3 The Adjusting Process 1 After studying this

3 The Adjusting Process 1

After studying this chapter, you should be able to: 1. Describe the nature of the adjusting process. 2. Journalize entries for accounts requiring adjustment. 3. Summarize the adjustment process. 4. Prepare an adjusted trial balance. 2

3 -1 Objective 1 Describe the nature of the adjusting process. 33

Reporting Revenue and Expense TWO METHODS Cash Basis of Accounting Accrual Basis of Accounting

Cash Basis of Accounting 4 Revenue reported when cash is received 4 Expense reported when cash is paid 4 Does not properly match revenues and expenses

Accrual Basis of Accounting 4 Revenue reported when earned 4 Expense reported when incurred 4 Properly matches revenues and expenses in determining net income 4 Requires adjusting entries at end of period 4 It just sounds mean – it really isn’t

Accrual Basis Vs. Cash Basis Accrual Basis Cash Basis Revenues are recognized when earned and expenses are recognized when incurred. Revenues are recognized when cash is received and expenses recorded when cash is paid. Not GAAP Accounting

3 -1 Under the accrual basis of accounting, revenues are reported in the income statement in the period in which they are earned. 8

3 -1 The accounting concept that supports this approach to reporting of revenues is called the revenue recognition concept. 9

3 -1 The accounting concept that supports reporting revenues and related expenses in the same period is called the matching concept, or matching principle. 10

3 -1 Under the cash basis of accounting, revenues and expenses are reported in the income statement in the period in which cash is received or paid. 11

3 -1 The analysis and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process. 12

1 The Adjusting Process Under the accrual basis, at the end of the accounting period some of the accounts need updating for the following reasons: 3 -13 1. Some expenses are not recorded daily. 2. Some revenues and expenses are incurred as time passes rather than as separate transactions. 3. Some revenues and expenses may be unrecorded. 13

3 -1 The journal entries that bring the accounts up to date at the end of the accounting period are called adjusting entries. 14

3 -1 Example Exercise 3 -1 Indicate with a Yes or No whether or not each of the following accounts normally requires an adjusting entry. a. b. Cash Prepaid Rent c. Wages Expense e. Accounts Receivable d. Office Equipment f. Unearned Rent Follow My Example 3 -1 a. No b. Yes c. Yes d. No? /Yes For Practice: PE 3 -1 A, PE 3 -1 B e. Yes f. Yes 15 10

Items That Need Adjusting 3 -1 Prepaid expenses, sometimes referred to as deferred expenses, are items that have been initially recorded as assets but are expected to become expenses over time or through the normal operations of the business. 16

Items That Need Adjusting 3 -1 Unearned revenues, sometimes referred to as deferred revenues, are items that have been initially recorded as liabilities but are expected to become revenues over time or through the normal operations of the business. 17

3 -1 Insert Exhibit 1 18 13

Items That Need Adjusting 3 -1 Accrued revenues, sometimes referred to as accrued assets (accrued means unpaid), are revenues that have been earned but have not been recorded in the accounts. 19

Items That Need Adjusting 3 -1 Accrued expenses, sometimes referred to as accrued liabilities, are expenses that have been incurred but have not been recorded in the accounts. 20

3 -1 21 16

3 -1 Example Exercise 3 -2 Classify the following items as (1) prepaid expense, (2) unearned revenue, (3) accrued expense, or (4) accrued revenue. a. Wages owed but not c. Fees received but not yet paid. earned. b. Supplies on hand. d. Fees earned but not yet received. Follow My Example 3 -2 a. Accrued expense b. Prepaid expense c. Unearned revenue d. Accrued revenue For Practice: PE 3 -2 A, PE 3 -2 B 22 17

3 -2 Objective 2 Journalize entries for accounts requiring adjustment. 23

3 -2 1924

Adjusting Process for Prepaid Expenses 3 -2 Net. Solutions’ Supplies account has a balance of $2, 000 in the unadjusted trial balance. Some of these supplies have been used. On December 31, a count reveals that $760 of supplies are on hand. 25

3 -2 Supplies (balance on trial balance) Supplies on hand, December 31 Supplies used $2, 000 – 760 $1, 240 26

3 -2 2007 Dec. 31 Supplies Expense Supplies 55 14 1 240 00 Supplies used ($2, 000 – $760) Bal. Supplies Expense Supplies 14 2, 000 Dec. 31 Adj Bal. 800 760 1, 240 Dec. 31 1, 240 2, 040 55 27 22

3 -2 The debit balance of $2, 400 in Net. Solutions’ Prepaid Insurance account represents the December 1 prepayment of insurance for 12 months. 28

3 -2 31 Insurance Expense Prepaid Insurance 56 200 00 15 200 00 Insurance expired ($2, 400/12). Prepaid Insurance Expense 15 Bal. 2, 400 Dec. 31 Adj 200 Dec. 31 Adj 200 2, 200 56 29 24

3 -2 Example Exercise 3 -3 The prepaid insurance account had a beginning balance of $6, 400 and was debited for $3, 600 of premiums paid during the year. Journalize the adjusting entry required at the end of the year assuming the amount of unexpired insurance related to future periods is $3, 250. Follow My Example 3 -3 Insurance Expense Prepaid Insurance expired ($6, 400 + $3, 600 – $3, 250). For Practice: PE 3 -3 A, PE 3 -3 B 6, 750 30 25

3 -2 On December 1, the tenant prepaid three months’ rent for use of an office building owned by Net. Solutions. As of December 31, only $120 has been earned. 31

3 -2 31 Unearned Rent Revenue Rent earned ($360/3 months) Unearned Rent Dec. 31 Adj 120 Bal. 23 360 240 23 42 120 00 Rent Revenue Dec. 31 Adj. 120 00 42 120 32 27

3 -2 Example Exercise 3 -4 The balance in the unearned fees account, before adjustment at the end of the year, is $44, 900. Journalize the adjusting entry required if the amount of unearned fees at the end of the year is $22, 300. Follow My Example 3 -4 Unearned Fees Earned Fees earned ($44, 900 – $22, 300). For Practice: PE 3 -4 A, PE 3 -4 B 22, 600 33 28

2 Accrued Revenues Net. Solutions signed an agreement with Danker Co. on December 15 to provide services at $20 per hour. As of December 31, Net. Solutions had provided 25 hours of assistance.

3 -2 Net. Solutions provided (25 hrs * $20) $500 in services during December for which the customer has not been billed. 35

3 -2 31 Accounts Receivable Fees Earned 12 41 500 00 Accrued fees (25 hrs. x $20) Accounts Receivable 12 Bal. 2, 220 Dec. 31 Adj 500 Bal. 2, 720 Fees Earned 41 Bal. 16, 340 Dec. 31 Adj 500 16, 840 Bal. 36 30

3 -2 Example Exercise 3 -5 At the end of the current year, $13, 680 of fees have been earned but have not been billed to clients. Journalize the adjusting entry to record the accrued fees. Follow My Example 3 -5 Accounts Receivable Fees Earned Accrued fees. For Practice: PE 3 -5 A, PE 3 -5 B 13, 680 37 31

2 Accrued Expenses Net. Solutions pays it employees biweekly. During December, Net. Solutions paid wages of $950 on December 13 and $1, 200 on December 27. As of December 31, Net. Solutions owes $250 of wages to employees for Monday and Tuesday. 3 -38 1 -38 38

3 -2 Without this adjusting entry, Wages Expense is understated. 39

3 -2 31 Wages Expense Wages Payable 51 22 250 00 Accrued wages. Wages Payable 22 Dec. 31 Adj 250 Wages Expense Bal. 4, 275 Dec. 31 Adj 250 Bal. 4, 525 51 40 33

3 -2 Wages Payable 22 Dec. 31 250 Wages Expense Bal. 4, 275 Dec. 31 250 Bal. 4, 525 51 Closing entries will be discussed in a later chapter. For now, just be aware that Wages Expense is closed after financial statements are prepared and its balance rolled back to zero. 41 34

3 -2 The payment of January 10 wages totaling $1, 275 is shown below. Jan. 10 Wages Expense Wages Payable Cash 1 025 00 250 00 1 275 00 42 35

3 -2 Jan. 10 Wages Payable 22 250 Dec. 31 250 The liability is cancelled. Wages Expense Bal. 4, 275 Dec. 31 250 Bal. 4, 525 51 Jan. 10 1, 025 An expense for wages of $1, 025 is recorded in the new fiscal year. 43 36

3 -2 Example Exercise 3 -6 Sanregret Realty Co. pays weekly salaries of $12, 500 on Friday for a five-day week ending on that day. Journalize the necessary adjusting entry at the end of the accounting period, assuming that the period ends on Thursday. Follow My Example 3 -6 Salaries Expense Salaries Payable Accrued salaries ($12, 500/5 x 4 days). For Practice: PE 3 -6 A, PE 3 -6 B 10, 000 44 37

3 -2 Physical resources that are owned and used by a business and are permanent or have a long life are called fixed assets, or plant assets. 45

3 -2 As time passes, a fixed asset loses its ability to provide useful services. This decrease in usefulness is called depreciation. 46

3 -2 Normal titles for fixed asset accounts and their related contra asset accounts are as follows: Fixed Asset Contra Asset Land Buildings None—Land is not depreciated Accumulated Depreciation— Buildings Accumulate Depreciation—Store Equipment Accumulated Depreciation—Office Equipment Store Equipment Office Equipment 47

3 -2 Net. Solutions estimates the depreciation on its office equipment to be $50 for the month of December. 48

3 -2 31 Depreciation Expense Accum. Depreciation— Office Equipment 53 19 50 00 Depreciation of office equipment. Depreciation Expense Dec. 31 Adj 50 53 Accum. Depr. —Office Equip. 19 Dec. 31 Adj 50 49 42

3 -2 Net. Solutions’ balance sheet would show the office equipment at cost, less the accumulated depreciation. Office equipment $1, 800 Less accumulated depreciation 50 $1, 750 Book value 50

3 -2 Example Exercise 3 -7 The estimated amount of depreciation on equipment for the current year is $4, 250. Journalize the adjusting entry to record the depreciation. Follow My Example 3 -7 Depreciation Expense Accumulated Depreciation— Equipment Depreciation on equipment. For Practice: PE 3 -7 A, PE 3 -7 B 4, 250 51 44

3 -3 Objective 3 Summarize the adjustment process 52

3 -3 4653

3 -3 Ledger with Adjusting Entries —Net. Solutions (Continued) 4754

(Continued) 3 -3 Ledger with Adjusting Entries —Net. Solutions 4855

(Continued) 3 -3 Ledger with Adjusting Entries —Net. Solutions 4956

(Concluded) 3 -3 Ledger with Adjusting Entries —Net. Solutions 57 50

3 -3 Example Exercise 3 -8 For the year ending December 31, 2008, Mann Medical Co. mistakenly omitted adjusting entries for (1) $8, 600 of unearned revenue that was earned, (2) earned revenue that was not billed of $12, 500, and (3) accrued wages of $2, 900. Indicate the combined effect of the errors on (a) revenues, (b) expenses, and (c) net income for 2008. Follow My Example 3 -8 a. Revenues were understated by $21, 100 ($8, 600 + $12, 500). b. Expenses were understated by $2, 900. c. Net income was understated by $18, 200 ($8, 600 +12, 500 – $2, 900). For Practice: PE 3 -8 A, PE 3 -8 B 58 51

3 -4 Objective 4 Prepare an adjusted trial balance. 59

3 -4 The purpose of the adjusted trial balance is to verify the equality of the total debit balances and total credit balances before the financial statements are prepared. 60

3 -4 5461

3 -4 Example Exercise 3 -9 For each of the following errors, considered individually, indicate whether the error would cause the adjusted trial balance totals to be unequal. If the error would cause the adjusted trial balance total to be unequal, indicate whether the debit or credit total is higher and by how much. a. The adjustment for accrued fees of $5, 340 was journalized as a debit to Accounts Payable for $5, 340 and a credit to Fees Earned of $5, 340. b. The adjustment for depreciation of $3, 260 was journalized as a debit to Depreciation Expense for $3, 620 and a credit to Accumulated Depreciation for $3, 260. 62 55

3 -4 Follow My Example 3 -9 a. The totals are equal even though the debit should have been to Accounts Receivable instead of Accounts Payable. b. The totals are unequal. The debit total is higher by $360 ($3, 620 – $3, 260). For Practice: PE 3 -9 A, PE 3 -9 B 63 56

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