chapter 3 financial accounting

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The Adjusting

The Adjusting

ProcessProcess

Chapter 3Chapter 3Chapter 3Chapter 3

Learning ObjectivesLearning Objectives

1.1. Describe the nature of the adjusting Describe the nature of the adjusting process.process.

2.2. Journalize entries for accounts requiring Journalize entries for accounts requiring adjustment.adjustment.

3.3. Summarize the adjustment process.Summarize the adjustment process.

4.4. Prepare an adjusted trial balance.Prepare an adjusted trial balance.

5.5. Describe and illustrate the use of vertical Describe and illustrate the use of vertical analysis in evaluating a company’s analysis in evaluating a company’s performance and financial condition.performance and financial condition.


Learning Learning Objective

ObjectiveDescribe the nature of the

Describe the nature of the adjusting process.

adjusting process.

11


Nature of the Adjusting ProcessNature of the Adjusting Process

o The The accounting period concept accounting period concept requires requires that revenues and expenses be reported in that revenues and expenses be reported in the proper period.the proper period.



o Under the Under the accrual basis of accountingaccrual basis of accounting, , revenues are reported on the income revenues are reported on the income statement in the period in which they are statement in the period in which they are earned.earned.



o The accounting concept supporting the The accounting concept supporting the reporting of revenues when they are reporting of revenues when they are earned regardless of when cash is earned regardless of when cash is received is called the received is called the revenue recognition revenue recognition conceptconcept..



o The accounting concept supporting The accounting concept supporting reporting revenues and related expenses reporting revenues and related expenses in the same period is called the in the same period is called the matching matching conceptconcept, or , or matching principlematching principle..



o Under the Under the cash basis of accountingcash basis of accounting, , revenues and expenses are reported on revenues and expenses are reported on the income statement in the period in the income statement in the period in which cash is received or paid.which cash is received or paid.


The Adjusting ProcessThe Adjusting Process

o Under the accrual basis, some of the Under the accrual basis, some of the accounts need updating at the end of the accounts need updating at the end of the accounting period for the following accounting period for the following reasons:reasons: Some expenses are not recorded daily.Some expenses are not recorded daily.

Some revenues and expenses are incurred as Some revenues and expenses are incurred as time passes rather than as separate time passes rather than as separate transactions.transactions.

Some revenues and expenses may be Some revenues and expenses may be unrecorded.unrecorded.



o The analysis and updating of accounts at The analysis and updating of accounts at the end of the period before the financial the end of the period before the financial statements are prepared is called the statements are prepared is called the adjusting processadjusting process. .



o The analysis and updating of accounts at The analysis and updating of accounts at the end of the period before the financial the end of the period before the financial statements are prepared is called the statements are prepared is called the adjusting process. adjusting process.

o The journal entries that bring the accounts The journal entries that bring the accounts up to date at the end of the accounting up to date at the end of the accounting period are called period are called adjusting entriesadjusting entries..


Types of Accounts Requiring Types of Accounts Requiring AdjustmentAdjustmento Prepaid expensesPrepaid expenses are the advance are the advance

payment of future expenses and are payment of future expenses and are recorded as assets when cash is paid.recorded as assets when cash is paid.

PREPAID PREPAID EXPENSESEXPENSES


Types of Accounts Requiring Types of Accounts Requiring AdjustmentAdjustmento Unearned revenues Unearned revenues are the advance are the advance

receipt of future revenues and are receipt of future revenues and are recorded as liabilities when cash is recorded as liabilities when cash is received.received.

UNEARNED UNEARNED REVENUESREVENUES


Types of Accounts Requiring Types of Accounts Requiring AdjustmentAdjustmento Accrued revenues Accrued revenues are unrecorded are unrecorded

revenues that have been earned and for revenues that have been earned and for which cash has yet to be received.which cash has yet to be received.

ACCRUED ACCRUED REVENUESREVENUES


Types of Accounts Requiring Types of Accounts Requiring AdjustmentAdjustmento Accrued expenses Accrued expenses are unrecorded are unrecorded

expenses that have been incurred and for expenses that have been incurred and for which cash has yet to be paid. which cash has yet to be paid.

ACCRUED ACCRUED EXPENSESEXPENSES



ObjectiveJournalize entries for accounts

Journalize entries for accounts

requiring adjustment.

requiring adjustment.

22

ADJUSTING ADJUSTING ENTRIESENTRIES


Prepaid ExpensesPrepaid Expenses

o NetSolutions’ Supplies account has a NetSolutions’ Supplies account has a balance of $2,000 on the unadjusted trial balance of $2,000 on the unadjusted trial balance. Some of these supplies have balance. Some of these supplies have been used. On December 31, a count been used. On December 31, a count reveals that the amount of supplies on reveals that the amount of supplies on hand is $760.hand is $760.

Assets = Liabilities + Stockholders’ Assets = Liabilities + Stockholders’ Equity (Expense)Equity (Expense)

Accounting Equation Accounting Equation ImpactImpact

decrease

increase

PREPAID PREPAID EXPENSESEXPENSES


Prepaid InsurancePrepaid Insurance

o The debit balance of $2,400 in The debit balance of $2,400 in NetSolutions’ Prepaid Insurance account NetSolutions’ Prepaid Insurance account represents the December 1 prepayment of represents the December 1 prepayment of insurance for 12 months.insurance for 12 months.



decrease

increase

PREPAID PREPAID INSURANCEINSURANCE

IMPACT OF IMPACT OF OMITTING OMITTING ADJUSTING ADJUSTING

ENTRIESENTRIES


Unearned RevenuesUnearned Revenues

o The credit balance of $360 in The credit balance of $360 in NetSolutions’ Unearned Rent account NetSolutions’ Unearned Rent account represents the receipt of three months’ represents the receipt of three months’ rent on December 1 for December, rent on December 1 for December, January, and February. At the end of January, and February. At the end of December, one month’s rent has been December, one month’s rent has been earned.earned.

Assets = Liabilities + Stockholders’ Assets = Liabilities + Stockholders’ Equity (Revenue)Equity (Revenue)


decrease increase



ENTRYENTRY


Accrued RevenuesAccrued Revenues

o NetSolutions signed an agreement with NetSolutions signed an agreement with Danker Co. on December 15 to provide Danker Co. on December 15 to provide services at a rate of $20 per hour. As of services at a rate of $20 per hour. As of December 31, NetSolutions had provided December 31, NetSolutions had provided 25 hours of services. The revenue will be 25 hours of services. The revenue will be billed on January 15.billed on January 15.

Assets = Liabilities + Stockholders’ Assets = Liabilities + Stockholders’ Equity (Revenue)Equity (Revenue)


increase

increase



ENTRYENTRY

ACCRUED ACCRUED WAGESWAGES


Accrued WagesAccrued Wages

o NetSolutions pays its employees biweekly. NetSolutions pays its employees biweekly. During December, NetSolutions paid During December, NetSolutions paid wages of $950 on December 13 and wages of $950 on December 13 and $1,200 on December 27. As of December $1,200 on December 27. As of December 31, NetSolutions owes $250 of wages to 31, NetSolutions owes $250 of wages to employees for Monday and Tuesday, employees for Monday and Tuesday, December 30 and 31.December 30 and 31.



increase

increase

ACCRUED ACCRUED WAGESWAGES


Accrued WagesAccrued Wages

o NetSolutions paid wages of $1,275 on NetSolutions paid wages of $1,275 on January 10. This payment includes the January 10. This payment includes the $250 of accrued wages recorded on $250 of accrued wages recorded on December 31.December 31.


ENTRYENTRY


Depreciation ExpenseDepreciation Expense

o Fixed assetsFixed assets, or , or plant assetsplant assets, are physical , are physical resources that are owned and used by a resources that are owned and used by a business and are permanent or have a business and are permanent or have a long life.long life.

o As time passes, a fixed asset loses its As time passes, a fixed asset loses its ability to provide useful services. This ability to provide useful services. This decrease in usefulness is called decrease in usefulness is called depreciationdepreciation..



o All fixed assets, except land, lose their All fixed assets, except land, lose their usefulness and , thus, are said to usefulness and , thus, are said to depreciatedepreciate..

o As a fixed asset depreciates, a portion of As a fixed asset depreciates, a portion of its cost should be recorded as an expense. its cost should be recorded as an expense. This periodic expense is called This periodic expense is called depreciationdepreciation expenseexpense..



o The fixed asset account is not decreased The fixed asset account is not decreased (credited) when making the related (credited) when making the related adjusting entry. This is because both the adjusting entry. This is because both the original cost of a fixed asset and the original cost of a fixed asset and the depreciation recorded since its purchase are depreciation recorded since its purchase are reported on the balance sheet. Instead, an reported on the balance sheet. Instead, an account entitled account entitled Accumulated Depreciation Accumulated Depreciation is increased (credited).is increased (credited).

o Accumulated depreciation accounts are Accumulated depreciation accounts are called called contra accountscontra accounts, or , or contra asset contra asset accountsaccounts..



o Normal titles for fixed asset accounts and Normal titles for fixed asset accounts and their related contra asset accounts are as their related contra asset accounts are as follows:follows:



o NetSolutions estimates the depreciation NetSolutions estimates the depreciation on its office equipment to be $50 for the on its office equipment to be $50 for the month of December.month of December.

DEPRECIATION DEPRECIATION EXPENSEEXPENSE



increase

increase



o The difference between the original cost of The difference between the original cost of the office equipment and the balance in the office equipment and the balance in the accumulated depreciation—office the accumulated depreciation—office equipment account is called the equipment account is called the book book value value of the asset (or of the asset (or net book valuenet book value). It is ). It is computed as shown below.computed as shown below.


ENTRYENTRY



ObjectiveSummarize the adjustment

Summarize the adjustment process.process.

33

SUMMARY OF SUMMARY OF ADJUSTMENT ADJUSTMENT

PROCESSPROCESS

ADJUSTING ADJUSTING ENTRIESENTRIES

LEDGER WITH LEDGER WITH ADJUSTING ADJUSTING

ENTRIESENTRIES



ObjectivePrepare an adjusted trial

Prepare an adjusted trial balance.balance.

44


Adjusted Trial BalanceAdjusted Trial Balance

o The purpose of the The purpose of the adjusted trial balanceadjusted trial balance is to verify the equality of the total debit is to verify the equality of the total debit and credit balances before the financial and credit balances before the financial statements are prepared.statements are prepared.

ADJUSTED ADJUSTED TRIAL BALANCETRIAL BALANCE



ObjectiveDescribe and illustrate the use of

Describe and illustrate the use of

vertical analysis in evaluating a

vertical analysis in evaluating a

company’s performance and

company’s performance and financial condition.

financial condition.

55


Vertical AnalysisVertical Analysis

o Comparing each item in a financial Comparing each item in a financial statement with a total amount from the statement with a total amount from the same statement is referred to as same statement is referred to as verticalvertical analysisanalysis..

VERTICAL VERTICAL ANALYSISANALYSIS

$ 12,500= .067 or 6.7%

$187,500

VERTICAL VERTICAL ANALYSISANALYSIS

$ 3,000= .02 or 2%

$150,000


The Adjusting

The Adjusting

ProcessProcess

The EndThe EndThe EndThe End

chapter 3 financial accounting

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adjusting processo

accounting period concept

accounting concept

learning objectives1

cash basis of accounting

reporting revenues