Prepared by: Carole Bowman, Sheridan College Accounting Principles Second Canadian Edition Weygandt · Kieso · Kimmel · Trenholm Prepared by: Carole Bowman, Sheridan College

ADJUSTING THE ACCOUNTS CHAPTER 3 ADJUSTING THE ACCOUNTS GAAP Principals (Time period assumption, Revenue Recognition, Matching Principal, Accrual Basis of Accounting) Types of Adjusting Entries (Prepaid Expenses such as rent, insurance, and supplies, unearned revenue, accrued revenues and expenses, and amortization/depreciation)

STEPS IN THE ACCOUNTING CYCLE 1. Analyse transactions 2. Journalize the transactions 9. Coming next chapter 3. Post to ledger accounts 8. Coming next chapter 4. Prepare a trial balance 7. Prepare financial statements 5. Journalize and post adjusting entries 6. Prepare adjusted trial balance

GAAP TIME PERIOD ASSUMPTION The time period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods — generally a month, a quarter (3 months), or a year (any 12 month period selected by the company). Periods of less than one year are called interim periods. The accounting time period of one year in length is usually known as a fiscal year. 1

GAAP REVENUE RECOGNITION PRINCIPLE The revenue recognition principle states that revenue should be recognized in the accounting period in which it is earned. In a service business, revenue is usually considered to be earned at the time the service is performed, even if the money has not been received. Example: Crocco Co. performed legal services and billed customer, Mr. Nojail, for $350.00 A/R $350.00 Legal Fees $350.00 In a merchandising business, revenue is usually earned at the time the goods are delivered. 2

GAAP THE 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). Example: For a fiscal year ending, December 31st, the last week of wages in December for the year, must be expensed even though they are not paid out until the end of the first week in January. These wages pertain to revenues earned right up to the end of December. Wages for the last week of December amounted to $1000, but are not paid out until the end of the first week of January. Salaries Expense $1000 Salaries Payable $1000 Revenues earned this month are offset against.... expenses incurred in earning the revenue 3

ACCRUAL BASIS OF ACCOUNTING GAAP Adheres to the: Revenue recognition principle Matching principle Revenue recorded when earned, not only when cash received. Expense recorded when services or goods are used or consumed in the generation of revenue, not only when cash paid. (i.e. Salaries Expense and Salaries Payable)

CASH BASIS OF ACCOUNTING PowerPoint Slides CASH BASIS OF ACCOUNTING NOT GAAP Revenue recorded only when cash received. Expense recorded only when cash paid. 5

PURPOSE OF ADJUSTING ENTRIES Adjusting entries make the revenue recognition and matching principles HAPPEN!

ILLUSTRATION 3-3 TRIAL BALANCE The Trial Balance is analysed to determine the need for adjusting entries.

ADJUSTING ENTRIES Adjusting entries are required each time financial statements are prepared. Adjusting entries can be classified as 1. prepayments (prepaid expenses or unearned revenues), 2. accruals (accrued revenues or accrued expenses), or 3. estimates (amortization/depreciation). 5

TYPES OF ADJUSTING ENTRIES Prepayments Prepaid Expenses — Expenses paid in cash and recorded as assets before they are used or consumed. (i.e. Prepaid Insurance) 2. Unearned Revenues — Revenues received in cash and recorded as liabilities before they are earned. (i.e. Unearned Revenue)

TYPES OF ADJUSTING ENTRIES Accruals Accrued Revenues — Revenues earned but not yet received in cash or recorded. (i.e. Accounts Receivable) 2. Accrued Expenses — Expenses incurred but not yet paid in cash or recorded. (i.e. Salaries Payable, Interest Payable)

TYPES OF ADJUSTING ENTRIES Estimates Amortization — Allocation of the cost of capital assets/fixed assets to expense over their useful lives. Amortization will replace the term Depreciation.

PREPAID EXPENSES Prepaid expenses are expenses paid in cash and recorded as assets before they are used or consumed. (i.e. insurance, rent) Jan.1 Banks Co. paid 3 months rent upfront for $3000 cash. Jan. 1 Prepaid Rent $3000 Cash $3000 Prepaid expenses expire with the passage of time or through use and consumption. The adjusting entry Jan. 30 in order to prepare monthly financial statements would be: Jan. 30 Banks Co. made monthly adjustments to prepare monthly financial statements. Jan. 30 Rent Expense $1000 Prepaid Rent $1000 An asset-expense account relationship exists with prepaid expenses. 6

PREPAID EXPENSES Prior to adjustment, assets are overstated and expenses are understated. The adjusting entry results in a debit to an expense account and a credit to an asset account. Examples of prepaid expenses include supplies, rent, insurance, and property tax. 7

UNEARNED REVENUES Unearned revenues are revenues received and recorded as liabilities before they are earned. Oct. 2 Crocco Co. received a payment of $3000 in advance from Mr. Nojail for legal work that would be completed by December 31st. Oct. 2 Cash $3000 Unearned Revenue $3000 Unearned revenues are subsequently earned by performing a service or providing a good to a customer. For the monthly financial statement prepared at the end of October, it was determined that $1000 of the legal work paid for by Mr. Nojail was earned. Oct. 31 Unearned Revenue $1000 Legal Fees $1000 A liability-revenue account relationship exists with unearned revenues. 10

UNEARNED REVENUES Prior to adjustment, liabilities are overstated and revenues are understated. The adjusting entry results in a debit to a liability account (Unearned Revenue) and a credit to a revenue account. Examples of unearned revenues include rent, magazine subscriptions, airplane tickets, and tuition.

ILLUSTRATION 3-4 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 (+)

ACCRUALS A different type of adjusting entry is accruals. Adjusting entries for accruals are required to record revenues earned and expenses incurred in the current period when no money has been received or paid out to date. The adjusting entry for accruals will increase both a balance sheet and an income statement accounts.

ACCRUED REVENUES Accrued revenues may accumulate with the passing of time or through services performed but not billed or collected. Dec. 31st, Crocco had not yet billed Mr. Bail for $400 for legal services performed last week. Dec. 31 A/R- Mr. Bail $400 Service Revenue $400 An asset-revenue account relationship exists with accrued revenues. Prior to adjustment, assets and revenues are understated. The adjusting entry requires a debit to an asset account and a credit to a revenue account. Examples of accrued revenues include accounts receivable, rent receivable, and interest receivable.

ACCRUED EXPENSES Accrued expenses are expenses incurred but not yet paid. A liability-expense account relationship exists. Prior to adjustment, liabilities and expenses are understated. The adjusting entry results in a debit to an expense account and a credit to a liability account. Examples of accrued expenses include accounts payable, rent payable, salaries payable, and interest payable.

ILLUSTRATION 3-6 FORMULA TO CALCULATE INTEREST Face Value of Note Annual Interest Rate Time (in Terms of One Year) Interest x x = $5,000 x (o.o6) 6% x 1/12 = $25 You are required to pay 6% annual interest on a Note Payable in the amount of $5,000 which you received on Oct. 1st. The interest will be paid in full when the note comes due at the end of 12 months. In order to calculate the interest expense accrued after one month, you perform the calculation above. Oct. 31 Interest Expense $25 Interest Payable $25

ILLUSTRATION 3-5 ADJUSTING ENTRIES FOR ACCRUALS Asset Debit Adjusting Entry (+) Accrued Revenues Revenue Credit Adjusting Entry (+) Accrued Expenses Expense Liability

AMORTIZATION/DEPRECIATION Amortization is the process of allocating the cost of certain capital assets to an expense over their useful life in a rational and systematic manner. Amortization attempts to match the cost of a long-term, capital asset to the revenue it generates each period.

AMORTIZATION Amortization is an estimate rather than a factual measurement of the cost that has expired. We’re not attempting to reflect the actual change in value of an asset!

Accumulated Amortization In recording amortization, Amortization Expense is debited and a contra asset account, Accumulated Amortization, is credited. Accumulated Amortization Amortization Expense xxx xxx There will be an Amortization Expense account and Accumulated Amortization account for each type of fixed asset. For example: Amortization Expense – Equipment (Income Statement Account) Accumulated Amortization – Equipment (Balance Sheet Account) Amortization Expense – Automobile (Income Statement Account) Accumulated Amortization – Automobile (Balance Sheet Account)

Balance Sheet Presentation AMORTIZATION The difference between the cost of the asset and its related Accumulated Amortization is referred to as the net book value of the asset. Balance Sheet Presentation Fixed Assets Office equipment $5,000 Less: Accumulated Amortization 83 Net book value $4,917 Estimate

ILLUSTRATION 3-8 SUMMARY OF ADJUSTING ENTRIES 1.Prepaid Assets and Assets overstated Dr. Expenses expenses expenses Expenses understated Cr. Assets 2.Unearned Liabilities and Liabilities overstated Dr. Liabilities revenues revenues Revenues understated Cr. Revenues 3.Accrued Assets and Assets understated Dr. Assets revenues revenues Revenues understate Cr. Revenues 4.Accrued Expenses and Expenses understated Dr. Expenses expenses liabilities Liabilities understated Cr. Liabilities 5.Amortization Expense and Expenses understated Dr. Amort. Exp contra asset Assets overstated Cr. Accum. Amortization Account Accounts before Adjusting Type of Adjustment Relationship Adjustment Entry

ADJUSTED TRIAL BALANCE An Adjusted Trial Balance is prepared after all adjusting entries have been journalized and posted. It shows the balances of all accounts at the end of the accounting period and the effects of all financial events that have occurred during the period. It proves 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.

ILLUSTRATION 3-11 TRIAL BALANCE AND ADJUSTED TRIAL BALANCE COMPARED

PREPARING FINANCIAL STATEMENTS Financial statements can be prepared directly from an adjusted trial balance. The income statement is prepared from the revenue and expense accounts. 2. The statement of owner’s equity is derived from the owner’s capital and drawings accounts and the net income (or net loss) shown in the income statement. 3. The balance sheet is then prepared from the asset and liability accounts and the ending owner’s capital balance as reported in the statement of owner’s equity.

ILLUSTRATION 3-12 PREPARATION OF THE INCOME STATEMENT AND THE STATEMENT OF OWNER’S EQUITY FROM THE ADJUSTED TRIAL BALANCE

From Statement of Owner’s Equity ILLUSTRATION 3-13 PREPARATION OF THE BALANCE SHEET FROM THE ADJUSTED TRIAL BALANCE From Statement of Owner’s Equity

STEPS IN THE ACCOUNTING CYCLE 1. Analyse transactions 2. Journalize the transactions 9. Coming next chapter 3. Post to ledger accounts 8. Coming next chapter 4. Prepare a trial balance 7. Prepare financial statements 5. Journalize and post adjusting entries 6. Prepare adjusted trial balance

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