CHAPTER 3
ADJUSTING THE ACCOUNTS
ACT 201 Lecture
By: Ms. Adina Malik
TIMING ISSUES
Time Period Assumption:
Also called periodicity assumption
Accountants divide the economic life of a business into
artificial time periods
Accounting time periods are generally a month, a quarter, or
a year.
Fiscal year vs. calendar year
Fiscal year: Accounting time period that is one year in length
Calendar year: January 1 to December 31
TIMING ISSUES
Accrual vs. Cash Basis Accounting:
Cash Basis Accounting
Revenues are recognized when cash is received.
Expenses are recognized when cash is paid.
Cash-basis accounting is not in accordance with generally
accepted accounting principles (GAAP).
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.
In accordance with generally accepted accounting principles
(GAAP).
TIMING ISSUES
Recognizing Revenues & Expenses
Revenue Recognition Principle: Companies recognize revenue in
the accounting period in which it is earned. In case of a service
enterprise, revenue is considered to be earned at the time the
service is performed.
Matching Principle: Match expenses with revenues in the period
when the company makes efforts to generate those revenues.
Let the expenses follow the revenues.
THE BASICS OF ADJUSTING ENTRIES
Adjusting entries are necessary because the trial balance may not
contain up-to-date and complete data.
A company must make adjusting entries every time it prepares
financial statements. (conform to GAAP)
Adjusting entries are needed to ensure that the revenue recognition
and matching principles are followed.
Adjusting entries make it possible to report correct amounts on the
balance sheet and on the income statement.
TYPES OF ADJUSTING ENTRIES
Deferrals
Accruals
Prepaid Expense:
Expenses paid in cash &
recorded as assets before
they are used or consumed.
Unearned Revenue:
Cash received & recorded as
liabilities before revenue is
earned.
Accrued Revenue:
Revenues earned but not yet
received in cash or recorded.
Accrued Expenses:
Expenses incurred but not yet
paid in cash or recorded.
DEFERRALS: PREPAID EXPENSES
Prepaid expenses are payment of cash, that is recorded as an asset
because service or benefit will be received in the future.
Prepayments often occur with regards to insurance, supplies,
advertising, rent & maintenance of equipment
Example: On Jan. 1st, Phoenix Consulting paid $12,000 for 12 months
of insurance coverage. Show the journal entry to record the payment
on Jan. 1st. (Time Period is monthly)
Dr.
Jan 1
Prepaid Insurance
Cr.
$12,000
Cash
Dr.
Cash
Prepaid Insurance
$ Cr.
12,000
$ 12,000
Dr.
Cash
$ Cr.
Prepaid
Insurance
$
12,000
DEFERRALS: PREPAID EXPENSES
At each statement date, there are adjustment entries: (1) to record
the expenses that apply to the current accounting period (2) to show
the unexpired costs in the assets account
Example: On Jan. 1st, Phoenix Consulting paid $12,000 for 12
months of insurance coverage. Show the adjusting journal entry
required at Jan. 31st.
Dr.
Jan 31
Insurance Expenses
$1,000
Prepaid Insurance
Dr.
Prepaid
Insurance
Insurance Expense
$ Cr.
Dr.
Cash
1,000
Cr.
Balance
$1,000
Prepaid Insurance
$ Cr.
12,000 Insurance
Expense
11,000
$
1,000
DEFERRALS: PREPAID EXPENSES
Adjusting Entry
Oct 31 Insurance Expense
Prepaid Insurance
Dr.
50
Cr.
50
DEFERRALS: PREPAID EXPENSES
PREPAID EXPENSES: SUMMARY
DEFERRALS: UNEARNED REVENUE
Receipt of cash that is recorded as a liability because the revenue has not
been earned.
Unearned Revenue often occurs with regards to airline tickets, school tuition,
magazine subscriptions, etc.
Example: On Jan. 1st, Phoenix Consulting received $24,000 from Arcadia
High School for 3 months rent in advance. Show the journal entry to record
the receipt on Jan. 1st in the books of Phoenix Company.
Dr.
Jan 1
Cash
Cr.
$24,000
Unearned Rent Revenue
Dr.
Unearned
Revenue
Cash
$ Cr.
24,000
$24,000
Dr.
Unearned Rent Revenue
$ Cr.
Cash
$
24,000
DEFERRALS: UNEARNED REVENUE
The company makes an adjustment entry to record the revenue that
it earns eventually and also to show the liability that remains.
Example: On Jan. 1st, Phoenix Consulting received $24,000 from
Arcadia High School for 3 months rent in advance. Show the adjusting
journal entry required on Jan. 31st.
Jan 31
Dr.
Unearned Rent Revenue
Rent Revenue
Rent Revenue
$ Cr.
Unearned Rent
Revenue
8,000
Dr.
Dr.
$ 8,000
Cr.
$ 8,000
Unearned Rent Revenue
$ Cr.
Rent Revenue
8,000 Cash
Balance
$
24,000
16,000
DEFERRALS: UNEARNED REVENUE
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.
UNEARNED REVENUE: SUMMARY
ACCRUALS: ACCRUED REVENUE
Revenues earned but not yet received in cash or recorded at the
statement date
May accumulate/accrue with the passing of time
Services performed, but not billed or collected
Example: In Oct 4, Star Advertising Agency earned $ 200 for
advertising service that has not been received and recorded.
Show the adjusting journal entry to record the revenue earned on
Oct. 31st.
Dr.
Oct 31
Accounts Receivable
Cr.
$200
Service Revenue
Dr.
Service
Revenue
Accounts Receivable
$ Cr.
200
$200
Dr.
Service Revenue
$ Cr.
Accounts
Receivable
$
200
ACCRUALS: ACCRUED REVENUE
In Nov 10, Star Advertising Agency receives $ 200
for the services it performed in October. Show the
journal entry to record the transaction.
Dr.
Nov 10
Cash
Cr.
$200
Accounts Receivable
$200
( To record cash collected on account)
Dr.
Accounts
Receivable
Cash
$ Cr.
Dr.
Accounts Receivable
$ Cr.
Cash
200
$
200
ACCRUED REVENUE: SUMMARY
ACCRUALS: ACCRUED EXPENSES
Expenses incurred but not yet paid in cash or recorded at the
statement date.
Accrued expenses often incur with regards to rent, taxes, salaries,
interest, etc.
Example: On Jan. 2nd, Phoenix Consulting borrowed $200,000 at a
rate of 9% per year. Interest is due on first of each month. Show the
journal entry to record the borrowing on Jan. 2nd.
Dr.
Jan 2
Cash
Cr.
$200,000
Notes Payable
Dr.
Notes
Payable
Cash
$ Cr.
$200,000
Dr.
Notes Payable
$ Cr.
Cash
200,000
$
200,000
ACCRUALS: ACCRUED EXPENSES
An adjusting entry for accrued expenses serves two purposes: (1) It records the
existing obligation (2) It recognizes the expenses of the current accounting
period.
Example: On Jan. 2nd, Phoenix Consulting borrowed $200,000 at a rate of 9%
per year. Interest is due on first of each month. Show the adjusting journal
entry required on Jan. 31st.
Interest Payable : ($200,000 x 9% / 12 months = $1,500)
Dr.
Jan 31
Interest Expenses
Cr.
$1,500
Interest Payable
$1,500
(To record interest on notes payable)
Dr.
Interest
Payable
Interest Expenses
$ Cr.
1,500
Dr.
Interest Payable
$ Cr.
Interest
Expense
$
1,500
ACCRUED EXPENSES: SUMMARY
ADJUSTED TRIAL BALANCE
After all adjusting entries are journalized and posted, the
company prepares another trial balance from the ledger
accounts (Adjusted Trial Balance).
Its purpose is to prove the equality of debit balances and
credit balances in the ledger.
The accounts in the adjusted trial balance contain all data that
the company needs to prepare financial statements.
ADJUSTING THE ACCOUNTS
Step 1: Preparing General Journal with the Adjusting Entries.
Step 2: Preparing General Ledger with the Adjusting Entries.
Step 3: Preparing Adjusted Trial Balance (to prove equality of debit and
credit balances in the ledger & primary basis for preparation of financial
statements)
Step 4: Preparing Financial Statements.
Financial
Statements
Income
Statement
Statement of
Retained
Earnings
Balance Sheet
Statement of
Cash Flows
QUESTION 1
Tony Masasi started his own consulting firm, Masasi Company, on June 1, 2010.
The trial balance at June 30 is shown below.
Acc. No
101
112
126
130
157
201
209
301
400
726
729
Masasi Company
Trial Balance
June 30, .2010
Details
Cash
Accounts Receivable
Supplies
Prepaid Insurance
Office Equipment
Accounts Payable
Unearned Service Revenue
[Link], Capital
Service Revenue
Salaries Expense
Rent Expense
Debit ($)
7,150
6,000
2,000
3,000
15,000
Credit ($)
4,500
4,000
21,750
7,900
4,000
1,000
$38,150
$38,150
In addition to the accounts listed on the trial balance, the chart of accounts for
Masasi Company also contains the following accounts and account numbers:
No. 212 Salaries Payable, No. 244 Utilities Payable, No. 631 Supplies Expense,
No. 722 Insurance Expense and No. 732 Utilities Expense
QUESTION 1 (CONTINUED)
Other data:
1.
Supplies on hand at June 30 are $600.
2.
A utility bill of $150 has not been recorded and will not be paid until
next month.
3.
The insurance policy is for a year.
4.
$2,500 of unearned service revenue has been earned at the end of
the month.
5.
Salaries of $2,000 are accrued at June 30.
6.
Invoices representing $1,000 of services performed during the
month have not been recorded as of June 30.
(a)
Prepare the adjusting entries for the month of June. Use J3 as the
page number for your journal.
(b)
Post the adjusting entries to the ledger accounts. Enter the totals
from the trial balance as beginning account balances.
(c)
Prepare an adjusted trial balance at June 30, 2010.
QUESTION 2
Terry Thomas opens the Green Thumb Lawn Care Company on April 1. At April 30,
the trial balance shows the following balances for selected accounts.
Prepaid Insurance
Notes Payable
Unearned Revenue
Service Revenue
$ 3,600
$ 20,000
$ 4,200
$ 1,800
Analysis reveals the following additional data.
1.
Prepaid insurance is the cost of a 2 year insurance policy, effective from April 1.
2.
The note payable is dated April 1. It is a 12% note per year.
3.
Seven customers paid for the companys 6 months lawn service package of
$600 each beginning in April. The company performed services for these
customers in April.
4.
Lawn services provided to other customers but not recorded at April 30 totaled
$ 1,500.
Prepare the adjusting entries for the month of April. Show computations.
