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Adjusting Accounts for Financial Statements C H A P T E R 3

1. Describe the purpose of adjusting accounts at the end of the period. (LO 1 ) 2. Explain how the timeliness, matching, and revenue recognition principles affect the adjusting process. (LO 2 ) 3. Explain accrual accounting and cash basis accounting and how accrual accounting adds to the usefulness of financial statements. (LO 3 ) Learning Objectives

4. Prepare and explain adjusting entries for prepaid expenses, depreciation, unearned revenues, accrued expenses, and accrued revenues. (LO 4 ) 5. Explain how accounting adjustments link to financial statements. ( LO 5 ) 6. Explain and prepare an adjusted trial balance. ( LO 6 ) Learning Objectives

7. Prepare financial statements from an adjusted trial balance. ( LO 7 ) 8. Explain and prepare correcting entries. (Appendix 3A) ( LO 8 ) 9. Identify and explain an alternative in recording prepaids and unearned revenues. (Appendix 3B) ( LO 9 ) Learning Objectives

Prepare post-closing trial balance Journalize Close Prepare unadjusted trial balance Post Analyze transactions Prepare adjusted trial balance Prepare statements Adjust The Accounting Cycle 5 LO 1 7

The first step in the accounting cycle is “Journalize”. A) True B) False

Adjustments are only made when financial statements are prepared. Affect both the income statement and the balance sheet. Do not affect cash. Adjustments & Financial Statements LO 5

Why Adjust? Fast v Right? I want my financial statements now and they better be right!

Why Adjust? Fast v Right? But… Some bills not received yet Billing to customers delayed Our assets are getting older

Financial information must be  timely  and accurate to be useful to decision makers. As grown ups would say: LO 1

Adjustments are based on three generally accepted accounting principles: Timeliness principle. Revenue recognition principle. Matching principle. GAAP and Adjustments LO 2

GAAP and Adjustments All earnings for the month of August? Are these Expenses related to August earnings (revenues)?

Accrual Basis Revenues and expenses are recognized when earned or incurred regardless of when cash is received or paid. Consistent with GAAP. Cash Basis Revenues and expenses are recognized when cash is received or paid. Not consistent with GAAP. Cash vs. Accrual Basis LO 3

Adjusting Accounts Bring an asset or liability account to its proper amount. Update related expense or revenue accounts. Prepare more accurate financial statements. LO 4

Prepaid expenses Depreciation Unearned revenues Accrued expenses Accrued revenues Adjustment Types LO 4 Similar?

Prepaid Expenses On January 1, a company purchases an insurance policy that covers three months and costs $1,800. The cost of the policy should be spread over the time period it benefits the organization. (matching principle). $600 $1,800 JanuaryFebruaryMarch

Prepaid Expenses — Example The entry to record the purchase of the insurance policy would be: Jan 1 Prepaid Insurance 1,800 Cash 1,800 LO 4

Prepaid Expenses — Example The entry to record the expiry (use) of the insurance for January would be: Jan 31 Insurance Expense 600 Prepaid Insurance 600 LO 4 The Insurance we used (or consumed) in January 600

Prepaid Expenses — Example $1,800 $1,800 The entry to record the expiry (use) of the insurance for February would be: Feb 28 Insurance Expense 600 Prepaid Insurance 600 LO 4 The Insurance we used (or consumed) in February

Prepaid Expenses — Example $1,800 $1,800 And finally, the entry to record the expiry of the insurance for March would be: Mar 31 Insurance Expense 600 Prepaid Insurance 600 LO 4 March Expense

Companies acquire assets such as equipment, buildings, vehicles, and patents to generate revenues. These assets are expected to provide benefits for more than one accounting period. Depreciation LO 4

Depreciation is the process of allocating the costs of assets over their useful lives. Based on the Matching Principle Looks a lot like Prepaid Expenses except… Depreciation LO 4

Depreciation is based on the matching principle where the cost of an asset is matched over the time the asset helped earn the revenue. Straight-Line Depreciation Expense = Asset cost – Estimated residual value Estimated useful lifeDepreciation LO 4

Cash received before providing products and services (before it is earned). The company has an obligation to provide goods or services. (owes the customer) So “Unearned Revenues” are liabilities. As products and services are provided, the amount of unearned revenues becomes earned revenues. Unearned Revenues LO 4

Unearned Revenues: Example On March 1, a company received a $12,000 payment from a customer for maintenance services to be provided over the next two months. The entry to record the receipt of cash would be: Cash 12,000 Unearned Revenue 12,000 LO 4

Unearned Revenues: Example On March 31, $6,000 of this revenue had been earned. The entry to record the earned revenue would be: Unearned Revenue 6,000 Maintenance Revenue 6,000 $12,000/2months= $6,000/month LO 4

Unearned Revenues: Example By April 30, another $6,000 of this unearned revenue had been earned. The entry to record the earned revenue would be: Unearned Revenue 6,000 Maintenance Revenue 6,000 $12,000/2months= $6,000/month LO 4

Costs incurred in a period that are both unpaid and unrecorded.  Examples: interest, wages, taxes, phone  Adjusting entries must be made to record the expense for the period and the related liability at the balance sheet date. We know we owe it but we don’t have the bill yet. Accrued Expenses LO 4

Accrued Expenses - Example On December 31, we owe our employees $1200 in wages but we won’t actually pay them until January 10. The December 31 entry to record the accrued interest would be: Wages Expense 1,200 Wages Payable 1,200 LO 4

Accrued Expenses - Example In December, a company incurred $3,700 of utilities expense. The company had not received the utility bill at December 31. The December 31 entry to record the accrued utilities expense would be: Utilities Expense 3,700 Accounts Payable 3,700 LO 4

We have Earned it but have not billed the customer  Adjusting entries must be made to record the revenue for the period and the related asset at the balance sheet date.  Examples: fees earned, interest earned, rent earned Accrued Revenues LO 4

Adjustments are only made when financial statements are prepared. Affect both the income statement and the balance sheet. Do not affect cash. Adjustments & Financial Statements LO 5

Unadjusted Trial Balance A listing of accounts and balances that is prepared before adjustments are recorded. Adjusted Trial Balance A listing of accounts and balances that is prepared after adjustments are recorded and posted to the ledger. It is used to prepare financial statements. Trial Balance(s) LO 6

Stuff to Try! QS 3-9 EX 3-2 PR 3-7A challenge! For guidance check out the Demo Problem page

 Adjust to bring the accounts up-to-date.  Use the adjusted trial balance to prepare the financial statements in the following order: Income Statement Statement of Changes in Equity Balance Sheet Statement of Cash Flows Financial Statement Preparation LO 7

Errors found before posting  Draw a line through the incorrect information.  Insert correct information above the original entry. Errors found after posting Two alternatives: 1. Prepare a single correcting entry. 2. Reverse the original entry and record the correct entry. Appendix 4A: Correcting Errors LO 8

Correcting Errors — Example A payment of $1,200 for Salaries Expense is erroneously posted to Interest Expense. The original entry was recorded as: Interest Expense 1,200 Cash 1,200 The original should have been recorded as: Salaries Expense 1,200 Cash 1,200 LO 8

Correcting Errors — Example Alternative 1 -Prepare a single correcting entry. The original entry was recorded as: Interest Expense 1,200 Cash 1,200 The correcting entry would be: Salaries Expense 1,200 Interest Expense 1,200 LO 8

Correcting Errors — Example Alternative 2 -Reverse the original entry and enter the correct entry. The original entry was recorded as: Interest Expense 1,200 Cash 1,200 The entry to reverse this would be: Cash 1,200 Interest Expense 1,200 The correct entry would be: Salaries Expense 1,200 Cash 1,200 LO 8

Prepaid Expenses Often recorded as assets when paid. Adjusting entries transfer expired portion to expense accounts at period end. Alternative Treatment Record as an expense when paid. Adjusting entries transfer unused portion of prepaid from the expense to the asset account. Appendix 4B: Alternatives in Recording Prepaids and Unearned Revenues LO 9

Example: On January 1, a company purchases an insurance policy that covers 3 months and costs $1,800. On January 31, $600 ($1,800 x 1/3) of the policy has expired and $1,200 ($1,800 x 2/3) remains unexpired. Appendix 4B: Alternatives in Recording Prepaids and Unearned Revenues LO 9

Payment Recorded as an AssetPayment Recorded as an Expense Jan.1 Prepaid Insurance 1,800Insurance Expense 1,800 Cash 1,800 Cash 1,800 Jan.31 Insurance Expense 600 Prepaid Insurance 1,200 Prepaid Insurance 600 Insurance Expense 1,200 Prepaids - Example LO 9

Unearned Revenues Often recorded as liabilities when cash is received. Adjusting entries transfer earned portion to revenue accounts at period end. Alternative Treatment Record as revenues when cash is received. Adjusting entries transfer unearned portion of the payment from the revenue account to the unearned account. Appendix 4B: Alternatives in Recording Prepaids and Unearned Revenues LO 9

Alternatives in Accounting for Prepaids and Unearned Revenues-Appendix 4B Example: On March 1, a company received a $12,000 payment from a customer for maintenance services to be provided over the next two months. On March 31, $6,000 ($12,000/2) of the revenue has been earned and $6,000 ($12,000/2) remains unearned. LO 9

Receipt Recorded as a Liability Receipt Recorded as a Revenue Mar.1 Cash 12,000 Cash 12,000 Unearned Revenue 12,000 Maintenance Revenue 12,000 Mar.31 Unearned Revenue 6000 Maintenance Revenue 6,000 Maintenance Revenue 6000 Unearned Revenue 6,000 Unearned Revenues- Example LO 9