Chapter 3 The Adjusting Process
Accrual Accounting Versus Cash-Basis Accounting • Accrual Basis • Revenues recognized when earned • Expenses recognized when incurred • Cash Basis • Revenues recognized when cash received • Expensesrecorded when cash paid Not GAAP
Accrual vs. Cash-Basis: Revenue Accrual basis revenue transactions Cash-basis revenue transactions
Accrual vs. Cash-Basis Accounting Accrual basis Cash-basis
S3-2: COMPARING ACCRUAL AND CASH-BASIS ACCOUNTING The Johnny Flowers Law Firm uses a client database. Suppose Johnny Flowers paid $2,900 for a computer. Requirements: 1. Describe how the business should account for the $2,900 expenditure under • the cash basis. b. the accrual basis.
S3-2: COMPARING ACCRUAL AND CASH-BASIS ACCOUNTING 2. State why the accrual basis is more realistic for this situation.
Accounting Period Concept • Businesses prepare financial statements for specific periods to evaluate performance • Basic accounting period = one year • Interim periods
Revenue Recognition Principle • When to record revenue? • When it is earned • The amount of revenue to recorded? • Value of item or service transferred to customer
The Matching Principle • Measure all expenses incurred during the period • Match the expenses against the revenues earned during the same period
The Time-Period Concept • Requires that accounting information be reported at regular intervals • Accounts are updated at the end of each accounting period
Time-Period Concept On May 31, Smart Touch recorded salary expense of $900 that is owed to an employee at the end of the month.
Adjusting Entries • Prepared at end of an accounting period • Assigns: • Revenues to the period when earned • Expenses to the period when incurred • Update asset and liability accounts • Need to properly match revenues and expenses to measure: • Net Income • Assets and Liabilities
Prepaid Expenses • Advance payments of expenses • Recorded as an asset • Adjusting entry records amount used as an expense
Depreciation • Plant assets • Long-lived tangible assets used in business operations • Depreciation • Allocation of a plant asset’s cost to expense over its useful life
Accumulated Depreciation • Contra asset • Holds sum of all depreciation recorded on a plant asset • Book value
Accrued Expenses • Expenses incurred before payment is made • Opposite of a prepaid expense
Accrued Revenues • Revenue earned before cash is received • Results in a receivable
Unearned Revenue • Cash is collected before revenue is earned • Also called deferred revenue BEFORE
Summary of Adjusting Entries • To properly measure net income for the period • To update the balance sheet
S3-5: IDENTIFYING TYPES OF ADJUSTING ENTRIES • A select list of transactions for Anuradha’s Goals follows: Apr 1 Paid six months of rent, $4,800. 10 Received $1,200 from customer for six-month service contract that began April 1. 15 Purchased computer for $1,000. Requirement: 1. For each transaction, identify what type of adjusting entry would be needed.
S3-5: IDENTIFYING TYPES OF ADJUSTING ENTRIES • A select list of transactions for Anuradha’s Goals follows: Apr 18 Purchased $300 of office supplies on account. 30 Work performed but not yet billed to customer, $500. 30 Employees earned $600 in salary that will be paid May 2.
E3-22: JOURNALIZING ADJUSTING ENTRIES AND ANALYZING THEIR EFFECT ON THE INCOME STATEMENT • The following data at January 31, 2012 is given for EBM, Inc. • a. Depreciation, $500 • b. Prepaid rent expired, $600 • c. Interest expense accrued, $300 • d. Employee salaries owed for Monday through Thursday of a five-day workweek; weekly payroll, $13,000 • e. Unearned service revenue earned, $1,300 • Requirement: • 1. Journalize the adjusting entries needed on January 31, 2012.
E3-22: JOURNALIZING ADJUSTING ENTRIES AND ANALYZING THEIR EFFECT ON THE INCOME STATEMENT
E3-22: JOURNALIZING ADJUSTING ENTRIES AND ANALYZING THEIR EFFECT ON THE INCOME STATEMENT 2. Suppose the adjustments made in Requirement 1 were not made. Compute the overall overstatement or understatement of net income as a result of the omission of these adjustments.
Adjusted Trial Balance • Prepared after adjusting entries are posted • Useful step in preparing financial statements • Often appears on a work sheet
E3-25: PREPARING THE FINANCIAL STATEMENTS Refer to the adjusted trial balance in Exercise 3-21 for the month ended April 30, 2012. Requirements: • Prepare the income statement. 2. Prepare the statement of retained earnings. 3. Prepare the balance sheet.
Alternative Treatment of PrepaidExpenses • Prepaid Expenses (normally) • Advance payments of expenses • Debit an asset account • Adjust at end of period • Alternative • Debit an expenseaccount • Adjust at end of period
Prepaid Expense Initially debit and expense account Adjust at end of period for unused amount