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Unit 1.3

Unit 1.3. Adjusting the Accounts. The Time Period 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.

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Unit 1.3

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  1. Unit 1.3 Adjusting the Accounts

  2. The Time Period Assumption • Thetime period(or periodicity) assumptionassumes 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 afiscal year.

  3. Revenue Recognition Principle • The revenue recognition principlestates 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.

  4. Revenue Recognition Principle • Revenue can be recognized: 1. At point of sale 2. During production 3. At completion of production 4. Upon collection of cash

  5. Revenue Recognition Principle - % of Completion • The percentage-of-completion method recognizes revenue and income on the basis of reasonable estimates of the project’s progress toward completion. • A project’s progress toward completion is measured by comparing the costs incurred in a year to total estimated costs of the entire project.

  6. Revenue Recognition Principle - % of Completion Method The costs incurred in the current period are then subtracted from the revenue recognized during the current period to arrive at the gross profit. Cost Incurred (Current Period) Total Estimated Cost Percent Complete (Current Period) = ÷ Percent Complete (Current Period) Total Revenue Revenue Recognized (Current Period) = 

  7. Installment Method of Revenue Recognition • The cash basis is generally used only when it is difficult to determine the revenue amount at the time of a credit sale because collection is so uncertain. • The installment method, which uses the cash basis, is a popular approach to revenue recognition. • Under the installment method gross profit is recognized in the period in which the cash is collected.

  8. Gross Profit Formula – Installment Method • Under the installment method, each cash collection from a customer consists of 1. a partial recovery of the cost of goods sold,and 2. a partial gross profit from the sale. • The formula to recognize gross profit is shown below. Gross Profit Sales Revenue Gross Profit Margin  = Gross Profit Recognized during the period Gross Profit Margin Cash Collections from Customer  =

  9. Revenues earned this month expenses incurred in earning the revenue are offset against.... The Matching Principle • The practice of expense recognition is referred to as thematching principle. • Thematching principledictates that efforts (expenses) be matched with accomplishments (revenues).

  10. The Matching Principle - continued • Expired costsare costs that will generate revenues only in the current period and are therefore reported as operating expenses on the income statement. • Unexpired costsare costs that will generate revenues in future accounting periods and are recognized as assets.

  11. The Matching Principle - continued Unexpired costsbecome expenses through: 1. Cost of goods sold– Costs carried as merchandise inventory are expensed as cost of goods sold in the period when the sale occurs – so there is a direct matching of expenses with revenues. 2. Operating expenses– Unexpired costs become operating expensesthrough use or consumption or through the passage of time.

  12. GAAP Accrual Basis of Accounting • Adheres to the • Revenue recognition principle • Matching principle • Revenue 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.

  13. NOT GAAP Cash Basis of Accounting • Revenue recorded only when cash received. • Expense recorded only when cash paid.

  14. Adjusting entries make the revenue recognition and matching principles Adjusting Entries HAPPEN!

  15. The Trial Balance The Trial Balance is analysed to determine the need for adjusting entries.

  16. Adjusting Entries • Adjusting entriesare required each time financial statements are prepared. • Adjusting entries can be classified as 1.prepayments (prepaid expensesor unearned revenues), 2.accruals (accruedrevenuesor accrued expenses), or 3. estimates (amortization).

  17. 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.

  18. Types of Adjusting Entries - continued 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.

  19. Types of Adjusting Entries - continued Estimates 1. Amortization— Allocation of the cost of capital assets to expense over their useful lives.

  20. 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.

  21. PrePaid Expenses • Prepaid expensesare 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. • Anasset-expenseaccount relationshipexists with prepaid expenses.

  22. PrePaid Expenses - continued • 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.

  23. Unearned Revenues • Unearned revenuesare 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-revenueaccount relationship exists with unearned revenues.

  24. Unearned Revenues - continued • 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.

  25. Adjusting Entries Asset Expense Unadjusted Balance Credit Adjusting Entry (-) Debit Adjusting Entry (+) Liability Revenue Debit Adjusting Entry (-) Unadjusted Balance Credit Adjusting Entry (+) Adjusting Entries for Prepayments Prepaid Expenses Unearned Revenues

  26. 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.

  27. Accrued Revenues • Accrued revenuesmay 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.

  28. Accrued Expenses • Accrued expensesare 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.

  29. Face Value of Note Annual Interest Rate Time (in Terms of One Year) Interest Formula to Calculate Interest x x = $5,000 x 6% x 1/12 = $25

  30. Adjusting Entries Accrued Revenues Asset Revenue Debit Adjusting Entry (+) Credit Adjusting Entry (+) Accrued Expenses Expense Liability Debit Adjusting Entry (+) Credit Adjusting Entry (+) Adjusting Entries for Accruals

  31. Amortization • Amortizationis 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.

  32. We’re not attempting to reflect the actual change in value of an asset! Amortization - continued • Amortization is an estimate rather than a factual measurement of the cost that has expired.

  33. Amortization - continued • In recording amortization, Amortization Expenseis 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 valueof the asset. Accumulated Amortization Amortization Expense XXXX XXXX

  34. Estimate Amortization - continued Balance Sheet Presentation Office equipment $5,000 Less: Accumulated amortization 83 Net book value $4,917

  35. Adjusted Trial balance • An Adjusted Trial Balanceis 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.

  36. Trial Balance & Adjusted Trial Balance

  37. Preparing Financial Statements Financial statementscan be prepared directly from an adjusted trial balance. 1. The income statement is prepared from the revenue and expense accounts. 2. The statement of owner’s equity is derived from the owner’s 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 owner’s capital balance as reported in the statement of owner’s equity.

  38. Preparation From Adjusted Trial Balance

  39. From Statement of Owner’s Equity Preparation From Adjusted Trial Balance

  40. 1. Analyse transactions 2. Journalize the transactions 9. Coming next Section 3. Post to ledger accounts 8. Coming next Section 4. Prepare a trial balance 7. Prepare financial statements 5. Journalize and post adjusting entries 6. Prepare adjusted trial balance Steps in the Accounting Cycle

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