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Adjusting the Accounts. Financial Accounting, Seventh Edition. Study Objectives. Explain the time period assumption. Explain the accrual basis of accounting. Explain the reasons for adjusting entries. Identify the major types of adjusting entries. Prepare adjusting entries for deferrals.

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slide2
Adjusting the

Accounts

Financial Accounting, Seventh Edition

study objectives
Study Objectives
  • Explain the time period assumption.
  • Explain the accrual basis of accounting.
  • Explain the reasons for adjusting entries.
  • Identify the major types of adjusting entries.
  • Prepare adjusting entries for deferrals.
  • Prepare adjusting entries for accruals.
  • Describe the nature and purpose of an adjusted trial balance.
slide4

Adjusting the Accounts

Timing Issues

The Basics of Adjusting Entries

The Adjusted Trial Balance and Financial Statements

Fiscal and calendar years

Accrual- vs. cash-basis accounting

Recognizing revenues and expenses

Types of adjusting entries

Adjusting entries for deferrals

Adjusting entries for accruals

Summary of journalizing and posting

Preparing the adjusted trial balance

Preparing financial statements

timing issues
Timing Issues

Accountants divide the economic life of a business into artificial time periods (Time Period Assumption).

. . . . .

Jan.

Feb.

Mar.

Apr.

Dec.

  • Generally a month, a quarter, or a year
  • Fiscal year vs. calendar year
  • Also known as the “Periodicity Assumption”

SO 1 Explain the time period assumption.

timing issues6
Timing Issues

The time period assumption states that:

Review

a. revenue should be recognized in the accounting period in which it is earned.

b. expenses should be matched with revenues.

c. the economic life of a business can be divided into artificial time periods.

d. the fiscal year should correspond with the calendar year.

a. revenue should be recognized in the accounting period in which it is earned.

b. expenses should be matched with revenues.

c. the economic life of a business can be divided into artificial time periods.

d. the fiscal year should correspond with the calendar year.

Solution on notes page

SO 1 Explain the time period assumption.

timing issues7
Timing Issues

Accrual- vs. Cash-Basis Accounting

  • Accrual-Basis Accounting
    • Transactions recorded in the periods in which the events occur.
    • Revenues are recognized when earned, rather than when cash is received.
    • Expenses are recognized when incurred, rather than when paid.

SO 2 Explain the accrual basis of accounting.

timing issues8
Timing Issues

Accrual- vs. Cash-Basis Accounting

  • Cash-Basis Accounting
    • Revenues are recognized when cash is received.
    • Expenses are recognized when cash is paid.
    • Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).

SO 2 Explain the accrual basis of accounting.

timing issues9
Timing Issues

Recognizing Revenues and Expenses

Revenue Recognition Principle

Companies recognize revenue in the accounting period in which it is earned.

In a service enterprise, revenue is considered to be earned at the time the service is performed.

SO 2 Explain the accrual basis of accounting.

timing issues10
Timing Issues

Recognizing Revenues and Expenses

Expense Recognition Principle – (Matching Principle)

Match expenses with revenues in the period when the company makes efforts to generate those revenues.

“Let the expenses follow the revenues.”

SO 2 Explain the accrual basis of accounting.

timing issues11
Timing Issues

GAAP relationships in revenue and expense recognition

Illustration 3-1

SO 2 Explain the accrual basis of accounting.

slide13

Timing Issues

Match the description of the concept to the concept.

g

f

c

b

Solution on notes page

SO 2 Explain the accrual basis of accounting.

timing issues14
Timing Issues

Review

One of the following statements about the accrual basis of accounting is false. That statement is:

  • Events that change a company’s financial statements are recorded in the periods in which the events occur.
  • Revenue is recognized in the period in which it is earned.
  • The accrual basis of accounting is in accord with generally accepted accounting principles.
  • Revenue is recorded only when cash is received, and expenses are recorded only when cash is paid.

One of the following statements about the accrual basis of accounting is false. That statement is:

  • Events that change a company’s financial statements are recorded in the periods in which the events occur.
  • Revenue is recognized in the period in which it is earned.
  • The accrual basis of accounting is in accord with generally accepted accounting principles.
  • Revenue is recorded only when cash is received, and expenses are recorded only when cash is paid.

Solution on notes page

SO 2 Explain the accrual basis of accounting.

the basics of adjusting entries
The Basics of Adjusting Entries
  • Adjusting entries make it possible to report correct amounts on the balance sheet and on the income statement.
  • A company must make adjusting entries every time it prepares financial statements.

SO 3 Explain the reasons for adjusting entries.

the basics of adjusting entries16
The Basics of Adjusting Entries
  • Revenues- recorded in the period in which they are earned.
  • Expenses - recognized in the period in which they are incurred.
  • Adjusting entries- needed to ensure that the revenue recognition and matching principles are followed.

SO 3 Explain the reasons for adjusting entries.

slide17

The Basics of Adjusting Entries

Review

Adjusting entries are made to ensure that:

a. expenses are recognized in the period in which they are incurred.

b. revenues are recorded in the period in which they are earned.

c. balance sheet and income statement accounts have correct balances at the end of an accounting period.

d. all of the above.

SO 3 Explain the reasons for adjusting entries.

types of adjusting entries
Types of Adjusting Entries

Types of Adjusting Entries

Illustration 3-2

Categories of adjusting entries

Deferrals

Accruals

1.Prepaid Expenses.Expenses paid in cash and recorded as assets before they are used or consumed.

3. Accrued Revenues. Revenues earned but not yet received in cash or recorded.

2. Unearned Revenues. Revenues received in cash and recorded as liabilities before they are earned.

4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded.

SO 4 Identify the major types of adjusting entries.

slide19

Types of Adjusting Entries

Illustration 3-3

Trial Balance – Illustrations are based on the October 31, trial balance of Pioneer Advertising Agency Inc.

SO 4 Identify the major types of adjusting entries.

slide20

Types of Adjusting Entries

Adjusting Entries for Deferrals

  • Deferralsare either:
  • Prepaid expenses
  • OR
  • Unearned revenues.

SO 5 Prepare adjusting entries for deferrals.

adjusting entries for prepaid expenses
Adjusting Entries for “Prepaid Expenses”

Payment of cash that is recorded as an asset because service or benefit will be received in the future.

Cash Payment

Expense Recorded

BEFORE

Prepayments often occur in regard to:

  • rent
  • maintenance on equipment
  • fixed assets (depreciation)
  • insurance
  • supplies
  • advertising

SO 5 Prepare adjusting entries for deferrals.

adjusting entries for prepaid expenses22
Adjusting Entries for “Prepaid Expenses”
  • Prepaid Expenses
  • Costs that expire either with the passage of time or through use.
  • Adjusting entries (1) to record the expenses that apply to the current accounting period, and (2) to show the unexpired costs in the asset accounts.

SO 5 Prepare adjusting entries for deferrals.

adjusting entries for prepaid expenses23
Adjusting Entries for “Prepaid Expenses”

Adjusting entries for prepaid expenses

Illustration 3-4

  • Increases (debits) an expense account and
  • Decreases (credits) an asset account.

SO 5 Prepare adjusting entries for deferrals.

slide24

Adjusting Entries for “Prepaid Expenses”

Illustration: Pioneer Advertising Agency purchased advertising supplies costing $2,500 on October 5. Pioneer recorded the payment by increasing (debiting) the asset Advertising Supplies. This account shows a balance of $2,500 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still on hand.

Oct. 31

Advertising supplies expense

1,500

Advertising supplies

1,500

Illustration 3-5

SO 5 Prepare adjusting entries for deferrals.

slide25

Adjusting Entries for “Prepaid Expenses”

Illustration: On October 4, Pioneer Advertising Agency paid $600 for a one-year fire insurance policy. Coverage began on October 1. Pioneer recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in the

October 31 trial balance. Insurance of $50 ($600 / 12) expires each month.

Oct. 31

Insurance expense

50

Prepaid insurance

50

Illustration 3-6

SO 5 Prepare adjusting entries for deferrals.

adjusting entries for prepaid expenses26
Adjusting Entries for “Prepaid Expenses”
  • Depreciation
  • Buildings, equipment, and vehicles (long-lived assets) are recorded as assets, rather than an expense, in the year acquired.
  • Companies report a portion of the cost of a long-lived asset as an expense (depreciation) during each period of the asset’s useful life (Matching Principle).

SO 5 Prepare adjusting entries for deferrals.

slide27

Adjusting Entries for “Prepaid Expenses”

Illustration: Pioneer Advertising estimates depreciation on the office equipment to be $480 a year, or $40 per month.

Oct. 31

Depreciation expense

40

Accumulated depreciation

40

Illustration 3-7

1

SO 5 Prepare adjusting entries for deferrals.

slide28

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.

Illustration 3-8

SO 5 Prepare adjusting entries for deferrals.

slide29

Adjusting Entries for “Prepaid Expenses”

Summary

Illustration 3-9

SO 5 Prepare adjusting entries for deferrals.

adjusting entries for unearned revenues
Adjusting Entries for “Unearned Revenues”

Receipt of cash that is recorded as a liability because the revenue has not been earned.

Cash Receipt

Revenue Recorded

BEFORE

Unearned revenues often occur in regard to:

  • magazine subscriptions
  • customer deposits
  • rent
  • airline tickets
  • school tuition

SO 5 Prepare adjusting entries for deferrals.

adjusting entries for unearned revenues31
Adjusting Entries for “Unearned Revenues”
  • Unearned Revenues
  • Company makes an adjusting entry to record the revenue that has been earned and to show the liability that remains.
  • The adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.

SO 5 Prepare adjusting entries for deferrals.

adjusting entries for unearned revenues32
Adjusting Entries for “Unearned Revenues”

Adjusting entries for unearned revenues

Illustration 3-10

  • Decrease (a debit) to a liability account and
  • Increase (a credit) to a revenue account.

SO 5 Prepare adjusting entries for deferrals.

adjusting entries for unearned revenues33
Adjusting Entries for “Unearned Revenues”

Illustration: Pioneer Advertising Agency received $1,200 on October 2 from R. Knox for advertising services expected to be completed by December 31. Unearned Service Revenue shows a balance of $1,200 in the October 31 trial balance. Analysis reveals that the company earned $400 of those fees in October.

Oct. 31

Unearned service revenue

400

Service revenue

400

Illustration 3-11

SO 5 Prepare adjusting entries for deferrals.

slide34

Adjusting Entries for “Unearned Revenues”

Summary

Illustration 3-12

SO 5 Prepare adjusting entries for deferrals.

slide36

Types of Adjusting Entries

Adjusting Entries for Accruals

  • Made to record:
    • Revenues earned and
    • OR
    • Expenses incurred
  • in the current accounting period that have not been recognized through daily entries.

SO 6 Prepare adjusting entries for accruals.

adjusting entries for accrued revenues
Adjusting Entries for “Accrued Revenues”

Revenues earned but not yet received in cash or recorded.

Adjusting entry results in:

Revenue Recorded

Cash Receipt

BEFORE

Accrued revenues often occur in regard to:

  • rent
  • interest
  • services performed

SO 6 Prepare adjusting entries for accruals.

adjusting entries for accrued revenues38
Adjusting Entries for “Accrued Revenues”

Accrued Revenues

An adjusting entry serves two purposes:

(1) It shows the receivable that exists, and

(2) It records the revenues earned.

SO 6 Prepare adjusting entries for accruals.

adjusting entries for accrued revenues39
Adjusting Entries for “Accrued Revenues”

Adjusting entries for accrued revenues

Illustration 3-13

  • Increases (debits) an asset account and
  • Increases (credits) a revenue account.

SO 6 Prepare adjusting entries for accruals.

slide40

Adjusting Entries for “Accrued Revenues”

Illustration: In October Pioneer Advertising Agency earned $200 for advertising services that had not been recorded.

Oct. 31

Accounts Receivable

200

Service Revenue

200

Illustration 3-14

SO 6 Prepare adjusting entries for accruals.

slide41

Adjusting Entries for “Accrued Revenues”

Summary

Illustration 3-15

SO 6 Prepare adjusting entries for accruals.

adjusting entries for accrued expenses
Adjusting Entries for “Accrued Expenses”

Expenses incurred but not yet paid in cash or recorded.

Adjusting entry results in:

Expense Recorded

Cash Payment

BEFORE

Accrued expenses often occur in regard to:

  • rent
  • interest
  • taxes
  • salaries

SO 6 Prepare adjusting entries for accruals.

adjusting entries for accrued expenses43
Adjusting Entries for “Accrued Expenses”

Accrued Expenses

An adjusting entry serves two purposes:

(1) It records the obligations, and

(2) It recognizes the expenses.

SO 6 Prepare adjusting entries for accruals.

adjusting entries for accrued expenses44
Adjusting Entries for “Accrued Expenses”

Adjusting entries for accrued expenses

Illustration 3-16

  • Increases (debits) an expense account and
  • Increases (credits) a liability account.

SO 6 Prepare adjusting entries for accruals.

slide45

Adjusting Entries for “Accrued Expenses”

Illustration: Pioneer Advertising Agency signed a three-month note payable in the amount of $5,000 on October 1. The note requires Pioneer to pay interest at an annual rate of 12%.

Illustration 3-17

Oct. 31

Interest expense

50

Interest payable

50

Illustration 3-18

SO 6 Prepare adjusting entries for accruals.

slide46

Adjusting Entries for “Accrued Expenses”

Illustration: Pioneer Advertising Agency last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 x 3 days).

Illustration 3-19

SO 6 Prepare adjusting entries for accruals.

slide47

Adjusting Entries for “Accrued Expenses”

Illustration: Pioneer Advertising Agency last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 x 3 days).

Oct. 31

Salaries expense

1,200

Salaries payable

1,200

Illustration 3-20

SO 6 Prepare adjusting entries for accruals.

slide48

Adjusting Entries for “Accrued Expenses”

Summary

Illustration 3-21

SO 6 Prepare adjusting entries for accruals.

the adjusted trial balance
The Adjusted Trial Balance

After all adjusting entries are journalized and posted the company prepares another trial balance from the ledger accounts (Adjusted Trial Balance).

Its purpose is to prove the equality of debit balances and credit balances in the ledger.

SO 7 Describe the nature and purpose of an adjusted trial balance.

slide50

The Adjusted Trial Balance

Illustration 3-24

Adjusted trial balance

SO 7

slide51

The Adjusted Trial Balance

Review Question

Which of the following statements is incorrect concerning the adjusted trial balance?

  • An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made.
  • The adjusted trial balance provides the primary basis for the preparation of financial statements.
  • The adjusted trial balance lists the account balances segregated by assets and liabilities.
  • The adjusted trial balance is prepared after the adjusting entries have been journalized and posted.

Which of the following statements is incorrect concerning the adjusted trial balance?

  • An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made.
  • The adjusted trial balance provides the primary basis for the preparation of financial statements.
  • The adjusted trial balance lists the account balances segregated by assets and liabilities.
  • The adjusted trial balance is prepared after the adjusting entries have been journalized and posted.

SO 7 Describe the nature and purpose of an adjusted trial balance.

preparing financial statements
Preparing Financial Statements

Financial Statements are prepared directly from the Adjusted Trial Balance.

Balance Sheet

Income Statement

Retained Earnings Statement

SO 7 Describe the nature and purpose of an adjusted trial balance.

preparing financial statements53
Preparing Financial Statements

Illustration 3-25Preparation of the income

statement and retained earnings statement from the adjusted trial balance

SO 7

slide54

Preparing Financial Statements

Illustration 3-26

SO 7

slide55

Is Your Old Computer a Liability?

  • California adds $6 to $10 of sales tax to the cost of computers and televisions to fund recycling programs.
  • Each cathode ray tube (CRT) monitor contains 4–6 pounds of lead. Consumer electronic products account for about 40% of the lead found in landfills.
  • Environmental groups put a resolution on a recent Apple Computer’s shareholder meeting agenda requiring the company to study how it can increase recycling.
  • The average household has two to three old computers in its garage or storage area.
slide57

Should companies accrue for environmental cleanup costs as liabilities on their financial statements?

YES: As more states impose laws holding companies responsible, and as more courts levy pollution-related fines, it becomes increasingly likely that companies will have to pay large amounts in the future.

NO: The amounts still are too difficult to estimate. Putting inaccurate estimates on the financial statements reduces their usefulness. Instead, why not charge the costs later, when the actual environmental cleanup or disposal occurs, at which time the company knows the actual cost?

slide58

Alternative Treatment of Prepaid Expenses and Unearned Revenues

APPENDIX

  • Some companies use an alternative treatment for prepaid expenses and unearned revenues.
  • When a company prepays an expense, it debits that amount to an expense account.
  • When a company receives payment for future services, it credits the amount to a revenue account.

SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

slide59

Alternative Treatment for “Prepaid Expenses”

Illustration: Pioneer Advertising purchased supplies on October 5 for $2,500 and debited Advertising

Supplies Expense for the full amount. What if an inventory

of $1,000 of advertising supplies remains on October 31?

Oct. 31

Advertising supplies

1,000

Advertising supplies expense

1,000

Illustration 3A-1

SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

slide60

Alternative Treatment for “Prepaid Expenses”

Adjustment approaches—a comparison

Illustration 3A-2

SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

slide61

Alternative Treatment for “Unearned Revenues”

Illustration: Assume that Pioneer Advertising received $1,200 for future services on October 2 and credited the entire amount to Service Revenue. If at the statement date Pioneer has not performed $800 of the services, it would make an adjusting entry.

Oct. 31

Service revenue

800

Unearned service revenue

800

Illustration 3A-4

SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

slide62

Alternative Treatment for “Unearned Revenues”

Adjustment approaches—a comparison

Illustration 3A-5

SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

slide63

Summary of Additional Adjustment Relationships

Illustration 3A-7

SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

copyright
Copyright

“Copyright © 2010 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.”