Chapter 3 The Adjusting Process Learning Objectives 1

Chapter 3 The Adjusting Process

Learning Objectives 1. Differentiate between cash basis accounting and accrual basis accounting 2. Define and apply the time period concept, revenue recognition, and matching principles 3. Explain the purpose of and journalize and post adjusting entries © 2016 Pearson Education, Inc. 3 -2

Learning Objectives 4. Explain the purpose of and prepare an adjusted trial balance 5.

Learning Objectives 6. Explain the purpose of a worksheet and use it to prepare adjusting entries and the adjusted trial balance 7. Understand the alternative treatments of recording deferred expenses and deferred revenues (Appendix 3 A) © 2016 Pearson Education, Inc. 3 -4

Learning Objective 1 Differentiate between cash basis accounting and accrual basis accounting © 2016

Cash Basis vs. Accrual Basis Accounting Cash basis accounting Accrual basis accounting • Revenue is recorded when cash is received • Expenses are recorded when cash is paid • Not allowed under GAAP • Revenue is recorded when earned • Expenses are recorded when incurred • Used by most businesses © 2016 Pearson Education, Inc. 3 -6

Learning Objective 2 Define and apply the time period concept, revenue recognition, and matching

The Time Period Concept • Time period concept • Business activities are sliced into small time segments. • Financial statements can be prepared monthly, quarterly, or annually. • Fiscal year • Any 12 -month accounting period • Often coincides with a calendar year © 2016 Pearson Education, Inc. 3 -8

The Revenue Recognition Principle • The revenue recognition principle dictates when to record revenue and the amount of revenue to record. – Record revenue when earned – May be different from cash collections – Revenue is based on the actual selling price of the item or service. © 2016 Pearson Education, Inc. 3 -9

The Revenue Recognition Principle A good has been delivered or a service has been

The Matching Principle • The matching principle guides accounting for expenses. – Expenses are recorded when they are incurred during the period. – Expenses are matched against the revenue of the period. • For example, record rent expense for January against January revenues, even if the rent was paid in December. © 2016 Pearson Education, Inc. 3 -11

Learning Objective 3 Explain the purpose of and journalize and post adjusting entries ©

The unadjusted trial balance comes from the general ledger. Adjustments are needed due to the time period concept, the revenue recognition principle, and the matching principle. © 2016 Pearson Education, Inc. 3 -13

Types of Adjusting Journal Entries Adjusting entries can be divided into two basic categories: Accruals Deferrals 1. Deferred expenses 2. Deferred revenues 1. Accrued expenses 2. Accrued revenues © 2016 Pearson Education, Inc. 3 -14

Deferred Expenses • Deferred expenses are: • Advance payments of future expenses • Treated as assets until used • Recognized as an expense by an adjusting journal entry when the prepayment is used • Types of deferred expenses: • Prepaid rent • Office supplies • Depreciation © 2016 Pearson Education, Inc. 3 -15

Prepaid Rent Paying $3, 000 for rent in advance gives us the right to

Prepaid Rent To adjust the Prepaid Rent account on Dec. 31 , we need

Prepaid Supplies On November 3, Smart Touch Learning purchased $500 of supplies on account.

Depreciation • Plant assets: • Long-lived, tangible assets • Used in the operations of the business • Value and usefulness decline as the assets are used • Similar to deferred expenses: • Paid for when acquired • Used up over time • Usage is recorded as Depreciation Expense © 2016 Pearson Education, Inc. 3 -19

Depreciation On December 2, Smart Touch Learning received a contribution of furniture with a

Depreciation • Depreciation is the allocation of a plant asset’s cost over its useful life. – All plant assets are depreciated, with the exception of land. • Residual value is the expected value of a depreciable asset at the end of its useful life. • The straight-line method allocates an equal amount of depreciation each year. © 2016 Pearson Education, Inc. 3 -21

Depreciation Using the straight-line method, Smart Touch Learning calculates $300 of depreciation for December.

Depreciation Recording the entry requires the use of two accounts: Depreciation Expense and Accumulated

Depreciation • The Accumulated Depreciation account is the sum of all depreciation expense recorded for the depreciable asset to date. – Accumulated Depreciation is a contra account; therefore, the account balance is the opposite of the normal balance of the related asset account. • The cost minus accumulated depreciation of a plant asset is called its book value. © 2016 Pearson Education, Inc. 3 -24

Depreciation © 2016 Pearson Education, Inc. 3 -25

Deferred Revenue • Deferred revenue: – Occurs when a company receives cash before it does the work or delivers a product – Is a liability because the business owes the customer the product, the service, or a refund • Upon performance or delivery, deferred revenue is converted to earned revenue. © 2016 Pearson Education, Inc. 3 -26

Deferred Revenue On December 21, a law firm engages Smart Touch Learning to provide

Deferred Revenue During the last 10 days of the month, Smart Touch Learning performs

Accrued Expenses • Accrued expenses are expenses a business has incurred but has not

Accrued Salaries Expense Smart Touch Learning pays its employee a monthly salary of $2,

Accrued Salaries Expense On December 31, Smart Touch Learning owes its employee $1, 200,

Accrued Interest Expense Smart Touch Learning borrows $60, 000 on December 1 to purchase a building. As of December 31, Smart Touch Learning incurs $100 of interest on the note. © 2016 Pearson Education, Inc. 3 -32

Accrued Revenue • Accrued revenues arise when: – A company performs a service but has not yet collected cash – A company delivers a product but has not yet collected cash • Record accrued revenues with a: – Debit to Accounts Receivable – Credit to Service Revenue © 2016 Pearson Education, Inc. 3 -33

Accrued Revenue On December 15, Smart Touch Learning agrees to perform e-learning services for $1, 600 per month. By the end of December, it has earned ½ of the monthly fee. © 2016 Pearson Education, Inc. 3 -34

• Exhibit 3 -4 summarizes the adjusting entries: • (a)‒(d) are deferred expenses • (e) represents deferred revenue • (f) and (g) are accrued expenses • (h) is accrued revenue © 2016 Pearson Education, Inc. 3 -36

Learning Objective 4 Explain the purpose of and prepare an adjusted trial balance ©

The Adjusted Trial Balance Journalize adjusting entries Post adjusting entries Prepare adjusted trial balance • At the end of the fiscal period, an adjusted trial balance is prepared. – A summary of all accounts with adjusted balances – The purpose is to ensure total debits equal total credits © 2016 Pearson Education, Inc. 3 -38

• The adjusted trial balance includes the balances after posting the adjusting journal

Learning Objective 5 Identify the impact of adjusting entries on the financial statements ©

Impact of Adjusting Entries • The adjusted trail balance is used to: – Confirm debits equal credits after adjusting entries – Ensure balance sheet items are properly valued • Failing to record adjusting entries results in incorrect financial statements. – See Exhibit 3 -6 for examples. © 2016 Pearson Education, Inc. 3 -41

Impact of Adjusting Journal Entry Errors or Omissions © 2016 Pearson Education, Inc. 3

Learning Objective 6 Explain the purpose of a worksheet and use it to prepare

Worksheet • A worksheet is an internal document that helps summarize data for the preparation of the financial statements. • The worksheet has four sections: – – Account names Unadjusted trial balance Adjustments Adjusted trial balance © 2016 Pearson Education, Inc. 3 -44

Worksheet © 2016 Pearson Education, Inc. 3 -45

Learning Objective 7 Understand the alternative treatments of recording deferred expenses and deferred revenues

Alternative Treatment of Deferred Expenses Rather than record the prepayment of an expense as a current asset, record the prepayment as an expense on the date of payment. © 2016 Pearson Education, Inc. 3 -47

Alternative Treatment of Deferred Expenses At the end of the period, if any of the expense remains “unused, ” then adjust some of it into the prepaid asset account. The results are the same as with the traditional approach. © 2016 Pearson Education, Inc. 3 -48

Alternative Treatment of Deferred Revenues Rather than record the early cash receipt from a customer as a current liability, record the cash receipt as a revenue on the date of receipt. © 2016 Pearson Education, Inc. 3 -49

Alternative Treatment of Deferred Revenues At the end of the period, an adjustment is made for the portion of revenue not earned in the period. The results are the same as with the traditional approach. © 2016 Pearson Education, Inc. 3 -50