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CHAPTER 3

ADJUSTMENTS FOR FINANCIAL REPORTING

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Income Statement
Revenues recognized as cash is received.
Expenses recognized as cash is paid. Not considered GAAP.

Revenues recognized as they are earned.

Expenses recognized as they are incurred. Mandated by GAAP.

Cash-Basis Accounting

vs.

Accrual Basis Accounting

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Matching - The Most Important Accounting Principle

l

Matching Principle
u

Expenses should be recognized in the same accounting period as are the revenues they generated. (i.e., match revenues and expenses.)

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Matching - The Most Important Accounting Principle

l

Matching Principle
u

Expenses should be recognized in the same accounting period as are the revenues they generated. (i.e., match revenues and expenses.)
1998 Revenues Expenses Net Income 1999 XXX - XX X 2000

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Matching - The Most Important Accounting Principle

l

Matching Principle
u

Expenses should be recognized in the same accounting period as are the revenues they generated. (i.e., match revenues and expenses.)
1998 Revenues Expenses Net Income 1999 XXX - XX X 2000

The Matching Principle is the reason for using the accrual basis of accounting.

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The Need for Adjusting Entries

l

Journal entries are made at the end of each accounting period to bring about a proper matching of revenues and expenses

Economic events (i.e., transactions) have been ongoing but never recorded.
Why not?

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The Need for Adjusting Entries

l

Journal entries are made at the end of each accounting period to bring about a proper matching of revenues and expenses

Economic events (i.e., transactions) have been ongoing but never recorded.
Why not?

Examples?

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The Need for Adjusting Entries

Revenue Example

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The Need for Adjusting Entries

Revenue Example
1/1/98 12/31/98 1/1/99 6/30/98 6/30/99 12/31/99

When the time necessary to earn a revenue extends into the next period . . .

12-Month Magazine Subscription

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The Need for Adjusting Entries

Revenue Example
1/1/98 12/31/98 1/1/99 6/30/98 6/30/99 12/31/99

When the time necessary to earn a revenue extends into the next period . . .

12-Month Magazine Subscription

. . . the adjusting process allows us to separate 1998 subscription revenue from from 1999 subscription revenue ...

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The Need for Adjusting Entries

Revenue Example
1/1/98 12/31/98 1/1/99 6/30/98 6/30/99 12/31/99

When the time necessary to earn a revenue extends into the next period . . .

12-Month Magazine Subscription

. . . the adjusting process allows us to separate 1998 subscription revenue from from 1999 subscription revenue as shown.

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The Need for Adjusting Entries

Expense Example
1/1/98 12/31/98 1/1/99 6/30/98 6/30/99 12/31/99

12-Month Real Estate Tax

Remember, we can also use adjustments to help us match expenses with revenues by making adjusting entries to put expenses in the same period as the related revenues.

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Adjusting Journal Entries (AJEs)

AJEs use the same recording format as regular journal entries.
GENERAL JOURNAL
Page:

Date

Description

PR

Debit

Credit

M/DD Account Name Account Name journal entry explanation

### ###

$$$ $$$

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Types of Adjusting Entries 104 Who Deferrals cares?

Entries involving transfer of amounts previously recorded in asset and liability accounts to expense and revenue accounts, respectively

Accruals
Entries involving the initial, or first, recording of assets and liabilities and their related revenues and expenses

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Prepaid Expenses
An asset awaiting assignment to an expense.
Prepaid Expense (debit)
Journal entry when payment is made. Cash (credit)

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Prepaid Expenses
An asset awaiting assignment to an expense.
Prepaid Expense (debit)
Journal entry when payment is made. Cash (credit) The prepaid expense is consumed during the period.

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Prepaid Expenses
An asset awaiting assignment to an expense.
Prepaid Expense (debit)
Journal entry when payment is made. Cash (credit) The prepaid expense is consumed during the period.

Prepaid Expense (credit)

AJE at end of period

Expense (debit)

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Prepaid Expenses
Example
On September 1, 1998, Bobs Bait Shop prepaid its rent for the next twelve months. Rent is $200 per month.
GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

Prepare the proper initial journal entry.

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Prepaid Expenses
Example
On September 1, 1998, Bobs Bait Shop prepaid its rent for the next twelve months. Rent is $200 per month.
GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

1-Sep Prepaid Rent Cash to record prepayment of twelve months of rent

2,400 2,400

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Prepaid Expenses
Example
Bobs fiscal year-end is December 31. Record the adjustment necessary on December 31 for the prepaid rent.
GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

Prepare the proper adjusting journal entry.

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Prepaid Expenses
Example
Bobs fiscal year-end is December 31. Record the adjustment necessary on December 31 for the prepaid rent.
GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

31-Dec Rent Expense Prepaid Rent to record recognition of four months of rent expense $200 x 4 months = $800

800 800

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Prepaid Expenses
Other Examples
Prepaid Insurance
Premiums are paid in advance.

Prepaid Subscriptions
Magazine and newspaper subscriptions are always paid in advance.

Supplies on Hand
Supplies are charged to expense periodically.

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Prepaid Expenses
Supplies on Hand
Blank paper used in a copier is a great example of how supplies on hand transform from being an asset to becoming an expenses.

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Accounting Estimates
Some assets are not fully used up in a single fiscal period.
A truck may last five years, but its value as a resource declines with time and usage.

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Accounting Estimates
Some assets are not fully used up in a single fiscal period.
A truck may last five years, but its value as a resource declines with time and usage.

Assets that benefit more than one year are called long-term or fixed assets.

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Accounting Estimates
The portion of an assets utility that is used up must be expensed in the period used.
Fixed Asset (debit)
Journal entry when payment is made. Cash (credit)

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Accounting Estimates
The portion of an assets utility that is used up must be expensed in the period used.
Fixed Asset (debit)
Journal entry when payment is made. Cash (credit) The assets usefulness is partially consumed during the period.

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Accounting Estimates
The portion of an assets utility that is used up must be expensed in the period used.
Fixed Asset (debit)
Journal entry when payment is made. Cash (credit) The assets usefulness is partially consumed during the period.

Accumulated Depreciation (credit)

Depreciation Expense (debit)

AJE at end of period

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Accounting Estimates
The portion of an assets utility that is used up must be expensed in the period used.
This is called a contra-asset account and has a credit balance. Accumulated Depreciation (credit)

Depreciation Expense (debit)

AJE at end of period

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Accounting Estimates
The portion of an assets utility that is used up must be expensed in the period used.
This is called a contra-asset account and has a credit balance. Accumulated Depreciation (credit)

Balance Sheet Presentation Asset (at cost) $40,000 Less: Accumulated Depr. 5,000 Book Value $35,000

Depreciation Expense (debit)

AJE at end of period

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Accounting Estimates
Definition of Book Value Asset cost - Accumulated Depreciation

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Accounting Estimates
Book Value = $35,000 Truck Bal. 40,000 Accumulated Depn - Truck 5,000 Bal.

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Accounting Estimates
Example
On 12/31/97, Putnam Plumbing, recorded $2,000 of Depreciation Expense on a $10,000 truck.
GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

Prepare the proper adjusting journal entry.

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Accounting Estimates
Example
On 12/31/97, Putnam Plumbing, recorded $2,000 of Depreciation Expense on a $10,000 truck.
GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

31-Dec Depreciation Expense Accumulated Depreciation to record depreciation expense on truck for the year

2,000 2,000

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Unearned Revenues
Assets that have been received, but have not yet been earned.
Unearned Revenue (credit)
Journal entry when payment is received. Cash (debit)

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Unearned Revenues
Assets that have been received, but have not yet been earned.
Unearned Revenue (credit)
Journal entry when payment is received. Cash (debit) The unearned revenue is earned during the period.

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Unearned Revenues
Assets that have been received, but have not yet been earned.
Unearned Revenue (credit)
Journal entry when payment is received. Cash (debit) The unearned revenue is earned during the period.

Unearned Revenue (debit)

AJE at end of period

Revenue (credit)

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Unearned Revenues
Example
On 10/1/98, the Cookeville Gazette received $240 for a one-year subscription. The monthly subscription rate is $20.
GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

Prepare the proper initial journal entry.

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Unearned Revenues
Example
On 10/1/98, the Cookeville Gazette received $240 for a one-year subscription. The monthly subscription rate is $20.
GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

1-Oct Cash Unearned Subscriptions to record receipt of one-year subscription payment

240 240

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Unearned Revenues
Example
The Cookeville Gazettes fiscal year-end is on 12/31/98 (three months later). Record the adjustment necessary at 12/31/98.
GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

Prepare the proper adjusting journal entry.

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Unearned Revenues
Example
The Cookeville Gazettes fiscal year-end is on 12/31/98 (three months later). Record the adjustment necessary at 12/31/98.
GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

31-Dec Unearned Subscriptions Subscription Revenue to record recognition of three months of subscription earned $20 x 3 months = $60

60 60

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Accrued Assets/Revenues
Assets and revenues that remain unrecorded at the end of the period.
During the period, revenues are earned, but are not recorded at that time.
GENERAL JOURNAL
Page:

1 Credit

Date

Description

PR

Debit

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Accrued Assets/Revenues
Assets and revenues that remain unrecorded at the end of the period.
During the period, revenues are earned, but are not recorded at that time.
GENERAL JOURNAL
Page:

Asset (debit) AJE at end of period Revenue (credit)

1 Credit

Date

Description

PR

Debit

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Accrued Assets/Revenues
Example
On 12/31/97, First Bank owes your company $100 of interest on your account. You will receive the interest on 1/10/98.
GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

Prepare the proper adjusting journal entry.

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Accrued Assets/Revenues
Example
On 12/31/97, First Bank owes your company $100 of interest on your account. You will receive the interest on 1/10/98.
GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

31-Dec Interest Receivable Interest Revenue to record interest earned but not yet received

100 100

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Accrued Liabilities/Expenses
Liabilities and expenses that remain unrecorded at the end of the period.
During the period, expenses are incurred, but are not recorded at that time.
GENERAL JOURNAL
Page:

1 Credit

Date

Description

PR

Debit

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Accrued Liabilities/Expenses
Liabilities and expenses that remain unrecorded at the end of the period.
During the period, expenses are incurred, but are not recorded at that time.
GENERAL JOURNAL
Page:

Expense (debit)
AJE at end of period

1 Credit

Date

Description

PR

Debit

Liability (credit)

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Accrued Liabilities/Expenses
Example
At 12/31/97, your company owes $235 of interest to Big Corp. You will not actually pay the interest until 1/10/98.
GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

Prepare the proper adjusting journal entry.

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Accrued Liabilities/Expenses
Example
At 12/31/97, your company owes $235 of interest to Big Corp. You will not actually pay the interest until 1/10/98.
GENERAL JOURNAL
Page:

1
Credit

Date

Description

PR

Debit

31-Dec Interest Expense Interest Payable to recognize interest owed to Big Corporation

235 235

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Adjusting Journal Entries

Question
On 10/1/98, BeeBee Inc. pays $3,600 for a 12-month insurance policy. What kind of transaction would this be called? a. b. c. d. Accrued Liability Prepaid Expense Accounting Estimate Unearned Revenue

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Adjusting Journal Entries

Question
On 10/1/98, BeeBee Inc. pays $3,600 for a 12-month insurance policy. What kind of transaction would this be called? a. b. c. d. Accrued Liability Prepaid Expense Accounting Estimate Unearned Revenue
BeeBee has an asset that is awaiting assignment to an expense account.

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Adjusting Journal Entries

Question
The last day of 1998 is on a Thursday. CeeCee Inc. will pay its employees on Friday. What kind of adjusting entry is required? a. b. c. d. Accrued Liability Accrued Asset Accounting Estimate Unearned Revenue

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Adjusting Journal Entries

Question
The last day of 1998 is on a Thursday. CeeCee Inc. will pay its employees on Friday. What kind of adjusting entry is required? a. b. c. d.
CeeCee has Accrued Liability incurred an Accrued Asset obligation to pay Accounting Estimate its workers after Unearned Revenue year-end.

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EFFECT OF FAILING TO MAKE 117 ADJUSTING ENTRIES

Affects both the Income Statement and the Balance Sheet.
Failure to Recognize Consumption of a Prepaid Expense Earning of an Unearned Revenue Accrual of Assets Effect on Net Income Overstates Net Income Understates Net Income Understates Net Income Overstates Net Income Effect on Balance Sheet Overstate Assets Overstates R/E Overstates Liabs Understates R/E Understates Assets Understates R/E Understates Liabs Overstates R/E

Accrual of Liabilities

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ROLL EM !

Video #1
(Approx. 8 min.)

Video #2
(Approx. 6 min.)

Video #3
(Approx. 8 min.)

Video #4
(Approx. 6 min.)

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Finally HOW PRECISE IS ACCOUNTING?

110

Annual depreciation expense =

Asset cost - Estimated Salvage value Estimated years of useful life

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Finally HOW PRECISE IS ACCOUNTING?

110

Estimated ^ Annual depreciation expense =

Asset cost - Estimated Salvage value Estimated years of useful life

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Crude Attempt at Humor

Why would anyone want to make a CRUDE journal entry?