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ACC 201-C Financial ing Professor Kiefer

Chapter 3 The Adjusting Process

ACC 201-C Financial ing Professor Kiefer

Chapter 3 The Adjusting Process

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Learning Objectives Differentiate between accrual and cash-basis ing Define and apply the ing period concept, revenue recognition and matching principles, and time period concept Explain why adjusting entries are needed Journalize and post adjusting entries

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Learning Objectives Explain the purpose of and prepare an adjusted trial balance Prepare the financial statements from the adjusted trial balance Understand the alternate treatment of unearned revenues and prepaid expenses (see Appendix 3A, located at myinglab.com)

1 Differentiate between accrual and cashbasis ing

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Accrual ing Versus Cash-Basis ing Accrual Basis

Cash Basis

Revenues recognized when earned

Revenues recognized when cash received

Expenses recognized when incurred

Expenses recorded when cash paid

Not GAAP

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Accrual vs. Cash-Basis: Revenue

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Accrual vs. Cash-Basis: Revenue Accrual basis revenue transactions

Cash-basis revenue transactions

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Accrual vs. Cash-Basis: Expenses

S3-2: COMPARING ACCRUAL AND CASH-BASIS ING

The Johnny Flowers Law Firm uses a client database. Suppose Johnny Flowers paid $2,900 for a computer. Requirements: 1. Describe how the business should for the $2,900 expenditure under a. the cash basis. Record expense

$2,900

b. the accrual basis. Record asset

$2,900

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S3-2: COMPARING ACCRUAL AND CASH-BASIS ING

2. State why the accrual basis is more realistic for this situation. The accrual basis is more realistic because the computer is an asset and it will benefit the business for more than one year. To record the cost of the computer as an expense is unrealistic.

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2 Define and apply the ing period concept, revenue, and matching principles

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ing Period Concept • Businesses prepare financial statements for specific periods to evaluate performance • Basic ing period = one year – Calendar year – Fiscal year

• Interim periods – Financial statements of less than one year • Monthly • Quarterly • Semi-annually

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Revenue Recognition Principle • When to record revenue? – When it is earned • When service is provided • When the product delivered • When the earnings process is complete

– Not when cash is received, cash method

• The amount of revenue to record? – Value of item or service transferred to customer

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Recording Revenue: The Revenue Recognition Principle

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The Matching Principle • Measure all expenses incurred during the period • Match the expenses against the revenues earned during the same period

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The Time-Period Concept • Requires that ing information be reported at regular intervals • s are updated at the end of each ing period

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Time-Period Concept On May 31, Smart Touch recorded salary expense of $900 that is owed to an employee at the end of the month.

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3 Explain why adjusting entries are needed

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Adjusting Entries

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Adjusting Entries • Prepared at end of an ing period • Assigns: – Revenues to the period when earned – Expenses to the period when incurred

• Update asset and liability s • Need to properly match revenues and expenses to measure: – Net income – Assets and Liabilities

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Adjusting Entry Rules

Never involve the cash

Either increase revenue or increase an expense

When worded as “accrued”, journalize the stated amount

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4 Journalize and post adjusting entries

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Types of Adjusting Entries Prepaid expenses

Depreciation

Accrued expenses

Accrued revenues

Unearned revenues

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Prepaid Expenses • Advance payments of expenses • Examples: – Rent – Insurance – Supplies

• Recorded as an asset • Adjusting entry records amount used as an expense

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Prepaid Expense: Rent

At May 31st, this amount is too high. One month has been used.

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Depreciation • Plant assets – Long-lived tangible assets used in business operations – Examples: • Land, buildings, equipment, and furniture

• Depreciation – Allocation of a plant asset’s cost to expense over its useful life • Land is not depreciated

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Depreciation Entry

Contra asset

Amount calculated based on depreciation method

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Accumulated Depreciation • Contra asset – Normal credit balance – Always paired with related

• Holds sum of all depreciation recorded on a plant asset • Book value: – Cost minus accumulated depreciation

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Depreciation Posting

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Accrued Expenses • Expenses incurred before payment is made – Results in a liability

• Opposite of a prepaid expense – Examples: • Salaries • Interest

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Accrued Expense Entries

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Accrued Revenues • Revenue earned before cash is received • Results in a receivable

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Unearned Revenue • Cash is collected before revenue is earned – Results in a liability – Owes a product or service or refund

• Also called deferred revenue

BEFORE

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Unearned Revenue Entries

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S3-5: IDENTIFYING TYPES OF ADJUSTING ENTRIES

• A select list of transactions for Anuradha’s Goals follows: Apr 1 Paid six months of rent, $4,800. Prepaid expense 10 Received $1,200 from customer for six-month service contract that began April 1. Unearned revenues 15 Purchased computer for $1,000. Depreciation Requirement: 1. For each transaction, identify what type of adjusting entry would be needed.

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S3-5: IDENTIFYING TYPES OF ADJUSTING ENTRIES

• A select list of transactions for Anuradha’s Goals follows: Apr 18 Purchased $300 of office supplies on Prepaid expense . Accrued 30 Work performed but revenues not yet billed to customer, $500. Accrued expenses 30 Employees earned $600 in salary that will be paid May 2.

E3-22: JOURNALIZING ADJUSTING ENTRIES AND ANALYZING THEIR EFFECT ON THE INCOME STATEMENT

The following data at January 31, 2012 is given for EBM, Inc.

a. Depreciation, $500 b. Prepaid rent expired, $600 c. Interest expense accrued, $300

d. Employee salaries owed for Monday through Thursday of a five-day workweek; weekly payroll, $13,000 e. Unearned service revenue earned, $1,300

Requirement: 1. Journalize the adjusting entries needed on January 31, 2012.

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E3-22: JOURNALIZING ADJUSTING ENTRIES AND ANALYZING THEIR EFFECT ON THE INCOME STATEMENT Journal S AND POST. DATE EXPLANATIONS REF. DEBIT CREDIT 2013 Adjusting Entries Jan 31 Depreciation expense 500 a. Accumulated depreciation 500 b.

c.

d.

e.

31 Rent expense Prepaid rent

600

31 Interest expense Interest payable

300

31 Salary expense Salary payable 31 Unearned service revenue Service revenue

600

300 10,400

10,400 1,300 1,300

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E3-22: JOURNALIZING ADJUSTING ENTRIES AND ANALYZING THEIR EFFECT ON THE INCOME STATEMENT

2. Suppose the adjustments made in Requirement 1 were not made. Compute the overall overstatement or understatement of net income as a result of the omission of these adjustments. Net income would be overstated by $10,500.

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Summary of Adjusting Entries • To properly measure net income for the period – The entry affects a revenue or an expense

• To update the balance sheet – The entry affects an asset or a liability

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Adjusted Trial Balance • Prepared after adjusting entries are posted • Useful step in preparing financial statements • Often appears on a work sheet – Tool ants use at end of period

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S3-10: PREPARING AN ADJUSTED TRIAL BALANCE

a) 600

$ 800 300 19,100

$ 2,000 200 600 2,500 7,400 14,800

b)1,000 c) 600

4,500 600 1,000 1,200

a) 600 b)1,000 c) 600

$2,200

$2,200

$27,500

______ $27,500 46

6 Prepare the financial statements from the adjusted trial balance

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The Balance Sheet is prepared last. A=L+E

Statement of Owner’s Equity is second

Income Statement is prepared first. Revenue - Expenses

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Income Statement

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Statement of Retained Earnings

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Balance Sheet

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S3-10: PREPARING AN INCOME STATEMENT Refer to the data in Short Exercise 3-10. Famous Cut Hair Stylists Income Statement Year Ended December 31, 2012 Revenue: Service revenue Expenses: Rent expense Interest expense Depreciation expense Supplies expense Total expenses Net income

$

$

14,800

$

7,300 7,500

4,500 1,200 1,000 600

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FOR 3-27: PREPARING A STATEMENT OF OWNER’S EQUITY (ADDITIONAL STEP)

Famous Cut Hair Stylists Statement of Owner’s Equity

Year Ended December 31, 2012 Fabio, capital, December 31, 2011

$ 7,400

Net income

7,500 14,900

Drawing Fabio, capital, December 31, 2012

0 $

14,900

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S3-12: PREPARING A BALANCE SHEET Compute Famous Cut’s total assets at December 31, 2012. Famous Cut Hair Stylists Balance Sheet December 31, 2012 ASSETS LIABILITIES Cash $ 800 s payable $ 200 Supplies 300 Interest payable 600 Equipment $19,100 Notes payable 2,500 Accu. Depr. (2,000) 17,100 Total liabilities 3,300 OWNER’ S EQUITY Fabio, capital $ 14,900 Total assets

$18,200

Total liabilities and owner’s equity

$18,200

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7 Understand the alternate treatment of unearned revenues and prepaid expenses (see Appendix 3A, located at myinglab.com)

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Alternative Treatment of Prepaid Expenses • Prepaid Expenses (normally) – Advance payments of expenses – Debit an asset – Adjust at end of period

• Alternative – Debit an expense – Adjust at end of period

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Prepaid Expense Initially debit and expense

Adjust at end of period for unused amount

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Unearned (Deferred) Revenues • Unearned Revenues (normally) – Advance receipt of revenues–creates liability – Credit a liability – Adjust at end of period

• Alternative – Credit a revenue – Adjust at end of period

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Unearned (Deferred) Revenues • Initially credit a revenue

Adjust at end of period for unearned amount

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Chapter 3 Summary

• Cash-basis ing and accrual ing are different. Accrual ing records revenues and expenses when they are earned/incurred. Cash-basis ing records revenues and expenses when cash is received or paid. • The principles guide us as to when (the time period and ing period concepts) and how (the revenue recognition and matching principles) to record revenues and expenses.

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Chapter 3 Summary

• We adjust s to make sure the balance sheet shows the value of what we own (assets) and what we owe (liabilities) on a specific date. We also adjust to make sure all revenues and expenses are recorded in the period they are earned or incurred. Adjusting journal entries either credit a revenue or debit an expense , but they NEVER affect the Cash .

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Chapter 3 Summary

• The adjusted trial balance includes all the transactions captured during the period on the trial balance plus/minus any adjusting journal entries made at the end of the period. The adjusted trial balance gives us the final adjusted values that we use to prepare the financial statements.

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Chapter 3 Summary

• The financial statements must be prepared in order: 1. income statement 2. statement of retained earnings 3. balance sheet, third.

• It is important for ants to prepare accurate and complete financial statements as other people rely on the data to make decisions.