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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

The Adjusting Process

Chapter 3

1


Adjusting Attack

2

Accrual versus cash-basis accounting & key elements of accrual accounting

Adjusting entries, why, what, how

Using the worksheet to facilitate the process


Accrual versus cash-basis accounting

3

1


Accrual Accounting Versus Cash-Basis Accounting

4

Accrual Basis

Revenues recognized when earned

Expenses recognized when incurred

Cash Basis

Revenues recognized when cash received

Expensesrecorded when cash paidNot

GAAP


Accounting Period ConceptFor reports to be meaningful, transactions that happen in a period, need to be reported in that period.Basic accounting period: one year

Calendar yearFiscal year

Interim periods < one yearMonthlyQuarterlySemi-annually

5


Revenue Recognition Principle

When to record revenue?When it is earned

When service is providedWhen the product deliveredWhen the earnings process is complete

Doing this requires some tools to allow revenue to be captured separate from the cash flow:

Asset: Accounts receivableLiability: Unearned revenue

Want to see a time line of these?

6


The Matching PrincipleWhen to record expenses?

When the resources is consumedWhen an asset is consumedWhen we generate a liability for the use of a serviceThis “Matches” the expense to the revenues earned

Doing this requires tools to allow expenses to be captured separate from the cash flow:

Prepaid or other assets: These store resources until we use and expense themLiabilities: Payables associate with expenses

eg wages payable

Want to see a time line of these?7


Work it out:How would each of these events be handled under: Accrual Cash-Basis

Cash sale of $500Credit sale of $900Bought 4 months of suppliesUsed 4 months of suppliesBought a fleet of trucks for cash

In each case, which options portrays more accurately the creation of wealth by the company?Which shows more accurate financial standing?8


Explain why adjusting entries are needed

9

3


Display Earnings for the Period

Display Financial Standing at a Point in

Time

Must show everything earned and consumed!

Including what we owe, are owed,

and current owner’s equity!

Two primary goals of financial accounting


How do adjusting entries help meet the goals of accrual accounting?

Adjusting entries capture real live transactions that took place, but for which there was no cause to enter during regular daily operations

Our job is to capture and report revenues and expenses, not just to process papers that come across your desk.

When you find a situation where a revenue or expense has occurred, but was not captured by the daily journal entries, you make an adjusting entry to capture it.


What’s that lady in the red coat doing?

Adjustments take place at period end.The LAST CHANCE to make changes that improve or damage the story told by the financial statements.Remember the conflict of interest inherent in accounting?Adjusting entries is a high-pressure, last minute opening when fraudulent reporting attempts might be made.Know how transactions affect the financial statements now and later. Know how to apply GAAP to form a first line defense.


Non-adjusted Example Situation:Car Broker’s cash basis income statementsAll Sales in cashCommissions paid early in month 2

Month 1Month 2

Sales $100,000$80,000

COGS 80,000 64,000

Commissions (5% of sales) 0 9,000

Other Expenses 7,000 7,000

Net Income 13,000 0,000Note: In this case we DID NOT make a month end adjustment to record

the commissions expense in Month 1. The result: Month 2 bears all of month 1 and month 2’s commissions expense – Ouch!@


Properly Adjusted Example Situation:An adjustment at month end recognizes the commissions expense in month 1 – when commissions were earned, before paid. Month 1

Month 2Sales $100,000

$80,000COGS 80,000

64,000Commissions (5% of sales) 5,000

4,000Other Expenses 7,000

7,000Net Income $8,000

$5,000Note: In this case we entered the commissions expense in Month 1 for the commissions “used” in Month 1. So both months bear the

commissions expenses that month “used”.


Adjusting entries capture real revenues and real expenses.

Adjusting entries make our income statement and our balance sheet more useful.


Adjusting Entries

16


Adjusting Entries

Prepared at end of an accounting periodAssigns:

Revenues to the period when earnedExpenses to the period when incurred

Update asset and liability accountsNeed to properly match revenues and expenses to measure:

Net IncomeAssets and Liabilities

17


Adjusting Entry Rules

18

Never involve the cash account

Eitherincrease revenue

orincrease an expense


Adjusting entries: Four situations

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Prepaid expenses

DepreciationAccrued expenses

Accrued revenues

Unearned revenues


Journalize and post adjusting entries

20

4


Unearned Revenues:

21

Regular daily journal entry: Collect cash in advance upcoming Nutcracker ballet

Cash 130,000Unearned revenue 130,000

Sold Nutcracker tickets in advance

20-Nov

Unearned revenue 25,000Theater revenue 25,000

Earned pre-sold ticket revenue thru Nov.

30-Nov

Activity: Do 4 weekend shows through November, earning $25,000 in performance revenue

Adjusting entry: Record earnings and reverse the earned portion of the liability


Accrued Revenues:

22

Regular daily journal entry: Collect from customer

Cash 4,500Accounts receivable 4,500

Customer picked up Porsche

4-Jan

Accounts receivable 4,500Repair revenue 4,500

Repaired Porsche steering, not picked up

31-Dec

Activity: We finish a $4,500 car repair on December 29th, customer pickup expected Jan 4thAdjusting entry: Record earnings and accrue the

receivable.


Prepaid Expense: Rent

23

Adjusting entry: Recognize that we used up one month of that rent.

Regular daily journal entry: Paid cash for three months rent

Activity: After a month passes, do we still really own three months rent?

Prepaid rent 3,000Cash 3,000

Purchased 3 months rent in advance

1-May

Rent expense 1,000Prepaid rent 1,000

recognize use of one months rent

31-May


Depreciation, a variation on prepaid expenses

Plant assetsLong-lived tangible assets used in business operationsExamples:

Land, buildings, equipment, and furniture

DepreciationAllocation of a plant asset’s cost to expense over its useful life

Conceptual guideline: If you are wearing it out, depreciate it. If you are completely consuming the asset and it is disappearing, decrease the account directly.

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Depreciation: Plant assets

25

Regular daily journal entry: Buying $12,000 gaming systems, {Equipment}.

Equipment 12,000Cash 12,000

Gaming systems, 3 year life, 0 salvage value

1-Jan

Depreciation expense 4,000Accumulated depreciation 4,000

Recognized 1 year depreciation expense

31-Dec

Activity: Use the equipment for a whole year to help us generate revenue.

Adjusting entry: Recognize one year depreciation expense, and log the accumulated depreciation


Accumulated Depreciation

Contra assetNormal credit balanceAlways paired with related account

Holds sum of all depreciation recorded on a plant assetBook value

Cost minus accumulated depreciationA hopelessly inaccurate approximation of value

Asset cost basis is maintained untouchedWhy?

26


Accrued Expenses:

27

Regular daily journal entry: Pay themWages payable 900

Cash 900Paid wages from Dec 15-31

1-Jan

Wages expense 900Wages payable 900

Recognized wages from Dec 15-31

31-Dec

Activity: We use $900 in employee wages through the end of the month, but do not have to pay until

next month.Adjusting entry: Recognize the use of those

wages, and accrue the associate liability.


Adjusting Entry Pick & Pull1) Spot revenue / expense2) Accruing or converting?

28

Unearned revenues

Prepaid expenses

Accrued revenues


We sold a house for a client, but the listing agent hasn’t sent the payment yet

We provided laundry service for clients who had paid in advance

We used legal services, but the invoice hasn’t arrived Used supplies without recording the consumption


P3-34A: Journalizing Adjusting entries

29

Just do the journal entries as indicated by the adjustment data given in the problem.

** Do not post. Do not prepare an adjusted trial balance. Just do the journal entries. **

Note to self: Now would be a good time to project the problem on the board.


Day two: Adjusting entries

RecapAdjusting entries in the newsUsing a worksheet to facilitate adjusting entriesRelating the adjusted trial balance to the upcoming financial statements

30


Adjusting Entries recap

Real journal entries, prepared at the end of an accounting period. Why?Assign:

Revenues to the period when earnedExpenses to the period when incurred

Need to properly match revenues and expenses to measure:

Net IncomeAssets and Liabilities

These transactions do not involve cash. Why?

31


Adjusting Entries in the newsAIG: $5 billion write down – no thank you

News!GE: a $50 million slap on the wrist

News!Krispy Kreme

Can donuts be crooked? News!

www.sec.gov Enforcement releases

http://www.insurancejournal.com/news/national/2008/02/12/87264.htm

http://www.sec.gov/news/press/2009/2009-178.htm

http://www.sec.gov/litigation/admin/2009/34-59499.pdf

http://www.sec.gov/


Explain the purpose of and prepare an adjusted trial balance

33

5


The Adjusted Trial Balance

Reflects adjusting entries to show final figuresRecalculate adjusted balances by incorporating adjustments with your unadjusted trial balance.Even if you use the worksheet to make adjusting work easier, ALWAYS enter your journal entries in the journal, then POST those journal entries to the ledger accounts.

Contain all information for financial statementsOften appears on a work sheet

Tool accountants use at end of period

34


S3-10: PREPARING AN ADJUSTED TRIAL BALANCE

36

Supplies on hand, $300.Depreciation, $1,000.Accrued interest expense, $600.

a) 600

a) 600

b)1,000

b)1,000

c) 600

c) 6002,200 2,200 27,500 27,500

800300

19,1002,000

200600

2,5007,400

14,8004,500

6001,0001,200


Complete practice set adjustments

37

Prepaid expenses


Accrued revenues

Unearned revenues

Do brain work on the worksheetUse page 69 journal

entry steps & Roberts’ Triangle

Find Rev/Exp firstTransfer JE work to the

general journalPost to the ledgerComplete and check

Adjusted Trial Balance columns to match ledger balances.


Prepare the financial statements from the adjusted trial balance

38

6


Income Statement is prepared first.

Revenue - Expenses

Statement of Retained Earnings is second

The Balance Sheet is prepared last.

A = L + E


Income Statement

40


Statement of Retained Earnings

41


Balance Sheet

42


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.

43


E3-21:ADJUSTED

TRIAL BALANCE



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

Month Ended April 30, 2012Revenue: Service revenue $ 10,600Expenses: Salary expense $ 3,700 Rent expense 1,000 Depreciation expense 1,000 Supplies expense 500

Total expenses 6,200Net income $ 4,400



46

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 $ 1,200Accounts 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



Chapter 3 SummaryCash-basis accounting and accrual accounting are different. Accrual accounting records revenues and expenses when they are earned/incurred. Cash-basis accounting records revenues and expenses when cash is received or paid.The principles guide us as to when (the time period and accounting period concepts) and how (the revenue recognition and matching principles) to record revenues and expenses.

53


Chapter 3 SummaryWe adjust accounts to make sure the balance sheet shows the value of what we own (assets) and what we owe (liabilities) on a specific date. We also adjust to make sure all revenues and expenses are recorded in the period they are earned or incurred. Adjusting journal entries either credit a revenue account or debit an expense account, but they NEVER affect the Cash account.

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Chapter 3 SummaryThe adjusting process has two purposes:

1. To capture all transactions that should be reported in the period shown on the income statement. Every adjustment affects a revenue or an expense. 2. To update the balance sheet so that all accounts are properly valued. Every adjustment affects an asset or a liability (but never the Cash account).

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Chapter 3 SummaryThe adjusted trial balance includes all the transactions captured during the period on the trial balance plus/minus any adjusting journal entries made at the end of the period. The adjusted trial balance gives us the final adjusted values that we use to prepare the financial statements.

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Chapter 3 SummaryThe financial statements must be prepared in order:

income statement first, statement of retained earnings, second, and balance sheet, third.

It is important for accountants to prepare accurate and complete financial statements as other people rely on the data to make decisions.

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Copyright

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