Adjusting the Accounts Chapter 3 Adjusting the Accounts Financial Accounting, IFRS Edition Weygandt Kimmel Kieso

Study Objectives Explain the time period assumption. Explain the accrual basis of accounting. Explain the reasons for adjusting entries. Identify the major types of adjusting entries. Prepare adjusting entries for deferrals. Prepare adjusting entries for accruals. Describe the nature and purpose of an adjusted trial balance.

Adjusting the Accounts Timing Issues The Basics of Adjusting Entries The Adjusted Trial Balance and Financial Statements Fiscal and calendar years Accrual- vs. cash-basis accounting Recognizing revenues and expenses Types of adjusting entries Adjusting entries for deferrals Adjusting entries for accruals Summary of journalizing and posting Preparing the adjusted trial balance Preparing financial statements

Timing Issues Accountants divide the economic life of a business into artificial time periods (Time Period Assumption). . . . . . Jan. Feb. Mar. Apr. Dec. Generally a month, a quarter, or a year Fiscal year vs. calendar year Also known as the “Periodicity Assumption” SO 1 Explain the time period assumption.

Timing Issues Accrual- vs. Cash-Basis Accounting Accrual-Basis Accounting Transactions recorded in the periods in which the events occur. Revenues are recognized when earned, rather than when cash is received. Expenses are recognized when incurred, rather than when paid. SO 2 Explain the accrual basis of accounting.

Timing Issues Accrual- vs. Cash-Basis Accounting Cash-Basis Accounting Revenues are recognized when cash is received. Expenses are recognized when cash is paid. Cash-basis accounting is not in accordance with International Financial Reporting Standards (IFRS). SO 2 Explain the accrual basis of accounting.

Timing Issues Recognizing Revenues and Expenses Revenue Recognition Principle Companies recognize revenue in the accounting period in which it is earned. In a service enterprise, revenue is considered to be earned at the time the service is performed. SO 2 Explain the accrual basis of accounting.

Timing Issues Recognizing Revenues and Expenses Expense Recognition Principle – (Matching Principle) Match expenses with revenues in the period when the company makes efforts to generate those revenues. “Let the expenses follow the revenues.” SO 2 Explain the accrual basis of accounting.

Timing Issues IFRS relationships in revenue and expense recognition Illustration 3-1 SO 2 Explain the accrual basis of accounting.

The Basics of Adjusting Entries Adjusting entries make it possible to report correct amounts on the statement of financial position and on the income statement. A company must make adjusting entries every time it prepares financial statements. SO 3 Explain the reasons for adjusting entries.

The Basics of Adjusting Entries Revenues - recorded in the period in which they are earned. Expenses - recognized in the period in which they are incurred. Adjusting entries - needed to ensure that the revenue recognition and expense recognition are followed. SO 3 Explain the reasons for adjusting entries.

Types of Adjusting Entries Illustration 3-2 Categories of adjusting entries Deferrals Accruals 1. Prepaid Expenses. Expenses paid in cash and recorded as assets before they are used or consumed. 3. Accrued Revenues. Revenues earned but not yet received in cash or recorded. 2. Unearned Revenues. Revenues received in cash and recorded as liabilities before they are earned. 4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded. SO 4 Identify the major types of adjusting entries.

Types of Adjusting Entries Illustration 3-3 Trial Balance – Illustrations are based on the October 31, trial balance of Pioneer Advertising Agency Inc. SO 4 Identify the major types of adjusting entries.

Types of Adjusting Entries Adjusting Entries for Deferrals Deferrals are either: Prepaid expenses OR Unearned revenues. SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” Payment of cash that is recorded as an asset because service or benefit will be received in the future. Cash Payment Expense Recorded BEFORE Prepayments often occur in regard to: insurance supplies advertising rent maintenance on equipment fixed assets (depreciation) SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” Costs that expire either with the passage of time or through use. Adjusting entries (1) to record the expenses that apply to the current accounting period, and (2) to show the unexpired costs in the asset accounts. SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” Illustration 3-4 Increases (debits) an expense account and Decreases (credits) an asset account. SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” Illustration: Pioneer Advertising Agency purchased advertising supplies costing $2,500 on October 5. Pioneer recorded the payment by increasing (debiting) the asset Advertising Supplies. This account shows a balance of $2,500 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still on hand. Oct. 31 Advertising supplies expense 1,500 Advertising supplies 1,500 Illustration 3-5 SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” Illustration: On October 4, Pioneer Advertising Agency paid $600 for a one-year fire insurance policy. Coverage began on October 1. Pioneer recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in the October 31 trial balance. Insurance of $50 ($600 / 12) expires each month. Oct. 31 Insurance expense 50 Prepaid insurance 50 Illustration 3-6 SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” Depreciation Buildings, equipment, and vehicles (long-lived assets) are recorded as assets, rather than an expense, in the year acquired. Companies report a portion of the cost of a long-lived asset as an expense (depreciation) during each period of the asset’s useful life. SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” Illustration: Pioneer Advertising estimates depreciation on the office equipment to be $480 a year, or $40 per month. Oct. 31 Depreciation expense 40 Accumulated depreciation 40 Illustration 3-7 SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” Depreciation (Statement Presentation) Accumulated Depreciation is a contra asset account. Appears just after the account it offsets (Equipment) on the statement of financial position. Illustration 3-8 SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” Summary Illustration 3-9 SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Unearned Revenues” Receipt of cash that is recorded as a liability because the revenue has not been earned. Cash Receipt Revenue Recorded BEFORE Unearned revenues often occur in regard to: rent airline tickets school tuition magazine subscriptions customer deposits SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Unearned Revenues” Company makes an adjusting entry to record the revenue that has been earned and to show the liability that remains. The adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account. SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Unearned Revenues” Illustration 3-10 Decrease (a debit) to a liability account and Increase (a credit) to a revenue account. SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Unearned Revenues” Illustration: Pioneer Advertising Agency received $1,200 on October 2 from R. Knox for advertising services expected to be completed by December 31. Unearned Service Revenue shows a balance of $1,200 in the October 31 trial balance. Analysis reveals that the company earned $400 of those fees in October. Oct. 31 Unearned service revenue 400 Service revenue 400 Illustration 3-11 SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Unearned Revenues” Summary Illustration 3-12 SO 5 Prepare adjusting entries for deferrals.

Types of Adjusting Entries Adjusting Entries for Accruals Made to record: Revenues earned and OR Expenses incurred in the current accounting period that have not been recognized through daily entries. SO 6 Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Revenues” Revenues earned but not yet received in cash or recorded. Adjusting entry results in: Revenue Recorded Cash Receipt BEFORE Accrued revenues often occur in regard to: rent interest services performed SO 6 Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Revenues” An adjusting entry serves two purposes: (1) It shows the receivable that exists, and (2) It records the revenues earned. SO 6 Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Revenues” Illustration 3-13 Increases (debits) an asset account and Increases (credits) a revenue account. SO 6 Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Revenues” Illustration: In October Pioneer Advertising Agency earned $200 for advertising services that had not been recorded. Oct. 31 Accounts Receivable 200 Service Revenue 200 Illustration 3-14 SO 6 Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Revenues” Summary Illustration 3-15 SO 6 Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Expenses” Expenses incurred but not yet paid in cash or recorded. Adjusting entry results in: Expense Recorded Cash Payment BEFORE Accrued expenses often occur in regard to: rent interest taxes salaries SO 6 Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Expenses” An adjusting entry serves two purposes: (1) It records the obligations, and (2) It recognizes the expenses. SO 6 Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Expenses” Illustration 3-16 Increases (debits) an expense account and Increases (credits) a liability account. SO 6 Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Expenses” Illustration: Pioneer Advertising Agency signed a three-month note payable in the amount of $5,000 on October 1. The note requires Pioneer to pay interest at an annual rate of 12%. Illustration 3-17 Oct. 31 Interest expense 50 Interest payable 50 Illustration 3-18 SO 6 Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Expenses” Illustration: Pioneer Advertising Agency last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 x 3 days). Illustration 3-19 SO 6 Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Expenses” Illustration: Pioneer Advertising Agency last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 x 3 days). Oct. 31 Salaries expense 1,200 Salaries payable 1,200 Illustration 3-20 SO 6 Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Expenses” Summary Illustration 3-21 SO 6 Prepare adjusting entries for accruals.

The Adjusted Trial Balance After all adjusting entries are journalized and posted the company prepares another trial balance from the ledger accounts (Adjusted Trial Balance). Its purpose is to prove the equality of debit balances and credit balances in the ledger. SO 7 Describe the nature and purpose of an adjusted trial balance.

The Adjusted Trial Balance Illustration 3-24 Adjusted trial balance SO 7

Preparing Financial Statements Financial Statements are prepared directly from the Adjusted Trial Balance. Statement of Financial Position Income Statement Retained Earnings Statement SO 7 Describe the nature and purpose of an adjusted trial balance.

Preparing Financial Statements Illustration 3-25 Preparation of the income statement and retained earnings statement from the adjusted trial balance SO 7

Preparing Financial Statements Illustration 3-26 SO 7

Understanding U.S. GAAP Key Differences Adjusting the Accounts Like IFRS, companies applying GAAP use accrual-basis accounting to ensure that they record transactions that change a company’s financial statements in the period in which events occur. Similar to IFRS, cash-basis accounting is not in accordance with GAAP. GAAP also divides the economic life of companies into artificial time periods. Under both GAAP and IFRS, this is referred to as the time period assumption. GAAP requires that companies present a complete set of financial statements, including comparative information annually.

Understanding U.S. GAAP Key Differences Adjusting the Accounts GAAP has more than 100 rules dealing with revenue recognition. Many of these rules are industry-specific. Revenue recognition under IFRS is determined primarily by a single standard, IAS 18. Despite this large disparity in the detailed guidance devoted to revenue recognition, the general revenue recognition principles required by IFRS that are used in this textbook are similar to those under GAAP. GAAP uses concepts such as realized, realizable, and earned as a basis for revenue recognition.

Understanding U.S. GAAP Key Differences Adjusting the Accounts Internal controls are a system of checks and balances designed to detect and prevent fraud and errors. The Sarbanes-Oxley Act requires U.S. companies to enhance their systems of internal control. However, many foreign companies do not have this requirement. Under IFRS, revaluation to fair value of items such as land and buildings is permitted. This is not permitted under GAAP. The form and content of financial statements are very similar under GAAP and IFRS. Any significant differences will be discussed in those chapters that address specific financial statements.

Understanding U.S. GAAP Looking to the Future Adjusting the Accounts The IASB and FASB are now involved in a joint project on revenue recognition. Presently, the Boards are considering an approach that focuses on changes in assets and liabilities (rather than on “when earned”) as the basis for revenue recognition. It is hoped that this approach will lead to more consistent accounting in this area. The IASB and the FASB also face a difficult task in attempting to update, modify, and complete a converged conceptual framework. For example, how do companies choose between information that is highly relevant but difficult to verify versus information that is less relevant but easy to verify? Should a single measurement method, such as historical cost or fair value, be used, or does it depend on whether it is an asset or liability that is being measured?

Alternative Treatment of Prepaid Expenses and Unearned Revenues APPENDIX Some companies use an alternative treatment for prepaid expenses and unearned revenues. When a company prepays an expense, it debits that amount to an expense account. When a company receives payment for future services, it credits the amount to a revenue account. SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

Alternative Treatment for “Prepaid Expenses” Illustration: Pioneer Advertising purchased supplies on October 5 for $2,500 and debited Advertising Supplies Expense for the full amount. What if an inventory of $1,000 of advertising supplies remains on October 31? Oct. 31 Advertising supplies 1,000 Advertising supplies expense 1,000 Illustration 3A-1 SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

Adjustment approaches—a comparison Alternative Treatment for “Prepaid Expenses” Adjustment approaches—a comparison Illustration 3A-2 SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

Alternative Treatment for “Unearned Revenues” Illustration: Assume that Pioneer Advertising received $1,200 for future services on October 2 and credited the entire amount to Service Revenue. If at the statement date Pioneer has not performed $800 of the services, it would make an adjusting entry. Oct. 31 Service revenue 800 Unearned service revenue 800 Illustration 3A-4 SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

Adjustment approaches—a comparison Alternative Treatment for “Unearned Revenues” Adjustment approaches—a comparison Illustration 3A-5 SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

Summary of Additional Adjustment Relationships Illustration 3A-7 SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

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