ch03 - CHAPTER 3 ADJUSTING THE ACCOUNTS Financial...

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Unformatted text preview: CHAPTER 3 ADJUSTING THE ACCOUNTS Financial Accounting, Sixth Edition Chapter 3-1 Study Objectives 1. 2. 3. 4. 5. 6. 7. Explain the time period assumption. Explain the accrual basis of accounting. Explain the reasons for adjusting entries. Identify the major types of adjusting entries. Prepare adjusting entries for deferrals. Prepare adjusting entries for accruals. Describe the nature and purpose of an adjusted trial balance. Chapter 3-2 Adjusting the Accounts Timing Issues The Basics of Adjusting Entries The Adjusted Trial Balance and Financial Statements Preparing the adjusted trial balance Preparing financial statements Time period assumption Fiscal and calendar years Accrual- vs. cashbasis accounting Recognizing revenues and expenses Chapter 3-3 Types of adjusting entries Adjusting entries for deferrals Adjusting entries for accruals Summary of journalizing and posting Timing Issues Accountants divide the economic life of a business into artificial time periods (Time Period Assumption). ..... Jan. Feb. Mar. Apr. Dec. Generally a month, a quarter, or a year. Fiscal year vs. calendar year Also known as the "Periodicity Assumption" Chapter 3-4 LO 1 Explain the time period assumption. Timing Issues Accrual- vs. Cash-Basis Accounting Accrual-Basis Accounting Transactions recorded in the periods in which the events occur Revenues are recognized when earned, rather than when cash is received. Expenses are recognized when incurred, rather than when paid. Chapter 3-5 LO 2 Explain the accrual basis of accounting. Timing Issues Accrual- vs. Cash-Basis Accounting Cash-Basis Accounting Revenues are recognized when cash is received. Expenses are recognized when cash is paid. Cashbasis accounting is not in accordance with generally accepted accounting principles (GAAP). Chapter 3-6 LO 2 Explain the accrual basis of accounting. Timing Issues Recognizing Revenues and Expenses Revenue Recognition Principle Companies recognize revenue in the accounting period in which it is earned. In a service enterprise, revenue is considered to be earned at the time the service is performed. Chapter 3-7 LO 2 Explain the accrual basis of accounting. Timing Issues Recognizing Revenues and Expenses Matching Principle Match expenses with revenues in the period when the company makes efforts to generate those revenues. "Let the expenses follow the revenues." Chapter 3-8 LO 2 Explain the accrual basis of accounting. Timing Issues GAAP relationships in revenue and expense recognition Illustration 3-1 Chapter 3-9 LO 2 Explain the accrual basis of accounting. Timing Issues Review The time period assumption states that: a. revenue should be recognized in the accounting period in which it is earned. b. expenses should be matched with revenues. c. the economic life of a business can be divided into artificial time periods. d. the fiscal year should correspond with the calendar year. Chapter 3-10 LO 1 Explain the time period assumption. Timing Issues Review One of the following statements about the accrual basis of accounting is false. That statement is: a. Events that change a company's financial statements are recorded in the periods in which the events occur. b. Revenue is recognized in the period in which it is earned. c. The accrual basis is in accord with generally accepted accounting principles. d. Revenue is recorded only when cash is received, and expense is recorded only when cash is paid. Chapter 3-11 LO 2 Explain the accrual basis of accounting. Timing Issues Chapter 3-12 LO 2 Explain the accrual basis of accounting. Timing Issues Chapter 3-13 LO 3 Explain the reasons for adjusting entries. The Basics of Adjusting Entries Adjusting entries make it possible to report correct amounts on the balance sheet and on the income statement. A company must make adjusting entries every time it prepares financial statements. Chapter 3-14 LO 3 Explain the reasons for adjusting entries. The Basics of Adjusting Entries Revenues recorded in the period in which they are earned. earned Expenses recognized in the period in which they are incurred. incurred Adjusting entries needed to ensure that the revenue entries recognition and matching principles are followed. Chapter 3-15 LO 3 Explain the reasons for adjusting entries. Trial Balance Trial Balance Each account is analyzed to determine whether it is Balance complete and uptodate. PIONEER ADVERTISING AGENCY INC. Trial Balance October 31, 2008 Debit $ 15,200 2,500 600 5,000 $ 5,000 2,500 1,200 10,000 0 500 10,000 4,000 900 $28,700 $ 28,700 Account Credit Cash Advertising Supplies Prepaid Insurance Office Equipment Notes Payable Accounts Payable Unearned Revenue Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Rent Expense Chapter 3-16 LO 4 Identify the major types of adjusting entries. The Basics of Adjusting Entries Explain the reasons for adjusting entries Some events are not recorded daily because it is not efficient to do so Some costs are not recorded during the accounting period because they expire with the passage of time rather than as a result of daily transactions Some items may be unrecorded Chapter 3-17 LO 3 Explain the reasons for adjusting entries. Timing Issues Review 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 they are earned. c. balance sheet and income statement accounts have correct balances at the end of an accounting period. d. all of the above. Chapter 3-18 LO 3 Explain the reasons for adjusting entries. Types of Adjusting Entries Deferrals 1. Prepaid 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. Accruals 1. Accrued Revenues. Revenues earned but not yet received in cash or recorded. 2. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded. Chapter 3-19 LO 4 Identify the major types of adjusting entries. Types of Adjusting Entries Chapter 3-20 LO 4 Identify the major types of adjusting entries. Adjusting Entries for "Prepaid Expenses" Payment of cash, that is recorded as an asset because service or benefit will be received in the future. Cash Payment BEFORE Expense Recorded Prepayments often occur in regard to: insurance supplies Advertising rent Chapter 3-21 building purchases equipment purchases LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Prepaid Expenses" Prepaid Expenses Costs that expire either with the passage of time or through use. Adjusting entries (1) to record the expenses that apply to the current accounting period, and (2) to show the unexpired costs in the asset accounts. Chapter 3-22 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Prepaid Expenses" Illustration 3-4 Adjusting entries for prepaid expenses Increases (debits) an expense account and Decreases (credits) an asset account. Chapter 3-23 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Prepaid Expenses" Example (Supplies): On Oct. 4th, Pioneer Advertising purchased advertising supplies costing $2,500. Show the journal entry to record the payment on Oct 4th. Oct. 4 Advertising supplies Cash Advertising Debit 2,500 Credit Debit Cash Credit 2,500 2500 2,500 Chapter 3-24 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Prepaid Expenses" Example (Supplies): An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still on hand. Show the adjusting journal entry required at Oct. 31st. Oct. 31 Advertising supplies expenses Advertising supplies Prepaid Ad Supplies Debit 10/5 2,500 10/31 1,000 Chapter 3-25 1,500 1,500 Supplies Expense Debit 10/31 1,500 Credit Credit 10/31 1,500 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Prepaid Expenses" Example (Insurance): On Oct. 4th, Pioneer Advertising paid $600 for a oneyear fire insurance policy. Show the journal entry to record the payment on Oct 4th. Oct. 4 Prepaid insurance Cash Prepaid Insurance Debit 600 Credit Debit Cash Credit 600 600 600 Chapter 3-26 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Prepaid Expenses" Example (Insurance): On Oct. 4th, Pioneer Advertising paid $600 for a one-year fire insurance policy. Show the adjusting journal entry required at Oct. 31st. Oct. 31 Insurance expense Prepaid insurance Prepaid Insurance Debit 600 550 Chapter 3-27 50 50 Insurance Expense Debit Credit 50 Credit 50 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Prepaid Expenses" Depreciation Buildings, equipment, and vehicles (longlived assets) are recorded as assets, rather than an expense, in the year acquired. Companies report a portion of the cost of a longlived asset as an expense (depreciation) during each period of the asset's useful life (Matching Principle). Depreciation is a process of cost allocation instead of asset valuation Chapter 3-28 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Prepaid Expenses" Example (Depreciation): On Oct. 2nd, Pioneer Advertising paid $5,000 for office equipment that has an expected useful life of 10 years. Show the journal entry to record the purchase of the equipment on Oct. 2nd. Oct. 2 Equipment Cash Equipment Debit 5,000 Credit Debit Cash Credit 5,000 5,000 5,000 Chapter 3-29 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Prepaid Expenses" Example (Depreciation): On Oct. 2nd, Pioneer Advertising paid $5,000 for office equipment that has an expected useful life of 10 years. Show the adjusting journal entry required at Oct. 31st. The equipment has a $200 salvage value. ([$5,000- $200 salvage value] / 10 yrs / 12 months = $40) Jan. 31 Depreciation expense Accumulated depreciation Depreciation Expense Debit 40 40 Chapter 3-30 40 40 Accumulated Depreciation Debit Credit 40 Credit LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Prepaid Expenses" Depreciation (Statement Presentation) Accumulated Depreciation--is a contra asset account. Appears just after the account it offsets (Equipment) on the balance sheet. Book value (vs market value) Office equipment $5,000 40 $4,960 Less: Accumulated depreciation-Office Equipment Chapter 3-31 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Prepaid Expenses" Accounting for prepaid expenses summary Examples Insurance, supplies, advertising, rent, depreciation Reasons for adjustment Prepaid Expenses recorded in asset accounts have been used Accounts before adjustment Assets overstated. Expenses understated Adjusting entry Dr. Expenses Cr. Assets Chapter 3-32 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Unearned Revenues" Receipt of cash that is recorded as a liability because the revenue has not been earned. Cash Receipt BEFORE Revenue Recorded Unearned revenues often occur in regard to: rent magazine subscriptions customer deposits for future service Chapter 3-33 sale of airline tickets school tuition LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Unearned Revenues" Unearned Revenues Company makes an adjusting entry to record the revenue that has been earned and to show the liability that remains. The adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account. Chapter 3-34 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Unearned Revenues" Illustration 3-10 Adjusting entries for unearned revenues Decrease (a debit) to a liability account and Increase (a credit) to a revenue account. Chapter 3-35 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Unearned Revenues" Example: On Oct. 2nd, Pioneer Advertising received $1,200 from R. Knox for services to be completed by December 31. Show the journal entry to record the receipt on Oct 2nd. Oct. 2 Cash Unearned Revenue Cash Debit 1,200 Credit Unearned Rent Revenue Debit Credit 1,200 1,200 1,200 Chapter 3-36 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Unearned Revenues" Example: On Oct. 2nd, Pioneer Advertising received $1,200 from R. Knox for services to be completed by December 31. Show the adjusting journal entry required on Oct. 31st. Oct. 31 Unearned Revenue Service Revenue Service Revenue Debit Credit 400 Unearned Revenue Debit 400 Credit 1,200 800 Chapter 3-37 400 400 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Unearned Revenues" Accounting for unearned revenues summary Examples Rent, magazine subscriptions, customer deposits for future service Reasons for adjustment Unearned revenues recorded in liability accounts have been earned Accounts before adjustment Adjusting entry Liabilities Dr. liabilities overstated. Revenues Cr. revenues understated. Chapter 3-38 LO 5 Prepare adjusting entries for deferrals. Prepare adjusting entry for supplies BE3-3 Windsor Advertising Company's trial balance at December 31 shows Advertising Supplies $6,700 and Advertising Supplies Expense $0. On December 31, there are $2,700 of supplies on hand. Prepare the adjusting entry at December 31, and using T accounts, enter the balances in the accounts, post the adjusting entry, and indicate the adjusted balance in each account. Chapter 3-39 LO 5 Prepare adjusting entries for deferrals. Prepare adjusting entry for depreciation BE3-4 At the end of its first year, the trial balance of Denton Company shows Equipment $30,000 and zero balances in Accumulated Depreciation--Equipment and Depreciation Expense. Depreciation for the year is estimated to be $5,000. Prepare the adjusting entry for depreciation at December 31, post the adjustments to T accounts, and indicate the balance sheet presentation of the equipment at December 31. Chapter 3-40 LO 5 Prepare adjusting entries for deferrals. Prepare adjusting entry for prepaid expenses BE3-5 On July 1, 2008, Spahn Co. pays $18,000 to Randle Insurance Co. for a 3-year insurance contract. Both companies have fiscal years ending December 31. For Spahn Co., journalize and post the entry on July 1 and the adjusting entry on December 31. Chapter 3-41 LO 5 Prepare adjusting entries for deferrals. Prepare adjusting entry for unearned revenue BE3-6 Using the data in BE3-5, journalize and post the entry on July 1 and the adjusting entry on December 31 for Randle Insurance Co. Randle uses the accounts Unearned Insurance Revenue and Insurance Revenue. Chapter 3-42 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for Accruals Made to record: Revenues earned and Expenses incurred in the current accounting period that have not been recognized through daily entries. Chapter 3-43 LO 6 Prepare adjusting entries for accruals. Adjusting Entries for "Accrued Revenues" Revenues earned but not yet received in cash or recorded. Adjusting entry results in: Revenue Recorded BEFORE Cash Receipt Accrued revenues often occur in regard to: interest rent services performed Chapter 3-44 LO 6 Prepare adjusting entries for accruals. Adjusting Entries for "Accrued Revenues" Accrued Revenues An adjusting entry serves two purposes: (1) It shows the receivable that exists, and (2) It records the revenues earned. Chapter 3-45 LO 6 Prepare adjusting entries for accruals. Adjusting Entries for "Accrued Revenues" Illustration 3-13 Adjusting entries for accrued revenues Increases (debits) an asset account and Increases (credits) a revenue account. Chapter 3-46 LO 6 Prepare adjusting entries for accruals. Adjusting Entries for "Accrued Revenues" Example: In October Pioneer Advertising earned $200 for advertising services that have not been recorded. Show the journal entry to record the accrued revenues in October. Oct. 31 Accounts Receivable Service Revenue Accounts Receivable Debit 200 Credit Service Revenue Debit Credit 200 200 200 Chapter 3-47 LO 6 Prepare adjusting entries for accruals. Adjusting Entries for "Accrued Revenues" Accounting for accrued revenues summary Examples Interest, rent, services performed but not collected Reasons for adjustment revenues have been earned but not yet received in cash or recorded Accounts before adjustment Assets understated. Revenues understated Adjusting entry Dr. Assets Cr. revenues Chapter 3-48 LO 5 Prepare adjusting entries for deferrals. Adjusting Entries for "Accrued Expenses" Expenses incurred but not yet paid in cash or recorded. Adjusting entry results in: Expense Recorded BEFORE Cash Payment Accrued expenses often occur in regard to: interest rent taxes salaries Chapter 3-49 LO 6 Prepare adjusting entries for accruals. Adjusting Entries for "Accrued Expenses" Accrued Expenses An adjusting entry serves two purposes: (1) It records the obligations, and (2) It recognizes the expenses. Chapter 3-50 LO 6 Prepare adjusting entries for accruals. Adjusting Entries for "Accrued Expenses" Illustration 3-16 Adjusting entries for accrued expenses Increases (debits) an expense account and Increases (credits) a liability account. Chapter 3-51 LO 6 Prepare adjusting entries for accruals. Adjusting Entries for "Accrued Expenses" Example: On Oct 1st, Pioneer Advertising signed a $,5000, 3month note payable at a rate of 12% per year. The total interest due on the note at its due date is $150 ($5,000 X 12% X 3/12). Show the journal entry to record the borrowing on Oct. 1st. Oct. 1 Cash Notes payable Cash Debit 5,000 Credit Notes Payable Debit Credit 5,000 5,000 5,000 Chapter 3-52 LO 6 Prepare adjusting entries for accruals. Adjusting Entries for "Accrued Expenses" Example: On Oct 1st, Pioneer Advertising signed a $,5000, 3month note payable at a rate of 12% per year. The total interest due on the note at its due date is $150 ([$5,000 x 12%] / 12 months). Show the adjusting journal entry required on Oct. 31st. Oct. 31 Interest expense Interest payable Interest Expense Debit 50 Credit Interest Payable Debit Credit 50 50 50 Chapter 3-53 LO 6 Prepare adjusting entries for accruals. Adjusting Entries for "Accrued Expenses" Example: Pioneer Advertising last paid salaries on October 26; the next payday is November 9. The employees receive total salaries of $400 per day. Show the adjusting journal entry on Oct. 31 (assume there are three working days from Oct. 26 to Oct. 31. Oct. 31 Salaries Expense Salaries Payable Salaries Expenses Debit 1,200 Credit Salaries Payable Debit Credit 1,200 1,200 1,200 Chapter 3-54 LO 6 Prepare adjusting entries for accruals. Adjusting Entries for "Accrued Expenses" Example: Pioneer Advertising pays salaries every two weeks. The next payday is November 9 when the employees receive total salaries of $4000. Show the journal entry on November 9 (assume there are 7 working days from Nov 1 to Nov 9). Oct. 1 Salaries Payable Salaries Expenses Cash 1,200 2,800 4,000 Chapter 3-55 LO 6 Prepare adjusting entries for accruals. Adjusting Entries for "Accrued Expenses" Accounting for accrued expenses summary Examples Reasons for adjustment Accounts before adjustment Expenses understated. Liabilities understated. Adjusting entry Dr. expenses Cr. liabilities Interest, rent salaries Expenses have been incurred but not yet paid in cash or recorded Chapter 3-56 LO 5 Prepare adjusting entries for deferrals. Deferrals and Accruals Chapter 3-57 LO 5 Prepare adjusting entries for deferrals. Deferrals and Accruals Chapter 3-58 LO 5 Prepare adjusting entries for deferrals. Deferrals and Accruals Chapter 3-59 LO 5 Prepare adjusting entries for deferrals. The Adjusted Trial Balance After all adjusting entries are journalized and posted the company prepares another trial balance from the ledger accounts (Adjusted Trial Balance). Its purpose is to prove the equality of debit balances and credit balances in the ledger. Chapter 3-60 LO 7 Describe the nature and purpose of an adjusted trial balance. Preparing Financial Statements Financial Statements are prepared directly from the Adjusted Trial Balance. Income Statement Retained Earnings Statement Balance Sheet Statement of Cash Flows Chapter 3-61 LO 7 Describe the nature and purpose of an adjusted trial balance. Preparing Financial Statements Account Debit Credit Cash $ 15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Depreciation-Off Equip Notes Payable Accounts Payable Unearned Revenue Salaries Payable Interest Payable Common Stock Retained Earnings Dividends 500 Service Revenue Salaries Expense 5,200 Advertising Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 $ 30,190 Chapter 3-62 Income Statement PIONEER ADVERTISING AGENCY INC. Income Statement For the Month Ended October 31, 2008 Revenues Service Revenue Expenses Salaries Expense 5,200 Advertising Supplies Expense1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 Total expenses Net income $40 5,000 2,500 800 1,200 50 10,000 0 10,600 10,600 7,740 $ 2,860 $ 30,190 LO 7 Describe the nature and purpose of an adjusted trial balance. Preparing Financial Statements Account Debit Credit Cash $ 15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Depreciation-Off Equip Notes Payable Accounts Payable Unearned Revenue Salaries Payable Interest Payable Common Stock Retained Earnings Dividends 500 Service Revenue Salaries Expense 5,200 Advertising Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 $ 30,190 Chapter 3-63 Retained Earnings Statement $40 5,000 2,500 800 1,200 50 10,000 0 10,600 PIONEER ADVERTISING AGENCY INC. Retained Earnings Statement For the Month Ended October 31, 2008 Retained earnings, October 1 Add: Net income Less: Dividends Retained Earnings, October 31 $0 2,860 2,860 500 2,360 $ 30,190 LO 7 Describe the nature and purpose of an adjusted trial balance. Preparing Financial Statements Account Debit Credit Cash $ 15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Depreciation-Off Equip Notes Payable Accounts Payable Unearned Revenue Salaries Payable Interest Payable Common Stock Retained Earnings Dividends 500 Service Revenue Salaries Expense 5,200 Advertising Supplies Expense 1,500 Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 $ 30,190 Chapter 3-64 PIONEER ADVERTISING AGENCY INC. Balance Sheet October 31, 2008 Assets Balance Sheet $40 5,000 2,500 800 1,200 50 10,000 0 10,600 Cash $ 15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment $5,000 Accumulated Depreciation-Off Equip 40 4,960 Total Assets $ 21,910 Liabilities and Stockholders' Equity $ 30,190 Liabilities Notes Payable Accounts Payable Unearned Revenue Salaries Payable Interest Payable Total liabilities Stockholders' Equity Common Stock Retained Earnings Total liabilities and stockholders' equity $ 5,000 2,500 800 1,200 50 9,550 10,000 2,360 $ 21,910 LO 7 Describe the nature and purpose of an adjusted trial balance. The adjusted trial balance Review Which of the following statements is incorrect concerning the adjusted trial balance? a. An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made. b. The adjusted trial balance provides the primary basis for the preparation of financial statements. c. The adjusted trial balance lists the account balances segregated by assets and liabilities. d. The adjusted trial balance is prepared after the adjusting entries have been journalized and posted. LO 7 Describe the nature and purpose of an adjusted trial balance. Chapter 3-65 P3-4C Chapter 3-66 P3-4C Cont'd Chapter 3-67 ...
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