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Chapter 3 Adjusting the Accounts Learning Objectives After studying this chapter, you should be able to: 1. Explain the time period assumption. 2. Explain the accrual basis of accounting. 3. Explain the reasons for adjusting entries. 4. Identify the major types of adjusting entries. 5. Prepare adjusting entries for deferrals. 6. Prepare adjusting entries for accruals. 7. Describe the nature and purpose of an adjusted trial balance. 3-2
Preview of Chapter 3 3-3 Financial Accounting IFRS Edition, 2e Weygandt Kimmel Kieso
Timing Issues Accountants divide the economic life of a business into artificial time periods (Time Period Assumption)...... Jan. Feb. Mar. Apr. Dec. Generally a month, a quarter, or a year. Also known as the Periodicity Assumption 3-4 LO 1 Explain the time period assumption.
Timing Issues Fiscal and Calendar Years Monthly and quarterly time periods are called interim periods. Most large companies must prepare both quarterly and annual financial statements. Fiscal Year = Accounting time period that is one year in length. Calendar Year = January 1 to December 31. 3-5 LO 1 Explain the time period assumption.
Timing Issues Accrual- vs. Cash-Basis Accounting Accrual-Basis Accounting Transactions recorded in the periods in which the events occur. Revenues are recognized when the services are performed, rather than when cash is received. Expenses are recognized when incurred, rather than when paid. 3-6 LO 2 Explain the accrual basis of accounting.
Timing Issues Accrual- vs. Cash-Basis Accounting Cash-Basis Accounting Revenues recognized when cash is received. Expenses recognized when cash is paid. Cash-basis accounting is not in accordance with International Financial Reporting Standards (IFRS). 3-7 LO 2 Explain the accrual basis of accounting.
Timing Issues Recognizing Revenues and Expenses Revenue Recognition Principle Recognize revenue in the accounting period in which the performance obligation is satisfied. In a service enterprise, revenue is considered to be earned at the time the service is performed. 3-8 LO 2 Explain the accrual basis of accounting.
Timing Issues Recognizing Revenues and Expenses Expense Recognition Principle Match expenses with revenues in the period when the company makes efforts to generate those revenues. Let the expenses follow the revenues. 3-9 LO 2 Explain the accrual basis of accounting.
Timing Issues Illustration 3-1 IFRS relationships in revenue and expense recognition 3-10 LO 2 Explain the accrual basis of accounting.
3-11 LO 2 Explain the accrual basis of accounting.
A list of concepts is provided in the left column below, with a description of the concept in the right column below. There are more descriptions provided than concepts. Match the description of the concept to the concept. f e c b 3-12 LO 2
The Basics of Adjusting Entries Adjusting Entries Ensure that the revenue recognition and expense recognition principles are followed. Necessary because the trial balance may not contain up-to-date and complete data. Required every time a company prepares financial statements. Will include one income statement account and one statement of financial position account. 3-13 LO 3 Explain the reasons for adjusting entries.
The Basics of Adjusting Entries Types of Adjusting Entries Illustration 3-2 Categories of adjusting entries Deferrals 1. Prepaid Expenses. Expenses paid in cash before they are used or consumed. 2. Unearned Revenues. Cash received before services are performed. Accruals 3. Accrued Revenues. Revenues for services performed but not yet received in cash or recorded. 4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded. 3-14 LO 4 Identify the major types of adjusting entries.
The Basics of Adjusting Entries Types of Adjusting Entries Trial Balance Each account is analyzed to determine whether it is complete and up-to-date. Illustration 3-3 3-15 LO 4 Identify the major types of adjusting entries.
The Basics of Adjusting Entries Adjusting Entries for Deferrals Deferrals are either: Prepaid expenses OR Unearned revenues. 3-16 LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries 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: insurance rent supplies equipment advertising buildings 3-17 LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries Prepaid Expenses Expire either with the passage of time or through use. Adjusting entry: Increase (debit) to an expense account and Decrease (credit) to an asset account. Illustration 3-4 3-18 LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries Illustration: Pioneer Advertising Agency purchased supplies costing $2,500 on October 5. Pioneer recorded the payment by increasing (debiting) the asset Supplies. This account shows a balance of $2,500 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still on hand. Oct. 31 Supplies expense 1,500 Supplies 1,500 3-19 LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries Illustration 3-5 3-20 LO 5
The Basics of Adjusting Entries Illustration: On October 4, Pioneer Advertising paid $600 for a one-year fire insurance policy. Coverage began on October 1. Pioneer recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in the October 31 trial balance. Insurance of $50 ($600 12) expires each month. Oct. 31 Insurance expense 50 Prepaid insurance 50 3-21 LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries Illustration 3-6 3-22 LO 5
The Basics of Adjusting Entries Depreciation Buildings, equipment, and vehicles (assets with long lives) are recorded as assets, rather than an expense, in the year acquired. Depreciation allocates a portion of the asset s cost as an expense during each period of the asset s useful life. Depreciation does not attempt to report the actual change in the value of the asset. 3-23 LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries Illustration: For Pioneer Advertising, assume that depreciation on the equipment is $480 a year, or $40 per month. Oct. 31 Depreciation expense 40 Accumulated depreciation 40 Accumulated Depreciation is called a contra asset account. 3-24 LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries Illustration 3-7 3-25 LO 5
The Basics of Adjusting Entries Statement Presentation Accumulated Depreciation is a contra asset account (credit). Appears just after the account it offsets (Equipment) on the statement of financial position. Book value is the difference between the cost of any depreciable asset and its accumulated depreciation. Illustration 3-8 3-26 LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries Illustration 3-9 3-27 LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries Unearned Revenues Receipt of cash that is recorded as a liability because service has not be performed. Cash Receipt BEFORE Revenue Recorded Unearned revenues often occur in regard to: Rent Magazine subscriptions Airline tickets Customer deposits 3-28 LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries Unearned Revenues Adjusting entry is made to record the revenue for services performed and to show the liability that remains. Results in a decrease (debit) to a liability account and an increase (credit) to a revenue account. Illustration 3-10 3-29 LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries Illustration: Pioneer Advertising received $1,200 on October 2 from R. Knox for advertising services expected to be completed by December 31. Unearned Service Revenue shows a balance of $1,200 in the October 31 trial balance. Analysis reveals that the company earned $ 400 of those fees in October. Oct. 31 Unearned service revenue 400 Service revenue 400 3-30 LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries Illustration 3-11 3-31 LO 5
The Basics of Adjusting Entries Illustration 3-12 3-32 LO 5 Prepare adjusting entries for deferrals.
3-33 LO 5
The Basics of Adjusting Entries Adjusting Entries for Accruals Accruals are made to record Revenues for services performed OR Expenses incurred in the current accounting period that have not been recognized through daily entries. 3-34 LO 6 Prepare adjusting entries for accruals.
The Basics of Adjusting Entries Accrued Revenues Revenues for services performed but not yet received in cash or recorded. Revenue Recorded BEFORE Cash Receipt Accrued revenues often occur in regard to: Interest Rent Services performed 3-35 LO 6 Prepare adjusting entries for accruals.
The Basics of Adjusting Entries Accrued Revenues Adjusting entry shows the receivable that exists and records the revenues for services performed. Adjusting entry: Increases (debits) an asset account and Increases (credits) a revenue account. Illustration 3-13 3-36 LO 6
The Basics of Adjusting Entries Illustration: In October Pioneer Advertising Agency recognized $200 for advertising services performed but not recorded. Oct. 31 Accounts receivable 200 Service revenue 200 On November 10, Pioneer receives cash of $ 200 for the services performed. Nov. 10 Cash 200 Accounts receivable 200 3-37 LO 6 Prepare adjusting entries for accruals.
The Basics of Adjusting Entries Illustration 3-14 3-38 LO 6
The Basics of Adjusting Entries Illustration 3-15 3-39 LO 6 Prepare adjusting entries for accruals.
The Basics of Adjusting Entries Accrued Expenses Expenses incurred but not yet paid in cash or recorded. Expense Recorded BEFORE Cash Payment Accrued expenses often occur in regard to: Rent Taxes Interest Salaries 3-40 LO 6 Prepare adjusting entries for accruals.
The Basics of Adjusting Entries Accrued Expenses Adjusting entry records the obligation and recognizes the expense. Adjusting entry: Increase (debit) an expense account and Increase (credit) a liability account. Illustration 3-16 3-41 LO 6
The Basics of Adjusting Entries Illustration: Pioneer Advertising signed a three-month note payable in the amount of $5,000 on October 1. The note requires Pioneer to pay interest at an annual rate of 12%. Illustration 3-17 Oct. 31 Interest expense 50 Interest payable 50 3-42 LO 6 Prepare adjusting entries for accruals.
The Basics of Adjusting Entries Illustration 3-18 3-43 LO 6
The Basics of Adjusting Entries Illustration: Pioneer Advertising last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($ 400 x 3 days). Illustration 3-19 3-44 LO 6 Prepare adjusting entries for accruals.
The Basics of Adjusting Entries Illustration 3-20 3-45 LO 6
The Basics of Adjusting Entries Illustration 3-21 3-46 LO 6 Prepare adjusting entries for accruals.
3-47 LO 6 Prepare adjusting entries for accruals.
Micro Computer Services Inc. began operations on August 1, 2014. At the end of August 2014, management attempted to prepare monthly financial statements. The following information relates to August. Prepare the adjusting journal entries needed at August 31, 2014. (Amounts are in Chinese yuan.) 1. At August 31, the company owed its employees 8,000 in salaries and wages that will be paid on September 1. Salaries and wages expense 8,000 Salaries and wages payable 8,000 3-48 LO 6
Micro Computer Services Inc. began operations on August 1, 2014. At the end of August 2014, management attempted to prepare monthly financial statements. The following information relates to August. Prepare the adjusting journal entries needed at August 31, 2014. (Amounts are in Chinese yuan.) 2. At August 1, the company borrowed 300,000 from a local bank on a 15-year mortgage. The annual interest rate is 10%. Interest expense ( 300,000 x 10% x 1/12) 2,500 Interest payable 2,500 3-49 LO 6
Micro Computer Services Inc. began operations on August 1, 2014. At the end of August 2014, management attempted to prepare monthly financial statements. The following information relates to August. Prepare the adjusting journal entries needed at August 31, 2014. (Amounts are in Chinese yuan.) 3. Revenue for services performed but unrecorded for August totaled 11,000. Accounts receivable 11,000 Service revenue 11,000 3-50 LO 6
The Basics of Adjusting Entries Summary of Basic Relationships Illustration 3-22 3-51 LO 6 Prepare adjusting entries for accruals.
The Adjusted Trial Balance Adjusted Trial Balance Prepared after all adjusting entries are journalized and posted. Purpose is to prove the equality of debit balances and credit balances in the ledger. Is the primary basis for the preparation of financial statements. 3-52 LO 7 Describe the nature and purpose of an adjusted trial balance.
3-53 Illustration 3-25
Preparing Financial Statements Financial Statements are prepared directly from the Adjusted Trial Balance. Income Statement Retained Earnings Statement Statement of Financial Position 3-54 LO 7 Describe the nature and purpose of an adjusted trial balance.
Illustration 3-26 3-55 LO 7
Illustration 3-27 3-56 LO 7
APPENDIX 3A Alternative Treatment of Prepaid Expenses and Unearned Revenues When a company prepays an expense, it debits that amount to an expense account. When a company receives payment for future services, it credits the amount to a revenue account. 3-57 LO 8 Prepare adjusting entries for the alternative treatment of deferrals.
APPENDIX 3A Prepaid Expenses Company may choose to debit (increase) an expense account rather than an asset account. This alternative treatment is simply more convenient. Illustration 3A-2 3-58 LO 8 Prepare adjusting entries for the alternative treatment of deferrals.
APPENDIX 3A Unearned Revenues Company may credit (increase) a revenue account when they receive cash for future services. Illustration 3A-5 3-59 LO 8 Prepare adjusting entries for the alternative treatment of deferrals.
APPENDIX 3A Summary of Additional Adjustment Relationships Illustration 3A-7 3-60 LO 8 Prepare adjusting entries for the alternative treatment of deferrals.
APPENDIX 3B CONCEPTS IN ACTION Qualities of Useful Information Illustration 3B-1 3-61 LO 9 Discuss financial reporting concepts.
APPENDIX 3B CONCEPTS IN ACTION Enhancing Qualities Comparability Consistency Verifiability Timeliness Understandability 3-62 LO 9 Discuss financial reporting concepts.
APPENDIX 3B CONCEPTS IN ACTION Assumptions in Financial Reporting Illustration 3B-2 3-63 LO 9
APPENDIX 3B CONCEPTS IN ACTION Assumptions in Financial Reporting Illustration 3B-2 3-64 LO 9
APPENDIX 3B CONCEPTS IN ACTION Principles of Financial Reporting Measurement Principles Historical Cost Principle Fair Value Principle Revenue Recognition Principle Expense Recognition Principle Full Disclosure Principle 3-65 LO 9 Discuss financial reporting concepts.
APPENDIX 3B CONCEPTS IN ACTION Principles of Financial Reporting Constraints in Financial Reporting Accounting standard-setters weigh the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available. 3-66 LO 9
Another Perspective Key Points 3-67 Like IFRS, companies applying GAAP use accrual-basis accounting to ensure that they record transactions that change a company s financial statements in the period in which events occur. Similar to IFRS, cash-basis accounting is not in accordance with GAAP. GAAP also divides the economic life of companies into artificial time periods. Under both GAAP and IFRS, this is referred to as the time period assumption. GAAP has more than 100 rules dealing with revenue recognition. Many of these rules are industry specific. Revenue recognition under IFRS is determined primarily by a single standard, IAS 18. Despite this large disparity in the detailed guidance devoted to revenue recognition, the general revenue recognition principles required by IFRS that are used in this textbook are similar to those under GAAP.
Another Perspective Key Points Internal controls are a system of checks and balances designed to detect and prevent fraud and errors. The Sarbanes-Oxley Act requires U.S. companies to enhance their systems of internal control. However, many foreign companies do not have this requirement. Under IFRS, revaluation to fair value of items such as land and buildings is permitted. This is not permitted under GAAP. The form and content of financial statements are very similar under GAAP and IFRS. Any significant differences will be discussed in those chapters that address specific financial statements. Revenue recognition fraud is a major issue in U.S. financial reporting. The same situation exists for most other countries as well. 3-68
Another Perspective Key Points As indicated above, both the IASB and FASB are working together on a common conceptual framework. Some of the major issues that are being addressed are: 3-69 What are the qualitative characteristics that make accounting information useful? What is the primary objective of financial reporting? What basis should be used to measure and report, that is, should a historical cost or fair value approach be used? What criteria should be used to determine when revenue should be recognized and when expenses have been incurred? What guidelines should be established for disclosing financial information?
Another Perspective Key Points Income includes both revenues, which arise during the normal course of operating activities, and gains, which arise from activities outside of the normal sales of goods and services. The term income is not used this way under GAAP. Instead, under GAAP income refers to the net difference between revenues and expenses. Expenses under IFRS include both those costs incurred in the normal course of operations, as well as losses that are not part of normal operations. This is in contrast to GAAP, which defines each separately. 3-70
Another Perspective Looking to the Future As this textbook is being written, the IASB and FASB are close to completing a joint project on revenue recognition. The purpose of this project is to develop comprehensive guidance on when to recognize revenue. This approach focuses on changes in assets and liabilities as the basis for revenue recognition. It is hoped that this approach will lead to more consistent accounting in this area. For more on this topic, see www.fasb.org/project/revenue_recognition.shtml. 3-71
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