1. ADJUSTING THE ACCOUNTS
LECTURE 3
ADJUSTING THE ACCOUNTS

2. TIME PERIOD ASSUMPTION
The time period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods — generally a month, a quarter, or a year.
Periods of less than one year are called interim periods.
The accounting time period of one year in length is usually known as a fiscal year. 1

3. 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 usually considered to be earned at the time the service is performed.
In a merchandising business, revenue is usually earned at the time the goods are delivered. 2

4. THE MATCHING 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 3

5. ACCRUAL BASIS OF ACCOUNTING
Adheres to the
Revenue recognition principle
Matching principle
Revenue recorded when earned, not only when cash received.
Expense recorded when services or goods are used or consumed in the generation of revenue, not only when cash paid.
GAAP

6. CASH BASIS OF ACCOUNTING
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CASH BASIS OF ACCOUNTING
NOT GAAP
Revenue recorded only when cash received.
Expense recorded only when cash paid. 5

7. HAPPEN! ADJUSTING ENTRIES
Adjusting entries make the revenue recognition and matching principles
HAPPEN!

8. ILLUSTRATION 3-3 TRIAL BALANCE
The Trial Balance is analysed to determine the need for adjusting entries.

9. ADJUSTING ENTRIES
Adjusting entries are required each time financial statements are prepared.
Adjusting entries can be classified as
1. prepayments (prepaid expenses or unearned revenues),
2. accruals (accrued revenues or accrued expenses), or
3. estimates (amortization). 5

10. 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.

11. TYPES OF ADJUSTING ENTRIES
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.

12. TYPES OF ADJUSTING ENTRIES
Estimates 1. Amortization — Allocation of the cost of capital assets to expense over their useful lives.

13. 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.

14. PREPAID EXPENSES
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. 6

15. 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, rent, insurance, and property tax. 7

16. UNEARNED REVENUES
Unearned revenues are revenues received and recorded as liabilities before they are earned.
Unearned revenues are subsequently earned by performing a service or providing a good to a customer.
A liability-revenue account relationship exists with unearned revenues. 10

17. 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, airplane tickets, and tuition.

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

19. ACCRUALS A different type of adjusting entry 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.

20. ACCRUED REVENUES
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.
Examples of accrued revenues include accounts receivable, rent receivable, and interest receivable.

21. ACCRUED EXPENSES
Accrued expenses are expenses incurred but not yet paid.
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.
Examples of accrued expenses include accounts payable, rent payable, salaries payable, and interest payable.

22. ILLUSTRATION 3-6 FORMULA TO CALCULATE INTEREST
Face Value of Note
Annual Interest Rate
Time
(in Terms of One Year)
Interest x x =
$5,000 x % x /12 = $25

23. ILLUSTRATION 3-5 ADJUSTING ENTRIES FOR ACCRUALS
Asset
Debit Adjusting Entry (+)
Accrued Revenues
Revenue
Credit Adjusting Entry (+)
Accrued Expenses
Expense
Liability

24. AMORTIZATION
Amortization is the process of allocating the cost of certain capital assets to expense over their useful life in a rational and systematic manner.
Amortization attempts to match the cost of a long-term, capital asset to the revenue it generates each period.

25. AMORTIZATION
Amortization is an estimate rather than a factual measurement of the cost that has expired.
We’re not attempting to reflect the
actual change in value of an asset!

26. Accumulated Amortization
In recording amortization, Amortization Expense is debited and a contra asset account, Accumulated Amortization, is credited.
The difference between the cost of the asset and its related accumulated amortization is referred to as the net book value of the asset.
XXX XXX
Amortization Expense
Accumulated Amortization

27. AMORTIZATION
Balance Sheet Presentation Office equipment $5,000 Less: Accumulated amortization 83 Net book value $4,917
Estimate

28. ILLUSTRATION 3-8 SUMMARY OF ADJUSTING ENTRIES
1.Prepaid Assets and Assets overstated Dr. Expenses expenses expenses Expenses understated Cr. Assets 2.Unearned Liabilities and Liabilities overstated Dr. Liabilities revenues revenues Revenues understated Cr. Revenues 3.Accrued Assets and Assets understated Dr. Assets revenues revenues Revenues understated Cr. Revenues 4.Accrued Expenses and Expenses understated Dr. Expenses expenses liabilities Liabilities understated Cr. Liabilities 5.Amortization Expense and Expenses understated Dr. Amort. Exp contra asset Assets overstated Cr. Accum. Amortization
Account
Accounts before
Adjusting
Type of
Adjustment
Relationship
Adjustment
Entry

29. 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.

30. PREPARING FINANCIAL STATEMENTS
Financial statements can be prepared directly from an adjusted trial balance.
1. The income statement is prepared from the revenue and expense accounts.
2. The statement of owner’s equity is derived from the owner’s capital and drawings accounts and the net income (or net loss) shown in the income statement.
3. The balance sheet is then prepared from the asset and liability accounts and the ending owner’s capital balance as reported in the statement of owner’s equity.

31. PIONEER ADVERTISING AGENCY INC.
Trial Balance
Trial Balance – Each account is analyzed to determine whether it is complete and up-to-date.
PIONEER ADVERTISING AGENCY INC.
Trial Balance
October 31, 2008
Account Debit Credit
Cash $ 15,200
Advertising Supplies 2,500
Prepaid Insurance 600
Office Equipment 5,000
Notes Payable $ 5,000
Accounts Payable 2,500
Unearned Revenue 1,200
Common Stock 10,000
Retained Earnings 0
Dividends 500
Service Revenue 10,000
Salaries Expense 4,000
Rent Expense 900
$28,700 $ 28,700

32. Adjusting Entries for “Prepaid Expenses”
Example (Insurance): On Oct. 4th, Pioneer Advertising paid $600 for a one-year fire insurance policy. Show the journal entry to record the payment on Oct 4th.
Oct. 4
Prepaid insurance
600
Cash
600
Prepaid Insurance
Cash
Debit
Credit
Debit
Credit
600
600

33. Adjusting Entries for “Prepaid Expenses”
Example (Insurance): On Oct. 4th, Pioneer Advertising paid $600 for a one-year fire insurance policy. Show the adjusting journal entry required at Oct. 31st.
Oct. 31
Insurance expense 50
Prepaid insurance 50
Prepaid Insurance
Insurance Expense
Debit
Credit
Debit
Credit
600 50 50
550

34. Adjusting Entries for “Prepaid Expenses”
Example (Depreciation): On Oct. 2nd, Pioneer Advertising paid $5,000 for office equipment that has an expected useful life of 10 years. Show the journal entry to record the purchase of the equipment on Oct. 2nd.
Oct. 2
Equipment
5,000
Cash
5,000
Equipment
Cash
Debit
Credit
Debit
Credit
5,000
5,000
LO 5 Prepare adjusting entries for deferrals.

35. Adjusting Entries for “Prepaid Expenses”
Example (Depreciation): On Oct. 2nd, Pioneer Advertising paid $5,000 for office equipment that has an expected useful life of 10 years. Show the adjusting journal entry required at Oct. 31st. The equipment has a $200 salvage value.
([$5,000- $200 salvage value] / 5 yrs / 12 months = $40)
Jan. 31
Depreciation expense 40
Accumulated depreciation 40
Depreciation Expense
Accumulated Depreciation
Debit
Credit
Debit
Credit 40 40 40

36. Adjusting Entries for “Prepaid Expenses”
Depreciation (Statement Presentation)
Accumulated Depreciation—is a contra asset account.
Appears just after the account it offsets (Equipment) on the balance sheet.
Office equipment $5,000
Less: Accumulated depreciation-Office Equipment $4,960

37. Adjusting Entries for “Unearned Revenues”
Example: On Oct. 2nd, Pioneer Advertising received $1,200 from R. Knox for services to be completed by December 31. Show the journal entry to record the receipt on Oct 2nd.
Oct. 2
Cash
1,200
Unearned Revenue
1,200
Cash
Unearned Rent Revenue
Debit
Credit
Debit
Credit
1,200
1,200
LO 5 Prepare adjusting entries for deferrals.

38. Adjusting Entries for “Unearned Revenues”
Example: On Oct. 2nd, Pioneer Advertising received $1,200 from R. Knox for services to be completed by December 31. Show the adjusting journal entry required on Oct. 31st.
Oct. 31
Unearned Revenue
400
Service Revenue
400
Service Revenue
Unearned Revenue
Debit
Credit
Debit
Credit
400
400
1,200
800

39. Adjusting Entries for “Accrued Revenues”
Example: In October Pioneer Advertising earned $200 for advertising services that have not been recorded. Show the journal entry to record the accrued revenues in October.
Oct. 31
Accounts Receivable
200
Service Revenue
200
Accounts Receivable
Service Revenue
Debit
Credit
Debit
Credit
200
200

40. Adjusting Entries for “Accrued Expenses”
Example: On Oct 1st, Pioneer Advertising signed a $,5000, 3-month note payable at a rate of 12% per year. The total interest due on the note at its due date is $150 ($5,000 X 12% X 3/12). Show the journal entry to record the borrowing on Oct. 1st.
Oct. 1
Cash
5,000
Notes payable
5,000
Cash
Notes Payable
Debit
Credit
Debit
Credit
5,000
5,000

41. Adjusting Entries for “Accrued Expenses”
Example: On Oct 1st, Pioneer Advertising signed a $,5000, 3-month note payable at a rate of 12% per year. The total interest due on the note at its due date is $150 ([$5,000 x 12%] / 12 months). Show the adjusting journal entry required on Oct. 31st.
Oct. 31
Interest expense 50
Interest payable 50
Interest Expense
Interest Payable
Debit
Credit
Debit
Credit 50 50

42. Preparing Financial Statements
Account Debit Credit
Cash $ 15,200
Accounts Receivable 200
Advertising Supplies 1,000
Prepaid Insurance 550
Office Equipment 5,000
Accumulated Depreciation-Off Equip $40
Notes Payable 5,000
Accounts Payable 2,500
Unearned Revenue 800
Salaries Payable 1,200
Interest Payable 50
Common Stock 10,000
Retained Earnings 0
Dividends 500
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 $ 30,190
Income Statement
PIONEER ADVERTISING AGENCY INC.
Income Statement
For the Month Ended October 31, 2008
Revenues
Service Revenue 10,600
Expenses
Salaries Expense 5,200
Advertising Supplies Expense 1,500
Rent Expense 900
Insurance Expense 50
Interest Expense 50
Depreciation Expense
Total expenses 7,740
Net income $ 2,860

43. Preparing Financial Statements
Account Debit Credit
Cash $ 15,200
Accounts Receivable 200
Advertising Supplies 1,000
Prepaid Insurance 550
Office Equipment 5,000
Accumulated Depreciation-Off Equip $40
Notes Payable 5,000
Accounts Payable 2,500
Unearned Revenue 800
Salaries Payable 1,200
Interest Payable 50
Common Stock 10,000
Retained Earnings 0
Dividends 500
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 $ 30,190
Retained Earnings Statement
PIONEER ADVERTISING AGENCY INC.
Retained Earnings Statement
For the Month Ended October 31, 2008
Retained earnings, October 1 $ 0
Add: Net income 2,860
2,860
Less: Dividends
Retained Earnings, October 31 2,360

44. Preparing Financial Statements
Balance Sheet
Account Debit Credit
Cash $ 15,200
Accounts Receivable 200
Advertising Supplies 1,000
Prepaid Insurance 550
Office Equipment 5,000
Accumulated Depreciation-Off Equip $40
Notes Payable 5,000
Accounts Payable 2,500
Unearned Revenue 800
Salaries Payable 1,200
Interest Payable 50
Common Stock 10,000
Retained Earnings 0
Dividends 500
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 $ 30,190
PIONEER ADVERTISING AGENCY INC.
Balance Sheet
October 31, 2008
Assets
Cash $ 15,200
Accounts Receivable 200
Advertising Supplies 1,000
Prepaid Insurance 550
Office Equipment $5,000
Accumulated Depreciation-Off Equip 40 4,960
Total Assets $ 21,910
Liabilities and Stockholders’ Equity
Liabilities
Notes Payable $ 5,000
Accounts Payable 2,500
Unearned Revenue 800
Salaries Payable 1,200
Interest Payable
Total liabilities 9,550
Stockholders’ Equity
Common Stock 10,000
Retained Earnings 2,360
Total liabilities and stockholders’ equity $ 21,910

45. STEPS IN THE ACCOUNTING CYCLE
1. Analyse transactions
2. Journalize the transactions
9. Coming next chapter
3. Post to ledger accounts
8. Coming next chapter
4. Prepare a trial balance
7. Prepare financial statements
5. Journalize and post adjusting entries
6. Prepare adjusted trial balance