Ch3 Additional

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Act 201: Study guide

Chapter 3

Adjusting The Accounts

Learning Objectives

1 Explain the time period assumption.

2 Explain the accrual basis of accounting.3 Explain why adjusting entries are needed.4 Identify the major types of adjusting entries.

5 Prepare adjusting entries for prepayments.

6 Prepare adjusting entries for accruals.7 Describe the nature and purpose of an adjusted trial balance.

Explain the time period assumption.

The time period (or periodicity) assumption assumes that the economic life of a business

can be divided into artificial time periods.

Accounting time periods are generally a month, a quarter, or a year.

The accounting time period of one year in length is referred to as a fiscal year.

Explain the accrual basis of accounting.

The revenue recognition and matching principles are used under the accrual basisof accounting.

Under cash basis accounting, revenue is recorded when cash is received, andexpenses are recorded when cash is paid.

Generally accepted accounting principles require accrual basis accounting

because the cash basis often causes misleading financial statements.

Revenue Recognition PrincipleThe revenue recognition principle dictates that revenue be recognized in the accounting

period in which it is earned.

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In a service business, revenue is considered to be earned at the time the service is

performed.

The Matching PrincipleThe practice of expense recognition is referred to as the matching principle.

The matching principle dictates that efforts (expenses) be matched with accomplishments(revenues).

Explain why adjusting entries are needed.Adjusting entries are made in order for:1 Revenues to be recorded in the period in which they are earned, and for......

2 Expenses to be recognized in the period in which they are incurred.

Identify the major types of adjusting entries.

Adjusting entries are required each time financial statements are prepared.

Adjusting entries can be classified as1 prepayments (prepaid expenses orunearned revenues)

2 accruals (accruedrevenues oraccrued expenses)

Types Of Adjusting EntriesPrepayments

1 Prepaid Expenses Expenses paid in cash and recorded as assets before they are usedor consumed

2 Unearned Revenues cash received and recorded as liabilities before revenue is

earnedAccruals

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

Prepare adjusting entries for prepayments.

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Prepayments are either prepaid expenses or unearned revenues.

Adjusting entries for prepayments are required to record the portion of the prepayment

that represents1 the expense incurred or

2 the revenue earned in the current accounting period.

Prepaid Expenses

Prepaid expenses are expenses paid in cash and recorded as assets before they are used orconsumed.

Prepaid expenses expire with the passage of time or through use and consumption.

An asset-expense account relationship exists with prepaid expenses.

Prior to adjustment, assets are overstated and expenses are understated.The adjusting entry results in a debit to an expense account and a credit to an asset

account.Examples of prepaid expenses include supplies, insurance, and depreciation.

DepreciationDepreciation is the allocation of the cost of an asset to expense over its useful life in a

rational and systematic manner.

The purchase of equipment or a building is viewed as a long-term prepayment of services

and, therefore, is allocated in the same manner as other prepaid expenses.Depreciation is an estimate rather than a factual measurement of the cost that has expired.

In recording depreciation, Depreciation Expense is debited and a contra asset account,Accumulated Depreciation, is credited

In the balance sheet, Accumulated Depreciation is offset against the asset account.

The difference between the cost of any depreciable asset and its related accumulated

depreciation is referred to as the book value of the asset.

Unearned RevenuesUnearned revenues are revenues received and recorded as liabilities before they are

earned.

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Unearned revenues are subsequently earned by rendering a service to a customer.

A liability-revenue account relationship exists with unearned revenues.

Prior to adjustment, liabilities are overstated and revenues are understated.The adjusting entry results in a debit to a liability account and a credit to a revenue

account.

Examples of unearned revenues include rent, magazine subscriptions, and customerdeposits for future services.

Prepare adjusting entries for accruals.The second category of adjusting entries is accruals.

Adjusting entries for accruals are required to record revenues earned and expenses

incurred in the current period.

The adjusting entry for accruals will increase both a balance sheet and an incomestatement account.

Accrued RevenuesAccrued revenues may accumulate with the passing of time or through services

performed but not billed or collected.An asset-revenue account relationship exists with accrued revenues.

Prior to adjustment, assets and revenues are understated.

The adjusting entry requires a debit to an asset account and a credit to a revenue account.

Accrued Expenses

Accrued expenses are expenses incurred but not paid yet.A liability-expense account relationship exists

Prior to adjustment, liabilities and expenses are understatedThe Adjusting Entry results in a debit to an expense account and a credit to a liability

account

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Describe the nature and purpose of an adjusted trial balance.

An Adjusted Trial Balance is prepared after all adjusting entries have been journalized

and posted.

Its purpose is to prove the equality of the total debit and credit balances in the ledger after

all adjustments have been made.Financial statements can be prepared directly from the adjusted trial balance.

Preparing Financial StatementsFinancial statements can be prepared directly from the adjusted trial balance.

1 The income statement is prepared from the revenue and expense accounts.2 The owners equity statement is derived from the owners capital and drawing

accounts and the net income (or net loss) from the income statement.

3 The balance sheet is then prepared from the asset and liability accounts and the endingowners capital balance as reported in the owners equity statement.

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Ch3 Additional

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Transcript of Ch3 Additional