1 3 The Adjusting Process

2 1. Describe the nature of the adjusting process. 2. Journalize entries for accounts requiring adjustment. 3. Summarize the adjustment process. 4. Prepare an adjusted trial balance. After studying this chapter, you should be able to:

3 Describe the nature of the adjusting process. Objective

TWO METHODS Reporting Revenue and Expense Cash Basis of Accounting Accrual Basis of Accounting

Cash Basis of Accounting 4 Revenue reported when cash is received 4 Expense reported when cash is paid 4 Does not properly match revenues and expenses

Accrual Basis of Accounting 4 Revenue reported when earned 4 Expense reported when incurred 4 Properly matches revenues and expenses in determining net income 4 Requires adjusting entries at end of period 4 It just sounds mean – it really isn’t

Accounting Accrual Basis Vs. Cash Basis Accrual 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

8 Under the accrual basis of accounting, revenues are reported in the income statement in the period in which they are earned. 3-1

9 The accounting concept that supports this approach to reporting of revenues is called the revenue recognition concept. 3-1

10 The accounting concept that supports reporting revenues and related expenses in the same period is called the matching concept, or matching principle. 3-1

11 Under the cash basis of accounting, revenues and expenses are reported in the income statement in the period in which cash is received or paid. 3-1

12 The analysis and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process. 3-1

13 The journal entries that bring the accounts up to date at the end of the accounting period are called adjusting entries. 3-1

14 Example Exercise 3-1 Indicate with a Yes or No whether or not each of the following accounts normally requires an adjusting entry. For Practice: PE 3-1A, PE 3-1B 10 Follow My Example 3-1 a.Noc. Yese. Yes b.Yesd. No?/Yesf. Yes a.Cashc.Wages Expensee.Accounts Receivable b.Prepaid Rentd.Office Equipmentf.Unearned Rent 3-1

15 Prepaid expenses, sometimes referred to as deferred expenses, are items that have been initially recorded as assets but are expected to become expenses over time or through the normal operations of the business. 3-1 Items That Need Adjusting

16 Unearned revenues, sometimes referred to as deferred revenues, are items that have been initially recorded as liabilities but are expected to become revenues over time or through the normal operations of the business. 3-1 Items That Need Adjusting

17 Insert Exhibit

18 Accrued revenues, sometimes referred to as accrued assets (accrued means unpaid), are revenues that have been earned but have not been recorded in the accounts. 3-1 Items That Need Adjusting

19 Accrued expenses, sometimes referred to as accrued liabilities, are expenses that have been incurred but have not been recorded in the accounts. 3-1 Items That Need Adjusting

21 Example Exercise 3-2 Classify the following items as (1) prepaid expense, (2) unearned revenue, (3) accrued expense, or (4) accrued revenue. For Practice: PE 3-2A, PE 3-2B 17 Follow My Example 3-2 a.Accrued expensec. Unearned revenue b.Prepaid expensed.Accrued revenue a.Wages owed but notc.Fees received but not yet yet paid.earned. b.Supplies on hand.d.Fees earned but not yet received. 3-1

22 Journalize entries for accounts requiring adjustment. Objective 2 3-2

24 NetSolutions’ Supplies account has a balance of $2,000 in the unadjusted trial balance. Some of these supplies have been used. On December 31, a count reveals that $760 of supplies are on hand. 3-2 Adjusting Process for Prepaid Expenses

25 Supplies (balance on trial balance)$2,000 Supplies on hand, December 31 – 760 Supplies used$1,

26 Supplies Supplies used ($2,000 – $760) Dec. 31 Adj 1,240 Dec. 311,240 Supplies Bal.2,000 Supplies Expense Bal , Dec. 31Supplies Expense

27 The debit balance of $2,400 in NetSolutions’ Prepaid Insurance account represents the December 1 prepayment of insurance for 12 months. 3-2

28 Dec. 31Adj 200 Prepaid Insurance Bal.2,400 Insurance Expense , Insurance Expense Prepaid Insurance Insurance expired ($2,400/12)

29 Example Exercise 3-3 The prepaid insurance account had a beginning balance of $6,400 and was debited for $3,600 of premiums paid during the year. Journalize the adjusting entry required at the end of the year assuming the amount of unexpired insurance related to future periods is $3,250. Follow My Example 3-3 Insurance Expense6,750 Prepaid Insurance6,750 Insurance expired ($6,400 + $3,600 – $3,250). For Practice: PE 3-3A, PE 3-3B

30 On December 1, the tenant prepaid three months’ rent for use of an office building owned by NetSolutions. As of December 31, only $120 has been earned. 3-2

31 27 Dec. 31Adj120 Dec. 31 Adj.120 Unearned Rent Bal.360 Rent Revenue Unearned Rent Rent Revenue Rent earned ($360/3 months) Bal.

32 Example Exercise 3-4 The balance in the unearned fees account, before adjustment at the end of the year, is $44,900. Journalize the adjusting entry required if the amount of unearned fees at the end of the year is $22,300. Follow My Example 3-4 Unearned Fees22,600 Fees Earned22,600 Fees earned ($44,900 – $22,300). For Practice: PE 3-4A, PE 3-4B

33 NetSolutions provided $500 in services during December for which the customer has not been billed. 3-2

34 30 Dec. 31Adj500 Accounts Receivable Bal.16,340 Fees Earned Bal.2,220 31Accounts Receivable Fees Earned Accrued fees (25 hrs. x $20) ,720 Bal. 16,840 Bal.

35 Example Exercise 3-5 At the end of the current year, $13,680 of fees have been earned but have not been billed to clients. Journalize the adjusting entry to record the accrued fees. Follow My Example 3-5 Accounts Receivable13,680 Fees Earned13,680 Accrued fees. For Practice: PE 3-5A, PE 3-5B

36 At the end of December, accrued wages amounted to $250. Without this adjusting entry, Wages Expense is understated. 3-2

37 33 Dec. 31Adj 250 Wages Payable Bal.4,275 Wages Expense Wages Expense Wages Payable Accrued wages Bal.4,525

38 34 Dec Wages Payable Bal.4,275 Wages Expense Bal.4, Closing entries will be discussed in a later chapter. For now, just be aware that Wages Expense is closed after financial statements are prepared and its balance rolled back to zero.

39 35 The payment of January 10 wages totaling $1,275 is shown below. Jan. 10Wages Expense Wages Payable Cash

Dec Wages Payable Bal.4,275 Wages Expense 2251 Bal.4,525 Jan. 101,025 Jan An expense for wages of $1,025 is recorded in the new fiscal year. The liability is cancelled. 36

41 Example Exercise 3-6 Sanregret Realty Co. pays weekly salaries of $12,500 on Friday for a five-day week ending on that day. Journalize the necessary adjusting entry at the end of the accounting period, assuming that the period ends on Thursday. Follow My Example 3-6 Salaries Expense10,000 Salaries Payable10,000 Accrued salaries ($12,500/5 x 4 days). For Practice: PE 3-6A, PE 3-6B

42 Physical resources that are owned and used by a business and are permanent or have a long life are called fixed assets, or plant assets. 3-2

43 As time passes, a fixed asset loses its ability to provide useful services. This decrease in usefulness is called depreciation. 3-2

44 Normal titles for fixed asset accounts and their related contra asset accounts are as follows: Fixed Asset Contra Asset LandNone—Land is not depreciated BuildingsAccumulated Depreciation— Buildings Store EquipmentAccumulate Depreciation—Store Equipment Office EquipmentAccumulated Depreciation—Office Equipment 3-2

45 NetSolutions estimates the depreciation on its office equipment to be $50 for the month of December. 3-2

46 42 Dec. 31Adj50 Depreciation Expense Dec. 31Adj50 Accum. Depr.—Office Equip Depreciation Expense50 00 Accum. Depreciation— Office Equipment50 00 Depreciation of office equipment

47 NetSolutions’ balance sheet would show the office equipment at cost, less the accumulated depreciation. Office equipment$1,800 Less accumulated depreciation 50$1,750 Book value 3-2

48 Example Exercise 3-7 The estimated amount of depreciation on equipment for the current year is $4,250. Journalize the adjusting entry to record the depreciation. Follow My Example 3-7 Depreciation Expense4,250 Accumulated Depreciation— Equipment4,250 Depreciation on equipment. For Practice: PE 3-7A, PE 3-7B

49 Summarize the adjustment process Objective 3 3-3

(Continued) Ledger with Adjusting Entries— NetSolutions 47

52 (Continued) 3-3 Ledger with Adjusting Entries— NetSolutions 48

53 (Continued) 3-3 Ledger with Adjusting Entries— NetSolutions 49

54 (Concluded) 3-3 Ledger with Adjusting Entries— NetSolutions 50

55 Example Exercise 3-8 For the year ending December 31, 2008, Mann Medical Co. mistakenly omitted adjusting entries for (1) $8,600 of unearned revenue that was earned, (2) earned revenue that was not billed of $12,500, and (3) accrued wages of $2,900. Indicate the combined effect of the errors on (a) revenues, (b) expenses, and (c) net income for Follow My Example 3-8 a.Revenues were understated by $21,100 ($8,600 + $12,500). b.Expenses were understated by $2,900. c.Net income was understated by $18,200 ($8, ,500 – $2,900). For Practice: PE 3-8A, PE 3-8B

Prepare an adjusted trial balance. Objective 4

57 The purpose of the adjusted trial balance is to verify the equality of the total debit balances and total credit balances before the financial statements are prepared. 3-4

59 Example Exercise 3-9 For each of the following errors, considered individually, indicate whether the error would cause the adjusted trial balance totals to be unequal. If the error would cause the adjusted trial balance total to be unequal, indicate whether the debit or credit total is higher and by how much. a.The adjustment for accrued fees of $5,340 was journalized as a debit to Accounts Payable for $5,340 and a credit to Fees Earned of $5,340. b.The adjustment for depreciation of $3,260 was journalized as a debit to Depreciation Expense for $3,620 and a credit to Accumulated Depreciation for $3,

6056 Follow My Example 3-9 a.The totals are equal even though the debit should have been to Accounts Receivable instead of Accounts Payable. b.The totals are unequal. The debit total is higher by $360 ($3,620 – $3,260). For Practice: PE 3-9A, PE 3-9B 3-4