Adjusting the Accounts Chapter 3 1 Accounting Principles

Adjusting the Accounts Chapter 3 -1 Accounting Principles, Ninth Edition

READ CH 3 Read CH 3 & DO: ONLINE QUESTIONS on website You can take it more than once online Chapter 3 -2

l Chapter 3 -3 GOAL: TO UNDERSTAND ACCRUAL BASE ACCOUNTING and HOW IT AFFECTS NET INCOME/LOSS.

Timing Issues FOR RECOGNIZING REVENUE Accrual- vs. Cash-Basis Accounting Accrual-Basis Accounting Transactions recorded in the periods in which the events occur- regardless of when cash is exchanged. Revenues are recognized when earned, rather than when cash is received. Expenses are recognized when incurred (received), rather than when paid. The benefit of the accrual approach is that financial statements reflect all the expenses associated with the reported revenues for an accounting period. Chapter 3 -4

Timing Issues Accrual- vs. Cash-Basis Accounting Revenues are recognized ONLY when cash is ______ Expenses are recognized ONLY when cash is ______ Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP). Chapter 3 -5 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. Transaction are recorded in the actual periods in which they 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. Chapter 3 -6 SO 2 Explain the accrual basis of accounting.

Timing Issues Recognizing Revenues and Expenses Revenue Recognition Principle Companies recognize revenue in the accounting period in which it is ________ In a service enterprise, revenue is considered to be earned at the time the service is performed. Chapter 3 -7 SO 2 Explain the accrual basis of accounting.

Timing Issues Recognizing Revenues and Expenses Matching Principle Match expenses with revenues in the period when the company makes efforts to generate those revenues. “Let the expenses follow the revenues. ” Chapter 3 -8 SO 2 Explain the accrual basis of accounting.

Identify timing concepts. A list of concepts is provided below, on the left, with a description of the concept on the right. There are more descriptions provided than concepts. Match the description of the concept to the concept. 1. ____ Cash basis accounting. 2. ____ Revenue recognition principle. 3. ____ Matching principle. Chapter 3 -9 (a) Monthly and quarterly time periods. (b) Accountants divide the economic life of a business into artificial time periods. (c) Expenses should be matched with Revenues. (d) Companies record revenues when they receive cash and record expenses when they pay out cash. (e) An accounting time period that is one year in length. (f ) An accounting time period that starts on January 1 and ends on December 31. (g) Companies record transactions in the period in which the events occur. (h) Recognize revenue in the accounting period in which it is earned.

Calculating Accrual vs. Cash-Basis Accounting EXAMPLE: You have $100 k collected in revenue for CURRENT YEAR. & $50 k of this was from PREVIOUS YEAR. To find out what the actual accrual revenue is for CURRENT YEAR you need to subtract out any PREVIOUS YEAR revenue bc revenue is recorded as its earned l Answer: $50 K REVENUE FOR CURRENT YEAR(100 -50) YEAR l To find Cash basis accounting there is No calculation needed bc you record cash as its received l In example above revenue for CURRENT YEAR Chapter would be $100 k. 3 -10

PRACTICE: Cash & Accrual Basis Problem: • Conan Industries collected $100, 000 from customers in CURRENT YEAR. Of the amount collected, $10, 000 was from revenue earned on account in PREVIOUS YEAR. • Conan Industries paid $50, 000 for expenses in CURRENT YEAR. Of the amount paid, $20, 000 was for expenses incurred on account in PREVIOUS YEAR. • Instructions Compute CURRENT YEAR accrualbasis net income. Chapter 3 -11

PRACTICE: Cash & Accrual Basis Problem: • Conan Industries collected $150, 000 from customers in CURRENT YEAR. Of the amount collected, $50, 000 was from revenue earned on account in PREVIOUS YEAR. • Conan Industries paid $70, 000 for expenses in CURRENT YEAR. Of the amount paid, $40, 000 was for expenses incurred on account in PREVIOUS YEAR. • Instructions Compute CURRENT YEAR accrual-basis net income. Chapter 3 -12

Cash & Accrual Basis Problem: • Conan Industries collected $100, 000 from customers in CURRENT YEAR. Of the amount collected, $25, 000 was from revenue earned on account in PREVIOUS YEAR. • In addition, Conan earned $40, 000 of revenue in CURRENT YEAR, which will not be collected until NEXT YEAR. • Conan Industries also paid $70, 000 for expenses in CURRENT YEAR. Of the amount paid, $30, 000 was for expenses incurred on account in PREVIOUS YEAR. • In addition, Conan incurred $42, 000 of expenses in CURRENT YEAR , which will not be PAID until NEXT YEAR Instructions (a) Compute CURRENT YEAR cash-basis net income. (b) Compute CURRENT YEAR accrual-basis net income. Chapter 3 -13

l Chapter 3 -14 GOAL: TO UNDERSTAND THE PURPOSE OF ADJUSTING ENTRIES & HOW TO RECORD THEM.

The Basics of Adjusting Entries Adjusting entries make it possible to report correct amounts on the balance sheet and on the income statement. They are also used to ensure all revenue & expenses are recognized in the period in which they are incurred. A company must make adjusting entries every time it prepares financial statements. Chapter 3 -15

Timing Issues 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. Chapter 3 -16 SO 3 Explain the reasons for adjusting entries.

Types of Adjusting Entries Deferrals (prepayments) Accruals 1. Prepaid Expenses paid in cash and recorded as assets before they are used or consumed. 3. Accrued Revenues earned but not yet received in cash or recorded. 2. Unearned Revenues received in cash and recorded as liabilities before they are earned. 4. Accrued Expenses incurred but not yet paid in cash or recorded. Chapter 3 -17

Adjusting entries can be classified as a. postponements and advances. b. accruals and prepayments. c. prepayments and postponements. d. accruals and advances. Chapter 3 -18

(open CH 3 adjusting entries cheat sheet) Adjusting Entries for “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: rent maintenance on equipment fixed assets (depreciation) insurance supplies advertising Chapter 3 -19 SO 5 Prepare adjusting entries for deferrals.

Adjusting Prepayments On Dec 1, You pay $800 as advance payment toward rent. The rental term begins on December 1, with monthly rental of $400. Journalize and post the entry on December 1 and the adjusting entry on December 31. Date Account Dec 01 Prepaid Rent Cash Adjusting Entry: Dec 31 Rent Expense Prepaid Rent Chapter 3 -21 Dr Cr 800 400

Adjusting Entries for “Prepaid Expenses”(open CH 3 adjusting entries cheat sheet) Example (Insurance): On Jan. 1 st, Phoenix Consulting paid $12, 000 for 12 months of insurance coverage. Show the journal entry to record the payment on Jan. 1 st. Jan. 1 Debit Credit Debit 12, 000 Chapter 3 -22 Credit 12, 000 SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” Example (Insurance): On Jan. 1 st, Phoenix Consulting paid $12, 000 for 12 months of insurance coverage. Show the adjusting journal entry required at Jan. 31 st. Convert this to a monthly expense (12, 000/12=1, 000) Jan. 31 Debit 12, 000 Credit Debit 1, 000 Credit 1, 000 11, 000 Chapter 3 -23 SO 5 Prepare adjusting entries for deferrals.

BE 3 -5 (prepaid expenses) DO NOW: On July 1, Spahn Co. pays $18, 000 to Randle Insurance Co. for a 3 -year insurance contract. Both companies have fiscal years ending December 31. For Spahn Co. , journalize and post the journal entry on July 1 and the adjusting entry on December 31. Chapter 3 -24

YOUR TURN On July 1, ABC Co. pays $15, 000 to ID Insurance for a 3 -year insurance contract. For ABC Co. , journalize and post the entry on July 1 and the adjusting entry on December 31. Chapter 3 -25

Adjustments for prepaid expenses: a. decrease assets and increase revenues. b. decrease expenses and increase assets. c. decrease assets and increase expenses. d. decrease revenues and increase assets. Chapter 3 -26

Adjusting Entries for “Depreciation” “ Depreciation (CH 3 OUTLINE) ______ is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner. Buildings, equipment, and vehicles (long-lived assets) are recorded as assets, rather than an expense, in the year acquired. Companies report a portion of the cost of a long-lived asset as an expense (depreciation) during each period of the asset’s useful life (Matching Principle). Chapter 3 -27 SO 5 Prepare adjusting entries for deferrals.

contra asset account l A contra asset account is a ________account. l Examples include assets like machinery that is depreciated. The depreciated amount is represented in the accounts as a contra asset. l Chapter 3 -28 EX: Land (+) & Accumulated Depreciation (-)

Adjusting Entry: Depreciation Expense Hardy Company purchased a computer for $2, 400 on December 1. It is estimated that annual depreciation on the computer will be $480. If financial statements are to be prepared on December 31, the company should make the following adjusting entry: Adjusting Entry Depreciation Expense Accumulated Depreciation **$480/12 = $40 per month Chapter 3 -29 $40

Adjusting Entries for “Depreciation Expenses” Example (Depreciation): On Jan. 1 st, Phoenix Consulting paid $24, 000 for equipment that has an estimated useful life of 20 years. Show the journal entry to record the purchase of the equipment on Jan. 1 st. Jan. 1 24, 000 Debit Credit Debit 24, 000 Chapter 3 -30 Credit 24, 000 SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Depreciation Expenses” Example (Depreciation): On Jan. 1 st, Phoenix Consulting paid $24, 000 for equipment that has an estimated useful life of 20 years. Show the adjusting journal entry required at Jan. 31 st. (Convert to a monthly expense): $24, 000 / 20 yrs. / 12 months = $100 Jan. 31 100 Debit Credit Debit 100 Chapter 3 -31 Credit 100 SO 5 Prepare adjusting entries for deferrals.

DEPRECIATION A business began on January 1. Depreciation for the year is estimated to be $3, 600. 1 - Prepare the adjusting entry for depreciation at December 31. 2 - prepare the adjusting entry for depreciation as of January 31. Chapter 3 -32

WHAT IS THE NAME OF ADJUSTING ENTRY? 1. You pay $1800 in advance toward advertising 2. You purchased a car 12/1. Depreciation is $100 for month of December. Chapter 3 -33

Adjusting Entries for “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: magazine subscriptions customer deposits rent airline tickets school tuition Chapter 3 -34 SO 5 Prepare adjusting entries for deferrals.

Adjusting Unearned Revenue On Dec 1, Mr. Landlord (YOU) receives $800 as advance payment toward rent. The rental term begins on December 1 with monthly rental of $400. Journalize the full transaction and the adjusting entry On 12/31 Date Account Dr Dec 01 Cash Unearned Rent Revenue Adjusting Entry: Dec 31 Unearned Rent Revenue Chapter 3 -35 Cr 800 400

Adjusting Entries for “Unearned Revenues” Example: On Jan. 1 st, Phoenix Consulting received $24, 000 from Arcadia High School for 3 months rent in advance. Show the journal entry to record the receipt on Jan. 1 st. Jan. 1 Cash Debit Unearned Rent Revenue Credit Debit 24, 000 Chapter 3 -36 Credit 24, 000 SO 5 Prepare adjusting entries for deferrals.

Adjusting Entries for “Unearned Revenues” Example: On Jan. 1 st, Phoenix Consulting received $24, 000 from Arcadia High School for 3 months rent in advance. Show the adjusting journal entry required on Jan. 31 st. Jan. 31 Debit Credit Debit 8, 000 Credit 24, 000 16, 000 Chapter 3 -37 SO 5 Prepare adjusting entries for deferrals.

BE 3 -6 (unearned revenue)-USE CHEAT SHEET On June 1, ABC pays $18, 000 to Randle Insurance Co (YOU). for a 3 -year insurance contract. Journalize and post the journal entry on June 1 AND the adjusting entry on December 31 for Randle Insurance Co. Chapter 3 -38

Adjusting Entries for “Accrued Revenues” Revenues earned but not yet received in cash or recorded. Adjusting entry results in: Revenue Recorded BEFORE Cash Receipt Accrued revenues often occur in regard to: rent interest services performed Chapter 3 -39 SO 6 Prepare adjusting entries for accruals.

Adjusting Accrued Revenue On Dec 1, Mr. Lender makes a loan of $8, 000 to Mr. Borrower. The loan term is 3 months. The interest rate is 12% per year. The Lender receives a note. Journalize the full transaction and the adjusting entry for the Lender on 12/31 Date Account Dec 01 Note Receivable Cash Adjusting Entry: Dec 31 Interest Receivable Interest Revenue (Accrue one month’s interest) Chapter 3 -40 * 8, 000 * 12% * 1/12 = 80 Dr Cr 8, 000 80 80

Adjusting Entries for “Accrued Revenues” Example: On Jan. 1 st, Phoenix Consulting invested $300, 000 in securities that return 5% interest per year. Show the journal entry to record the investment on Jan. 1 st. Jan. 1 Investments Debit Chapter 3 -41 Cash Credit Debit SO 6 Credit Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Revenues” Example: On Jan. 1 st, Phoenix Consulting invested $300, 000 in securities that return 5% interest per year. Show the adjusting journal entry required on Jan. 31 st. Jan. 31 Interest Receivable Debit Chapter 3 -42 Interest Revenue Credit Debit SO 6 Credit Prepare adjusting entries for accruals.

On Jan. 1 st, ABC invested $500, 000 in securities that return 12% interest per year. Show the adjusting journal entry required on Jan. 31 st. Chapter 3 -43

Adjusting Entries for “Accrued Expenses” Expenses incurred but not yet paid in cash or recorded. Adjusting entry results in: Expense Recorded BEFORE Cash Payment Accrued expenses often occur in regard to: rent interest Chapter 3 -44 taxes salaries SO 6 Prepare adjusting entries for accruals.

Adjusting Accrued Expenses On Dec 1, Mr. Borrower takes a loan of $8, 000 from Mr. Lender. The loan term is 3 months. The interest rate is 12% per year. Lender receives a note for the amount. Journalize the full transaction and the adjusting entry for the borrower on 12/31 Date Account Dr Dec 01 Cash Note Payable 8, 000 Adjusting Entry: Dec 31 Interest Expense Interest Payable (Accrue one month’s interest) Chapter 3 -45 *8, 000 * 12% * 1/12 = 80 Cr 8, 000 80 80

Adjusting Entries for “Accrued Expenses” Example: On Jan. 2 nd, Phoenix Consulting borrowed $200, 000 at a rate of 9% per year. Interest is due on first of each month. Show the journal entry to record the borrowing on Jan. 2 nd. Jan. 2 Cash Debit Chapter 3 -46 Notes Payable Credit Debit SO 6 Credit Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Expenses” Example: On Jan. 2 nd, Phoenix Consulting borrowed $200, 000 at a rate of 9% per year. Interest is due on first of each month. Show the adjusting journal entry required on Jan. 31 st. Accrue one month’s interest expense Jan. 31 Interest Expense Debit Chapter 3 -47 Interest Payable Credit Debit SO 6 Credit Prepare adjusting entries for accruals.

1. On Aug. 1 st, ABC purchased $250, 000 in securities that return 10% interest per year. Show the adjusting journal entry required on Aug. 31 st. 2. On July. 1 st, ABC borrowed $125, 000 from a bank with 8% interest per year. Show the adjusting journal entry required on Aug. 31 st. Chapter 3 -48

Adjusting Entries: Supplies Amber Company bought supplies costing $5, 600 on January 1. On January 31, supplies remaining on hand were $4, 200. Record supplies expense for January. Amber debits all purchases of supplies to the appropriate asset account. Original entry: Supplies Cash 5, 600

Recording supplies expense Expense the used supplies at the end of an accounting period Account Pur: $5, 600 End: ($4, 200) Expense: $1, 400 Supplies $5, 600 $4, 200 $1, 400 Dr Cr Supplies Expense $1, 400

Adjusting for Supplies On 12/1 there were $3200 in supplies. As of 12/31 Supplies remaining were $1, 300. The appropriate adjusting journal entry to be made at the end of the period would be Chapter 3 -51

Adjusting for Supplies A Company purchased office supplies costing $5, 000 and debited Office Supplies for the full amount. At the end of the accounting period, a physical count of office supplies revealed $1, 600 still on hand. The appropriate adjusting journal entry to be made at the end of the period would be a. Debit Office Supplies Expense, $1, 600; Credit Office Supplies, $1, 600. b. Debit Office Supplies, $3, 400; Credit Office Supplies Expense, $3, 400. c. Debit Office Supplies Expense, $3, 400; Credit Office Supplies, $3, 400. d. Debit Office Supplies, $1, 600; Credit Office Supplies Expense, $1, 600. Chapter 3 -52

Adjusting Salary Entries l l l Chapter 3 -53 Thornton Company pays its employees on a weekly basis, the week after the work week. It owed $3, 400 in salaries for the last work week in December. The payment was made on January 3 of the following year.

Adjusting Salary Entries Dec 31 (adjusting entry): Dr Salaries Expense $3, 400 Salaries Payable Cr $3, 400 January 03 (PAYMENT in the following year): Salaries Payable $3, 400 Cash $3, 400 Chapter 3 -54

Salaries earned by employees of $900 have not been paid yet. Create the adjusting entry Chapter 3 -56

Adjusting Salary Entries l l Chapter 3 -57 Drew Carey Company pays its employees total salaries of $8, 000 every Monday for a 5 day work week (Monday through Friday). On Monday, December 29, employees were paid for the week ending December 26. Employees only worked the last 3 days of the 12/26 week. Create the adjusting entry

CH 3 Adjusting Entries Review l What Adjusting Entry cheat sheet would you use if: 1. 2. 3. 4. 5. 6. 7. Chapter 3 -58 You “make a loan” to someone You Prepay for insurance or rent, etc You “take a loan” from a bank You receive $$ in advance for a service you will provide in future You own Buildings, equipment, and vehicles & report a portion of the cost each year as useful life You used supplies You paid salaries