Week 6 – Lecture

Adjusting the accounts and preparing financial statements

Measurement of profit
Cash basis:
- Income is recorded when cash is received
- Expenses are recorded when cash is paid
Accrual Basis:
- Income recognised when the anticipated inflow of economic benefit can be reliably
measured
- Expenses recognised when the consumption of benefits can be reliably measured

Temporary and Permanent accounts

Temporary (nominal) accounts:
- Income statement accounts
- Reduced to zero balance at the end of each accounting period (closed)
- Reset the business “stopwatch”
Permanent (real) accounts:
- Balance sheet accounts
- Ending balances carried forward to next accounting period

Expanded accounting cycle including adjusting entries

1. Recognise and record transactions (source documents)
2. Journalise transactions (general journal)
3. Post to ledger accounts (general ledger)
4. Prepare unadjusted trial balance of general ledger (trial balance unadjusted)
5. Determine adjusting entries and journalise (general journal)
6. Post adjusting entries to general ledger (general ledger – accounts adjusted)
7. Prepare adjusted trial balance (trial balance – adjusted)
8. Prepare financial statements (financial statements)

The need for adjusting entries

In many cases the period in which cash is paid or received does not coincide with period in
which expense and income are recognised. Therefore, in order for our statements to reflect
what has actually happened, some accounts must be adjusted on the last day of the
accounting period to correctly recognise income and expense not reflected in cash receipts
or payments.

Classification of adjusting entries

Deferrals (prepayments)
- Prepaid Expense:
o Costs/expenses paid before they are consumed
- Unearned revenue:
o Revenues that are collected or received but not yet earned
Accruals (unrecorded)
- Accrued expense:
 o Expenses incurred but not yet paid
- Accrued revenue:
o Revenue earned but not yet received

The rules of adjusting entries

Attempting to account for the “timing difference” between receipt/payment of cash, and
recognition of income/expense. One side of the entry affects an income statement account
- That is revenue or expense
The other side of the entry affects an account reported in the balance sheet
- That is asset or liability
*Cash is never adjusted

Adjusting entries
Revenue:
- Unearned revenue  revenues collected in advance, but not yet earned e.g.
magazine subscription received in advance
- Accrued revenue  revenues earned, but not yet received in cash or entered e.g.
interest earned on a bank term deposit but not paid

$$$.  revenue revenue 

Last year | Current year | Net year

Expenses:
- Expenses paid for before they are consumed e.g. insurance premium paid 12 months
in advance
Accrued expenses:
- Expenses incurred, but not yet paid for or entered e.g. wages earned by employees,
but not yet paid

$$$.  expense expense 

Last year | Current year | Net year

Deferrals
Prepaid expenses:
- Cash paid before benefits are consumed
- Initially recorded as assets when paid
- At the end of the period the amount consumed/expired is expensed
Example: depreciation
- Depreciation = Allocation of the historic cost of an asset (less any residual value) over
the useful life of that asset

Unearned revenue:
- Cash received in advance for services that are to be performed in the future
- Initially recorded as liability when received
- Recognised as revenue as earned

Accruals
Accrued expenses:
- Expenses that have been consumed but have not been recorded because payment
has not yet been made
- Expense must be recognised along with a liability for future payment

Accrued revenue:
- Usually recorded when service is performed
o No adjusting entry would be necessary
- Any unrecorded revenue earned needs to be recorded
Adjusted trial balance
- Unadjusted trial balance used as starting point
- Adjusting entries are posted to the general ledger
- An adjusted trial balance can then be prepared
- Debits must still equal credits
- Adjusting entries always affect an income statement and a balance sheet account