ADJUSTING THE ACCOUNTS

Lecture-7

By M. Mehmood Ur Rehman

3-1
 Timing Issues

Accountants divide the economic life of a business into

artificial time periods (Time Period Assumption).

.....
Jan. Feb. Mar. Apr. Dec.

 Generally a month, a quarter, or a year.

 Also known as the “Periodicity Assumption”

3-2 1- Explain the time period assumption.

 Timing Issues

Fiscal and Calendar Years

 Monthly and quarterly time periods are called interim
periods.
 Public companies must prepare both quarterly and
annual financial statements.
 Fiscal Year = Accounting time period that is one year
in length.
 Calendar Year = January 1 to December 31.

3-3 1- Explain the time period assumption.

 Timing Issues

Review
The time period assumption states that:
a. revenue should be recognized in the accounting
period in which it is earned.
b. expenses should be matched with revenues.
c. the economic life of a business can be divided into
artificial time periods.
d. the fiscal year should correspond with the calendar
year.

3-4 1- Explain the time period assumption.

 Timing Issues

Accrual- vs. Cash-Basis Accounting

Accrual-Basis Accounting
 Transactions recorded in the periods in which the
events occur.
 Revenues are recognized when earned, rather than
when cash is received.
 Expenses are recognized when incurred, rather
than when paid.

3-5 2 - Explain the accrual basis of accounting.

 Timing Issues

Accrual- vs. Cash-Basis Accounting

Cash-Basis Accounting
 Revenues recognized when cash is received.
 Expenses recognized when cash is paid.
 Cash-basis accounting is not in accordance with
generally accepted accounting principles (GAAP).

3-6 2- Explain the accrual basis of accounting.

 Timing Issues

Recognizing Revenues and Expenses

Revenue Recognition Principle
Recognize revenue in the
accounting period in which it
is earned.
In a service enterprise,
revenue is considered to be
earned at the time the
service is performed.

3-7 2- Explain the accrual basis of accounting.

 Timing Issues

Recognizing Revenues and Expenses

Expense Recognition Principle
Match expenses with
revenues in the period
when the company makes
efforts to generate those
revenues.
“Let the expenses follow
the revenues.”

3-8 2- Explain the accrual basis of accounting.

 Timing Issues

Review
One of the following statements about the accrual basis of
accounting is false. That statement is:
a. Events that change a company’s financial statements
are recorded in the periods in which the events occur.
b. Revenue is recognized in the period in which it is
earned.
c. The accrual basis of accounting is in accord with
generally accepted accounting principles.
d. Revenue is recorded only when cash is received, and
expenses are recorded only when cash is paid.

3-9 2- Explain the accrual basis of accounting.

 The Basics of Adjusting Entries

 Adjusting entries are necessary because the trial

balance may not contain up-to-date and complete
data.
 Ensure that the revenue recognition and expense
recognition principles are followed.
 Required every time a company prepares financial
statements.
 Will include one income statement account and
one balance sheet account.

3-10 3- Explain the reasons for adjusting entries.

 The Basics of Adjusting Entries

Review
Adjusting entries are made to ensure that:
a. expenses are recognized in the period in which
they are incurred.
b. revenues are recorded in the period in which they
are earned.
c. balance sheet and income statement accounts
have correct balances at the end of an accounting
period.
d. all of the above.

3-11 3- Explain the reasons for adjusting entries.

 The Basics of Adjusting Entries

Types of Adjusting Entries

Deferrals Accruals
1. Prepaid Expenses. 3. Accrued Revenues.
Expenses paid in cash and Revenues earned but not yet
recorded as assets before received in cash or
they are used or consumed. recorded.

2. Unearned Revenues. 4. Accrued Expenses.

Cash received and recorded Expenses incurred but not
as liabilities before revenue yet paid in cash or recorded.
is earned.

3-12 4- Identify the major types of adjusting entries.

 The Basics of Adjusting Entries

Types of Adjusting Entries

Trial Balance –
Each account is
analyzed to
determine
whether it is
complete and up-
to-date.

3-13 4- Identify the major types of adjusting entries.

 The Basics of Adjusting Entries

Adjusting Entries for Deferrals

Deferrals are either:

 Prepaid expenses
OR
 Unearned revenues.

3-14 5- Prepare adjusting entries for deferrals.

 The Basics of Adjusting Entries

Prepaid Expenses
Payment of cash, that is recorded as an asset because
service or benefit will be received in the future.

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

 insurance  rent
 supplies  equipment
 advertising  buildings

3-15 5- Prepare adjusting entries for deferrals.

 The Basics of Adjusting Entries

Prepaid Expenses
 Expire either with the passage of time or through use.
 Adjusting entry:
► Increase (debit) to an expense account and
► Decrease (credit) to an asset account.
Illustration 3-4

3-16 5- Prepare adjusting entries for deferrals.

 The Basics of Adjusting Entries

Illustration: Pioneer Advertising Agency

purchased supplies costing $2,500 on
October 5. Pioneer recorded the payment
by increasing (debiting) the asset
Supplies. This account shows a balance
of $2,500 in the October 31 trial balance.
An inventory count at the close of
business on October 31 reveals that
$1,000 of supplies are still on hand.

Oct. 31 Supplies expense 1,500

Supplies 1,500

3-17 5- Prepare adjusting entries for deferrals.

 The Basics of Adjusting Entries

3-18
 The Basics of Adjusting Entries

Illustration: On October 4, Pioneer

Advertising Agency paid $600 for a one-
year fire insurance policy. Coverage
began on October 1. Pioneer recorded
the payment by increasing (debiting)
Prepaid Insurance. This account shows a
balance of $600 in the October 31 trial
balance. Insurance of $50 ($600 / 12)
expires each month.

Oct. 31 Insurance expense 50

Prepaid insurance 50

3-19 5- Prepare adjusting entries for deferrals.

 The Basics of Adjusting Entries

3-20
 The Basics of Adjusting Entries

Depreciation
 Buildings, equipment, and vehicles (assets with long
lives) are recorded as assets, rather than an expense,
in the year acquired.
 Companies report a portion of the cost of the asset as
an expense (depreciation expense) during each period
of the asset’s useful life.
 Depreciation does not attempt to report the actual
change in the value of the asset.

3-21 SO 5 Prepare adjusting entries for deferrals.

 The Basics of Adjusting Entries

Illustration: For Pioneer Advertising,

assume that depreciation on the
equipment is $480 a year, or $40 per
month.

Oct. 31
Depreciation expense 40
Accumulated depreciation 40

Accumulated Depreciation is called a contra asset account.

3-22 5- Prepare adjusting entries for deferrals.

 The Basics of Adjusting Entries

3-23
 The Basics of Adjusting Entries

Statement Presentation
 Accumulated Depreciation is a contra asset account.
 Appears just after the account it offsets (Equipment)
on the balance sheet.
 Normal balance of a contra asset account is a credit.

Illustration 3-8

3-24 5- Prepare adjusting entries for deferrals.

 The Basics of Adjusting Entries

Illustration 3-9

3-25 5- Prepare adjusting entries for deferrals.

 The Basics of Adjusting Entries

Unearned Revenues
Receipt of cash that is recorded as a liability because the
revenue has not been earned.

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

 Rent  Magazine subscriptions
 Airline tickets  Customer deposits

3-26 5- Prepare adjusting entries for deferrals.

 The Basics of Adjusting Entries

Unearned Revenues
 Adjusting entry is made to record the revenue that
has been earned and to show the liability that remains.
 Results in a decrease (debit) to a liability account
and an increase (credit) to a revenue account.

Illustration 3-10

3-27 5- Prepare adjusting entries for deferrals.

 The Basics of Adjusting Entries

Illustration: Pioneer Advertising Agency received $1,200 on

October 2 from R. Knox for advertising services expected to be
completed by December 31. Unearned Service Revenue shows a
balance of $1,200 in the October 31 trial balance. Analysis reveals
that the company earned $400 of those fees in October.

Oct. 31 Unearned service revenue 400

Service revenue 400

3-28 SO 5 Prepare adjusting entries for deferrals.

 The Basics of Adjusting Entries
Illustration 3-11

3-29 SO 5
 The Basics of Adjusting Entries

Illustration 3-12

3-30 SO 5 Prepare adjusting entries for deferrals.

 The Basics of Adjusting Entries

Adjusting Entries for Accruals

Accruals are made to record

 Revenues earned
OR
 Expenses incurred
in the current accounting period that have not been
recognized through daily entries.

3-31 SO 6 Prepare adjusting entries for accruals.

 The Basics of Adjusting Entries

Accrued Revenues
Revenues earned but not yet received in cash or recorded.

Revenue Recorded BEFORE Cash Receipt

Accrued revenues often occur in regard to:

 Rent  Services performed
 Interest

3-32 SO 6 Prepare adjusting entries for accruals.

 The Basics of Adjusting Entries

Accrued Revenues
 Adjusting entry shows the receivable that exists and
records the revenues earned.
 Adjusting entry:
► Increases (debits) an asset account and
► Increases (credits) a revenue account.

Illustration 3-13

3-33 SO 6
 The Basics of Adjusting Entries

Illustration: In October Pioneer Advertising

Agency earned $200 for advertising services
that had not been recorded.

Oct. 31
Accounts receivable 200
Service revenue 200

On November 10, Pioneer receives cash of

$200 for the services performed.

Nov. 10 Cash 200

Accounts receivable 200
3-34 SO 6 Prepare adjusting entries for accruals.
 The Basics of Adjusting Entries
Illustration 3-14

3-35 SO 6
 The Basics of Adjusting Entries
Illustration 3-15

3-36 SO 6 Prepare adjusting entries for accruals.

 The Basics of Adjusting Entries

Accrued Expenses
Expenses incurred but not yet paid in cash or recorded.

Expense Recorded BEFORE Cash Payment

Accrued expenses often occur in regard to:

 Rent  Taxes
 Interest  Salaries

3-37 SO 6 Prepare adjusting entries for accruals.

 The Basics of Adjusting Entries

Accrued Expenses
 Adjusting entry records the obligation and recognizes
the expense.
 Adjusting entry:
► Increase (debit) an expense account and
► Increase (credit) a liability account.

Illustration 3-16

3-38 SO 6
 The Basics of Adjusting Entries

Illustration: Pioneer Advertising Agency signed a three-month

note payable in the amount of $5,000 on October 1. The note
requires Pioneer to pay interest at an annual rate of 12%.

Oct. 31 Interest expense 50

Interest payable 50

3-39 SO 6 Prepare adjusting entries for accruals.

 The Basics of Adjusting Entries
Illustration 3-18

3-40 SO 6
 The Basics of Adjusting Entries

Illustration: Pioneer Advertising Agency last paid salaries on

October 26; the next payment of salaries will not occur until
November 9. The employees receive total salaries of $2,000 for a
five-day work week, or $400 per day. Thus, accrued salaries at
October 31 are $1,200 ($400 x 3 days).
Illustration 3-19

3-41 SO 6 Prepare adjusting entries for accruals.

 The Basics of Adjusting Entries
Illustration 3-20

3-42 SO 6
 The Basics of Adjusting Entries

Illustration 3-21

3-43 SO 6 Prepare adjusting entries for accruals.

 The Basics of Adjusting Entries

Summary of Basic Relationships

Illustration 3-22

3-44 SO 6 Prepare adjusting entries for accruals.

 The Adjusted Trial Balance

Adjusted Trial Balance

 Prepared after all adjusting entries are journalized
and posted.
 Purpose is to prove the equality of debit balances
and credit balances in the ledger.
 Is the primary basis for the preparation of financial
statements.

3-45 SO 7 Describe the nature and purpose of the adjusted trial balance.
 Illustration 3-25

3-46
 The Adjusted Trial Balance

Review
Which of the following statements is incorrect concerning the
adjusted trial balance?
a. An adjusted trial balance proves the equality of the total
debit balances and the total credit balances in the ledger
after all adjustments are made.
b. The adjusted trial balance provides the primary basis for
the preparation of financial statements.
c. The adjusted trial balance lists the account balances
segregated by assets and liabilities.
d. The adjusted trial balance is prepared after the adjusting
entries have been journalized and posted.

3-47 SO 7 Describe the nature and purpose of the adjusted trial balance.
 The Financial Statements

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FinancialStatements
Statementsare
areprepared
prepareddirectly
directlyfrom
fromthe
the
Adjusted
AdjustedTrial
TrialBalance.
Balance.

Owner’s
Balance Income
Equity
Sheet Statement
Statement

3-48 SO 7 Describe the nature and purpose of the adjusted trial balance.
 Illustration 3-26

3-49 SO 7
 Illustration 3-27

3-50 SO 7