Adjusting Accounts for Financial Statements PowerPoint Slides to accompany Fundamental Accounting Principles, 14ce Prepared by Joe Pidutti, Durham College CHAPTER 3

1. Describe the purpose of adjusting accounts at the end of the period. (LO 1 ) 2. Explain how the timeliness, matching, and revenue recognition principles affect the adjusting process. (LO 2 ) 3. Explain accrual accounting and cash basis accounting and how accrual accounting adds to the usefulness of financial statements. (LO 3 ) Learning Objectives 2 © 2013 McGraw-Hill Ryerson Limited.

4. Prepare and explain adjusting entries for prepaid expenses, depreciation, unearned revenues, accrued expenses, and accrued revenues. (LO 4 ) 5. Explain how accounting adjustments link to financial statements. ( LO 5 ) 6. Explain and prepare an adjusted trial balance. ( LO 6 ) Learning Objectives 3 © 2013 McGraw-Hill Ryerson Limited.

Prepare post-closing trial balance Journalize Close Prepare unadjusted trial balance Post Analyze transactions Prepare adjusted trial balance Prepare statements Adjust The Accounting Cycle 5 LO © 2013 McGraw-Hill Ryerson Limited.

Financial information must be timely and accurate to be useful to decision makers. Financial statements need to be prepared at regular intervals (periods). Accounts need to be adjusted (updated) to ensure all revenues, expenses, assets, and liabilities are recorded. Adjusting the Accounts LO 1 5 © 2013 McGraw-Hill Ryerson Limited.

Adjustments are based on three generally accepted accounting principles: Timeliness principle. Revenue recognition principle. Matching principle. GAAP and the Adjusting Process LO 2 6 © 2013 McGraw-Hill Ryerson Limited.

Timeliness Principle Assumes that the organization’s activities can be divided into specific time periods such as: Months Quarters Years Requires that financial statements be presented at least annually. Accounting Principles LO 2 7 © 2013 McGraw-Hill Ryerson Limited.

Revenue Recognition Principle Revenue is recognized (reported) in the time period when it is earned regardless when the cash is received. Matching Principle Expenses are to be matched in the same accounting period as the revenues they helped to earn. Accounting Principles 8 LO 2 © 2013 McGraw-Hill Ryerson Limited.

Accrual Basis Revenues and expenses are recognized when earned or incurred regardless of when cash is received or paid. Consistent with GAAP. Cash Basis Revenues and expenses are recognized when cash is received or paid. Not consistent with GAAP. Cash vs. Accrual Basis LO 3 9 © 2013 McGraw-Hill Ryerson Limited.

Adjusting Accounts Accounts are adjusted at the end of each accounting period to bring an asset or liability account to its proper amount. Adjusting entries also update the related expense or revenue accounts. These adjustments are necessary for the preparation of financial statements. LO 4 10 © 2013 McGraw-Hill Ryerson Limited.

Types: Prepaid expenses Depreciation Unearned revenues Accrued expenses Accrued revenues Adjustments 11 LO 4 © 2013 McGraw-Hill Ryerson Limited.

Costs paid in advance of receiving their benefits. They are recorded as assets. As these assets are used, their costs become expenses. These costs expire with the passage of time or through use and consumption, e.g., insurance, supplies. Prepaid Expenses 12 LO 4 © 2013 McGraw-Hill Ryerson Limited.

Prepaid Expenses–Example On January 1, a company purchases an insurance policy that covers three months and costs $1,800. The policy will benefit the company for three months and will be expired at the end of three months. The cost of the policy should be spread over the time period it benefits the organization. (matching principle). $600 $1,800 JanuaryFebruaryMarch 13 LO 4 © 2013 McGraw-Hill Ryerson Limited.

$1,800 $1,800 $1,800 $1,800 The entry to record the purchase of the insurance policy would be: Prepaid Insurance 1,800 Cash 1, LO 4 Prepaid Expenses–Example © 2013 McGraw-Hill Ryerson Limited.

$1,800 $1,800 $1,800 $1,800 The entry to record the expiry of the insurance for January would be: Insurance Expense 600 Prepaid Insurance LO 4 Prepaid Expenses–Example © 2013 McGraw-Hill Ryerson Limited.

$1,800 $1,800 $1,800 $1,800 The entry to record the expiry of the insurance for February would be: Insurance Expense 600 Prepaid Insurance LO 4 Prepaid Expenses–Example © 2013 McGraw-Hill Ryerson Limited.

$1,800 $1,800 $1,800 $1,800 The entry to record the expiry of the insurance for March would be: Insurance Expense 600 Prepaid Insurance LO 4 Prepaid Expenses–Example © 2013 McGraw-Hill Ryerson Limited.

Companies acquire assets such as equipment, buildings, vehicles, and patents to generate revenues. These assets are expected to provide benefits for more than one accounting period. Depreciation is the process of allocating the costs of assets over their expected useful lives. Depreciation 18 LO 4 © 2013 McGraw-Hill Ryerson Limited.

Depreciation is based on the matching principle where the cost of an asset is matched over the time the asset helped earn the revenue. Straight-Line Depreciation Expense = Asset cost – Estimated residual value Estimated useful lifeDepreciation 19 LO 4 © 2013 McGraw-Hill Ryerson Limited.

Depreciation - Example On January 1, 2014, a company purchased a piece of equipment for $72,000. The equipment is expected to have a useful life of four years and have a residual value of $8,000. = $72,000 - $8,000 4 years = $16,000/year Straight-Line Depreciation Expense = Asset cost – Estimated residual value Estimated useful life 20 LO 4 © 2013 McGraw-Hill Ryerson Limited.

Depreciation - Example The entry to record the purchase of the equipment would be: Equipment 72,000 Cash 72, LO 4 © 2013 McGraw-Hill Ryerson Limited.

Depreciation - Example The entry to record Depreciation at the end of the first year would be: Depreciation Expense, Equipment 16,000 Accumulated Depreciation, Equip. 16, LO 4 © 2013 McGraw-Hill Ryerson Limited.

Depreciation - Example The entry to record Depreciation at the end of the second year would be: Depreciation Expense, Equipment 16,000 Accumulated Depreciation, Equip. 16, LO 4 © 2013 McGraw-Hill Ryerson Limited.

Depreciation - Example The entry to record Depreciation at the end of the third year would be: Depreciation Expense, Equipment 16,000 Accumulated Depreciation, Equip. 16, LO 4 © 2013 McGraw-Hill Ryerson Limited.

Depreciation - Example The entry to record Depreciation at the end of the fourth year would be: Depreciation Expense, Equipment 16,000 Accumulated Depreciation, Equip. 16, LO 4 © 2013 McGraw-Hill Ryerson Limited.

Depreciation - Example 26 LO 4 © 2013 McGraw-Hill Ryerson Limited.

Cash received in advance of providing products and services. The company has an obligation to provide goods or services. Unearned revenues are liabilities. As products and services are provided, the amount of unearned revenues becomes earned revenues. Unearned Revenues 27 LO 4 © 2013 McGraw-Hill Ryerson Limited.

Unearned Revenues — Example On March 1, a company received a $12,000 payment from a customer for maintenance services to be provided over the next two months. The entry to record the receipt of cash would be: Cash 12,000 Unearned Revenue 12, LO 4 © 2013 McGraw-Hill Ryerson Limited.

Unearned Revenues - Example On March 31, $6,000 of this revenue had been earned. The entry to record the earned revenue would be: Unearned Revenue 6,000 Maintenance Revenue 6,000 $12,000/2months= $6,000/month 29 LO 4 © 2013 McGraw-Hill Ryerson Limited.

Unearned Revenues - Example By April 30, another $6,000 of this unearned revenue had been earned. The entry to record the earned revenue would be: Unearned Revenue 6,000 Maintenance Revenue 6,000 $12,000/2months= $6,000/month 30 LO 4 © 2013 McGraw-Hill Ryerson Limited.

Costs incurred in a period that are both unpaid and unrecorded. Adjusting entries must be made to record the expense for the period and the related liability at the balance sheet date. Examples: interest, wages, rent, taxes Accrued Expenses 31 LO 4 © 2013 McGraw-Hill Ryerson Limited.

Accrued Expenses - Example On December 31, $1,200 of interest has accrued on a company’s bank loan. The payment of the interest is not due until January 1. The December 31 entry to record the accrued interest would be: Interest Expense 1,200 Interest Payable 1, LO 4 © 2013 McGraw-Hill Ryerson Limited.

Accrued Expenses - Example In December, a company incurred $3,700 of utilities expense. The company had not received the utility bill at December 31. The December 31 entry to record the accrued utilities expense would be: Utilities Expense 3,700 Accounts Payable 3, LO 4 © 2013 McGraw-Hill Ryerson Limited.

Revenues earned in a period that are both unrecorded and not yet received in cash. Adjusting entries must be made to record the revenue for the period and the related asset at the balance sheet date. Examples: fees earned, interest earned, rent earned Accrued Revenues 34 LO 4 © 2013 McGraw-Hill Ryerson Limited.

Accrued Revenues - Example On December 31, $16,500 of consulting fees have been earned but have not been recorded or billed to the client. The entry to record the accrued consulting fees earned would be: Accounts Receivable 16,500 Consulting Fees Earned 16, LO 4 © 2013 McGraw-Hill Ryerson Limited.

Adjustments are only made when financial statements are prepared. Affect both the income statement and the balance sheet. Do not affect cash. Adjustments & Financial Statements LO 5 36 © 2013 McGraw-Hill Ryerson Limited.

Q If the year-end adjusting entry to record accrued wages was not recorded, how would this affect the company’s financial statements? Would the balance sheet balance? A Wages expense-understated Net income-overstated Equity-overstated Wages payable-understated The balance sheet would balance since liabilities would be overstated and equity would be understated. Mini-Quiz 37 © 2013 McGraw-Hill Ryerson Limited.

Unadjusted Trial Balance A listing of accounts and balances that is prepared before adjustments are recorded. Adjusted Trial Balance A listing of accounts and balances that is prepared after adjustments are recorded and posted to the ledger. It is used to prepare financial statements. Trial Balance LO 6 38 © 2013 McGraw-Hill Ryerson Limited.

Adjusting entries bring the accounts up-to-date. The adjusted trial balance is used to prepare the financial statements in the following order: Income Statement Statement of Changes in Equity Balance Sheet Statement of Cash Flows Financial Statement Preparation LO 7 39 © 2013 McGraw-Hill Ryerson Limited.

Q When and why are adjusting entries prepared? A They are prepared when a company wishes to issue financial statements. Adjusting entries bring the account balances up-to-date. Review © 2013 McGraw-Hill Ryerson Limited. 40

End of Chapter 41 © 2013 McGraw-Hill Ryerson Limited.