The Adjusting Process

Copyright © 2007 Prentice-Hall. All rights reserved 1

The Adjusting ProcessThe Adjusting Process

Chapter 3


Objective 1Objective 1

Distinguish accrual accounting from cash-basis accounting


Accrual Basis Vs. Cash BasisAccrual Basis Vs. Cash Basis

Accrual Basis

Revenues are recognized when

earned and expenses are recognized when

incurred.

Cash Basis

Revenues are recognized when

cash is received and expenses recorded when cash is paid.

Not GAAPNot GAAP


S3-1S3-1

• Service revenue:(a)Cash basis $600(b)Accrual basis (600+500) $1,100


Accounting PeriodAccounting Period

• Managers adopt an artificial period of time to evaluate performance– Monthly– Quarterly– Semiannually– Annually

Interim Statements


Recognizing Revenues and Recognizing Revenues and ExpensesExpenses

Three new basic accounting principles• Revenue Recognition• Matching• Time Period



Apply the revenue and matching principles


Revenue PrincipleRevenue Principle

• When is revenue recognized?– When it is earned– Not necessarily when cash is received

• How much revenue should be recognized?– Cash value of item transferred to customer


S3-3S3-3

a. When should revenue be recorded?When the magazines are mailed to customers

b. How much revenue should be recorded?As of March, three month’s revenue should be recognized


The Matching PrincipleThe Matching Principle

• Measure all expenses incurred during the accounting period

• When are expenses recognized?– Match the expenses against the revenues

earned during the period


Adjusting EntriesAdjusting Entries

• At the end of an accounting period, ask yourself these questions:– Have I recorded all revenues earned during

this accounting period?– Have I recognized all expenses incurred

during this accounting period?• If the answer is “No”, you need to prepare

an adjusting entry


S3-4S3-4

Jan 1 – Paid rent for the entire year

GENERAL JOURNALDATE DESCRIPTION REF DEBIT CREDIT

Jan 1 Prepaid Rent 3,600Cash 3,600

Prepaid rent for 1 year

Prepaid rent is an asset – this will benefit the company

in the future. Since you have not occupied the

apartment yet, it is not an expense yet


S3-4S3-4Prepaid Rent

Jan 1 3,600 300 Jan 31300 Feb 28300 Mar 31300 Apr 30300 May 31300 Jun 30300 Jul 31300 Aug 31300 Sep 30

Bal 900Bal 900

Rent Expense300300300300300300300300300

Bal 2,700Bal 2,700

Each month, we’ll recognize rent expense; and each month, we’ll reduce the

prepaid account until the year is over


The Time Period ConceptThe Time Period Concept

• Requires that accounting information be reported at regular intervals



• Prepared at end of an accounting period• Recorded to bring an asset or liability

account balance to its proper amount– Recognize all revenues when earned– Recognize all expenses incurred



Make adjusting entries



At the end of an accounting period, ask yourself these questions:

• Have I recognized all revenues earned this period?

• Have I recorded all expenses incurred this period?If the answer is “No”, you need to prepare an adjusting entry



Five categories• Prepaid expenses• Depreciation• Accrued revenues• Accrued expenses• Unearned revenues


Adjusting Prepaid ExpensesAdjusting Prepaid Expenses

Resources paid for prior to receiving the actual benefits

Prepaid Asset

Used up portion = Expense

Unused portion = Prepaid


S3-5S3-5GENERAL JOURNAL

DATE DESCRIPTION REF DEBIT CREDIT

Apr 1 Prepaid Rent 3,000Cash 3,000

Prepaid rent for 6 months

4/1 3,000

Prepaid Rent




Apr 30 Rent Expense 500Prepaid Rent 500

To record rent for April

4/1 3,000

Prepaid Rent4/30 500

Rent Expense4/30 500

Bal 2,500

Rent is $500 per month

($3,000/6)


Depreciation - process of allocating the cost of a plant asset to expense over its expected useful life

Straight-LineDepreciation Expense =

Asset CostUseful Life

Adjusting for DepreciationAdjusting for DepreciationLong term

plant assets except for land are

depreciated




May 1 Computer Equipment 36,000Cash 36,000

Purchased computer

5/1 36,000Computer Equipment


DepreciationDepreciation• Depreciation, for accounting purposes, is not an

attempt to assign a market value to assets• It is merely a systematic way of allocating some

of the cost of the asset to each period that asset helps the company earn revenue

• Accumulated Depreciation– A contra asset account– Represents the amount of depreciation that has been

taken over the life of the asset to date




May 31 Depreciation Expense, Computer Equipment 1,000

Accumulated Depreciation,Computer Equipment 1,000

To record depreciation for May

Accumulated depreciation isa contra asset account

Income Statement Account

Balance Sheet Account


S3-6S3-6

5/31 1,000

Accumulated Depreciation,Computer Equipment

5/31 1,000

Depreciation Expense,Computer Equipment

Bal 1,000

5/1 36,000Computer Equipment

Bal 1,000


Book ValueBook Value

• Reported on balance sheet• Cost minus accumulated depreciation

Your CompanyBalance SheetMay 31, 20XX

AssetsCash $XXXX ...

Computer Equipment $ 36,000 Less: Accumulated Depreciation (1,000) 35,000

Total Assets $XXXX

Book Value

S3-6S3-6

Your CompanyBalance SheetJune 30, 20XX

AssetsCash $XXXX ...

Computer Equipment $ 36,000 Less: Accumulated Depreciation (2,000) 34,000

Total Assets $XXXX

Book Value

S3-6S3-6 Notice: accumulated depreciation increases

each accounting period. The book

value gradually gets smaller


Accrued ExpensesAccrued Expenses

Costs incurred in a period that are both unpaid and unrecorded




Dec 31 Interest Expense 700Interest Payable 700

To record accrued interest

12/31 700Interest Expense

700 12/31Interest Payable

When you borrow money, interest expense is accumulating everyday.

At the end of an accounting period, you need to figure out how

much interest has accrued and recognize the expense. You also have to recognize that you must pay that money sometime in the

future.


Accrued RevenuesAccrued Revenues

Revenues earned in a period that are both unrecorded and not yet received


Accrued RevenuesAccrued Revenues• Your lawn maintenance company agrees to

provide 30 hours of work at $60 per hour for Company A. It is also agreed that you will bill them when the work had been completed

• As of May 31, you have worked 20 hours on this contract. The 20 hours’ worth of revenues earned in May, must be recorded in May, even though you haven’t billed your customer yet


Accrued RevenuesAccrued RevenuesGENERAL JOURNAL


May 31 Accounts Receivable 1,200Service Revenue 1,200

To record accrued revenues

5/31 1,200Accounts Receivable

1,200 5/31Service Revenue

How much revenue was earned in May? $60 x 20 = $1200


Unearned RevenueUnearned Revenue

Cash received in advance of providing products or services


S 3-9S 3-9GENERAL JOURNAL


Dec 31 Unearned SubscriptionRevenue 5,000

Subscription Revenue 5,000To record revenue earned

When the money is received, the company debits cash and credits Unearned Revenue (a liability recognizing that the company owes their customer a service or

product)

At the end of an accounting period, you must determine how

much of that unearned revenue has actually

been earned


TipsTips

• An adjusting entry will NEVER involve a debit or credit to Cash

• Each adjusting entry will affect at least one balance sheet account and one income statement account


SummarySummary

Prepaid expenses

Depreciation

Accrued revenues

Debit Expense

Credit Asset (Prepaid)

Debit Depreciation Expense

Credit Accumulated Depreciation

Debit Receivable

Credit Revenue


SummarySummary

Accrued expenses

Unearned revenues

Debit Expense

Credit Liability

Debit Liability (Unearned)

Credit Revenue

E3-19 aE3-19 a

Unearned Rent Revenue Rent Revenue10/1 4,000 12/31 1,000

12/31 1,000Bal. 3,000


Dec 31 Unearned Rent Revenue 1,000Rent Revenue 1,000

To record revenue earned

This is an example of unearned revenues:$4,000 /12 = $333.33 per month3 months have expired. $333.33 x 3 = $1,000

E3-19 bE3-19 b

Salaries Expense Salaries Payable12/31 3,00012/31 3,000


Dec 31 Salary Expense 3,000Salary Payable 3,000

To record accrued salaries

This is an example of accrued expenses.The company owes employees salaries for two days’ work – Monday and Tuesday

E3-19cE3-19c

Supplies Supplies Expense 3,100 12/31 1,900

12/31 1,900Bal. 1,200


Dec 31 Supplies Expense 1,900Supplies 1,900

To record supplies used

How much of the supplies have been used up? We stared with $3,100 and ended up with $1,200. The rest was used up


Dec 31 Depreciation Expense,Equipment 2,500

Accumulated Depreciation,Equipment 2,500

To record depreciation

Accumulated Depreciation

E3-19dE3-19d

12/31 2,500 12/31 2,500Depreciation Expense

E3-19fE3-19f

Prepaid Insurance Insurance ExpenseBal 1,200 12/31 200

12/31 200Bal. 1,000


Dec 31 Insurance Expense 200Prepaid Insurance 200

To record insurance expired



Prepare an adjusted trial balance

S 3-10S 3-10Scissors Hair Stylists

WorksheetDecember 31, 2005

Trial Balance

Adjustments

AdjustedTrial Balance

Account Title Dr. Cr. Dr. Cr. Dr. Cr.Cash 400 Supplies 700 Equipment 17,000 Accum. depr. - Equip. 1,000 Accounts payable 200 Interest payable Note payable 3,000 Suzanne Byrd, capital 6,000 Service revenue 12,000 Rent expense 4,000 Supplies expense Depreciation expense Interest expense 100 Totals 22,200 22,200

a. 500

a. 500

b. 1,000

b. 1,000

c. 100

c. 100

400200

17,000

4,000500

1,000200

23,300

2,000200100

3,0006,000

12,000

23,3001,600 1,600

S3-11S3-11Scissors Hair StylistsWorksheet

December 31, 2005


Account Title Dr. Cr.Cash Supplies Equipment Accum. depr. - Equip. Accounts payable Interest payable Note payable Suzanne Byrd, capital Service revenue Rent expense Supplies expense Depreciation expense Interest expense Totals

400200

17,000

4,000500

1,000200

23,300

2,000200100

3,0006,000

12,000

23,300

Net Income $6,300

S3-12S3-12Scissors Hair StylistsWorksheet

December 31, 2005



400200

17,000

4,000500

1,000200

23,300

2,000200100

3,0006,000

12,000

23,300

Total Assets = $15,600


Scissors Hair StylistsWorksheet

December 31, 2005



400200

17,000

4,000500

1,000200

23,300

2,000200100

3,0006,000

12,000

23,300

Income Statement Accounts

Balance Sheet Accounts



Prepare the financial statements from the adjusted trial balance



December 31, 2005



400200

17,000

4,000500

1,000200

23,300

2,000200100

3,0006,000

12,000

23,300

Income Statement Accounts

Scissors Hair StylistsIncome Statement

For the Year Ended December 31, 2005Service revenue $12,000 Expenses: Rent expense $ 4,000 Supplies expense 500

Depreciation expense 1,000 Interest expense 200 Total Expenses 5,700 Net Income $ 6,300



December 31, 2005



400200

17,000

4,000500

1,000200

23,300

2,000200100

3,0006,000

12,000

23,300

Scissors Hair StylistsStatement of Owner's Equity

For the Year Ended December 31, 2005

S. Byrd, Capital, Jan. 1, 2005 $ 6,000

Add: Net Income 6,300

S. Byrd, Capital, Dec. 31, 2005 $12,300



December 31, 2005



400200

17,000

4,000500

1,000200

23,300

2,000200100

3,0006,000

12,000

23,300

Balance Sheet Accounts

Scissors Hair StylistsBalance

December 31, 2005Assets Liabilities

Cash $ 400 Accounts payable $ 200 Supplies 200 Interest payable 100

Equipment $17,000 Note payable 3,000 Less:

Accumulated Depreciation 2,000 15,000

Total Liabilities $ 3,300

Owner's EquityS. Byrd, Capital 12,300

Total Assets $15,600 $ 15,600


End of Chapter 3End of Chapter 3

The Adjusting Process

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