John Wiley & Sons, Inc. Financial Accounting, 3e Weygandt, Kieso, & Kimmel Prepared by Gregory K. Lowry Mercer University Marianne Bradford The University of Tennessee

After studying this chapter, you should be able to: CHAPTER 3 ADJUSTING THE ACCOUNTS 1 Explain the time period assumption. 2 Distinguish between the revenue recognition principle and the matching principle. 3 Explain why adjusting entries are needed. 4 Identify the major types of adjusting entries. 5 Prepare adjusting entries for prepayments. 6 Prepare adjusting entries for accruals. 7 Describe the nature and purpose of an adjusted trial balance. 8 Explain the accrual basis of accounting.

PREVIEW OF CHAPTER 3 ADJUSTING THE ACCOUNTS The Adjusted Trial Balance and Financial Statements Accrual vs. Cash Basis of Accounting The Basics of Adjusting Entries Types of adjusting entries Adjusting entries for prepayments Adjusting entries for accruals Summary Preparing the adjusted trial balance Preparing financial statements Time Period assumption Fiscal and calendar years Recognizing revenues and expenses Timing Issues

The time period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods. Accounting time periods are generally a month, a quarter, or a year. The accounting time period of one year in length is usually known as a fiscal year. The accounting period used by most businesses coincides with the calendar year (January 1 to December 31). TIME-PERIOD ASSUMPTION

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 considered to be earned at the time the service is performed.

The practice of expense recognition is referred to as the matching principle. The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues). Revenues earned this month are offset against.... expenses incurred in earning the revenue THE MATCHING PRINCIPLE

Time-Period Assumption Revenue-Recognition Principle Matching Principle Revenue and Expense Recognition Economic life of business can be divided into artificial time periods Revenue recognized in the accounting period in which it is earned In accordance with generally accepted accounting principles (GAAP) Expenses matched with revenues in the period when efforts are expended to generate revenues ILLUSTRATION 3-1 GAAP RELATIONSHIPS IN REVENUE AND EXPENSE RECOGNITION

ADJUSTING ENTRIES Adjusting entries are made in order for: 1 Revenues to be recorded in the period in which they are earned, and for Expenses to be recognized in the period in which they are incurred.

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

TYPES OF ADJUSTING ENTRIES Prepayments 1 Prepaid Expenses - expenses paid in cash and recorded as assets before they are used or consumed 2 Unearned Revenues - revenues received in cash and recorded as liabilities before they are earned

Accruals 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 TYPES OF ADJUSTING ENTRIES

PIONEER ADVERTISING AGENCY, INC. Trial Balance October 31, 2001 DebitCredit Cash$ 15,200 Advertising Supplies2,500 Prepaid Insurance600 Office Equipment5,000 Notes Payable$ 5,000 Accounts Payable2,500 Unearned Revenue 1,200 Common Stock10,000 Retained Earnings -0- Dividends500 Service Revenue 10,000 Salaries Expense4,000 Rent Expense900 $ 28,700 ILLUSTRATION 3-3 TRIAL BALANCE The Trial Balance is the starting place for adjusting entries.

PREPAYMENTS Prepayments are either prepaid expenses or unearned revenues. Adjusting entries for prepayments are required to record the portion of the prepayment that represents 1 the expense incurred or 2 the revenue earned in the current accounting period.

Adjusting Entries Asset Unadjusted Balance Credit Adjusting Entry (-) Expense Debit Adjusting Entry (+) Prepaid Expenses Liability Unadjusted Balance Debit Adjusting Entry (-) Revenue Credit Adjusting Entry (+) Unearned Revenues ILLUSTRATION 3-4 ADJUSTING ENTRIES FOR PREPAYMENTS

Prepaid expenses are expenses paid in cash and recorded as assets before they are used or consumed. Prepaid expenses expire with the passage of time or through use and consumption. An asset-expense account relationship exists with prepaid expenses. 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, insurance, and depreciation. PREPAID EXPENSES

Adjustment Journal Entry Posting October 31, an inventory count reveals that $1,000 of $2,500 of supplies arestill on hand. ADJUSTING ENTRIES FOR PREPAYMENTS SUPPLIES

ADJUSTING ENTRIES FOR PREPAYMENTS INSURANCE Journal Entry Posting October 31, an analysis of the policy reveals that $50 of insurance expires each month. Adjustment

Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner. The purchase of equipment or a building is viewed as a long-term prepayment of services and, therefore, is allocated in the same manner as other prepaid expenses. DEPRECIATION

Depreciation is an estimate rather than a factual measurement of the cost that has expired. In recording depreciation, Depreciation Expense is debited and a contra asset account, Accumulated Depreciation, is credited xxx xxx DEPRECIATION

In the balance sheet, Accumulated Depreciation is offset against the asset account. The difference between the cost of the asset and its related accumulated depreciation is referred to as the book value of the asset. DEPRECIATION

ADJUSTING ENTRIES FOR PREPAYMENTS DEPRECIATION Journal Entry Posting Adjustment October 31, depreciation on the office equipment is estimated to be $480 a year, or $40 per month.

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

Prior to adjustment, liabilities are overstated and revenues are understated. The adjusting entry results in a debit to a liability account and a credit to a revenue account. Examples of unearned revenues include rent, magazine subscriptions, and customer deposits for future services. UNEARNED REVENUES

Adjustment Unearned Revenue Oct Oct. 21, Service Revenue Oct. 3110, Journal Entry Posting October 31, analysis reveals that, of $1,200 in fees, $400 has been earned in October. DateAccount Titles and ExplanationDebitCredit Oct. 31 Unearned Revenue 400 Service Revenue400 ADJUSTING ENTRIES FOR PREPAYMENTS UNEARNED REVENUES (To record revenue for services provided

ACCRUALS The second category of adjusting entries 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.

ILLUSTRATION 3-10 ADJUSTING ENTRIES FOR ACCRUALS Adjusting Entries Asset Debit Adjusting Entry (+) Accrued Revenues Revenue Credit Adjusting Entry (+) Accrued Expenses Expense Debit Adjusting Entry (+) Liability Credit Adjusting Entry (+)

Accrued revenues may accumulate with the passing of time or through services performed but not billed or collected. 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. ACCRUED REVENUES

DateAccount Titles and ExplanationDebitCredit Oct. 31Accounts Receivable200 Service Revenue 200 (To accrue fees earned but not billed or collected) ADJUSTING ENTRIES FOR ACCRUALS ACCRUED REVENUES Adjustment Journal Entry Posting Service Revenue Oct. 3110, ,600 October 31, the agency earned $200 in fees for advertising services that were not billed to clients before October 31.

Accrued expenses are expenses incurred but not paid yet. 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 ACCRUED EXPENSES

ADJUSTING ENTRIES FOR ACCRUALS ACCRUED INTEREST Adjustment Journal Entry Posting October 31, the portion of the interest to be accrued on a 3-month note payable is calculated to be $50.

ADJUSTING ENTRIES FOR ACCRUALS ACCRUED SALARIES Adjustment Journal Entry Posting October 31, accrued salaries are calculated to be $1,200.

ILLUSTRATION 3-14 SUMMARY OF ADJUSTING ENTRIES 1 PrepaidAssets andAssets overstated Dr. Expenses expensesexpensesExpenses understated Cr. Assets 2 UnearnedLiabilities andLiabilities overstated Dr. Liabilities revenuesrevenuesRevenues understated Cr. Revenues 3 AccruedAssets andAssets understated Dr. Assets revenues revenuesRevenues understated Cr. Revenues 4 AccruedExpenses andExpenses understated Dr. Expenses expenses liabilitiesLiabilities understated Cr. Liabilities 1 PrepaidAssets andAssets overstated Dr. Expenses expensesexpensesExpenses understated Cr. Assets 2 UnearnedLiabilities andLiabilities overstated Dr. Liabilities revenuesrevenuesRevenues understated Cr. Revenues 3 AccruedAssets andAssets understated Dr. Assets revenues revenuesRevenues understated Cr. Revenues 4 AccruedExpenses andExpenses understated Dr. Expenses expenses liabilitiesLiabilities understated Cr. Liabilities

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.

PIONEER ADVERTISING AGENCY, INC. Trial Balances October 31, 2001 BeforeAfter Adjustment DebitCreditDebitCredit Cash$ 15,200 Accounts Receivable200 Advertising Supplies2,5001,000 Prepaid Insurance Office Equipment5,000 Accumulated Depreciation - Office Equipment$40 Notes Payable$ 5,0005,000 Accounts Payable2,500 Interest Payable50 Unearned Revenue 1, Salaries Payable1,200 Common Stock10,000 Retained Earnings–0– Dividends500 Service Revenue10,00010,600 Salaries Expense4,0005,200 Advertising Supplies Expense1,500 Rent Expense900 Insurance Expense50 Interest Expense50 Depreciation Expense40 $ 28,700 $ 30,190 ILLUSTRATION 3-18 TRIAL BALANCE AND ADJUSTED TRIAL BALANCE COMPARED

ACCRUAL BASIS OF ACCOUNTING The revenue recognition and matching principles are used under the accrual basis of accounting. Under cash-basis accounting, revenue is recorded only when cash is received, and expenses are recorded only when paid. Generally accepted accounting principles require accrual basis accounting because the cash basis often causes misleading financial statements.

ALTERNATIVE TREATMENT Some businesses use an alternative treatment for prepaids and unearned revenues. Instead of debiting an asset at the time an expense is prepaid, the amount is charged to an expense account. Instead of crediting a liability at the time cash is received in advance of earning it, the amount is credited to a revenue account. This treatment of prepaid expenses and unearned revenues will ultimately result in the same effect on the financial statements as initial entries to balance sheet accounts and then adjusting entries.

ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS SUPPLIES Adjustment Journal Entry Posting October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand.

ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS UNEARNED REVENUES Journal Entry Unearned Revenue Oct Posting Service Revenue Oct Oct. 21, DateAccount Titles and ExplanationDebitCredit Oct. 31 Service Revenue 800 Unearned Revenue800 (To record unearned revenue) Adjustment October 31, analysis reveals that, of $1,200 in revenue, $400 has been earned in October.

ILLUSTRATION 3A-7 SUMMARY OF BASIC RELATIONSHIPS FOR PREPAYMENTS 1 PrepaidAssets and a Prepaid expensesAssets overstated Dr Expenses ExpensesExpensesinitially recorded inExpenses understated Cr Assets asset accounts have been used. b Prepaid expensesAssets understated Dr Assets initially recorded inExpenses overstated Cr Expenses expense accounts have not been used. 2 UnearnedLiabilities and a Unearned revenuesLiabilities overstated Dr Liabilities RevenuesRevenuesinitially recorded inRevenues understated Cr Revenues liability accounts have been earned. b Unearned revenuesLiabilities understated Dr Revenues initially recorded inRevenues understated Cr Liabilities revenue accounts have not been earned. 1 PrepaidAssets and a Prepaid expensesAssets overstated Dr Expenses ExpensesExpensesinitially recorded inExpenses understated Cr Assets asset accounts have been used. b Prepaid expensesAssets understated Dr Assets initially recorded inExpenses overstated Cr Expenses expense accounts have not been used. 2 UnearnedLiabilities and a Unearned revenuesLiabilities overstated Dr Liabilities RevenuesRevenuesinitially recorded inRevenues understated Cr Revenues liability accounts have been earned. b Unearned revenuesLiabilities understated Dr Revenues initially recorded inRevenues understated Cr Liabilities revenue accounts have not been earned.

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CHAPTER 3 ADJUSTING THE ACCOUNTS