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3-1
3-2
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.
3-3
Financial AccountingIFRS Edition, 2e
Weygandt Kimmel Kieso
Preview of Chapter 3
3-4
Generally a month, a quarter, or a year.
Also known as the “Periodicity Assumption”
Timing Issues
Accountants divide the economic life of a business into
artificial time periods (Time Period Assumption).
LO 1 Explain the time period assumption.
Jan. Feb. Mar. Apr. Dec.. . . . .
3-5
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.
Timing Issues
LO 1 Explain the time period assumption.
Fiscal and Calendar Years
3-6
The time period assumption states that:
a. revenue should be recognized in the accounting
period in which a performance obligation is satisfied.
b. expenses should be matched with revenues.
c. the economic life of a business can be divided into
artificial time periods.
d. the fiscal year should correspond with the calendar
year.
LO 1 Explain the time period assumption.
Timing Issues
Question
3-7
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.
Accrual- vs. Cash-Basis Accounting
LO 2 Explain the accrual basis of accounting.
Timing Issues
3-8
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).
Accrual- vs. Cash-Basis Accounting
LO 2 Explain the accrual basis of accounting.
Timing Issues
3-9
Revenue Recognition Principle
Recognizing Revenues and Expenses
LO 2 Explain the accrual basis of accounting.
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.
Timing Issues
3-10
Expense Recognition Principle
Recognizing Revenues and Expenses
LO 2 Explain the accrual basis of accounting.
Match expenses with
revenues in the period when
the company makes efforts to
generate those revenues.
“Let the expenses follow
the revenues.”
Timing Issues
3-11 LO 2 Explain the accrual basis of accounting.
Timing Issues
Illustration 3-1 IFRS relationships in revenue and expense recognition
3-12 LO 2 Explain the accrual basis of accounting.
3-13
Which of the following statements about the accrual basis of accounting is false.
a. Events that change a company’s financial statements are recorded in the periods in which the events occur.
b. Revenue is recognized in the period in which services are performed.
c. The accrual basis is in accord with IFRS.
d. Revenue is recorded only when cash is received, and expenses are recorded only when cash is paid.
LO 2 Explain the accrual basis of accounting.
Timing Issues
Question
3-14
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.
LO 2
fecb
3-15
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.
LO 3 Explain the reasons for adjusting entries.
The Basics of Adjusting Entries
3-16
Adjusting entries are made to ensure that:
a. expenses are recognized in the period in which they
are incurred.
b. revenues are recorded in the period in which services
are provided.
c. statement of financial position and income statement
accounts have correct balances at the end of an
accounting period.
d. all of the above.
LO 3 Explain the reasons for adjusting entries.
The Basics of Adjusting Entries
Question
3-17
1. Prepaid Expenses. Expenses paid in cash before they are used or consumed.
Deferrals
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.
2. Unearned Revenues. Cash received before services are performed.
Accruals
Illustration 3-2Categories of adjusting entries
The Basics of Adjusting Entries
LO 4 Identify the major types of adjusting entries.
Types of Adjusting Entries
3-18
Trial Balance –
Each account is
analyzed to
determine whether
it is complete and
up-to-date.
Illustration 3-3
The Basics of Adjusting Entries
LO 4 Identify the major types of adjusting entries.
Types of Adjusting Entries
3-19
Deferrals are either:
Prepaid expenses
OR
Unearned revenues.
LO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for Deferrals
The Basics of Adjusting Entries
3-20
Payment of cash, that is recorded as an asset because
service or benefit will be received in the future.
insurance
supplies
advertising
Cash PaymentCash Payment Expense RecordedExpense RecordedBEFORE
rent
equipment
buildings
Prepayments often occur in regard to:
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Prepaid Expenses
3-21
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.
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Prepaid Expenses
Illustration 3-4
3-22
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.
Supplies 1,500
Supplies expense 1,500Oct. 31
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
3-23
The Basics of Adjusting Entries
Illustration 3-5
LO 5
3-24
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.
Prepaid insurance 50
Insurance expense 50Oct. 31
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
3-25
The Basics of Adjusting Entries
Illustration 3-6
LO 5
3-26
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.
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
3-27
40
Illustration: For Pioneer Advertising, assume
that depreciation on the equipment is $480 a
year, or $40 per month.
Accumulated depreciation 40
Depreciation expense
Oct. 31
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Accumulated Depreciation is called a contra
asset account.
3-28
The Basics of Adjusting Entries
LO 5
Illustration 3-7
3-29
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.
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Illustration 3-8
3-30
Illustration 3-9
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
3-31
Receipt of cash that is recorded as a liability because service
has not be performed.
Rent
Airline tickets
Cash ReceiptCash Receipt Revenue RecordedRevenue RecordedBEFORE
Magazine subscriptions
Customer deposits
Unearned revenues often occur in regard to:
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Unearned Revenues
3-32
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.
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Unearned Revenues
Illustration 3-10
3-33
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.
Service revenue 400
Unearned service revenue 400Oct. 31
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
3-34
The Basics of Adjusting Entries
LO 5
Illustration 3-11
3-35
Illustration 3-12
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
3-36 LO 5
3-37
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.
Adjusting Entries for Accruals
The Basics of Adjusting Entries
LO 6 Prepare adjusting entries for accruals.
3-38
Revenues for services performed but not yet received in cash or recorded.
Interest
Services performed
Rent
Accrued revenues often occur in regard to:
The Basics of Adjusting Entries
Accrued Revenues
LO 6 Prepare adjusting entries for accruals.
BEFORE Cash ReceiptCash ReceiptRevenue RecordedRevenue Recorded
3-39
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.
The Basics of Adjusting Entries
Illustration 3-13
LO 6
Accrued Revenues
3-40
Illustration: In October Pioneer Advertising
Agency recognized $200 for advertising
services performed but not recorded.
Accounts receivable 200
Cash 200Nov. 10
The Basics of Adjusting Entries
LO 6 Prepare adjusting entries for accruals.
200
Service revenue 200
Accounts receivable
Oct. 31
On November 10, Pioneer receives cash of
$ 200 for the services performed.
3-41
The Basics of Adjusting Entries
Illustration 3-14
LO 6
3-42
Illustration 3-15
The Basics of Adjusting Entries
LO 6 Prepare adjusting entries for accruals.
3-43
Expenses incurred but not yet paid in cash or recorded.
Rent
Interest
Taxes
Salaries
Accrued expenses often occur in regard to:
The Basics of Adjusting Entries
Accrued Expenses
BEFORE Cash PaymentCash PaymentExpense RecordedExpense Recorded
LO 6 Prepare adjusting entries for accruals.
3-44
Adjusting entry records the obligation and recognizes
the expense.
Adjusting entry:
► Increase (debit) an expense account and
► Increase (credit) a liability account.
LO 6
The Basics of Adjusting Entries
Accrued Expenses
Illustration 3-16
3-45
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%.
Interest payable 50
Interest expense 50Oct. 31
The Basics of Adjusting Entries
LO 6 Prepare adjusting entries for accruals.
Illustration 3-17
3-46
The Basics of Adjusting Entries
Illustration 3-18
LO 6
3-47
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).
The Basics of Adjusting Entries
LO 6 Prepare adjusting entries for accruals.
Illustration 3-19
3-48
The Basics of Adjusting Entries
Illustration 3-20
LO 6
3-49
Illustration 3-21
The Basics of Adjusting Entries
LO 6 Prepare adjusting entries for accruals.
3-50 LO 6 Prepare adjusting entries for accruals.
3-51
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.
LO 6
Salaries and wages expense 8,000
Salaries and wages payable 8,000
3-52 LO 6
Interest expense (¥ 300,000 x 10% x 1/12) 2,500
Interest payable2,500
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%.
3-53 LO 6
Accounts receivable 11,000
Service revenue 11,000
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.
3-54
The Basics of Adjusting Entries
LO 6 Prepare adjusting entries for accruals.
Summary of Basic RelationshipsIllustration 3-22
3-55
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.
LO 7 Describe the nature and purpose of an adjusted trial balance.
The Adjusted Trial Balance
Adjusted Trial Balance
3-56
Illustration 3-25
3-57
Which of the following statements is incorrect concerning the
adjusted trial balance?
a. An adjusted trial balance proves the equality of the total debit
balances and the total credit balances in the ledger after all
adjustments are made.
b. The adjusted trial balance provides the primary basis for the
preparation of financial statements.
c. The adjusted trial balance lists the account balances
segregated by assets and liabilities.
d. The adjusted trial balance is prepared after the adjusting
entries have been journalized and posted.
LO 7
The Adjusted Trial Balance
Question
3-58
Financial Statements are prepared directly from the Adjusted Trial Balance.
Financial Statements are prepared directly from the Adjusted Trial Balance.
Statement of Financial
Position
Income Statement
Retained Earnings
Statement
LO 7 Describe the nature and purpose of an adjusted trial balance.
Preparing Financial Statements
3-59 LO 7Illustration 3-26
3-60 LO 7Illustration 3-27
3-61
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.
Alternative Treatment of Prepaid Expenses and Unearned Revenues
LO 8 Prepare adjusting entries for the alternative treatment of deferrals.
APPENDIX 3A
3-62 LO 8 Prepare adjusting entries for the alternative treatment of deferrals.
Illustration 3A-2
Prepaid Expenses
Company may choose to debit (increase) an expense account
rather than an asset account. This alternative treatment is simply
more convenient.
APPENDIX 3A
3-63 LO 8 Prepare adjusting entries for the alternative treatment of deferrals.
Illustration 3A-5
Company may credit (increase) a revenue account when they
receive cash for future services.
APPENDIX 3A
Unearned Revenues
3-64 LO 8 Prepare adjusting entries for the alternative treatment of deferrals.
Illustration 3A-7
APPENDIX 3A
Summary of Additional Adjustment Relationships
3-65 LO 9 Discuss financial reporting concepts.
APPENDIX 3B CONCEPTS IN ACTION
Qualities of Useful InformationIllustration 3B-1
3-66 LO 9 Discuss financial reporting concepts.
APPENDIX 3B CONCEPTS IN ACTION
Enhancing Qualities
Comparability
Consistency
Verifiability
Timeliness
Understandability
3-67 LO 9
APPENDIX 3B CONCEPTS IN ACTION
Assumptions in Financial Reporting
Illustration 3B-2
3-68 LO 9
APPENDIX 3B CONCEPTS IN ACTION
Assumptions in Financial Reporting
Illustration 3B-2
3-69 LO 9 Discuss financial reporting concepts.
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
3-70 LO 9
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.
3-71
Key Points
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
3-72
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.
Another Perspective
3-73
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:
► 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
3-74
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.
Another Perspective
3-75
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.
Another Perspective
3-76
GAAP:
a) provides the same type of guidance as IFRS for revenue
recognition.
b) provides only general guidance on revenue recognition,
compared to the detailed guidance provided by IFRS.
c) allows revenue to be recognized when a customer makes an
order.
d) requires that revenue not be recognized until cash is received.
GAAP Self-Test Questions
Another Perspective
3-77
Which of the following statements is false?
a) GAAP employs the time period assumption.
b) GAAP employs accrual accounting.
c) GAAP requires that revenues and costs must be capable of
being measured reliably.
d) GAAP uses the cash basis of accounting.
GAAP Self-Test Questions
Another Perspective
3-78
Which of the following statements is false?
a) Under IFRS, the term income describes both revenues and
gains.
b) Under IFRS, the term expenses includes losses.
c) Under IFRS, firms do not engage in the closing process.
d) IFRS has fewer standards than GAAP that address revenue
recognition.
GAAP Self-Test Questions
Another Perspective
3-79
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