Prepared by Kurt M. Hull, MBA CPA California State University, Los Angeles Financial A ccounting, 5e John Wiley & Sons, Inc. Weygandt, Kieso, & Kimmel

STUDY OBJECTIVES After studying this chapter, you should understand: Time period assumptionAdjusting entries for prepayments Accrual basis of accountingAdjusting entries for accruals Why adjusting entries are necessary Purpose of an adjusted trial balance Major types of adjusting entries Alternate treatment of prepayments & accruals CHAPTER 3 ADJUSTING THE ACCOUNTS CHAPTER 3 ADJUSTING THE ACCOUNTS

The time period 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 (fiscal year) STUDY OBJECTIVE 1 TIME PERIOD ASSUMPTION STUDY OBJECTIVE 1 TIME PERIOD ASSUMPTION

STUDY OBJECTIVE 2 ACCRUAL vs. CASH-BASIS ACCOUNTING STUDY OBJECTIVE 2 ACCRUAL vs. CASH-BASIS ACCOUNTING Accrual Basis Revenue recognized when earned Expenses are matched against revenues Required by GAAP Accrual Basis Revenue recognized when earned Expenses are matched against revenues Required by GAAP Cash-Basis Revenues and expenses recorded when cash is paid or received Not GAAP Cash-Basis Revenues and expenses recorded when cash is paid or received Not GAAP

The revenue recognition principle dictates that revenue be recognized in the accounting period in which it is earned. In a service business, revenue is considered to be earned when the service is performed. –Dry cleaner –Airlines REVENUE RECOGNITION PRINCIPLE

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 MATCHING PRINCIPLE

Time-Period Assumption Economic life of business can be divided into artificial time periods Revenue-Recognition Principle Revenue recognized in the accounting period in which it is earned Matching Principle Expenses matched with revenues in the same period when efforts are expended to generate revenues GAAP RELATIONSHIPS IN REVENUE & EXPENSE RECOGNITION GAAP RELATIONSHIPS IN REVENUE & EXPENSE RECOGNITION

Adjusting entries are needed to ensure that revenue recognition and matching principles are followed 1 Revenues are recorded in the period earned, and Expenses are recognized in the period incurred. STUDY OBJECTIVE 3 WHY ADJUSTING ENTRIES ARE NECESSARY STUDY OBJECTIVE 3 WHY ADJUSTING ENTRIES ARE NECESSARY

STUDY OBJECTIVE 4 TYPES OF ADJUSTING ENTRIES STUDY OBJECTIVE 4 TYPES OF ADJUSTING ENTRIES Adjusting entries are required each time financial statements are prepared. Two main categories of adjustments are: Adjusting entries are required each time financial statements are prepared. Two main categories of adjustments are: PREPAYMENTS ACCRUALS

ADJUSTING ENTRIES: PREPAYMENTS ADJUSTING ENTRIES: PREPAYMENTS Prepaid Expenses Expenses are paid and recorded as assets before they are used or consumed Example: Prepaid Insurance Prepaid Expenses Expenses are paid and recorded as assets before they are used or consumed Example: Prepaid Insurance Unearned Revenues Cash received and recorded as liabilities before revenue is earned Example: Cash received for services provided in future Unearned Revenues Cash received and recorded as liabilities before revenue is earned Example: Cash received for services provided in future

ADJUSTING ENTRIES: ACCRUALS ADJUSTING ENTRIES: ACCRUALS Accrued Revenues Revenues earned but Not yet received In cash or recorded Example: Sales of merchandise On account Accrued Revenues Revenues earned but Not yet received In cash or recorded Example: Sales of merchandise On account Accrued Expenses Expenses incurred but not yet paid in cash or recorded Example: Utilities used but not yet paid for Accrued Expenses Expenses incurred but not yet paid in cash or recorded Example: Utilities used but not yet paid for

$ 28,700 The Trial Balance is the starting place for adjusting entries. TRIAL BALANCE

Adjusting entries for prepayments are required to record the portion of the prepayment representing: 1 the expense incurred, or 2 the revenue earned in the current period. The adjusting entry results in a debit to an expense account and a credit to an asset account. STUDY OBJECTIVE 5 ADJUSTING ENTRIES FOR PREPAYMENTS STUDY OBJECTIVE 5 ADJUSTING ENTRIES FOR PREPAYMENTS

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 ADJUSTING ENTRIES FOR PREPAYMENTS ADJUSTING ENTRIES FOR PREPAYMENTS

Basic Analysis Debit-Credit Analysis Transaction October 5, an estimated 3-month supply of advertising materials is purchased on account from Aero Supply for $2,500. The asset Advertising Supplies is increased $2,500; the liability Accounts Payable is increased $2,500. Debits increase assets: debit Advertising Supplies $2,500. Credits increase liabilities: credit Accounts Payable $2,500. PURCHASE OF SUPPLIES ON CREDIT PURCHASE OF SUPPLIES ON CREDIT

Accounts Payable201 Oct. 52,500 Advertising Supplies126 Oct. 52,500 Date Account Titles and Explanation Ref. Debit Credit Oct. 5 Advertising Supplies 126 2,500 Accounts Payable 201 2,500 (Purchased supplies on account from Aero Supply) JOURNAL ENTRY POSTING PURCHASE OF SUPPLIES ON CREDIT PURCHASE OF SUPPLIES ON CREDIT

Advertising Supplies Expense Oct. 311,500 Advertising Supplies Oct. 52,500Oct. 311, ,000 Date Account Titles and Explanation Debit Credit Oct. 31 Advertising Supplies Expense 1,500 Advertising Supplies 1,500 (To record supplies used) JOURNAL ENTRY POSTING ADJUSTMENT October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand. ADJUSTING ENTRIES FOR PREPAYMENTS SUPPLIES ADJUSTING ENTRIES FOR PREPAYMENTS SUPPLIES

The asset Prepaid Insurance is increased $600 because the payment extends to more than the current month; the asset Cash is decreased $600. Note that payments of expenses that will benefit more than one accounting period are identified as prepaid expenses or prepayments. When a payment is made, an asset account is debited in order to show the service or benefit that will be received in the future. Transaction October 4, $600 is paid for a one-year insurance policy that will expire next year on September 30. Debit-Credit Analysis Debits increase assets: debit Prepaid Insurance $600. Credits decrease assets: credit Cash $600. Basic Analysis PAYMENT FOR INSURANCE

Cash101 Oct. 110,000 Oct , JOURNAL ENTRY POSTING Prepaid Insurance130 Oct PAYMENT FOR INSURANCE

Insurance Expense63 Oct Prepaid Insurance10 Oct. 4600Oct DateAccount Titles and ExplanationDebitCredit Oct. 31Insurance Expense50 Prepaid Insurance50 (To record insurance expired) JOURNAL ENTRY POSTING ADJUSTMENT October 31, an analysis of the policy reveals that $50 of insurance expires each month. ADJUSTING ENTRIES FOR PREPAYMENTS INSURANCE ADJUSTING ENTRIES FOR PREPAYMENTS INSURANCE

REVIEW QUESTION ADJUSTING ENTRY-SUPPLIES REVIEW QUESTION ADJUSTING ENTRY-SUPPLIES The trial balance shows supplies of $1,350 and supplies expense of $0. If $750 of supplies are on hand at the end of the period, what is the adjusting entry? $600 Supplies $600Supplies Expense CreditDebitAccount The balance in supplies after adjustment is $750, the amount remaining unused. The amount used Is transferred to expense.

Depreciation is the allocation of the cost of an asset to expense over its useful life. Depreciation is an estimate of expired cost. Depreciation Expense is debited and a contra-asset account, Accumulated Depreciation, is credited Cost – accumulated depreciation = Book value Depreciation Expense XXX Accumulated Depreciation XXX ADJUSTING ENTRIES FOR PREPAYMENTS DEPRECIATION ADJUSTING ENTRIES FOR PREPAYMENTS DEPRECIATION

Basic Analysis Debit-Credit Analysis Transaction October 1, office equipment costing $5,000 is purchased by signing a 3-month, 12%, $5,000 note payable. The asset Office Equipment is increased $5,000, and the liability Notes Payable is increased $5,000. Debits increase assets: debit Office Equipment $5,000. Credits increase liabilities: credit Notes Payable $5,000. PURCHASE OF OFFICE EQUIPMENT PURCHASE OF OFFICE EQUIPMENT

Notes Payable 200 Oct. 1 5,000 Office Equipment157 Oct. 15,000 DateAccount Titles and ExplanationRef.DebitCredit Oct. 1Office Equipment1575,000 Notes Payable2005,000 (Issued 3-month, 12% note for office equipment) JOURNAL ENTRY POSTING PURCHASE OF OFFICE EQUIPMENT PURCHASE OF OFFICE EQUIPMENT

Accumulated Depreciation - Office Equipment Oct DateAccount Titles and ExplanationDebitCredit Oct. 31Depreciation Expense40 Accumulated Depreciation - Office Equipment40 (To record monthly depreciation) JOURNAL ENTRY POSTING ADJUSTMENT October 31, depreciation on the office equipment is estimated to be $480 a year, or $40 per month. Depreciation Expense Oct ADJUSTING ENTRIES FOR PREPAYMENTS DEPRECIATION ADJUSTING ENTRIES FOR PREPAYMENTS DEPRECIATION

Basic Analysis Debit-Credit Analysis Transaction October 2, a $1,200 cash advance is received from R. Knox, a client, for advertising services that are expected to be completed by December 31. The asset Cash is increased $1,200; the liability Unearned Fees is increased $1,200 because the service has not been rendered yet. Note that although many liabilities have the word “payable” in their title, unearned fees are considered a liability even though the word payable is not used. Debits increase assets: debit Cash $1,200. Credits increase liabilities: credit Unearned Fees $1,200. RECEIPT OF CASH FOR FUTURE SERVICES RECEIPT OF CASH FOR FUTURE SERVICES

Unearned Fees209 Oct. 21,200 Cash101 Oct. 110,000 21,200 JOURNAL ENTRY POSTING RECEIPT OF CASH FOR FUTURE SERVICES RECEIPT OF CASH FOR FUTURE SERVICES

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

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. STUDY OBJECTIVE 6 ADJUSTING ENTRIES FOR ACCRUALS STUDY OBJECTIVE 6 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 (+) ADJUSTING ENTRIES FOR ACCRUALS ADJUSTING ENTRIES FOR ACCRUALS

Service Revenue Oct. 3110, ,600 Accounts Receivable Oct DateAccount Titles and ExplanationDebitCredit Oct. 31Accounts Receivable200 Service Revenue200 (To accrue revenue for services provided) October 31, the agency earned $200 for advertising services that were not billed to clients before October 31. JOURNAL ENTRY POSTING ADJUSTMENT ADJUSTING ENTRIES FOR ACCRUALS ACCRUED REVENUE ADJUSTING ENTRIES FOR ACCRUALS ACCRUED REVENUE

Basic Analysis Debit-Credit Analysis Transaction October 1, office equipment costing $5,000 is purchased by signing a 3-month, 12%, $5,000 note payable. The asset Office Equipment is increased $5,000, and the liability Notes Payable is increased $5,000. Debits increase assets: debit Office Equipment $5,000. Credits increase liabilities: credit Notes Payable $5,000. PURCHASE OF OFFICE EQUIPMENT PURCHASE OF OFFICE EQUIPMENT

Notes Payable 200 Oct. 1 5,000 Office Equipment157 Oct. 15,000 DateAccount Titles and ExplanationRef.DebitCredit Oct. 1Office Equipment1575,000 Notes Payable2005,000 (Issued 3-month, 12% note for office equipment) JOURNAL ENTRY POSTING PURCHASE OF OFFICE EQUIPMENT PURCHASE OF OFFICE EQUIPMENT

Interest Payable Oct Interest Expense Oct DateAccount Titles and ExplanationDebitCredit Oct. 31Interest Expense50 Interest Payable50 (To accrue interest on notes payable) JOURNAL ENTRY POSTING ADJUSTMENT 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 INTEREST ADJUSTING ENTRIES FOR ACCRUALS ACCRUED INTEREST

Basic Analysis Debit-Credit Analysis Transaction October 26, employee salaries of $4,000 are owed and paid in cash. (See October 9 transaction.) The expense account Salaries Expense is increased $4,000; the asset Cash is decreased $4,000. Debits increase expenses: debit Salaries Expense $4,000. Credits decrease assets: credit Cash $4,000. PAYMENT OF SALARIES

DateAccount Titles and ExplanationRef.DebitCredit Oct. 26Salaries Expense7264,000 Cash1014,000 (Paid salaries to date) Cash101 Oct. 110,000 Oct , ,000 JOURNAL ENTRY POSTING Salaries Expense726 Oct. 264,000 PAYMENT OF SALARIES

Salaries Payable Oct. 311,200 DateAccount Titles and ExplanationDebitCredit Oct. 31Salaries Expense1,200 Salaries Payable1,200 (To record accrued salaries) JOURNAL ENTRY POSTING ADJUSTMENT October 31, accrued salaries are calculated to be $1,200. Salaries Expense Oct. 264, , ,200 ADJUSTING ENTRIES FOR ACCRUALS ACCRUED SALARIES ADJUSTING ENTRIES FOR ACCRUALS ACCRUED SALARIES

REVIEW QUESTION ADJUSTING ENTRY-SALARIES REVIEW QUESTION ADJUSTING ENTRY-SALARIES $400 Salaries Payable $400Salaries Expense CreditDebitAccount This entry recognizes an expense for the salary earned by Kathy in the last week of September, and a liability for the amount due to Kathy at September 30 th. Kathy Siska earned a salary of $400 for the last week of September. She will be paid on October 1. What is the required adjusting entry?

An Adjusted Trial Balance is prepared after all adjusting entries have been journalized and posted. Its purpose is to prove 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. STUDY OBJECTIVE 7 ADJUSTED TRIAL BALANCE STUDY OBJECTIVE 7 ADJUSTED TRIAL BALANCE

Service Revenue 10,600 Salaries Expense 5,200 Advertising Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 $ 30,190 PREPARING THE INCOME STATEMENT FROM THE ADJUSTED TRIAL BALANCE PREPARING THE INCOME STATEMENT FROM THE ADJUSTED TRIAL BALANCE INCOME STATEMENT ACCOUNTS INCOME STATEMENT ACCOUNTS

PIONEER ADVERTISING AGENCY Income Statement For the Month Ended October 31, 2006 Revenues Fees earned $ 10,600 Expenses Salaries expense $ 5,200 Advertising supplies expense 1,500 Rent expense 900 Insurance expense 50 Interest expense 50 Depreciation expense 40 Total expenses 7,740 Net income $ 2,860 The income statement is prepared from the revenue and expense accounts. INCOME STATEMENT

Service Revenue 10,600 Salaries Expense 5,200 Advertising Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 $ 30,190 PREPARING THE RETAINED EARNINGS STATEMENT FROM THE ADJUSTED TRIAL BALANCE PREPARING THE RETAINED EARNINGS STATEMENT FROM THE ADJUSTED TRIAL BALANCE RETAINED EARNINGS STATEMENT ACCOUNTS BALANCE SHEET ACCOUNTS

The retained earnings statement is prepared from the revenue, expense, dividends, and retained earnings accounts. RETAINED EARNINGS STATEMENT

Stockholders’ Equity Common Stock 10,000 Retained Earnings 2,360 Total liabilities and owner’s Total assets $ 21,910 equity $ 21,910 The balance sheet is prepared from asset and liability and stockholders equity accounts. BALANCE SHEET

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 STUDY OBJECTIVE 8 ALTERNATIVE METHOD--PREPAYMENTS & ACCRUALS STUDY OBJECTIVE 8 ALTERNATIVE METHOD--PREPAYMENTS & ACCRUALS

Advertising Supplies Expense Oct. 52,500Oct. 311, ,500 Advertising Supplies Oct. 311,000 DateAccount Titles and ExplanationDebitCredit Oct. 31Advertising Supplies1,000 Advertising Supplies Expense1,000 (To record supplies inventory) JOURNAL ENTRY POSTING ADJUSTMENT October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand. ALTERNATIVE METHOD--PREPAYMENTS & ACCRUALS SUPPLIES ALTERNATIVE METHOD--PREPAYMENTS & ACCRUALS SUPPLIES

Service Revenue Oct Oct. 21, DateAccount Titles and ExplanationDebitCredit Oct. 31Service Revenue800 Unearned Revenue800 (To record unearned revenue) JOURNAL ENTRY POSTING ADJUSTMENT October 31, analysis reveals that, of $1,200 in fees, $400 has been earned in October. Unearned Revenue Oct ALTERNATIVE METHOD--PREPAYMENTS & ACCRUALS UNEARNED REVENUES ALTERNATIVE METHOD--PREPAYMENTS & ACCRUALS UNEARNED REVENUES

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CHAPTER 3 ADJUSTING THE ACCOUNTS