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Adjusting Adjusting Accounts for Accounts for Financial Financial StatementsStatements

C H A P T E R 3

1. Describe the purpose of adjusting accounts at the end of the period. (LO1)

2. Explain how the timeliness, matching, and revenue recognition principles affect the adjusting process. (LO2)

3. Explain accrual accounting and cash basis accounting and how accrual accounting adds to the usefulness of financial statements. (LO3)

Learning ObjectivesLearning Objectives

4. Prepare and explain adjusting entries for prepaid expenses, depreciation, unearned revenues, accrued expenses, and accrued revenues. (LO4)

5. Explain how accounting adjustments link

to financial statements. (LO5)6. Explain and prepare an adjusted trial

balance. (LO6)

Learning ObjectivesLearning Objectives

7. Prepare financial statements from an

adjusted trial balance. (LO7)8. Explain and prepare correcting entries.

(Appendix 3A) (LO8)9. Identify and explain an alternative in

recording prepaids and unearned

revenues. (Appendix 3B) (LO9)

Learning ObjectivesLearning Objectives

Prepare post-closingtrial balance

Journalize

Close

Prepareunadjusted trial balance

Post

Analyzetransactions

Prepare adjusted

trial balance

Prepare statements

Adjust

2

3

4

6

8

19

The Accounting CycleThe Accounting Cycle

5

LO 1

7

The first step in the accounting cycle is “Journalize”.

A) True

B) False

• Adjustments are only made when financial statements are prepared.

• Affect both the income statement and the balance sheet.

• Do not affect cash.

Adjustments & Financial Adjustments & Financial StatementsStatements

LO 5

Why Adjust?Why Adjust?Fast v Right?Fast v Right?

I want my financial statements now and they better be right!

Why Adjust?Why Adjust?Fast v Right?Fast v Right?

But… Some bills not

received yet Billing to customers

delayed Our assets are

getting older

Financial information must be timely and accurate

to be useful to decision makers.

As grown ups would say:As grown ups would say:

LO 1

Adjustments are based on three generally accepted accounting principles:

• Timeliness principle.• Revenue recognition principle.• Matching principle.

GAAP and AdjustmentsGAAP and Adjustments

LO 2

GAAP and AdjustmentsGAAP and Adjustments

All All earnings earnings for the for the month of month of August?August?Are these Are these

Expenses related Expenses related to August to August earnings earnings (revenues)?(revenues)?

Accrual Basis• Revenues and expenses are recognized

when earned or incurred regardless of when cash is received or paid.

• Consistent with GAAP.

Cash Basis• Revenues and expenses are recognized

when cash is received or paid.• Not consistent with GAAP.

Cash vs. Accrual BasisCash vs. Accrual Basis

LO 3

Adjusting AccountsAdjusting Accounts• Bring an asset or liability account

to its proper amount.• Update related expense or

revenue accounts.• Prepare more accurate financial

statements.

LO 4

• Prepaid expenses• Depreciation• Unearned revenues• Accrued expenses• Accrued revenues

Adjustment TypesAdjustment Types

LO 4

Similar?

Prepaid ExpensesPrepaid ExpensesOn January 1, a company purchases an insurance policy that covers three months and costs $1,800.•The cost of the policy should be spread over the time period it benefits the organization. (matching principle).

$600 $600 $600

$1,800January February March

Prepaid Expenses — ExamplePrepaid Expenses — Example

Prepaid InsuranceJan. 1 1,800 1,800

Cash

$600 $600 $600

$1,800January February March

The entry to record the purchase of the insurance policy would be: Jan 1 Prepaid Insurance 1,800

Cash 1,800

LO 4

Prepaid Expenses — ExamplePrepaid Expenses — Example

Prepaid Insurance Insurance ExpenseJan. 1 1,800Jan.31 600 600balance 1,200

$600 $600 $600

$1,800January February March

The entry to record the expiry (use) of the insurance for January would be:Jan 31 Insurance Expense 600

Prepaid Insurance 600

LO 4

The Insurance we used (or consumed) in January

600

Prepaid Insurance Insurance ExpenseJan. 1 1,800Jan.31 600 600Feb.28 600 600balance 600

$600 $600 $600

$1,800January February March

Prepaid Expenses — ExamplePrepaid Expenses — Example

$1,800

The entry to record the expiry (use) of the insurance for February would be: Feb 28 Insurance Expense 600

Prepaid Insurance 600

LO 4

The Insurance we used (or consumed) in February

Prepaid Expenses — ExamplePrepaid Expenses — Example

Prepaid Insurance Insurance ExpenseJan. 1 1,800Jan.31 600 600Feb.28 600 600Mar.31 600 600balance 0

$600 $600 $600

$1,800January February March

$1,800

And finally, the entry to record the expiry of the insurance for March would be:Mar 31 Insurance Expense 600

Prepaid Insurance 600

LO 4

March Expense

• Companies acquire assets such as equipment, buildings, vehicles, and patents to generate revenues.

• These assets are expected to provide benefits for more than one accounting period.

DepreciationDepreciation

LO 4

• Depreciation is the process of allocating the costs of assets over their useful lives.

• Based on the Matching Principle• Looks a lot like Prepaid Expenses except…

DepreciationDepreciation

LO 4

• Depreciation is based on the matching principle where the cost of an asset is matched over the time the asset helped earn the revenue.

Straight-LineDepreciationExpense

= Asset cost – Estimated residual value

Estimated useful life

DepreciationDepreciation

LO 4

Cash received before providing products and services (before it is earned).

• The company has an obligation to provide goods or services. (owes the customer)

• So “Unearned Revenues” are liabilities.• As products and services are provided, the

amount of unearned revenues becomes earned revenues.

Unearned RevenuesUnearned Revenues

LO 4

Unearned Revenues: ExampleUnearned Revenues: Example On March 1, a company received a $12,000 payment

from a customer for maintenance services to be provided over the next two months.

Unearned Revenue12,000 Mar.1 12,000

Cash

The entry to record the receipt of cash would be: Cash 12,000

Unearned Revenue 12,000

LO 4

Unearned Revenues: ExampleUnearned Revenues: Example

On March 31, $6,000 of this revenue had been earned.

Maintenance Revenue12,000 Mar.1

6,000 Mar.31 6,0006,000 balance

Unearned Revenue

The entry to record the earned revenue would be: Unearned Revenue 6,000 Maintenance Revenue 6,000

$12,000/2months= $6,000/month

LO 4

Unearned Revenues: ExampleUnearned Revenues: Example

By April 30, another $6,000 of this unearned revenue had been earned.

Maintenance Revenue12,000 Mar.1

6,000 Mar.31 6,0006,000 Apr.30 6,000

0 balance

Unearned Revenue

The entry to record the earned revenue would be: Unearned Revenue 6,000 Maintenance Revenue 6,000

$12,000/2months= $6,000/month

LO 4

Costs incurred in a period that are both unpaid and unrecorded. Examples: interest, wages, taxes, phone Adjusting entries must be made to record the

expense for the period and the related liability at the balance sheet date.

We know we owe it but we don’t have the bill yet.

Accrued ExpensesAccrued Expenses

LO 4

Accrued Expenses - ExampleAccrued Expenses - Example

On December 31, we owe our employees $1200 in wages but we won’t actually pay them until January 10.

The December 31 entry to record the accrued interest would be:

Wages Expense 1,200 Wages Payable 1,200

LO 4

Accrued Expenses - ExampleAccrued Expenses - Example

In December, a company incurred $3,700 of utilities expense. The company had not received the utility bill at December 31.

The December 31 entry to record the accrued utilities expense would be:

Utilities Expense 3,700

Accounts Payable 3,700

LO 4

We have Earned it but have not billed the customerAdjusting entries must be made to record the revenue for the period and the related asset at the balance sheet date.Examples: fees earned, interest earned, rent earned

Accrued RevenuesAccrued Revenues

LO 4

• Adjustments are only made when financial statements are prepared.

• Affect both the income statement and the balance sheet.

• Do not affect cash.

Adjustments & Financial Adjustments & Financial StatementsStatements

LO 5

Unadjusted Trial Balance• A listing of accounts and balances that is

prepared before adjustments are recorded.

Adjusted Trial Balance• A listing of accounts and balances that is

prepared after adjustments are recorded and posted to the ledger.

• It is used to prepare financial statements.

Trial Balance(s)Trial Balance(s)

LO 6

Stuff to Try!Stuff to Try!

QS 3-9 EX 3-2 PR 3-7A challenge! For guidance check out the

Demo Problem page 144 - 148

Adjust to bring the accounts up-to-date. Use the adjusted trial balance to prepare

the financial statements in the following order:• Income Statement• Statement of Changes in Equity• Balance Sheet• Statement of Cash Flows

Financial Statement PreparationFinancial Statement Preparation

LO 7

Errors found Errors found beforebefore posting posting Draw a line through the incorrect information. Insert correct information above the original

entry.

Errors found Errors found afterafter posting postingTwo alternatives:1. Prepare a single correcting entry.2. Reverse the original entry and record the

correct entry.

Appendix 4A: Correcting ErrorsAppendix 4A: Correcting Errors

LO 8

Correcting Errors — Example

A payment of $1,200 for Salaries Expense is erroneously posted to Interest Expense.

The original entry was recorded as:

Interest Expense 1,200 Cash 1,200

The original should have been recorded as:

Salaries Expense 1,200 Cash 1,200

LO 8

Correcting Errors — Example

Alternative 1 -Prepare a single correcting entry.

The original entry was recorded as:

Interest Expense 1,200 Cash 1,200

The correcting entry would be:

Salaries Expense 1,200 Interest Expense 1,200

LO 8

Correcting Errors — Example Alternative 2 -Reverse the original entry and enter

the correct entry.

The original entry was recorded as: Interest Expense 1,200

Cash 1,200 The entry to reverse this would be: Cash 1,200

Interest Expense 1,200 The correct entry would be: Salaries Expense 1,200

Cash 1,200

LO 8

Prepaid Expenses• Often recorded as assets when paid.• Adjusting entries transfer expired portion to

expense accounts at period end.

Alternative Treatment• Record as an expense when paid.• Adjusting entries transfer unused portion of

prepaid from the expense to the asset account.

Appendix 4B: Alternatives in Recording Appendix 4B: Alternatives in Recording Prepaids and Unearned RevenuesPrepaids and Unearned Revenues

LO 9

Example:

On January 1, a company purchases an insurance policy that covers 3 months and costs $1,800.

On January 31, $600 ($1,800 x 1/3) of the policy has expired and $1,200 ($1,800 x 2/3) remains unexpired.

Appendix 4B: Alternatives in Recording Appendix 4B: Alternatives in Recording Prepaids and Unearned RevenuesPrepaids and Unearned Revenues

LO 9

Payment Recorded as an Asset Payment Recorded as an Expense

Jan.1 Prepaid Insurance 1,800 Insurance Expense 1,800 Cash 1,800 Cash 1,800

Jan.31 Insurance Expense 600 Prepaid Insurance 1,200 Prepaid Insurance 600 Insurance Expense 1,200

Prepaids - ExamplePrepaids - Example

Prepaid Insurance1,800 Jan.1

600 Jan.31 1,2001,200 balance 1,200

Jan.1 1,800600 Jan.31 1,200600 balance 600

Insurance ExpenseInsurance Expense

Prepaid Insurance

LO 9

Unearned RevenuesUnearned Revenues• Often recorded as liabilities when cash is

received.• Adjusting entries transfer earned portion to

revenue accounts at period end.

Alternative Treatment• Record as revenues when cash is received.• Adjusting entries transfer unearned portion of

the payment from the revenue account to the unearned account.

Appendix 4B: Alternatives in Recording Appendix 4B: Alternatives in Recording Prepaids and Unearned RevenuesPrepaids and Unearned Revenues

LO 9

Alternatives in Accounting for Prepaids and Alternatives in Accounting for Prepaids and Unearned Revenues-Appendix 4BUnearned Revenues-Appendix 4B

Example:

On March 1, a company received a $12,000 payment from a customer for maintenance services to be provided over the next two months.

On March 31, $6,000 ($12,000/2) of the revenue has been earned and $6,000 ($12,000/2) remains unearned.

LO 9

Receipt Recorded as a Liability Receipt Recorded as a Revenue

Mar.1 Cash 12,000 Cash 12,000 Unearned Revenue 12,000 Maintenance Revenue 12,000

Mar.31 Unearned Revenue 6000 Maintenance Revenue 6,000 Maintenance Revenue 6000 Unearned Revenue 6,000

Unearned Revenues- ExampleUnearned Revenues- Example

LO 9

Unearned Revenue12,000 Mar.1

6,000 Mar.31 6,0006,000 balance 6,000

Mar.1 12,0006,000 Mar.31 6,0006,000 balance 6,000

Maintenance RevenueMaintenance Revenue

Unearned Revenue