Chapter 3

Chapter 3

Accounting Principles Second Canadian Edition Weygandt Kieso Kimmel Trenholm Prepared by: Carole Bowman, Sheridan College Edited by: Carolyn Doering, HHSS CHAPTER 3 ADJUSTING THE ACCOUNTS TIME TIME PERIOD PERIOD ASSUMPTION ASSUMPTION The time period (or periodicity) assumption assumes

that the economic life of a business can be divided into artificial time periods generally a month, a quarter, or a year. Periods of less than one year are called interim periods. The accounting time period of one year in length is usually known as a fiscal year. REVENUE RECOGNITION PRINCIPLE The revenue recognition principle states that revenue should be recognized in the accounting period in which it is earned. In a service business, revenue is usually considered to be earned at the time the service is performed. In a merchandising business, revenue is usually earned at the time the goods are delivered. THE MATCHING PRINCIPLE The

practice of expense recognition is referred to as the matching principle. The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues). Revenues earned this month are offset against.... expenses incurred in earning the revenue ACCRUAL BASIS OF ACCOUNTING to the Revenue

recognition principle Matching principle Revenue GAAP Adheres recorded when earned, not only when cash received. Expense recorded when services or goods are used or consumed in the generation of revenue, not only when cash paid. CASH BASIS OF ACCOUNTING Revenue T NO GA AP

recorded only when cash received. Expense recorded only when cash paid. ADJUSTING ENTRIES Adjusting entries make the revenue recognition and matching principles HAPPEN! ILLUSTRATION 3-3 TRIAL BALANCE Pioneer Advertising Agency Trial Balance October 31, 2002 Cash

Advertising Supplies Prepaid Insurance Office Equipment Notes Payable Accounts Payable Unearned Revenue C.R. Byrd, Capital C.R. Byrd, Drawings Service Revenue Salaries Expense Rent Expense The Trial Balance is analysed to determine the need for adjusting entries. Debit $ 15,200 2,500 600 5,000

Credit $ 5,000 2,500 1,200 10,000 500 10,000 4,000 900 $ 28,700 $ 28,700 ADJUSTING ENTRIES Adjusting entries are required each time financial statements are prepared. Adjusting

entries can be classified as 1. prepayments (prepaid expenses or unearned revenues), 2. accruals (accrued revenues or accrued expenses), or 3. estimates (amortization). TYPES OF ADJUSTING ENTRIES Prepayments 1. Prepaid Expenses Expenses paid in cash and recorded as assets before they are used or consumed. 2. Unearned Revenues Revenues received in cash and recorded as liabilities before they are earned. TYPES OF ADJUSTING ENTRIES Accruals 1. Accrued Revenues Revenues earned but not yet received in cash or recorded. 2. Accrued Expenses Expenses incurred but not yet paid in cash or recorded.

TYPES OF ADJUSTING ENTRIES Estimates 1. Amortization Allocation of the cost of capital assets to expense over their useful lives. PREPAYMENTS Prepayments are either prepaid expenses or unearned revenues. Adjusting entries for prepayments are required to record the portion of the prepayment that represents 1. the expense incurred or, 2. the revenue earned in the current accounting period. PREPAID EXPENSES Prepaid expenses are expenses paid in cash and recorded as assets before they are used

or consumed. Prepaid expenses expire with the passage of time or through use and consumption. An asset-expense account relationship exists with prepaid expenses. PREPAID EXPENSES Prior to adjustment, assets are overstated and expenses are understated. The adjusting entry results in a debit to an expense account and a credit to an asset account. Examples of prepaid expenses include supplies, rent, insurance, and property tax. UNEARNED REVENUES Unearned revenues are revenues received and recorded as liabilities before they are earned.

Unearned revenues are subsequently earned by performing a service or providing a good to a customer. A liability-revenue account relationship exists with unearned revenues. UNEARNED REVENUES Prior to adjustment, liabilities are overstated and revenues are understated. The adjusting entry results in a debit to a liability account and a credit to a revenue account. Examples of unearned revenues include rent, magazine subscriptions, airplane tickets, and tuition. ILLUSTRATION 3-4 ADJUSTING ENTRIES FOR PREPAYMENTS Adjusting Entries

Prepaid Expenses Asset Expense Unadjusted Credit Balance Adjusting Entry (-) Debit Adjusting Entry (+) Unearned Revenues Liability Debit Adjusting Entry (-) Unadjusted Balance

Revenue Credit Adjusting Entry (+) PREPAID SUPPLIES EXAMPLE A company purchases supplies (eg. pens, pencils, paper, envelopes, worth $2000) Recorded as an asset when purchased, but they get used up An inventory is taken valued at $500 and the amount used up must be expensed an adjusting entry is needed: Dec. 31 Supplies Expense 1500 Advertising Supplies 1500 To record supplies used. PREPAID INSURANCE EXPENSE EXAMPLE

A company purchases insurance (fire, theft, liability, etc...) valued at $1200 on Sept. 1st It is recorded as an asset when purchased for the year At the end of the fiscal year the amount that has been used up must be expensed-an adjusting entry is needed (4 months has been used up): Dec. 31 Insurance Expense400 Prepaid Insurance 400 To record expired insurance UNEARNED REVENUE EXAMPLE A company receives payment for a product before the customer receives the benefit (eg. Airline ticket, tuition, etc.) It is recorded as a liability (obligation still exists) until it is earned At the end of the fiscal year, revenues that have now been earned need an adjusting entry: Dec. 31

Unearned Revenue 1000 Service Revenue1000 To record revenue for service provided. ACCRUALS A different type of adjusting entry is accruals. Adjusting entries for accruals are required to record revenues earned and expenses incurred in the current period. The adjusting entry for accruals will increase both a balance sheet and an income statement account. ACCRUED REVENUES Accrued revenues may accumulate with the passing of time or through services performed but not billed or collected. An asset-revenue account relationship exists with

accrued revenues. Prior to adjustment, assets and revenues are understated. The adjusting entry requires a debit to an asset account and a credit to a revenue account. Examples of accrued revenues include accounts receivable, rent receivable, and interest receivable. ACCRUED REVENUE EXAMPLE Revenue is earned, but the bill has not yet been sent to the customer An adjusting entry at the end of the fiscal period is needed: Dec. 31 Accounts Receivable 200 Service Revenue 200 To accrue revenue earned but not yet billed ACCRUED EXPENSES

Accrued expenses are expenses incurred but not yet paid. A liability-expense account relationship exists. Prior to adjustment, liabilities and expenses are understated. The adjusting entry results in a debit to an expense account and a credit to a liability account. Examples of accrued expenses include accounts payable, rent payable, salaries payable, and interest payable. ACCRUED SALARIES EXAMPLE Salaries are often paid after the work has been performed At the end of a fiscal period salaries will need to be accrued For example an employee earns $500 for the week; 3 days fall into the next fiscal period, so 2 days need to be accrued: Dec. 31 Salaries Expense 200 Salaries Payable 200

To record accrued salaries. Jan. 3 Salaries Payable 200 Salaries Expense 300 Cash 500 To record payment of salaries. ILLUSTRATION 3-6 FORMULA TO CALCULATE INTEREST Face Value of Note x

Annual Interest Rate x $5,000 x 6% x Time (in Terms of One Year) 1/12 = = Interest $25 eg. A note payable, and one month of interest falls into the

current fiscal year. One month of interest must be accrued. ILLUSTRATION 3-5 ADJUSTING ENTRIES FOR ACCRUALS Adjusting Entries Accrued Revenues Asset Revenue Debit Adjusting Entry (+) Credit Adjusting Entry (+) Accrued Expenses Expense Debit Adjusting

Entry (+) Liability Credit Adjusting Entry (+) AMORTIZATION Amortization is the process of allocating the cost of certain capital assets to expense over their useful life in a rational and systematic manner. Amortization attempts to match the cost of a long-term, capital asset to the revenue it generates each period. AMORTIZATION Amortization is an estimate rather than a factual measurement of the cost

that has expired. Were not attempting to reflect the actual change in value of an asset! AMORTIZATION In recording amortization, Amortization Expense is debited and a contra asset account, Accumulated Amortization, is credited. The difference between the cost of the asset and its related accumulated amortization is referred to as the net book value of the asset. Amortization Expense xxx Accumulated Amortization xxx

AMORTIZATION Balance Sheet Presentation Office equipment Less: Accumulated amortization Net book value $5,000 Estimate 83 $4,917 ILLUSTRATION 3-8 SUMMARY OF ADJUSTING ENTRIES Type of Adjustment Account Relationship

Accounts before Adjustment Adjusting Entry 1.Prepaid Assets and Assets overstated Dr. Dr. Expenses expenses expenses Expenses understated Cr. Cr. Assets 2.Unearned Liabilities and Liabilities overstated Dr. Dr. Liabilities revenues revenues Revenues understated Cr. Cr. Revenues 3.Accrued Assets and Assets understated Dr. Dr. Assets revenues revenues Revenues understated Cr. Cr. Revenues 4.Accrued Expenses and Expenses understated Dr. Dr. Expenses expenses liabilities Liabilities understated Cr.

Cr. Liabilities 5.AmortizationExpense and Expenses understated Dr. Dr. Amort. Exp contra asset Assets overstated Cr. Amortization Cr. Accum. ADJUSTED TRIAL BALANCE An Adjusted Trial Balance is prepared after all adjusting entries have been journalized and posted. It shows the balances of all accounts at the end of the accounting period and the effects of all financial events that have occurred during the period. It proves the equality of the total debit and credit balances in the ledger after all adjustments have been made. Financial statements can be prepared directly from the adjusted trial balance. ILLUSTRATION 3-11

TRIAL BALANCE AND ADJUSTED TRIAL BALANCE COMPARED Pioneer Advertising Agency Trial Balance October 31, 2002 Before Adjustment After Adjustment Debit Credit Debit Credit Cash $ 15,200 $ 15,200 Accounts Receivable 200 Advertising Supplies 2,500 1,000 Prepaid Insurance 600 550 Office Equipment 5,000

5,000 Accumulated Amort'n. $ 83 Notes Payable $ 5,000 5,000 Accounts Payable 2,500 2,500 Unearned Revenue 1,200 800 Salaries Payable 1,200 Interest Payable 25 C.R. Byrd, Capital 10,000 10,000 C.R. Byrd, Drawings 500 500

Service Revenue 10,000 10,600 Adv. Supplies Expense 1,500 Amortization Expense 83 Insurance Expense 50 Salaries Expense 4,000 5,200 Rent Expense 900 900 Interest Expense 25 $ 28,700 $ 28,700 $ 30,208 $ 30,208 PREPARING

PREPARING FINANCIAL FINANCIAL STATEMENTS STATEMENTS Financial statements can be prepared directly from an adjusted trial balance. 1. The income statement is prepared from the revenue and expense accounts. 2. The statement of owners equity is derived from the owners capital and drawings accounts and the net income (or net loss) shown in the income statement. 3. The balance sheet is then prepared from the asset and liability accounts and the ending owners capital balance as reported in the statement of owners equity. ILLUSTRATION 3-12 PREPARATION OF THE INCOME STATEMENT AND THE STATEMENT OF OWNERS EQUITY FROM THE ADJUSTED TRIAL BALANCE Pioneer Advertising Agency Adjusted Trial Balance October 31, 2002 Debit Credit

Cash $ 15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Amort'n. $ 83 Notes Payable 5,000 Accounts Payable 2,500 Unearned Revenue 800 Salaries Payable 1,200 Interest Payable 25

C.R. Byrd, Capital 10,000 C.R. Byrd, Drawings 500 Service Revenue 10,600 Adv. Supplies Expense 1,500 Amortization Expense 83 Insurance Expense 50 Salaries Expense 5,200 Rent Expense 900 Interest Expense 25 $ 30,208 $ 30,208 Pioneer Advertising Agency Income Statement

For the Month Ended October 31, 2002 Revenues Service Revenue $ 10,600 Expenses Adv. Supplies Expense $ 1,500 Amortization Expense 83 Insurance Expense 50 Salaries Expense 5,200 Rent Expense 900 Interest Expense 25 Total Expenses 7,758 Net Income $ 2,842 Pioneer Advertising Agency

Statement of Owner's Equity For the Month Ended October 31, 2002 C.R. Byrd, Capital, October 1 $ Add: Investments 10,000 Net income 2,842 12,842 Less: Drawings 500 C.R. Byrd, Capital, October 31 $ 12,342 ILLUSTRATION 3-13 PREPARATION OF THE BALANCE SHEET FROM THE ADJUSTED TRIAL BALANCE Pioneer Advertising Agency Adjusted Trial Balance October 31, 2002 Debit

Cash $ 15,200 Accounts Receivable 200 Advertising Supplies 1,000 Prepaid Insurance 550 Office Equipment 5,000 Accumulated Amort'n. Notes Payable Accounts Payable Unearned Revenue Salaries Payable Interest Payable C.R. Byrd, Capital C.R. Byrd, Drawings 500 Service Revenue Adv. Supplies Expense 1,500 Amortization Expense

83 Insurance Expense 50 Salaries Expense 5,200 Rent Expense 900 Interest Expense 25 $ 30,208 Credit $ 83 5,000 2,500 800 1,200 25 10,000 10,600

$ 30,208 Pioneer Advertising Agency Balance Sheet October 31, 2002 Assets Cash Accounts Receivable Advertising Supplies Prepaid Insurance Office Equipment Less: Accumulated Amortization Total Assets $ 15,200 200 1,000 550 $ 5,000 83

4,917 $ 21,867 Liabilities and Owner's Equity Liabilities Notes Payable Accounts Payable Unearned Revenue From Salaries Payable Interest Payable Statement Total Liabilities of Owners Owner's Equity Equity C.R. Byrd, Capital Total Liabilities and Owner's Equity $ $

5,000 2,500 800 1,200 25 9,525 12,342 $ 21,867 STEPS IN THE ACCOUNTING CYCLE 1. Analyse transactions 9. Coming next chapter 2. Journalize the transactions 3. Post to ledger accounts 8. Coming

next chapter 7. Prepare financial statements 4. Prepare a trial balance 6. Prepare adjusted trial balance 5. Journalize and post adjusting entries COPYRIGHT Copyright 2002 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by CANCOPY (Canadian Reprography Collective) is unlawful. Request for further information should

be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his / her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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