ACCOUNTING PRINCIPLES SIXTH CANADIAN EDITION Chapter 3 Adjusting the Accounts Prepared by: Debbie Musil Kwantlen Polytechnic University CHAPTER 3: Adjusting the Accounts STUDY OBJECTIVE: 1. Explain accrual basis accounting, and when to recognize revenues and expenses. 2. Prepare adjusting entries for prepayments. 3. Prepare adjusting entries for accruals. 4. Describe the nature and purpose of an adjusted trial balance, and prepare one. 5. Prepare adjusting journal entries for the alternative treatment of prepayments. Copyright John Wiley & Sons Canada, Ltd. 2 Adjusting the Accounts • Timing issues – Selecting an accounting time period – Accrual versus cash basis of accounting – Revenue and expense recognition • Basics of adjusting entries – Types of adjusting entries – Prepayments and accruals • Adjusted trial balance and financial statements Copyright John Wiley & Sons Canada, Ltd. 3 Time Periods • The economic life of a business can be divided into time periods – Generally a month, quarter, or year • Periods of less than one year are called interim periods • Period of one year is called a fiscal year Copyright John Wiley & Sons Canada, Ltd. 4 Accrual Versus Cash Basis Accounting • Accrual basis: – Events are recorded in the period when they occur – Not when the cash is paid or received • Cash basis: – Revenue recorded when cash is received – Expenses recorded when cash is paid Copyright John Wiley & Sons Canada, Ltd. 5 Revenue Recognition • Revenue is recognized when there is an increase in assets or a decrease in liabilities as a result of business activities with customers • Revenue recognition criteria provides guidance: – Generally when the service is performed or when goods are sold and delivered Copyright John Wiley & Sons Canada, Ltd. 6 Expense Recognition • Expenses are decreases in assets or increases in liabilities from business activities • Expense recognition criteria provides guidance: – Tied to revenue recognition when a direct association exists between costs incurred and earning of revenue – For long-lived assets, expenses are recognized over the life of the asset – Otherwise expenses are reported in period incurred Copyright John Wiley & Sons Canada, Ltd. 7 The Accounting Cycle Copyright John Wiley & Sons Canada, Ltd. 8 Adjusting Entries - Basics • Required for the preparation of financial statements – To ensure that revenue and expense recognition criteria are followed – Make it possible to accurately report assets, liabilities and owner’s equity • Part of the accounting cycle • Classified as prepayments or accruals Copyright John Wiley & Sons Canada, Ltd. 9 CHAPTER 3: Adjusting the Accounts STUDY OBJECTIVE: 1. Explain accrual basis accounting, and when to recognize revenues and expenses. 2. Prepare adjusting entries for prepayments. 3. Prepare adjusting entries for accruals. 4. Describe the nature and purpose of an adjusted trial balance, and prepare one. 5. Prepare adjusting journal entries for the alternative treatment of prepayments. Copyright John Wiley & Sons Canada, Ltd. 10 Adjusting Entries – Prepayments • Prepaid Expenses: – Expenses paid in cash and recorded as assets before they are used or consumed • Unearned Revenues: – Cash received and recorded as a liability before revenue earned Copyright John Wiley & Sons Canada, Ltd. 11 Prepaid Expenses • Expire through the passage of time or as an asset is used up – Portion used up is an expense of the period • Prior to adjustment, assets are overstated and expenses are understated • Adjusting entry: Dr. An expense account (to increase) Cr. An asset account (to decrease) • Examples: supplies, rent, insurance Copyright John Wiley & Sons Canada, Ltd. 12 Depreciation • The allocation of the cost of long-lived assets to expense over their useful lives – The portion of the asset that is used up (or expires) in each period is reported as an expense • Straight-line depreciation: Annual depreciation expense = Cost ÷ Estimated useful life Copyright John Wiley & Sons Canada, Ltd. 13 Depreciation – Recording • Adjusting entry: Dr. Depreciation expense (to increase) Cr. Accumulated depreciation (to increase) • Contra asset account: An account with the opposite balance (credit) compared to its related asset account – Deducted from its related asset on the balance sheet Copyright John Wiley & Sons Canada, Ltd. 14 Depreciation – Presentation • Accumulated depreciation is deducted from the cost of the asset on the balance sheet • This difference is called the Carrying Amount Copyright John Wiley & Sons Canada, Ltd. 15 Unearned Revenues • Cash received before revenue is earned is recorded as a liability • Subsequently earned by performing a service or providing a good • Prior to adjustment, liabilities are overstated and revenues are understated • Adjusting entry: Dr. A liability account (to decrease) Cr. A revenue account (to increase) • Examples: subscriptions, customer deposits Copyright John Wiley & Sons Canada, Ltd. 16 Adjusting Entries for Prepayments Copyright John Wiley & Sons Canada, Ltd. 17 CHAPTER 3: Adjusting the Accounts STUDY OBJECTIVE: 1. Explain accrual basis accounting, and when to recognize revenues and expenses. 2. Prepare adjusting entries for prepayments. 3. Prepare adjusting entries for accruals. 4. Describe the nature and purpose of an adjusted trial balance, and prepare one. 5. Prepare adjusting journal entries for the alternative treatment of prepayments. Copyright John Wiley & Sons Canada, Ltd. 18 Adjusting Entries - Accruals • Required where items are not yet recorded in the accounts • Accrued Revenues: – Revenues earned but not yet received in cash or recorded • Accrued Expenses: – Expenses incurred but not yet paid in cash or recorded Copyright John Wiley & Sons Canada, Ltd. 19 Accrued Revenues • Accrue with the passage of time or result from services performed but not billed or collected • Prior to adjustment, assets and revenues are understated • Adjusting entry: Dr. An asset account (to increase) Cr. A revenue account (to increase) • Examples: accounts receivable, rent receivable, and interest receivable Copyright John Wiley & Sons Canada, Ltd. 20 Accrued Expenses • Expenses incurred but not yet paid or recorded • Prior to adjustment, liabilities and expenses are understated • Adjusting entry: Dr. An expense account (to increase) Cr. A liability account (to increase) • Examples: accounts payable, rent payable, salaries payable, and interest payable Copyright John Wiley & Sons Canada, Ltd. 21 Adjusting Entries for Accruals Copyright John Wiley & Sons Canada, Ltd. 22 CHAPTER 3: Adjusting the Accounts STUDY OBJECTIVE: 1. Explain accrual basis accounting, and when to recognize revenues and expenses. 2. Prepare adjusting entries for prepayments. 3. Prepare adjusting entries for accruals. 4. Describe the nature and purpose of an adjusted trial balance, and prepare one. 5. Prepare adjusting journal entries for the alternative treatment of prepayments. Copyright John Wiley & Sons Canada, Ltd. 23 Preparing the Adjusted Trial Balance Copyright John Wiley & Sons Canada, Ltd. 24 Adjusted Trial Balance • Prepared after adjusting entries have been journalized and posted • Proves that total debit and credit balances are equal after all adjustments have been made • Provides all data needed for preparing financial statements Copyright John Wiley & Sons Canada, Ltd. 25 Preparing the Income Statement and Statement of Owner’s Equity The income statement is prepared from the revenue and expense accounts. The statement of owner’s equity is prepared from the owner’s capital and drawing accounts and Profit from the Income statement. To: Balance Sheet – Owner’s equity 26 Preparing the Balance Sheet The balance sheet is prepared from the asset and liability accounts and the Statement of owner’s equity From: Statement of Owner’s Equity – Capital Copyright John Wiley & Sons Canada, Ltd. 27 CHAPTER 3: Adjusting the Accounts STUDY OBJECTIVE: 1. Explain accrual basis accounting, and when to recognize revenues and expenses. 2. Prepare adjusting entries for prepayments. 3. Prepare adjusting entries for accruals. 4. Describe the nature and purpose of an adjusted trial balance, and prepare one. 5. Prepare adjusting journal entries for the alternative treatment of prepayments. Copyright John Wiley & Sons Canada, Ltd. 28 Appendix 3A: Alternative Treatment of Prepayments • Prepaid Expenses: – Record initial transaction as an expense – Adjust at end of period for amount that has not been used up • Unearned Revenues: – Record initial transaction as revenue – Adjust at end of period for services not yet provided or goods not yet delivered Copyright John Wiley & Sons Canada, Ltd. 29 COPYRIGHT Copyright © 2013 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. 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