1. Copyright © 2014 Pearson Canada Inc. 3 - 1 Chapter 3

2. Copyright © 2014 Pearson Canada Inc. 3 - 2 Learning Objective 1 Apply the recognition criteria for revenues and expenses When does a sale really happen? When do we record an expense?

3. Copyright © 2014 Pearson Canada Inc. 3 - 3 The Time-Period Assumption Ensures that accounting information is reported at regular intervals Interacts with the revenue- and expense-recognition criteria, and the matching objective Requires that income be measured accurately each period Period: Monthly, Quarterly, Annually

4. Copyright © 2014 Pearson Canada Inc. 3 - 4 The Accounting Period Businesses need periodic (annual) reports on their progress Fiscal year ends do not need to be the same as the calendar year end Interim statements can be presented: Monthly Quarterly Semi-annually

5. Copyright © 2014 Pearson Canada Inc. 3 - 5 Recognition Criteria for Revenues Revenue recognition states that revenue should be recognized when it is earned. Revenue is earned when: a. Goods delivered or services completed b. Contractual agreements have been met Record revenue equal to the cash value of the goods or service transferred to the customer

6. Copyright © 2014 Pearson Canada Inc. 3 - 6 Recognition Criteria for Expenses Matching objective: a. Matches expenses incurred with revenues earned during the accounting period Definition of Expenses: Cost of assets and services consumed when earning revenue. To match expenses against revenues means to subtract the related expenses from the revenue to compute net income (or net loss)

7. Copyright © 2014 Pearson Canada Inc. 3 - 7 Learning Objective 2 Distinguish accrual-basis accounting from cash-basis accounting Why can't we wait to record transactions until the cash comes in or the cash goes out?

8. Copyright © 2014 Pearson Canada Inc. 3 - 8 Accrual-Basis Accounting vs. Cash-Basis Accounting Accrual accounting records the effect of every business transaction as it occurs Cash-basis accounting records transactions only when cash receipts and cash payments occur Accrual Basis Records revenues when they are earned Records expenses when they are incurred Cash Basis Records cash receipts as revenue Records cash payments as expenses

9. Copyright © 2014 Pearson Canada Inc. 3 - 9 Accrual-basis vs. Cash-basis James purchases $4,000 of supplies on account James completed a job on credit for $15,000 Supplies4,000 Accounts Payable4000 Purchased supplies on credit. No entry because no cash was paid Accrual EntryCash Entry Accounts Receivable 15,000 Service Revenue 15,000 Earned revenue on account. Accrual Entry Cash Entry No entry because no cash was received

10. Copyright © 2014 Pearson Canada Inc. 3 - 10 Accrual-Basis Accounting Called accrual accounting Based on the time period assumption and recognition criteria for revenues and expenses. For the above reason, accrual accounting is required by GAAP for both ASPE and IFRS

11. Copyright © 2014 Pearson Canada Inc. 3 - 11 Learning Objective 3 Make adjusting entries What is the adjusting process, and why is it important?

12. Copyright © 2014 Pearson Canada Inc. 3 - 12 Adjusting the Accounts Accrual-basis accounting requires adjusting entries at the end of the period in order to produce correct balances for the financial statements Adjusting entries: Assign revenues to the period in which they are earned Assign expenses to the period in which they are incurred Update the asset and liability accounts

13. Copyright © 2014 Pearson Canada Inc. 3 - 13 Five Categories of Adjusting Entries Prepaid expenses Amortization of property, plant, and equipment, and intangible assets Unearned revenues Accrued expenses Accrued revenues Prepaids ( Deferrals ) Accruals

14. Copyright © 2014 Pearson Canada Inc. 3 - 14 Prepaid Expenses Prepaid expenses are advance payments of the expense Examples include: prepaid rent, prepaid insurance, and supplies

15. Copyright © 2014 Pearson Canada Inc. 3 - 15 Prepaid Insurance Example On April 1, 2014, HEC purchases an annual insurance policy for $3,600; the journal entry would be: The adjusting entry on April 30 is: Prepaid Insurance3,600 Cash3,600 To record payment for an annual policy. Insurance Expense300 Prepaid Insurance300 To record insurance expense for the month.

16. Copyright © 2014 Pearson Canada Inc. 3 - 16 Prepaid Insurance Example, posting Correct asset amount, $3,300 Total accounted for, $3,600 Correct expense amount, $300 ASSETS EXPENSES Prepaid Insurance Insurance Expense Apr. 1 3,600Apr. 30 300 Bal. 3,300 Apr. 30 300 Bal. 300

17. Copyright © 2014 Pearson Canada Inc. 3 - 17 Supplies Example On April 2, 2014, HEC purchases supplies for $1,500 cash. The April 2, 2014, journal entry would be: On April 30, a physical count of the supplies indicated that $1,000 remained; the adjusting entry would be: Supplies1,500 Cash1,500 To record supplies purchased. Supplies Expense500 Supplies500 To record supplies used.

18. Copyright © 2014 Pearson Canada Inc. 3 - 18 Supplies Example, posting ASSETS EXPENSES SuppliesSupplies Expense Correct asset amount, $1,000 Total accounted for, $1,500 Correct expense amount, $500 Apr. 2 1,500Apr. 30 500 Bal. 1,000 Apr. 30 500 Bal. 500

19. Copyright © 2014 Pearson Canada Inc. 3 - 19 Amortization of Property, Plant, and Equipment, and Intangible Assets Amortization (depreciation) defined: The process of allocating the cost of property, plant, and equipment to an expense account over its estimated useful life Intangible assets, such as patents and trademarks, are amortized over the intangible asset’s useful life

20. Copyright © 2014 Pearson Canada Inc. 3 - 20 Amortization Example On April 3, HEC purchases furniture for $45,000 with an expected life of 5 years The April 3 journal entry, to record the purchase: Furniture45,000 Cash45,000 To record the purchase of furniture.

21. Copyright © 2014 Pearson Canada Inc. 3 - 21 Amortization Example, Continued A portion of the furniture’s cost is transferred from the asset account to Amortization Expense each period the asset is used. After one month, the April 30, 2014 entry is: To record monthly amortization expense on furniture; 45,000 ÷ 5 years = $9,000 per year. $9,000 ÷ 12 months = $750 per month. Accumulated Amortization – Furniture is known as a contra account Amortization Expense – Furniture750 Accumulated Amortization – Furniture750

22. Copyright © 2014 Pearson Canada Inc. 3 - 22 Contra Account A contra account has: a companion account a normal balance opposite that of the companion account Accumulated Amortization is a contra account to property, plant, and equipment assets. It has a normal credit balance.

23. Copyright © 2014 Pearson Canada Inc. 3 - 23 Amortization, Example HEC owns a building that cost $120,000 with annual amortization of $6,000 (monthly amortization of $500) The amortization expense to be recorded on April 30 is: Amortization Expense – Building500 Accumulated Amortization – Building500 To record monthly amortization expense on building.

24. Copyright © 2014 Pearson Canada Inc. 3 - 24 Partial Balance Sheet of HEC Property, Plant, and Equipment Furniture$ 45,000 Less: Accumulated amortization – furniture750$ 44,250 Building120,000 Less: Accumulated amortization – building500119,500 Property, Plant, and Equipment, net$163,750

25. Copyright © 2014 Pearson Canada Inc. 3 - 25 Accrued Expenses Accrued expenses defined: An expense that the business has incurred but has not yet paid Accrued expenses always create a liability Accruals are the recording of the expense or revenue before the related cash is paid or received

26. Copyright © 2014 Pearson Canada Inc. 3 - 26 Accrued Expense Example HEC pays its two employees a semi-monthly salary of $4,000 in total on the 15 th and on the last day of the month The employees are paid on April 15, but April 30 is a Saturday: thus employees will receive their pay cheques on Monday, May 2 The journal entry on April 30 to accrue the salaries is: Salaries Expense4,000 Salary Payable4,000 To accrue salaries expense.

27. Copyright © 2014 Pearson Canada Inc. 3 - 27 Accrued Expense Example, Continued EXPENSES LIABILITIES Salaries Expense Salaries Payable After posting, the Salaries Expense and Salaries Payable accounts contain the complete salary information for the month of April. Apr. 15 4,000 Apr. 30 4,000 Bal. 8,000 Apr. 30 4,000 Bal. 4,000

28. Copyright © 2014 Pearson Canada Inc. 3 - 28 Accrued Revenues Accrued revenues defined: Revenue that has been earned but not yet invoiced or collected.

29. Copyright © 2014 Pearson Canada Inc. 3 - 29 Accrued Revenue Example HEC is hired on April 15 to provide monthly services for $3,000 monthly, with the first payment to be received on May 15. Service is provided from April 15 to April 30. The adjusting entry on April 30 is: Adjusting for accrued revenues illustrates the concept of revenue recognition. Accounts Receivable1,500 Service Revenue1,500 To accrue revenue: $3,000 × ½.

30. Copyright © 2014 Pearson Canada Inc. 3 - 30 Unearned Revenues, or Deferred Revenue Unearned revenue defined: Receiving Cash in advance from customers prior to providing the service or delivering the product Unearned revenue is a liability Only when the service is provided or product delivered is the revenue earned.

31. Copyright © 2014 Pearson Canada Inc. 3 - 31 Unearned Revenue Example HEC receives a cash advance of $3,000 on April 20 from a customer The journal entry on April 20 is: Cash3,000 Unearned Revenue3,000 To record cash received in advance of providing the service.

32. Copyright © 2014 Pearson Canada Inc. 3 - 32 Unearned Revenue Example Continued On April 30, $1,000 of the cash advance has been earned by HEC: The adjusting entry on April 30 is: Unearned Revenue1,000 Service Revenue1,000 To record service revenue earned that was collected in advance: $3,000 × 1/3.

33. Copyright © 2014 Pearson Canada Inc. 3 - 33 Unearned Revenue Example Continued The balance prior to adjustment was $24,000 LIABILITIESREVENUES Unearned Service Revenue Service Revenue Correct liability amount, $2,000 Total accounted for, $3,000 Correct revenue amount, $1,000 Apr. 30 1,000Apr. 20 3,000 Bal. 2,000 24,000 Apr. 30 1,500 Apr. 30 1,000 Bal. 26,500

34. Copyright © 2014 Pearson Canada Inc. 3 - 34 Summary of Adjusting Entries Type of Account Category of Adjusting Entry DebitedCredited Prepaid expenseExpenseAsset AmortizationExpenseContra asset Accrued expenseExpenseLiability Accrued revenueAssetRevenue Unearned revenueLiabilityRevenue

35. Copyright © 2014 Pearson Canada Inc. 3 - 35 Learning Objective 4 Prepare an adjusted trial balance How do we get the accounting records ready to prepare the financial statements?

36. Copyright © 2014 Pearson Canada Inc. 3 - 36 The Adjusted Trial Balance The adjusting process starts with the unadjusted trial balance Adjusting entries are journalized and posted to the ledgers The adjusted trial balance is prepared, which serves as a basis for the preparation of the financial statements

37. Copyright © 2014 Pearson Canada Inc. 3 - 37 Learning Objective 5 Prepare the financial statements from the adjusted trial balance Remind me. How do we prepare the financial statements?

38. Copyright © 2014 Pearson Canada Inc. 3 - 38 Preparing the Financial Statements from the Adjusted Trial Balance The financial statements should be prepared in the following order: Income statement Statement of owner’s equity Balance sheet The essential features of all financial statements: Heading - name of the entity, title of the statement, and date or period covered Body of the statement

39. Copyright © 2014 Pearson Canada Inc. 3 - 39 Relationships among the Three Financial Statements HUNTER ENVIRONMENTAL CONSULTING Partial Preparation of Adjusted Trial Balance April 30, 2014 Account TitleTrial Balance AdjustmentsAdjusted Trial Balance Debits = Credits for the trial balance, adjustments, and adjusted trial balance DebitCredit Debit Credit Debit Credit Cash Accounts receivable Supplies Prepaid insurance Furniture Accum. amort.– furniture Land Accounts payable Salaries payable Utilities expense 31,000 14,000 1,500 3,600 45,000 50,000 1,000 159,100 12,000 0 159,100 1,500 8,050 500 300 750 4,000 8,050 31,000 15,500 1,000 3,300 45,000 50,000 1,000 165,350 750 12,000 4,000 165,350

40. Copyright © 2014 Pearson Canada Inc. 3 - 40 The Income Statement HUNTER ENVIRONMENTAL CONSULTING Income Statement For the Month Ended April 30, 2014 Revenue Service revenue$26,500 Expenses: Salaries expense Rent expense Utilities expense Amortization expense Supplies expense Insurance expense $8,000 3,000 1,000 750 500 300 Total expenses13,550 Net income$12,950

41. Copyright © 2014 Pearson Canada Inc. 3 - 41 The Statement of Owner’s Equity HUNTER ENVIRONMENTAL CONSULTING Statement of Owner’s Equity For the Month Ended April 30, 2014 Lisa Hunter, capital, April 1, 2014 Add: Net income $120,100 12,950 133,050 Less: Withdrawals Lisa Hunter, capital, April 30, 2014 6,000 $127,050

42. Copyright © 2014 Pearson Canada Inc. 3 - 42 The Balance Sheet HUNTER ENVIROMENTAL CONSULTING Balance Sheet April 30, 2014 AssetsLiabilities Cash Accounts receivable Supplies Prepaid insurance Furniture Less: Accumulated amortization – furniture Land Total assets 45,000 750 $31,000 15,500 1,000 3,300 44,250 50,000 $145,050 Accounts payable Salaries payable Unearned service revenue Total liabilities Owner’s Equity Lisa Hunter, capital Total liabilities and owner’s equity $12,000 4,000 2,000 18,000 127,050 $145,050

43. Copyright © 2014 Pearson Canada Inc. 3 - 43 Learning Objective 6 Describe the adjusting-process implications of international financial reporting standards (IFRS) How does IFRS apply to adjusting entries?

44. Copyright © 2014 Pearson Canada Inc. 3 - 44 Adjusting-Process Implications of International Financial Reporting Standards (IFRS) IFRS for publicly accountable enterprises has no direct impact on the adjusting process. Companies reporting under IFRS or ASPE have the same adjusting process Financial statement presentation may be impacted if reporting under IFRS versus ASPE.

45. Copyright © 2014 Pearson Canada Inc. 3 - 45 Learning Objective A1 Account for a prepaid expense recorded initially as an expense Is there another way to record prepaids?

46. Copyright © 2014 Pearson Canada Inc. 3 - 46 Prepaid Expenses Recorded Initially as an Expense On August 1, a business paid $3,600 for an annual insurance policy. The August 1 journal entry to record the payment is: The adjusting entry on December 31 to record prepaid insurance is: Insurance Expense3,600 Cash3,600 To record annual insurance payment. Prepaid Insurance2,100 Insurance Expense2,100 To record prepaid insurance: 3,600 × 7/12.

47. Copyright © 2014 Pearson Canada Inc. 3 - 47 Prepaid Expense Example, Continued At December 31, only five months’ prepayment has expired, leaving seven months still prepaid ASSETSEXPENSES Prepaid Insurance Insurance Expense Dec. 31 2,100 Dec. 31 Bal. 2,100 Aug. 1 3,600Dec. 31 2,100 Dec. 31 Bal. 1,500

48. Copyright © 2014 Pearson Canada Inc. 3 - 48 Learning Objective A2 Account for an unearned (deferred) revenue recorded initially as a revenue Is there another way to record unearned revenues?

49. Copyright © 2014 Pearson Canada Inc. 3 - 49 Unearned Revenue Recorded Initially as a Revenue On October 1, a consulting firm records as consulting revenue the receipt of $18,000 cash for revenue to be earned over nine months The journal entry on October 1 to record the cash receipt is: The adjusting entry on December 31 to record unearned revenue is: Cash18,000 Consulting Revenue18,000 To record cash received. Consulting Revenue12,000 Unearned Consulting Revenue12,000 To record revenue earned in advance: $18,000 × 6/9.

50. Copyright © 2014 Pearson Canada Inc. 3 - 50 Unearned Revenue, Example Continued At December 31, the adjusting entry moves the unearned portion into the liability account because the business still owes consulting service to the client during January to June of the following year LIABILITIESREVENUE Unearned Consulting Revenue Consulting Revenue Dec. 31 12,000 Dec. 31 Bal. 12,000 Dec. 31 12,000Oct. 1 18,000 Dec. 31 Bal. 6,000