ADJUSTING THE ACCOUNTS LECTURE 3 ADJUSTING THE ACCOUNTS

TIME PERIOD ASSUMPTION The time period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods — generally a month, a quarter, or a year. Periods of less than one year are called interim periods. The accounting time period of one year in length is usually known as a fiscal year. 1

REVENUE RECOGNITION PRINCIPLE The revenue recognition principle states that revenue should be recognized in the accounting period in which it is earned. In a service business, revenue is usually considered to be earned at the time the service is performed. In a merchandising business, revenue is usually earned at the time the goods are delivered. 2

THE MATCHING PRINCIPLE The practice of expense recognition is referred to as the matching principle. The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues). Revenues earned this month are offset against.... expenses incurred in earning the revenue 3

ACCRUAL BASIS OF ACCOUNTING Adheres to the Revenue recognition principle Matching principle Revenue recorded when earned, not only when cash received. Expense recorded when services or goods are used or consumed in the generation of revenue, not only when cash paid. GAAP

CASH BASIS OF ACCOUNTING PowerPoint Slides CASH BASIS OF ACCOUNTING NOT GAAP Revenue recorded only when cash received. Expense recorded only when cash paid. 5

HAPPEN! ADJUSTING ENTRIES Adjusting entries make the revenue recognition and matching principles HAPPEN!

ILLUSTRATION 3-3 TRIAL BALANCE The Trial Balance is analysed to determine the need for adjusting entries.

ADJUSTING ENTRIES Adjusting entries are required each time financial statements are prepared. Adjusting entries can be classified as 1. prepayments (prepaid expenses or unearned revenues), 2. accruals (accrued revenues or accrued expenses), or 3. estimates (amortization). 5

TYPES OF ADJUSTING ENTRIES Prepayments 1. Prepaid Expenses — Expenses paid in cash and recorded as assets before they are used or consumed. 2. Unearned Revenues — Revenues received in cash and recorded as liabilities before they are earned.

TYPES OF ADJUSTING ENTRIES Accruals 1. Accrued Revenues — Revenues earned but not yet received in cash or recorded. 2. Accrued Expenses — Expenses incurred but not yet paid in cash or recorded.

TYPES OF ADJUSTING ENTRIES Estimates 1. Amortization — Allocation of the cost of capital assets to expense over their useful lives.

PREPAYMENTS Prepayments are either prepaid expenses or unearned revenues. Adjusting entries for prepayments are required to record the portion of the prepayment that represents 1. the expense incurred or, 2. the revenue earned in the current accounting period.

PREPAID EXPENSES Prepaid expenses are expenses paid in cash and recorded as assets before they are used or consumed. Prepaid expenses expire with the passage of time or through use and consumption. An asset-expense account relationship exists with prepaid expenses. 6

PREPAID EXPENSES Prior to adjustment, assets are overstated and expenses are understated. The adjusting entry results in a debit to an expense account and a credit to an asset account. Examples of prepaid expenses include supplies, rent, insurance, and property tax. 7

UNEARNED REVENUES Unearned revenues are revenues received and recorded as liabilities before they are earned. Unearned revenues are subsequently earned by performing a service or providing a good to a customer. A liability-revenue account relationship exists with unearned revenues. 10

UNEARNED REVENUES Prior to adjustment, liabilities are overstated and revenues are understated. The adjusting entry results in a debit to a liability account and a credit to a revenue account. Examples of unearned revenues include rent, magazine subscriptions, airplane tickets, and tuition.

ILLUSTRATION 3-4 ADJUSTING ENTRIES FOR PREPAYMENTS Prepaid Expenses Asset Unadjusted Balance Credit Adjusting Entry (-) Expense Debit Adjusting Entry (+) Unearned Revenues Liability Unadjusted Balance Debit Adjusting Entry (-) Revenue Credit Adjusting Entry (+)

ACCRUALS A different type of adjusting entry is accruals. Adjusting entries for accruals are required to record revenues earned and expenses incurred in the current period. The adjusting entry for accruals will increase both a balance sheet and an income statement account.

ACCRUED REVENUES Accrued revenues may accumulate with the passing of time or through services performed but not billed or collected. An asset-revenue account relationship exists with accrued revenues. Prior to adjustment, assets and revenues are understated. The adjusting entry requires a debit to an asset account and a credit to a revenue account. Examples of accrued revenues include accounts receivable, rent receivable, and interest receivable.

ACCRUED EXPENSES Accrued expenses are expenses incurred but not yet paid. A liability-expense account relationship exists. Prior to adjustment, liabilities and expenses are understated. The adjusting entry results in a debit to an expense account and a credit to a liability account. Examples of accrued expenses include accounts payable, rent payable, salaries payable, and interest payable.

ILLUSTRATION 3-6 FORMULA TO CALCULATE INTEREST Face Value of Note Annual Interest Rate Time (in Terms of One Year) Interest x x = $5,000 x 6% x 1/12 = $25

ILLUSTRATION 3-5 ADJUSTING ENTRIES FOR ACCRUALS Asset Debit Adjusting Entry (+) Accrued Revenues Revenue Credit Adjusting Entry (+) Accrued Expenses Expense Liability

AMORTIZATION Amortization is the process of allocating the cost of certain capital assets to expense over their useful life in a rational and systematic manner. Amortization attempts to match the cost of a long-term, capital asset to the revenue it generates each period.

AMORTIZATION Amortization is an estimate rather than a factual measurement of the cost that has expired. We’re not attempting to reflect the actual change in value of an asset!

Accumulated Amortization In recording amortization, Amortization Expense is debited and a contra asset account, Accumulated Amortization, is credited. The difference between the cost of the asset and its related accumulated amortization is referred to as the net book value of the asset. XXX XXX Amortization Expense Accumulated Amortization

AMORTIZATION Balance Sheet Presentation Office equipment $5,000 Less: Accumulated amortization 83 Net book value $4,917 Estimate

ILLUSTRATION 3-8 SUMMARY OF ADJUSTING ENTRIES 1.Prepaid Assets and Assets overstated Dr. Expenses expenses expenses Expenses understated Cr. Assets 2.Unearned Liabilities and Liabilities overstated Dr. Liabilities revenues revenues Revenues understated Cr. Revenues 3.Accrued Assets and Assets understated Dr. Assets revenues revenues Revenues understated Cr. Revenues 4.Accrued Expenses and Expenses understated Dr. Expenses expenses liabilities Liabilities understated Cr. Liabilities 5.Amortization Expense and Expenses understated Dr. Amort. Exp contra asset Assets overstated Cr. Accum. Amortization Account Accounts before Adjusting Type of Adjustment Relationship Adjustment Entry

ADJUSTED TRIAL BALANCE An Adjusted Trial Balance is prepared after all adjusting entries have been journalized and posted. It shows the balances of all accounts at the end of the accounting period and the effects of all financial events that have occurred during the period. It proves the equality of the total debit and credit balances in the ledger after all adjustments have been made. Financial statements can be prepared directly from the adjusted trial balance.

PREPARING FINANCIAL STATEMENTS Financial statements can be prepared directly from an adjusted trial balance. 1. The income statement is prepared from the revenue and expense accounts. 2. The statement of owner’s equity is derived from the owner’s capital and drawings accounts and the net income (or net loss) shown in the income statement. 3. The balance sheet is then prepared from the asset and liability accounts and the ending owner’s capital balance as reported in the statement of owner’s equity.

PIONEER ADVERTISING AGENCY INC. Trial Balance Trial Balance – Each account is analyzed to determine whether it is complete and up-to-date. PIONEER ADVERTISING AGENCY INC. Trial Balance October 31, 2008 Account Debit Credit Cash $ 15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable $ 5,000 Accounts Payable 2,500 Unearned Revenue 1,200 Common Stock 10,000 Retained Earnings 0 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 $28,700 $ 28,700

Adjusting Entries for “Prepaid Expenses” Example (Insurance): On Oct. 4th, Pioneer Advertising paid $600 for a one-year fire insurance policy. Show the journal entry to record the payment on Oct 4th. Oct. 4 Prepaid insurance 600 Cash 600 Prepaid Insurance Cash Debit Credit Debit Credit 600 600

Adjusting Entries for “Prepaid Expenses” Example (Insurance): On Oct. 4th, Pioneer Advertising paid $600 for a one-year fire insurance policy. Show the adjusting journal entry required at Oct. 31st. Oct. 31 Insurance expense 50 Prepaid insurance 50 Prepaid Insurance Insurance Expense Debit Credit Debit Credit 600 50 50 550

Adjusting Entries for “Prepaid Expenses” Example (Depreciation): On Oct. 2nd, Pioneer Advertising paid $5,000 for office equipment that has an expected useful life of 10 years. Show the journal entry to record the purchase of the equipment on Oct. 2nd. Oct. 2 Equipment 5,000 Cash 5,000 Equipment Cash Debit Credit Debit Credit 5,000 5,000 LO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” Example (Depreciation): On Oct. 2nd, Pioneer Advertising paid $5,000 for office equipment that has an expected useful life of 10 years. Show the adjusting journal entry required at Oct. 31st. The equipment has a $200 salvage value. ([$5,000- $200 salvage value] / 5 yrs / 12 months = $40) Jan. 31 Depreciation expense 40 Accumulated depreciation 40 Depreciation Expense Accumulated Depreciation Debit Credit Debit Credit 40 40 40

Adjusting Entries for “Prepaid Expenses” Depreciation (Statement Presentation) Accumulated Depreciation—is a contra asset account. Appears just after the account it offsets (Equipment) on the balance sheet. Office equipment $5,000 Less: Accumulated depreciation-Office Equipment 40 $4,960

Adjusting Entries for “Unearned Revenues” Example: On Oct. 2nd, Pioneer Advertising received $1,200 from R. Knox for services to be completed by December 31. Show the journal entry to record the receipt on Oct 2nd. Oct. 2 Cash 1,200 Unearned Revenue 1,200 Cash Unearned Rent Revenue Debit Credit Debit Credit 1,200 1,200 LO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Unearned Revenues” Example: On Oct. 2nd, Pioneer Advertising received $1,200 from R. Knox for services to be completed by December 31. Show the adjusting journal entry required on Oct. 31st. Oct. 31 Unearned Revenue 400 Service Revenue 400 Service Revenue Unearned Revenue Debit Credit Debit Credit 400 400 1,200 800

Adjusting Entries for “Accrued Revenues” Example: In October Pioneer Advertising earned $200 for advertising services that have not been recorded. Show the journal entry to record the accrued revenues in October. Oct. 31 Accounts Receivable 200 Service Revenue 200 Accounts Receivable Service Revenue Debit Credit Debit Credit 200 200

Adjusting Entries for “Accrued Expenses” Example: On Oct 1st, Pioneer Advertising signed a $,5000, 3-month note payable at a rate of 12% per year. The total interest due on the note at its due date is $150 ($5,000 X 12% X 3/12). Show the journal entry to record the borrowing on Oct. 1st. Oct. 1 Cash 5,000 Notes payable 5,000 Cash Notes Payable Debit Credit Debit Credit 5,000 5,000

Adjusting Entries for “Accrued Expenses” Example: On Oct 1st, Pioneer Advertising signed a $,5000, 3-month note payable at a rate of 12% per year. The total interest due on the note at its due date is $150 ([$5,000 x 12%] / 12 months). Show the adjusting journal entry required on Oct. 31st. Oct. 31 Interest expense 50 Interest payable 50 Interest Expense Interest Payable Debit Credit Debit Credit 50 50

Preparing Financial Statements Account Debit Credit Cash $ 15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Depreciation-Off Equip $40 Notes Payable 5,000 Accounts Payable 2,500 Unearned Revenue 800 Salaries Payable 1,200 Interest Payable 50 Common Stock 10,000 Retained Earnings 0 Dividends 500 Service Revenue 10,600 Salaries Expense 5,200 Advertising Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 $ 30,190 $ 30,190 Income Statement PIONEER ADVERTISING AGENCY INC. Income Statement For the Month Ended October 31, 2008 Revenues Service Revenue 10,600 Expenses Salaries Expense 5,200 Advertising Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 Total expenses 7,740 Net income $ 2,860

Preparing Financial Statements Account Debit Credit Cash $ 15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Depreciation-Off Equip $40 Notes Payable 5,000 Accounts Payable 2,500 Unearned Revenue 800 Salaries Payable 1,200 Interest Payable 50 Common Stock 10,000 Retained Earnings 0 Dividends 500 Service Revenue 10,600 Salaries Expense 5,200 Advertising Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 $ 30,190 $ 30,190 Retained Earnings Statement PIONEER ADVERTISING AGENCY INC. Retained Earnings Statement For the Month Ended October 31, 2008 Retained earnings, October 1 $ 0 Add: Net income 2,860 2,860 Less: Dividends 500 Retained Earnings, October 31 2,360

Preparing Financial Statements Balance Sheet Account Debit Credit Cash $ 15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Depreciation-Off Equip $40 Notes Payable 5,000 Accounts Payable 2,500 Unearned Revenue 800 Salaries Payable 1,200 Interest Payable 50 Common Stock 10,000 Retained Earnings 0 Dividends 500 Service Revenue 10,600 Salaries Expense 5,200 Advertising Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 $ 30,190 $ 30,190 PIONEER ADVERTISING AGENCY INC. Balance Sheet October 31, 2008 Assets Cash $ 15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment $5,000 Accumulated Depreciation-Off Equip 40 4,960 Total Assets $ 21,910 Liabilities and Stockholders’ Equity Liabilities Notes Payable $ 5,000 Accounts Payable 2,500 Unearned Revenue 800 Salaries Payable 1,200 Interest Payable 50 Total liabilities 9,550 Stockholders’ Equity Common Stock 10,000 Retained Earnings 2,360 Total liabilities and stockholders’ equity $ 21,910

STEPS IN THE ACCOUNTING CYCLE 1. Analyse transactions 2. Journalize the transactions 9. Coming next chapter 3. Post to ledger accounts 8. Coming next chapter 4. Prepare a trial balance 7. Prepare financial statements 5. Journalize and post adjusting entries 6. Prepare adjusted trial balance