The Adjusting Process Chapter 3

The Adjusting Process Chapter 3
Chapter 3 will explain the adjusting process.

Learning Objective 1 Differentiate between accrual and cash-basis accounting The first learning objective differentiates between accrual and cash-basis accounting. Copyright (c) 2009 Prentice Hall. All rights reserved.

Accrual Basis vs. Cash Basis
Revenues are recognized when earned and expenses are recognized when incurred. Cash Basis Revenues are recognized when cash is received and expenses recorded when cash is paid. Not GAAP There are two methods of accounting. Accrual accounting records the effect of each transaction as it occurs—that is, revenues are recorded when earned and expenses are recorded when incurred. Most businesses use the accrual basis. Cash-basis accounting records only cash receipts and cash payments. It ignores receivables, payables, and depreciation. Only very small businesses use the cash basis of accounting. Copyright (c) 2009 Prentice Hall. All rights reserved. 9 9

Accrual vs. Cash Basis: Revenue
Accrual – Revenue recognized when services provided Now let’s see how differently the accrual basis and the cash basis account for a revenue. Suppose a dentist performed service and earned revenue on May 20, 2010, but did not collect cash until June 5, Under the accrual basis, the business records $1,000 of revenue on account on May 20 by debiting accounts receivable and crediting revenue. Under the cash basis, the business would record no revenue until the cash receipt, which in this case would be on June 5. As a result, cash-basis accounting never reports accounts receivable from customers. In this case, cash-basis accounting actually shows the revenue in the wrong accounting period (June). Cash – Revenue recognized when cash is received Copyright (c) 2009 Prentice Hall. All rights reserved.

Accrual vs. Cash-Basis: Expenses
Accrual – Expense recognized when incurred Suppose a company received a bill for a $200 expense on May 15, 2010, and paid the account in full on June 3, On the accrual basis, the business records this transaction as a debit to an expense and a credit to Accounts payable. In contrast, cash-basis accounting ignores this transaction on May 15 because the business paid no cash. Under the cash basis, the company would recognize the cash-basis expense on June 3, 2010, because that is the date that cash was paid. Cash – Expense recognized when cash is paid Copyright (c) 2009 Prentice Hall. All rights reserved.

Learning Objective 2 Define and apply the accounting period concept, revenue, and matching principles The second learning objective defines and applies the accounting period concept and the revenue and matching principles. Copyright (c) 2009 Prentice Hall. All rights reserved.

Accounting Period Businesses prepare financial statements for specific periods to evaluate performance Basic accounting period = one year Calendar year Fiscal year Interim periods Financial statements of less than one year Monthly Quarterly Semiannually Because businesses need periodic reports on their affairs, accountants slice time into small segments and prepare financial statements for specific periods, such as a month, quarter, or year. The basic accounting period is one year, and all businesses prepare annual financial statements. For most companies, the annual accounting period runs the calendar year from January 1 through December 31. Other companies use a fiscal year, which ends on a date other than December 31. The year-end date is usually the low point in business activity for the year. Retailers are a notable example. Many retailers use a fiscal year that ends on January 31 because their low point comes about a month after Christmas. Companies also prepare financial statements for interim periods, such as monthly, quarterly, and semiannually. Copyright (c) 2009 Prentice Hall. All rights reserved.

Revenue Principle When to record revenue?
When it is earned When service is provided or product delivered This is not necessarily the time when cash is received What amount of revenue should be recorded? Value of item or service transferred to customer The revenue principle tells accountants when to record revenue—that is, when to make a journal entry for a revenue and the amount of revenue to record. “Recording” something in accounting means making an entry in the journal. The revenue principle says to record revenue when it has been earned—but not before. Revenue has been earned when the business has delivered a good or service to the customer. The company has done everything required by the sale agreement—that is, the earnings process is complete. The amount of revenue to record is the actual value of the item or service transferred to the customer. Copyright (c) 2009 Prentice Hall. All rights reserved.

The Matching Principle
Measure all expenses incurred during the accounting period Match the expenses against the revenues earned during the same period The matching principle guides accounting for expenses. Expenses—such as salaries, rent, utilities, and advertising—are assets used up and liabilities incurred in order to earn revenue. The matching principle measures all the expenses incurred during the period and matches them against the revenues of the period. There is a natural link between some expenses and revenues. For example, a company pays a commission to the salesperson who sells the services. Other expenses are not so easy to link to sales. For example, monthly rent expense occurs regardless of the revenues earned that month. The matching principle tells us to identify those expenses within a particular period, such as a month or a year. The business will record rent expense each month based on the rental agreement. Copyright (c) 2009 Prentice Hall. All rights reserved.

The Time-Period Concept
Requires that accounting information be reported at regular intervals Accounts are updated at the end of each accounting period Owners need periodic reports on their businesses. The time-period concept ensures that information is reported often. To measure income, companies update their accounts at the end of each period. Copyright (c) 2009 Prentice Hall. All rights reserved.

? Which Principle….. Which principle is a guide to accounting for expenses. Identify all expenses incurred during the period, measure the expenses, and match them against the revenue earned during that same time period. A. Time-Period Principle B. Matching Principle C. Revenue Principle D. Objectivity Principle E. Reliability Principle Copyright (c) 2009 Prentice Hall. All rights reserved.

? Which Principle….. Which principle says:
Record revenue only after you have earned it. A. Time-Period Principle B. Matching Principle C. Revenue Principle D. Objectivity Principle E. Reliability Principle Copyright (c) 2009 Prentice Hall. All rights reserved.

? Which Principle says….. Record revenue only after you have earned it. A. Time-Period Principle B. Matching Principle C. Revenue Principle D. Objectivity Principle E. Reliability Principle Copyright (c) 2009 Prentice Hall. All rights reserved.

Learning Objective 3 Explain why adjusting entries are needed
The third learning objective explains why adjusting entries are needed. Copyright (c) 2009 Prentice Hall. All rights reserved.

Adjusting Entries Prepared at end of an accounting period Assign:
Revenues to the period when earned Expenses to the period when incurred Update asset and liability accounts Need to properly measure: Net Income Assets & Liabilities Adjusting entries assign revenues to the period when they are earned and expenses to the period when they are incurred. Adjusting entries also update the asset and liability accounts. Adjustments are needed to properly measure net income on the income statement and assets and liabilities on the balance sheet. Copyright (c) 2009 Prentice Hall. All rights reserved. 12 12

Adjusting Entry Rules Either increase revenue or increase an expense
Never involve cash Either increase revenue or increase an expense “Accrued” means amount must be recorded Remember the following three facts about adjusting entries: 1. Adjusting entries never involve cash. 2. Adjusting entries either: Increase revenue earned (Revenue credit) or Increase an expense (Expense debit). 3. The word “accrued” means you must journalize whatever amount you are being told about. Copyright (c) 2009 Prentice Hall. All rights reserved.

Learning Objective 4 Journalize and post adjusting entries
The fourth learning objective shows how to journalize and post adjusting entries. Copyright (c) 2009 Prentice Hall. All rights reserved.

Types of Adjusting Entries
Prepaid expenses Depreciation Accrued expenses Accrued revenues Unearned revenues The two basic categories of adjustments are prepaids and accruals. In a prepaid adjustment, the cash payment occurs before an expense is recorded. Accrual adjustments are the opposite. An accrual records an expense before the cash payment. Adjusting entries fall into five types: 1. Prepaid expenses 2. Depreciation 3. Accrued expenses 4. Accrued revenues 5. Unearned revenues Copyright (c) 2009 Prentice Hall. All rights reserved.

Prepaid Expenses Advance payments of expenses Examples:
Rent Insurance Supplies Recorded as an asset Adjusting entry records amount used as an expense Prepaid expenses are advance payments of expenses. For example, companies often make prepayments for rent, insurance, and supplies. Prepaid expenses are assets, rather than expenses. When the prepayment is used up, the used portion of the asset becomes an expense via an adjusting journal entry. Copyright (c) 2009 Prentice Hall. All rights reserved.

Short Exercise 3-6 Prepaid rent Apr 1 Prepaid Rent 4,800 Cash 4,800
GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Apr Prepaid Rent ,800 Cash ,800 Prepaid rent for 6 months Prepaid rent Short exercise S3-6 provides an example of how to adjust a prepaid expense. A company prepays for six months of rent on April 1. On that date, the asset account, Prepaid rent, is debited for the full amount. 4/ ,800 Copyright (c) 2009 Prentice Hall. All rights reserved. 16 16

Short Exercise 3-6 (continued)
GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Apr 30 Rent expense 800 Prepaid rent 800 To record rent expired in April Prepaid rent Rent expense Adjusting entries are made on April 30. At this time, one month of the rent has expired. The $4,800 represented six months. So $4,800 divided by 6 months is $800 per month. Rent expense is recorded for the one month of rent that has expired. Prepaid rent is reduced for the same amount. Notice that the prepaid rent account now has a balance of $4,000. That represents the five months remaining. 4/ ,800 4/ 4/ Bal 4,000 Copyright (c) 2009 Prentice Hall. All rights reserved. 16 16

Depreciation Plant assets Examples: Depreciation
Long-lived tangible assets used in business operations Examples: Land, buildings, equipment, and furniture Depreciation Allocation of a plant asset’s cost to expense over its useful life Land is not depreciated Plant assets are long-lived tangible assets used in the operation of a business. Examples include land, buildings, equipment, and furniture. As a business uses the assets, their value and usefulness declines. The decline in usefulness of a plant asset is an expense, and accountants systematically spread the asset’s cost over its useful life. The allocation of a plant asset’s cost to expense is called depreciation. Land is the exception. We record no depreciation for land, as its value typically does not decline with use. Copyright (c) 2009 Prentice Hall. All rights reserved.

Amount calculated based on depreciation method
Depreciation Entry GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT 12 31 Depreciation expense $$$$ Accumulated depreciation The adjusting entry to record depreciation is a debit to Depreciation expense and a credit to Accumulated depreciation. Accumulated depreciation is a contra-asset account. The amount of depreciation is computed based on the depreciation method (discussed in Chapter 9). Amount calculated based on depreciation method Contra-asset account Copyright (c) 2009 Prentice Hall. All rights reserved.

Accumulated Depreciation
Contra asset Normal credit balance Always paired with related account Holds sum of all depreciation recorded on a plant asset Book value: Cost minus accumulated depreciation Accumulated depreciation, rather than the plant asset account, is credited because it’s helpful to keep the original cost in the plant asset account. The Accumulated depreciation account holds the sum of all the depreciation recorded for the asset and that total increases over time. Accumulated Depreciation is a contra asset, which means an asset account with a normal credit balance. A contra account has two main characteristics: A contra account is paired with and follows its related account. (2) A contra account’s normal balance (debit or credit) is the opposite of the balance of the related account. The balance sheet reports both the plant asset accounts and accumulated depreciation. Because it’s a contra account, Accumulated depreciation is subtracted from the plant asset account. The resulting net amount of a plant asset (cost minus accumulated depreciation) is called its book value. Copyright (c) 2009 Prentice Hall. All rights reserved.

Accrued Expenses Expenses incurred before payment is made
Results in a liability Opposite of a prepaid expense Examples: Salaries Interest Businesses often incur expenses before paying for them. The term accrued expense refers to an expense of this type. Consider an employee’s salary. The salary expense grows as the employee works, so the expense is said to accrue. Another accrued expense is interest expense on a note payable. Interest accrues as time passes on the note. An accrued expense always creates a liability. Companies don’t make weekly journal entries to accrue expenses. Instead they wait until the end of the period. They make an adjusting entry to bring each expense (and the related liability) up-to-date for the financial statements. Remember that prepaids and accruals are opposites. Copyright (c) 2009 Prentice Hall. All rights reserved. 31 31

Accrued Expense Entries
GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Dec 31 Interest expense $$$$ Interest payable $$$$$ To record accrued interest GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Dec 31 Salaries expense $$$$ Salaries payable To record accrued salaries Here are two examples of how to account for accrued expenses. In the first entry, the company is recording interest expense on a note payable. Interest expense is accruing each day the company has debt. Usually, the interest is recorded when payment is made. However, at the end of the period, any interest that has accrued must be recorded. Similarly, each day that employees work, a company incurs salaries expense. Usually, salaries expense is recorded on pay day. Again, at the end of the period, any salaries attributed to work done in the current period must be recorded. Note that both entries debit an expense and credit a payable. Copyright (c) 2009 Prentice Hall. All rights reserved. 16 16

Accrued Revenues Revenue earned before cash is received
Results in a receivable GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Dec 31 Accounts receivable $$$$ Service revenue To record accrued revenues As we have just seen, expenses can occur before a company makes a cash payment for them, and that creates an accrued expense. Similarly, businesses can earn revenue before they receive the cash. This calls for an accrued revenue, which is a revenue that has been earned but not yet collected in cash. Since cash will be collected, a receivable account is debited. Since revenue has been earned, the revenue account is credited. Copyright (c) 2009 Prentice Hall. All rights reserved. 36 36

Unearned Revenue Cash is collected before revenue is earned
Results in a liability as the company owes a product or service or they will have to give the money back Also called deferred revenue Some businesses collect cash from customers in advance of performing work. Receiving cash before earning it creates a liability to perform work in the future called unearned revenue. The company owes a product or a service to the customer, or it owes the customer his or her money back. Only after completing the job will the business earn the revenue. Because of this delay, unearned revenue is also called deferred revenue. BEFORE Copyright (c) 2009 Prentice Hall. All rights reserved. 25 25

Unearned Revenue Entries
GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Dec Cash $$$$ Unearned revenue $$$$ To record cash received before service is provided GENERAL JOURNAL DATE DESCRIPTION REF DEBIT CREDIT Dec 31 Unearned revenue $$$$ Service revenue To record earned portion of unearned revenue Unearned revenue is a liability account. When the company receives the advance payment from a customer, Cash is debited and Unearned revenue is credited. The adjusting entry decreases Unearned revenue (debit) and records revenue (credit). Copyright (c) 2009 Prentice Hall. All rights reserved. 16 16

Summary of Adjusting Entries
To properly measure net income on the income statement Each adjusting entry affects a revenue or an expense To update the balance sheet Each adjusting entry affects an asset or a liability The adjusting process has two purposes: 1. To properly measure net income or net loss on the income statement. Every adjustment affects a revenue or an expense. 2. To update the balance sheet. Every adjustment affects an asset or a liability. Copyright (c) 2009 Prentice Hall. All rights reserved.

Summary of Adjusting Entries
Category of Adjusting Entry Debit Credit Prepaid expense Expense Asset Depreciation Contra asset Accrued expense Liability Accrued revenue Revenue Unearned revenue This table summarizes the accounting for adjusting entries. Note that each entry impacts an income statement account and a balance sheet account. Copyright (c) 2009 Prentice Hall. All rights reserved.

?Which types of adjusting entries are natural opposites?
A. PRE-PAID & DEPRECIATION B. PRE-PAID & ACCRUALS C. UNEARNED & DEPRECIATION D. ACCUMULATED DEPRECIATION & ACCRUALS E. DEPRECIATION & ACCRUALS Copyright (c) 2009 Prentice Hall. All rights reserved.

Explain the purpose of and prepare an adjusted trial balance
Learning Objective 5 Explain the purpose of and prepare an adjusted trial balance The fifth learning objective explains the purpose of and prepares an adjusted trial balance.

Adjusted Trial Balance
Prepared after adjusting entries are posted Useful step in preparing financial statements Often appears on a work sheet Tool accountants use at end of period A useful step in preparing the financial statements is to list the accounts, along with their adjusted balances, on an adjusted trial balance. Accountants often use a work sheet at year-end to help with preparation of financial statements. The adjusted trial balance is part of this work sheet. Copyright (c) 2009 Prentice Hall. All rights reserved.

Any Company Worksheet December 31, 2010 Trial Balance Adjustments
Trial Balance Adjustments Adjusted Account Title Dr. Cr. Cash 5,400 Supplies 700 a. 500 200 Equipment 17,000 Accum. depr. - Equip. 1,000 b. 1,000 2,000 Accounts payable Interest payable c. 100 100 Note payable 9,000 9,000 Josie Smith, Capital 6,000 6,000 Josie Smith, W/D Service revenue 12,000 12,000 Rent expense 4,000 4,000 Supplies expense a. 500 500 Depreciation expense 1,000 Interest expense 100 200 Totals 27,200 1,600 28,300 This is an example of the first three sets of columns of a work sheet. In the first set of columns is the unadjusted trial balance that you learned about in Chapter 2. The next set of columns show the adjusting entries in columnar format. The last set of columns is the adjusted trial balance. These are the amounts that will appear on the financial statements. 43

Prepare the financial statements from the adjusted trial balance
Learning Objective 6 Prepare the financial statements from the adjusted trial balance The sixth learning objective is to prepare the financial statements from the adjusted trial balance.

The Financial Statements
Reports revenue and expenses Determines net income Income statement Shows why Capital changed during the period Computes ending Capital Statement of owner’s equity Reports assets, liabilities, and owner’s equity Needs ending Capital to balance Balance sheet The three main financials statements are: (1) the income statement, which reports revenues and expenses, (2) the statement of owner’s equity, which shows why Capital changed during the period, and (3) the balance sheet, which reports assets, liabilities, and owner’s equity. The financial statements should be prepared in the following order: 1. Income statement—to determine net income or net loss 2. Statement of owner’s equity—to compute ending Capital 3. Balance sheet—which needs the amount of ending Capital to achieve its balancing Copyright (c) 2009 Prentice Hall. All rights reserved.

S 3-10 Balance sheet Income statement Any Company Worksheet
December 31, 2010 Adjusted Trial Balance Account Title Dr. Cr. Cash Supplies Equipment Accum. depr. - Equip. Accounts payable Interest payable Note payable Josie Smith, Capital Josie Smith, W/D Service revenue Rent expense Supplies expense Depreciation expense Interest expense Totals 5,400 200 17,000 1,000 4,000 500 28,300 Balance sheet 2,000 200 100 9,000 6,000 12,000 28,300 Using the previous example of the first three sets of columns of a work sheet, the adjusted trial balance columns contain the amounts that will appear on the financial statements. Income statement 43

Income Statement Using the amounts from the work sheet, the income statement is prepared first. All financial statements should have a heading that includes the name of the company, the name of the statement, and the time period it covers. Expenses should be listed largest to smallest. Net income is computed by subtracting the total expenses from the revenue. Copyright (c) 2009 Prentice Hall. All rights reserved.

Statement of Owner’s Equity
Any Company Statement of Owner’s Equity Year ended December 31, 2010 Josie Smith, Capital, January 1, 2010 $ 5,000 Add: Net income 6,300 Josie Smith, Capital, December 31, 2010 $11,300 Next, the statement of owner’s equity is prepared. The net income from the income statement is added to the beginning balance to determine the ending balance of the owner’s Capital. This amount will carry forward to the balance sheet. Copyright (c) 2009 Prentice Hall. All rights reserved.

Last, the balance sheet is prepared listing the assets, liabilities, and equity of the company. Notice that accumulated depreciation is reported in the asset section, directly underneath the equipment account. It is then subtracted from the cost of the equipment to compute book value. Also notice the Capital balance does not come from the work sheet, but from the statement of owner’s equity. Always make sure your balance sheet balances. Assets = liabilities + equity. Copyright (c) 2009 Prentice Hall. All rights reserved.

?NET INCOME flows from? A. Balance Sheet to Income Statement
B. Income Statement to Balance Sheet C. Income Statement to Statement of Cash Flow D. Income Statement to Statement of Equity E. Statement of Equity to Income Statement F. Statement of Cash Flow to Statement of Equity Copyright (c) 2009 Prentice Hall. All rights reserved.

?NET INCOME flows from? D. Income Statement to Statement of Equity
A. Balance Sheet to Income Statement B. Income Statement to Balance Sheet C. Income Statement to Statement of Cash Flow D. Income Statement to Statement of Equity E. Statement of Equity to Income Statement F. Statement of Cash Flow to Statement of Equity Copyright (c) 2009 Prentice Hall. All rights reserved.

The Adjusted Trial Balance Sheet shows?
A. Balance Sheet B. Income Statement C. Statement of Cash Flow D. Statement of Equity E. Balance Sheet & Income Statement F. Statement of Cash Flow & Statement of Equity Copyright (c) 2009 Prentice Hall. All rights reserved.

End of Chapter 3 This concludes Chapter 3.

The Adjusting Process Chapter 3

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