THE ACCOUNTING CYCLE: Adjusting The Accounts Chapter 4 2

Accrual- vs. Cash-Basis Accounting 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. LO 2 Explain the accrual basis of accounting.

Accrual- vs. Cash-Basis 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. Problem! Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP). LO 2 Explain the accrual basis of accounting.

Timing Issues Recognizing Revenues and Expenses When to record Revenue?—Realization Principle Companies recognize revenue in the accounting period in which it is earned. (Realization Principle) In a service business, revenue is considered to be earned at the time the service is performed. LO 2 Explain the accrual basis of accounting.

Timing Issues Recognizing Revenues and Expenses When to record Expenses? Match expenses with revenues in the period when the company incurred expenses to produce those revenues. This is known as the Matching Principle “Let the expenses follow the revenues.” LO 2 Explain the accrual basis of accounting.

Timing Issues 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. This basis is in accord with generally accepted accounting principles. Revenue is recorded only when cash is received, and expense is recorded only when cash is paid. LO 2 Explain the accrual basis of accounting.

At the end of the period, we need to make adjusting entries to get the accounts up to date for the end of the period financial statements.

Adjusting Entries are needed to ensure that the realization and matching principles are followed Every adjusting needed whenever revenue or expenses affect more than one entry involves a change in either a revenue or expense accounting period. and an asset or liability. Some Balance Sheet and Income Statement accounts will need to be adjusted. Note: Cash is never used in an adjusting entry!! 4

These entries: Assign revenues to the period in which they are earned. Assign expenses to the periods in which the related goods/services are used. Are made at the end of each accounting period, usually on a monthly basis.

Timing Issues Review Adjusting entries are made to ensure that: a. expenses are recognized in the period in which they are incurred. b. revenues are recorded in the period in which they are earned. c. balance sheet and income statement accounts have correct balances at the end of an accounting period. d. all of the above. LO 3 Explain the reasons for adjusting entries.

Types of Adjusting Entries Converting Asset to Expense Unearned Revenues Accrued expenses Accrued revenues 4

Converting Assets to Expenses Examples Include: Supplies Expiring Insurance Policies Depreciation of Assets 4

Converting Assets to Expenses End of Current Period Prior Periods Current Period Future Periods Transaction Purchased an asset such as supplies Adjusting Entry Recognize portion of asset consumed as expense, and Reduce balance of asset account. 4

Entry for Purchasing Supplies Example (supplies): On Jan. 1st, Phoenix Consulting purchased $800 of supplies. Show the journal entry to record the payment on Jan. 1st. Jan. 1 Supplies 800 Cash 800 Supplies Cash Debit Credit Debit Credit 800 800 LO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Recording Supplies Used Up” Example (Supplies): On Jan. 31st, Phoenix Consulting had an inventory of supplies on hand worth $650 Jan. 31 Supplies expense 150 Supplies 150 Supplies Supplies expense Debit Credit Debit Credit 800 150 150 650 LO 5 Prepare adjusting entries for deferrals.

Practice Problem On July 1 Wild Waters Co. purchased $600 worth of supplies for cash. At the end of the month their inventory of supplies showed that they had $400 of supplies on hand. Using t-accounts, show the accounts involved when the supplies were purchased on July 1, and then show the adjusting entry required to bring the accounts up to date at the end of the month.

Purchase of Supplies for cash 600 600

The adjusting entry required at the end of the month Supplies Supplies Exp. 600 200 200

Adjusting entry for expiring insurance policy ** Prepaid expenses – Assets that become expenses as the goods & services are used. (Insurance, Advertising) $12,000 Insurance Policy Coverage for 12 Months $1,000 Monthly Insurance Expense Jan. 1 Dec. 31 4

Entries for “Prepaid Expenses” Example (Insurance): On Jan. 1st, Phoenix Consulting paid $12,000 for 12 months of insurance coverage. Show the journal entry to record the payment on Jan. 1st. How do we record this? What would you debit? What could we call it? Prepaid Insurance or Unexpired Insurance Jan. 1 Prepaid insurance 12,000 Cash 12,000 Prepaid Insurance Cash Debit Credit Debit Credit 12,000 12,000 LO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” Example (Insurance): On Jan. 1st, Phoenix Consulting paid $12,000 for 12 months of insurance coverage. Show the adjusting journal entry required at Jan. 31st. Jan. 31 Insurance expense 1,000 Prepaid insurance 1,000 Prepaid Insurance Insurance expense Debit Credit Debit Credit 12,000 1,000 1,000 11,000 LO 5 Prepare adjusting entries for deferrals.

Practice Problem Wild Waters Co. prepaid $4,800 for a 12-month insurance policy. Using t-accounts, show the accounts involved when the insurance policy was purchased, and then show the adjusting entry required to bring the accounts up to date when one month’s insurance coverage expires.

Prepaid insurance policy for $4,800 cash

The adjusting entry required at the end of the month Prepaid Insurance Insurance Exp. 4,800 400 400

The Concept of Depreciation Depreciable assets are physical objects that retain their size and shape but eventually wear out or become obsolete. Some examples are? Delivery Truck, Building, Equipment Depreciation is spreading out or allocating the cost of an asset to expense over the asset’s useful life. The rationale for depreciation lies in the matching principle.

Depreciation Is Only an Estimate The most widely used means of estimating depreciation expense is the straight - line method. Using the straight-line method, an estimated* portion of the asset’s cost is allocated to depreciation expense in every period of the asset’s estimated useful life. On May 2, 2010, JJ’s Lawn Care Service purchased a lawn mower with a useful life of 50 months for $2,500 cash. Depreciation expense (per period) = Cost of the asset Estimated useful life $2,500 50 = $50 *Use of an estimated life is the major reason that depreciation expense is only an estimate

Entry for purchasing equipment Example: On May 2, 2010, JJ’s Lawn Care Service purchased a lawn mower with a useful life of 50 months for $2,500 cash. Record the purchase of the lawn mower. May 2 Equipment 2,500 Cash 2,500 Equipment Cash Debit Credit Debit Credit 2,500 2,500 LO 5 Prepare adjusting entries for deferrals.

A new account: Accumulated Depreciation Accumulated Depreciation is the account that will be credited when depreciating an asset. It is called a Contra- Asset account because it is offset against the asset account .

Adjusting Entry for Depreciation Example (Depreciation): On May 2, 2010, JJ’s Lawn Care Service purchased a lawn mower with a useful life of 50 months for $2,500 cash. Show the adjusting journal entry required on May 31. ($2,500 / 50 months = $50) May. 31 Depreciation expense: Equip. 50 Accumulated depreciation: Equip 50 Depreciation expense: Equip Accumulated depreciation: Equip Debit Credit Debit Credit 50 50 50 LO 5 Prepare adjusting entries for deferrals.

Book Value Accountants use the term book value to describe the net value of an asset in a company’s accounting records. BV=Asset’s Original Cost – Accum. Depreciation Book Value is based upon an asset’s original cost and is NOT intended to represent an asset’s current market value.

Accumulated depreciation would appear on the balance sheet as follows: *The book value of Tools & Equipment is $_________ *The book value of Truck is $_______________ 4

Practice Problem Wild Waters Co. purchased a used bus for $36,000 on account to transport tourists to the river for white water rafting. The bus should have a useful life of 5 years. Using t-accounts, show the accounts involved when the asset was purchased, and then show the adjusting entry required to depreciate the asset at the end of the month and bring the accounts up to date.

Purchase of bus for $36,000 on account AP 36,000 36,000

Accumulated Depreciation The adjusting entry required at the end of the month to depreciate the asset Accumulated Depreciation Depreciation Exp. 600 600

Adjusting Entry needed Converting Liabilities to Revenue Amounts collected in advance do not represent revenue because these amounts have not yet been earned. End of Current Period Prior Periods Current Period Future Periods Transaction When a company collects $ from customers in advance (ie. Health Club membership), it creates a liability called Unearned Revenue. Adjusting Entry needed 1. Recognize portion earned as revenue, and 2. Reduce balance of liability account. 4

Adjusting Entries for Unearned Revenue Examples Include: Airline Ticket Sales Sports Teams’ Sales of Season Tickets Health Club Memberships 4

Adjusting Entries for Unearned Revenue $6,000 Rental Contract Coverage for 12 Months $500 Monthly Rental Revenue Jan. 1 Dec. 31 On January 1, Webb Co. received $6,000 in advance for a one-year rental contract. 4

Recording an “Unearned Revenue” Example: On January 1, Webb Co. received $6,000 in advance for a one-year rental contract. Show the journal entry to record the receipt on Jan. 1 Jan. 1 Cash 6,000 Unearned rent revenue 6,000 Cash Unearned Rent Revenue Debit Credit Debit Credit 6,000 6,000 LO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Unearned Revenues” Example: On January 1, Webb Co. received $6,000 in advance for a one-year rental contract. Show the adjusting journal entry required on Jan. 31st. Jan. 31 Unearned rent revenue 500 Rent revenue 500 Rent Revenue Unearned Rent Revenue Debit Credit Debit Credit 500 500 6,000 5,500 LO 5 Prepare adjusting entries for deferrals.

Unearned revenue differs from other liabilities because it usually will be settled by rendering a Service or product rather than by making payment in cash. In short, it will be worked off rather than paid off. Practice Problem On June 1 Wild Waters Co. received $7,500 from Outdoor Adventure (a youth summer camp) for a summer rafting program. Outdoor Adventure paid 3 months in advance. Using t-accounts, show the accounts involved when the unearned revenue was received, and then show the adjusting entry required to record the revenue when it has actually been earned.

Recording an “Unearned Revenue” Example: On June 1, Wild Waters Co. received $7,500 in advance for a three-month youth white water rafting program. Show the journal entry to record the receipt on June 1 Cash Unearned Rafting Revenue Debit Credit Debit Credit 7,500 7,500 LO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Unearned Revenues” Example: On June 1, Wild Waters Co. received $7,500 in advance for a three-month youth white water rafting program. Show the adjusting journal entry required on June 30. Rafting Revenue Unearned Rafting Revenue Debit Credit Debit Credit 2,500 2,500 7,500 5,000 LO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for Accrued Expenses An accrued expense is an expense that will be paid in the future. These expenses accumulate from day to day—but without an adjusting entry, they would not be recorded until they are paid. Hey, when do we get paid? Examples Include: Wages and Salaries Interest . 4

Accruing Unpaid Expenses End of Current Period Prior Periods Current Period Future Periods Adjusting Entry Recognize expense incurred, and Record liability for future payment. Transaction Liability will be paid. 4

Adjusting Entries for Accrued Expenses $3,000 Wages Expense Monday, May 29 Wednesday, May 31 Friday, June 2 On May 31, Webb Co. owes wages of $3,000. Pay day is Friday, June 2. 4

Adjusting Entries for “Accrued Expenses” Example: On May 31, Webb Co. owes wages of $3,000. Pay day is Friday, June 2. Show the adjusting journal entry required on May 31st. May 31 Wages Expense 3,000 Wages Payable 3,000 Wages Expense Wages Payable Debit Credit Debit Credit 3,000 3,000 LO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for Accrued Expenses $5,000 Weekly Wages $3,000 Wages Expense $2,000 Wages Expense Monday, May 29 Wednesday, May 31 Friday, June 2 Let’s look at the entry for June 2. 4

Entry for wages paid in the next period Example: Recording the entry on June 2. June 2 Wages Payable 3,000 Wages Expense 2,000 Cash 5,000 Debit Credit Wages Payable 3,000 Debit Credit Wages Expense 2,000 Debit Credit Cash 5,000 3,000 LO 5 Prepare adjusting entries for deferrals.

Practice Problem June 30 falls on a Wednesday with payday on Friday, July 2. Wild Waters Co. will pay its employees $7,000 on Friday for the weekly payroll. (Wild Waters operates 7 days a week, paying its employees $1,000 a day.) Using t-accounts, show the accounts involved when an accrued expense (payroll) is owed at the end of the fiscal period (June 30), and then record the entry required when the payroll is paid on July 2.

Adjusting Entries for “Accrued Expenses” Example: On June 30, Wild Waters Co. owes wages of $5,000. Pay day is Friday, July 2. Show the adjusting journal entry required on June 30. Wages Expense Wages Payable Debit Credit Debit Credit 5,000 5,000 LO 5 Prepare adjusting entries for deferrals.

Entry for wages paid in the next period Example: Recording the payroll entry on July 2. Wages Payable Debit Credit Wages Expense 5,000 Cash Debit Credit Debit Credit 5,000 5,000 7,000 2,000 LO 5 Prepare adjusting entries for deferrals.

Accrued Interest Expense (recording expense related to borrowing money) Example: On Jan. 2nd, Phoenix Consulting borrowed $200,000 at a rate of 9% per year. Interest is due on first of each month. First, record the journal entry to record the money borrowed on Jan. 2: Jan. 2 Cash 200,000 Notes payable 200,000 Cash Notes Payable Debit Credit Debit Credit 200,000 200,000 LO 6 Prepare adjusting entries for accruals.

Accruing Interest Expense How do you determine the monthly interest on a Note Payable? $200,000 Note Payable 12 month note 9% interest I = P x R x T I = $200,000 x .09 x 1/12 I = $1,500

Adjusting Entries for “Accrued Expenses” Example: On Jan. 2nd, Phoenix Consulting borrowed $200,000 at a rate of 9% per year. Interest is due when the note is due. Show the adjusting entry required on Jan. 31st. ($200,000 x 9% / 12 months = $1,500) Jan. 31 Interest expense 1,500 Interest payable 1,500 Interest Expense Interest Payable Debit Credit Debit Credit 1,500 1,500 LO 6 Prepare adjusting entries for accruals.

Paying a liability with accrued expenses Let’s look at the journal entry to pay off this liability when the note comes due. Remember that the interest expense for December has not been recorded in an adjusting entry.

Practice Problem Wild Waters Co. obtained a bank loan to purchase additional rafts and equipment on May 1. The company signed a 6-month note payable in the amount of $10,000. The annual interest is 12%. Record the adjusting entry required on May 31 to record the accrued interest on the loan, and then record the entry required to pay off the note payable.

Adjusting Entries for “Accrued Expenses” Example: On May 31, Wild Waters Co. borrowed $10,000 at a rate of 12% per year for 6 months. Show the adjusting entry required on May 31. ($10,000 x 12% x ½ = $600 for 6 mos.) Interest Expense Interest Payable Debit Credit Debit Credit 100 100 LO 6 Prepare adjusting entries for accruals.

Paying a liability with accrued expenses Let’s look at the journal entry to pay off this liability when the note comes due on October 31. Remember that the interest expense for October has not been recorded in an adjusting entry.

Adjusting Entries for Accrued Revenues A business may earn revenue during the current accounting period but not receive it until a future accounting period. Any revenue that has been earned but not recorded during the current accounting period should be recorded at the end of the period with an adjusting entry. Examples Include: Interest Earned Work Completed (Revenue Earned) But Not Yet Billed to Customer 4

Adjusting Entries for Accrued Revenue End of Current Period Prior Periods Current Period Future Periods Adjusting Entry Recognize revenue earned but not yet recorded, and Record receivable. Transaction Receivable will be collected. 4

Accruing Uncollected Revenue $170 Interest Revenue Saturday, Jan. 15 Monday, Jan. 31 Tuesday, Feb. 15 On Jan. 31, the bank owes Webb Co. interest of $170. Interest is paid on the 15th day of each month. 4

Adjusting Entries for Accrued Revenues Initially, the revenue is recognized and a receivable is created. 4

Adjusting Entries for Accrued Revenues $320 Monthly Interest $170 Interest Revenue $150 Interest Revenue Saturday, Jan. 15 Monday, Jan. 31 Tuesday, Feb. 15 Let’s look at the entry for February 15. 4

Accruing Uncollected Revenue The receivable is collected in a future period. 4

Practice Problem $100 Interest Revenue Monday, Nov. 15 Friday, Nov. 30 Tuesday, Dec. 15 On Nov. 30 the bank owes Wild Waters Co. interest of $100. Interest is paid on the 15th day of each month. How would you record this adjusting entry? 4

Adjusting Entries for Accrued Revenues Initially, the revenue is recognized and a receivable is created. 4

Adjusting Entries for Accrued Revenues $400 Monthly revenue $200 Revenue $200 Revenue Monday, Nov. 15 Friday, Nov. 30 Tuesday, Dec. 15 Gage Garbage receives the $400 for providing garbage services. They are paid on the 15th of every month. How would you record this entry? 4

Adjusting Entries for Accrued Revenues Initially, the revenue is recognized and a receivable is created. 4

Accruing Uncollected Revenue The receivable is collected in a future period. 4

Adjusting Entries for Accrued Revenues $200 Monthly Interest $100 Interest Revenue $100 Interest Revenue Monday, Nov. 15 Friday, Nov. 30 Tuesday, Dec. 15 Wild Waters Co. receives the $200 interest payment from the bank on Dec. 15. How would you record this entry? 4

Accruing Uncollected Revenue The receivable is collected in a future period. 4

When are Adjusting Entries made in the accounting cycle? Journalize transactions. Post entries to the ledger accounts. Prepare trial balance. Make adjustments & post. Prepare adjusted trial balance. 3

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. LO 7 Describe the nature and purpose of an adjusted trial balance.

Preparing Financial Statements Financial Statements are prepared directly from the Adjusted Trial Balance. Balance Sheet Income Statement Statement of Owner’s Equity LO 7 Describe the nature and purpose of an adjusted trial balance.

End of Chapter 4 It’s about time!!!! 4