Chapter 4
Adjusting Accounts for
Financial Statements
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
The Accounting Cycle
• Chapter 4 covers the purple boxes
plus Step 7 and Chapter 5 covers
Steps 8 and 9
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Purpose of Adjusting
• Until now, we have largely been processing “external
transactions”, which are stimulated by exchanges with
another party
• But there are also “internal transactions” that must be
entered in order to give a more complete picture of the
organization’s performance during the period
• Adjusting takes into account 3 of the GAAP rules
– Time period principle
– Revenue recognition principle
– Matching principle
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Time principle
• As time passes, economic events or business transactions
can be “deemed” to occur.
• Consider the payment of rent.
– Even though one pays rent in advance, the prepaid rent “asset” is
actually “consumed” over the month or year for which it was paid
• The time principle becomes especially evident when you
consider the rent prepaid for a whole year.
– If financial statements are prepared for each quarter, then
adjustments must be made to recognize the portion of the prepaid
rent that has been consumed into rent expense for that time of the
year
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Revenue and Expense Recognition
• Revenue Recognition
– Revenue is recognized (counted as an increase in the economic
state of the organization) when there is evidence the firm is
economically better off, regardless of when cash is received
• Sale has been made
• Products have been delivered to customers who are expected to pay
• Sufficient time has passed to earn the revenue (rent revenues)
• Matching Principle
– The matching principle calls for the reporting or “matching” of
expenses in the same accounting period as the revenues which they
helped to create
– Expenses are goods and services that are consumed in the creation
of revenues
– Costs associated with revenues that are to be earned in the future
are maintained in asset accounts (or often called “capitalized”) and
drawn against over future periods
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Cash vs. Accrual Accounting Methods
• Accrual Method
– The method where revenues and expenses are recognized
(recorded in financial statements) at the time they provide the
economic impact, not necessarily when cash is received or
disbursed
• Cash Method
– The method by which revenues and expenses are recorded when
cash is received or disbursed
• The Accrual method more closely supports the qualitative
standards put forward by the accounting profession. It is a
more conservative and relevant method.
• The Accrual method supports the need for comparability
• The Cash method is not consistent with GAAP
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Example
• Your company opens up shop on January 1, 2005.
• On the first day you
– Take possession of a new building you contracted to have built for
your purposes
– You arrange for hydro, water, telephone and cable service
• Even though you may end up taking a mortgage to buy the
building, you still do not record the complete purchase
price of the new building on Jan 1.
– You can’t expense a whole building in one day – it provides
economic benefit (shelter in which you can earn revenue) for many
years
• However, at the end of the first quarter, you can expense
all the utilities to that date, because they have already been
(they are continually) consumed
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Adjusting Accounts
• An Adjusting Entry is recorded/entered at the end of the
accounting period to bring the asset or liability account
balance to its proper amount
• The entry also adjusts the proper revenue or expense
account
• The 5 main adjustments (Exhibit 4.4)
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Adjusting Prepaid Expenses
• Prepaid expenses are items paid for in advance of receiving
their benefits. Prepaid expenses are assets until they are
consumed, which are adjusted into expenses
– Remember the prepaid rent and prepaid insurance from previous
examples?
Date
Account Titles and explanation
PR
Jan 1 Prepaid insurance
Debit
3600
Cash
Jan
31
Credit
3600
Insurance Expense
300
Prepaid insurance
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
300
Amortization and Depreciation
• Capital assets are long-term assets such as property, plant
and equipment which are used to sell products/services over
a long period of time (crossing over more than one
accounting period)
• Intangible assets are (generally long term assets) which
provide some intangible benefit over a period of time
(patents, trademarks, goodwill)
• Amortization or depreciation is the process of “writing
down” or expensing these assets over the course of their
useful lives
• The word “Depreciation” is used to refer to the write down
of tangible assets and the word “Amortization” is used to
refer to the write down of intangible assets
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Calculating Amortization
• Most common way is to use Straight Line depreciation
• Example:
– The business buys a delivery truck for $20000 on Jan 1
– The business expects to use the truck for 10 years, at which time it
expects it could dispose of the vehicle for $2000
– Annual amortization: (20000-2000)/10 = $1800 / year
Truck Book Value
20000
18000
16000
14000
12000
10000
8000
6000
4000
2000
0
1
2
3
4
5
6
7
8
9
Year
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
10
Amortization terms
• Cost of Asset/Purchase price: The original cash outlay
required to acquire the asset
• Salvage Value/Disposal Value: The amount that the asset
can be disposed of for
• Useful life: The number of accounting periods during
which the asset contributes to earning revenue
• Book Value: The cost of the asset less the accumulated
depreciation during any period
• Market Value: The amount the asset can actually be sold
for at any given time. It is not recorded on the books
unless the asset is actually sold
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Mid-chapter Demonstration Problem
• Lets try the Mid-chapter Demo Problem
• Complete part A and B
– journalize all the transactions
• Bonus points (well, not really)
– Draw a graph for Part A (b) showing how the accumulated
depreciation of the tractor progressively reduces the book value of
the tractor over its useful life
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Contra Accounts
• A contra account is an offset account in which the balance
is always opposite and reported directly beneath, that of
the account with which it is associated
• Contra accounts allow balance sheet readers to know both
the costs of assets and the total amount of depreciation
charged to expense to date.
• Sample Contra accounts
–
–
–
–
Accumulated Depreciation (Fixed Assets)
Accumulated Amortization (Intangible Assets)
Allowance for Doubtful Accounts (Accounts Receivable)
Bond Discount (Either a payable or asset, depending on the
organization’s position)
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Unearned Revenues
• Unearned Revenues refer to cash received in advance of
providing products or services.
– When cash is received an obligation to provide products/services is
accepted
– Unearned revenues (aka deferred revenues) are liabilities until
earned, when they get converted to revenues
Date
Account Titles and explanation
PR
Jan 1 Cash
Debit
2000
Unearned revenue
Jan
31
Credit
Unearned revenue
2000
2000
Revenue
2000
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Accrued Expenses
• Accrued Expenses refer to costs incurred in a period that
are both unpaid and unrecorded. Accrued expenses are
part of expenses and reported on the income statement
• Example:
– Accrued interest expense
– Accrued salaries expense
Date
Account Titles and explanation
Jan 28
Accrued salary expense
PR
Debit
750
Salaries payable
Jan 31
750
Salaries Expense
250
Salaries payable
750
Cash
Credit
1000
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Accrued Revenues
• Accrued revenues are revenues earned in a period that are
unrecorded and not yet received in cash
• Relevant in a large project organization where revenue can be
recognized at completion of various project phases, even
though invoicing and payment may not occur for some time
• I set up a separate Asset account for un-invoiced revenue, if it
is not invoiced
– Reserve the use of AR for invoiced but unpaid revenue
Date
Account Titles and explanation
Jan 28
Un-invoiced revenue (not AR)
PR
Debit
750
Revenue
Jan 31
Credit
750
Cash
750
Un-invoiced revenue
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
750
Demonstration Problem
• Lets try the Demonstration Problem. Lets create a
– Balance Sheet,
– Income Statement,
– Statement of Owner’s Equity and
• Along the way,
–
–
–
–
journalize all the transactions
Summarize them into T-account entries
Create a trial balance
Make sure you properly show the contra accounts on the Balance
Sheet
• Again, this is a representative question for the Mid-term
exam
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Onward…
• Try problems
– 4-14A, 4-6B
• Chapter 5
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD