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Copyright © 2014 Pearson Canada Inc. 3 - 1
Chapter 3
Copyright © 2014 Pearson Canada Inc. 3 - 2
Learning Objective 1Apply the recognition criteria for revenues and
expenses
When does a sale really happen?
When do we record an expense?
Copyright © 2014 Pearson Canada Inc. 3 - 3
The Time-Period AssumptionEnsures that accounting information is reported at regular
intervals
Interacts with the revenue- and expense-recognition criteria, and the matching
objective
Requires that income be measured accurately
each period
Period: Monthly, Quarterly, Annually
Copyright © 2014 Pearson Canada Inc. 3 - 4
The Accounting PeriodBusinesses need periodic (annual) reports on their
progressFiscal year ends do not need to be the same as the
calendar year endInterim statements can be presented:
MonthlyQuarterlySemi-annually
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Recognition Criteria for Revenues
Revenue recognition states that revenue should be recognized when it is earned.
Revenue is earned when:
a. Goods delivered or services completed
b. Contractual agreements have been met Record revenue equal to the cash value of the goods or
service transferred to the customer
Copyright © 2014 Pearson Canada Inc. 3 - 6
Recognition Criteria for ExpensesMatching objective:
a. Matches expenses incurred with revenues earned during
the accounting period
Definition of Expenses:
Cost of assets and services consumed when earning revenue.
To match expenses against revenues means to subtract the related expenses from the revenue to compute net income (or net loss)
Copyright © 2014 Pearson Canada Inc. 3 - 7
Learning Objective 2Distinguish accrual-basis accounting from
cash-basis accounting
Why can't we wait to record transactions until the cash comes in or the cash goes out?
Copyright © 2014 Pearson Canada Inc. 3 - 8
Accrual-Basis Accounting vs. Cash-Basis Accounting
Accrual accounting records the effect of every business transaction as it occurs
Cash-basis accounting records transactions only when cash receipts and cash payments occur
Accrual Basis
Records revenues when they are earned
Records expenses when they are incurred
Cash Basis
Records cash receipts as revenueRecords cash payments as expenses
Copyright © 2014 Pearson Canada Inc. 3 - 9
Accrual-basis vs. Cash-basisJames purchases $4,000 of supplies on account
James completed a job on credit for $15,000
Supplies 4,000 Accounts Payable 4000Purchased supplies on credit.
No entry because no cash was paid
Accrual Entry Cash Entry
Accounts Receivable 15,000 Service Revenue 15,000Earned revenue on account.
Accrual Entry Cash Entry
No entry because no cash was received
Copyright © 2014 Pearson Canada Inc. 3 - 10
Accrual-Basis AccountingCalled accrual accountingBased on the time period assumption and recognition
criteria for revenues and expenses.For the above reason, accrual accounting is required by
GAAP for both ASPE and IFRS
Copyright © 2014 Pearson Canada Inc. 3 - 11
Learning Objective 3Make adjusting entries
What is the adjusting process, and why is it important?
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Adjusting the AccountsAccrual-basis accounting requires adjusting entries at the
end of the period in order to produce correct balances for the financial statements
Adjusting entries:Assign revenues to the period in which they are earnedAssign expenses to the period in which they are incurredUpdate the asset and liability accounts
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Five Categories of Adjusting EntriesPrepaid expensesAmortization of property, plant, and
equipment, and intangible assetsUnearned revenuesAccrued expensesAccrued revenues
Prepaids
(Deferrals)
Accruals
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Prepaid Expenses
Prepaid expenses are advance payments of the expense
Examples include: prepaid rent, prepaid insurance, and supplies
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Prepaid Insurance Example
On April 1, 2014, HEC purchases an annual insurance policy for $3,600; the journal entry would be:
The adjusting entry on April 30 is:
Prepaid Insurance 3,600
Cash 3,600
To record payment for an annual policy.
Insurance Expense 300
Prepaid Insurance 300
To record insurance expense for the month.
Copyright © 2014 Pearson Canada Inc. 3 - 16
Prepaid Insurance Example, posting
Correct asset amount, $3,300
Total accounted for,
$3,600
Correct expense amount,
$300
ASSETS EXPENSES
Prepaid Insurance Insurance Expense
Apr. 1 3,600 Apr. 30 300
Bal. 3,300
Apr. 30 300
Bal. 300
Copyright © 2014 Pearson Canada Inc. 3 - 17
Supplies Example
On April 2, 2014, HEC purchases supplies for $1,500 cash. The April 2, 2014, journal entry would be:
On April 30, a physical count of the supplies indicated that $1,000 remained; the adjusting entry would be:
Supplies 1,500
Cash 1,500
To record supplies purchased.
Supplies Expense 500
Supplies 500
To record supplies used.
Copyright © 2014 Pearson Canada Inc. 3 - 18
Supplies Example, posting
ASSETS EXPENSES
Supplies Supplies Expense
Correct asset amount, $1,000
Total accounted for,
$1,500
Correct expense amount,
$500
Apr. 2 1,500 Apr. 30 500
Bal. 1,000
Apr. 30 500
Bal. 500
Copyright © 2014 Pearson Canada Inc. 3 - 19
Amortization of Property, Plant, and Equipment, and Intangible Assets
Amortization (depreciation) defined: The process of allocating the cost of property, plant, and equipment to an expense account over its estimated useful life
Intangible assets, such as patents and trademarks, are amortized over the intangible asset’s useful life
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Amortization Example
On April 3, HEC purchases furniture for $45,000 with an expected life of 5 years
The April 3 journal entry, to record the purchase:
Furniture 45,000
Cash 45,000
To record the purchase of furniture.
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Amortization Example, Continued
A portion of the furniture’s cost is transferred from the asset account to Amortization Expense each period the asset is used. After one month, the April 30, 2014 entry is:
To record monthly amortization expense on furniture; 45,000 ÷ 5 years = $9,000
per year. $9,000 ÷ 12 months = $750 per month.
Accumulated Amortization – Furniture is known as a
contra account
Amortization Expense – Furniture 750
Accumulated Amortization – Furniture 750
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Contra Account
A contra account has:a companion accounta normal balance opposite that of the companion
account
Accumulated Amortization is a contra account to property, plant, and equipment assets. It has a normal credit balance.
Copyright © 2014 Pearson Canada Inc. 3 - 23
Amortization, Example
HEC owns a building that cost $120,000 with annual amortization of $6,000 (monthly amortization of $500)
The amortization expense to be recorded on April 30 is:
Amortization Expense – Building 500
Accumulated Amortization – Building 500
To record monthly amortization expense on building.
Copyright © 2014 Pearson Canada Inc. 3 - 24
Partial Balance Sheet of HEC
Property, Plant, and Equipment
Furniture $ 45,000
Less: Accumulated amortization – furniture 750 $ 44,250
Building 120,000
Less: Accumulated amortization – building 500 119,500
Property, Plant, and Equipment, net $163,750
Copyright © 2014 Pearson Canada Inc. 3 - 25
Accrued ExpensesAccrued expenses defined: An expense that the business
has incurred but has not yet paid
Accrued expenses always create a liability
Accruals are the recording of the expense or revenue before the related cash is paid or received
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Accrued Expense ExampleHEC pays its two employees a semi-monthly salary of
$4,000 in total on the 15th and on the last day of the monthThe employees are paid on April 15, but April 30 is a
Saturday: thus employees will receive their pay cheques on Monday, May 2
The journal entry on April 30 to accrue the salaries is:
Salaries Expense 4,000
Salary Payable 4,000
To accrue salaries expense.
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Accrued Expense Example, Continued
EXPENSES LIABILITIES
Salaries Expense Salaries Payable
After posting, the Salaries Expense and Salaries Payable accounts contain the complete salary information for the month of April.
Apr. 15 4,000
Apr. 30 4,000
Bal. 8,000
Apr. 30 4,000
Bal. 4,000
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Accrued RevenuesAccrued revenues defined: Revenue that has been earned
but not yet invoiced or collected.
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Accrued Revenue Example
HEC is hired on April 15 to provide monthly services for $3,000 monthly, with the first payment to be received on May 15. Service is provided from April 15 to April 30.
The adjusting entry on April 30 is:
Adjusting for accrued revenues illustrates the concept of revenue recognition.
Accounts Receivable 1,500
Service Revenue 1,500
To accrue revenue: $3,000 × ½.
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Unearned Revenues, or Deferred Revenue
Unearned revenue defined: Receiving Cash in advance from customers prior to providing the service or delivering the product
Unearned revenue is a liability
Only when the service is provided or product delivered is the revenue earned.
Copyright © 2014 Pearson Canada Inc. 3 - 31
Unearned Revenue ExampleHEC receives a cash advance of $3,000 on April 20 from
a customerThe journal entry on April 20 is:
Cash 3,000
Unearned Revenue 3,000
To record cash received in advance of providing the service.
Copyright © 2014 Pearson Canada Inc. 3 - 32
Unearned Revenue Example Continued
On April 30, $1,000 of the cash advance has been earned by HEC: The adjusting entry on April 30 is:
Unearned Revenue 1,000
Service Revenue 1,000
To record service revenue earned that was collected in advance: $3,000 × 1/3.
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Unearned Revenue Example Continued
The balance prior to adjustment was $24,000
LIABILITIES REVENUES
Unearned Service Revenue Service Revenue
Correct liability amount, $2,000
Total accounted for,
$3,000
Correct revenue amount, $1,000
Apr. 30 1,000 Apr. 20 3,000
Bal. 2,000
24,000
Apr. 30 1,500
Apr. 30 1,000
Bal. 26,500
Copyright © 2014 Pearson Canada Inc. 3 - 34
Summary of Adjusting Entries
Type of Account
Category of Adjusting Entry
Debited Credited
Prepaid expense Expense Asset
Amortization Expense Contra asset
Accrued expense Expense Liability
Accrued revenue Asset Revenue
Unearned revenue Liability Revenue
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Learning Objective 4Prepare an adjusted trial balance
How do we get the accounting records ready to prepare the financial statements?
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The Adjusted Trial BalanceThe adjusting process starts with the unadjusted trial
balance
Adjusting entries are journalized and posted to the ledgers
The adjusted trial balance is prepared, which serves as a
basis for the preparation of the financial statements
Copyright © 2014 Pearson Canada Inc. 3 - 37
Learning Objective 5Prepare the financial statements from the
adjusted trial balance
Remind me. How do we prepare the financial statements?
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Preparing the Financial Statements from the Adjusted Trial Balance
The financial statements should be prepared in the following order:Income statementStatement of owner’s equityBalance sheet
The essential features of all financial statements:Heading - name of the entity, title of the statement, and
date or period coveredBody of the statement
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Relationships among the Three Financial Statements
HUNTER ENVIRONMENTAL CONSULTING
Partial Preparation of Adjusted Trial Balance
April 30, 2014
Account Title Trial Balance Adjustments Adjusted Trial Balance
Debits = Credits for the trial balance, adjustments, and adjusted trial balance
Debit Credit Debit Credit Debit CreditCashAccounts receivableSuppliesPrepaid insuranceFurnitureAccum. amort.– furnitureLandAccounts payableSalaries payable
Utilities expense
31,00014,0001,5003,600
45,000
50,000
1,000159,100
12,0000
159,100
1,500
8,050
500300
750
4,000
8,050
31,00015,5001,0003,300
45,000
50,000
1,000165,350
750
12,0004,000
165,350
Copyright © 2014 Pearson Canada Inc. 3 - 40
The Income StatementHUNTER ENVIRONMENTAL CONSULTING
Income Statement
For the Month Ended April 30, 2014
Revenue
Service revenue $26,500
Expenses: Salaries expense Rent expense Utilities expense Amortization expense Supplies expense Insurance expense
$8,000 3,0001,000
750500300
Total expenses 13,550
Net income $12,950
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The Statement of Owner’s Equity
HUNTER ENVIRONMENTAL CONSULTING
Statement of Owner’s Equity
For the Month Ended April 30, 2014
Lisa Hunter, capital, April 1, 2014Add: Net income
$120,10012,950
133,050
Less: WithdrawalsLisa Hunter, capital, April 30, 2014
6,000$127,050
Copyright © 2014 Pearson Canada Inc. 3 - 42
The Balance SheetHUNTER ENVIROMENTAL CONSULTING
Balance Sheet
April 30, 2014
Assets Liabilities
CashAccounts receivableSuppliesPrepaid insuranceFurnitureLess: Accumulated amortization – furnitureLand
Total assets
45,000
750
$31,00015,5001,0003,300
44,25050,000
$145,050
Accounts payableSalaries payableUnearned service revenue Total liabilitiesOwner’s EquityLisa Hunter, capital
Total liabilities and owner’s equity
$12,0004,000
2,00018,000
127,050
$145,050
Copyright © 2014 Pearson Canada Inc. 3 - 43
Learning Objective 6Describe the adjusting-process implications of
international financial reporting standards (IFRS)
How does IFRS apply to adjusting entries?
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Adjusting-Process Implications of International Financial Reporting
Standards (IFRS)
IFRS for publicly accountable enterprises has no direct impact on the adjusting process.
Companies reporting under IFRS or ASPE have the same adjusting process
Financial statement presentation may be impacted if reporting under IFRS versus ASPE.
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Learning Objective A1Account for a prepaid expense recorded initially
as an expense
Is there another way to record prepaids?
Copyright © 2014 Pearson Canada Inc. 3 - 46
Prepaid Expenses Recorded Initially as an Expense
On August 1, a business paid $3,600 for an annual insurance policy.
The August 1 journal entry to record the payment is:
The adjusting entry on December 31 to record prepaid insurance is:
Insurance Expense 3,600
Cash 3,600
To record annual insurance payment.
Prepaid Insurance 2,100
Insurance Expense 2,100
To record prepaid insurance: 3,600 × 7/12.
Copyright © 2014 Pearson Canada Inc. 3 - 47
Prepaid Expense Example, ContinuedAt December 31, only five months’ prepayment has
expired, leaving seven months still prepaid
ASSETS EXPENSES
Prepaid Insurance Insurance ExpenseDec. 31 2,100
Dec. 31 Bal. 2,100
Aug. 1 3,600 Dec. 31 2,100
Dec. 31 Bal. 1,500
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Learning Objective A2Account for an unearned (deferred) revenue
recorded initially as a revenue
Is there another way to record unearned revenues?
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Unearned Revenue Recorded Initially as a Revenue
On October 1, a consulting firm records as consulting revenue the receipt of $18,000 cash for revenue to be earned over nine months
The journal entry on October 1 to record the cash receipt is:
The adjusting entry on December 31 to record unearned revenue is:
Cash 18,000
Consulting Revenue 18,000
To record cash received.
Consulting Revenue 12,000
Unearned Consulting Revenue 12,000
To record revenue earned in advance: $18,000 × 6/9.
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Unearned Revenue, Example ContinuedAt December 31, the adjusting entry moves the unearned
portion into the liability account because the business still owes consulting service to the client during January to June of the following year
LIABILITIES REVENUEUnearned Consulting Revenue Consulting Revenue
Dec. 31 12,000
Dec. 31 Bal. 12,000Dec. 31 12,000 Oct. 1 18,000
Dec. 31 Bal. 6,000