Chapter 3: Adjusting the Accounts

Prepaid Expenses

type of deferral. future expenses that have been paid in advance. prepaid expenses as costs that have been paid but have not yet been used up or have not yet expired.

Accrued Expenses

Interest, Taxes, salaries

Fiscal Year

An accounting period that is one year in length. Begins on the first day of the month and ends 12 months later on the last day of the month.

Every adjusting entry will include

one income statement and one balance sheet account

Expense Recognition Principle example

For example, a business pays $100,000 for merchandise, which it sells in the following month for $150,000. Under the expense recognition principle, the $100,000 cost should not be recognized until the following month, when the related revenue is also recognized. Otherwise, expenses will be overstated by $100,000 in the current month, and understated by $100,000 in the following month.

Example of Cash Basis Accounting

For example, say a construction company secures a major contract in a given year but is only going to be paid for its efforts upon completion of the project. Using cash-basis accounting, the company is only able to recognize the revenue from its project upon its completion, while it records the project's expenses as they are being paid. If the project's time span is greater than one year, the company's income statements are misleading; they show the company incurring large losses one year followed by great gains the next.

Examples of Accrued Revenues

Interest, rent, services

What will happen if a business does not make an adjusting entry at the end of the period to record an accrued expense?

It will cause an understatement of expenses and an understatement of liabilities.

Book Value

The book value of an asset is the asset's cost minus the asset's accumulated depreciation. For example, in the general ledger account, Automobile, is the automobile's cost of $22,000. In the contra asset account, Accumulated Depreciation on Automobile, is a credit balance of $16,000. The net of those two amounts ($22,000 minus $16,000) is the book value or the carrying value of the automobile. In this example the $6,000 is the amount being reported on the company's books.

Prepaid Expense: Insurance

The cost of insurance paid is advance is recorded as an increase (debit) to an asset account Prepaid Insurance. At the financial statement date, companies increase (debit) Insurance Expense and decrease credit Prepaid Insurance for the cost of insurance that has expired during the period.

Prepaid Expense: Supplies

The purchase of supplies, results in an increase (a debit) to an asset account. During the accounting period, the company uses supplies. Rather than record supplies expense as the supplies are used, companies recognize supplies expense at the end of the accounting period where they count the remaining supplies and make adjustments.

What do we use to determine when to report revenues and expenses?

The revenue recognition principle and the expense recognition principle.

Performance Obligation

When a company agrees to perform a service of sell a product to a customer. When the company does this ir recognises revenue.

Unearned Revenues

When companies receive cash before services are performed, they record a liability by increasing (crediting) a liability account, called Unearned Revenues. Now the company has a performance obligation to transfer a service to one of its customers. Opposite of Prepaid Expenses.

Two types of deferrals

prepaid expenses and unearned revenues

Adjusting entry for depreciation

recognise the cost that has been used (an expense) during the period and to report the unused cost (an asset) at the end of the period.

Examples of Unearned Revenues

rent, magazine subscriptions, and customer deposits for future services

Accrued Revenues

revenues for services performed but not yet recorded or received in cash at the statement date.

interim periods

monthly and quarterly time periods

Accounts before adjustment for accrued revenues

Assets understated and revenues understated.

4 types of adjustments

1. Prepaid Expenses: assets overstated, expenses understated. adjusting entry : debit expenses and credit assets or contra assets 2. Unearned Revenues: liabilities overstates, revenues understated. adjusting entry: debit liabilities and credit revenues 3. Accrued revenues: assets understated and revenues understated adjusting entry: debit assets and credit revenues 4. Accrued expenses: expenses understated and liabilities understated. adjusting entry: debit expenses and credit liabilities.

3 factors of Interest Recorded

1. the face value of the note 2. interest rate expressed as an annual rate 3. the length of time the note is outstanding Interest = Face Value of Note x Annual Interest Rate x Time in Terms of one year

Accrued salaries and wages

Companies pay for some types of expenses, such as employee salaries and wages, after the services have been performed.accrual increases a liability, Salaries and Wages payable. It also dec erases stockholders' equity by increasing an expense account, Salaries and Wages Expenses.

Cash-Basis Accounting

Companies record revenue at the time they receive cash and record an expense at the time they pay out cash.

Accrual-Basis Accounting

Companies record transactions that change a company's financial statements in the periods in which the events occur. Revenue is recognized when companies perform services (rather then when they receive cash) and expenses are recognised when charged (rather then when they are paid). In accordance with the GAAP.

Adjusting entry for accrued expenses

Debit Expenses and Credit Liabilities

Types of adjusting entries

Deferrals: 1. Prepaid expenses: Expenses paid in cash before they are used or consumed. 2. Unearned revenues: cash received before services are performed. Accruals: 1.Accrued Revenue: Revenues of services performed but not yet received in cash or recorded. 2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.

Prepaid Expense: Depreciation

Depreciation is the prodicess of allocating the cost an asset to expense over its useful life.Buildings, machinery, equipment, furniture, fixtures, computers, outdoor lighting, parking lots, cars, and trucks are examples of assets that will last for more than one year, but will not last indefinitely. During each accounting period (year, quarter, month, etc.) a portion of the cost of these assets is being used up. The portion being used up is reported as Depreciation Expense on the income statement.

Accounts before adjustment of accrued expenses

Expenses understated and liabilities understated

Problem with Cash-Basis Accounting

Produces misleading financial statements. It fails to record revenue for a company that has performed services but has not yet received payment. So the cash basis may not recognise revenue in the period that a performance obligation is satisfied. The cash-basis method can paint an inaccurate picture of a business' health and growth. For example, if a business has slow sales one month but a large number of clients happen to pay their invoices that month, cash-basis accounting indicates a large influx of cash when sales are actually slow. If the business owner tries to compare numbers from that month with numbers from other months to make projections or assess trends, he has an inaccurate view of what is happening.

Expense Recognition Principle

Requires that companies recognize expenses in the period in which they make efforts to generate revenue. So expenses should be recognized in the same period as the revenues to which they relate.

Accumulated Depreciation- Equipment

account keeps track of the total amount of depreciation expense taken over the life of the asset

time period assumption

accountants divide the economic life of a business into artificial time periods

Adjusting entry for Unearned Revenues

decrease (debit) to a liability account and an increase (credit) to a revenue account.

Revenues for services performed but not yet recorded at the statement date are ________ revenues.

deferred

Revenue Recognition Principle

determines the specific conditions under which revenue is recognized or accounted for.Companies recognize revenue in the accounting period in which the performance obligation is satisfies.

Reason for adjustment for accrued expenses

expenses have been incurred but not yet paid or recorded

Accrued Expenses

expenses incurred but not yet paid or recorded at the statement date

Deferrals

expenses or revenues that are recognised at a date later than the point when cash was originally exchanged.

Adjusting entry for prepaid expenses

increase (a debit) to an expense account and a decrease (a credit) to an asset account.

adjusting entries for accruals

increase both a balance sheet and an income statement account. Prior to an accrual adjustment the revenue account or the expense account are understated.

Adjusting entry for accrued revenues

increase to an asset account (debit) and an increase to a revenue account (credit). Increase in revenue account leads to an increase in stockholders' equity. Debit Assets Credit Revenues

Examples of prepaid expenses

insurance, suppliers, advertising, and rent.

Reason for Adjusting Entry for accrued interest

liabilities and interest expense are understated and net income and stockholders' equity are overstated

Accrued Interest

the accrual of interest increases a liability account, Interest Payable. Decreases stockholders' equity by increasing an expense account, Interest Expense. Interest expense shows the interest charges for a month and Interest Payable shows the amount of interest the company owes at statement due.

Trial Balance

the first pulling together of transaction data

What is the reason for adjusting entries

to ensure that the revenue recognition principle and the expense recognition principle are followed. This is needed because the trial balance may not contain up-to-date and complete data because: 1. Some events are not recorded daily because it is not efficient to do so. Like use of supplies and earning of wages by employees. 2. Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result if recurring daily transactions. 3. some items may be unrecorded. adjusting entries is required overtime a company prepares financial statements