Chapter 3 The Adjusting Process

Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3rd ed. Pearson Slide 1 of 23

Chapter 3Chapter 3

The Adjusting Process


Accrual Accounting Versus Accrual Accounting Versus Cash-Basis AccountingCash-Basis Accounting

Accrual Basis

Revenues recognized when earned

Expenses recognized when incurred

Cash Basis

Revenues recognized when cash received

Expensesrecorded when cash paid

Not GAAPNot GAAP


Accrual vs. Cash-Basis: RevenueAccrual vs. Cash-Basis: Revenue


Accrual vs. Cash-Basis: RevenueAccrual vs. Cash-Basis: Revenue

Cash-basis revenue transactions

Accrual basis revenue transactions


Accrual vs. Cash-Basis: Accrual vs. Cash-Basis: ExpensesExpenses


Accrual vs. Cash-Basis Accrual vs. Cash-Basis AccountingAccounting

Accrual basis

Cash-basis


S3-2: COMPARING ACCRUAL AND CASH-BASIS ACCOUNTING

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.

b. the accrual basis.


2. State why the accrual basis is more realistic for this situation.

S3-2: COMPARING ACCRUAL AND CASH-BASIS ACCOUNTING


Accounting Period ConceptAccounting Period Concept• Businesses prepare financial statements for

specific periods to evaluate performance• Basic accounting period = one year• Interim periods


Revenue Recognition Revenue Recognition PrinciplePrinciple

• When to record revenue?– When it is earned

• The amount of revenue to recorded?– Value of item or service transferred to customer


Recording Revenue: The Recording Revenue: The Revenue Recognition PrincipleRevenue Recognition Principle


The Matching PrincipleThe Matching Principle• Measure all expenses incurred during

the period

• Match the expenses against the revenues earned during the same period


The Time-Period ConceptThe Time-Period Concept• Requires that accounting information be

reported at regular intervals

• Accounts are updated at the end of each accounting period


Time-Period ConceptTime-Period Concept

On May 31, Smart Touch recorded salary expense of $900 that is owed to an employee at the end of the month.


Adjusting EntriesAdjusting Entries


Adjusting EntriesAdjusting 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


Adjusting Entry RulesAdjusting Entry Rules


Types of Adjusting EntriesTypes of Adjusting Entries


Prepaid ExpensesPrepaid Expenses• Advance payments of expenses• Recorded as an asset• Adjusting entry records amount used as an

expense


Prepaid Expense: RentPrepaid Expense: Rent


DepreciationDepreciation• Plant assets

– Long-lived tangible assets used in business operations

• Depreciation– Allocation of a plant asset’s cost to expense over its

useful life


Depreciation EntryDepreciation Entry


Accumulated DepreciationAccumulated Depreciation• Contra asset• Holds sum of all depreciation recorded on a

plant asset• Book value


Depreciation PostingDepreciation Posting


Accrued ExpensesAccrued Expenses• Expenses incurred before payment is made• Opposite of a prepaid expense


Accrued Expense EntriesAccrued Expense Entries


Accrued RevenuesAccrued Revenues

• Revenue earned before cash is received

• Results in a receivable


Unearned RevenueUnearned Revenue• Cash is collected before revenue is earned • Also called deferred revenue

BEFORE


Unearned Revenue EntriesUnearned Revenue Entries


Summary of Adjusting EntriesSummary of Adjusting Entries• To properly measure net income for the period• To update the balance sheet


Summary of Adjusting EntriesSummary of Adjusting EntriesCategory of Adjusting Entry Debit Credit

Prepaid expense Expense Asset

Depreciation Expense Contra asset

Accrued expense Expense Liability

Accrued revenue Asset Revenue

Unearned revenue Liability Revenue


S3-5: IDENTIFYING TYPES OF ADJUSTING ENTRIES

• A select list of transactions for Anuradha’s Goals follows:

Apr 1 Paid six months of rent, $4,800.

10 Received $1,200 from customer for six-month service contract that began April 1.

15 Purchased computer for $1,000.

Requirement:

1. For each transaction, identify what type of adjusting entry would be needed.


S3-5: IDENTIFYING TYPES OF ADJUSTING ENTRIES

• A select list of transactions for Anuradha’s Goals follows:

Apr 18 Purchased $300 of office supplies on account.

30 Work performed but not yet billed to customer, $500.

30 Employees earned $600 in salary that will be paid May 2.


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

STATEMENTThe 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

DATEACCOUNTS AND EXPLANATIONS

POST.

REF. DEBIT CREDIT2013 Adjusting Entries

Jan 31 Depreciation expenseAccumulated depreciation

31 Rent expensePrepaid rent

31 Interest expenseInterest payable

31 Salary expenseSalary payable

31 Unearned service revenueService revenue


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

STATEMENT

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.


Adjusted Trial BalanceAdjusted Trial Balance• Prepared after adjusting entries are posted

• Useful step in preparing financial statements

• Often appears on a work sheet


S3-10: PREPARING AN ADJUSTED TRIAL BALANCE


Income Statement Income Statement


Statement of Retained EarningsStatement of Retained Earnings


Balance SheetBalance Sheet


E3-25: PREPARING THE FINANCIAL STATEMENTS

Refer to the adjusted trial balance in Exercise 3-21 for the month ended April 30, 2012.

Requirements:1.Prepare the income statement.

2. Prepare the statement of retained earnings.

3. Prepare the balance sheet.


E3-21:ADJUSTED

TRIAL BALANCE



Jobs-4-U Employment Service, Inc.Income Statement

Month Ended April 30, 2012Revenue:

Service revenue $ 10,600

Expenses: Salary expense $ 3,700

Rent expense 1,000

Depreciation expense 1,000

Supplies expense 500Total expenses 6,200

Net income $ 4,400



Jobs-4-U Employment Service, Inc.

Statement of Retained Earnings

Month Ended April 30, 2012

Retained earnings, March 31, 2012 $ 10,300

Net income 4,400

17,900

Dividends 4,800

Retained earnings, April 30, 2012 $ 9,900


Jobs-4-U Employment Service, Inc. Balance SheetApril 30, 2012

Assets LiabilitiesCash $ 900 Salary payable $ 1,200

Accounts receivable 5,600

Supplies 500 Stockholders’ Equity

Equipment $32,500 Common stock 13,000

Accu. Depr. (15,400) 17,100 Retained earnings 9,900

Total stockholders’ equity 22,900

Total assets $24,100Total liabilities and stockholders’ equity $24,100



Alternative Treatment of PrepaidAlternative Treatment of PrepaidExpensesExpenses

• 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


Prepaid ExpensePrepaid ExpenseInitially debit and expense account

Adjust at end of period for unused amount


Unearned (Deferred) Unearned (Deferred) RevenuesRevenues

• Unearned Revenues (normally)– Advance receipt of revenues–creates liability– Credit a liability account– Adjust at end of period

• Alternative– Credit a revenue account– Adjust at end of period


Unearned (Deferred) Unearned (Deferred) RevenuesRevenues

• Initially credit a revenue account

Adjust at end of period for unearned amount

Chapter 3 The Adjusting Process

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