Copyright © 2014 Pearson Canada Inc. 3 - 1 Chapter 3

Copyright © 2014 Pearson Canada Inc. 3 - 1

Chapter 3


Learning Objective 1Apply the recognition criteria for revenues and

expenses

When does a sale really happen?

When do we record an expense?


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


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


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


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)


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?


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


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


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


Learning Objective 3Make adjusting entries

What is the adjusting process, and why is it important?


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


Five Categories of Adjusting EntriesPrepaid expensesAmortization of property, plant, and

equipment, and intangible assetsUnearned revenuesAccrued expensesAccrued revenues

Prepaids

(Deferrals)

Accruals


Prepaid Expenses

Prepaid expenses are advance payments of the expense

Examples include: prepaid rent, prepaid insurance, and supplies

Copyright © 2014 Pearson Canada Inc.3 - 15

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.


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


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.


Supplies Example, posting

ASSETS EXPENSES

Supplies Supplies Expense

Correct asset amount, $1,000


$1,500

Correct expense amount,

$500

Apr. 2 1,500 Apr. 30 500

Bal. 1,000

Apr. 30 500

Bal. 500


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


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.


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


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.


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.


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


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


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.


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


Accrued RevenuesAccrued revenues defined: Revenue that has been earned

but not yet invoiced or collected.


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.


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.


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.


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.


Unearned Revenue Example Continued

The balance prior to adjustment was $24,000

LIABILITIES REVENUES

Unearned Service Revenue Service Revenue

Correct liability amount, $2,000


$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


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


Learning Objective 4Prepare an adjusted trial balance

How do we get the accounting records ready to prepare the financial statements?


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


Learning Objective 5Prepare the financial statements from the

adjusted trial balance

Remind me. How do we prepare the financial statements?


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


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


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


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


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


Learning Objective 6Describe the adjusting-process implications of

international financial reporting standards (IFRS)

How does IFRS apply to adjusting entries?


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.


Learning Objective A1Account for a prepaid expense recorded initially

as an expense

Is there another way to record prepaids?


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.


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


Learning Objective A2Account for an unearned (deferred) revenue

recorded initially as a revenue

Is there another way to record unearned revenues?


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.


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

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Copyright © 2014 Pearson Canada Inc. 3 - 1 Chapter 3