Chapter 3 The Adjusting Process Financial Managerial Accounting

Chapter 3 The Adjusting Process Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 1 of 23

Accrual Accounting Versus Cash-Basis Accounting Accrual Basis Cash Basis Revenues recognized when earned Revenues recognized when cash received Expenses recognized when incurred Expenses recorded when cash paid Not GAAP Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 2 of 23

Accrual vs. Cash-Basis: Revenue Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 3 of 23

Accrual vs. Cash-Basis: Revenue Accrual basis revenue transactions Cash-basis revenue transactions Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 4 of 23

Accrual vs. Cash-Basis: Expenses Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 5 of 23

Accrual vs. Cash-Basis Accounting Accrual basis Cash-basis Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 6 of 23

S 3 -2: COMPARING ACCRUAL AND CASH-BASIS ACCOUNTING The Johnny Flowers Law Firm uses a client database. Suppose Johnny Flowers paid $2, 900 for a computer. Requirements: 1. Describe how the business should account for the $2, 900 expenditure under a. the cash basis. b. the accrual basis. Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 7 of 23

S 3 -2: COMPARING ACCRUAL AND CASH-BASIS ACCOUNTING 2. State why the accrual basis is more realistic for this situation. Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 8 of 23

Accounting Period Concept • Businesses prepare financial statements for specific periods to evaluate performance • Basic accounting period = one year • Interim periods Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 9 of 23

Revenue Recognition Principle • When to record revenue? – When it is earned • The amount of revenue to recorded? – Value of item or service transferred to customer Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 10 of 23

Recording Revenue: The Revenue Recognition Principle Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 11 of 23

The Matching Principle • Measure all expenses incurred during the period • Match the expenses against the revenues earned during the same period Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 12 of 23

The Time-Period Concept • Requires that accounting information be reported at regular intervals • Accounts are updated at the end of each accounting period Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 13 of 23

Time-Period Concept On May 31, Smart Touch recorded salary expense of $900 that is owed to an employee at the end of the month. Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 14 of 23

Adjusting Entries Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 15 of 23

Adjusting Entries • Prepared at end of an accounting period • Assigns: – Revenues to the period when earned – Expenses to the period when incurred • Update asset and liability accounts • Need to properly match revenues and expenses to measure: – Net Income – Assets and Liabilities Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 16 of 23

Adjusting Entry Rules Never involve the cash account Either increase revenue or increase an expense Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson When worded as “accrued”, journalize the stated amount Slide 17 of 23

Types of Adjusting Entries Prepaid expenses Depreciation Accrued expenses Accrued revenues Unearned revenues Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 18 of 23

Prepaid Expenses • Advance payments of expenses • Recorded as an asset • Adjusting entry records amount used as an expense Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 19 of 23

Prepaid Expense: Rent Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 20 of 23

Depreciation • Plant assets – Long-lived tangible assets used in business operations • Depreciation – Allocation of a plant asset’s cost to expense over its useful life Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 21 of 23

Depreciation Entry Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 22 of 23

Accumulated Depreciation • Contra asset • Holds sum of all depreciation recorded on a plant asset • Book value Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 23 of 23

Depreciation Posting Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 24 of 23

Accrued Expenses • Expenses incurred before payment is made • Opposite of a prepaid expense Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 25 of 23

Accrued Expense Entries Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 26 of 23

Accrued Revenues • Revenue earned before cash is received • Results in a receivable Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 27 of 23

Unearned Revenue • Cash is collected before revenue is earned • Also called deferred revenue BEFORE Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 28 of 23

Unearned Revenue Entries Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 29 of 23

Summary of Adjusting Entries • To properly measure net income for the period • To update the balance sheet Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 30 of 23

Summary of Adjusting Entries Category of Adjusting Entry Debit Credit Prepaid expense Expense Asset Depreciation Expense Contra asset Accrued expense Expense Liability Accrued revenue Asset Revenue Unearned revenue Liability Revenue Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 31 of 23

S 3 -5: IDENTIFYING TYPES OF ADJUSTING ENTRIES • A select list of transactions for Anuradha’s Goals follows: Apr 1 Paid six months of rent, $4, 800. 10 Received $1, 200 from customer for six-month service contract that began April 1. 15 Purchased computer for $1, 000. Requirement: 1. For each transaction, identify what type of adjusting entry would be needed. Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 32 of 23

S 3 -5: IDENTIFYING TYPES OF ADJUSTING ENTRIES • A select list of transactions for Anuradha’s Goals follows: Apr 18 Purchased $300 of office supplies on account. 30 Work performed but not yet billed to customer, $500. 30 Employees earned $600 in salary that will be paid May 2. Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 33 of 23

E 3 -22: JOURNALIZING ADJUSTING ENTRIES AND ANALYZING THEIR EFFECT ON THE INCOME STATEMENT The following data at January 31, 2012 is given for EBM, Inc. a. Depreciation, $500 b. Prepaid rent expired, $600 c. Interest expense accrued, $300 d. Employee salaries owed for Monday through Thursday of a five-day workweek; weekly payroll, $13, 000 e. Unearned service revenue earned, $1, 300 Requirement: 1. Journalize the adjusting entries needed on January 31, 2012. Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 34 of 23

E 3 -22: JOURNALIZING ADJUSTING ENTRIES AND ANALYZING THEIR EFFECT ON THE INCOME STATEMENT Journal ACCOUNTS AND POST. DATE EXPLANATIONS REF. DEBIT CREDIT 2013 Adjusting Entries Jan 31 Depreciation expense Accumulated depreciation 31 Rent expense Prepaid rent 31 Interest expense Interest payable 31 Salary expense Salary payable 31 Unearned service revenue Service revenue Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 35 of 23

E 3 -22: JOURNALIZING ADJUSTING ENTRIES AND ANALYZING THEIR EFFECT ON THE INCOME STATEMENT 2. Suppose the adjustments made in Requirement 1 were not made. Compute the overall overstatement or understatement of net income as a result of the omission of these adjustments. Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 36 of 23

Adjusted Trial Balance • Prepared after adjusting entries are posted • Useful step in preparing financial statements • Often appears on a work sheet Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 37 of 23

Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 38 of 23

S 3 -10: PREPARING AN ADJUSTED TRIAL BALANCE Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 39 of 23

Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 40 of 23

Income Statement Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 41 of 23

Statement of Retained Earnings Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 42 of 23

Balance Sheet Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 43 of 23

E 3 -25: PREPARING THE FINANCIAL STATEMENTS Refer to the adjusted trial balance in Exercise 3 -21 for the month ended April 30, 2012. Requirements: 1. Prepare the income statement. 2. Prepare the statement of retained earnings. 3. Prepare the balance sheet. Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 44 of 23

E 3 -21: ADJUSTED TRIAL BALANCE Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 45 of 23

E 3 -25: PREPARING THE FINANCIAL STATEMENTS Jobs-4 -U Employment Service, Income Statement Month Ended April 30, 2012 Revenue: Service revenue Expenses: Salary expense Rent expense Depreciation expense Supplies expense Total expenses Net income Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson $ $ 10, 600 $ 6, 200 4, 400 3, 700 1, 000 500 Slide 46 of 23

E 3 -25: PREPARING THE FINANCIAL STATEMENTS Jobs-4 -U Employment Service, Inc. Statement of Retained Earnings Month Ended April 30, 2012 Retained earnings, March 31, 2012 $ 10, 300 Net income 4, 400 17, 900 Dividends Retained earnings, April 30, 2012 Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson 4, 800 $ 9, 900 Slide 47 of 23

E 3 -25: PREPARING THE FINANCIAL STATEMENTS Jobs-4 -U Employment Service, Inc. Balance Sheet April 30, 2012 Assets Cash Accounts receivable Supplies Equipment $32, 500 Accu. Depr. (15, 400) Liabilities $ 900 5, 600 500 17, 100 Salary payable Stockholders’ Equity Common stock 13, 000 Retained earnings 9, 900 Total stockholders’ equity Total assets $24, 100 $ 1, 200 Total liabilities and stockholders’ equity Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson 22, 900 $24, 100 Slide 48 of 23

Alternative Treatment of Prepaid Expenses • Prepaid Expenses (normally) – Advance payments of expenses – Debit an asset account – Adjust at end of period • Alternative – Debit an expense account – Adjust at end of period Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 49 of 23

Prepaid Expense Initially debit and expense account Adjust at end of period for unused amount Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 50 of 23

Unearned (Deferred) Revenues • Unearned Revenues (normally) – Advance receipt of revenues–creates liability – Credit a liability account – Adjust at end of period • Alternative – Credit a revenue account – Adjust at end of period Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 51 of 23

Unearned (Deferred) Revenues • Initially credit a revenue account Adjust at end of period for unearned amount Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 52 of 23