After studying this chapter, you should be able to:

1. CHAPTER 3ADJUSTING THE ACCOUNTS After studying this chapter, you should be able to: 1 Explain the time period assumption. 2 Explain the accrual basis of accounting. 3 Explain why adjusting entries are needed. 4 Identify the major types of adjusting entries. 5 Prepare adjusting entries for prepayments. 6 Prepare adjusting entries for accruals. 7Describe the nature and purpose of an adjusted trial balance.

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. 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.

8. 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)

9. 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

10. 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

11. 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.

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

13. 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. • Anasset-expense account relationship exists with prepaid expenses.

14. 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, insurance, and depreciation.

15. ADJUSTING ENTRIES 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

16. ADJUSTING ENTRIES FOR PREPAYMENTS INSURANCE ADJUSTMENT October 31, an analysis of the policy reveals that $50 of insurance expires each month. JOURNAL ENTRY POSTING

17. DEPRECIATION • Depreciation is the allocation of the cost of an asset to expense over its useful life in a rational and systematic manner. • The purchase of equipment or a building is viewed as a long-term prepayment of services and, therefore, is allocated in the same manner as other prepaid expenses.

18. XXX XXX DEPRECIATION • Depreciation is an estimate rather than a factual measurement of the cost that has expired. • In recording depreciation, Depreciation Expenseis debited and a contra asset account, Accumulated Depreciation, is credited

19. DEPRECIATION • In the balance sheet, Accumulated Depreciation is offset against the asset account. • The difference between the cost of any depreciable asset and its related accumulated depreciation is referred to as the book value of the asset.

20. ADJUSTING ENTRIES FOR PREPAYMENTS DEPRECIATION ADJUSTMENT October 31, depreciation on the office equipment is estimated to be $480 a year, or $40 per month. JOURNAL ENTRY POSTING

21. UNEARNED REVENUES • Unearned revenues are revenues received and recorded as liabilities before they are earned. • Unearned revenues are subsequently earned by rendering a service to a customer. • A liability-revenueaccount relationship exists with unearned revenues.

22. 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, and customer deposits for future services.

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

24. 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.

25. 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

26. 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.

27. 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

28. 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

29. 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

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

31. 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

32. 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.

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

34. 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.

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

36. 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.

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

38. 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.

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

40. 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.