Adjusting the Accounts Chapter 3 PDF

CHAPTER Adjusting the Accounts LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Explain the time period assumption. 2. Explain the accrual basis of accounting. 3. Explain the reasons for adjusting entries. 4. Identi...

CHAPTER Adjusting the Accounts LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Explain the time period assumption. 2. Explain the accrual basis of accounting. 3. Explain the reasons for adjusting entries. 4. Identify the major types of adjusting entries. 5. Prepare adjusting entries for deferrals. 6. Prepare adjusting entries for accruals. 7. Describe the nature and purpose of an adjusted trial balance. 3-1  Timing Issues Learning Objective 1 Accountants divide the economic life of Explain the time period a business into artificial time periods assumption. (Time Period Assumption)...... Jan. Feb. Mar. Apr. Dec.  Accounting time periods are generally a month, a quarter, or a year.  Also known as the “Periodicity Assumption” 3-2 LO 1  Fiscal and Calendar Years  Monthly and quarterly time periods are called interim periods.  Most large companies must prepare both quarterly and annual financial statements.  Fiscal Year = Accounting time period that is one year in length.  Calendar Year = January 1 to December 31. 3-3 LO 1  Accrual- versus Cash-Basis Accounting Learning Accrual-Basis Accounting Objective 2 Explain the accrual basis of  Transactions recorded in the periods in accounting. which the events occur.  Revenue recognition and expense recognition principles are used.  Companies recognize revenues when they perform services (rather than when they receive cash).  Expenses are recognized when incurred (rather than when paid). 3-4 LO 2  Accrual- versus Cash-Basis Accounting Cash-Basis Accounting  Revenues are recorded when cash is received.  Expenses are recorded when cash is paid.  Cash-basis accounting is not in accordance with International Financial Reporting Standards (IFRS). 3-5 LO 2  Recognizing Revenues and Expenses REVENUE RECOGNITION PRINCIPLE Recognize revenue in the accounting period in which the performance obligation is satisfied. 3-6 LO 2  Recognizing Revenues and Expenses EXPENSE RECOGNITION PRINCIPLE Match expenses with revenues in the period when the company makes efforts (expenses) to generate those revenues. “Let the expenses follow the revenues.” 3-7 LO 2  Illustration 3-1 IFRS relationships in revenue and expense recognition 3-8 LO 2  The Basics of Adjusting Entries Learning Adjusting Entries Objective 3 Explain the reasons for adjusting  Ensure that the revenue recognition and entries. expense recognition principles are followed.  Necessary because the trial balance may not contain up-to-date and complete data.  Required every time a company prepares financial statements.  Will include one income statement account and one statement of financial position account. 3-9 LO 3  Adjusting Entries Question 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 services are performed. c. statement of financial position and income statement accounts have correct balances at the end of an accounting period. d. All the responses above are correct. 3-10 LO 3  Types of Adjusting Entries Learning Objective 4 Identify the major types of adjusting entries. Deferrals Accruals 1. Prepaid Expenses. 1. Accrued Revenues. Expenses paid in cash Revenues for services before they are used or performed but not yet consumed. received in cash or recorded. 2. Unearned Revenues. 2. Accrued Expenses. Cash received before Expenses incurred but not services are performed. yet paid in cash or recorded. Illustration 3-2 Categories of adjusting entries 3-11 LO 4  Illustration 3-3 Trial balance Each account is analyzed to determine whether it is complete and up-to-date for financial statement purposes. 3-12 LO 4  Adjusting Entries for Deferrals Learning Deferrals are expenses or revenues that are Objective 5 Prepare adjusting recognized at a date later than the point when entries for deferrals. cash was originally exchanged. There are two types:  Prepaid expenses and  Unearned revenues. 3-13 LO 5  PREPAID EXPENSES Payments of expenses that will benefit more than one accounting period. Cash Payment BEFORE Expense Recorded Prepayments often occur in regard to:  insurance  rent  supplies  buildings and equipment  advertising 3-14 LO 5  PREPAID EXPENSES  Expire either with the passage of time or through use.  Adjusting entry: ► Increase (debit) to an expense account and ► Decrease (credit) to an asset account. Illustration 3-4 Adjusting entries for prepaid expenses 3-15 LO 5  PREPAID EXPENSES Illustration: Yazici Advertising Inc. Inc. purchased supplies costing ₺2,500 on October 5. Yazici recorded the purchase by increasing (debiting) the asset 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 Supplies Expense 1,500 Supplies 1,500 3-16 LO 5 Illustration 3-5 Adjustment for supplies 3-17 LO 5  PREPAID EXPENSES Illustration: On October 4, Yazici Advertising Inc. paid ₺600 for a one-year fire insurance policy. Coverage began on October 1. Yazici 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 3-18 LO 5 Illustration 3-6 Adjustment for insurance 3-19 LO 5  PREPAID EXPENSES DEPRECIATION  Buildings, equipment, and motor vehicles (assets that provide service for many years) are recorded as assets, rather than an expense, on the date acquired.  Depreciation is the process of allocating the cost of an asset to expense over its useful life.  Depreciation does not attempt to report the actual change in the value of the asset. 3-20 LO 5  PREPAID EXPENSES Illustration: For Yazici Advertising, assume that depreciation on the equipment is ₺480 a year, or ₺40 per month. Oct. 31 Depreciation Expense 40 Accumulated Depreciation 40 Accumulated Depreciation is called a contra asset account. HELPFUL HINT All contra accounts have increases, decreases, and normal balances opposite to the account to which they relate. 3-21 LO 5  Illustration 3-7 3-22 Adjustment for depreciation LO 5  PREPAID EXPENSES Statement Presentation  Accumulated Depreciation is a contra asset account (credit).  Appears just after the account it offsets (Equipment) on the balance sheet.  Book value is the difference between the cost of any depreciable asset and its accumulated depreciation. Illustration 3-8 3-23 Statement of financial position presentation of accumulated depreciation LO 5  PREPAID EXPENSES Illustration 3-9 Accounting for prepaid expenses 3-24 LO 5  UNEARNED REVENUES Receipt of cash that is recorded as a liability because the service has not been performed. Cash Receipt BEFORE Revenue Recorded Unearned revenues often occur in regard to:  Rent  Magazine subscriptions  Airline tickets  Customer deposits 3-25 LO 5  UNEARNED REVENUES  Adjusting entry is made to record the revenue for services performed during the period and to show the liability that remains at the end of the accounting period.  Results in a decrease (debit) to a liability account and an increase (credit) to a revenue account. Illustration 3-10 Adjusting entries for unearned revenues 3-26 LO 5  UNEARNED REVENUES Illustration: Yazici Advertising Inc. 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 performed ₺400 of services in October. Oct. 31 Unearned Service Revenue 400 Service Revenue 400 3-27 LO 5  Illustration 3-11 Service revenue accounts after adjustment 3-28 LO 5  UNEARNED REVENUES Illustration 3-12 Accounting for unearned revenues 3-29 LO 5  > DO IT! The ledger of Zhu Company on March 31, 2017, includes these selected accounts before adjusting entries are prepared. (amounts in thousands) Debit Credit Prepaid Insurance ¥ 3,600 Supplies 2,800 Equipment 25,000 Accumulated Depreciation—Equipment ¥ 5,000 Unearned Service Revenue 9,200 An analysis of the accounts shows the following. 1. Insurance expires at the rate of ¥100 per month. 2. Supplies on hand total ¥800. 3. The equipment depreciates ¥200 a month. 4. One-half of the unearned service revenue was performed in March. Prepare the adjusting entries for the month of March. 3-30 LO 5  > DO IT! The ledger of Zhu Company on March 31, 2017, includes these selected accounts before adjusting entries are prepared. (amounts in thousands) Debit Credit Prepaid Insurance ¥ 3,600 Supplies 2,800 Equipment 25,000 Accumulated Depreciation—Equipment ¥ 5,000 Unearned Service Revenue 9,200 Prepare the adjusting entries for the month of March. 1. Insurance expires at the rate of ¥100 per month. Insurance Expense 100 Prepaid Insurance 100 3-31 LO 5  > DO IT! The ledger of Zhu Company on March 31, 2017, includes these selected accounts before adjusting entries are prepared. (amounts in thousands) Debit Credit Prepaid Insurance ¥ 3,600 Supplies 2,800 Equipment 25,000 Accumulated Depreciation—Equipment ¥ 5,000 Unearned Service Revenue 9,200 Prepare the adjusting entries for the month of March. 2. Supplies on hand total ¥800. Supplies Expense 2,000 Supplies 2,000 3-32 LO 5  > DO IT! The ledger of Zhu Company on March 31, 2017, includes these selected accounts before adjusting entries are prepared. (amounts in thousands) Debit Credit Prepaid Insurance ¥ 3,600 Supplies 2,800 Equipment 25,000 Accumulated Depreciation—Equipment ¥ 5,000 Unearned Service Revenue 9,200 Prepare the adjusting entries for the month of March. 3. The equipment depreciates ¥200 a month. Depreciation Expense 200 Accumulated Depreciation—Equipment 200 3-33 LO 5  > DO IT! The ledger of Zhu Company on March 31, 2017, includes these selected accounts before adjusting entries are prepared. (amounts in thousands) Debit Credit Prepaid Insurance ¥ 3,600 Supplies 2,800 Equipment 25,000 Accumulated Depreciation—Equipment ¥ 5,000 Unearned Service Revenue 9,200 Prepare the adjusting entries for the month of March. 4. One-half of the unearned service revenue was performed in March. Unearned Service Revenue 4,600 Service Revenue 4,600 3-34 LO 5  Adjusting Entries for Accruals Learning Accruals are made to record Objective 6 Prepare adjusting entries for accruals.  Revenues for services performed but not yet recorded at the statement date (accrued revenues). OR  Expenses incurred but not yet paid or recorded at the statement date (accrued expenses). 3-35 LO 6  ACCRUED REVENUES Revenues for services performed but not yet received in cash or recorded. Revenue Recorded BEFORE Cash Receipt Accrued revenues often occur in regard to:  Rent  Services performed  Interest 3-36 LO 6  ACCRUED REVENUES  Adjusting entry records the receivable that exists and records the revenues for services performed.  Adjusting entry: ► Increases (debits) an asset account and ► Increases (credits) a revenue account. Illustration 3-13 Adjusting entries for accrued revenues 3-37 LO 6  ACCRUED REVENUES Illustration: In October, Yazici Advertising Inc. performed services worth ₺200 that were not billed to clients in October. Oct. 31 Accounts Receivable 200 Service Revenue 200 On November 10, Yazici receives cash of ₺200 for the services performed. Nov. 10 Cash 200 Accounts Receivable 200 3-38 LO 6  Illustration 3-14 Adjustment for accrued revenue 3-39 LO 6  ACCRUED REVENUES Illustration 3-15 Accounting for accrued revenues 3-40 LO 6  ACCRUED EXPENSES Expenses incurred but not yet paid in cash or recorded. Expense Recorded BEFORE Cash Payment Accrued expenses often occur in regard to:  Interest  Taxes  Salaries 3-41 LO 6  ACCRUED EXPENSES  Adjusting entry records the obligation and recognizes the expense.  Adjusting entry: ► Increase (debit) an expense account and ► Increase (credit) a liability account. Illustration 3-16 Adjusting entries for accrued expenses 3-42 LO 6  ACCRUED INTEREST Illustration: Yazici Advertising Inc. signed a three-month note payable in the amount of ₺5,000 on October 1. The note requires Yazici to pay interest at an annual rate of 12%. Illustration 3-17 Formula for computing interest Oct. 31 Interest Expense 50 Interest Payable 50 3-43 LO 6  Illustration 3-18 Adjustment for accrued interest 3-44 LO 6  ACCRUED SALARIES AND WAGES Illustration: Yazici paid salaries and wages 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 Calendar showing Yazici’s pay periods 3-45 LO 6  Illustration 3-20 Adjustment for accrued salaries and wages 3-46 LO 6  ACCRUED EXPENSES Illustration 3-21 Accounting for accrued expenses 3-47 LO 6  > DO IT! Micro Computer Services began operations on August 1, 2017. At the end of August 2017, management prepares monthly financial statements. The following information relates to August. 1. At August 31, the company owed its employees ¥8,000 in salaries and wages that will be paid on September 1. 2. On August 1, the company borrowed ¥300,000 from a local bank on a 15-year mortgage. The annual interest rate is 10%. 3. Revenue for services performed but unrecorded for August totaled ¥11,000. Prepare the adjusting entries needed at August 31, 2017. 3-48 LO 6  > DO IT! Prepare the adjusting entries needed at August 31, 2017. 1. At August 31, the company owed its employees ¥8,000 in salaries and wages that will be paid on September 1. Salaries and Wages Expense 8,000 Salaries and Wages Payable 8,000 2. On August 1, the company borrowed ¥300,000 from a local bank on a 15-year mortgage. The annual interest rate is 10%. Interest Expense 2,500 Interest Payable 2,500 3. Revenue for services performed but unrecorded for August totaled ¥11,000. Accounts Receivable 11,000 Service Revenue 11,000 3-49 LO 6  Summary of Basic Relationships Illustration 3-22 Summary of adjusting entries 3-50 LO 6 3-51  The Adjusted Trial Balance and Financial Statements Learning Preparing the Adjusted Trial Balance Objective 7 Describe the nature and  Prepared after all adjusting entries are purpose of an adjusted trial journalized and posted. balance.  Purpose is to prove the equality of debit balances and credit balances in the ledger.  Is the primary basis for the preparation of financial statements. 3-52 LO 7  Illustration 3-25 3-53 Adjusted trial balance LO 7  Preparing Financial Statements Financial Statements are prepared directly from the Adjusted Trial Balance. Retained Statement of Income Earnings Financial Statement Statement Position 3-54 LO 7  Illustration 3-26 Preparation of the income statement and retained earnings statement from the adjusted trial balance 3-55 LO 7  Illustration 3-27 Preparation of the statement of financial position from the adjusted trial balance 3-56 LO 7  > DO IT! 3-57 LO 7  > DO IT! (a) Determine the net income for the quarter April 1 to June 30. 3-58 LO 7  > DO IT! (b) Determine the total assets and total liabilities at June 30, 2017, for Skolnick Co. 3-59 LO 7  > DO IT! (c) Determine the amount that appears for retained earnings at June 30, 2017. 3-60 LO 7