3-1 Chapter 3 Adjusting the Accounts Learning Objectives After studying this chapter, you should be able to: 3-2 1. Explain the time period assumption. 2. Explain the accrual basis of accounting. 3. Explain the reasons for adjusting entries. 4. Identify the major types of adjusting entries. 5. Prepare adjusting entries for deferrals. 6. Prepare adjusting entries for accruals. 7. Describe the nature and purpose of an adjusted trial balance. Preview of Chapter 3 Financial Accounting IFRS Edition, 2e Weygandt Kimmel Kieso 3-3 Timing Issues Accountants divide the economic life of a business into artificial time periods (Time Period Assumption). ..... Jan. 3-4 Feb. Mar. Apr. Generally a month, a quarter, or a year. Also known as the “Periodicity Assumption” Dec. LO 1 Explain the time period assumption. Preview of Chapter 3 3-5 Timing Issues Fiscal and Calendar Years 3-6 Monthly and quarterly time periods are called interim periods. Most large companies must prepare both quarterly and annual financial statements. Fiscal Year = Accounting time period that is one year in length. Calendar Year = January 1 to December 31. LO 1 Explain the time period assumption. Timing Issues Question The time period assumption states that: a. revenue should be recognized in the accounting period in which a performance obligation is satisfied. b. expenses should be matched with revenues. c. the economic life of a business can be divided into artificial time periods. d. the fiscal year should correspond with the calendar year. 3-7 LO 1 Explain the time period assumption. Preview of Chapter 3 3-8 Timing Issues Accrual- vs. Cash-Basis Accounting Accrual-Basis Accounting 3-9 Transactions recorded in the periods in which the events occur. Revenues are recognized when the services are performed, rather than when cash is received. Expenses are recognized when incurred, rather than when paid. LO 2 Explain the accrual basis of accounting. 3-10 CEH Timing Issues Accrual- vs. Cash-Basis Accounting Cash-Basis Accounting 3-11 Revenues recognized when cash is received. Expenses recognized when cash is paid. Cash-basis accounting is not in accordance with International Financial Reporting Standards (IFRS). LO 2 Explain the accrual basis of accounting. Preview of Chapter 3 3-12 Timing Issues Recognizing Revenues and Expenses Revenue Recognition Principle Recognize revenue in the accounting period in which the performance obligation is satisfied. In a service enterprise, revenue is considered to be earned at the time the service is performed. 3-13 LO 2 Explain the accrual basis of accounting. Timing Issues Recognizing Revenues and Expenses Expense Recognition Principle Match expenses with revenues in the period when the company makes efforts to generate those revenues. “Let the expenses follow the revenues.” 3-14 LO 2 Explain the accrual basis of accounting. Timing Issues Illustration 3-1 IFRS relationships in revenue and expense recognition 3-15 LO 2 Explain the accrual basis of accounting. 3-16 LO 2 Explain the accrual basis of accounting. Timing Issues Question Which of the following statements about the accrual basis of accounting is false. a. Events that change a company’s financial statements are recorded in the periods in which the events occur. b. Revenue is recognized in the period in which services are performed. c. The accrual basis is in accord with IFRS. d. Revenue is recorded only when cash is received, and expenses are recorded only when cash is paid. 3-17 LO 2 Explain the accrual basis of accounting. A list of concepts is provided in the left column below, with a description of the concept in the right column below. There are more descriptions provided than concepts. Match the description of the concept to the concept. f e c b 3-18 LO 2 Preview of Chapter 3 3-19 The Basics of Adjusting Entries Adjusting Entries 3-20 Ensure that the revenue recognition and expense recognition principles are followed. Necessary because the trial balance may not contain up-to-date and complete data. Required every time a company prepares financial statements. Will include one income statement account and one statement of financial position account. LO 3 Explain the reasons for adjusting entries. 1B 2013 = eco =10 yrs Dr (car); cr (cash) = 10B 1 Jan 2013 At the end 2013 31 dec Deprc exp; acc depre = 10B/10yrs 3-21 The Basics of Adjusting Entries Question Adjusting entries are made to ensure that: a. expenses are recognized in the period in which they are incurred. b. revenues are recorded in the period in which services are provided. c. statement of financial position and income statement accounts have correct balances at the end of an accounting period. d. all of the above. 3-22 LO 3 Explain the reasons for adjusting entries. The Basics of Adjusting Entries Types of Adjusting Entries Illustration 3-2 Categories of adjusting entries 3-23 Deferrals Accruals 1. Prepaid Expenses. Expenses paid in cash before they are used or consumed. 3. Accrued Revenues. Revenues for services performed but not yet received in cash or recorded. 2. Unearned Revenues. Cash received before services are performed. 4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded. LO 4 Identify the major types of adjusting entries. The Basics of Adjusting Entries Types of Adjusting Entries Trial Balance – Each account is analyzed to determine whether it is complete and up-to-date. Illustration 3-3 3-24 LO 4 Identify the major types of adjusting entries. The Basics of Adjusting Entries Adjusting Entries for Deferrals Deferrals are either: Prepaid expenses OR 3-25 Unearned revenues. LO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Prepaid Expenses Payment of cash, that is recorded as an asset because service or benefit will be received in the future. Cash Payment BEFORE Expense Recorded Prepayments often occur in regard to: 3-26 insurance rent supplies equipment advertising buildings LO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Prepaid Expenses Expire either with the passage of time or through use. Adjusting entry: ► Increase (debit) to an expense account and ► Decrease (credit) to an asset account. Illustration 3-4 3-27 LO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Illustration: Pioneer Advertising Agency purchased supplies costing $2,500 on October 5. Pioneer recorded the payment by increasing (debiting) the asset Supplies. This account shows a balance of $2,500 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still on hand. Oct. 31 Supplies expense Supplies 3-28 1,500 1,500 LO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Illustration 3-5 3-29 LO 5 The Basics of Adjusting Entries Illustration: On October 4, Pioneer Advertising paid $600 for a one-year fire insurance policy. Coverage began on October 1. Pioneer recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in the October 31 trial balance. Insurance of $50 ($600 ÷ 12) expires each month. Oct. 31 Insurance expense 50 Prepaid insurance 3-30 50 LO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Illustration 3-6 3-31 LO 5 The Basics of Adjusting Entries Depreciation 3-32 Buildings, equipment, and vehicles (assets with long lives) are recorded as assets, rather than an expense, in the year acquired. Depreciation allocates a portion of the asset’s cost as an expense during each period of the asset’s useful life. Depreciation does not attempt to report the actual change in the value of the asset. LO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Illustration: For Pioneer Advertising, assume that depreciation on the equipment is $480 a year, or $40 per month. Oct. 31 Depreciation expense Accumulated depreciation 40 40 Accumulated Depreciation is called a contra asset account. 3-33 LO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Illustration 3-7 3-34 LO 5 The Basics of Adjusting Entries Statement Presentation Accumulated Depreciation is a contra asset account (credit). Appears just after the account it offsets (Equipment) on the statement of financial position. Book value is the difference between the cost of any depreciable asset and its accumulated depreciation. Illustration 3-8 3-35 LO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Illustration 3-9 3-36 LO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Unearned Revenues Receipt of cash that is recorded as a liability because service has not be performed. Cash Receipt BEFORE Revenue Recorded Unearned revenues often occur in regard to: 3-37 Rent Magazine subscriptions Airline tickets Customer deposits LO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Unearned Revenues Adjusting entry is made to record the revenue for services performed and to show the liability that remains. Results in a decrease (debit) to a liability account and an increase (credit) to a revenue account. Illustration 3-10 3-38 LO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Illustration: Pioneer Advertising received $1,200 on October 2 from R. Knox for advertising services expected to be completed by December 31. Unearned Service Revenue shows a balance of $1,200 in the October 31 trial balance. Analysis reveals that the company earned $ 400 of those fees in October. Oct. 31 Unearned service revenue Service revenue 3-39 400 400 LO 5 Prepare adjusting entries for deferrals. The Basics of Adjusting Entries Illustration 3-11 3-40 LO 5 The Basics of Adjusting Entries Illustration 3-12 3-41 LO 5 Prepare adjusting entries for deferrals. 3-42 LO 5 The Basics of Adjusting Entries Adjusting Entries for Accruals Accruals are made to record Revenues for services performed OR Expenses incurred in the current accounting period that have not been recognized through daily entries. 3-43 LO 6 Prepare adjusting entries for accruals. The Basics of Adjusting Entries Accrued Revenues Revenues for services performed but not yet received in cash or recorded. Revenue Recorded BEFORE Cash Receipt Accrued revenues often occur in regard to: 3-44 Interest Services performed Rent LO 6 Prepare adjusting entries for accruals. The Basics of Adjusting Entries Accrued Revenues Adjusting entry shows the receivable that exists and records the revenues for services performed. Adjusting entry: ► Increases (debits) an asset account and ► Increases (credits) a revenue account. Illustration 3-13 3-45 LO 6 The Basics of Adjusting Entries Illustration: In October Pioneer Advertising Agency recognized $200 for advertising services performed but not recorded. Oct. 31 Accounts receivable 200 Service revenue 200 On November 10, Pioneer receives cash of $ 200 for the services performed. Nov. 10 Cash 200 Accounts receivable 3-46 200 LO 6 Prepare adjusting entries for accruals. The Basics of Adjusting Entries Illustration 3-14 3-47 LO 6 The Basics of Adjusting Entries Illustration 3-15 3-48 LO 6 Prepare adjusting entries for accruals. The Basics of Adjusting Entries Accrued Expenses Expenses incurred but not yet paid in cash or recorded. Expense Recorded BEFORE Cash Payment Accrued expenses often occur in regard to: 3-49 Rent Taxes Interest Salaries LO 6 Prepare adjusting entries for accruals. The Basics of Adjusting Entries Accrued Expenses Adjusting entry records the obligation and recognizes the expense. Adjusting entry: ► Increase (debit) an expense account and ► Increase (credit) a liability account. Illustration 3-16 3-50 LO 6 The Basics of Adjusting Entries Illustration: Pioneer Advertising signed a three-month note payable in the amount of $5,000 on October 1. The note requires Pioneer to pay interest at an annual rate of 12%. Illustration 3-17 Oct. 31 Interest expense Interest payable 3-51 50 50 LO 6 Prepare adjusting entries for accruals. The Basics of Adjusting Entries Illustration 3-18 3-52 LO 6 The Basics of Adjusting Entries Illustration: Pioneer Advertising last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($ 400 x 3 days). Illustration 3-19 3-53 LO 6 Prepare adjusting entries for accruals. The Basics of Adjusting Entries Illustration 3-20 3-54 LO 6 The Basics of Adjusting Entries Illustration 3-21 3-55 LO 6 Prepare adjusting entries for accruals. 3-56 LO 6 Prepare adjusting entries for accruals. Micro Computer Services Inc. began operations on August 1, 2014. At the end of August 2014, management attempted to prepare monthly financial statements. The following information relates to August. Prepare the adjusting journal entries needed at August 31, 2014. (Amounts are in Chinese yuan.) 1. At August 31, the company owed its employees ¥8,000 in salaries and wages that will be paid on September 1. Salaries and wages expense Salaries and wages payable 3-57 8,000 8,000 LO 6 Micro Computer Services Inc. began operations on August 1, 2014. At the end of August 2014, management attempted to prepare monthly financial statements. The following information relates to August. Prepare the adjusting journal entries needed at August 31, 2014. (Amounts are in Chinese yuan.) 2. At August 1, the company borrowed ¥300,000 from a local bank on a 15-year mortgage. The annual interest rate is 10%. Interest expense (¥ 300,000 x 10% x 1/12) Interest payable 3-58 2,500 2,500 LO 6 Micro Computer Services Inc. began operations on August 1, 2014. At the end of August 2014, management attempted to prepare monthly financial statements. The following information relates to August. Prepare the adjusting journal entries needed at August 31, 2014. (Amounts are in Chinese yuan.) 3. Revenue for services performed but unrecorded for August totaled ¥11,000. Accounts receivable Service revenue 3-59 11,000 11,000 LO 6 The Basics of Adjusting Entries Summary of Basic Relationships Illustration 3-22 3-60 LO 6 Prepare adjusting entries for accruals. Preview of Chapter 3 3-61 The Adjusted Trial Balance Adjusted Trial Balance 3-62 Prepared after all adjusting entries are journalized and posted. Purpose is to prove the equality of debit balances and credit balances in the ledger. Is the primary basis for the preparation of financial statements. LO 7 Describe the nature and purpose of an adjusted trial balance. The Basics of Adjusting Entries Types of Adjusting Entries Trial Balance – Each account is analyzed to determine whether it is complete and up-to-date. Illustration 3-3 3-63 LO 4 Identify the major types of adjusting entries. Illustration 3-25 3-64 The Adjusted Trial Balance Question Which of the following statements is incorrect concerning the adjusted trial balance? a. An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made. b. The adjusted trial balance provides the primary basis for the preparation of financial statements. c. The adjusted trial balance lists the account balances segregated by assets and liabilities. d. The adjusted trial balance is prepared after the adjusting entries have been journalized and posted. 3-65 LO 7 Preparing Financial Statements Financial Statements are prepared directly from the Adjusted Trial Balance. Income Statement 3-66 Retained Earnings Statement Statement of Financial Position LO 7 Describe the nature and purpose of an adjusted trial balance. Illustration 3-26 3-67 LO 7 Illustration 3-27 3-68 LO 7 Exercises & Problems Exercises: E3-4, 3-5, 3-10, 3-13 Problems: P3-1A, 3-5A 3-87 Copyright “Copyright © 2013 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. 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