The Adjusting Process Chapter 3 3-1

What is the Difference between Cash Basis Accounting & Accrual Basis Accounting? CASH BASIS Revenue is recorded when Cash is received Expenses are recorded when Cash is paid Not allowed under GAAP ACCRUAL BASIS Revenue is recorded when it is earned Expenses are recorded when incurred Generally used by larger businesses 3-2

The Time Period Concept Assumes that a business’s activities can be sliced into small segments and that financial statements can be prepared for specific time periods, such as a month, quarter, or year. Any twelve month period is referred to as a fiscal year. 3-3

The Revenue Recognition Principle 3-4 Revenue should be recorded when it is EARNED. A good has been delivered or a service has been performed.. The earnings process is complete. The amount of revenues must represent the actually selling price.. If a $200 item is discounted to $100, then the revenue is $100.

The Matching Principle 3-5. Expenses are recorded when they are incurred during the period. Expenses are matched at the end of the period against the revenues for that period. For example, rent expense for January should be matched against January revenues, even if was actually paid in December.

3-6 The initial trial balance that comes from the General Ledger is referred to as an Unadjusted Trial Balance. Because of the Time Period Concept, Revenue Recognition Principle, and Matching Principle some adjustments are needed.

3-7 For example, the Office Supplies account shows $500 at the end of December. If a count of the actual supplies on hand shows that some supplies have been used, we will need to adjust the account.

Adjusting Journal Entries Adjustments to the Trial Balance are made by recording actual Adjusting Journal Entries. 3-8

Adjusting Journal Entries Each Adjusting Journal Entry will adjust a balance sheet account and an income statement account. 3-9

Adjusting Journal Entries Adjusting Journal Entries (AJE’s) can be divided into two basic categories: 3-10 Prepaids 1.Prepaid Expenses Revenues 2.Unearned Revenues Accruals 1.Accrued revenues 2.Accrued expenses

Information for Adjustments a.Prepaid rent expired, $1,000. b.Supplies used, $400. c.Depreciation on furniture, $300. d.Depreciation on building, $250. e.Service revenue collected in advance and now earned $200 f.Accrued salaries expense, $1,200. g.Accrued interest on note, $100. h.Accrued service revenue, $

Prepaid Rent Example Paying rent in advance gives us the right to use the property for 3 months (in this case). By the end of December, 1/3 of that right has been used. 3-12

Prepaid rent expired, $1,000. To adjust the Prepaid Rent account, we need to reduce it by 1/3, and we need to show the rent expense related to the December revenues. 3-13

Supplies used, $

Depreciation Long-lived, tangible assets used to generate revenue are referred to as plant assets. Plant assets act like Prepaid Expenses 3-15 Paid for when acquired Used to produce revenues Used up over time

Depreciation The process of systematically recording the periodic usage of plant assets to generate revenues is called Depreciation. The accounts used are: –Depreciation Expense –Accumulated Depreciation 3-16 Land is never depreciated. Accumulated Depreciation is a contra-asset. - Has a credit balance - Appears in the Asset section of the Balance Sheet

Depreciation Example Assume that, on December 2, Smart Touch Learning received a contribution of furniture with a market value of $18,000 from a stockholder. At the end of December, Smart Touch Learning will need to record depreciation for the use of the furniture, assuming it has a 5 year useful life. 3-17

Depreciation on furniture, $300. Using the straight-line method of computing depreciation, Smart Touch Learning will need to record $300 of depreciation for December. 3-18

Depreciation Example Recording the entry requires the use of two accounts: Depreciation Expense and Accumulated Depreciation. 3-19Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall

3-21

Depreciation on building, $

Unearned Revenue Example On December 21, a law firm engages Smart Touch Learning to provide e-learning services for the next 30 days, paying $600 in advance. 3-23

Unearned Revenue Example Smart Touch Learning is obligated to perform the services. During the last 10 days of the month, 1/3 of the services are performed. 3-24Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall

Accrued Expenses Example Smart Touch Learning pays its employee a monthly salary of $2,400, half on the 15 th and half on the first day of the next month. 3-25

Accrued Expenses Example On December 31, Smart Touch Learning still owes the employee $1,200, which won’t be paid until January Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall 1,200

Accrued interest on note, $

Accrued Revenue Example Accrued revenues arise when the company recognizes that it has performed a service, or delivered a product, but has not yet recorded that they have “earned” the revenue. 3-28

Accrued Revenue Example On December 15, Smart Touch Learning agrees to perform e-learning services for $1,600 per month. By the end of December, they have earned ½ of the monthly fee for December. 3-29Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall

3-30©2014 Pearson Education, Inc. Publishing as Prentice Hall Prepaid Adjusting entries Never involve cash Will either Increase expense account and reduce asset account or Reduce Liability account and increase Revenue account

Accrual Adjusting entries Never involve cash Increase Revenue account or Expense account 3-31

3-32©2014 Pearson Education, Inc. Publishing as Prentice Hall Account Balances after Posting

The Adjusted Trial Balance After journalizing and posting all the adjusting journal entries at the end of the fiscal period, a new adjusted trial balance is prepared. –List all accounts –List debit balances in the debit column –List credit balance in the credit column If it balances, financial statements can be prepared. 3-33Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall

The adjusted trial balance includes accounts that did not appear on the original unadjusted trial balance. The financial statements are prepared directly from the adjusted trial balance. 3-34Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall

impact of adjusting entries on the financial statements 3-35

Purpose of a worksheet 3-36 Useful tool for the adjusting process Typically done on a spreadsheet Lists –Accounts –Unadjusted balances –Adjustments –Adjusted balance

3-37 First, enter the information from the unadjusted trial balance into the first two columns of the worksheet.

3-38 Second, enter the information for the adjusting journal entries into the Adjustments columns.

3-39 Third, cross-foot the numbers across the spreadsheet to the Adjusted Trial Balance columns.