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3-2 CHAPTER3 Adjusting the Accounts

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3-4  Generally a month, a quarter, or a year.  Also known as the “Periodicity Assumption” Timing Issues Accountants divide the economic life of a business into artificial time periods (Time Period Assumption). SO 1 Explain the time period assumption. Jan.Feb.Mar.Apr.Dec......

3-5  Monthly and quarterly time periods are called interim periods.  Public companies must prepare both quarterly and annual financial statements.  Fiscal Year = Accounting time period that is one year in length.  Calendar Year = January 1 to December 31. Timing Issues SO 1 Explain the time period assumption. Fiscal and Calendar Years

3-6 The time period assumption states that: a.revenue should be recognized in the accounting period in which it is earned. b. expenses should be matched with revenues. c. the economic life of a business can be divided into artificial time periods. d. the fiscal year should correspond with the calendar year. Review SO 1 Explain the time period assumption. Timing Issues

3-7 Accrual-Basis Accounting  Transactions recorded in the periods in which the events occur.  Revenues are recognized when earned, rather than when cash is received.  Expenses are recognized when incurred, rather than when paid. Accrual- vs. Cash-Basis Accounting SO 2 Explain the accrual basis of accounting. Timing Issues

3-8 Cash-Basis Accounting  Revenues recognized when cash is received.  Expenses recognized when cash is paid.  Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP). Accrual- vs. Cash-Basis Accounting SO 2 Explain the accrual basis of accounting. Timing Issues

3-9 Revenue Recognition Principle Recognizing Revenues and Expenses SO 2 Explain the accrual basis of accounting. Recognize revenue in the accounting period in which it is earned. In a service enterprise, revenue is considered to be earned at the time the service is performed. Timing Issues

3-10 Expense Recognition Principle Recognizing Revenues and Expenses SO 2 Explain the accrual basis of accounting. Match expenses with revenues in the period when the company makes efforts to generate those revenues. “Let the expenses follow the revenues.” Timing Issues

3-11 SO 2 Explain the accrual basis of accounting. Timing Issues Illustration 3-1 GAAP relationships in revenue and expense recognition

3-12 SO 2 Explain the accrual basis of accounting.

3-13 One of the following statements about the accrual basis of accounting is false. That statement is: a.Events that change a company’s financial statements are recorded in the periods in which the events occur. b.Revenue is recognized in the period in which it is earned. c.The accrual basis of accounting is in accord with generally accepted accounting principles. d.Revenue is recorded only when cash is received, and expenses are recorded only when cash is paid. Review SO 2 Explain the accrual basis of accounting. Timing Issues

3-14  Adjusting entries are necessary because the trial balance may not contain up-to-date and complete data.  Ensure that the revenue recognition and expense recognition principles are followed.  Required every time a company prepares financial statements.  Will include one income statement account and one balance sheet account. SO 3 Explain the reasons for adjusting entries. The Basics of Adjusting Entries

3-15 Adjusting entries are made to ensure that: a.expenses are recognized in the period in which they are incurred. b.revenues are recorded in the period in which they are earned. c.balance sheet and income statement accounts have correct balances at the end of an accounting period. d.all of the above. SO 3 Explain the reasons for adjusting entries. Review The Basics of Adjusting Entries

Prepaid Expenses. Expenses paid in cash and recorded as assets before they are used or consumed. Deferrals 3. Accrued Revenues. Revenues earned but not yet received in cash or recorded. 4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded. 2. Unearned Revenues. Cash received and recorded as liabilities before revenue is earned. Accruals Illustration 3-2 Categories of adjusting entries The Basics of Adjusting Entries SO 4 Identify the major types of adjusting entries. Types of Adjusting Entries

3-17 Trial Balance Trial Balance – Each account is analyzed to determine whether it is complete and up- to-date. Illustration 3-3 The Basics of Adjusting Entries SO 4 Identify the major types of adjusting entries. Types of Adjusting Entries

3-18 Deferrals are either:  Prepaid expenses OR  Unearned revenues. SO 5 Prepare adjusting entries for deferrals. Adjusting Entries for Deferrals The Basics of Adjusting Entries

3-19 Payment of cash, that is recorded as an asset because service or benefit will be received in the future.  insurance  supplies  advertising Cash Payment Expense Recorded BEFORE  rent  equipment  buildings Prepayments often occur in regard to: SO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Prepaid Expenses

3-20  Expire either with the passage of time or through use.  Adjusting entry: ► Increase (debit) to an expense account and ► Decrease (credit) to an asset account. SO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Prepaid Expenses Illustration 3-4

3-21 Illustration: Pioneer Advertising Agency purchased supplies costing $2,500 on October 5. Pioneer recorded the payment by increasing (debiting) the asset Supplies. This account shows a balance of $2,500 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still on hand. Supplies1,500 Supplies expense1,500Oct. 31 SO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries

3-22 The Basics of Adjusting Entries Illustration 3-5 SO 5

3-23 Illustration: On October 4, Pioneer Advertising Agency paid $600 for a one- year fire insurance policy. Coverage began on October 1. Pioneer recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in the October 31 trial balance. Insurance of $50 ($600 / 12) expires each month. Prepaid insurance50 Insurance expense50Oct. 31 SO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries

3-24 The Basics of Adjusting Entries Illustration 3-6 SO 5

3-25 Depreciation  Buildings, equipment, and vehicles (assets with long lives) are recorded as assets, rather than an expense, in the year acquired.  Companies report a portion of the cost of the asset as an expense (depreciation expense) during each period of the asset’s useful life.  Depreciation does not attempt to report the actual change in the value of the asset. SO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries

Illustration: For Pioneer Advertising, assume that depreciation on the equipment is $480 a year, or $40 per month. Accumulated depreciation40 Depreciation expense Oct. 31 SO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Accumulated Depreciation is called a contra asset account.

3-27 The Basics of Adjusting Entries SO 5 Illustration 3-7

3-28 Statement Presentation  Accumulated Depreciation is a contra asset account.  Appears just after the account it offsets (Equipment) on the balance sheet.  Normal balance of a contra asset account is a credit. SO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Illustration 3-8

3-29 Illustration 3-9 SO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries

3-30 Receipt of cash that is recorded as a liability because the revenue has not been earned.  Rent  Airline tickets Cash Receipt Revenue Recorded BEFORE  Magazine subscriptions  Customer deposits Unearned revenues often occur in regard to: SO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Unearned Revenues

3-31  Adjusting entry is made to record the revenue that has been earned and to show the liability that remains.  Results in a decrease (debit) to a liability account and an increase (credit) to a revenue account. SO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Unearned Revenues Illustration 3-10

3-32 Illustration: Pioneer Advertising Agency received $1,200 on October 2 from R. Knox for advertising services expected to be completed by December 31. Unearned Service Revenue shows a balance of $1,200 in the October 31 trial balance. Analysis reveals that the company earned $400 of those fees in October. Service revenue400 Unearned service revenue400Oct. 31 SO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries

3-33 The Basics of Adjusting Entries SO 5 Illustration 3-11

3-34 Illustration 3-12 SO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries

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3-36 Accruals are made to record  Revenues earned OR  Expenses incurred in the current accounting period that have not been recognized through daily entries. Adjusting Entries for Accruals The Basics of Adjusting Entries SO 6 Prepare adjusting entries for accruals.

3-37 Revenues earned but not yet received in cash or recorded.  Rent  Interest  Services performed Accrued revenues often occur in regard to: The Basics of Adjusting Entries Accrued Revenues SO 6 Prepare adjusting entries for accruals. BEFORE Cash Receipt Revenue Recorded

3-38  Adjusting entry shows the receivable that exists and records the revenues earned.  Adjusting entry: ► Increases (debits) an asset account and ► Increases (credits) a revenue account. The Basics of Adjusting Entries Illustration 3-13 SO 6 Accrued Revenues

3-39 Illustration: In October Pioneer Advertising Agency earned $200 for advertising services that had not been recorded. Accounts receivable200 Cash200Nov. 10 The Basics of Adjusting Entries SO 6 Prepare adjusting entries for accruals. 200 Service revenue200 Accounts receivable Oct. 31 On November 10, Pioneer receives cash of $200 for the services performed.

3-40 The Basics of Adjusting Entries Illustration 3-14 SO 6

3-41 Illustration 3-15 The Basics of Adjusting Entries SO 6 Prepare adjusting entries for accruals.

3-42 Expenses incurred but not yet paid in cash or recorded.  Rent  Interest  Taxes  Salaries Accrued expenses often occur in regard to: The Basics of Adjusting Entries Accrued Expenses BEFORE Cash Payment Expense Recorded SO 6 Prepare adjusting entries for accruals.

3-43  Adjusting entry records the obligation and recognizes the expense.  Adjusting entry: ► Increase (debit) an expense account and ► Increase (credit) a liability account. SO 6 The Basics of Adjusting Entries Accrued Expenses Illustration 3-16

3-44 Illustration: Pioneer Advertising Agency signed a three-month note payable in the amount of $5,000 on October 1. The note requires Pioneer to pay interest at an annual rate of 12%. Interest payable50 Interest expense50Oct. 31 The Basics of Adjusting Entries SO 6 Prepare adjusting entries for accruals.

3-45 The Basics of Adjusting Entries Illustration 3-18 SO 6

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3-47 Illustration: Pioneer Advertising Agency last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 x 3 days). The Basics of Adjusting Entries SO 6 Prepare adjusting entries for accruals. Illustration 3-19

3-48 The Basics of Adjusting Entries Illustration 3-20 SO 6

3-49 Illustration 3-21 The Basics of Adjusting Entries SO 6 Prepare adjusting entries for accruals.

3-50 The Basics of Adjusting Entries SO 6 Prepare adjusting entries for accruals. Summary of Basic Relationships Illustration 3-22

3-51 Adjusted Trial Balance  Prepared after all adjusting entries are journalized and posted.  Purpose is to prove the equality of debit balances and credit balances in the ledger.  Is the primary basis for the preparation of financial statements. SO 7 Describe the nature and purpose of the adjusted trial balance. The Adjusted Trial Balance

3-52 Illustration 3-25

3-53 Which of the following statements is incorrect concerning the adjusted trial balance? a.An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made. b.The adjusted trial balance provides the primary basis for the preparation of financial statements. c.The adjusted trial balance lists the account balances segregated by assets and liabilities. d.The adjusted trial balance is prepared after the adjusting entries have been journalized and posted. Review SO 7 Describe the nature and purpose of the adjusted trial balance. The Adjusted Trial Balance

3-54 Financial Statements are prepared directly from the Adjusted Trial Balance. Balance Sheet Income Statement Owner’s Equity Statement SO 7 Describe the nature and purpose of the adjusted trial balance. The Financial Statements

3-55 SO 7 Illustration 3-26

3-56 Illustration 3-27 SO 7

3-57  When a company prepays an expense, it debits that amount to an expense account.  When a company receives payment for future services, it credits the amount to a revenue account. Alternative Treatment of Prepaid Expenses and Unearned Revenues SO 8 Prepare adjusting entries for the alternative treatment of deferrals. APPENDIX3A

3-58 SO 8 Prepare adjusting entries for the alternative treatment of deferrals. Illustration 3A-2 Prepaid Expenses APPENDIX3A Company may choose to debit (increase) an expense account rather than an asset account. This alternative treatment is simply more convenient.

3-59 SO 8 Prepare adjusting entries for the alternative treatment of deferrals. Illustration 3A-5 Unearned Revenues APPENDIX3A Company may credit (increase) a revenue account when they receive cash for future services.

3-60 SO 8 Prepare adjusting entries for the alternative treatment of deferrals. Illustration 3A-7 Summary of Additional Adjustment Relationships APPENDIX3A

3-61 Key Points  Companies applying IFRS also use accrual-basis accounting to ensure that they record transactions that change a company’s financial statements in the period in which events occur.  Similar to GAAP, cash-basis accounting is not in accordance with IFRS.  IFRS also divides the economic life of companies into artificial time periods. Under both GAAP and IFRS, this is referred to as the time period assumption.  IFRS requires that companies present a complete set of financial statements, including comparative information annually. IFRS A Look at IFRS

3-62 Key Points  GAAP has more than 100 rules dealing with revenue recognition. Many of these rules are industry specific. In contrast, revenue recognition under IFRS is determined primarily by a single standard. Despite this large disparity in the amount of detailed guidance devoted to revenue recognition, the general revenue recognition principles required by GAAP that are used in this textbook are similar to those under IFRS.  As the Feature Story illustrates, revenue recognition fraud is a major issue in U.S. financial reporting. The same situation occurs in other countries, as evidenced by revenue recognition breakdowns at Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch grocer AHold NV. IFRS A Look at IFRS

3-63 Key Points  A specific standard exists for revenue recognition under IFRS (IAS 18). In general, the standard is based on the probability that the economic benefits associated with the transaction will flow to the company selling the goods, providing the service, or receiving investment income. In addition, the revenues and costs must be capable of being measured reliably. GAAP uses concepts such as realized, realizable (that is, it is received, or expected to be received), and earned as a basis for revenue recognition.  Under IFRS, revaluation of items such as land and buildings is permitted. IFRS allows depreciation based on revaluation of assets, which is not permitted under GAAP. IFRS A Look at IFRS

3-64 Key Points  The terminology used for revenues and gains, and expenses and losses, differs somewhat between IFRS and GAAP. For example, income is defined as: Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from shareholders. Expenses are defined as: Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity other than those r elating to distributions to shareholders. IFRS A Look at IFRS

3-65 Looking into the Future IFRS A Look at IFRS The IASB and FASB are now involved in a joint project on revenue recognition. The purpose of this project is to develop comprehensive guidance on when to recognize revenue. Presently, the Boards are considering an approach that focuses on changes in assets and liabilities (rather than on earned and realized) as the basis for revenue recognition.

3-66 GAAP: a.provides very detailed, industry-specific guidance on revenue recognition, compared to the general guidance provided by IFRS. b.provides only general guidance on revenue recognition, compared to the detailed guidance provided by IFRS. c.allows revenue to be recognized when a customer makes an order. d.requires that revenue not be recognized until cash is received. IFRS A Look at IFRS

3-67 Which of the following statements is false? a.IFRS employs the periodicity assumption. b.IFRS employs accrual accounting. c.IFRS requires that revenues and costs must be capable of being measured reliably. d.IFRS uses the cash basis of accounting. IFRS A Look at IFRS

3-68 As a result of the revenue recognition project being undertaken by the FASB and IASB: a.revenue recognition will place more emphasis on when revenue is earned. b.revenue recognition will place more emphasis on when revenue is realized. c.revenue recognition will place more emphasis on when changes occur in assets and liabilities. d.revenue will no longer be recorded unless cash has been received IFRS A Look at IFRS

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