Financial Accounting, 5e California State University, Weygandt, Kieso, & Kimmel Prepared by Kurt M. Hull, MBA CPA California State University, Los Angeles John Wiley & Sons, Inc.

ADJUSTING THE ACCOUNTS CHAPTER 3 ADJUSTING THE ACCOUNTS STUDY OBJECTIVES After studying this chapter, you should understand: Time period assumption Adjusting entries for prepayments Accrual basis of accounting Adjusting entries for accruals Why adjusting entries are necessary Purpose of an adjusted trial balance Major types of adjusting entries Alternate treatment of prepayments & accruals

TIME PERIOD ASSUMPTION STUDY OBJECTIVE 1 TIME PERIOD ASSUMPTION The time period assumption assumes that the economic life of a business can be divided into artificial time periods. Accounting time periods are generally a month, a quarter, or a year (fiscal year) 1

Accrual Basis ACCRUAL vs. CASH-BASIS ACCOUNTING Cash-Basis STUDY OBJECTIVE 2 ACCRUAL vs. CASH-BASIS ACCOUNTING Accrual Basis Revenue recognized when earned Expenses are matched against revenues Required by GAAP Cash-Basis Revenues and expenses recorded when cash is paid or received Not GAAP

REVENUE RECOGNITION PRINCIPLE The revenue recognition principle dictates that revenue be recognized in the accounting period in which it is earned. In a service business, revenue is considered to be earned when the service is performed. 2

MATCHING PRINCIPLE The practice of expense recognition is referred to as the matching principle. The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues). Revenues earned this month expenses incurred in earning the revenue are offset against.... 3

REVENUE & EXPENSE RECOGNITION GAAP RELATIONSHIPS IN REVENUE & EXPENSE RECOGNITION Time-Period Assumption Economic life of business can be divided into artificial time periods Revenue-Recognition Principle Revenue recognized in the accounting period in which it is earned Matching Principle Expenses matched with revenues in the same period when efforts are expended to generate revenues

WHY ADJUSTING ENTRIES ARE NECESSARY STUDY OBJECTIVE 3 WHY ADJUSTING ENTRIES ARE NECESSARY Adjusting entries are needed to ensure that revenue recognition and matching principles are followed 1 Revenues are recorded in the period earned, and...... 2 Expenses are recognized in the period incurred. 4

TYPES OF ADJUSTING ENTRIES Two main categories of adjustments are: STUDY OBJECTIVE 4 TYPES OF ADJUSTING ENTRIES Adjusting entries are required each time financial statements are prepared. Two main categories of adjustments are: PREPAYMENTS ACCRUALS 5

ADJUSTING ENTRIES: PREPAYMENTS Prepaid Expenses Unearned Revenues Expenses are paid and recorded as assets before they are used or consumed Example: Prepaid Insurance Unearned Revenues Cash received and recorded as liabilities before revenue is earned Example: Cash received for services provided in future

ACCRUALS Accrued Revenues Accrued Expenses ADJUSTING ENTRIES: ACCRUALS Accrued Revenues Revenues earned but Not yet received In cash or recorded Example: Sales of merchandise On account Accrued Expenses Expenses incurred but not yet paid in cash or recorded Example: Utilities used but not yet paid for

The Trial Balance is the starting place for adjusting entries. PIONEER ADVERTISING AGENCY Trial Balance October 31, 2006 Debit Credit Cash $ 15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable $ 5,000 Accounts Payable Unearned Revenue 1,200 Common Stock Retained Earnings 10,000 Dividends 500 Service Revenue Salaries Expense 4,000 Rent Expense 900 $ 28,700 The Trial Balance is the starting place for adjusting entries. $ 28,700

ADJUSTING ENTRIES FOR PREPAYMENTS STUDY OBJECTIVE 5 ADJUSTING ENTRIES FOR PREPAYMENTS Adjusting entries for prepayments are required to record the portion of the prepayment representing: 1 the expense incurred, or 2 the revenue earned in the current period. The adjusting entry results in a debit to an expense account and a credit to an asset account.

ADJUSTING ENTRIES FOR PREPAYMENTS Prepaid Expenses Asset Unadjusted Balance Credit Adjusting Entry (-) Expense Debit Adjusting Entry (+) Unearned Revenues Liability Unadjusted Balance Debit Adjusting Entry (-) Revenue Credit Adjusting Entry (+)

ADJUSTING ENTRIES FOR PREPAYMENTS SUPPLIES ADJUSTMENT October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand. JOURNAL ENTRY Date Account Titles and Explanation Debit Credit Oct. 31 Advertising Supplies Expense 1,500 Advertising Supplies 1,500 (To record supplies used) POSTING Advertising Supplies Advertising Supplies Expense Oct. 5 2,500 Oct. 31 1,500 Oct. 31 1,500 31 1,000

ADJUSTING ENTRIES FOR PREPAYMENTS INSURANCE ADJUSTMENT October 31, an analysis of the policy reveals that $50 of insurance expires each month. JOURNAL ENTRY Date Account Titles and Explanation Debit Credit Oct. 31 Insurance Expense 50 Prepaid Insurance 50 (To record insurance expired) POSTING Prepaid Insurance 10 Insurance Expense 63 Oct. 4 600 Oct. 31 50 Oct. 31 50 31 550

ADJUSTING ENTRY-SUPPLIES REVIEW QUESTION ADJUSTING ENTRY-SUPPLIES The trial balance shows supplies of $1,350 and supplies expense of $0. If $750 of supplies are on hand at the end of the period, what is the adjusting entry? Account Debit Credit Supplies Expense $600 Supplies $600 The balance in supplies after adjustment is $750, the amount remaining unused. The amount used Is transferred to expense.

ADJUSTING ENTRIES FOR PREPAYMENTS DEPRECIATION Depreciation is the allocation of the cost of an asset to expense over its useful life. Depreciation is an estimate of expired cost. Depreciation Expense is debited and a contra-asset account, Accumulated Depreciation, is credited Cost – accumulated depreciation = Book value Depreciation Expense Accumulated Depreciation XXX XXX

ADJUSTING ENTRIES FOR PREPAYMENTS DEPRECIATION ADJUSTMENT October 31, depreciation on the office equipment is estimated to be $480 a year, or $40 per month. JOURNAL ENTRY Date Account Titles and Explanation Debit Credit Oct. 31 Depreciation Expense 40 Accumulated Depreciation - Office Equipment 40 (To record monthly depreciation) POSTING Accumulated Depreciation - Depreciation Expense Office Equipment Oct. 31 40 Oct. 31 40 9

ADJUSTING ENTRIES FOR PREPAYMENTS UNEARNED REVENUES ADJUSTMENT October 31, analysis reveals that, of $1,200 in fees received , $400 has been earned in October. JOURNAL ENTRY Date Account Titles and Explanation Debit Credit Oct. 31 Unearned Revenue 400 Service Revenue 400 (To record revenue for services provided) POSTING Unearned Revenue Service Revenue Oct. 31 400 Oct. 2 1,200 Oct. 31 10,000 31 800 31 400 11

ADJUSTING ENTRIES FOR ACCRUALS STUDY OBJECTIVE 6 ADJUSTING ENTRIES FOR ACCRUALS Adjusting entries for accruals are required to record revenues earned and expenses incurred in the current period. The adjusting entry for accruals will increase both a balance sheet and an income statement account.

ADJUSTING ENTRIES FOR ACCRUALS Accrued Revenues Asset Debit Adjusting Entry (+) Revenue Credit Adjusting Entry (+) Accrued Expenses Expense Debit Adjusting Entry (+) Liability Credit Adjusting Entry (+)

ADJUSTING ENTRIES FOR ACCRUALS ACCRUED REVENUE ADJUSTMENT October 31, the agency earned $200 for advertising services that were not billed to clients before October 31. JOURNAL ENTRY Date Account Titles and Explanation Debit Credit Oct. 31 Accounts Receivable 200 Service Revenue 200 (To accrue revenue for services provided) POSTING Accounts Receivable Service Revenue Oct. 31 200 Oct. 31 10,000 31 400 31 200 31 10,600

ADJUSTING ENTRIES FOR ACCRUALS ACCRUED INTEREST ADJUSTMENT October 31, the portion of the interest to be accrued on a 3-month note payable is calculated to be $50. JOURNAL ENTRY Date Account Titles and Explanation Debit Credit Oct. 31 Interest Expense 50 Interest Payable 50 (To accrue interest on notes payable) POSTING Interest Expense Interest Payable Oct. 31 50 Oct. 31 50

ADJUSTING ENTRIES FOR ACCRUALS ACCRUED SALARIES ADJUSTMENT October 31, accrued salaries are calculated to be $1,200. JOURNAL ENTRY Date Account Titles and Explanation Debit Credit Oct. 31 Salaries Expense 1,200 Salaries Payable 1,200 (To record accrued salaries) POSTING Salaries Expense Salaries Payable Oct. 26 4,000 Oct. 31 1,200 31 1,200 31 5,200

ADJUSTING ENTRY-SALARIES REVIEW QUESTION ADJUSTING ENTRY-SALARIES Kathy Siska earned a salary of $400 for the last week of September. She will be paid on October 1. What is the required adjusting entry? Account Debit Credit Salaries Expense $400 Salaries Payable $400 This entry recognizes an expense for the salary earned by Kathy in the last week of September, and a liability for the amount due to Kathy at September 30th.

ADJUSTED TRIAL BALANCE STUDY OBJECTIVE 7 ADJUSTED TRIAL BALANCE An Adjusted Trial Balance is prepared after all adjusting entries have been journalized and posted. Its purpose is to prove the equality of the total debit and credit balances in the ledger after all adjustments have been made. Financial statements can be prepared directly from the adjusted trial balance.

PREPARING THE INCOME STATEMENT FROM THE ADJUSTED TRIAL BALANCE PIONEER ADVERTISING AGENCY Adjusted Trial Balance October 31, 2006 Debit Credit Cash $ 15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Depreciation - Office Equi pment $ 40 Notes Payable Accounts Payable 2,500 Interest Payable 50 Unearned Revenue 800 Salaries Payable 1,200 Common Stock Retained Earnings 10,000 Dividends 500 INCOME STATEMENT ACCOUNTS Service Revenue 10,600 Salaries Expense 5,200 Ad vertising Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 $ 30,190 $ 30,190

INCOME STATEMENT PIONEER ADVERTISING AGENCY Income Statement For the Month Ended October 31, 200 6 Revenues Fees earned $ 10,600 Expenses Salaries expense $ 5,200 Advertising supplies expense 1,500 Rent expense 900 Insurance expense 50 Interest expense 50 Depreciation expense 40 Total expenses 7,740 Net income $ 2,860 The income statement is prepared from the revenue and expense accounts.

RETAINED EARNINGS STATEMENT FROM THE ADJUSTED TRIAL BALANCE PREPARING THE RETAINED EARNINGS STATEMENT FROM THE ADJUSTED TRIAL BALANCE PIONEER ADVERTISING AGENCY Adjusted Trial Balance October 31, 2006 Debit Credit Cash $ 15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Depreciation - Office Equi pment $ 40 Notes Payable Accounts Payable 2,500 Interest Payable 50 Unearned Revenue 800 Salaries Payable 1,200 C.ommon Stock Retained Earnings 10,000 Dividends 500 BALANCE SHEET ACCOUNTS RETAINED EARNINGS STATEMENT ACCOUNTS Service Revenue 10,600 Salaries Expense 5,200 A dvertising Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 $ 30,190 $ 30,190

RETAINED EARNINGS STATEMENT PIONEER ADVERTISING AGENCY Retained Earnings Statement For the Month Ended October 31, 2006 Retained earnings, October 1 $ - Add: Net income 2,860 Less: Dividends 500 Retained earnings, October 31 2,360 The retained earnings statement is prepared from the revenue, expense, dividends, and retained earnings accounts.

BALANCE SHEET PIONEER ADVERTISING AGENCY Balance Sheet October 31, 2006 Assets Liabilities and Stockholders’ Equity Cash $ 15,200 Liabilities Accounts receivable 200 Notes payable $ 5,000 Advertising supplies 1,000 Accounts payable 2,500 Prepaid insurance 550 Interest payable 50 Office equipment Unearned fees 800 Less: Accumulated Salaries payable 1,200 depreciation 40 4,960 Total liabilities 9,550 Stockholders’ Equity Common Stock 10,000 Retained Earnings 2,360 Total liabilities and owner’s Total assets $ 21,910 equity $ 21,910 The balance sheet is prepared from asset and liability and stockholders equity accounts.

ALTERNATIVE METHOD--PREPAYMENTS & ACCRUALS STUDY OBJECTIVE 8 ALTERNATIVE METHOD--PREPAYMENTS & ACCRUALS Instead of debiting an asset at the time an expense is prepaid, the amount is charged to an expense account. Instead of crediting a liability at the time cash is received in advance of earning it, the amount is credited to a revenue account. This treatment of prepaid expenses and unearned revenues will ultimately result in the same effect on the financial statements

ALTERNATIVE METHOD--PREPAYMENTS & ACCRUALS SUPPLIES ADJUSTMENT October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand. JOURNAL ENTRY Date Account Titles and Explanation Debit Credit Oct. 31 Advertising Supplies 1,000 Advertising Supplies Expense 1,000 (To record supplies inventory) POSTING Advertising Supplies Advertising Supplies Expense Oct. 31 1,000 Oct. 5 2,500 Oct. 31 1,000 31 1,500

ALTERNATIVE METHOD--PREPAYMENTS & ACCRUALS UNEARNED REVENUES ADJUSTMENT October 31, analysis reveals that, of $1,200 in fees, $400 has been earned in October. JOURNAL ENTRY Date Account Titles and Explanation Debit Credit Oct. 31 Service Revenue 800 Unearned Revenue 800 (To record unearned revenue) POSTING Unearned Revenue Service Revenue Oct. 31 800 Oct. 31 800 Oct. 2 1,200 31 400

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CHAPTER 3 ADJUSTING THE ACCOUNTS