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The Adjusting Process
Chapter 3
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Adjusting Attack
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Accrual versus cash-basis accounting & key elements of accrual accounting
Adjusting entries, why, what, how
Using the worksheet to facilitate the process
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Accrual versus cash-basis accounting
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Accrual Accounting Versus Cash-Basis Accounting
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Accrual Basis
Revenues recognized when earned
Expenses recognized when incurred
Cash Basis
Revenues recognized when cash received
Expensesrecorded when cash paidNot
GAAP
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Accounting Period ConceptFor reports to be meaningful, transactions that happen in a period, need to be reported in that period.Basic accounting period: one year
Calendar yearFiscal year
Interim periods < one yearMonthlyQuarterlySemi-annually
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Revenue Recognition Principle
When to record revenue?When it is earned
When service is providedWhen the product deliveredWhen the earnings process is complete
Doing this requires some tools to allow revenue to be captured separate from the cash flow:
Asset: Accounts receivableLiability: Unearned revenue
Want to see a time line of these?
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The Matching PrincipleWhen to record expenses?
When the resources is consumedWhen an asset is consumedWhen we generate a liability for the use of a serviceThis “Matches” the expense to the revenues earned
Doing this requires tools to allow expenses to be captured separate from the cash flow:
Prepaid or other assets: These store resources until we use and expense themLiabilities: Payables associate with expenses
eg wages payable
Want to see a time line of these?7
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Work it out:How would each of these events be handled under: Accrual Cash-Basis
Cash sale of $500Credit sale of $900Bought 4 months of suppliesUsed 4 months of suppliesBought a fleet of trucks for cash
In each case, which options portrays more accurately the creation of wealth by the company?Which shows more accurate financial standing?8
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Explain why adjusting entries are needed
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Display Earnings for the Period
Display Financial Standing at a Point in
Time
Must show everything earned and consumed!
Including what we owe, are owed,
and current owner’s equity!
Two primary goals of financial accounting
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How do adjusting entries help meet the goals of accrual accounting?
Adjusting entries capture real live transactions that took place, but for which there was no cause to enter during regular daily operations
Our job is to capture and report revenues and expenses, not just to process papers that come across your desk.
When you find a situation where a revenue or expense has occurred, but was not captured by the daily journal entries, you make an adjusting entry to capture it.
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What’s that lady in the red coat doing?
Adjustments take place at period end.The LAST CHANCE to make changes that improve or damage the story told by the financial statements.Remember the conflict of interest inherent in accounting?Adjusting entries is a high-pressure, last minute opening when fraudulent reporting attempts might be made.Know how transactions affect the financial statements now and later. Know how to apply GAAP to form a first line defense.
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Non-adjusted Example Situation:Car Broker’s cash basis income statementsAll Sales in cashCommissions paid early in month 2
Month 1Month 2
Sales $100,000$80,000
COGS 80,000 64,000
Commissions (5% of sales) 0 9,000
Other Expenses 7,000 7,000
Net Income 13,000 0,000Note: In this case we DID NOT make a month end adjustment to record
the commissions expense in Month 1. The result: Month 2 bears all of month 1 and month 2’s commissions expense – Ouch!@
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Properly Adjusted Example Situation:An adjustment at month end recognizes the commissions expense in month 1 – when commissions were earned, before paid. Month 1
Month 2Sales $100,000
$80,000COGS 80,000
64,000Commissions (5% of sales) 5,000
4,000Other Expenses 7,000
7,000Net Income $8,000
$5,000Note: In this case we entered the commissions expense in Month 1 for the commissions “used” in Month 1. So both months bear the
commissions expenses that month “used”.
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Adjusting entries capture real revenues and real expenses.
Adjusting entries make our income statement and our balance sheet more useful.
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Adjusting Entries
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Adjusting Entries
Prepared at end of an accounting periodAssigns:
Revenues to the period when earnedExpenses to the period when incurred
Update asset and liability accountsNeed to properly match revenues and expenses to measure:
Net IncomeAssets and Liabilities
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Adjusting Entry Rules
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Never involve the cash account
Eitherincrease revenue
orincrease an expense
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Adjusting entries: Four situations
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Prepaid expenses
DepreciationAccrued expenses
Accrued revenues
Unearned revenues
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Journalize and post adjusting entries
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Unearned Revenues:
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Regular daily journal entry: Collect cash in advance upcoming Nutcracker ballet
Cash 130,000Unearned revenue 130,000
Sold Nutcracker tickets in advance
20-Nov
Unearned revenue 25,000Theater revenue 25,000
Earned pre-sold ticket revenue thru Nov.
30-Nov
Activity: Do 4 weekend shows through November, earning $25,000 in performance revenue
Adjusting entry: Record earnings and reverse the earned portion of the liability
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Accrued Revenues:
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Regular daily journal entry: Collect from customer
Cash 4,500Accounts receivable 4,500
Customer picked up Porsche
4-Jan
Accounts receivable 4,500Repair revenue 4,500
Repaired Porsche steering, not picked up
31-Dec
Activity: We finish a $4,500 car repair on December 29th, customer pickup expected Jan 4thAdjusting entry: Record earnings and accrue the
receivable.
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Prepaid Expense: Rent
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Adjusting entry: Recognize that we used up one month of that rent.
Regular daily journal entry: Paid cash for three months rent
Activity: After a month passes, do we still really own three months rent?
Prepaid rent 3,000Cash 3,000
Purchased 3 months rent in advance
1-May
Rent expense 1,000Prepaid rent 1,000
recognize use of one months rent
31-May
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Depreciation, a variation on prepaid expenses
Plant assetsLong-lived tangible assets used in business operationsExamples:
Land, buildings, equipment, and furniture
DepreciationAllocation of a plant asset’s cost to expense over its useful life
Conceptual guideline: If you are wearing it out, depreciate it. If you are completely consuming the asset and it is disappearing, decrease the account directly.
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Depreciation: Plant assets
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Regular daily journal entry: Buying $12,000 gaming systems, {Equipment}.
Equipment 12,000Cash 12,000
Gaming systems, 3 year life, 0 salvage value
1-Jan
Depreciation expense 4,000Accumulated depreciation 4,000
Recognized 1 year depreciation expense
31-Dec
Activity: Use the equipment for a whole year to help us generate revenue.
Adjusting entry: Recognize one year depreciation expense, and log the accumulated depreciation
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Accumulated Depreciation
Contra assetNormal credit balanceAlways paired with related account
Holds sum of all depreciation recorded on a plant assetBook value
Cost minus accumulated depreciationA hopelessly inaccurate approximation of value
Asset cost basis is maintained untouchedWhy?
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Accrued Expenses:
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Regular daily journal entry: Pay themWages payable 900
Cash 900Paid wages from Dec 15-31
1-Jan
Wages expense 900Wages payable 900
Recognized wages from Dec 15-31
31-Dec
Activity: We use $900 in employee wages through the end of the month, but do not have to pay until
next month.Adjusting entry: Recognize the use of those
wages, and accrue the associate liability.
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Adjusting Entry Pick & Pull1) Spot revenue / expense2) Accruing or converting?
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Unearned revenues
Prepaid expenses
Accrued revenues
DepreciationAccrued expenses
We sold a house for a client, but the listing agent hasn’t sent the payment yet
We provided laundry service for clients who had paid in advance
We used legal services, but the invoice hasn’t arrived Used supplies without recording the consumption
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P3-34A: Journalizing Adjusting entries
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Just do the journal entries as indicated by the adjustment data given in the problem.
** Do not post. Do not prepare an adjusted trial balance. Just do the journal entries. **
Note to self: Now would be a good time to project the problem on the board.
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Day two: Adjusting entries
RecapAdjusting entries in the newsUsing a worksheet to facilitate adjusting entriesRelating the adjusted trial balance to the upcoming financial statements
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Adjusting Entries recap
Real journal entries, prepared at the end of an accounting period. Why?Assign:
Revenues to the period when earnedExpenses to the period when incurred
Need to properly match revenues and expenses to measure:
Net IncomeAssets and Liabilities
These transactions do not involve cash. Why?
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Adjusting Entries in the newsAIG: $5 billion write down – no thank you
News!GE: a $50 million slap on the wrist
News!Krispy Kreme
Can donuts be crooked? News!
www.sec.gov Enforcement releases
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Explain the purpose of and prepare an adjusted trial balance
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The Adjusted Trial Balance
Reflects adjusting entries to show final figuresRecalculate adjusted balances by incorporating adjustments with your unadjusted trial balance.Even if you use the worksheet to make adjusting work easier, ALWAYS enter your journal entries in the journal, then POST those journal entries to the ledger accounts.
Contain all information for financial statementsOften appears on a work sheet
Tool accountants use at end of period
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S3-10: PREPARING AN ADJUSTED TRIAL BALANCE
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Supplies on hand, $300.Depreciation, $1,000.Accrued interest expense, $600.
a) 600
a) 600
b)1,000
b)1,000
c) 600
c) 6002,200 2,200 27,500 27,500
800300
19,1002,000
200600
2,5007,400
14,8004,500
6001,0001,200
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Complete practice set adjustments
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Prepaid expenses
DepreciationAccrued expenses
Accrued revenues
Unearned revenues
Do brain work on the worksheetUse page 69 journal
entry steps & Roberts’ Triangle
Find Rev/Exp firstTransfer JE work to the
general journalPost to the ledgerComplete and check
Adjusted Trial Balance columns to match ledger balances.
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Prepare the financial statements from the adjusted trial balance
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Income Statement is prepared first.
Revenue - Expenses
Statement of Retained Earnings is second
The Balance Sheet is prepared last.
A = L + E
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Income Statement
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Statement of Retained Earnings
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Balance Sheet
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E3-25: PREPARING THE FINANCIAL STATEMENTS
Refer to the adjusted trial balance in Exercise 3-21 for the month ended April 30, 2012.
Requirements:1. Prepare the income statement.
2. Prepare the statement of retained earnings.
3. Prepare the balance sheet.
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E3-21:ADJUSTED
TRIAL BALANCE
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E3-25: PREPARING THE FINANCIAL STATEMENTS
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Jobs-4-U Employment Service, Inc.Income Statement
Month Ended April 30, 2012Revenue: Service revenue $ 10,600Expenses: Salary expense $ 3,700 Rent expense 1,000 Depreciation expense 1,000 Supplies expense 500
Total expenses 6,200Net income $ 4,400
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E3-25: PREPARING THE FINANCIAL STATEMENTS
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Jobs-4-U Employment Service, Inc.
Statement of Retained Earnings
Month Ended April 30, 2012
Retained earnings, March 31, 2012 $ 10,300
Net income 4,400
17,900
Dividends 4,800
Retained earnings, April 30, 2012 $ 9,900
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Jobs-4-U Employment Service, Inc. Balance SheetApril 30, 2012
Assets LiabilitiesCash $ 900 Salary payable $ 1,200Accounts receivable 5,600 Supplies 500 Stockholders’ Equity Equipment $32,500 Common stock 13,000 Accu. Depr. (15,400) 17,100 Retained earnings 9,900
Total stockholders’ equity 22,900
Total assets $24,100Total liabilities and stockholders’ equity $24,100
E3-25: PREPARING THE FINANCIAL STATEMENTS
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Chapter 3 SummaryCash-basis accounting and accrual accounting are different. Accrual accounting records revenues and expenses when they are earned/incurred. Cash-basis accounting records revenues and expenses when cash is received or paid.The principles guide us as to when (the time period and accounting period concepts) and how (the revenue recognition and matching principles) to record revenues and expenses.
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Chapter 3 SummaryWe adjust accounts to make sure the balance sheet shows the value of what we own (assets) and what we owe (liabilities) on a specific date. We also adjust to make sure all revenues and expenses are recorded in the period they are earned or incurred. Adjusting journal entries either credit a revenue account or debit an expense account, but they NEVER affect the Cash account.
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Chapter 3 SummaryThe adjusting process has two purposes:
1. To capture all transactions that should be reported in the period shown on the income statement. Every adjustment affects a revenue or an expense. 2. To update the balance sheet so that all accounts are properly valued. Every adjustment affects an asset or a liability (but never the Cash account).
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Chapter 3 SummaryThe adjusted trial balance includes all the transactions captured during the period on the trial balance plus/minus any adjusting journal entries made at the end of the period. The adjusted trial balance gives us the final adjusted values that we use to prepare the financial statements.
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Chapter 3 SummaryThe financial statements must be prepared in order:
income statement first, statement of retained earnings, second, and balance sheet, third.
It is important for accountants to prepare accurate and complete financial statements as other people rely on the data to make decisions.
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