3CHAPTER

Adjusting Accounts for Financial Statements

Start upTime period concept

• Definition: The life of a business is divisible into time periods of equal length– Annual financial reports once a year – Interim financial reports

–monthly, quarterly or semi-annually

• Annual accounting periods are the norm• Fiscal year – any 12 consecutive months

• Calendar year – 12 months ending December 31• Natural business year – ends when inventories and business activities

are at their lowest point

Period 1Period 1 Period 2Period 2 Period 3Period 3

Cash CollectedServices Performed- recognize revenue

Match Expenses

OrderTaken

Revenue

Need for adjustment at the end of the period

• Purpose – makes the information on the accounting statements comparable

from period to period

• The revenue recognition principle – requires that revenue be assigned to the accounting period in which it

is earned, rather than the period in which it is collected in cash

• The matching principle – requires that expenses be matched to the period the revenue was

earned

Accrual Basis Revenues are

recognized when earned and

expenses are recognized when

incurred.

Cash BasisRevenues are

recognized when cash is received and expenses recorded when cash is paid.

Accounting

Accrual Basis Vs. Cash Basis

Accrual Basis Revenues are

recognized when earned and expenses are recognized when

incurred.

Cash BasisRevenues are

recognized when cash is received and expenses recorded when cash is paid.

Accounting

Accrual Basis Vs. Cash Basis

Not GAAPNot GAAP

Time Passes

Assets are used up, consumed or expire

Need for adjustment at the end of the period

• Unadjusted trial balance– some balances are incorrect for financial statement

purposes, not through error but due to the passage of time

– accountants must record internal economic events such as the use of an asset

– these internal transactions are not evidenced by business papers as were the transactions presented in previous chapters.

Framework for Adjustments

PrepaidExpenses

Amortization UnearnedRevenues

AccruedExpenses

AccruedRevenues

Adjustments

Transactions where cash is paid orreceived after a related expense

or revenue is recognized.

Exhibit 4.5

An adjusting entry is recorded to bring an asset or liability account balance to its proper amount.

Adjusting Accounts

Transactions where cash is paid orreceived before a related expense

or revenue is recognized.

BAT Entertainment• The Gr. 12 BAT class has decided to enter into an

employment venture and we started our own entertainment business. We offer many services: catering, DJ, consulting, photography, etc.

• We rented office space downtown and have started to incur expenses and earn revenue since our opening on October 1st, 2011. Since we are accounting experts from Ms. Delorme’s accounting class we have decided to keep our own records. We are doing our month end recording and there are some transactions that we need to make adjustments for using the appropriate GAAPs. They are as follows:

Paid for in advance of receiving benefits.

Here is the chequefor my first

6 months’ rent.

Prepaid Expenses

Prepaid asset Expense

UnadjustedBalance

CreditAdjustment

DebitAdjustment

Adjusting Prepaid Expenses

As time goes by, a prepaid asset will be consumed or will expire and its cost will become an expense. This adjusting entry records the amount of the prepaid asset that has been consumed or that has expired as an expense and reduces the

prepaid asset account accordingly.

E.g. Prepaid Rent• On Oct. 1st, we prepaid for 6 months of our office space

downtown. The monthly rent is $2000. Therefore we prepaid $12,000 and the entry was:

Prepaid Rent 12000

Cash 12000

By Oct. 31st, one month’s rent is used and must be recorded:

Rent Expense 2000

Prepaid Rent 2000

Amortization is the process of computing expense from allocating the cost of capital assets over

their expected useful lives.

Straight-LineAmortizationExpense

= Asset Cost - Salvage Value

Useful Life

Amortization

Accumulated Amortization

Amortization Expense

CreditAdjustment

DebitAdjustment

Adjusting for Amortization

As a capital asset wears out over time, an expense is recorded to match the cost of the asset over the periods benefited. This

adjusting entry uses a contra account called Accumulated Amortization. This account would be subtracted from the

capital asset account to which it related on the balance sheet.

e.g. Amortization of our DJ equipment

On Oct. 1st BAT Entertainment purchased $18,000 of DJ equipment:Equipment 18000

Cash 18000The cost of the equipment needs to be amortized

(we are going to use straight-line) – estimated life is 3 years and salvage value is $5,000 – the adjustment for one month on Oct. 31st is:Amortization exp, equip. 361

Accumulated amortiz., equip. 361

Calculation: 18,000 – 5000/36 = 361

Cash received in advance of providing products or services.

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Unearned Revenue

Unearned Revenue

Consulting Revenue

UnadjustedBalance

DebitAdjustment

CreditAdjustment

Adjusting Unearned Revenue

Unearned revenue is a liability account because the company has an obligation to supply future services. As these services

are provided, an unearned revenue will become an earned revenue. This adjusting entry records the amount of unearned

revenue that later becomes earned.

e.g. Unearned photography consulting revenue

On Oct. 16th, BAT Entertainment agreed to do some consulting for an upcoming wedding. On the same day we were paid $4,200 to provide these services:Cash 4200

Unearned consulting rev. 4200On Oct. 31st, we had provided one day of the two days of

service so we recorded the adjustment as follows:Unearned consulting Rev. 2100

Consulting Rev. 2100