Chapter 3 The Adjusting Process

Book Value

A depreciable asset's cost minus accumulated depreciation.

Straight-Line Method

A depreciation method that allocates an equal amount of depreciation each year. (Cost - Residual value)/ Useful life.

Deferred Revenue

A liability created when a business collects cash from customers in advance of completing a service or delivering a product. Only after completing the job or delivering the product does the business EARN the revenue.

Adjusted Trial Balance

A list of all the accounts with their adjusted balances.

What is the purpose of the adjusted trial balance & how do we prepare it?

A list of all the accounts with their adjusted balances. It ensures that total debits equal total credits.

Accrued Revenue

A revenue that has been earned but for which the cash has not yet been collected.

Cash Basis Accounting

Accounting method that records revenues only when cash is received and expenses only when cash is paid.

Accrual Basis Accounting

Accounting method that records revenues when earned and expenses when incurred. Records each transaction as it occurs. Provides a better picture of a business revenues and expenses. It is irrelevant when cash is received or paid.

Two rules to remember about adjusting entries

Adjusting entries NEVER involve the Cash account 2. Adjusting entries either a. increase a revenue account ( credit revenue ) or b. increase an expense account ( debit expense ).

Accrued Expense

An Expense that the business has incurred but has not yet paid. An accrued expense ALWAYS creates an accrued liability.

Contra Account

An account that is paired with, and is listed immediately after, its related account in the chart of accounts and associated financial statement & Whose normal balance (Debit or Credit) is the opposite of the normal balance of the related account.

Fiscal Year

An accounting year of any 12 consecutive months that may or may not coincide with the calendar year.

Deferred Expense ( Prepaid Expense)

An asset created when a business makes advance payments of future expenses. They are deferrals because the expense is not recognized at the time of payment but deferred until they are used up. Considered assets rather than expenses until they are used up. Then the prepayment is used up, the used portion of the asset becomes an expense via an adjusting entry.

Worksheet

An internal document that helps summarize data for the preparation of financial statements.

2 basic categories of adjusting entries

Deferral Type 1: Cash payment occurs before an expense is incurred Type 2: Cash receipt occurs before the revenue is earned. Accruals Type 1: An expense is recorded before the cash is paid Type 2:The Revenue is earned before the cash is received

Deferral & Accrual Adjustments

Deferrals- Cash receipt or Cash payment occurs first. Accruals- Cash receipt or Cash payment occurs later.

4 types of adjusting entries

Deferred expenses ( or prepaid expenses): advance payment of future expenses adjusted for amount used Deferred revenues ( or unearned revenues ): advance receipts of future revenues adjusted for amount earned Accrued Expenses: Expenses that have been incurred but not paid. Accrued Revenues: Revenues that have been earned but not collected.

Cash Basis Vs Accrual

Ex: In May Business paid $1,200 for insurance for the next 6 months ($200 per month). Cash Basis records Insurance Expense of $1,200 on May 1st. Accrual requires the company to prorate the expense. Business would record a $200 expense every month from May- October.

Matching Principle ( Expense Recognition Principle )

Guides accounting for expenses, ensures All expenses are recorded when they are incurred during the period, and Matches those expenses against the revenues of the period.

What is the impact of adjusting entries on the financial statements?

If adjusting entries are not recorded, the balance sheet & income statement accounts will either be overstated or understated. Overstating or understating accounts causes the financial statements to be incorrect.

Plant asset

Long-lived, tangible asset, such as land, buildings, and equipment, used in the operation of a business.

Maching expenses against revenues

Means to subtract expenses incurred during one month from revenues earned during that same month. Goal is to compute an accurate net income or net loss for the time period.

Which is an example of a deferral​ (or prepaid) adjusting​ entry?

Recording the usage of office supplies during the period.

Revenue Recognition Principle

Requires companies to record revenue when it has been earned and determines the amount of revenue to record.

When to record revenue?

Revenue has been earned when the business has delivered a good or service to the customer, NOT necessarily when the business received the cash from the customer.

Amount of revenue to record

Revenue is recorded for the actual selling price of the item or service transferred to the customer.

When recording depreciation, why don't we record a credit to the Furniture account?

We need to keep the original cost of the furniture separate from the accumulated depreciation because of the cost principle. Managers can then refer to the Furniture account to see how much the asset originally cost. This info may help decide how much to sell the asset for in the future or how much to pay for new furniture.

If cash basis accounting is not allowed by GAAP, why would a business choose to use this method?

The cash method is an easier accounting method to follow because it generally requires less knowledge of accounting concepts and principles. The cash basis accounting method also does a good job of tracking a business's cash flow.

Residual Value

The expected value of a depreciable asset at the end of its useful life.

Depreciation

The process by which businesses spread the allocation of a plant asset's cost over its useful life.

Accumulated Depreciation

The sum of all the depreciation expense recorded to date for a depreciable asset. Is a contra asset, which means that it is an asset account with a normal credit balance.

Time Period Concept

Assumes that a business's activities can be sliced into small time segments and that financial statements can be prepared for specific periods, such as a month, quarter, or year.

How could a worksheet help in preparing adjusting entries and the adjusted trial balance?

A worksheet is an internal document that helps identify the accounts that need adjustments. Summarizes data for the preparation of the financial statements.

Adjusting Entry

An entry made at the end of the accounting period that is used to record revenues to the period in which they are earned and expenses to the period in which they occur. Also update the assets and liability accounts. There are four types.

What is an alternative treatment of recording deferred expenses and deferred revenues? ( Appendix 3A)

Deferred expenses can be recorded to an expense account at the time of payment. The adjusting entry would transfer any remaining prepayment to the asset account, Prepaid Expenses. Deferred revenues can be recorded to a revenue account at the time of cash receipt. The adjusting entry would transfer any remaining liability to the liability account , Unearned Revenue.