Chapter 3 The Adjusting Process 3-1

What is the Difference Between Cash Basis Accounting and 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. 3-2

On May 1, Smart Touch Learning paid $1,200 for insurance for the next six months ($200 per month). 3-3 What is the Difference Between Cash Basis Accounting and Accrual Basis Accounting?

On April 30, Smart Touch Learning received $600 for services to be performed for the next six months. 3-4 What is the Difference Between Cash Basis Accounting and Accrual Basis Accounting?

Learning Objective 2 Define and apply the time period concept, revenue recognition, and matching principles 3-5

The Time Period Concept 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. 3-6

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. 3-7

A good has been delivered or a service has been performed. The earnings process is complete. The Revenue Recognition Principle 3-8

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. 3-9

Learning Objective 3 Explain the purpose of and journalize and post adjusting entries 3-10

What are Adjusting Entries, and How Do We Record Them? 3-11

Adjusting entries can be divided into two basic categories: Deferrals 1. Deferred expenses 2. Deferred revenues Deferrals 1. Deferred expenses 2. Deferred revenues Accruals 1. Accrued expenses 2. Accrued revenues Accruals 1. Accrued expenses 2. Accrued revenues What are Adjusting Entries, and How Do We Record Them? 3-12

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 3-13

Prepaid Rent Paying $3,000 for rent in advance gives us the right to use the property for three months. 3-14

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. 3-15

On November 3, Smart Touch Learning purchased $500 of supplies on account. As of December 31, only $100 of supplies remain on hand. Office Supplies 3-16

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 3-17

On December 2, Smart Touch Learning received a contribution of furniture with a market value of $18,000 from a Sheena Bright, the owner. Depreciation 3-18

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. 3-19

Depreciation Using the straight-line method, Smart Touch Learning calculates $300 of depreciation for December. Assume the residual value of the asset is zero and the useful life is 5 years. 3-20

Depreciation Recording the entry requires the use of two accounts: Depreciation Expense and Accumulated Depreciation. 3-21

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. 3-22

Depreciation 3-23

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. 3-24

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. 3-25

Deferred Revenue During the last 10 days of the month, Smart Touch Learning performs 1/3 of the services. 3-26

Accrued Expenses Accrued expenses are expenses a business has incurred but has not yet paid. Examples of accrued expenses: – Salaries – Interest – Utilities 3-27

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. 3-28

On December 31, Smart Touch Learning owes its employee $1,200, which won’t be paid until January 1. Accrue salaries for December. Accrued Salaries Expense 3-29

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. 3-30

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 3-31

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. Accrued Revenue 3-32

3-33

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 3-34

Learning Objective 4 Explain the purpose of and prepare an adjusted trial balance 3-35

What is the Purpose of the Adjusted Trial Balance, and How Do We Prepare it? 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 Journalize adjusting entries Post adjusting entries Prepare adjusted trial balance 3-36

The adjusted trial balance includes the balances after posting the adjusting journal entries. Prepare the financial statements from the adjusted trial balance. 3-37

Learning Objective 5 Identify the impact of adjusting entries on the financial statements 3-38

What is the Impact of Adjusting Entries on the Financial Statements? The adjusted trail balance is used to: – Confirm debits equal credits after adjusting entries. – Ensure balance sheet items are properly valued. – Prepare the financial statements. Failing to record adjusting entries results in incorrect financial statements. 3-39

3-40 What is the Impact of Adjusting Entries on the Financial Statements?

Learning Objective 6 Explain the purpose of a worksheet and use it to prepare adjusting entries and the adjusted trial balance 3-41

How Could a Worksheet Help in Preparing Adjusting Entries and the Adjusted Trial Balance? A worksheet is an internal document that helps summarize data for the preparation of the financial statements. The worksheet has four sections that we will work with in the chapter: – Account names – Unadjusted trial balance – Adjustments – Adjusted trial balance 3-42

How Could a Worksheet Help in Preparing Adjusting Entries and the Adjusted Trial Balance? 3-43

Learning Objective 7 Understand the alternative treatment of recording deferred expenses and deferred revenues (Appendix 3A) 3-44

What is an Alternative Treatment of Recording Deferred Expenses and Deferred Revenues? An alternative approach to account for deferred expenses and deferred revenues. Deferred expenses: – The alternative approach records an expense and adjusts for any unused portion. Deferred revenues: – The alternative approach records Service Revenue and adjusts for any unearned portion. 3-45

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. 3-46

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. 3-47

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. 3-48

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. 3-49