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Unit 1.3. Adjusting the Accounts. The 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.

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Unit 1.3

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Unit 1 3

Unit 1.3

Adjusting the Accounts


The time period assumption

The Time Period Assumption

  • Thetime period(or periodicity) assumptionassumes 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 afiscal year.


Revenue recognition principle

Revenue Recognition Principle

  • The revenue recognition principlestates 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.


Revenue recognition principle1

Revenue Recognition Principle

  • Revenue can be recognized:

    1.At point of sale

    2. During production

    3.At completion of production

    4.Upon collection of cash


Revenue recognition principle of completion

Revenue Recognition Principle - % of Completion

  • The percentage-of-completion method recognizes revenue and income on the basis of reasonable estimates of the project’s progress toward completion.

  • A project’s progress toward completion is measured by comparing the costs incurred in a year to total estimated costs of the entire project.


Revenue recognition principle of completion method

Revenue Recognition Principle - % of Completion Method

The costs incurred in the current period are then subtracted from the revenue recognized during the current period to arrive at the gross profit.

Cost Incurred (Current Period)

Total Estimated Cost

Percent Complete (Current Period)

=

÷

Percent Complete (Current Period)

Total Revenue

Revenue Recognized (Current Period)

=


Installment method of revenue recognition

Installment Method of Revenue Recognition

  • The cash basis is generally used only when it is difficult to determine the revenue amount at the time of a credit sale because collection is so uncertain.

  • The installment method, which uses the cash basis, is a popular approach to revenue recognition.

  • Under the installment method gross profit is recognized in the period in which the cash is collected.


Gross profit formula installment method

Gross Profit Formula – Installment Method

  • Under the installment method, each cash collection from a customer consists of

    1. a partial recovery of the cost of goods sold,and

    2. a partial gross profit from the sale.

  • The formula to recognize gross profit is shown below.

Gross Profit

Sales

Revenue

Gross Profit Margin

=

Gross Profit Recognized during the period

Gross Profit Margin

Cash Collections from Customer

=


The matching principle

Revenues

earned

this month

expenses

incurred in

earning the

revenue

are offset

against....

The Matching Principle

  • The practice of expense recognition is referred to as thematching principle.

  • Thematching principledictates that efforts (expenses) be matched with accomplishments (revenues).


The matching principle continued

The Matching Principle - continued

  • Expired costsare costs that will generate revenuesonly in the current period and are therefore reported as operating expenses on the income statement.

  • Unexpired costsare costs that will generate revenues in future accounting periods and are recognized as assets.


The matching principle continued1

The Matching Principle - continued

Unexpired costsbecome expenses through:

1.Cost of goods sold– Costs carried as merchandise inventory are expensed as cost of goods sold in the period when the sale occurs – so there is a direct matching of expenses with revenues.

2.Operating expenses– Unexpired costs become operating expensesthrough use or consumption or through the passage of time.


Accrual basis of accounting

GAAP

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.


Unit 1 3

NOT GAAP

Cash Basis of Accounting

  • Revenue recorded only when cash received.

  • Expense recorded only when cash paid.


Adjusting entries

  • Adjusting entries make the revenue recognition and matching principles

Adjusting Entries

HAPPEN!


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The Trial Balance

The Trial Balance is analysed to determine the need for adjusting entries.


Unit 1 3

Adjusting Entries

  • Adjusting entriesare required each time financial statements are prepared.

  • Adjusting entries can be classified as

    1.prepayments (prepaid expensesor unearned revenues),

    2.accruals (accruedrevenuesor accrued expenses), or

    3. estimates (amortization).


Types of adjusting entries

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.


Types of adjusting entries continued

Types of Adjusting Entries - continued

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.


Types of adjusting entries continued1

Types of Adjusting Entries - continued

Estimates

1. Amortization— Allocation of the cost of capital assets to expense over their useful lives.


Prepayments

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.


Unit 1 3

PrePaid Expenses

  • Prepaid expensesare 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.

  • Anasset-expenseaccount relationshipexists with prepaid expenses.


Unit 1 3

PrePaid Expenses - continued

  • 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.


Unit 1 3

Unearned Revenues

  • Unearned revenuesare 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-revenueaccount relationship exists with unearned revenues.


Unit 1 3

Unearned Revenues - continued

  • 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.


Unit 1 3

Adjusting Entries

Asset

Expense

Unadjusted Balance

Credit Adjusting Entry (-)

Debit Adjusting Entry (+)

Liability

Revenue

Debit Adjusting Entry (-)

Unadjusted Balance

Credit Adjusting Entry (+)

Adjusting Entries for Prepayments

Prepaid Expenses

Unearned Revenues


Accruals

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.


Unit 1 3

Accrued Revenues

  • Accrued revenuesmay 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.


Unit 1 3

Accrued Expenses

  • Accrued expensesare 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.


Formula to calculate interest

Face Value of Note

Annual Interest Rate

Time

(in Terms of One Year)

Interest

Formula to Calculate Interest

x

x

=

$5,000 x 6% x 1/12 = $25


Unit 1 3

Adjusting Entries

Accrued Revenues

Asset

Revenue

Debit Adjusting Entry (+)

Credit Adjusting Entry (+)

Accrued Expenses

Expense

Liability

Debit Adjusting Entry (+)

Credit Adjusting Entry (+)

Adjusting Entries for Accruals


Unit 1 3

Amortization

  • Amortizationis 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.


Amortization continued

We’re not attempting to reflect the

actual change in value of an asset!

Amortization - continued

  • Amortization is an estimate rather than a factual measurement of the cost that has expired.


Amortization continued1

Amortization - continued

  • In recording amortization, Amortization Expenseis 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 valueof the asset.

Accumulated Amortization

Amortization Expense

XXXX

XXXX


Amortization continued2

Estimate

Amortization - continued

Balance Sheet Presentation

Office equipment $5,000

Less: Accumulated amortization 83

Net book value $4,917


Adjusted trial balance

Adjusted Trial balance

  • An Adjusted Trial Balanceis 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.


Unit 1 3

Trial Balance & Adjusted Trial Balance


Preparing financial statements

Preparing Financial Statements

Financial statementscan 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.


Preparation from adjusted trial balance

Preparation From Adjusted Trial Balance


Unit 1 3

From Statement of Owner’s Equity

Preparation From Adjusted Trial Balance


Unit 1 3

1. Analyse transactions

2. Journalize the transactions

9. Coming next Section

3. Post to ledger accounts

8. Coming next Section

4. Prepare a trial balance

7. Prepare financial statements

5. Journalize and post adjusting entries

6. Prepare adjusted trial balance

Steps in the Accounting Cycle


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