The Adjusting Process Chapter 3 3-1© 2k015 Pearson Education, Limited.

Learning Objectives 1.Differentiate between cash basis accounting and accrual basis accounting 2.Define and apply the time period concept, revenue recognition, and matching principles 3.Explain the purpose of and journalize and post adjusting entries 4.Explain the purpose of and prepare an adjusted trial balance 3-2© 2k015 Pearson Education, Limited.

Learning Objectives 5.Identify the impact of adjusting entries on the financial statements 6.Explain the purpose of a worksheet and use it to prepare adjusting entries and the adjusted trial balance 7.Understand the alternative treatments of recording prepaid expenses and unearned revenues 3-3© 2k015 Pearson Education, Limited.

Learning Objective 1 Differentiate between cash basis accounting and accrual basis accounting 3-4© 2k015 Pearson Education, Limited.

What is the Difference between Cash Basis Accounting & Accrual Basis Accounting? CASH BASIS Revenue is recorded when Cash is received Expenses are recorded when Cash is paid Not allowed under GAAP ACCRUAL BASIS Revenue is recorded when it is earned Expenses are recorded when incurred Generally used by larger businesses 3-5© 2k015 Pearson Education, Limited.

Learning Objective 2 Define and apply the time period concept, revenue recognition, and matching principles 3-6© 2k015 Pearson Education, Limited.

The Time Period Concept Assumes that a business’s activities can be sliced into small segments and that financial statements can be prepared for specific time periods, such as a month, quarter, or year. Any twelve month period is referred to as a fiscal year. 3-7© 2k015 Pearson Education, Limited.

The Revenue Recognition Principle 3-8© 2k015 Pearson Education, Limited. Revenue should be recorded when it is EARNED 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 amount of revenues must represent the actually selling price. If a $200 item is discounted to $100, then the revenue is $100.

The Matching Principle 3-9© 2k015 Pearson Education, Limited. Expenses are recorded when they are incurred during the period. Expenses are matched at the end of the period against the revenues for that period. For example, rent expense for January should be matched against January revenues, even if was actually paid in December.

Learning Objective 3 Explain the purpose of and journalize and post adjusting entries 3-10© 2k015 Pearson Education, Limited.

3-11© 2k015 Pearson Education, Limited. Unadjusted Trial Balance adjustments The initial trial balance that comes from the General Ledger is referred to as an Unadjusted Trial Balance. Because of the Time Period Concept, Revenue Recognition Principle, and Matching Principle some adjustments are needed.

3-12© 2k015 Pearson Education, Limited. adjust For example, the Office Supplies account shows $500 at the end of December. If a count of the actual supplies on hand shows that some supplies have been used, we will need to adjust the account.

Adjusting Journal Entries Adjusting Journal EntriesAdjustments to the Trial Balance are made by recording actual Adjusting Journal Entries. 3-13© 2k015 Pearson Education, Limited.

Adjusting Journal Entries Adjusting Journal EntryEach Adjusting Journal Entry will adjust a balance sheet account and an income statement account. 3-14© 2k015 Pearson Education, Limited.

Adjusting Journal Entries Adjusting Journal Entries (AJE’s) can be divided into two basic categories: 3-15© 2k015 Pearson Education, Limited. Prepaids 1.Prepaid Expenses 2.Unearned Revenues Accruals 1.Accrued revenues 2.Accrued expenses

Prepaid Rent Example In Transaction #10 (see Chapter 2), on December 1, Smart Touch Learning prepaid 3 months rent of $3,000 ($1,000 x 3 months). 3-16© 2k015 Pearson Education, Limited.

Prepaid Rent Example Paying rent in advance gives us the right to use the property for 3 months (in this case). By the end of December, 1/3 of that right has been used. 3-17© 2k015 Pearson Education, Limited.

Prepaid Rent Example To adjust the Prepaid Rent account, we need to reduce it by 1/3, and we need to show the rent expense related to the December revenues. 3-18© 2k015 Pearson Education, Limited.

Depreciation plant assetsLong-lived, tangible assets used to generate revenue are referred to as plant assets. Plant assets act like Prepaid Expenses 3-19© 2k015 Pearson Education, Limited. Paid for when acquired Used to produce revenues Used up over time

Depreciation DepreciationThe process of systematically recording the periodic usage of plant assets to generate revenues is called Depreciation. The accounts used are: –Depreciation Expense –Accumulated Depreciation 3-20© 2k015 Pearson Education, Limited. Land is never depreciated. Accumulated Depreciation is a contra-asset. - Has a credit balance - Has a credit balance - Appears in the Asset section of the Balance Sheet

Depreciation Example Assume that, on December 2, Smart Touch Learning received a contribution of furniture with a market value of $18,000 from Sheena Bright. At the end of December, Smart Touch Learning will need to record depreciation for the use of the furniture, assuming it has a 5 year useful life. 3-21© 2k015 Pearson Education, Limited.

Depreciation Example Using the straight-line method of computing depreciation, Smart Touch Learning will need to record $300 of depreciation for December. 3-22© 2k015 Pearson Education, Limited.

Depreciation Example Recording the entry requires the use of two accounts: Depreciation Expense and Accumulated Depreciation. 3-23© 2k015 Pearson Education, Limited.

Unearned Revenue Example On December 21, a law firm engages Smart Touch Learning to provide e-learning services for the next 30 days, paying $600 in advance. 3-24© 2k015 Pearson Education, Limited.

Unearned Revenue Example Smart Touch Learning is obligated to perform the services. During the last 10 days of the month, 1/3 of the services are performed. 3-25© 2k015 Pearson Education, Limited.

Accrued Expenses Example Smart Touch Learning pays its employee a monthly salary of $2,400, half on the 15 th and half on the first day of the next month. 3-26© 2k015 Pearson Education, Limited.

Accrued Expenses Example On December 31, Smart Touch Learning still owes the employee $1,200, which won’t be paid until January © 2k015 Pearson Education, Limited.

Accrued Revenue Example Accrued revenues arise when the company recognizes that it has performed a service, or delivered a product, but has not yet recorded that they have “earned” the revenue. 3-28© 2k015 Pearson Education, Limited.

Accrued Revenue Example On December 15, Smart Touch Learning agrees to perform e-learning services for $1,600 per month. By the end of December, they have earned ½ of the monthly fee for December. 3-29© 2k015 Pearson Education, Limited.

Learning Objective 4 Explain the purpose of and prepare an adjusted trial balance 3-30© 2k015 Pearson Education, Limited.

The Adjusted Trial Balance adjustedAfter journalizing and posting all the adjusting journal entries at the end of the fiscal period, a new adjusted trial balance is prepared. –List all accounts –List debit balances in the debit column –List credit balance in the credit column balancesIf it balances, financial statements can be prepared. 3-31© 2k015 Pearson Education, Limited.

The adjusted trial balance includes accounts that did not appear on the original unadjusted trial balance. The financial statements are prepared directly from the adjusted trial balance. 3-32© 2k015 Pearson Education, Limited.

Learning Objective 5 Identify the impact of adjusting entries on the financial statements 3-33© 2k015 Pearson Education, Limited.

3-34© 2k015 Pearson Education, Limited.

Learning Objective 6 Explain the purpose of a worksheet and use it to prepare adjusting entries and the adjusted trial balance 3-35© 2k015 Pearson Education, Limited.

3-36© 2k015 Pearson Education, Limited. First, enter the information from the unadjusted trial balance into the first two columns of the worksheet.

3-37© 2k015 Pearson Education, Limited. Second, enter the information for the adjusting journal entries into the Adjustments columns.

3-38© 2k015 Pearson Education, Limited. Third, cross-foot the numbers across the spreadsheet to the Adjusted Trial Balance columns.

Learning Objective 7 Understand the alternative treatments of recording prepaid expenses and unearned revenues 3-39© 2k015 Pearson Education, Limited.

Alternative Treatment of Prepaid Expenses Rather than record the prepayment of an expense as a current asset, record the prepayment as an expense on the date of payment. 3-40© 2k015 Pearson Education, Limited.

Alternative Treatment of Prepaid Expenses INTO 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 the traditional approach. 3-41© 2k015 Pearson Education, Limited.

Alternative Treatment of Unearned 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. 3-42© 2k015 Pearson Education, Limited.

Alternative Treatment of Unearned Revenues INTO At the end of the period, if any of the revenue remains “unearned,” then adjust some of it INTO the unearned revenue account. The results are the same as the traditional approach. 3-43© 2k015 Pearson Education, Limited.

End of Chapter © 2k015 Pearson Education, Limited.