Humanities and International Exchange Faculty Shanghai Second Polytechnic University Lesson 3 Adjusting Accounts for Financial Statement

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 2 Outline  Describe the purpose of adjusting accounts at the end of the period.  Prepare and explain adjusting entries for prepaid expenses, amortization, unearned revenues, accrued expenses, and accrued revenues.  Explain how accounting adjustments link to financial statements.  Explain and prepare an adjusted trial balance.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 3  Definition: the continued life of a business is divided into time periods of equal length. Review: Time period concept This year income statement Next year income statement Last year income statement Past period Current period Future period Dec. 31, B/S date going concern (business will not stop)

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 4 Review: Revenue Recognition Principle  Revenue is recorded at the time it is earned regardless of whether cash or another asset has been exchanged.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 5 Review: Matching Principle  Expenses are to be matched in the same accounting period as the revenues they helped to earn.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 6 Accrual and cash basis  The accrual basis of accounting matches revenues earned with expenses incurred.  The cash basis matches revenues received with expenses paid. It is not satisfactory for most businesses because it results in financial statements that are not comparable from period to period, except when the amounts of prepaid, unearned, and accrued items are not material.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 7 Adjust: A Step in Accounting cycle 1. Analyze Transactions 2. Journalize 3. Post 4. Unadjusted trial balance 5. Adjust 6. Adjusted trial balance 7. Prepare finance statements 8.Close Now that we have covered the trial balance, let’s discuss adjusting entries.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 8 Why Need to Adjust  Some events are not evidenced by the obvious documents. the effects of these events are recorded at the end of the accounting period by means of adjusting entries.  The purpose of adjusting the accounts at the end of period is to make the accounting information comparable from period to period.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 9 Why Need to Adjust  Adjustments are based on three generally accepted accounting principles: Time period principle. Revenue recognition principle. Matching principle.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 10 Type of Adjusting Entries AdjustingentriesAdjustingentries Accruing unrecorded revenues revenues Accruing unrecorded revenues revenues Converting liabilities to revenues revenues Converting liabilities to revenues revenues Accruing unrecorded expenses expenses Converting assets to expenses expenses Converting assets to expenses expenses

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 11 Adjusting Entries – Accruals  Accruals occur when revenues have been earned or expenses incurred but no cash has been exchanged. End of accounting period. Cash received Revenues earned Example: interest revenue earned during the period but not received until the next period.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 12 Adjusting Entries – Accruals  Example: On Jun 1, 2004, Smith Inc. invests $100,000 for a bonds which pays 5% interest per year. Smith Inc. will not receive the interest until March 31, On December 31, 2004, Smith, Inc. need to make the following entry for the interest earned so far.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 13 Adjusting Entries – Accrued  Unrecorded expenses incurred End of accounting period. Cash paid Expense incurred Example: wages should be paid to employees during this period but not paid until the next period.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 14 Adjusting Entries – Accrued  Example: On the year-end, Dec. 31, 2004, Smith Inc.’s employees have earned total wages of $35,000 for the Monday, but Smith Inc. will not pay the wages until 5 th of next month. So at the end of the accounting period, Smith need to make the following entries to accrued the wage expenses.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 15 Adjusting Entries – Deferrals  Prepaid expense is used up Paid cash for 12 month’s rent 7/1/0412/31/04 Year end 6/30/05

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 16 Adjusting Entries – Deferrals  Example: On July 1, 2004, Smith Inc. paid $20000 for whole year’s rent covered from 1 st of July to 30 th of June. At the end of 2004, $10000 of rent expenses have occurred so Smith Inc. need to make the following entries to transfer the deferrals to expenses.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 17 Adjusting Entries – Deferrals End of accounting period. Cash received Revenues earned Example: service revenue received in advance.  Converting liabilities to revenues:

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 18 Adjusting Entries – Deferrals  Example: On Oct. 1, 2004, Smith Inc. signed a contract for providing a special service to Cone. Smith received $50000 for the service to be provided. At the end of 2004 half of the services have been proved to Cone. Smith should make the following entries to record earned revenue.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 19 Adjust: Allocating the Costs of long-term assets  Certain circumstances require adjusting entries to record accounting estimates. Amortization is an example.  Amortization is the process of allocating the costs of assets over their useful lives.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 20 Amortization  Companies acquire capital assets such as equipment, buildings, vehicles, and patents to generate revenues.  These assets are expected to provide benefits for more than one period.  The accounting concept of amortization involves the systematic and rational allocation of cost of a long-lived asset to the periods during which it is used to generate revenue.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 21 Amortization  On January 1,2004, a company purchased a piece of equipment for $100,000. The equipment is expected to have a useful life of five years and have a salvage value of $5000.Asume the company use the straight-line method. Asset Cost - Salvage Value Asset Cost - Salvage Value Useful Life Straight-LineAmortizationExpense = = $ $5,000 $ $5,000 5 years = $19000/year

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 22 Amortization  The required journal entry includes a debit to Amortization expense and a credit to an account called accumulated amortization.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 23 Adjusted Trial Balance  The adjusted trial balance is used to check if there are any mistakes in the adjusted accounts and it is used for the financial statement.  Assume that Smith Inc. has the following unadjusted trial balance:

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 24 Adjusted Trial Balance

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 25 Adjusted trial balance

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 26 Adjustments & Financial Statements  Adjusting entries bring the accounts up-to-date.  Adjustments are only made when financial statements are prepared.  Adjust entries will affect both the income statement and the balance sheet.  Will not affect the cash flow of the company.

Humanities and International Exchange Faculty Shanghai Second Polytechnic University The End of Lesson 3