The Adjusting Process
Chapter 3
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Learning Objectives
1. Differentiate between cash basis accounting and accrual basis accounting
2. Define and apply the time period concept, revenue recognition, and matching principles
3. Explain the purpose of and journalize and post adjusting entries
4. Explain the purpose of and prepare an adjusted trial balance
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Learning Objectives
5. Identify the impact of adjusting entries on the financial statements
6. Explain the purpose of a worksheet and use it to prepare adjusting entries and the adjusted trial balance
7. Understand the alternative treatments of recording prepaid expenses and unearned revenues (Appendix 3A)
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Learning Objective 1
Differentiate between cash basis accounting
and accrual basis accounting
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What is the Difference between Cash Basis Accounting & Accrual Basis Accounting?
CASH BASIS• Revenue is recorded
when Cash is received
• Expenses are recorded when Cash is paid
• Not allowed under GAAP
ACCRUAL BASIS• Revenue is recorded
when it is earned• Expenses are
recorded when incurred
• Generally used by larger businesses
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Learning Objective 2
Define and apply the time period concept, revenue recognition,
and matching principles
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The Time Period Concept
• Assumes that a business’s activities can be sliced into small segments and that financial statements can be prepared for specific time periods, such as a month, quarter, or year.
• Any twelve month period is referred to as a fiscal year.
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OCTOBER 2012
The Revenue Recognition Principle
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Revenue should be recorded when it is
EARNED.
A good has been delivered
or a service has been
performed.
The earnings
process is complete.
The amount of revenues must represent the
actually selling price.
If a $200 item is discounted to $100, then the
revenue is $100.
The Matching Principle
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Expenses are recorded when
they are incurred during
the period.
Expenses are matched at the end of the period
against the revenues for that period.
For example, rent expense for January should be
matched against January revenues, even if was
actually paid in December.
Learning Objective 3
Explain the purpose of and journalize and post
adjusting entries
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The initial trial balance that comes from the
General Ledger is referred to as an Unadjusted Trial
Balance.
Because of the Time Period Concept,
Revenue Recognition Principle, and Matching
Principle some adjustments are
needed.
Smart Touch Learning
Trial Balance
December 31, 2014
Debit Credit
Cash 12,200$
Accounts Receivable 1,000
Office Supplies 500
Prepaid Rent 3,000
Furniture 18,000
Building 60,000
Land 20,000
Accounts Payable 200
Utilities Payable 100
Unearned Revenue 600
Notes Payable 60,000
Common Stock 48,000
Dividends 5,000
Service Revenue 16,500
Rent Expense 2,000
Salaries Expense 3,600
Utilities Expense 100
125,400$ 125,400$
Smart Touch Learning
Trial Balance
December 31, 2014
Debit Credit
Cash 12,200$
Accounts Receivable 1,000
Office Supplies 500
Prepaid Rent 3,000
Furniture 18,000
Building 60,000
Land 20,000
Accounts Payable 200
Utilities Payable 100
Unearned Revenue 600
Notes Payable 60,000
Common Stock 48,000
Dividends 5,000 -
Service Revenue 16,500
Rent Expense 2,000
Salaries Expense 3,600
Utilities Expense 100
125,400$ 125,400$
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For example, the Office Supplies
account shows $500 at the end of December.
If a count of the actual supplies on hand shows that some
supplies have been used, we will need to adjust the account.
Adjusting Journal Entries
• Adjustments to the Trial Balance are made by recording actual Adjusting Journal Entries.
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Date Accounts and Explanation Debit Credit
Dec. 31 Account $$$ Account $$$
Adjusting Journal Entries
• Each Adjusting Journal Entry will adjust a balance sheet account and an income statement account.
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Date Accounts and Explanation Debit Credit
Dec. 31 Supplies Expense $$$ Office Supplies $$$To record office supplies used.
Adjusting Journal Entries
Adjusting Journal Entries (AJE’s) can be divided into two basic categories:
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Prepaids1.Prepaid Expenses2.Unearned Revenues
Accruals1.Accrued revenues2.Accrued expenses
Prepaid Rent Example
In Transaction #10 (see Chapter 2), on December 1, Smart Touch Learning prepaid 3 months rent of
$3,000 ($1,000 x 3 months).
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Date Accounts and Explanation Debit Credit
Dec. 1 Prepaid Rent 3,000 Cash 3,000 Paid rent in advance.
Dec. 1 3,000 Prepaid Rent
Prepaid Rent Example
Paying rent in advance gives us the right to use the property for 3 months (in this case). By the end
of December, 1/3 of that right has been used.
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Date Accounts and Explanation Debit Credit
Dec. 1 Prepaid Rent 3,000 Cash 3,000 Paid rent in advance.
Dec. 1 3,000 Prepaid Rent
Prepaid Rent Example
To adjust the Prepaid Rent account, we need to reduce it by 1/3, and we need to show the rent expense related to the December revenues.
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Date Accounts and Explanation Debit Credit
Dec. 31 Rent Expense 1,000 Prepaid Rent 1,000 To record rent expense.
Dec. 1 3,000 1,000 Dec. 31Prepaid Rent
Depreciation
• Long-lived, tangible assets used to generate revenue are referred to as plant assets.
• Plant assets act like Prepaid Expenses
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Paid for when
acquired
Used to produce revenues
Used up over time
Depreciation
• The process of systematically recording the periodic usage of plant assets to generate revenues is called Depreciation.
• The accounts used are:– Depreciation Expense– Accumulated
Depreciation
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Land is never depreciated.
Accumulated Depreciation is a
contra-asset. - Has a credit balance- Appears in the Asset section of the Balance
Sheet
Depreciation Example
Assume that, on December 2, Smart Touch Learning received a contribution of furniture with a
market value of $18,000 from a stockholder.
At the end of December, Smart Touch Learning will need to record depreciation for the use of the furniture, assuming it has a 5 year useful life.
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Date Accounts and Explanation Debit Credit
Dec. 2 Furniture 18,000 Common Stock 18,000 Contribution of furniture in exchange for common stock
Depreciation Example
Using the straight-line method of computing depreciation, Smart Touch Learning will need to
record $300 of depreciation for December.
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Straight-Line Depreciation = ( Cost - Residual Value ) ÷ Useful Life = ( $18,000 - $0 ) ÷ 5 Years = $3,600 per year
Monthly Amount = $3,600 ÷ 12 months = $300
Depreciation Example
Recording the entry requires the use of two accounts: Depreciation Expense and
Accumulated Depreciation.
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Date Accounts and Explanation Debit Credit
Dec. 31 Depreciation Expense—Furniture 300 Accumulated Depreciation—Furniture 300 To record depreciation on furniture.
Unearned Revenue Example
On December 21, a law firm engages Smart Touch Learning to provide e-learning services for the next
30 days, paying $600 in advance.
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Date Accounts and Explanation Debit Credit
Dec. 21 Cash 600 Unearned Revenue 600 Collected cash for future services.
600 Dec. 21Unearned Revenue
Dec. 31 200 600 Dec. 21Unearned Revenue
Date Accounts and Explanation Debit Credit
Dec. 31 Unearned Revenue 200 Service Revenue 200 To record service revenue earned that was collected in advance.
Unearned Revenue Example
Smart Touch Learning is obligated to perform the services. During the last 10 days of the month, 1/3
of the services are performed.
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Accrued Expenses Example
Smart Touch Learning pays its employee a monthly salary of $2,400, half on the 15th and half
on the first day of the next month.
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Accrued Expenses Example
On December 31, Smart Touch Learning still owes the employee $1,200, which won’t be paid until
January 1.
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Date Accounts and Explanation Debit Credit
Dec. 31 Salaries Expense 1,200 Salaries Payable 1,200 To accrue salaries expense.
Dec. 31 1,200 1,200 Dec. 31
Salaries Expense Salaries Payable
Accrued Revenue Example
Accrued revenues arise when the company recognizes that it has performed a service, or
delivered a product, but has not yet recorded that they have “earned” the revenue.
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Date Accounts and Explanation Debit Credit
Dec. 31 Accounts Receivable xxxx Service Revenue xxxxTo accrue service revenue.
Accrued Revenue Example
On December 15, Smart Touch Learning agrees to perform e-learning services for $1,600 per month. By the end of December, they have earned ½ of
the monthly fee for December.
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Date Accounts and Explanation Debit Credit
Dec. 31 Accounts Receivable 800 Service Revenue 800 To accrue service revenue.
Learning Objective 4
Explain the purpose of and prepare an
adjusted trial balance
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The Adjusted Trial Balance
• After journalizing and posting all the adjusting journal entries at the end of the fiscal period, a new adjusted trial balance is prepared.– List all accounts– List debit balances in the debit column– List credit balance in the credit column
• If it balances, financial statements can be prepared.
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• The adjusted trial balance includes accounts that did not appear on the original unadjusted trial balance.
• The financial statements are prepared directly from the adjusted trial balance.
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Learning Objective 5
Identify the impact of adjusting entries on
the financial statements
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Learning Objective 6
Explain the purpose of a worksheet and use it
to prepare adjusting entries and the
adjusted trial balance
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Account Names Debit Credit Debit Credit Debit CreditCash 6,500 Accounts Receivable 800 Offi ce Supplies 250 Prepaid Rent 1,000 Delivery Van 23,000 Accumulated Depreciation - Delivery VanEquipment 15,000 Accumulated Depreciation - EquipmentAccounts Payable 800 Utilities Payable 230 Salaries PayableUnearned Revenue 400 Common Stock 37,800 Dividends 8,000 Delivery Revenue 23,000 Rent Expense 3,000 Salaries Expense 4,500 Supplies ExpenseUtilities Expense 180 Depreciation Expense - Delivery VanDepreciation Expense - EquipmentTotal 62,230 62,230
Unadjusted Trial Balance Adjustments
Adjusted Trial Balance
First, enter the information from the unadjusted
trial balance into the first two
columns of the worksheet.
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Account Names Debit Credit Debit Credit Debit CreditCash 6,500 Accounts Receivable 800 225 Offi ce Supplies 250 80 Prepaid Rent 1,000 800 Delivery Van 23,000 Accumulated Depreciation - Delivery Van 750 Equipment 15,000 Accumulated Depreciation - Equipment 300 Accounts Payable 800 Utilities Payable 230 Salaries Payable 875 Unearned Revenue 400 130 Common Stock 37,800 Dividends 8,000 Delivery Revenue 23,000 355 Rent Expense 3,000 800 Salaries Expense 4,500 875 Supplies Expense 80 Utilities Expense 180 Depreciation Expense - Delivery Van 750 Depreciation Expense - Equipment 300 Total 62,230 62,230 3,160 3,160
Unadjusted Trial Balance Adjustments
Adjusted Trial Balance
Second, enter the information
for the adjusting journal entries
into the Adjustments
columns.
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Account Names Debit Credit Debit Credit Debit CreditCash 6,500 6,500 Accounts Receivable 800 225 1,025 Offi ce Supplies 250 80 170 Prepaid Rent 1,000 800 200 Delviery Van 23,000 23,000 Accumulated Depreciation - Delivery Van 750 750 Equipment 15,000 15,000 Accumulated Depreciation - Equipment 300 300 Accounts Payable 800 800 Utilities Payable 230 230 Salaries Payable 875 875 Unearned Revenue 400 130 270 Common Stock 37,800 37,800 Dividends 8,000 8,000 Delivery Revenue 23,000 355 23,355 Rent Expense 3,000 800 3,800 Salaries Expense 4,500 875 5,375 Supplies Expense 80 80 Utilities Expense 180 180 Depreciation Expense - Delivery Van 750 750 Depreciation Expense - Equipment 300 300 Total 62,230 62,230 3,160 3,160 64,380 64,380
Unadjusted Trial Balance Adjustments
Adjusted Trial Balance
Third, cross-foot the numbers across the
spreadsheet to the Adjusted Trial Balance
columns.
Learning Objective 7
Understand the alternative treatments of recording prepaid
expenses and unearned revenues
(Appendix 3A)
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Alternative Treatment of Prepaid Expenses
Rather than record the prepayment of an expense as a current asset, record the prepayment as an
expense on the date of payment.
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Date Accounts and Explanation Debit Credit
Dec. 1 Rent Expense 3,000 Cash 3,000 Paid rent in advance.
Alternative Treatment of Prepaid Expenses
At the end of the period, if any of the expense remains “unused,” then adjust some of it INTO the
prepaid asset account.
The results are the same as the
traditional approach.3-41Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall
Date Accounts and Explanation Debit Credit
Dec. 31 Prepaid Rent 2,000 Rent Expense 2,000 To record prepaid rent.
Alternative Treatment of Unearned Revenues
Rather than record the early cash receipt from a customer as a current liability, record the cash
receipt as a revenue on the date of receipt.
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Date Accounts and Explanation Debit Credit
Dec. 1 Cash 600 Service Revenue 600 Collected cash for future services.
Alternative Treatment of Unearned Revenues
At the end of the period, if any of the revenue remains “unearned,” then adjust some of it INTO
the unearned revenue account.
The results are the same as the
traditional approach.3-43Copyright ©2014 Pearson Education, Inc. publishing as Prentice Hall
Date Accounts and Explanation Debit Credit
Dec. 31 Service Revenue 400 Unearned Revenue 400 To record unearned revenue.
End of Chapter 3
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