Adjusting Entries

TWO METHODS  Some companies will employ different methods of accounting based on the nature of their operations.  These methods change the time in which revenue and expenses are recorded and ultimately, it will result in different net profits/losses

ACCRUAL Accrual Basis  Revenues and expenses are recognized when earned or incurred regardless of when cash is received or paid.  Consistent with GAAP

CASH BASIS Cash Basis  Revenues and expenses are recognized when cash is received or paid.  Not consistent with GAAP.

EXAMPLE  On Jan , customers owed Murray Co. $ for services provided in During 2014 Murray Co. received $ cash from customers. On December 31, 2014 customers owed Murray Co. $ for services provided in Calculate revenue for 2014 using:  Cash basis  Accrual Basis

SOLUTION  Revenue for $125,000 (Using Cash Basis, Revenue is recorded as cash is received)  Cash received from Customers $ Deduct: Collection of 2013 A/R - (30 000) Add: A/R at Dec 31/ Revenue for 2014 using accrual - $

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.

ADJUSTMENT TYPES  Prepaid expenses  Depreciation  Unearned revenues  Accrued expenses  Accrued revenues

PREPAID EXPENSES  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.

EXAMPLE On January 1, a company purchases an insurance policy that covers three months and costs $1,800. What will the transaction look like using T-accounts?

DEPRECIATION  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.

UNEARNED REVENUES  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.

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.

ACCRUED EXPENSES  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

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 1,200

ACCRUED REVENUES  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

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 16,50

ADJUSTMENTS  Adjustments are only made when financial statements are prepared.  Affect both the income statement and the balance sheet.  Do not affect cash.

HOME WORK  Text page Brief Exercises 1-4 & 6