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ACC 201-C Financial Accounting

Professor Kiefer

Chapter 3 The Adjusting Process

ACC 201-C Financial Accounting


Professor Kiefer

Chapter 3 The Adjusting Process

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

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 myaccountinglab.com)

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Differentiate between accrual and cashbasis accounting

Accrual Accounting Versus Cash-Basis Accounting


Accrual Basis Revenues recognized when earned Expenses recognized when incurred

Cash Basis
Revenues recognized when cash received Expenses recorded when cash paid

Not GAAP

Accrual vs. Cash-Basis: Revenue

Accrual vs. Cash-Basis: Revenue


Accrual basis revenue transactions

Cash-basis revenue transactions

Accrual vs. Cash-Basis: Expenses

S3-2: COMPARING ACCRUAL AND CASH-BASIS ACCOUNTING

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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 account for the $2,900 expenditure under a. the cash basis.
Record expense $2,900
$2,900

b. the accrual basis.


Record asset

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S3-2: COMPARING ACCRUAL AND CASH-BASIS ACCOUNTING

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 accounting period concept, revenue, and matching principles

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Accounting Period Concept


Businesses prepare financial statements for specific periods to evaluate performance Basic accounting 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 accounting information be reported at regular intervals Accounts are updated at the end of each accounting 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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Explain why adjusting entries are needed

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Adjusting Entries

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

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

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Adjusting Entry Rules


Either increase revenue or increase an expense When worded as accrued, journalize the stated amount

Never involve the cash account

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Journalize and post adjusting entries

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Types of Adjusting Entries


Prepaid expenses Accrued expenses

Depreciation

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 assets cost to expense over its useful life
Land is not depreciated

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Depreciation Entry

Contra asset account

Amount calculated based on depreciation method

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Accumulated Depreciation
Contra asset
Normal credit balance Always paired with related account

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 Anuradhas 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 Anuradhas Goals follows: Apr 18 Purchased $300 of office supplies on Prepaid expense account. 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

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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.

E3-22: JOURNALIZING ADJUSTING ENTRIES AND ANALYZING THEIR EFFECT ON THE INCOME STATEMENT
Journal ACCOUNTS AND POST. DATE EXPLANATIONS REF. DEBIT CREDIT 2013 Adjusting Entries Jan 31 Depreciation expense 500 a. Accumulated depreciation 500 b. 31 Rent expense Prepaid rent 31 Interest expense Interest payable 31 Salary expense Salary payable 31 Unearned service revenue Service revenue 600 600 300 300 10,400

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c.

d.

10,400
1,300 1,300

e.

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

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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 accountants use at end of period

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S3-10: PREPARING AN ADJUSTED TRIAL BALANCE

a) 600 b)1,000 c) 600

$ 800 300 19,100

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


4,500 600 1,000 1,200

a) 600 b)1,000 c) 600

______ $27,500 46

$2,200

$2,200

$27,500

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Prepare the financial statements from the adjusted trial balance

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

Statement of Owners 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 $ $ 4,500 1,200 1,000 600 $ 7,300 7,500 14,800

FOR 3-27: PREPARING A STATEMENT OF OWNERS EQUITY (ADDITIONAL STEP)

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Famous Cut Hair Stylists Statement of Owners Equity

Year Ended December 31, 2012


Fabio, capital, December 31, 2011 Net income $ 7,400 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 Cuts total assets at December 31, 2012.
Famous Cut Hair Stylists Balance Sheet December 31, 2012 ASSETS LIABILITIES Cash $ 800 Accounts 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 owners equity $18,200

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7 Understand the alternate treatment of


unearned revenues and prepaid expenses
(see Appendix 3A, located at myaccountinglab.com)

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Alternative Treatment of Prepaid Expenses


Prepaid Expenses (normally)
Advance payments of expenses Debit an asset account Adjust at end of period

Alternative
Debit an expense account Adjust at end of period

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Prepaid Expense
Initially debit and expense account

Adjust at end of period for unused amount

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Unearned (Deferred) Revenues


Unearned Revenues (normally)
Advance receipt of revenuescreates liability Credit a liability account Adjust at end of period

Alternative
Credit a revenue account Adjust at end of period

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Unearned (Deferred) Revenues


Initially credit a revenue account

Adjust at end of period for unearned amount

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

Chapter 3 Summary

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We adjust accounts 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 account or debit an expense account, but they NEVER affect the Cash account.

Chapter 3 Summary

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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.

Chapter 3 Summary

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The financial statements must be prepared in order:


1. income statement 2. statement of retained earnings 3. balance sheet, third.

Chapter 3 Summary

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