Adjusting Entries: Prepayments

Financial Accounting Chapter 4 The Accounting Cycle Adjusting Entries: Prepayments

TIME-PERIOD ASSUMPTION • Thetime period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods. • Accounting time periods are generally a month, a quarter, or a year. • The accounting time period of one year in length is referred to as afiscal year.

ACCRUAL BASIS OF ACCOUNTING • The revenue recognition and matching principles are used under the accrual basis of accounting. • Under cash basis accounting, revenue is recorded when cash is received, and expenses are recorded when cash is paid. • Generally accepted accounting principles require accrual basis accounting because the cash basis often causes misleading financial statements.

REVENUE RECOGNITION PRINCIPLE • The revenue recognition principle dictates that revenue be recognized in the accounting period in which it is earned. • In a service business, revenue is considered to be earned at the time the service is performed.

THE MATCHING PRINCIPLE • The practice of expense recognition is referred to as the matching principle. • Thematching principle dictates that efforts (expenses) be matched with accomplishments (revenues). Revenues earned this month expenses incurred in earning the revenue are offset against....

Time-Period Assumption Economic life of business can be divided into artificial time periods Revenue-Recognition Principle Matching Principle Revenue recognized in the accounting period in which it is earned Expenses matched with revenues in the same period when efforts are expended to generate revenues ILLUSTRATION 3-1 GAAP RELATIONSHIPS IN REVENUE AND EXPENSE RECOGNITION

At the end of the period, we need to make adjusting entries to get the accounts up to date for the financial statements.

Adjusting Entries Adjusting entries are Every adjusting needed whenever revenue or expenses affectmore than one entry involves a change in either arevenue or expense and anasset or liability. accounting period.

ADJUSTING ENTRIES Adjusting entries are made in order for: 1 Revenues to be recorded in the period in which they are earned, and for...... 2 Expenses to be recognized in the period in which they are incurred.

ADJUSTING ENTRIES • Adjusting entries are required each time financial statements are prepared. • Adjusting entries can be classified as 1prepayments (prepaid expenses or unearned revenues) OR 2accruals (accruedrevenues or accruedexpenses)

TYPES OF ADJUSTING ENTRIES Prepayments 1Prepaid Expenses — Expenses paid in cash and recorded as assets before they are used or consumed 2 Unearned Revenues — cash received and recorded as liabilities before revenue is earned

TYPES OF ADJUSTING ENTRIES Accruals 1Accrued Revenues — Revenues earned but not yet received in cash or recorded 2Accrued Expenses — Expenses incurred but not yet paid in cash or recorded

Types of Adjusting Entries • Converting assets to expenses • Converting liabilities to revenue • Accruing unpaid expenses • Accruing uncollected revenue

ILLUSTRATION 3-3 TRIAL BALANCE The Trial Balance is the starting place for adjusting entries.

Adjusting Entries Prepaid Expenses Asset Expense Unadjusted Balance Credit Adjusting Entry (-) Debit Adjusting Entry (+) Unearned Revenues Liability Revenue Debit Adjusting Entry (-) Unadjusted Balance Credit Adjusting Entry (+) ILLUSTRATION 3-4 ADJUSTING ENTRIES FOR PREPAYMENTS

Learning Objective To prepare adjusting entries to convert assets to expenses.

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. • Anasset-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, insurance, and depreciation.

Adjusting Entry • Recognizes portion of asset consumed as expense, and • Reduces balance of asset account. Converting Assets to Expenses End of Current Period Prior Periods Current Period Future Periods Transaction Paid cash in advance of incurring expense (creates an asset).

Converting Assets to Expenses Examples Include: Depreciation Supplies Expiring Insurance Policies

Converting Assets to Expenses $2,400 Insurance Policy Coverage for 12 Months $200 Monthly Insurance Expense Jan. 1 Dec. 31 On January 1, Webb Co. purchased a one-year insurance policy for $2,400.

Converting Assets to Expenses Initially, costs that benefit more than one accounting period are recorded as assets.

Converting Assets to Expenses The costs are expensed as they are used to generate revenue.

Converting Assets to Expenses Balance Sheet Cost of assets that benefit future periods. Income Statement Cost of assets used this period to generate revenue.

ADJUSTING ENTRIES FOR PREPAYMENTS INSURANCE ADJUSTMENT October 31, an analysis of the policy reveals that $50 of insurance expires each month. JOURNAL ENTRY POSTING

ADJUSTING ENTRIES FOR PREPAYMENTS SUPPLIES ADJUSTMENT October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand. JOURNAL ENTRY POSTING

The Concept of Depreciation Depreciable assets are physical objects that retain their size and shape but lose their economic usefulness over time. Depreciation is the systematic allocation of the cost of a depreciable asset to expense.

The Concept of Depreciation The portion of an asset’s utility that is used up must be expensed in the period used. The asset’s usefulness is partially consumed during the period. Fixed Asset (debit) Depreciation Expense (debit) On date when initial payment is made . . . At end of period . . . Accumulated Depreciation (credit) Cash (credit)

DEPRECIATION • Depreciation is the allocation of the cost of an asset to expense over its useful life in a rational and systematic manner. • The purchase of equipment or a building is viewed as a long-term prepayment of services and, therefore, is allocated in the same manner as other prepaid expenses.

DEPRECIATION • In the balance sheet, Accumulated Depreciation is offset against the asset account. • The difference between the cost of any depreciable asset and its related accumulated depreciation is referred to as the book value of the asset.

XXX XXX DEPRECIATION • Depreciation is an estimate rather than a factual measurement of the cost that has expired. • In recording depreciation, Depreciation Expenseis debited and a contra asset account, Accumulated Depreciation, is credited

Depreciation expense (per period) Cost of the asset Estimated useful life = $2,500 50 $50 = Depreciation Is Only an Estimate On May 2, 2007, JJ’s Lawn Care Service purchased a lawn mower with a useful life of 50 months for $2,500 cash. Using the straight-line method, calculate the monthly depreciation expense.

Contra-asset Depreciation Is Only an Estimate JJ’s Lawn Care Service would make the following adjusting entry.

$15,00060 months = $250 per month Depreciation Is Only an Estimate JJ’s $15,000 truck is depreciated over 60 months as follows:

Accumulated depreciation would appear on the balance sheet as follows:

ADJUSTING ENTRIES FOR PREPAYMENTS DEPRECIATION ADJUSTMENT October 31, depreciation on the office equipment is estimated to be $480 a year, or $40 per month. JOURNAL ENTRY POSTING

Learning Objective To prepare adjusting entries to convert liabilities to revenue.

UNEARNED REVENUES • Unearned revenues are revenues received and recorded as liabilities before they are earned. • Unearned revenues are subsequently earned by rendering a service to a customer. • A liability-revenueaccount 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, and customer deposits for future services.

ADJUSTING ENTRIES FOR PREPAYMENTS UNEARNED REVENUES ADJUSTMENT October 31, analysis reveals that, of $1,200 in fees, $400 has been earned in October. JOURNAL ENTRY POSTING

Adjusting Entry • Recognizes portion earned as revenue, and • Reduces balance of liability account. Converting Liabilities to Revenue End of Current Period Prior Periods Current Period Future Periods Transaction Collect cash in advance of earning revenue (creates a liability).

Converting Liabilities to Revenue Examples Include: Airline Ticket Sales Sports Teams’ Sales of Season Tickets

Converting Liabilities to Revenue $6,000 Rental Contract Coverage for 12 Months $500 Monthly Rental Revenue Jan. 1 Dec. 31 On January 1, Webb Co. received $6,000 in advance for a one-year rental contract.

Converting Liabilities to Revenue Initially, revenues that benefit more than one accounting period are recorded as liabilities.

Converting Liabilities to Revenue Over time, the revenue is recognized as it is earned.

Converting Liabilities to Revenue Balance Sheet Liability for future periods. Income Statement Revenue earned this period.

Learning Objective To prepare adjusting entries to accrue unpaid expenses.

Adjusting Entry • Recognizes expense incurred, and • Records liability for future payment. Accruing Unpaid Expenses End of Current Period Prior Periods Current Period Future Periods Transaction Pay cash in settlement of liability.

Accruing Unpaid Expenses Hey, when do we get paid? Examples Include: Interest Wages and Salaries Property Taxes

Adjusting Entries: Prepayments