3 The Adjusting Process

After studying this chapter, you should be able to: Describe the nature of the adjusting process. Journalize entries for accounts requiring adjustment. Summarize the adjustment process. Prepare an adjusted trial balance.

Describe the nature of the adjusting process. 3-1 Objective 1 Describe the nature of the adjusting process. 3

3-1 Under the accrual basis of accounting, revenues are reported in the income statement in the period in which they are earned.

3-1 The accounting concept that supports this approach to reporting of revenues is called the revenue recognition concept.

3-1 The accounting concept that supports reporting revenues and related expenses in the same period is called the matching concept, or matching principle.

3-1 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.

3-1 The analysis and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process.

3-1 The journal entries that bring the accounts up to date at the end of the accounting period are called adjusting entries.

For Practice: PE 3-1A, PE 3-1B 3-1 Example Exercise 3-1 Indicate with a Yes or No whether or not each of the following accounts normally requires an adjusting entry. Cash c. Wages Expense e. Accounts Receivable Prepaid Rent d. Office Equipment f. Unearned Rent Follow My Example 3-1 No c. Yes e. Yes Yes d. No f. Yes For Practice: PE 3-1A, PE 3-1B 10

Items That Need Adjusting 3-1 Prepaid expenses, sometimes referred to as deferred expenses, are items that have been initially recorded as assets but are expected to become expenses over time or through the normal operations of the business.

Items That Need Adjusting 3-1 Unearned revenues, sometimes referred to as deferred revenues, are items that have been initially recorded as liabilities but are expected to become revenues over time or through the normal operations of the business.

3-1 Insert Exhibit 1 13

Items That Need Adjusting 3-1 Accrued revenues, sometimes referred to as accrued assets (accrued means unpaid), are revenues that have been earned but have not been recorded in the accounts.

Items That Need Adjusting 3-1 Accrued expenses, sometimes referred to as accrued liabilities, are expenses that have been incurred but have not been recorded in the accounts.

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Wages owed but not c. Fees received but not yet yet paid. earned. 3-1 Example Exercise 3-2 Classify the following items as (1) prepaid expense, (2) unearned revenue, (3) accrued expense, or (4) accrued revenue. Wages owed but not c. Fees received but not yet yet paid. earned. Supplies on hand. d. Fees earned but not yet received. Follow My Example 3-2 Accrued expense c. Unearned revenue Prepaid expense d. Accrued revenue 17 For Practice: PE 3-2A, PE 3-2B

Journalize entries for accounts requiring adjustment. 3-2 Objective 2 Journalize entries for accounts requiring adjustment.

3-2 19

Adjusting Process for Prepaid Expenses 3-2 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.

Supplies (balance on trial balance) $2,000 3-2 Supplies (balance on trial balance) $2,000 Supplies on hand, December 31 – 760 Supplies used $1,240

3-2 Supplies Supplies Expense Bal. 2,000 Dec. 31 1,240 Bal. 800 3-2 Dec. 31 Supplies Expense 1 240 00 2007 55 Supplies 1 240 00 14 Supplies used ($2,000 – $760) Supplies Supplies Expense 14 55 Bal. 2,000 Dec. 31 1,240 Bal. 800 Dec. 31 1,240 760 2,040 22

3-2 The debit balance of $2,400 in NetSolutions’ Prepaid Insurance account represents the December 1 prepayment of insurance for 12 months.

3-2 Prepaid Insurance 15 Insurance Expense 56 Bal. 2,400 Dec. 31 200 3-2 31 Insurance Expense 200 00 56 Prepaid Insurance 200 00 15 Insurance expired ($2,400/12). Prepaid Insurance 15 Insurance Expense 56 Bal. 2,400 Dec. 31 200 Dec. 31 200 2,200 24

For Practice: PE 3-3A, PE 3-3B 3-2 Example Exercise 3-3 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 insurance related to future periods is $3,250. Follow My Example 3-3 Insurance Expense 6,750 Prepaid Insurance 6,750 Insurance expired ($6,400 + $3,600 – $3,250). 25 For Practice: PE 3-3A, PE 3-3B

3-2 On December 1, the tenant prepaid three months’ rent for use of an office building owned by NetSolutions. As of December 31, only $120 has been earned.

3-2 31 Unearned Rent 120 00 23 Rent Revenue 120 00 42 3-2 31 Unearned Rent 120 00 23 Rent Revenue 120 00 42 Rent earned ($360/3 months) Unearned Rent 23 Rent Revenue 42 Dec. 31 120 Bal. 360 Dec. 31 120 240 Bal. 27

For Practice: PE 3-4A, PE 3-4B 3-2 Example Exercise 3-4 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 $22,300. Follow My Example 3-4 Unearned Fees 22,600 Fees Earned 22,600 Fees earned ($44,900 – $22,300). 28 For Practice: PE 3-4A, PE 3-4B

3-2 NetSolutions provided $500 in services during December for which the customer has not been billed.

3-2 31 Accounts Receivable 500 00 12 Fees Earned 500 00 41 3-2 31 Accounts Receivable 500 00 12 Fees Earned 500 00 41 Accrued fees (25 hrs. x $20) Accounts Receivable 12 Fees Earned 41 Bal. 2,220 Bal. 16,340 Dec. 31 500 Dec. 31 500 2,720 Bal. 16,840 Bal. 30

For Practice: PE 3-5A, PE 3-5B 3-2 Example Exercise 3-5 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. 31 For Practice: PE 3-5A, PE 3-5B

3-2 At the end of December, accrued wages amounted to $250. Without this adjusting entry, Wages Expense is understated.

3-2 31 Wages Expense 250 00 51 Wages Payable 250 00 22 Accrued wages. 3-2 31 Wages Expense 250 00 51 Wages Payable 250 00 22 Accrued wages. Wages Payable Wages Expense 51 22 Dec. 31 250 Bal. 4,275 Dec. 31 250 Bal. 4,525 33

3-2 Wages Payable 22 Wages Expense 51 Dec. 31 250 Bal. 4,275 Dec. 31 250 Bal. 4,525 Closing entries will be discussed in a later chapter. For now, just be aware that this account is closed after financial statements are prepare and its balance rolled back to zero. 34

The payment of January 10 wages totaling $1,275 is shown below. 3-2 The payment of January 10 wages totaling $1,275 is shown below. Jan. 10 Wages Expense 1 025 00 Wages Payable 250 00 Cash 1 275 00 35

3-2 Dec. 31 250 Wages Payable Bal. 4,275 Wages Expense 22 51 3-2 Dec. 31 250 Wages Payable Bal. 4,275 Wages Expense 22 51 Bal. 4,525 Jan. 10 1,025 Jan. 10 250 The liability is cancelled. An expense for wages of $1,025 is recorded in the new fiscal year. 36

For Practice: PE 3-6A, PE 3-6B 3-2 Example Exercise 3-6 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. Follow My Example 3-6 Salaries Expense 10,000 Salaries Payable 10,000 Accrued salaries ($12,500/5 x 4 days). 37 For Practice: PE 3-6A, PE 3-6B

3-2 Physical resources that are owned and used by a business and are permanent or have a long life are called fixed assets, or plant assets.

3-2 As time passes, a fixed asset loses its ability to provide useful services. This decrease in usefulness is called depreciation.

3-2 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 Accumulate Depreciation—Store Equipment Office Equipment Accumulated Depreciation—Office

3-2 NetSolutions estimates the depreciation on its office equipment to be $50 for the month of December.

Accum. Depr.—Office Equip. 3-2 31 Depreciation Expense 50 00 53 Accum. Depreciation— Office Equipment 50 00 19 Depreciation of office equipment. Depreciation Expense 53 Accum. Depr.—Office Equip. 19 Dec. 31 50 Dec. 31 50 42

3-2 NetSolutions’ balance sheet would show the office equipment at cost, less the accumulated depreciation. Office equipment $1,800 Less accumulated depreciation 50 $1,750 Book value

Accumulated Depreciation— Equipment 4,250 Depreciation on equipment. 3-2 Example Exercise 3-7 The estimated amount of depreciation on equipment for the current year is $4,250. Journalize the adjusting entry to record the depreciation. Follow My Example 3-7 Depreciation Expense 4,250 Accumulated Depreciation— Equipment 4,250 Depreciation on equipment. 44 For Practice: PE 3-7A, PE 3-7B

Summarize the adjustment process 3-3 Objective 3 Summarize the adjustment process

3-3 46

Ledger with Adjusting Entries—NetSolutions 3-3 Ledger with Adjusting Entries—NetSolutions 47 (Continued)

Ledger with Adjusting Entries—NetSolutions Ledger with Adjusting Entries—NetSolutions 3-3 (Continued) 48

Ledger with Adjusting Entries—NetSolutions Ledger with Adjusting Entries—NetSolutions 3-3 (Continued) 49

Ledger with Adjusting Entries—NetSolutions Ledger with Adjusting Entries—NetSolutions 3-3 (Concluded) 50

Revenues were understated by $21,100 ($8,600 + $12,500). 3-3 Example Exercise 3-8 For the year ending December 31, 2008, Mann Medical Co. mistakenly omitted adjusting entries for (1) $8,600 of unearned revenue that was earned, (2) earned revenue that was not billed of $12,500, and (3) accrued wages of $2,900. Indicate the combined effect of the errors on (a) revenues, (b) expenses, and (c) net income for 2008. Follow My Example 3-8 Revenues were understated by $21,100 ($8,600 + $12,500). Expenses were understated by $2,900. Net income was understated by $18,200 ($8,600 +12,500 – $2,900). 51 For Practice: PE 3-8A, PE 3-8B

Prepare an adjusted trial balance. 3-4 Objective 4 Prepare an adjusted trial balance.

3-4 The purpose of the adjusted trial balance is to verify the equality of the total debit balances and total credit balances before the financial statements are prepared.

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3-4 Example Exercise 3-9 For each of the following errors, considered individually, indicate whether the error would cause the adjusted trial balance totals to be unequal. If the error would cause the adjusted trial balance total to be unequal, indicate whether the debit or credit total is higher and by how much. The adjustment for accrued fees of $5,340 was journalized as a debit to Accounts Payable for $5,340 and a credit to Fees Earned of $5,340. The adjustment for depreciation of $3,260 was journalized as a debit to Depreciation Expense for $3,620 and a credit to Accumulated Depreciation for $3,260. 55

For Practice: PE 3-9A, PE 3-9B 3-4 Follow My Example 3-9 The totals are equal even though the debit should have been to Accounts Receivable instead of Accounts Payable. The totals are unequal. The debit total is higher by $360 ($3,620 – $3,260). For Practice: PE 3-9A, PE 3-9B 56