Chapter 3. Learning Objectives. Distinguish accrual accounting from cash-basis accounting. Objective 1. The Adjusting Process

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1 PowerPoint to accompany Chapter 3 The Adjusting Process Learning Objectives 1. Distinguish accrual accounting from cash-basis accounting. 2. Make adjusting entries at the end of the accounting period. 3. Prepare an adjusted trial balance. 4. Prepare the financial statements from the adjusted trial balance. Objective 1 Distinguish accrual accounting from cash-basis accounting.

2 The Two Bases of Accounting: Accrual: Transactions are recorded when revenues are earned or expenses are incurred. Cash-basis: Transactions are recorded when cash is paid or cash is received. Accrual Versus Cash Example In January 2010, Prensa Insurance sells a three-year health insurance policy to Qantas. The contract specifies that Qantas has to pay $150,000 in advance. Yearly expenses for Prensa amount to $20,000. What is Prensa s profit or loss? Accrual Versus Cash Example Accrual-Basis Accounting ( 000 omitted) Revenues $50 $50 $50 Expenses Net profit (loss) $30 $30 $30 Note: profit of $90,000 over the three years

3 Accrual Versus Cash Example (000 omitted) Cash-Basis Accounting Cash inflows $150 $ 0 $ 0 Cash outflows Net profit (loss) $130 ($20) ($20) Note: profit of $90,000 over the three years The issue is in which years it is recorded! Objective 2 Make adjusting entries at the end of the accounting period. The End-of-period Process We have recorded transactions in the journal, posted to the ledger and extracted a trial balance. The unadjusted trial balance reflects all the transactions recorded. But it is incomplete because it omits transactions that affect more than one accounting period. Accrual accounting requires adjustments.

4 Adjusting Entries Assign revenue to the period earned. Assign expenses to the period incurred. Bring related asset and liability accounts into correct balance. Two Types Of Adjusting Entries Prepayments or Deferrals Accruals Five Categories Of Adjusting Entries Prepaid expenses Accrued revenues Depreciation Accrued expenses Unearned revenues

5 Prepaid Rent Example On July 1, Paula Lee prepays $3,000 for three months rent. Prepaid Rent 3,000 Cash 3,000 Prepaid Rent Example What is the journal entry on July 31? Rent Expense 1,000 Prepaid Rent 1,000 To record rent expense Reduces the asset (Prepaid Rent from $3,000 to $2,000) and increases the expense (Rent Expense) from zero to $1,000. Prepaid Rent Example What was the determining factor in matching this expense? Time

6 Supplies Example On 2 July Paula Lee purchased $200 worth of office supplies, in addition to the $500 she had on hand Supplies Example Office Supplies OB 200 Cash A count of the supplies at month end indicated that $400 in office supplies remained. What is the supplies expense for the month? Supplies Example Supplies Expense Supplies Bal. 400 What was the determining factor in matching this expense? Usage

7 Depreciation Example On 3 July, Paula Lee purchased furniture for $16,500 credit. The furniture is expected to last for 5 years and be worthless at the end of three years. Depreciation Example The cost of the furniture must be matched with the accounting periods in which it was used to earn revenue. What is the journal entry at the end of the month? ($16,500 - $0) / 5 = $3,300 per year $3,300/12 = $275 per month Depreciation Expense 275 Accumulated Depreciation 275 To record depreciation on furniture Contra Accounts A contra account has a companion account. Accumulated depreciation is a contra account to Furniture asset account. A contra account s normal balance is opposite to that of the companion account.

8 Example Partial Balance Sheet July 31, Plant assets: Machinery $16,500 Less: Accumulated depreciation 275 Total $16,225 Contra account Carrying Amount or Book Value Accruals What is an accrual? It is the recognition of an expense or revenue that has arisen but has not yet been recorded. Expenses or revenues are recorded before the cash settlement. Accrued Expense Example Paula Lee pays her employee $1,900 per month She pays her employees twice a month on the same days, 15 th and the last day of the month Each pay is $950 The business is closed on Saturday and Sunday. July 31 is a Sunday so she pays her employee on the Monday

9 Accrued Expenses Example July August Accrued Expenses Example What is the adjusting entry on July 31? Salaries Expense 950 Salaries Payable (not Cash) 950 To accrue salary expense Accrued Revenues Example On 15 July, Paula Lee is hired by Fosters to deal with their travel arrangements. She will receive $500 monthly with the first payment will be paid on 15 July

10 Accrued Revenues Example What is the July 31 adjusting entry? July 31, Accounts Receivable 500 Service Revenue 500 To accrue service revenue Accrued Revenues Example What is the determining factor in recognising this service revenue? Performance Unearned or Deferred Revenue Example On 20 July Baldwin Computing Services engages Paula Lee agreeing to pay her $450 monthly. July 20 (the transaction) Cash 450 Unearned Revenue 450 Received revenue in advance

11 Unearned or Deferred Revenue Example What is the adjusting journal entry on July 31? Unearned revenue 150 Revenue 150 To record revenue collected in advance Correct liability $300 Correct revenue $150 Total accounted for $450 Notice Adjusting entries always have... one income statement account (an expense or revenue) and... one balance sheet account (asset or liability). Adjusting entries never involve cash. Objective 3 Prepare an adjusted trial balance.

12 Adjusted Trial Balance The adjusting process starts with the unadjusted trial balance. Adjusting entries are made at the end of the accounting period and then an adjusted trial balance is prepared. The adjusted trial balance serves as the basis for the preparation of the financial statements. See exhibit 3.7 page 115 of your textbook. Objective 4 Prepare the financial statements from the adjusted trial balance. Financial Statements Financial statements have two parts: 1 The first part includes the following: name of the entity title of the statement t t date or period covered 2 The second part is the body of the statement.

13 Financial Statements Example Financial Statements Example Financial Statements Example Paula Lee etravel Balance Sheet (extract) as at July 31 Owner s Equity Paula Lee, Capital $31,575 See Exhibit 3-11 on page 117 for a complete balance sheet

14 Ethical Issues in Accrual Accounting Accrual accounting provides opportunity for unethical accounting. An unethical person could overlook an accrued expense or exaggerate the useful life of a non-current asset. This would paint a more favourable financial picture. Users of the financial statements could be misled. PowerPoint to accompany End of Chapter 3