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  1. Accounting Principles Adjusting Entries: Accruals

  2. TIME-PERIOD ASSUMPTION • Thetime period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods. • Accounting time periods are generally a month, a quarter, or a year. • The accounting time period of one year in length is referred to as afiscal year.

  3. ACCRUAL BASIS OF ACCOUNTING • The revenue recognition and matching principles are used under the accrual basis of accounting. • Under cash basis accounting, revenue is recorded when cash is received, and expenses are recorded when cash is paid. • Generally accepted accounting principles require accrual basis accounting because the cash basis often causes misleading financial statements.

  4. REVENUE RECOGNITION PRINCIPLE • The revenue recognition principle dictates that revenue be recognized in the accounting period in which it is earned. • In a service business, revenue is considered to be earned at the time the service is performed.

  5. THE MATCHING PRINCIPLE • The practice of expense recognition is referred to as the matching principle. • Thematching principle dictates that efforts (expenses) be matched with accomplishments (revenues). Revenues earned this month expenses incurred in earning the revenue are offset against....

  6. Time-Period Assumption Economic life of business can be divided into artificial time periods Revenue-Recognition Principle Matching Principle Revenue recognized in the accounting period in which it is earned Expenses matched with revenues in the same period when efforts are expended to generate revenues ILLUSTRATION 3-1 GAAP RELATIONSHIPS IN REVENUE AND EXPENSE RECOGNITION

  7. STUDY OBJECTIVE 3 Explain why adjusting entries are needed.

  8. ADJUSTING ENTRIES Adjusting entries are made in order for: 1 Revenues to be recorded in the period in which they are earned, and for...... 2 Expenses to be recognized in the period in which they are incurred.

  9. STUDY OBJECTIVE 4 Identify the major types of adjusting entries.

  10. ADJUSTING ENTRIES • Adjusting entries are required each time financial statements are prepared. • Adjusting entries can be classified as 1prepayments (prepaid expenses or unearned revenues) OR 2accruals (accruedrevenues or accruedexpenses)

  11. TYPES OF ADJUSTING ENTRIES Prepayments 1Prepaid Expenses — Expenses paid in cash and recorded as assets before they are used or consumed 2 Unearned Revenues — cash received and recorded as liabilities before revenue is earned

  12. TYPES OF ADJUSTING ENTRIES Accruals 1Accrued Revenues — Revenues earned but not yet received in cash or recorded 2Accrued Expenses — Expenses incurred but not yet paid in cash or recorded

  13. ILLUSTRATION 3-3 TRIAL BALANCE The Trial Balance is the starting place for adjusting entries.

  14. STUDY OBJECTIVE 6 Prepare adjusting entries for accruals.

  15. ACCRUALS • The second category of adjusting entries 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.

  16. Adjusting Entries Accrued Revenues Asset Revenue Debit Adjusting Entry (+) Credit Adjusting Entry (+) Accrued Expenses Expense Liability Debit Adjusting Entry (+) Credit Adjusting Entry (+) ILLUSTRATION 3-10ADJUSTING ENTRIES FOR ACCRUALS

  17. 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.

  18. ADJUSTING ENTRIES FOR ACCRUALS ACCRUED REVENUES ADJUSTMENT October 31, the agency earned $200 for advertising services that were not billed to clients before October 31. JOURNAL ENTRY POSTING

  19. ACCRUED EXPENSES • Accrued expenses are expenses incurred but not paid yet. • 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

  20. ADJUSTING ENTRIES FOR ACCRUALS ACCRUED INTEREST ADJUSTMENT October 31, the portion of the interest to be accrued on a 3-month note payable is calculated to be $50. JOURNAL ENTRY POSTING

  21. ADJUSTING ENTRIES FOR ACCRUALS ACCRUED SALARIES ADJUSTMENT October 31, accrued salaries are calculated to be $1,200. JOURNAL ENTRY POSTING

  22. ILLUSTRATION 3-16SUMMARY 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

  23. STUDY OBJECTIVE 7 Describe the nature and purpose of an adjusted trial balance.

  24. ADJUSTED TRIAL BALANCE • An Adjusted Trial Balance is prepared after all adjusting entries have been journalized and posted. • Its purpose is to prove 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.

  25. ILLUSTRATION 3-19 TRIAL BALANCE AND ADJUSTED TRIAL BALANCE COMPARED

  26. PREPARING FINANCIAL STATEMENTS Financial statements can be prepared directly from the adjusted trial balance. 1 The income statement is prepared from the revenue and expense accounts. 2 The owner’s equity statement is derived from the owner’s capital and drawing accounts and the net income (or net loss) from 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 owner’s equity statement.

  27. ILLUSTRATION 3-20 PREPARATION OF THE INCOME STATEMENT AND THE OWNER’S EQUITY STATEMENT FROM THE ADJUSTED TRIAL BALANCE

  28. ILLUSTRATION 3-20 PREPARATION OF THE INCOME STATEMENT AND THE OWNER’S EQUITY STATEMENT FROM THE ADJUSTED TRIAL BALANCE The income statement is prepared from the revenue and expense accounts.

  29. ILLUSTRATION 3-20 PREPARATION OF THE INCOME STATEMENT AND THE OWNER’S EQUITY STATEMENT FROM THE ADJUSTED TRIAL BALANCE

  30. ILLUSTRATION 3-20 PREPARATION OF THE INCOME STATEMENT AND THE OWNER’S EQUITY STATEMENT FROM THE ADJUSTED TRIAL BALANCE The owner’s equity statement is prepared from the owner’s capital and drawing accounts and the net income (or net loss) shown in the income statement.

  31. ILLUSTRATION 3-21 PREPARATION OF THE BALANCE SHEET FROM THE ADJUSTED TRIAL BALANCE

  32. ILLUSTRATION 3-21 PREPARATION OF THE BALANCE SHEET FROM THE ADJUSTED TRIAL BALANCE The balance sheet is then prepared from the asset and liability accounts and the ending owner’s capital balance as reported in the owner’s equity statement.

  33. STUDY OBJECTIVE 8 Prepare adjusting entries for the alternative treatment of prepayments.

  34. ALTERNATIVE TREATMENTOF PREPAID EXPENSES AND UNEARNED REVENUES • Some businesses use an alternative treatment for prepaids and unearned revenues. • Instead of debiting an asset at the time an expense is prepaid, the amount is charged to an expense account. • Instead of crediting a liability at the time cash is received in advance of earning it, the amount is credited to a revenue account. • This treatment of prepaid expenses and unearned revenues will ultimately result in the same effect on the financial statements as initial entries to balance sheet accounts and then adjusting entries.

  35. ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS SUPPLIES ADJUSTMENT October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand. JOURNAL ENTRY POSTING

  36. ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS UNEARNED REVENUES ADJUSTMENT October 31, analysis reveals that, of $1,200 in fees, $400 has been earned in October. JOURNAL ENTRY POSTING

  37. ILLUSTRATION 3A-7SUMMARY OF BASIC RELATIONSHIPS FOR PREPAYMENTS 1 Prepaid Assets and a Prepaid expenses Assets overstated DrExpenses Expenses Expenses initially recorded in Expenses understated Cr Assets asset accounts have been used. b Prepaid expenses Assets understated DrAssets initially recorded in Expenses overstated Cr Expenses expense accounts have not been used. 2 Unearned Liabilities and a Unearned revenues Liabilities overstated Dr Liabilities Revenues Revenues initially recorded in Revenues understated Cr Revenues liability accounts have been earned. b Unearned revenues Liabilities understated Dr Revenues initially recorded in Revenues overstated Cr Liabilities revenue accounts have not been earned.

  38. Many companies immediately charge the cost of immaterial items to expense. Lightbulbs Supplies The Concept of Materiality An item is “material” if knowledge of the item might reasonably influence the decisions of users of financial statements.

  39. Effects of the Adjusting Entries Make end-of-year adjustments. Journalize transactions. Post entries to the ledger accounts. Prepare trial balance. Let’s look at JJ’s Lawn Care Services’ adjusted trial balance. Prepare adjusted trial balance.