Chapter 3: Adjusting the Accounts Timing Issues E.g.: Management monthly financial statements. Investors quarterly.

ly. Canada customs and Revenue agency annual financial statements + annual tax returns. Time Period Assumption: Periodicity: accountants make the assumption that the economic life of a business can be divided into artificial time periods. A month, a quarter, a year. Interim Periods: time periods less than 1 year. Fiscal Year: 1 year accounting period Revenue Recognition Principle: revenue must be recognized in the accounting period in which it is earned. (e.g. service: earned at the time it is performed. Merchandise: when goods are delivered/installed. If you return it after a month, its not revenue yet) Matching Principle: Expense recognition: matches efforts (expenses with accomplishments (revenues) (expenses can be generated in 1 period, paid later. Recorded: in the same month w/ revenue, with salary exp + salary payable) Accrual Versus Cash Basis of Accounting Accrual basis of accounting: transactions recorded in the periods in which the events occur, not cash received. (revenues when earned, expenses when g+s are used/consumed to generate revenue) Cash basis of accounting: revenue + expenses recorded when cash received. Misleading: not GAAP (small businesses may use, because of few receivables + payables) The Basics of Adjusting Entries Adjusting entries: revenue recognition and matching principles: correct A, L, OE, and correct net income/loss. Every time financial statements are prepared. Unadjusted trial balance: why? 1) not efficient to journalize daily (supplies + wages), 2) costs expire with time and not daily transactions (rent + insurance + amortization), 3) unrecorded items (service bill of next month with costs for this month). Needs: physical inventory, supporting schedules of insurance policies, rental agreements, etc. Types Prepayments: A + L overstated, E + R understated before. Prepaid Expenses: Costs paid in cash assets before used or consumed. Initial record: DR Asset (future service or benefit). Expire with time or use/consumption, recorded with financial statements: to show expenses (expired costs) + unexpired costs in asset. Before: assets over, expenses under. After: DR Expense, CR Asset. Supplies: Initially asset, becomes expense as it gets depleted (recorded during adjustment process with physical inventory). Before: assets + OE over, expenses U. After: DR Supplies Expense, CR Supplies. Insurance: Insurance premiums (cost of policy) usually for 1 year, initially asset, becomes expense at financial statement date + expiration. Before: assets + OE over, expenses U. After: DR Insurance Expense, CR Prepared Insurance. Unearned Revenues: Revenues received in cash not yet earned. Initial record: CR Liability (obligation). Earned when service is provided (recognition at end of accounting period). Before: Liabilities over, Revenues and Net income under. After: DR Liability, CR Revenue Accruals: Revenue <-> Asset are understated. Expense <-> Liability understated. Accrued Revenues: Revenues earned, not yet received in cash or recorded at statement date. May accrue with time (interest + rent revenue. Not daily transactions), or from past services not billed or collected (commissions + fees. Possibly not total service.) Before: Assets + Revenues understated. After: DR Asset, CR Revenue. E.G. Billing $3000 in November, with $200 earned in October. October 31: DR Accounts Receivable 200, CR Service Revenue 200 November 10: DR Accounts Receivable 2800, CR Service Revenue 2800 November 30: DR Cash 3000, CR Accounts Receivable 3000 Accrued Expenses: Expenses incurred but not paid or recorded. Before: both liabilities + expenses understated. After: DR Expense, CR Liability Accrued Interest: amount of interest accumulation: face value x annual interest rate x time in terms of one year = interest. Rate is always annual. Before: L + E understated. NI + OE overstated. After: DR Interest Expense, CR Interest Payable (paid when note is due) Accrued Salaries: Some expenses are paid after work is performed. If Salary is paid next month, but covers this month as well, it is accrued. E.G.: OCT 31 DR Salaries Expense 1200, CR Salaries Payable 1200. NOV 9 DR Salaries Payable 1200, DR Salaries Expense 2800, CR Cash 4000. Before: L + E understated. NI + OE overstated. After: DR Salaries Expense, CR Salaries Payable (paid when due) Estimates: current period affected by future events Amortization: allocation of cost of capital assets (productive facilities) to expense over useful lives (time of service) (except for land: unlimited)

Need: productive facilities are long-term prepayments for services: like prepaid expenses (recognizing cost (expenses) + reporting unexpired cost (asset) at the end). Useful life depends on actual use, deterioration, obsolescence estimate of amortization (calculation: cost divided by useful life) Presentation: contra account: offset against related account. Accumulated Amortization contra asset account. Shows original cost of asset + portion of cost allocated to expense. Difference = net book value/ book value. (different from market value because amortization is cost allocation not valuation = shows unallocated cost, not worth) Before: A + OE + NI overstated, E understated. Office Equipment $5000 Less: Accumulated amortization office equipment 83 Net book value $4917 Summary: Types of Adjustments Reasons Accounts Before Adjusting Entry Prepayments Prepaid Expenses Prepaid Expenses (asset) A OVER DR EXPENSE used up. E UNDER CR ASSET Unearned Revenues Unearned revenues L OVER DR LIABILITY (liability) earned. R UNDER CR REVENUE Accruals Accrued Revenues Revenues earned without A UNDER DR ASSETS payment R UNDER CR REVENUE Accrued Expenses Expenses incurred, not E UNDER DR EXPENSE paid L UNDER CR LIABILITY Estimates Amortization Cost of capital assets A OVER DR AMORTIZATION allocated to expense over E UNDER EXPENSE useful life CR ACCUMULATED AMORTIZATION The Adjusted Trial Balance and Financial Statements Adjusted Trial Balance financial statements (shows Balances + effects of financial events of period)
PIONEER ADVERTISING AGENCY Adjusted Trial Balance October 31, 2002 Cash Accounts Receivable Advertising Supplies Prepaid Insurance Office Equipment Accumulated Amortization Office Equipment Notes Payable Accounts Payable Unearned Revenue Salaries Payable Interest Payable C.R. Byrd, Capital C.R. Byrd, Drawings Service Revenue Advertising Supplies Expense Amortization Expense Insurance Expense Salaries Expense Rent Expense Interest Expense $15,200 200 1,000 550 5,000 $83 5,000 2,500 800 1,200 25 10,000 500 1,500 83 50 5,200 900 25 $30,208 PIONEER ADVERTISING AGENCY Income Statement For the Month Ended October 31, 2002 Revenues Service Revenue Expenses Advertising supplies expense Amortization expense Insurance Expense Salaries Expense $1,500 83 50 5,200 $10,600 10,600

__________ $30,208

Financial Statements

Rent Expense Interest Expense Total Expenses Net Income PIONEER ADVERTISING AGENCY Statement of Owners Equity For the Month Ended October 31, 2002 C.R. Byrd, Capital, October 1 Add: Investments Net Income Less: Drawings C.R. Byrd, Capital, October 31 PIONEER ADVERTISING AGENCY Balance Sheet October 31, 2002 Assets

900 25

7,758 $2,842

$0 10,000 2,842 12,842 500 $12,342

Cash Accounts Receivable Advertising Supplies Prepaid Insurance Office Equipment Less: Accumulated amortization Total Assets Liabilities Notes Payable Accounts Payable Unearned Revenue Salaries Payable Interest Payable Total Liabilities

$5,000 83 Liabilities and Owners Equity

$15,200 200 1,000 550 4,917 $21,867 $5,000 2,500 800 1,200 25 9,525 12,342 $21,867

Owners Equity C.R. Byrd, Capital Total Liabilities and owners equity

Reversing Entries Reverse certain adjusting entries at next accounting period. Simplifies recording of transactions. Reverse accruals: accrued revenues + expenses. Adjusting Entry: DR ACCOUNTS RECEIVABLE 200, CR SERVICE REVENUE 200 Next Month: DR SERVICE REVENUE 200, CR ACCOUNTS RECEIVABLE 200. When bill is sent: DR. ACCOUNTS RECEIVABLE 3000, CR. SERVICE REVENUE 3000 (total amount)