Adjusting entries make the revenue recognition and matching principles  Why do you adjust accounts  Accuracy  Materiality HAPPEN! ADJUSTING ENTRIES p.106

Adjusting entries are required each time financial statements are prepared. Adjusting entries can be classified as 1. prepayments (prepaid expenses or unearned revenues)  assets & liabilities 2. accruals (accrued revenues or accrued expenses), or  think revenue recognition and matching principle 3. estimates (amortization)  depreciation ADJUSTING ENTRIES p.106

TYPES OF ADJUSTING ENTRIES Prepayments 1. Prepaid Expenses — Expenses paid in cash and recorded as assets before they are used or consumed. ex: supplies or prepaid rent and insurance 2. Unearned Revenues — Revenues received in cash and recorded as liabilities before they are earned. ex: selling of tickets before the show date

PREPAYMENTS examples 1. At the end of the accounting period the trial balance indicates there are $5000 of supplies; a physical inventory indicates that there are actually only $1000 of supplies  PROBLEM? Supply Expense4000 Supplies4000

PREPAYMENTS examples 2. On Sept 1, ABC Co. paid $2400 for a one year fire insurance policy. What is the adjustment at the end of the calendar year (Dec. 31)? Insurance Expense800 Prepaid Insurance800

Prepaid expenses are expenses paid in cash and recorded as assets before they are used or consumed.  CAPITALIZATION because the expense is recorded as a capital asset Prepaid expenses expire with the passage of time or through use and consumption. An asset-expense account relationship exists with prepaid expenses. PREPAID EXPENSES

UNEARNED REVENUE example 3. Cubana Airlines sells Mr. S an all-inclusive Cuban holiday for March break. Mr. S pays $3500 on Dec 15 th ; Record both the original transaction and the adjustment made by Cubana when Mr. S flys to Cuba March 12. Dec. 15 Bank3500 Unearned Revenue3500 March 12 Unearned Revenue3500 Revenue3500

Unearned revenues are revenues received and recorded as liabilities before they are earned. Unearned revenues are subsequently earned by performing a service or providing a good to a customer. A liability-revenue account relationship exists with unearned revenues. UNEARNED REVENUES

TYPES OF ADJUSTING ENTRIES Accruals think Revenue Recognition & Matching 1. Accrued Revenues — Revenues earned but not yet received in cash or recorded. 2. Accrued Expenses — Expenses incurred but not yet paid in cash or recorded.

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. The adjusting entry for accruals will increase both a balance sheet and an income statement account.

ACCRUAL EXAMPLE: Revenue Recognition and Matching Principle JB pharma contracts to produce Life brand energy bars for Shoppers on August 10th.  JB purchases $400 K of ingredients on account August 24  JB manufactures $1 mm of energy bars in Sept, and ships them to Shoppers, Sept. 22.  JB incurs $200 of overhead and production costs for the energy bars  Shoppers pays JB December 23. Aug 24 Ingredient Inventory400 AP 400 Sept 22 AR1,000 Revenue 1,000 COGS (ingredients exp)400 Ingredient Inventory 400 Production Expenses200 Accrued Liability 200 (AP for wages overhead such as hydro etc.) Dec 23 Bank1,000 AR 1,000

INTEREST ADJUSTMENT P. 113 On Oct 1. Pioneer Advertising signed a $5000 three year note payable. Pioneer’s Interest Adjustment, Oct. 31: Oct 31: Interest Expense (accrued)25 Interest Payable25 Face Value of Note Annual Interest Rate Time (in Terms of One Year) xx Interest $5,000 x 6% x 1/12 = $25 =

TYPES OF ADJUSTING ENTRIES Estimates 1. Amortization — Allocation of the cost of capital assets to expense over their useful lives.

Amortization is the process of allocating the cost of certain capital assets to 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! Depreciation DOES NOT represent the market value of the asset!

Depreciation (Amortization) Straight Line Example 1. Moe purchased a mechanical bull was purchased on September 1, 2006 for $2,000 with an estimated life of five years and an expected salvage value of $200. Calculate the Depreciation for both 2006 (1/2 year rule) and 2007 Dec 31, 2006 Depreciation Expense180 Accumulated Depreciation (mech. Bull) 180 Dec 31, 2007 Depreciation Expense360 Accumulated Depreciation (mech. Bull)360

Depreciation (Amortization) Declining Balance Example Moe moved his business into the new building on August 31, The building cost $50,000 amortized at 10% over 25 years with no expected salvage value. Calculate the Depreciation for both 2006 (1/2 year rule) and 2007 Dec 31, 2006 Depreciation Expense2500 Accumulated Depreciation (building) 2500 Dec 31, 2007 Depreciation Expense4750 Accumulated Depreciation (building)4750

Accumulated Amortization Amortization Expense AMORTIZATION In recording amortization, Amortization Expense is debited and a contra asset account, Accumulated Amortization, is credited. The difference between the cost of the asset and its related accumulated amortization is referred to as the net book value of the asset. xxx

AMORTIZATION Balance Sheet Presentation Office equipment $5,000 Less: Accumulated amortization 83 Net book value $4,917 Estimate

ILLUSTRATION 3-8 SUMMARY OF ADJUSTING ENTRIES 1.Prepaid Assets andAssets overstated Dr. Expenses expensesexpensesExpenses understated Cr. Assets 2.UnearnedLiabilities andLiabilities overstated Dr. Liabilities revenues revenues Revenues understated Cr. Revenues 3.AccruedAssets andAssets understated Dr. Assets revenuesrevenuesRevenues understated Cr. Revenues 4.AccruedExpenses andExpenses understated Dr. Expenses expensesliabilitiesLiabilities understated Cr. Liabilities 5.AmortizationExpense andExpenses understated Dr. Amort. Exp contra assetAssets overstated Cr. Accum. Amortization 1.Prepaid Assets andAssets overstated Dr. Expenses expensesexpensesExpenses understated Cr. Assets 2.UnearnedLiabilities andLiabilities overstated Dr. Liabilities revenues revenues Revenues understated Cr. Revenues 3.AccruedAssets andAssets understated Dr. Assets revenuesrevenuesRevenues understated Cr. Revenues 4.AccruedExpenses andExpenses understated Dr. Expenses expensesliabilitiesLiabilities understated Cr. Liabilities 5.AmortizationExpense andExpenses understated Dr. Amort. Exp contra assetAssets overstated Cr. Accum. Amortization Type of AccountAccounts beforeAdjusting Adjustment RelationshipAdjustmentEntry

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. 1. 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

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

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