ACCT 201 FINANCIAL REPORTING Chapter 3 Dr. Lale Guler Office: CAS 102 E-Mail: LGuler@ku.edu.tr

CHAPTER3 Adjusting the Accounts Study Objectives Adjusting entries Adjusted trial balance Financial statements Comparison between the U.S. GAAP and IFRS

Timing Issues: The Basics of Adjusting Entries are necessary because the trial balance may not contain up-to-date and complete data. ensure that the revenue recognition and expense recognition principles are followed. required every time a company prepares financial statements. will include one income statement account and one balance sheet account. will never include cash.

Timing Issues: Time Period Assumption For financial reporting purposes, we divide the economic life of a business into artificial time periods. . . . . . Jan. Feb. Mar. Apr. Dec. Generally a month, a quarter, or a year. Also known as the “periodicity assumption”. Monthly and quarterly time periods are called interim periods. Public companies must prepare both quarterly and annual financial statements.

Cash vs. Accrual Accounting Primary objective: help investors and creditors predict future cash flows Two models to achieve the objective: Cash-Basis Accounting Revenues recognized when cash is received. Expenses recognized when cash is paid. Accrual-Basis Accounting Revenues are recognized when earned, not necessarily when cash is received. Expenses are recognized when incurred, not necessarily when paid.

Cash vs. Accrual Accounting Example: Carter Company has sales on account totaling $100,000 per year for three years. Carter collected $50,000 in the first year and $125,000 in the second and third years. The company prepaid $60,000 for three years’ rent in the first year. Utilities are $10,000 per year, but in the first year only $5,000 was paid. Payments to employees are $50,000 per year. Measure company’s 3-year performance using cash basis and accrual accounting models.

Cash vs. Accrual Accounting Cash Basis Accounting Revenue is recognized when cash is received. Expenses are recognized when cash is paid.

Cash vs. Accrual Accounting Revenue is recognized when earned. Expenses are recognized when incurred.

Timing Issues Recognizing Revenues and Expenses Revenue Recognition Principle Recognize revenue in the accounting period in which it is earned. Revenue is considered to be earned at the time the product is delivered or the service is performed.

Timing Issues Recognizing Revenues and Expenses Expense Recognition Principle Match expenses with revenues in the period when the company makes efforts to generate those revenues. “Let the expenses follow the revenues.”

The Basics of Adjusting Entries Types of Adjusting Entries Deferrals Accruals 1. Prepaid Expenses. Expenses paid in cash and recorded as assets, and then they are used. 3. Accrued Revenues. Revenues earned but not yet received in cash or recorded. 2. Unearned Revenues. Cash received and recorded as liabilities, and then revenue is earned. 4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded.

The Basics of Adjusting Entries 1. Prepaid Expenses Payment of cash, that is recorded as an asset because service or benefit will be received in the future. Cash payment (Asset recorded) Expense recorded OK Prepayments often occur in regard to: insurance supplies rent equipment, buildings

The Basics of Adjusting Entries Trial Balance – Each account is analyzed to determine whether it is complete and up-to-date.

The Basics of Adjusting Entries Illustration: Pioneer Advertising Agency purchased supplies costing $2,500 on October 5. Pioneer recorded the payment by increasing (debiting) the asset 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 Adjusting entry

T-Accounts

The Basics of Adjusting Entries 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 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 Adjusting entry

T-Accounts SO 5

The Basics of Adjusting Entries Depreciation Buildings, equipment, and vehicles (assets with long lives) are recorded as assets, rather than an expense, in the year acquired. Companies report a portion of the cost of the asset as an expense (depreciation expense) during each period of the asset’s useful life. Depreciation does not attempt to report the actual change in the value of the asset.

The Basics of Adjusting Entries Illustration: For Pioneer Advertising, assume that depreciation on the equipment is $480 a year, or $40 per month. Oct. 31 Adjusting entry Accumulated Depreciation is called a contra asset account.

T-Accounts

The Basics of Adjusting Entries Balance Sheet Presentation Accumulated Depreciation is a contra asset account. Appears just after the account it offsets (Equipment) on the balance sheet. Normal balance of a contra asset account is a credit. Balance Sheet (partial) Assets

The Basics of Adjusting Entries 2. Unearned Revenues Receipt of cash that is recorded as a liability because the revenue has not been earned. Cash Receipt (LIABILITY recorded) Revenue Recorded Unearned revenues often occur in regard to: Rent Airline tickets Magazine subscriptions Customer advances

T-Accounts 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 Adjusting entry

The Basics of Adjusting Entries 3. Accrued Revenues Revenues earned but not yet received in cash or recorded. Revenue Recorded Cash Receipt Accrued revenues often occur in regard to: Rent Interest Services performed

The Basics of Adjusting Entries Illustration: In October Pioneer Advertising Agency earned $200 for advertising services that had not been recorded. Oct. 31 Adjusting entry On November 10, Pioneer receives cash of $200 for the services performed. Nov. 10

T-Accounts

The Basics of Adjusting Entries 4. Accrued Expenses Expenses incurred but not yet paid in cash or recorded. Expense Recorded Cash Payment Accrued expenses often occur in regard to: Rent Interest Taxes Salaries

The Basics of Adjusting Entries 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%. Oct. 31 Adjusting entry

T-Accounts

The Basics of Adjusting Entries 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

The Journal Entry and T-Accounts

The Basics of Adjusting Entries Summary of Basic Relationships

The Adjusted Trial Balance Prepared after all adjusting entries are journalized and posted. Purpose is to prove the equality of debit balances and credit balances in the ledger. Is the primary basis for the preparation of financial statements.

Owner’s Equity Statement The Financial Statements Financial Statements are prepared directly from the Adjusted Trial Balance. Balance Sheet Income Statement Owner’s Equity Statement

SO 7

Illustration 3-27

Concept of Fiscal Year Fiscal vs. Calendar Years Calendar Year = January 1 to December 31. Fiscal Year = Accounting time period that is one year in length.

APPENDIX3A Alternative Treatment of Prepaid Expenses Company may choose to debit (increase) an expense account rather than an asset account. This alternative treatment is simply more convenient.

APPENDIX3A Alternative Treatment of Unearned Revenues Company may credit (increase) a revenue account when they receive cash for future services.

APPENDIX3A Summary of Additional Adjustment Relationships

IFRS A Look at IFRS Key Points GAAP has more than 100 rules dealing with revenue recognition. Many of these rules are industry specific. In contrast, revenue recognition under IFRS is determined primarily by a single standard. Despite this large disparity in the amount of detailed guidance devoted to revenue recognition, the general revenue recognition principles required by GAAP that are used in this textbook are similar to those under IFRS. A specific standard exists for revenue recognition under IFRS (IAS 18). In general, the standard is based on the probability that the economic benefits associated with the transaction will flow to the company selling the goods, providing the service, or receiving investment income. In addition, the revenues and costs must be capable of being measured reliably. GAAP uses concepts such as realized, realizable (that is, it is received, or expected to be received), and earned as a basis for revenue recognition.

IFRS A Look at IFRS Key Points Under IFRS, revaluation of items such as land and buildings is permitted. IFRS allows depreciation based on revaluation of assets, which is not permitted under GAAP. Revenue recognition fraud is a major issue in U.S. financial reporting. The same situation occurs in other countries, as evidenced by revenue recognition breakdowns at Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch grocer AHold NV.

IFRS A Look at IFRS Looking into the Future The IASB and FASB are now involved in a joint project on revenue recognition. The purpose of this project is to develop comprehensive guidance on when to recognize revenue. Presently, the Boards are considering an approach that focuses on changes in assets and liabilities (rather than on earned and realized) as the basis for revenue recognition.

IFRS A Look at IFRS GAAP: provides very detailed, industry-specific guidance on revenue recognition, compared to the general guidance provided by IFRS. provides only general guidance on revenue recognition, compared to the detailed guidance provided by IFRS. allows revenue to be recognized when a customer makes an order. requires that revenue not be recognized until cash is received.

Review Adjusting entries are made to ensure that: expenses are recognized in the period in which they are incurred. revenues are recorded in the period in which they are earned. balance sheet and income statement accounts have correct balances at the end of an accounting period. all of the above.

Review One of the following statements about the accrual basis of accounting is false. That statement is: Events that change a company’s financial statements are recorded in the periods in which the events occur. Revenue is recognized in the period in which it is earned. The accrual basis of accounting is in accord with generally accepted accounting principles. Revenue is recorded only when cash is received, and expenses are recorded only when cash is paid.