Ch03

2

Chapter 3

Adjusting the Adjusting the AccountsAccounts

Financial Accounting, IFRS EditionWeygandt Kimmel Kieso

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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.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

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Types of adjusting Types of adjusting entriesentries

Adjusting entries for Adjusting entries for deferralsdeferrals

Adjusting entries for Adjusting entries for accrualsaccruals

Summary of Summary of journalizing and journalizing and postingposting

Timing IssuesTiming IssuesTiming IssuesTiming Issues

Fiscal and calendar Fiscal and calendar yearsyears

Accrual- vs. cash-Accrual- vs. cash-basis accountingbasis accounting

Recognizing Recognizing revenues and revenues and expensesexpenses

Preparing the Preparing the adjusted trial balanceadjusted trial balance

Preparing financial Preparing financial statementsstatements

The Basics of The Basics of Adjusting EntriesAdjusting Entries

The Basics of The Basics of Adjusting EntriesAdjusting Entries

The Adjusted Trial The Adjusted Trial Balance and Balance and

Financial StatementsFinancial Statements

The Adjusted Trial The Adjusted Trial Balance and Balance and

Financial StatementsFinancial Statements

Adjusting the AccountsAdjusting the AccountsAdjusting the AccountsAdjusting the Accounts

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Generally a month, a quarter, or a year

Fiscal year vs. calendar year

Also known as the “Periodicity Assumption”


Accountants divide the economic life of a business into artificial time periods (Time Period Assumption).

SO 1 Explain the time period assumption.SO 1 Explain the time period assumption.

Jan. Feb. Mar. Apr. Dec.. . . . .

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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.

ReviewReview


SO 1 Explain the time period assumption.SO 1 Explain the time period assumption.

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.

Solution on notes page

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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.


Accrual- vs. Cash-Basis Accounting

SO 2 Explain the accrual basis of accounting.SO 2 Explain the accrual basis of accounting.

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Cash-Basis Accounting

Revenues are recognized when cash is received.

Expenses are recognized when cash is paid.

Cash-basis accounting is not in accordance with

International Financial Reporting Standards (IFRS).


Accrual- vs. Cash-Basis Accounting


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Revenue Recognition Principle


Recognizing Revenues and Expenses


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.

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Expense Recognition Principle – (Matching Principle)


Recognizing Revenues and Expenses


Match expenses with

revenues in the period when

the company makes efforts to

generate those revenues.

“Let the expenses follow

the revenues.”

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IFRS relationships in revenue and expense recognition

Illustration 3-1

12 SO 2SO 2

Answer on notes page

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Match the description of the concept to the concept.




gfcb

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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 of accounting is in accord with

generally accepted accounting principles.

d. Revenue is recorded only when cash is received, and

expenses are recorded only when cash is paid.

ReviewReview


SO 2 Explain the accrual basis of accounting.SO 2 Explain the accrual basis of accounting.Solution on notes page

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 of accounting is in accord with

generally accepted accounting principles.

d. Revenue is recorded only when cash is received, and

expenses are recorded only when cash is paid.

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Adjusting entries make it possible to report correct

amounts on the statement of financial position

and on the income statement.

A company must make adjusting entries every time

it prepares financial statements.

The Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting Entries

SO 3 Explain the reasons for adjusting entries.SO 3 Explain the reasons for adjusting entries.

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RevenuesRevenues - recorded in the period in which they are - recorded in the period in which they are

earnedearned.

Expenses Expenses - recognized in the period in which they - recognized in the period in which they

are incurredare incurred.

Adjusting entriesAdjusting entries - needed to ensure that the - needed to ensure that the

revenue recognitionrevenue recognition and and expense recognitionexpense recognition are are

followed.followed.



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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. statement of financial position and income statement accounts have correct balances at the end of an accounting period.

d. all of the above.

ReviewReview



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. statement of financial position and income statement accounts have correct balances at the end of an accounting period.

d. all of the above.


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Types of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting Entries

1. Prepaid Expenses. Expenses paid in cash and recorded as assets before they are used or consumed.

Deferrals

3. Accrued Revenues. Revenues earned but not yet received in cash or recorded.

4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded.

2. Unearned Revenues. Revenues received in cash and recorded as liabilities before they are earned.

Accruals

SO 4 Identify the major types of adjusting entries.SO 4 Identify the major types of adjusting entries.

Illustration 3-2Categories of adjusting entries

Types of Adjusting Entries

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Trial BalanceTrial Balance – Illustrations are based on the October 31, trial balance of Pioneer Advertising Agency Inc.

Illustration 3-3


SO 4 Identify the major types of adjusting entries.SO 4 Identify the major types of adjusting entries.

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Deferrals are either:

Prepaid expenses

OR

Unearned revenues.

SO 5 Prepare adjusting entries for deferrals.SO 5 Prepare adjusting entries for deferrals.


Adjusting Entries for Deferrals

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Payment of cash that is recorded as an asset because Payment of cash that is recorded as an asset because service or benefit will be received in the future.service or benefit will be received in the future.

Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”

insuranceinsurance

suppliessupplies

advertisingadvertising

Cash PaymentCash Payment Expense RecordedExpense RecordedBEFORE


rentrent

maintenance on equipmentmaintenance on equipment

fixed assets (depreciation)fixed assets (depreciation)

Prepayments often occur in regard to:Prepayments often occur in regard to:

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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.



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Adjusting entries for prepaid expenses

Increases (debits) an expense account and

Decreases (credits) an asset account.

Illustration 3-4

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Illustration: Pioneer Advertising Agency purchased advertising supplies costing $2,500 on October 5. Pioneer recorded the payment by increasing (debiting) the asset Advertising 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.

Advertising supplies 1,500

Advertising supplies expense 1,500Oct. 31

Illustration 3-5



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Illustration: On October 4, Pioneer Advertising Agency paid $600 for a one-year fire insurance policy. Coverage began on October 1. Pioneer recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in theOctober 31 trial balance. Insurance of $50 ($600 / 12) expires each month.

Prepaid insurance 50

Insurance expense 50Oct. 31

Illustration 3-6



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Depreciation

Buildings, equipment, and vehicles (long-lived assets)

are recorded as assets, rather than an expense, in the

year acquired.

Companies report a portion of the cost of a long-lived

asset as an expense (depreciation) during each period

of the asset’s useful life.



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Illustration: Pioneer Advertising estimates depreciation on the office equipment to be $480 a year, or $40 per month.

Accumulated depreciation 40

Depreciation expense 40Oct. 31

Illustration 3-7



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Depreciation (Statement Presentation)

Accumulated Depreciation is a contra asset account.

Appears just after the account it offsets (Equipment) on the statement of financial position.

Illustration 3-8



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SummaryIllustration 3-9



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Receipt of cash that is recorded as a liability because the Receipt of cash that is recorded as a liability because the revenue has not been earned.revenue has not been earned.

Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”

rentrent

airline ticketsairline tickets

school tuitionschool tuition

Cash ReceiptCash Receipt Revenue RecordedRevenue RecordedBEFORE

magazine subscriptionsmagazine subscriptions

customer depositscustomer deposits

Unearned revenues often occur in regard to:Unearned revenues often occur in regard to:


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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.



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Adjusting entries for unearned revenues

Decrease (a debit) to a liability account and

Increase (a credit) to a revenue account.


Illustration 3-10


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Illustration: Pioneer Advertising Agency 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 earned $400 of those fees in October.

Service revenue 400

Unearned service revenue 400Oct. 31

Illustration 3-11


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Summary


Illustration 3-12


35 SO 5SO 5

Answer on notes page

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Made to record:

Revenues earned and

OR

Expenses incurred

in the current accounting period that have not been recognized through daily entries.

SO 6 Prepare adjusting entries for accruals.SO 6 Prepare adjusting entries for accruals.


Adjusting Entries for Accruals

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Revenues earned but not yet received in cash or Revenues earned but not yet received in cash or recorded.recorded.

Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”

rentrent

interestinterest

services performedservices performed

BEFORE

Accrued revenues often occur in regard to:Accrued revenues often occur in regard to:

Cash ReceiptCash ReceiptRevenue RecordedRevenue Recorded

Adjusting entry results in:Adjusting entry results in:


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Accrued Revenues

An adjusting entry serves two purposes:

(1) It shows the receivable that exists, and

(2) It records the revenues earned.



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Adjusting entries for accrued revenues

Increases (debits) an asset account and

Increases (credits) a revenue account.



Illustration 3-13

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Illustration: In October Pioneer Advertising Agency earned $200 for advertising services that had not been recorded.

Service Revenue 200

Accounts Receivable 200Oct. 31

Illustration 3-14



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Expenses incurred but not yet paid in cash or recorded.Expenses incurred but not yet paid in cash or recorded.

Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”

rentrent

interestinterest

BEFORE

Accrued expenses often occur in regard to:Accrued expenses often occur in regard to:

Cash PaymentCash PaymentExpense RecordedExpense Recorded

taxestaxes

salariessalaries

Adjusting entry results in:Adjusting entry results in:


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Accrued Expenses

An adjusting entry serves two purposes:

(1) It records the obligations, and

(2) It recognizes the expenses.



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Adjusting entries for accrued expenses

Increases (debits) an expense account and

Increases (credits) a liability account.



Illustration 3-16

45 SO 6 Prepare adjusting entries for accruals.SO 6 Prepare adjusting entries for accruals.

Illustration: Pioneer Advertising Agency signed a three-month note payable in the amount of $5,000 on October 1. The note requires Pioneer to pay interest at an annual rate of 12%.

Interest payable 50

Interest expense 50Oct. 31

Illustration 3-18

Illustration 3-17



Illustration: Pioneer Advertising Agency last paid salaries 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



Illustration: Pioneer Advertising Agency last paid salaries 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).

Salaries payable 1,200

Salaries expense 1,200Oct. 31

Illustration 3-20


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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.

The Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial Balance

SO 7 Describe the nature and purpose of an adjusted trial balance.SO 7 Describe the nature and purpose of an adjusted trial balance.

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SO 7SO 7

Illustration 3-24Adjusted trial balance

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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.

Review QuestionReview Question



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.

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Financial Statements are prepared directly from the Adjusted Trial Balance.

Financial Statements are prepared directly from the Adjusted Trial Balance.

Statement of Financial

Position

Income Statement

Retained Earnings

Statement

Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements


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Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements

Illustration 3-25 Preparation of the incomestatement and retained earnings statement from the adjusted trial balance

SO 7SO 7

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Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsIllustration 3-26

SO 7SO 7

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Like IFRS, companies applying GAAP use accrual-basis

accounting to ensure that they record transactions that change a

company’s financial statements in the period in which events

occur.

Similar to IFRS, cash-basis accounting is not in accordance with

GAAP.

GAAP also divides the economic life of companies into artificial

time periods. Under both GAAP and IFRS, this is referred to as the

time period assumption. GAAP requires that companies present a

complete set of financial statements, including comparative

information annually.

Adjusting the Accounts

Understanding U.S. GAAPUnderstanding U.S. GAAPUnderstanding U.S. GAAPUnderstanding U.S. GAAP

Key DifferencesKey Differences

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GAAP has more than 100 rules dealing with revenue recognition.

Many of these rules are industry-specific. Revenue recognition

under IFRS is determined primarily by a single standard, IAS 18.

Despite this large disparity in the detailed guidance devoted to

revenue recognition, the general revenue recognition principles

required by IFRS that are used in this textbook are similar to those

under GAAP.

GAAP uses concepts such as realized, realizable, and earned as a

basis for revenue recognition.


Key DifferencesKey Differences Adjusting the Accounts

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Internal controls are a system of checks and balances designed to

detect and prevent fraud and errors. The Sarbanes-Oxley Act

requires U.S. companies to enhance their systems of internal

control. However, many foreign companies do not have this

requirement.

Under IFRS, revaluation to fair value of items such as land and

buildings is permitted. This is not permitted under GAAP.

The form and content of financial statements are very similar under

GAAP and IFRS. Any significant differences will be discussed in

those chapters that address specific financial statements.


Key DifferencesKey Differences Adjusting the Accounts

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Looking to the FutureLooking to the Future


The IASB and FASB are now involved in a joint project on revenue

recognition. Presently, the Boards are considering an approach

that focuses on changes in assets and liabilities (rather than on

“when earned”) as the basis for revenue recognition. It is hoped

that this approach will lead to more consistent accounting in this

area. The IASB and the FASB also face a difficult task in attempting

to update, modify, and complete a converged conceptual

framework. For example, how do companies choose between

information that is highly relevant but difficult to verify versus

information that is less relevant but easy to verify? Should a single

measurement method, such as historical cost or fair value, be

used, or does it depend on whether it is an asset or liability that is

being measured?

Adjusting the Accounts

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Some companies use an alternative treatment for

prepaid expenses and unearned revenues.

When a company prepays an expense, it debits that

amount to an expense account.

When a company receives payment for future services,

it credits the amount to a revenue account.

Alternative Treatment of Prepaid Expenses Alternative Treatment of Prepaid Expenses and Unearned Revenuesand Unearned RevenuesAlternative Treatment of Prepaid Expenses Alternative Treatment of Prepaid Expenses and Unearned Revenuesand Unearned Revenues

SO 8 Prepare adjusting entries for the alternative treatment of deferrals.SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

APPENDIX

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Illustration: Pioneer Advertising purchased supplies on October 5 for $2,500 and debited AdvertisingSupplies Expense for the full amount. What if an inventoryof $1,000 of advertising supplies remains on October 31?

Alternative Treatment for “Prepaid Expenses”Alternative Treatment for “Prepaid Expenses”Alternative Treatment for “Prepaid Expenses”Alternative Treatment for “Prepaid Expenses”


Advertising supplies expense 1,000

Advertising supplies 1,000Oct. 31

Illustration 3A-1

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Alternative Treatment for “Prepaid Expenses”Alternative Treatment for “Prepaid Expenses”Alternative Treatment for “Prepaid Expenses”Alternative Treatment for “Prepaid Expenses”


Adjustment approaches—a comparisonIllustration 3A-2

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Illustration: Assume that Pioneer Advertising received $1,200 for future services on October 2 and credited the entire amount to Service Revenue. If at the statement date Pioneer has not performed $800 of the services, it would make an adjusting entry.

Alternative Treatment for “Unearned Revenues”Alternative Treatment for “Unearned Revenues”Alternative Treatment for “Unearned Revenues”Alternative Treatment for “Unearned Revenues”


Unearned service revenue 800

Service revenue 800Oct. 31

Illustration 3A-4

63 SO 8 Prepare adjusting entries for the alternative treatment of deferrals.SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

Adjustment approaches—a comparisonIllustration 3A-5

Alternative Treatment for “Unearned Revenues”Alternative Treatment for “Unearned Revenues”Alternative Treatment for “Unearned Revenues”Alternative Treatment for “Unearned Revenues”

64 SO 8 Prepare adjusting entries for the alternative treatment of deferrals.SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

Summary of Additional Adjustment RelationshipsSummary of Additional Adjustment RelationshipsSummary of Additional Adjustment RelationshipsSummary of Additional Adjustment Relationships

Illustration 3A-7

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Ch03

Business

Transcript of Ch03