance sheet would show the office equipment at cost, less the accumulated depreciation. Office equipment$1,800 Less accumulated depreciation 50 $1,750 Book value

42 Prepare an adjusted trial balance.

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

4-8 Review Chapter Concepts Topic AppliedResultsJustification 1. Time Period AssumptionEconomic life of business is divided into time periods. To provide information to prepare financial statements and tax return 2. Revenue RecognitionRevenue is recorded in period earned. Requires adjusting entries. To record assets or decreases in liabilities and proper reporting of revenue earned. 3. Matching PrincipleRecord expenses in the period they occur. Requires adjusting entries. To record liabilities or use of assets and expenses incurred in earning revenues. 4. Accrual Basis AccountingApplies revenue recognition principle, matching principle, and time period assumption. To record revenue when earned and expenses when incurred.