Chapter 3 The Adjusting Process

Chapter 3 The Adjusting Process

© 2016 Pearson Education, Inc.
Learning Objectives Differentiate between cash basis accounting and accrual basis accounting Define and apply the time period concept, revenue recognition, and matching principles Explain the purpose of and journalize and post adjusting entries © 2016 Pearson Education, Inc.

Learning Objectives Explain the purpose of a worksheet and use it to prepare adjusting entries and the adjusted trial balance Understand the alternative treatments of recording deferred expenses and deferred revenues (Appendix 3A) © 2016 Pearson Education, Inc.

Cash Basis vs. Accrual Basis Accounting
Cash basis accounting Revenue is recorded when cash is received Expenses are recorded when cash is paid Not allowed under GAAP Accrual basis accounting Revenue is recorded when earned Expenses are recorded when incurred Used by most businesses There are two ways to record transactions: cash basis accounting and accrual basis accounting. Cash basis records transactions based upon the receipt or payment of cash. Under cash basis, revenues are recorded only when cash is received, and expenses are recorded only when cash payments are made. Accrual basis records the effect of each transaction as it occurs—when revenues are earned and expenses are incurred. Therefore, revenue is recognized when the service is performed, not when the cash payment is received as the receipt of cash may occur at a later date. Accrual basis accounting is required by Generally Accepted Accounting Principles (GAAP). Cash Basis accounting is not allowed under GAAP. © 2016 Pearson Education, Inc.

The Time Period Concept
Business activities are sliced into small time segments. Financial statements can be prepared monthly, quarterly, or annually. Fiscal year Any 12-month accounting period Often coincides with a calendar year The time period concept simply states that a business’s activities can be sliced into small time segments, such as months, quarters, or years. Typically, a company’s fiscal year spans a period of 12 months. A calendar year is a fiscal year that begins on January 1 and ends on December 31. Many companies begin their fiscal year at the beginning of a quarter following a slow period. For example, retail organizations, such as Wal-Mart, J. C. Penney, Target, etc. may have a fiscal year from February 1 to January 31 since January is a slow month following the holiday season. © 2016 Pearson Education, Inc.

The Revenue Recognition Principle
The revenue recognition principle dictates when to record revenue and the amount of revenue to record. Record revenue when earned May be different from cash collections Revenue is based on the actual selling price of the item or service. The revenue recognition principle dictates when a journal entry is required to record revenue and the amount of revenue to record. In addition, the amount recorded for revenue is based on the actual selling price of the item, not necessarily the retail price. For example, if we normally sell an item for $200, but it is currently on sale for $100, then when it is actually sold for $100, the amount of revenue recorded will be $100. The original $200 sales price is irrelevant because the item was not sold for $200; it was sold for $100. © 2016 Pearson Education, Inc.

The Revenue Recognition Principle
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 revenue recognition principle guides when to record revenue and the amount that must be recognized. Under accrual basis accounting, revenue is recognized when it is earned. The earnings process is deemed complete when the seller has either delivered a product or performed a service. © 2016 Pearson Education, Inc.

The Matching Principle
The matching principle guides accounting for expenses. Expenses are recorded when they are incurred during the period. Expenses are matched against the revenue of the period. For example, record rent expense for January against January revenues, even if the rent was paid in December. The matching principle guides accounting for expenses and states that all expenses are recorded when they are incurred during the period and expenses are matched against the revenues of the period. The purpose of the matching principle is to accurately record expenses in the same period as revenues to compute an accurate net income or net loss for the time period. For example, Rent Expense and Salaries Expense for November should be matched to the revenue earned during November. The building was used during November, and the employees worked during November as well. Therefore, the revenues and all applicable expenses will be reported in the same month to ensure proper accounting for the monthly transactions. © 2016 Pearson Education, Inc.

The unadjusted trial balance comes from the general ledger. Adjustments are needed due to the time period concept, the revenue recognition principle, and the matching principle. The trial balance that was generated in Chapter 2 is generally referred to as an unadjusted trail balance. The unadjusted trial balance is incomplete because it omits various revenue and expense transactions in the account balances. The adjusting journal entries record use of assets, the change in liability accounts, and/or recognition of revenue or expense items. © 2016 Pearson Education, Inc.

Types of Adjusting Journal Entries
Adjusting entries can be divided into two basic categories: Deferrals Deferred expenses Deferred revenues Accruals Accrued expenses Accrued revenues There are two basic categories of adjusting entries: deferrals and accruals. There are two types of deferrals: deferred expenses (often called prepaid expenses) and deferred revenues (often called unearned revenues). Deferred revenues represent payments made by customers prior to when the services are performed or the products are delivered. Accrued revenues are revenues that have been earned but for which the cash has not yet been collected. Accrued revenues are the opposite for deferred revenues, where cash is collected before the revenues have been earned. Deferrals refer to any transaction where cash is involved PRIOR to the recognition of an expense or a revenue. Accruals refer to any transactions where cash is involved AFTER the recognition of an expense or a revenue. © 2016 Pearson Education, Inc.

Deferred Expenses Deferred expenses are: Advance payments of future expenses Treated as assets until used Recognized as an expense by an adjusting journal entry when the prepayment is used Types of deferred expenses: Prepaid rent Office supplies Depreciation A deferred expense is an item paid for in advance by the company for use in the future. Such payments are considered assets rather than expenses until they are used up. When the prepayment is used up, the used portion of the asset becomes an expense via an adjusting entry. © 2016 Pearson Education, Inc.

Prepaid Rent Paying $3,000 for rent in advance gives us the right to use the property for three months. In Transaction 10 in Chapter 2, Smart Touch Learning prepaid three months of the lease on its building, paying $3,000 ($1,000 per month). The initial entry required a debit to the Prepaid Rent current asset account and a credit to Cash for $3,000. This represents that Smart Touch Learning has the right to use the property for the next three months and, as such, records an asset on the balance sheet. Each month Smart Touch Learning will adjust the Prepaid Rent account for the use of the facilities. © 2016 Pearson Education, Inc.

Prepaid Rent To adjust the Prepaid Rent account on Dec. 31 , we need to reduce it by 1/3 since the company has used the space for one month. By the end of December, Smart Touch Learning has used one full month of the rent previously paid. The allocation for the one month is $1,000 (remember: $3,000/3 months). As assets are used, they are converted into expenses, which is Rent Expense in this case. At the end of the December, the remaining balance in the Prepaid Rent asset account is $2,000, which is found by taking the original prepayment of $3,000 less the one month usage of $1,000, which equals $2,000. At the end of January the same adjustment will be posted to show another month of rent has been used. © 2016 Pearson Education, Inc.

Prepaid Supplies On November 3, Smart Touch Learning purchased $500 of supplies on account. As of December 31, only $100 of supplies remain on hand. The December 31 unadjusted trial balance for Smart Touch Learning shows a balance in Office Supplies of $500. This represents the amount of office supplies that were purchased earlier in the period. Assume the ending balance of supplies is $100, which was found by counting the office supplies on hand at the end of the month. Since there are only $100 of supplies left on hand, the company has used $400 worth of supplies (found by taking $500 beginning balance ‒ $100 ending balance). This would mean that the current Office Supplies balance of $500 is no longer a fair representation of the amount of office supplies that Smart Touch Learning currently owns. Therefore, the adjusting journal entry is needed to properly report the correct balance of Office Supplies on the balance sheet. © 2016 Pearson Education, Inc.

Depreciation Plant assets: Long-lived, tangible assets Used in the operations of the business Value and usefulness decline as the assets are used Similar to deferred expenses: Paid for when acquired Used up over time Usage is recorded as Depreciation Expense Most prepaid adjusting journal entries are related to the adjustment of a current asset account. However, long-lived tangible assets are also used in the operations of the business. They act much like other prepaid assets, except adjustments will be made to the plant assets over a number of years instead of one or two years through Depreciation Expense. Depreciation is a type of prepaid expense adjustment. Plant assets are recorded in full at the time of purchase; therefore, an adjustment is recorded to reduce the value of the asset over its useful life. The prepaid adjustment for plant assets is called depreciation. © 2016 Pearson Education, Inc.

Depreciation On December 2, Smart Touch Learning received a contribution of furniture with a market value of $18,000 from a stockholder. In Chapter 2 on December 2, Smart Touch Learning received a contribution of furniture having a market value of $18,000 from a stockholder. The original entry included a debit to the Furniture account on the balance sheet and a credit to the Common Stock account. Assume that the furniture has a five-year useful life. © 2016 Pearson Education, Inc.

Depreciation Depreciation is the allocation of a plant asset’s cost over its useful life. All plant assets are depreciated, with the exception of land. Residual value is the expected value of a depreciable asset at the end of its useful life. The straight-line method allocates an equal amount of depreciation each year. Depreciation is usually defined as the periodic, systematic allocation of the cost of a long-lived tangible asset to expense over its estimated useful life. When recording depreciation, a debit is made to an expense account, called Depreciation Expense. Under Generally Accepted Accounting Principles, land is never depreciated. Residual value is the expected value of a depreciable asset at the end of its useful life. The residual value is used in the numerator of the straight-line method. The straight-line depreciation method is a method used to allocate depreciation expense each year over the useful life of the plant asset. © 2016 Pearson Education, Inc.

Depreciation Using the straight-line method, Smart Touch Learning calculates $300 of depreciation for December. For this example, we will use the straight-line method of computing depreciation. Using this method, the cost of the asset, after adjusting for residual value, is allocated evenly over the estimated useful life of the asset. In this case, we will divide the cost of the furniture of $18,000 by the estimated useful life of 5 years to arrive at an annual depreciation expense of $3,600 per year. Note: The residual value was zero, so there is no adjustment to cost in the numerator. We only want to depreciate this asset for one month, December, instead of a full year; therefore, we divide the annual depreciation expense amount by 12 months, so $3,600 / 12 months = $300 per month. © 2016 Pearson Education, Inc.

Depreciation Recording the entry requires the use of two accounts: Depreciation Expense and Accumulated Depreciation. The adjusting journal entry records a debit to Depreciation Expense of $300 for the one month the furniture has been used. The corresponding credit for the depreciation adjusting entry is Accumulated Depreciation for the same $300. Every plant asset account will have its own corresponding Accumulated Depreciation account. The book value for the furniture as of December 31 would be $17,700, which is the original cost of $18,000 less the $300 accumulated depreciation for the month. © 2016 Pearson Education, Inc.

Depreciation The Accumulated Depreciation account is the sum of all depreciation expense recorded for the depreciable asset to date. Accumulated Depreciation is a contra account; therefore, the account balance is the opposite of the normal balance of the related asset account. The cost minus accumulated depreciation of a plant asset is called its book value. The Accumulated Depreciation account is the sum of all depreciation expense recorded for the depreciable asset to date. Adjustments to the value of the plant assets are not made directly to the original asset account so that we do not violate the cost principle. Instead, the adjustment is made to a contra account called Accumulated Depreciation. A contra account has an account balance that is the opposite of the normal balance of the related asset account. The net result of the cost of the plant asset less Accumulated Depreciation is called book value. The book value is the amount reported in the assets section of the balance sheet. © 2016 Pearson Education, Inc.

Depreciation The cost principle requires the plant asset account to maintain the cost value in the asset account. However, the corresponding contra account is reported in the assets section of the balance sheet. The plant asset and corresponding accumulated depreciation accounts are netted so that the depreciated value (i.e., book value) of the asset is reported properly in the assets section of the balance sheet. © 2016 Pearson Education, Inc.

Deferred Revenue Deferred revenue: Occurs when a company receives cash before it does the work or delivers a product Is a liability because the business owes the customer the product, the service, or a refund Upon performance or delivery, deferred revenue is converted to earned revenue. Deferred revenues occur when a company receives cash from a customer prior to performing services or delivering a product. For example, an attorney requires a new client to pay a retainer fee of $1,000, yet no services have been performed. The attorney debits Cash and credits Unearned Revenue to establish the liability. If the client decides to not use the attorney, he or she can request a refund. Upon performance of the service, the revenue will be recognized. © 2016 Pearson Education, Inc.

Deferred Revenue On December 21, a law firm engages Smart Touch Learning to provide e-learning services for the next 30 days, paying $600 in advance. Deferred revenues arise when the company receives payment from a customer prior to services being performed or products being delivered. Since the company has not yet performed the service or delivered the product, the customer has a right to request a refund; therefore, the company still “owes” the customer either performance or money back. Therefore, a prepayment from a customer is considered a liability. © 2016 Pearson Education, Inc.

Deferred Revenue During the last 10 days of the month, Smart Touch Learning performs 1/3 of the services. In our example, Smart Touch Learning initially recorded a liability of $600 for Unearned Revenue. Between the time the payment was received and the end of December, Smart Touch Learning performed 1/3 of the services, which means it has earned $200 of the original $600 received from the customer (10 days / 30 days = 1/3 × $600 = $200 earned). Therefore, 1/3, or $200, is required to be recorded as Service Revenue. © 2016 Pearson Education, Inc.

Accrued Expenses Accrued expenses are expenses a business has incurred but has not yet paid. Examples of accrued expenses: Salaries Interest Utilities Businesses often incur expenses prior to paying for them. An accrued expense hasn’t been paid for yet. A great example is Salaries Expense: Employees work for a period of time before the business pays them for their time. This is an example of receiving a service prior to providing payment. © 2016 Pearson Education, Inc.

Accrued Salaries Expense
Smart Touch Learning pays its employee a monthly salary of $2,400, half on the 15th and half on the first day of the next month. Assume that Smart Touch Learning normally pays its employee a monthly salary of $2,400. Smart Touch Learning typically pays half the salary on the 15th of the month and the remainder on the first day of the next month. If we look at a calendar for December 2016, we see that December 31, 2016, falls on a Saturday. On December 31, Smart Touch Learning will need to recognize that it owes its employee for one-half month of salary, or $1,200. © 2016 Pearson Education, Inc.

Accrued Salaries Expense
On December 31, Smart Touch Learning owes its employee $1,200, which won’t be paid until January 1. Accrue salaries for December. The adjusting entry to record salaries accrued during the month of December is a debit to Salaries Expense and a credit to Salaries Payable of $1,200 (found by taking the monthly salary of $2,400 / 2 pay periods). The accrual is necessary because the company has incurred the expense since the employee has performed the work. When the payment is made on January 1, the Salaries Payable account will be debited, effectively eliminating the liability, and Cash will be credited. © 2016 Pearson Education, Inc.

Accrued Interest Expense
Smart Touch Learning borrows $60,000 on December 1 to purchase a building. As of December 31, Smart Touch Learning incurs $100 of interest on the note. Companies often borrow money for purchase of equipment or buildings. The interest on the loan could be paid monthly, quarterly, or annually. Regardless of when the interest expense is actually paid, a business must accrue the interest expense owed but not yet paid each month. The entry to record accrued interest is a debit to Interest Expense and a credit to Interest Payable. When the interest is paid, Interest Payable will be debited, and Cash will be credited. © 2016 Pearson Education, Inc.

Accrued Revenue Accrued revenues arise when: A company performs a service but has not yet collected cash A company delivers a product but has not yet collected cash Record accrued revenues with a: Debit to Accounts Receivable Credit to Service Revenue Accrued revenue occurs when the company earns revenue, usually as a result of performing services or delivering products to a customer, before receiving payment. If the revenue has been earned, it is recorded even if payment has not been received from the customer. Accrued revenue entries generally require a debit to the customer’s Accounts Receivable and a credit to a Revenue account. © 2016 Pearson Education, Inc.

Accrued Revenue On December 15, Smart Touch Learning agrees to perform e-learning services for $1,600 per month. By the end of December, it has earned ½ of the monthly fee. On December 15, Smart Touch Learning agreed to perform e-learning services for $1,600 per month. Over the next two weeks (the second half of December), Smart Touch Learning performs 1/2 month of services. The company has earned 1/2 month of revenue, but it has not yet collected it. Under GAAP, the revenue is recorded since it has been earned, even though payment has not yet been received from the customer. The entry requires a debit to Accounts Receivable for $800 and a credit to Service Revenue for $800. © 2016 Pearson Education, Inc.

Exhibit 3-3 is a summary of the deferral and accrual adjusting entries. The original entry and the corresponding adjusting entry is shown for the deferral adjustments. For example, the asset account, Prepaid Rent, is a debit and Cash is the credit in the original entry. When the rent is used, the Prepaid Rent account is adjusted with a credit, which decreases the value of the asset. A debit to Rent Expense captures the usage of the building. Accrual entries do not have an original entry. They are adjustments for revenues earned but not yet collected and expenses incurred but not yet paid. © 2016 Pearson Education, Inc.

Exhibit 3-4 summarizes the adjusting entries: (a)‒(d) are deferred expenses (e) represents deferred revenue (f) and (g) are accrued expenses (h) is accrued revenue Adjustments to the unadjusted trial balance are accomplished using adjusting entries. Mechanically, adjusting entries are similar other journal entries. First, the accounts to be adjusted are identified. Then a determination is made as to whether to debit or credit each account. Then the adjusting entry is created and posted to the general ledger. Exhibit 3-4 is a summary of the adjusting entries discussed throughout the chapter. Entries (a)–(d) are examples of deferred expenses. Item (e) is a deferred revenue adjustment. Entries (f) and (g) are accrued expenses, and entry (h) is an accrued revenue adjustment. © 2016 Pearson Education, Inc.

The Adjusted Trial Balance
Journalize adjusting entries Post adjusting entries Prepare adjusted trial balance At the end of the fiscal period, an adjusted trial balance is prepared. A summary of all accounts with adjusted balances The purpose is to ensure total debits equal total credits The adjusted trial balance includes all of the adjusting journal entries associated with deferred expenses, deferred revenues, accrued expenses, and accrued revenues. The purpose of the adjusted trial balance is to ensure the debits and credits are equal. Even if the debits are equal to the credits, there could still be potential errors in the journaling or posting processes. The adjusted trial balance is used to create the financial statements prior to the closing process. © 2016 Pearson Education, Inc.

The adjusted trial balance includes the balances after posting the adjusting journal entries. Prepare the financial statements from the adjusted trial balance. The debits are equal to the credits in the adjusted trial balance, which is similar to the unadjusted trial balance discussed in Chapter 2. The information from the adjusted trial balance is used to create the financial statements in the following order: income statement, statement of retained earnings, and the balance sheet. © 2016 Pearson Education, Inc.

Impact of Adjusting Entries
The adjusted trail balance is used to: Confirm debits equal credits after adjusting entries Ensure balance sheet items are properly valued Failing to record adjusting entries results in incorrect financial statements. See Exhibit 3-6 for examples. Failure to record the adjusting entries results in inaccurate financial statements. For example, if the adjustment for a deferred expense is not made, the asset account will be overstated and the expense account understated. This type of error results in an overstatement of net income because the expenses are too low. A summary of the impact on the financial statements is shown in Exhibit 3-6 on the next slide. © 2016 Pearson Education, Inc.

Impact of Adjusting Journal Entry Errors or Omissions
The adjusting journal entries are absolutely necessary to the financial accounting and reporting process. Without them, many accounts will be understated, and others will be overstated. For example, if we fail to record accrued revenues, both the assets and the revenues (and subsequently the net income) will be understated. Or if we fail to record depreciation expense during the period, assets will be overstated, while expenses will be understated (i.e., too low), thereby resulting in an overstatement of net income. © 2016 Pearson Education, Inc.

Worksheet A worksheet is an internal document that helps summarize data for the preparation of the financial statements. The worksheet has four sections: Account names Unadjusted trial balance Adjustments Adjusted trial balance A worksheet is a useful tool to aid in preparing the adjusted trial balance. The worksheet provides columns for the unadjusted trial balance, the adjusting entries, and the adjusted trial balance. The worksheet is an internal document and is often prepared in Microsoft Excel. © 2016 Pearson Education, Inc.

Alternative Treatment of Deferred Expenses
Rather than record the prepayment of an expense as a current asset, record the prepayment as an expense on the date of payment. The nature of most deferred expenses is that they have very short lives and will expire in the current accounting period. Therefore, the accountant may decide to record the expense rather than create a prepaid account. At the end of the period, adjustments are made if the full amount did not expire during the accounting period. In this example, the full three months of rent was recorded as an expense instead of as an asset. © 2016 Pearson Education, Inc.

Alternative Treatment of Deferred Expenses
At the end of the period, if any of the expense remains “unused,” then adjust some of it into the prepaid asset account The results are the same as with the traditional approach. The full three months of rent was recorded as rent expense, but only one month of rent expired during the accounting period, so an adjustment is required to show the amount unused. The overall result is the same as with the traditional approach. © 2016 Pearson Education, Inc.

Alternative Treatment of Deferred Revenues
Rather than record the early cash receipt from a customer as a current liability, record the cash receipt as a revenue on the date of receipt. The nature of most deferred revenues is that they have very short lives and are expected to be earned in the accounting period. Therefore, the accountant may record the entire amount as revenue instead of using the Unearned Revenue account. An adjustment will be made at the end of the accounting period if any of the Service Revenue has not yet been earned. © 2016 Pearson Education, Inc.

Alternative Treatment of Deferred Revenues
At the end of the period, an adjustment is made for the portion of revenue not earned in the period The results are the same as with the traditional approach. If the service is not performed during the accounting period, an adjustment is made to decrease the Service Revenue account, with a debit, and the Unearned Revenue account is increased with a credit. The net result is the same as with the traditional approach. © 2016 Pearson Education, Inc.

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