Financial Accounting, 3e

Weygandt, Kieso, & Kimmel

Prepared by Gregory K. Lowry Mercer University Marianne Bradford The University of Tennessee

John Wiley & Sons, Inc.

CHAPTER 3
ADJUSTING THE ACCOUNTS
After studying this chapter, you should be able to: 1 Explain the time period assumption. 2 Distinguish between the revenue recognition principle and the matching principle. 3 Explain why adjusting entries are needed. 4 Identify the major types of adjusting entries. 5 Prepare adjusting entries for prepayments. 6 Prepare adjusting entries for accruals. 7 Describe the nature and purpose of an adjusted trial balance. 8 Explain the accrual basis of accounting.

PREVIEW OF CHAPTER 3
ADJUSTING THE ACCOUNTS

Timing Issues

The Basics of Adjusting Entries

The Adjusted Trial Balance and Financial Statements

Accrual vs. Cash Basis of Accounting

Time Period assumption

Types of adjusting entries

Fiscal and calendar years

Recognizing revenues and expenses

Adjusting entries for prepayments

Adjusting entries for accruals Summary

Preparing the adjusted trial balance Preparing financial statements

TIME-PERIOD ASSUMPTION
The time period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods. Accounting time periods are generally a month, a quarter, or a year. The accounting time period of one year in length is usually known as a fiscal year. The accounting period used by most businesses coincides with the calendar year (January 1 to December 31).

REVENUE RECOGNITION PRINCIPLE

The revenue recognition principle states that revenue should be recognized in the accounting period in which it is earned. In a service business, revenue is considered to be earned at the time the service is performed.

THE MATCHING PRINCIPLE

The practice of expense recognition is referred to as the matching principle. The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues).
Revenues earned this month

are offset against....

expenses incurred in earning the revenue

ILLUSTRATION 3-1
GAAP RELATIONSHIPS IN REVENUE AND EXPENSE RECOGNITION
Time-Period Assumption

Economic life of business can be divided into artificial time periods

Revenue-Recognition Principle Matching Principle
Expenses matched with revenues in the period when efforts are expended to generate revenues

Revenue recognized in the accounting period in which it is earned

Revenue and Expense Recognition

In accordance with generally accepted accounting principles (GAAP)

ADJUSTING ENTRIES
Adjusting entries are made in order for: 1 Revenues to be recorded in the period in which they are earned, and for...... 2 Expenses to be recognized in the period in which they are incurred.

ADJUSTING ENTRIES
Adjusting entries are required each time financial statements are prepared. Adjusting entries can be classified as 1 prepayments (prepaid expenses or unearned revenues) or 2 accruals (accrued revenues or accrued expenses)

TYPES OF ADJUSTING ENTRIES

Prepayments 1 Prepaid Expenses - expenses paid in cash and recorded as assets before they are used

or consumed
2 Unearned Revenues - revenues received in cash and recorded as liabilities before they are earned

TYPES OF ADJUSTING ENTRIES

Accruals 1 Accrued Revenues - revenues earned but not yet received in cash or recorded 2 Accrued Expenses - expenses incurred but not yet paid in cash or recorded

ILLUSTRATION 3-3

TRIAL BALANCE
PIONEER ADVERTISING AGENCY, INC. Trial Balance October 31, 2001
Cash Advertising Supplies Prepaid Insurance Office Equipment Notes Payable Accounts Payable Unearned Revenue Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Rent Expense Debit $ 15,200 2,500 600 5,000 Credit

The Trial Balance is the starting place for adjusting entries.

$ 5,000 2,500 1,200 10,000 -0500 10,000

4,000 900 $ 28,700 $ 28,700

PREPAYMENTS
Prepayments are either prepaid expenses or unearned revenues. Adjusting entries for prepayments are required to record the portion of the prepayment that represents 1 the expense incurred or 2 the revenue earned in the current accounting period.

ILLUSTRATION 3-4
ADJUSTING ENTRIES FOR PREPAYMENTS
Adjusting Entries
Prepaid Expenses
Asset Unadjusted Credit Balance Adjusting Entry (-) Expense Debit Adjusting Entry (+)

Unearned Revenues
Liability Debit Adjusting Entry (-) Unadjusted Balance Revenue Credit Adjusting Entry (+)

PREPAID EXPENSES
Prepaid expenses are expenses paid in cash and recorded as assets before they are used or consumed. Prepaid expenses expire with the passage of time or through use and consumption. An asset-expense account relationship exists with prepaid expenses.

PREPAID EXPENSES
Prior to adjustment, assets are overstated and expenses are understated. The adjusting entry results in a debit to an expense account and a credit to an asset account. Examples of prepaid expenses include supplies, insurance, and depreciation.

ADJUSTING ENTRIES FOR PREPAYMENTS

SUPPLIES
Adjustment
October 31, an inventory count reveals that $1,000 of $2,500 of supplies arestill on hand.

Journal Entry

Date Oct. 31

Account Titles and Explanation Advertising Supplies Expense Advertising Supplies (To record supplies used)

Debit Credit 1,500 1,500

Posting

Advertising Supplies Oct. 5 2,500 Oct. 31 1,500 31 1,000

Advertising Supplies Expense Oct. 31 1,500

ADJUSTING ENTRIES FOR PREPAYMENTS

INSURANCE
Adjustment
October 31, an analysis of the policy reveals that $50 of insurance expires each month.

Journal Entry

Date Oct. 31

Account Titles and Explanation Insurance Expense Prepaid Insurance (To record insurance expired)

Debit 50

Credit 50

Posting

Prepaid Insurance Oct. 4 600 Oct. 31 31 550

10 50

Insurance Expense Oct. 31 50

63

DEPRECIATION
Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner. The purchase of equipment or a building is viewed as a long-term prepayment of services and, therefore, is allocated in the same manner as other prepaid expenses.

DEPRECIATION
Depreciation is an estimate rather than a factual measurement of the cost that has expired. In recording depreciation, Depreciation Expense is debited and a contra asset account, Accumulated Depreciation, is credited
xxx Depreciation Expense
Accumulatedxxx Depreciation

DEPRECIATION
In the balance sheet, Accumulated Depreciation is offset against the asset account. The difference between the cost of the asset and its related accumulated depreciation is referred to as the book value of the asset.

ADJUSTING ENTRIES FOR PREPAYMENTS

DEPRECIATION
Adjustment
October 31, depreciation on the office equipment is estimated to be $480 a year, or $40 per month.

Journal Entry

Date Oct. 31

Account Titles and Explanation Depreciation Expense Accumulated Depreciation - Office Equipment (To record monthly depreciation)

Debit Credit 40 40

Posting

Accumulated Depreciation Office Equipment Oct. 31 40

Depreciation Expense Oct. 31 40

UNEARNED REVENUES
Unearned revenues are revenues received and recorded as liabilities before they are earned. Unearned revenues are subsequently earned by rendering a service to a customer. A liability-revenue account relationship exists with unearned revenues.

UNEARNED REVENUES
Prior to adjustment, liabilities are overstated and revenues are understated. The adjusting entry results in a debit to a liability account and a credit to a revenue account. Examples of unearned revenues include rent, magazine subscriptions, and customer deposits for future services.

ADJUSTING ENTRIES FOR PREPAYMENTS

UNEARNED REVENUES
Adjustment
October 31, analysis reveals that, of $1,200 in fees, $400 has been earned in October.

Journal Entry

Date Oct. 31

Account Titles and Explanation Unearned Revenue Service Revenue (To record revenue for services provided

Debit Credit 400 400

Posting

Unearned Revenue Oct. 31 400 Oct. 2 1,200 31 800

Service Revenue Oct. 31 10,000 31 400

ACCRUALS
The second category of adjusting entries is accruals. Adjusting entries for accruals are required to record revenues earned and expenses incurred in the current period. The adjusting entry for accruals will increase both a balance sheet and an income statement account.

ILLUSTRATION 3-10
ADJUSTING ENTRIES FOR ACCRUALS
Adjusting Entries
Accrued Revenues
Asset Debit Adjusting Entry (+) Revenue Credit Adjusting Entry (+)

Accrued Expenses
Expense Debit Adjusting Entry (+) Liability Credit Adjusting Entry (+)

ACCRUED REVENUES
Accrued revenues may accumulate with the passing of time or through services performed but not billed or collected. An asset-revenue account relationship exists with accrued revenues. Prior to adjustment, assets and revenues are understated. The adjusting entry requires a debit to an asset account and a credit to a revenue account.

ADJUSTING ENTRIES FOR ACCRUALS

ACCRUED REVENUES
Adjustment
October 31, the agency earned $200 in fees for advertising services that were not billed to clients before October 31.

Journal Entry

Date Oct. 31

Account Titles and Explanation Accounts Receivable Service Revenue (To accrue fees earned but not billed or collected)

Debit Credit 200 200

Posting

Accounts Receivable Oct. 31 200

Service Revenue Oct. 31 10,000 31 400 31 200 31 10,600

ACCRUED EXPENSES
Accrued expenses are expenses incurred but not paid yet. A liability-expense account relationship exists Prior to adjustment, liabilities and expenses are understated The Adjusting Entry results in a debit to an expense account and a credit to a liability account

ADJUSTING ENTRIES FOR ACCRUALS

ACCRUED INTEREST
Adjustment
October 31, the portion of the interest to be accrued on a 3-month note payable is calculated to be $50.

Journal Entry

Date Oct. 31

Account Titles and Explanation Interest Expense Interest Payable (To accrue interest on notes payable)

Debit Credit 50 50

Posting

Interest Expense Oct. 31 50

Interest Payable Oct. 31

50

ADJUSTING ENTRIES FOR ACCRUALS

ACCRUED SALARIES
Adjustment
October 31, accrued salaries are calculated to be $1,200.

Journal Entry

Date Oct. 31

Account Titles and Explanation Salaries Expense Salaries Payable (To record accrued salaries)

Debit Credit 1,200 1,200

Posting

Salaries Expense Oct. 26 4,000 31 1,200 31 5,200

Salaries Payable Oct. 31

1,200

ILLUSTRATION 3-14 SUMMARY OF ADJUSTING ENTRIES

Type of 1Adjustment Prepaid expenses 2 Unearned revenues 3 Accrued revenues 4 Accrued expenses Account Relationship Assets and expenses Liabilities and revenues Assets and revenues Expenses and liabilities Accounts before Adjusting Adjustment Entry Assets overstated Dr. Expenses Expenses understated Cr. Assets Liabilities overstated Dr. Liabilities Revenues understated Cr. Revenues Assets understated Dr. Assets Revenues understated Cr. Revenues Expenses understated Dr. Expenses Liabilities understated Cr. Liabilities

ADJUSTED TRIAL BALANCE

An Adjusted Trial Balance is prepared after all adjusting entries have been journalized and posted. It shows the balances of all accounts at the end of the accounting period and the effects of all financial events that have occurred during the period. It proves the equality of the total debit and credit balances in the ledger after all adjustments have been made. Financial statements can be prepared directly from the adjusted trial balance.

ILLUSTRATION 3-18
TRIAL BALANCE AND ADJUSTED TRIAL BALANCE COMPARED
PIONEER ADVERTISING AGENCY, INC. Trial Balances October 31, 2001
Before Adjustment Debit Credit $ 15,200 2,500 600 5,000 $ 5,000 2,500 1,200 10,000 0 500 10,000 4,000 900 After Adjustment Debit Credit $ 15,200 200 1,000 550 5,000 $ 40 5,000 2,500 50 800 1,200 10,000 0 500 10,600 5,200 1,500 900 50 50 40 $ 30,190 $ 30,190

Cash Accounts Receivable Advertising Supplies Prepaid Insurance Office Equipment Accumulated Depreciation - Office Equipment Notes Payable Accounts Payable Interest Payable Unearned Revenue Salaries Payable Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Advertising Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense

$ 28,700

$ 28,700

ACCRUAL BASIS OF ACCOUNTING

The revenue recognition and matching principles are used under the accrual basis of accounting. Under cash-basis accounting, revenue is recorded only when cash is received, and expenses are recorded only when paid. Generally accepted accounting principles require accrual basis accounting because the cash basis often causes misleading financial statements.

ALTERNATIVE TREATMENT
Some businesses use an alternative treatment for prepaids and unearned revenues. Instead of debiting an asset at the time an expense is prepaid, the amount is charged to an expense account. Instead of crediting a liability at the time cash is received in advance of earning it, the amount is credited to a revenue account. This treatment of prepaid expenses and unearned revenues will ultimately result in the same effect on the financial statements as initial entries to balance sheet accounts and then adjusting entries.

ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS

SUPPLIES
Adjustment
October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand.

Journal Entry

Date Oct. 31

Account Titles and Explanation Advertising Supplies Advertising Supplies Expense (To record supplies inventory)

Debit Credit 1,000 1,000

Posting

Advertising Supplies Oct. 31 1,000

Advertising Supplies Expense Oct. 5 2,500 Oct. 31 1,000 31 1,500

ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS

UNEARNED REVENUES
Adjustment
October 31, analysis reveals that, of $1,200 in revenue, $400 has been earned in October.

Journal Entry

Date Account Titles and Explanation Oct. 31 Service Revenue Unearned Revenue (To record unearned revenue)

Debit Credit 800 800

Posting

Unearned Revenue Oct. 31

800

Service Revenue Oct. 31 800 Oct. 2 31

1,200 400

ILLUSTRATION 3A-7
SUMMARY OF BASIC RELATIONSHIPS FOR PREPAYMENTS
Type of Adjustment 1 Prepaid Account Relationship Assets and Reason for Adjustment a Prepaid expenses Account Balances before Adjustment Assets overstated Adjusting Entry Dr Expenses

Expenses

Expenses

2 Unearned Revenues

Liabilities and Revenues

initially recorded in asset accounts have been used. b Prepaid expenses initially recorded in expense accounts have not been used. a Unearned revenues initially recorded in liability accounts have been earned. b Unearned revenues initially recorded in revenue accounts have not been earned.

Expenses understated Cr Assets

Assets understated Expenses overstated

Dr Assets

Cr Expenses

Liabilities overstated Dr Liabilities Revenues understated Cr Revenues

Liabilities understated Dr Revenues Revenues understated Cr Liabilities

COPYRIGHT

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CHAPTER 3
ADJUSTING THE ACCOUNTS