Chapter 3 The Adjusting Process Unit 4

Accrual versus Cash Basis of Accounting p100

Under the accrual basis of accounting, revenues are reported in the income statement in the period in which they are earned.

Under the cash basis of accounting, revenues and expenses are reported in the income statement in the period in which cash is received or paid.

The Adjusting Process The analysis and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process. -- Making the records as correct as we can.

The Adjusting Process Under the accrual basis, at the end of the accounting period some of the accounts need updating for the following reasons: Some expenses are not recorded daily. Some revenues and expenses are incurred as time passes rather than as separate transactions. Some revenues and expenses may be unrecorded.

Example Exercise 3-1 p101 Accounts Requiring Adjustment Indicate with a Yes or No whether or not each of the following accounts normally requires an adjusting entry. Cash d. Office Equipment Prepaid Rent e. Accounts Receivable Wages Expense f. Unearned Rent

Cash d. Office Equipment Prepaid Rent e. Accounts Receivable Example Exercise 3-1 (continued) Cash d. Office Equipment Prepaid Rent e. Accounts Receivable Wages Expense f. Unearned Rent No No Yes Yes Yes Yes

Types of Accounts Requiring Adjustment Prepaid expenses are the advance payment of future expenses and are recorded as assets when cash is paid. Ex. Prepaid Insurance

Types of Accounts Requiring Adjustment Unearned revenues are the advance receipt of future revenues and are recorded as liabilities when cash is received. Ex. Unearned Rent

Types of Accounts Requiring Adjustment Accrued revenues are unrecorded revenues that have been earned and for which cash has yet to be received. Ex. Fees earned but not yet billed.

Types of Accounts Requiring Adjustment Accrued expenses are unrecorded expenses that have been incurred and for which cash has not been paid. Ex. Wages earned but not yet paid.

Example Exercise 3-2 p104 Type of Adjustment Classify the following items as (1) prepaid expense, (2) unearned revenue, (3) accrued expense, or (4) accrued revenue. Wages owed but not yet paid. Supplies on hand. Fees received but not yet earned. Fees earned but not yet received. a. Accrued expense c. Unearned revenue b. Prepaid expense d. Accrued revenue

Journalize entries for accounts requiring adjustment. Objective 2 Journalize entries for accounts requiring adjustment.

Prepaid Expenses NetSolutions’ Supplies account has a balance of $2,000 in the unadjusted trial balance. Some of these supplies have been used. On December 31, a count reveals that $760 of supplies are on hand. Think of a supply cabinet here. Supplies (balance on trial balance – from ledger card) $2,000 Supplies on hand, December 31 (looked in cabinet) – 760 Supplies used (so these are gone) $1,240 Here’s the problem with this. Our accounting records show we still have $2000 in supplies but we really only have $760 left. So we need to adjust or correct the supplies account.

Supplies Supplies Expense Dec. 31 1,240 Bal. 800 Dec. 31 1,240 760 14 55 Bal. 2000 Dec. 31 1,240 Bal. 800 Dec. 31 1,240 760 2,040

Example Exercise 3-3 p107 Adjustment for Prepaid Expenses The prepaid insurance account had a beginning balance of $6,400 and was debited for $3,600 of premiums paid during the year. Journalize the adjusting entry required at the end of the year assuming the amount of unexpired (what wasn’t used up) insurance related to future periods is $3,250. So we started with $6400 in that account and during the year paid $3600 more in premiums for a total balance in the account of? $10,000. We only want what wasn’t used in the account so… Insurance Expense……………………… 6,750 Prepaid Insurance…………………… 6,750 Insurance expired ($6,400 + $3,600 – $3,250).

Unearned Revenues The December 31 unadjusted trial balance of NetSolutions indicates a balance in the unearned rent account of $360. This was 3 months of rent received from a renter for the months of Dec, Jan and Feb. So on Dec. 31st one month has been earned and two months are still unearned. We need to move one month out of the unearned account.

Example Exercise 3-4 p108 Adjustment for Unearned Revenue The balance in the unearned fees account, before adjustment at the end of the year, is $44,900. Journalize the adjusting entry required if the amount of unearned fees at the end of the year is really $22,300 (so we earned the difference). Unearned Fees……………………………. 22,600 Fees Earned………………………….. 22,600 Fees earned ($44,900 – $22,300).

Accrued Revenues NetSolutions signed an agreement with Danker Co. on December 15 to provide services at $20 per hour. As of December 31, NetSolutions had provided 25 hours of assistance. So we need to record the money owed to us for the work that we completed. $20 times 25 hours = $500

Example Exercise 3-5 p109 Follow My Example 3-5 Adjustment for Accrued Fees At the end of the current year, $13,680 of fees have been earned but have not been billed to clients. Journalize the adjusting entry to record the accrued fees. Follow My Example 3-5 Accounts Receivable……………………. 13,680 Fees Earned………………………….. 13,680 Accrued fees.

Accrued Expenses NetSolutions pays it employees biweekly. During December, NetSolutions paid wages of $950 on December 13 and $1,200 on December 27. As of December 31, NetSolutions owes $250 of wages to employees for Monday and Tuesday. (Assume that the 27th is a Friday, no one worked on the 28th and 29th so we owe for Monday the 30th and Tuesday the 31st).

Note: Make sure you read page 110 to see how to record the payment of wages after recording this adjusting entry.

Example Exercise 3-6 p111 Adjustment for Accrued Expenses Sanregret Realty Co. pays weekly salaries of $12,500 on Friday for a five-day week ending on that day. Journalize the necessary adjusting entry at the end of the accounting period, assuming that the period ends on Thursday. Salaries Expense……………………….. 10,000 Salaries Payable…………………….. 10,000 Accrued salaries [($12,500 ÷ 5 days) × 4 days].

Fixed Assets (getting into the depreciation expense on this one p111) Fixed assets, or plant assets, are physical resources that are owned and used by a business and are permanent or have a long life.

Depreciation As time passes, a fixed asset loses its ability to provide useful services. This decrease in usefulness is called depreciation.

Normal titles for fixed asset accounts and their related contra asset accounts are as follows: Fixed Asset Contra Asset Land None—Land is not depreciated Buildings Accumulated Depreciation—Buildings Store Equipment Accumulated Depreciation—Store Equipment Office Equipment Accumulated Depreciation—Office Equipment

NetSolutions estimates the depreciation on its office equipment to be $50 for the month of December.

NetSolutions’ balance sheet would show office equipment at cost, less accumulated depreciation. Book value

Let’s work through it - next slide. Example Exercise 3-8 p113 Effect of Omitting Adjustments For the year ending December 31, 2010, Mann Medical Co. mistakenly omitted adjusting entries for (1) $8,600 of unearned revenue that was earned, (2) earned revenue of $12,500 that was not billed, and (3) accrued wages of $2,900. Indicate the combined effect of the errors on (a) revenues, (b) expenses, and (c) net income for 2010. Let’s work through it - next slide.

1. $8,600 of unearned rent was earned 1. $8,600 of unearned rent was earned. So this should have been moved to rent revenue. Therefore, revenue is short by $8600. 2. Earned revenue of $12,500 was not billed. So we did the work but didn’t get the $12,500 into our books. Again, revenue is short but by $12,500 this time. 3. Accrued wages means wages were earned but not yet paid – accrued. So our expenses are going to be short by $2900 for this one. Finally, remember that net income is revenues minus expenses = net income.

Expenses were understated by $2,900. For #3. Example Exercise 3-8 (continued) Revenues were understated by $21,100 ($8,600 + $12,500). For number 1 and 2. Expenses were understated by $2,900. For #3. Net income was understated by $18,200 ($8,600 +12,500 – $2,900). The revenue figure is short by $21,100 so net income is smaller than it should be for A. The expense figure is short by $2900 so net income is bigger than it should be for B. Revenue (missing $21,100) makes NI too little Expense (missing $2,900) makes NI too big = Net income would be short $18,200.

Adjusted Trial Balance p 118 The purpose of the adjusted trial balance is to verify the equality of the total debit and credit balances before the financial statements are prepared. Better to do it before you pass out the information than to find errors after the statements have gone to the boss and others.

Questions?? Textbook Exercises for this unit are: Exercise 3-1(use Example Exercise 3-2) Exercise 3-2 (use Example Exercises 3-1 & 3-2) Exercise 3-23 (use Example Exercise 3-9) Exercise 3-26 (example exercises 3-3 to 3-7 and page 116) Problem 3-5A (Problem 3-5B) Don’t forget to work on the B problems before tackling these. The solutions for the Bs are in Doc Sharing.