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CHAPTER3
Adjusting the
Accounts

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Timing Issues
Accountants divide the economic life of a business into artificial time periods (Time Period Assumption).

.....
Jan. Feb. Mar. Apr. Dec.

Generally a month, a quarter, or a year.

Also known as the Periodicity Assumption

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SO 1 Explain the time period assumption.

Timing Issues
Fiscal and Calendar Years

Monthly and quarterly time periods are called interim periods.

Public 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.

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SO 1 Explain the time period assumption.

Timing Issues Review

The time period assumption states that:
a. revenue should be recognized in the accounting period in which it is earned. 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.

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SO 1 Explain the time period assumption.

Timing Issues
Accrual- vs. Cash-Basis Accounting
Accrual-Basis Accounting

Transactions recorded in the periods in which the events occur. Revenues are recognized when earned, rather than when cash is received.

Expenses are recognized when incurred, rather than when paid.

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SO 2 Explain the accrual basis of accounting.

Timing Issues
Accrual- vs. Cash-Basis Accounting
Cash-Basis Accounting

Revenues recognized when cash is received.

Expenses recognized when cash is paid.

Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).

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SO 2 Explain the accrual basis of accounting.

Timing Issues
Recognizing Revenues and Expenses
Revenue Recognition Principle
Recognize revenue in the accounting period in which it is earned. In a service enterprise, revenue is considered to be earned at the time the service is performed.

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SO 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.

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SO 2 Explain the accrual basis of accounting.

Timing Issues
Illustration 3-1 GAAP relationships in revenue and expense recognition

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SO 2 Explain the accrual basis of accounting.

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SO 2 Explain the accrual basis of accounting.

Timing Issues Review

One of the following statements about the accrual basis of accounting is false. That statement is:
a. Events that change a companys financial statements are recorded in the periods in which the events occur.

b. Revenue is recognized in the period in which it is earned.

c. The accrual basis of accounting is in accord with generally accepted accounting principles. d. Revenue is recorded only when cash is received, and expenses are recorded only when cash is paid.
SO 2 Explain the accrual basis of accounting.

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The Basics of Adjusting Entries

Adjusting entries are necessary because the trial balance may not contain up-to-date and complete data. Ensure that the revenue recognition and expense recognition principles are followed.

Required every time a company prepares financial statements.

Will include one income statement account and one balance sheet account.

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SO 3 Explain the reasons for adjusting entries.

The Basics of Adjusting Entries Review

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 they are earned. c. balance sheet and income statement accounts have correct balances at the end of an accounting period. d. all of the above.
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SO 3 Explain the reasons for adjusting entries.

The Basics of Adjusting Entries

Types of Adjusting Entries
Illustration 3-2 Categories of adjusting entries

Deferrals
1. Prepaid Expenses. Expenses paid in cash and recorded as assets before they are used or consumed. 2. Unearned Revenues. Cash received and recorded as liabilities before revenue is earned.

Accruals
3. Accrued Revenues. Revenues earned but not yet received in cash or recorded.

4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded.

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SO 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 upto-date.

Illustration 3-3

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SO 4 Identify the major types of adjusting entries.

The Basics of Adjusting Entries

Adjusting Entries for Deferrals
Deferrals are either:

Prepaid expenses OR

Unearned revenues.

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SO 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:

insurance supplies

rent equipment buildings

advertising

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SO 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

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SO 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
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1,500 1,500
SO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Illustration 3-5

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SO 5

The Basics of Adjusting Entries

Illustration: On October 4, Pioneer Advertising Agency paid $600 for a oneyear 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 Prepaid insurance
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50 50

SO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Illustration 3-6

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SO 5

The Basics of Adjusting Entries

Depreciation

Buildings, equipment, and vehicles (assets with long lives) are recorded as assets, rather than an expense, in the year acquired. Companies report a portion of the cost of the asset as an expense (depreciation expense) during each period of the assets useful life. Depreciation does not attempt to report the actual change in the value of the asset.

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SO 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.

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SO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Illustration 3-7

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SO 5

The Basics of Adjusting Entries

Statement Presentation

Accumulated Depreciation is a contra asset account.

Appears just after the account it offsets (Equipment) on the balance sheet. Normal balance of a contra asset account is a credit.
Illustration 3-8

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SO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Illustration 3-9

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SO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Unearned Revenues
Receipt of cash that is recorded as a liability because the revenue has not been earned.
Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

Rent Airline tickets

Magazine subscriptions Customer deposits

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SO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Unearned Revenues

Adjusting entry is made to record the revenue that has been earned 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

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SO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Illustration: Pioneer Advertising Agency 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 400 400

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SO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Illustration 3-11

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SO 5

The Basics of Adjusting Entries

Illustration 3-12

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SO 5 Prepare adjusting entries for deferrals.

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The Basics of Adjusting Entries

Adjusting Entries for Accruals
Accruals are made to record

Revenues earned OR

Expenses incurred

in the current accounting period that have not been recognized through daily entries.

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SO 6 Prepare adjusting entries for accruals.

The Basics of Adjusting Entries

Accrued Revenues
Revenues earned but not yet received in cash or recorded.

Revenue Recorded

BEFORE

Cash Receipt

Accrued revenues often occur in regard to:

Rent Interest

Services performed

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SO 6 Prepare adjusting entries for accruals.

The Basics of Adjusting Entries

Accrued Revenues

Adjusting entry shows the receivable that exists and records the revenues earned.

Adjusting entry:

Increases (debits) an asset account and Increases (credits) a revenue account.

Illustration 3-13

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SO 6

The Basics of Adjusting Entries

Illustration: In October Pioneer Advertising Agency earned $200 for advertising services that had not been recorded. Oct. 31 Accounts receivable Service revenue 200 200

On November 10, Pioneer receives cash of $200 for the services performed.

Nov. 10

Cash
Accounts receivable

200
200

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SO 6 Prepare adjusting entries for accruals.

The Basics of Adjusting Entries

Illustration 3-14

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SO 6

The Basics of Adjusting Entries

Illustration 3-15

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SO 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:

Rent Interest

Taxes Salaries

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SO 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

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SO 6

The Basics of Adjusting Entries

Illustration: Pioneer Advertising Agency 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%.

Oct. 31

Interest expense

50

Interest payable

50

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SO 6 Prepare adjusting entries for accruals.

The Basics of Adjusting Entries

Illustration 3-18

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SO 6

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The Basics of Adjusting Entries

Illustration: Pioneer Advertising Agency 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

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SO 6 Prepare adjusting entries for accruals.

The Basics of Adjusting Entries

Illustration 3-20

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SO 6

The Basics of Adjusting Entries

Illustration 3-21

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SO 6 Prepare adjusting entries for accruals.

The Basics of Adjusting Entries

Summary of Basic Relationships
Illustration 3-22

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SO 6 Prepare adjusting entries for accruals.

The Adjusted Trial Balance

Adjusted Trial Balance

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.

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SO 7 Describe the nature and purpose of the adjusted trial balance.

Illustration 3-25

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The Adjusted Trial Balance Review

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.
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SO 7 Describe the nature and purpose of the adjusted trial balance.

The Financial Statements

Financial Statements are prepared directly from the Adjusted Trial Balance.

Balance Sheet

Income Statement

Owners Equity Statement

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SO 7 Describe the nature and purpose of the adjusted trial balance.

Illustration 3-26

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SO 7

Illustration 3-27

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SO 7

APPENDIX3A
Alternative Treatment of Prepaid Expenses and Unearned Revenues

When a company prepays an expense, it debits that amount to an expense account. When a company receives payment for future services, it credits the amount to a revenue account.

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SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

APPENDIX3A
Prepaid Expenses
Company may choose to debit (increase) an expense account rather than an asset account. This alternative treatment is simply more convenient.
Illustration 3A-2

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SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

APPENDIX3A
Unearned Revenues
Company may credit (increase) a revenue account when they receive cash for future services.
Illustration 3A-5

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SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

APPENDIX3A
Summary of Additional Adjustment Relationships
Illustration 3A-7

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SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

IFRS
Key Points

A Look at IFRS

Companies applying IFRS also use accrual-basis accounting to ensure that they record transactions that change a companys financial statements in the period in which events occur.
Similar to GAAP, cash-basis accounting is not in accordance with IFRS. IFRS also divides the economic life of companies into artificial time periods. Under both GAAP and IFRS, this is referred to as the time period assumption. IFRS requires that companies present a complete set of financial statements, including comparative information annually.

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IFRS
Key Points

A Look at IFRS

GAAP has more than 100 rules dealing with revenue recognition. Many of these rules are industry specific. In contrast, revenue recognition under IFRS is determined primarily by a single standard. Despite this large disparity in the amount of detailed guidance devoted to revenue recognition, the general revenue recognition principles required by GAAP that are used in this textbook are similar to those under IFRS.
As the Feature Story illustrates, revenue recognition fraud is a major issue in U.S. financial reporting. The same situation occurs in other countries, as evidenced by revenue recognition breakdowns at Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch grocer AHold NV.

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IFRS
Key Points

A Look at IFRS

A specific standard exists for revenue recognition under IFRS (IAS 18). In general, the standard is based on the probability that the economic benefits associated with the transaction will flow to the company selling the goods, providing the service, or receiving investment income. In addition, the revenues and costs must be capable of being measured reliably. GAAP uses concepts such as realized, realizable (that is, it is received, or expected to be received), and earned as a basis for revenue recognition.
Under IFRS, revaluation of items such as land and buildings is permitted. IFRS allows depreciation based on revaluation of assets, which is not permitted under GAAP.

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IFRS
Key Points

A Look at IFRS

The terminology used for revenues and gains, and expenses and losses, differs somewhat between IFRS and GAAP. For example, income is defined as:
Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from shareholders. Expenses are defined as: Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity other than those r elating to distributions to shareholders.

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IFRS

A Look at IFRS

Looking into the Future

The IASB and FASB are now involved in a joint project on revenue recognition. The purpose of this project is to develop comprehensive guidance on when to recognize revenue. Presently, the Boards are considering an approach that focuses on changes in assets and liabilities (rather than on earned and realized) as the basis for revenue recognition.

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IFRS
GAAP:

A Look at IFRS

a. provides very detailed, industry-specific guidance on revenue recognition, compared to the general guidance provided by IFRS. b. provides only general guidance on revenue recognition, compared to the detailed guidance provided by IFRS. c. allows revenue to be recognized when a customer makes an order. d. requires that revenue not be recognized until cash is received.
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IFRS

A Look at IFRS

Which of the following statements is false? a. IFRS employs the periodicity assumption. b. IFRS employs accrual accounting. c. IFRS requires that revenues and costs must be capable of being measured reliably. d. IFRS uses the cash basis of accounting.

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IFRS

A Look at IFRS

As a result of the revenue recognition project being undertaken by the FASB and IASB: a. revenue recognition will place more emphasis on when revenue is earned. b. revenue recognition will place more emphasis on when revenue is realized.

c. revenue recognition will place more emphasis on when changes occur in assets and liabilities.
d. revenue will no longer be recorded unless cash has been received
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