1. Warren Reeve Duchac Accounting 26e The Adjusting Process 3 C H A P T E R human/iStock/360/Getty Images

2. Learning Objectives LO1: Describe the nature of the adjusting process. LO2: Journalize entries for accounts requiring adjustment. LO3: Summarize the adjustment process. LO4: Prepare an adjusted trial balance. LO5: Describe and illustrate the use of vertical analysis in evaluating a company’s performance and financial condition. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3. Nature of the Adjusting Process (slide 1 of 2) The accounting period concept requires that revenues and expenses be reported in the proper period. Under the accrual basis of accounting, revenues are reported on the income statement in the period in which they are earned. o For example, revenue is reported when the services are provided to customers. o Cash may or may not be received from customers during this period. The accounting concept supporting this reporting of revenues is called the revenue recognition concept. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4. Nature of the Adjusting Process (slide 2 of 2) Under accrual accounting, revenues are recognized when services have been performed or products have been delivered to customers. Revenue is measured as assets received, such as cash or accounts receivable, in exchange for a service or product. This process of recording revenues is called revenue recognition. The accounting concept supporting reporting revenues and related expenses in the same period is called the matching concept. Under the cash basis of accounting, revenues and expenses are reported on the income statement in the period in which cash is received or paid. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5. The Adjusting Process (slide 1 of 2) Under the accrual basis, some of the accounts need updating at the end of the accounting period for the following reasons: o Some expenses are not recorded daily. o Some revenues and expenses are incurred as time passes rather than as separate transactions. o Some revenues and expenses may be unrecorded. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6. The Adjusting Process (slide 2 of 2) The analysis and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process. The journal entries that bring the accounts up to date at the end of the accounting period are called adjusting entries. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. Example Exercise ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Indicate with a Yes or No whether or not each of the following accounts normally requires an adjusting entry: a.Cash b.Prepaid Rent c.Wages Expense d.Land e.Accounts Receivable f.Unearned Rent a.No b.Yes c.Yes d.No e.Yes f.Yes Accounts Requiring Adjustment

8. Types of Accounts Requiring Adjustment The following basic types of accounts require adjusting entries: o Prepaid expenses o Unearned revenues o Accrued revenues o Accrued expenses ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9. Prepaid Expenses (slide 1 of 2) Prepaid expenses are the advance payment of future expenses and are recorded as assets when cash is paid. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10. Prepaid Expenses (slide 2 of 2) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11. Unearned Revenues (slide 1 of 2) Unearned revenues are the advance receipt of future revenues and are recorded as liabilities when cash is received. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. Unearned Revenues (slide 2 of 2) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13. Accrued Revenues (slide 1 of 2) Accrued revenues are unrecorded revenues that have been earned and for which cash has yet to be received. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

14. Accrued Revenues (slide 2 of 2) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15. Accrued Expenses (slide 1 of 2) Accrued expenses are unrecorded expenses that have been incurred and for which cash has yet to be paid. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

16. Accrued Expenses (slide 2 of 2) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

17. Example Exercise ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Classify the following items as (1) prepaid expense, (2) unearned revenue, (3) accrued expense, or (4) accrued revenue: a.Wages owed but not yet paid. b.Supplies on hand. c.Fees received but not yet earned. d.Fees earned but not yet received. a.Accrued expense b.Prepaid expense c.Unearned revenue d.Accrued revenue Type of Adjustment

18. Unadjusted Trial Balance for NetSolutions ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. Expanded Chart of Accounts for NetSolutions ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

20. Prepaid Expenses (slide 1 of 2) NetSolutions’ supplies account has a balance of $2,000 on the unadjusted trial balance. Some of these supplies have been used. Assuming that on December 31 the amount of supplies on hand is $760, the amount to be transferred from the asset account to the expense account is computed as follows: ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

21. Assets = Liabilities + Owner’s Equity (Expense) Accounting Equation Impact decrease increase Prepaid Expenses (slide 2 of 2) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

22. The debit balance of $2,400 in NetSolutions’ prepaid insurance account represents the December 1 prepayment of insurance for 12 months. Assets = Liabilities + Owner’s Equity (Expense) Accounting Equation Impact decrease increase Prepaid Insurance ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

23. Impact of Omitting Adjusting Entries for Prepaid Expenses ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Arrow (1) indicates the effect of the understated expenses on assets. Arrow (2) indicates the effect of the overstated net income on owner’s equity.

24. Example Exercise ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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. Adjustment for Prepaid Expense

25. Unearned Revenues The credit balance of $360 in NetSolutions’ unearned rent account represents the receipt of three months’ rent on December 1 for December, January, and February. At the end of December, one month’s rent has been earned. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Assets = Liabilities + Owner’s Equity (Revenue) Accounting Equation Impact decrease increase

26. Impact of Omitting Adjusting Entry for Unearned Revenues ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

27. Example Exercise ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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. Adjustment for Unearned Revenue

28. Accrued Revenues NetSolutions signed an agreement with Danker Co. on December 15 to provide services at a rate of $20 per hour. As of December 31, NetSolutions had provided 25 hours of services. The revenue will be billed on January 15. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Assets = Liabilities + Owner’s Equity (Revenue) Accounting Equation Impact increase

29. Impact of Omitting Adjusting Entry for Accrued Revenues ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

30. Example Exercise ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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. Adjustment for Accrued Revenues

31. Accrued Wages ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

32. Accrued Expenses (slide 1 of 2) 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, December 30 and 31. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Assets = Liabilities + Owner’s Equity (Expense) Accounting Equation Impact increase

33. Accrued Expenses (slide 2 of 2) NetSolutions paid wages of $1,275 on January 10. This payment includes the $250 of accrued wages recorded on December 31. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

34. Impact of Omitting Adjusting Entry for Accrued Expenses ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

35. Example Exercise ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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. Adjustment for Accrued Expense

36. Depreciation Expense (slide 1 of 5) Fixed assets, or plant assets, are physical resources that are owned and used by a business and are permanent or have a long life. As time passes, a fixed asset loses its ability to provide useful services. This decrease in usefulness is called depreciation. All fixed assets, except land, lose their usefulness and, thus, are said to depreciate. As a fixed asset depreciates, a portion of its cost should be recorded as an expense. This periodic expense is called depreciation expense. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

37. Depreciation Expense (slide 2 of 5) The fixed asset account is not decreased (credited) when making the related adjusting entry. This is because both the original cost of a fixed asset and the depreciation recorded since its purchase are reported on the balance sheet. Instead, an account entitled Accumulated Depreciation is increased (credited). Accumulated depreciation accounts are called contra accounts, or contra asset accounts. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

38. Depreciation Expense (slide 3 of 5) Normal titles for fixed asset accounts and their related contra asset accounts are as follows: ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

39. Assets = Liabilities + Owner’s Equity (Expense) Accounting Equation Impact increase Depreciation Expense (slide 4 of 5) NetSolutions estimates the depreciation on its office equipment to be $50 for the month of December. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

40. Depreciation Expense (slide 5 of 5) The difference between the original cost of the office equipment and the balance in the accumulated depreciation—office equipment account is called the book value of the asset (or net book value). It is computed as follows: ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Book Value of Asset = Cost of the Asset – Accumulated Depreciation of Asset

41. Impact of Omitting Adjusting Entry for Depreciation ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

42. Example Exercise ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The estimated amount of depreciation on equipment for the current year is $4,250. Journalize the adjusting entry to record the depreciation. Adjustment for Depreciation

43. Summary of Adjustments (slide 1 of 3) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

44. Summary of Adjustments (slide 2 of 3) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

45. Summary of Adjustments (slide 3 of 3) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

46. Adjusting Entries—NetSolutions ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

47. Ledger with Adjusting Entries—NetSolutions (slide 1 of 5) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

48. Ledger with Adjusting Entries—NetSolutions (slide 2 of 5) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

49. Ledger with Adjusting Entries—NetSolutions (slide 3 of 5) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

50. Ledger with Adjusting Entries—NetSolutions (slide 4 of 5) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

51. Ledger with Adjusting Entries—NetSolutions (slide 5 of 5) ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

52. Example Exercise ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. For the year ending December 31, 2016, 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 the year ended December 31, 2016. Effect of Omitting Adjustments

53. Adjusted Trial Balance 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. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

54. Adjusted Trial Balance ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

55. Example Exercise ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 totals to be unequal, indicate whether the debit or credit total is higher and by how much. a.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. b.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 Effect of Errors on Adjusted Trial Balance

56. Financial Analysis and Interpretation: Vertical Analysis (slide 1 of 3) Comparing each item in a financial statement with a total amount from the same statement is referred to as vertical analysis. ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

57. $12,500 =.067 or 6.7% $187,500 ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Financial Analysis and Interpretation: Vertical Analysis (slide 2 of 3)

58. $36,250 = 0.263 or 26.3% $137,764 ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Financial Analysis and Interpretation: Vertical Analysis (slide 3 of 3)

59. Example Exercise ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Two income statements for Fortson Company follow: a.Prepare a vertical analysis of Fortson Company’s income statements. b.Does the vertical analysis indicate a favorable or an unfavorable trend? Vertical Analysis (slide 1 of 2)

60. Example Exercise ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Vertical Analysis (slide 2 of 2)