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Chapter 3: Adjusting the Accounts

by: Stacy OK

Chapter 3: Adjusting the Accounts 51499

Marketplace > Leeward Community College > Accounting > 51499 > Chapter 3 Adjusting the Accounts
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Outline of Chapter 3 from Wiley's Financial and Managerial Accounting Second Edition
Introduction to Financial Accounting
Class Notes
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This 13 page Class Notes was uploaded by Stacy OK on Wednesday September 14, 2016. The Class Notes belongs to 51499 at Leeward Community College taught by Kamida in Fall 2016. Since its upload, it has received 19 views. For similar materials see Introduction to Financial Accounting in Accounting at Leeward Community College.

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Date Created: 09/14/16
Sunday, September 11, 2016 Financial and Managerial Accounting Chapter 3: Adjusting the Accounts I. Chapter 3
 LO1: Explain the accrual basis of accounting and the reasons for adjusting entries.
 Time period assumption - accountants divide the economic life of a business into artificial time periods A. Fiscal and Calendar Years
 *Accounting time periods are generally a month, a quarter or a year.
 Interim periods - monthly and quarterly time periods, most large companies prepare both quarterly and annual financial statements
 Fiscal year - an accounting time period that is one year in length
 Calendar year - Jan 1 - Dec 31
 B. Accrual- versus Cash-Basis Accounting
 Accrual-basis accounting - companies record transactions that change a company’s financial statements in the periods in which the events occur. (Recognizing revenue after performing services vs when receiving cash, recognizing expenses when incurred vs when paid, etc.)
 Cash-basis accounting - companies record revenue when they receive cash or an expense when they pay out cash, alternative to accrual-basis accounting. 
 -Often produces misleading financial statements. Fails to record revenue for a company that has performed services but has yet to receive cash. Expenses do not match revenues.
 *Accrual-basis accounting is therefore in accordance with generally accepted accounting principles (GAAP).
 -Individuals/small companies are justified in using cash-basis accounting if they have few receivables and payables
 -Medium and large companies use accrual-basis accounting C. Recognizing Revenues and Expenses 1. Revenue Recognition Principle
 Performance Obligation - when company agrees to perform a service or sell product to a customer
 Revenue Recognition Principle - Requires that companies recognize 1 Sunday, September 11, 2016 revenue in the accounting period in which the performance obligation is satisfied. 2. Expense Recognition Principle
 -“Let the expenses follow the revenues” - Expense recognition is tied to revenue recognition
 -must report salary expense incurred from performing service in the same period in which it recognizes the service revenue, may not be in the same period in which the expense is paid.
 Expense Recognition Principle/Matching Principle - Efforts (expenses) must be matched with Results (Revenues) D. The Need for Adjusting Entries
 Adjusting Entries - ensures that the revenue recognition and expense recognition principles are followed.
 Trial balance - the first pulling together of the transaction data, may not contain up-to-date and complete data making adjusting entries necessary
 Reasons why trial balances are not up-to-date:
 1. Some events are not recorded daily because it is not efficient to do so, such as use of supplies and earning of wages by employees
 2. Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transaction such as rent, insurance, use of buildings and equipment
 3. Some items may be unrecorded such as a bill not received until the next accounting period
 *Adjusting entires are required every time a company prepares financial statements
 *Every adjusting entry will include one inch statement account and one balance sheet account E. Types of Adjusting Entries
 1. Prepaid expenses: Expenses paid in cash before they are used or consumed
 2. Unearned revenues: Cash Received before services are performed
 1. Accrued revenues: Revenues for services performed but not yet received in 2 Sunday, September 11, 2016 cash or recorded
 2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded
 LO2: Prepare adjusting entries for deferrals.
 Deferrals - expenses are revenues that are recognized at a date later than the point when cash was originally exchanged. Two types: prepaid expenses and unearned revenues.
 F. Prepaid Expenses
 Prepaid Expenses/Prepayments - expenses that will benefit more than one accounting period such as insurance, supplies, advertising and rent. 
 *Prepaid expenses are costs that expire either with the passage of time (rent and insurance) or through use (supplies, equipment).
 *An adjusting entry for prepaid expenses results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account. 1. Supplies
 -Supplies purchased; record Asset under Supplies. At end of accounting period: Record supplies used in Supplies Expense under Stockholders’ Equity.
 -Supplies balance should be equal to the cost of supplies on-hand
 -Supplies Expense balance should be equal to the cost of supplies used
 *If adjusting entry is not made, expenses are understated and net income is overstated. Both assets and stockholders’ equity will be overstated on balance sheet. 2. Insurance
 -Cost of Insurance (premiums) is recorded as an increase (debit) in the asset account Prepaid Insurance. At the financial statement date, companies increase (debit) Insurance Expense and decrease (credit) Prepaid Insurance for the cost of insurance that has expired during the period.
 -Prepaid Insurance should be equal to unexpired cost of coverage.
 -Insurance Expense balance equals the insurance cost that expired.
 *If adjustment is not made, expenses and net income are understated and both assets and stockholders’ equity will be overstated. 3. Deprecation
 Useful life - period of service of an asset, such as buildings, equipment and motor vehicles.
 3 Sunday, September 11, 2016 -Assets are recorded at cost, as required by historical cost principle. To follow expense recognition principle, companies allocate a portion of this cost as an expense during each period of the asset’s useful life.
 Deprecation - process of allocating the cost of an asset to expense over its useful life a) Need for Adjustment
 *Deprecation is an allocation concept, not a valuation concept (needed to recognize the cost that has been used [an expense] during the period and to report the unused cost [as asset] at the end of period.)
 *Deprecation allocates an asset’s cost to the periods in which it is used. Does not attempt to report the actual change in the value of the asset.
 -Equipment purchased; record asset. Deprecation recognized; record Deprecation Expense.
 -Instead of decreasing (credit) the asset account directly, credit Accumulated Depreciation — Equipment account to offset the asset account Equipment for the balance sheet.
 Contra asset account - an account that is offset against an asset account on the balance sheet, all contra accounts have increases, decreases and normal balances opposite to the account to which they relate, normal balance is credit.
 *This account keeps track of the total amount of depreciation expense taken over the life of the asset.
 -To keep accounting equation in balance, decrease stockholders’ equity by increasing an expense account, Deprecation Expense.
 -Balance in the Accumulated Deprecation — Equipment account will increase each month and the balance in Equipment remains the same. b) Statement Presentation
 -The use of a contra asset account is preferable to decreasing the asset account because it discloses both the original cost of the equipment and the total cost that has been expensed to date.
 Book Value - difference between the cost of any depreciable asset and its related accumulated depreciation, book value and fair value of the asset are generally two different values.
 *Without this adjusting entry, total assets, total stockholders’ equity, and net income are overstated and depreciation expense is understated.
 4 Sunday, September 11, 2016 
 Summary for Accounting for Prepaid Expenses Examples Reason for Accounts Before Adjusting Entry Adjustment Adjustment Insurance, supplies, Prepaid expenses Assets overstated. Dr. Expenses
 advertising, rent, recorded in asset Expenses understated. Cr. Assets or Contra deprecation accounts have been Assets used G. Unearned Revenues
 Unearned revenues - a liability account to record when companies receive cash before services are performed (opposite of prepaid expenses)
 -Company receives payment for services to be performed, increases (credits) an unearned revenue (liability) account. Company delays recognition of revenue until adjustment process. Adjusting entry records the revenue for services performed during period.
 -Prior to adjustment, liabilities are overstated and revenues are understated
 *The adjusting entry for unearned revenues results in a decrease (debit) to a liability account and an increase (credit) to a revenue account.
 -Company receives cash for services expected to be completed. Payment is credited to Unearned Service Revenue. After evaluation of services, company determines how much revenue should be recognized for the month. Liability (Unearned Service Revenue) is decreased an stockholders’ equity (Service Revenue) is increased.
 -Liability Unearned Service Revenue should equal the amount remaining of services expected to be performed in the future.
 -Service Revenue equals total revenue recognized/services already performed.
 *Without this adjustment, revenues and net income are understated in the income statement. Liabilities will be overstated and stockholders equity will be understated on balance sheet. Summary of Accounting for Unearned Revenues Examples Reason for Accounts Before Adjusting Entry Adjustment Adjustment 5 Sunday, September 11, 2016 Rent, magazines, Unearned revenues Liabilities overstated. Dr. Liabilities
 subscriptions, customer recorded in liability Revenues understated. Cr. Revenues deposits for future accounts are now service recognized as revenue for services performed 
 LO3. Prepare Adjusting entries for accruals.
 accruals - second category of adjusting entries, prior to an accrual adjustment, the revenue account (and related asset account) or the expense account (and the related liability account) are understated.
 *adjusting entry for accruals will increase both a balance sheet and an income statement account H. Accrued Revenues
 Accrued Revenues - revenues for services performed but not yet recorded at the statement date
 -Accrued revenues may accumulate with the passing of time, as in the case of interest revenue. Unrecorded (until adjustment balance) because earning of interest does not involve daily transactions and impractical. 
 -Accrued revenues also may result from services that have been performed but not yet billed or collected.
 -Adjusting entry records the receivable that exists at the balance sheet date and the revenue for the services performed during the period. Prior to adjustment both assets and revenues are understated.
 *An adjusting entry for accrued revenues results in an increase (debit) to an asset account and an increase (credit) to a revenue account.
 -When services are not billed, they are not recorded. The accrual of unrecorded service revenue increases an asset account, Accounts Receivable. It also increases stockholders’ equity by increasing a revenue account, Service Revenue.
 -The asset Accounts Receivable is equal to what clients owe at the balance sheet date.
 -The balance of Service Revenue represents the total revenue for services performed during the month.
 *Without the adjusting entry, assets and stockholders’ equity on the balance sheet and revenues and net income on the income statement are understated.
 6 Sunday, September 11, 2016 -Company receives cash for services performed; company records the collection of receivables by a debit (increase) to Cash and a credit (decrease) to Accounts Receivable (to record cash collected on account) Summary of Accounting for Accrued Revenues Examples Reason for Accounts Before Adjusting Entry Adjustment Adjustment Interest, rent, servicesServices performed but Assets understated.
 Dr. Assets
 not yet recorded in cash Revenues understated. Cr. Revenues or recorded I. Accrued Expenses
 Accrued Expenses - Expenses uncured but not yet paid or recorded at the statement date (ex. interest, taxes, and salaries)
 -Companies make adjustments for accrued expenses to record the obligations that exist at the balance sheet date and to recognize the expenses that apply to the current accounting period. Prior to adjustment, both liabilities and expenses are understated.
 *An adjusting entry for accrued expenses results in an increase (debit) to an expense account and an increase (credit) to a liability account. 1. Accrued Interest
 The amount of interest recorded is determined by three factors:
 1. the face value of the note
 2. the interest rate, which is always expressed as an annual rate
 3. the length go time the note is outstanding
 Formula for Computing Interest Annual Time in Face Value x Interest Rate x Terms of equals Interest of Note (APR) One Year $5000 x 12% x 1/12 equals $50 
 -Accrual of interest increases a liability account, Interest Payable, decreases stockholders’ equity by increasing an expense account, Interest Expense.
 -Interest Expense equals interest charges for the month
 -Interest Payable shows the amount of interest the company owes at the statement date.
 -Companies use the Interest Payable account instead of crediting Note Payable, to disclose the two different types of obligations — interest and 7 Sunday, September 11, 2016 principal — in the accounts and statements.
 *Without this adjusting entry, liabilities and interest expense are understated, and net income and stockholders’ equity are overstated. 2. Accrued Salaries and Wages
 -Companies pay for some types of expenses after the services have been performed, such as salaries and wages. 
 -If pay period falls between two months, the days in the first month need to be accounted for, even if next payment of salaries isn’t until the second month. These days represent an accrued expense and related liability.
 -Accrued salty increases a liability, Salaries and Wages Payable.
 -Decreases stockholders’ equity by increasing an expense account, Salaries and Wages Expense.
 *Without the adjustment for salaries ands ages, expenses are understated and liabilities are understated.
 Summary for Accounting for Accrued Expenses Examples Reason for Accounts Before Adjusting Entry Adjustment Adjustment Interest, rent, salaries Expenses have been Expenses understated.
 Dr. Expenses
 incurred but not yet paid Liabilities understated. Cr. Liabilities in cash or recorded J. Summary of Basic Relationships
 *Each adjusting entry affects one balance sheet account and one income statement account.
 Type of Adjustment Accounts Before Adjustment Adjusting Entry Prepaid expenses Assets overstated
 Dr. Expenses
 Expenses understated Cr. Assets or Contra Assets Unearned Revenues Liabilities overstated
 Dr. Liabilities
 Revenues understated Cr. Revenues Accrued revenues Assets understated
 Dr. Assets
 Revenues understated Cr. Revenues Accrued expenses Expenses understated 
 Dr. Expenses
 Liabilities understated Cr. Liabilities 
 Helpful Hints: 
 8 Sunday, September 11, 2016 (1)Adjusting entries should not involve debits or credits to Cash
 (2) Evaluate whether the adjustment makes sense. For example, an adjustment to recognize supplies used should increase Supplies Expense.
 (3) Double-check all computations.
 (4) Each adjusting entry affects one balance sheet account and one income statement account. 
 LO4. Describe the nature and purpose of an adjusted trial balance.
 Adjusted trial balance - after a company has journalized and posted all adjusting entries, to prepares another trial balance from the ledger accounts.
 -THe purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments.
 -Adjusted trial balance is the primary basis for the preparation of financial statements. K. Preparing the Adjusted Trial Balance L. Preparing Financial Statements
 *Companies can prepare financial statements directly from the adjusted trial balance.
 -Companies prepare the income statement from the revenue and expense accounts
 -Use the Retained Earnings and Dividends accounts and the net income (or net loss) from the income statement to prepare the retained earnings statement.
 -Prepare the balance sheet from the asset and liability accounts and the ending retained earnings balance as reported in the retained earnings statement.
 LO5. Appendix 3A: Prepare adjusting entries for the alternative treatment of deferrals.
 Prepaid expenses: Debited prepayments to an asset account
 Unearned revenue: Credit to liability account to record cash received
 (1) When a company prepays an expense: debit amount to an expense account.
 (2) Payment for future services: credit amount to revenue account. M. Prepaid Expenses
 -Prepaid expenses become expired cost either through the passage of time (insurance) or through consumption (advertising, supplies).
 9 Sunday, September 11, 2016 -If these expenses become expired before the next financial statement date, it may choose to debit (increase) an expense account rather than an asset account. This alternative treatment is simple more convenient.
 -If the company has a leftover inventory at the end of the month, it needs to make an adjusting entry to the asset Supplies (equal to the cost of supplies on hand at end of the month). N. Unearned Revenues
 —Companies may credit (increase) a revenue account (Service Revenue) when they receive cash for future services if the company expects to perform the services before the end of the month. 
 -If at the statement date the service was not fully performed, it would make an adjusting entry for the amount not done: Credit to Unearned Service Revenue, Debit to Service Revenue. O. Summary of Additional Adjustment Relationships
 Type of Adjustment Reason for Adjustment Account Balances Adjusting Entry before Adjustment 1. Prepaid Expenses (a) Prepaid expenses Assets overstated
 Dr. Expenses
 initially recorded in Expenses understated Cr. Assets asset accounts have been used (b) Prepaid expenses Assets understated
 Dr. Assets
 initially recorded in Expenses overstated Cr. Expenses expenses accounts have not been used 2. Unearned Revenues (a) Unearned revenues Liabilities overstated
 Dr. Liabilities
 initially recorded in Revenues understated Cr. Revenues liability accounts are not recognized as revenue (b) Unearned revenues Liabilities understated
 Dr. Revenues
 initially recorded in Revenues overstated Cr. Liabilities revenue accounts are still unearned 
 *Alternative adjusting entries do not apply to accrued revenues and accrued expenses because no entries occur before companies make these types of adjusting entries.
 LO6. Appendix 3B: Discuss finical reporting concepts. 10 Sunday, September 11, 2016 P. Qualities of Useful Information
 Useful information (to investors and creditors for making decisions about providing capital) should possess two fundamental qualities, relevance and faithful representation.
 -Does it make a difference in a business decision?
 -Does it provide information that has predictive value?
 -Does it have confirmatory value?
 -Does it have company-specific materiality? Is its size likely to influence decisions of an investor or creditor?
 Faithful Representation:
 -Does the information accurately depict what really happened?
 -Is information complete, neutral, and free from error? 1. Enhancing Qualities
 Comparability - when different companies use the same accounting principles.
 Consistency - when a company uses the same accounting principles and methods from year to year.
 Verifiable- if independent observers, using the same methods, obtain similar results.
 Timely - the information must be available to decision-makers before it loses its capacity to influence decisions.
 Understandability - presented in a clear and concise fashion so that reasonably informed uses of that information can interpret it and comprehend its meaning. Q. Assumptions in Financial Reporting
 Monetary Unit Assumption - requires that only those things that can be expressed in money are included in the accounting records
 Economic Entity Assumption - every economic entity cane separately identified and accounted for. 
 Time Period Assumption - the life of a business can be divided into artificial time periods and that useful reports covering those periods can be prepared for the business.
 Going Concern Assumption - business will remain in operation for the 11 Sunday, September 11, 2016 foreseeable future, reasonable to assume that the business will continue operating. R. Principles in Financial Reporting 1. Measurement Principles
 GAAP generally uses one of two measurement principles, selection of which to follow generally relates to trade-offs between relevance and faithful representation: a) Historical Cost Principle
 Historical Cost Principle/Cost Principle - dictates that companies record assets at their cost. b) Fair Value Principle
 Fair Value Principle - indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). 
 -In general, most assets follow historical cost principle because fair values may not be representationally faithful. Only in situations where assets are actively traded, such as investment securities, is the fair value principle added. 2. Revenue Recognition Principle
 Revenue recognition principle - requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. 3. Expense Recognition Principle
 Expense recognition principle/Matching principle - dictates that efforts (expenses) be matched with results (revenues). Expenses follow revenues. 4. Full Disclosure Principle
 Full Disclosure Principle - requires that companies disclose all circumstances and events that would make a difference to financial statement users.
 -If an important item cannot reasonable be reported directly in one of the four types of financial statements, then it should be discussed in notes that accompany the statements. S. Cost Constraint
 Cost Constraint - weighs the cost that companies will incur to provide the 12 Sunday, September 11, 2016 information against the benefit that financial statement users will gain from having the information available. 13


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