Adjusting the Accounts

Accrual-Basis Accounting and

Adjusting Entries
• Objective: Explain the accrual basis of accounting and the reasons for
adjusting entries
•Net worth : $ 16 bn
•Ave. daily growth: $ 15M
Accounting issues:
• What happens when they make a sale (e.g. $30 for Highrise
Hamburgers)?
• Record the whole $30 as “Sale / Revenue”
• Give $15 to Highrise Hamburgers and record $15 as “Sale / Revenue”
• When does Groupon record the Sale / Revenue?
• When the groupon is sold
• When the customer uses the groupon
• Groupon uses estimates in its financial reporting
Accrual-Basis Accounting and
Adjusting Entries
• If financial statements are prepared only at the end of
a company’s operations, no adjustments would be
needed.
• HOWEVER, companies need feedback on how they
are performing during a period of time.
• Hence, accountants divide the economic life of the
business into artificial time periods.
Time period assumption
• Also called as the periodicity
assumption
• Many business transactions
affect more than one of these
arbitrary time periods.
• Accounting time periods are
generally a month, quarter, or a
year.
Time period assumption
• Monthly and quarterly time
periods are called interim
periods.
• Most large companies must
prepare both quarterly and
annual financial statements.
Fiscal and Calendar Years
• An accounting time period that is one year in length is
a fiscal year.
• A fiscal year usually begins with the first day of a month
and ends 12 months later on the last day of a month.
• Many businesses use the calendar year (January 1 to
December 31) as their fiscal period
Fiscal and Calendar Years
Accrual- versus Cash-
Basis Accounting
Accrual-Basis Accounting
• Under the accrual basis, companies record
transactions that change a company’s financial
statements in the periods in which the events occur.
• Using the accrual basis to determine net income means
companies recognize revenues when they perform
services (rather than when they receive cash).
• It also means recognizing expenses when incurred (rather
than when they pay cash).
Cash-Basis Accounting
• An alternative to the accrual-basis accounting
• Under cash-basis accounting, companies record
revenue at the time they receive cash.
• They record an expense at the time they pay out cash.
• The cash basis seems appealing due to its simplicity, but it
often produces misleading financial statements.
• The cash basis may not recognize revenue in the period
that a performance obligation is satisfied
Accrual- versus Cash-Basis
Accounting
• Accrual-basis accounting is required by generally
accepted accounting principles (GAAP).
• Individuals and some small companies, however, do
use cash-basis accounting.
• The cash basis is justified for small businesses because
they often have few receivables and payables.
• Medium and large companies use accrual-basis
accounting.
Recognizing Revenues
and Expenses
Revenue Recognition Principle
• When a company agrees to
perform a service or sell a
product to a customer, it has a
performance obligation.
• When the company meets this
performance obligation, it
recognizes revenue.
Revenue Recognition Principle
• The revenue recognition principle
requires that companies recognize
revenue in the accounting period in
which the performance obligation
is satisfied.
• A company satisfies its
performance obligation by
performing a service or providing a
good to a customer.
Revenue Recognition Principle
• To illustrate, assume Conrad Dry Cleaners performs cleaning services
for $100 on June 30, but customers do not claim and pay for their
clothes until July 5.
• Under the revenue recognition principle, Conrad records revenue on
June 30 when it satisfies its performance obligation, which is when it
performs the service, not in July when it receives the cash.
• At June 30, Conrad would report a receivable on its balance sheet and
revenue in its income statement for the service performed.
Revenue Recognition Principle
• To illustrate, assume Conrad Dry Cleaners performs cleaning services
for $100 on June 30, but customers do not claim and pay for their
clothes until July 5.
• Under the revenue recognition principle, Conrad records revenue on
June 30 when it satisfies its performance obligation, which is when it
performs the service, not in July when it receives the cash.
• At June 30, Conrad would report a receivable on its balance sheet and
revenue in its income statement for the service performed.
Revenue Recognition Principle
Five-Step Revenue Recognition
Process
• Revenue recognition
results from a five-
step process.
Five-Step Revenue Recognition
Process
• Assume that Sierra Company signs a contract with the
Lewis family to provide guide services for a one-week
backpacking trip for $1,500.
Expense Recognition Principle
• “Let the expenses follow the
revenues.”
• The critical issue in expense
recognition is when the expense
makes its contribution to revenue.
• This may or may not be the same
period in which the expense is
paid.
Expense Recognition Principle
• The expense recognition principle
requires that companies recognize
expenses in the period in which they
make efforts (consume assets or
incur liabilities) to generate revenue.
• The term matching is sometimes
used in expense recognition to
indicate the relationship between
the effort expended and the
revenue generated.
GAAP relationships in revenue and
expense recognition
Adjusting Entries
The Need for Adjusting Entries
• In order for revenues to be recorded in the period in
which the performance obligations are satisfied and
for expenses to be recognized in the period in which
they are incurred, companies make adjusting entries.
• Adjusting entries ensure that the revenue recognition and
expense recognition principles are followed.
• Adjusting entries are necessary because the trial balance
—the first pulling together of the transaction data—may
not contain up-to-date and complete data.
Reasons the trial balance may
contain incomplete or outdated data
• Some events are not recorded daily because it is not efficient
to do so.
• 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 transactions.
• Some items may be unrecorded.
The Need for Adjusting Entries
• Adjusting entries are required every time a company
prepares financial statements.
• Rules of Adjusting entries:
• Every adjusting entry will include one income statement
account and one balance sheet account
• Adjusting entries never affect the Cash account.
Types of Adjusting Entries
• Adjusting entries are classified as either deferrals or
accruals
Types of Adjusting Entries
Types of Adjusting Entries
Adjusting Entry for Deferrals
Adjusting Entry for Deferrals

• Deferrals are expenses or revenues that are

recognized at a date later than the point when cash
was originally exchanged
• Companies make adjusting entries for deferred expenses
to record the portion that was incurred during the period.
• Companies also make adjusting entries for deferred
revenues to record services performed during the period.
• The two types of deferrals are prepaid expenses and
unearned revenues.
Prepaid expenses
• A prepaid expense is a good or service that has been
paid for in advance but not yet incurred.
• Prepaid expenses are costs that expire either with the
passage of time (e.g., rent and insurance) or through
use (e.g., supplies).
• Common examples include rent, insurance, leased
equipment, advertising, legal retainers, and estimated
taxes.
Prepaid expenses
• In business, prepaid expenses are recorded as assets
on the balance sheet because they represent future
benefits, but they are expensed at the time when
those benefits are realized.

• Although prepaid expenses are initially recorded as

assets, their value is expensed over time onto the
income statement.
Prepaid expenses
Supplies
Adjustment for supplies
• The business conducted an inventory count at the end
of October, they found that $1,000 of supplies are still
on hand.
• This means that:
• Income statement : October expenses are understated by
$1,500 and net income is overstated by $1,500.
• Balance sheet (as of October 31): Assets and Equity are
overstated by $1,500.
Adjustment for supplies
Insurance
Insurance
• The cost of insurance (premiums) paid in advance 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.
Adjustment for insurance

• $50 represents the expired insurance cost which

equals the insurance expense
• Prepaid insurance shows a balance of $550, which
represents the unexpired cost for the remaining 11
months of coverage
Adjustment for insurance
• This means:
• Income statement: October expenses are understated by
$50 and net income is overstated by $50.
• Balance sheet (as of October 31): Assets and Owner’s equity
are overstated by $50.
Adjustment for insurance
Depreciation
• Depreciation is the process of allocating the cost of an
asset to expense over its useful life
• Depreciation is an allocation concept, not a valuation
concept.
• Depreciation allocates an asset’s cost to the periods in
which it is used.
• Depreciation does not attempt to report the actual
change in the value of the asset.
Depreciation
• The adjusting entry for depreciation includes a
debit to Depreciation Expense and a credit to
Accumulated Depreciation–Equipment.
• Accumulated Depreciation is called a contra
asset account.
• Such an account is offset against an asset account on
the balance sheet.
• This account keeps track of the total amount of
depreciation expense taken over the life of the asset.
Depreciation
• For Pioneer Advertising, assume that depreciation on
the equipment is $480 a year, or $40 per month.
Adjusting for depreciation
Depreciation – Statement
presentation
• The normal balance of a contra asset account is a credit.
• A theoretical alternative to using a contra asset account would be to
decrease (credit) the asset account by the amount of depreciation
each period.
• Using the contra account is preferable for a simple reason: It discloses
both the original cost of the equipment and the total cost that has
been expensed to date.
Depreciation and book value
• Book value is the difference between the cost of any depreciable
asset and its related accumulated depreciation
Adjustment for depreciation
• Depreciation expense identifies the portion of an
asset’s cost that expired during the period (in this
case, in October).
• This means:
• Income statement: October expenses are understated by
$40 and net income is overstated by $40.
• Balance sheet (as of October 31): Assets and Owner’s
equity are overstated by $40.
Unearned Revenues
• When companies receive cash before services are
performed, they record a liability by increasing
(crediting) a liability account called unearned
revenues.
• A company now has a performance obligation (liability) to
perform a service for one of its customers.
• Items like rent, magazine subscriptions, and customer
deposits for future service may result in unearned
revenues.
Recognizing revenue
• During the accounting period, it is not practical to
make daily entries as the company performs services.
• Instead, the company delays recognition of revenue
until the adjustment process.
• Then, the company makes an adjusting entry to
record the revenue for services performed during the
period and to show the liability that remains at the
end of the accounting period.
Unearned Revenues
Adjustment for unearned revenues
• This means:
• Income statement: October revenues and net income are
understated by $400.
• Balance sheet (as of October 31): Liabilities are overstated
by $400 and Owner’s equity is understated by $400
Adjustment for unearned revenues
• Pioneer recognized revenue for service performed for Knox for the
month of October.
Adjusting Entries for Deferrals
Adjusting Entries for Deferrals
Adjusting Entry for Accruals
Adjusting Entry for Accruals
• Accruals are revenues earned or expenses incurred
that impact a company's net income on the income
statement but cash related to the transaction hasn't
yet changed hands.
• Prior to an accrual adjustment, the revenue account (and
the related asset account) or the expense account (and
the related liability account) are understated.
Adjusting Entry for Accruals
• Accruals also affect the balance sheet because they
involve non-cash assets and liabilities.
• Adjusting entry for accruals will increase both a
balance sheet and an income statement account.
Accrued Revenues
• Revenues for services performed but not yet recorded at the
statement date are accrued revenues.
• Accrued revenues may accumulate (accrue) with the passing of time,
as in the case of interest revenue.
• Accrued revenues also may result from services that have been
performed but not yet billed or collected, as in the case of
commissions and fees. These may be unrecorded because only a
portion of the total service has been performed and the clients will
not be billed until the service has been completed.
Accrued Revenues
Accrued Revenues
• In October, Pioneer Advertising Inc. performed
services worth $200 that were not billed to clients on
or before October 31. Because these services were
not billed, they were not recorded.
• This means:
• Income statement: October revenues are understated by
$200, and net income is understated by $200.
• Balance sheet (as of October 31): Assets and Owner’s
equity are understated by $200.
Adjustment for Accrued Revenues
• In October, Pioneer Advertising Inc. performed
services worth $200 that were not billed to clients on
or before October 31. Because these services were
not billed, they were not recorded.
• The accrual of unrecorded service revenue increases an
asset account, Accounts Receivable.
• It also increases owner’s equity by increasing a revenue
account, Service Revenue.
Adjustment for Accrued Revenues
• On November 10, Pioneer receives cash of $200 for
the services performed in October and makes the
following entry.
Accrued Expenses
• Accrued expenses are expenses incurred but not yet
paid or recorded at the statement date.
• Common examples are interest, taxes, and salaries.
• Prior to adjustment both liabilities and expenses are
understated.
Accrued Expenses
Accrued Interest
• Accrued interest refers to interest generated on an
outstanding debt during a period of time, but the
payment has not yet been made or received by the
borrower or lender.
Accrued Interest
• The amount of the 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 of time the note is outstanding.
Accrued Interest
• Pioneer Advertising signed a three-month note payable in the amount
of $5,000 on October 1.
• The note requires Pioneer to pay interest at an annual rate of 12%.
The note and the interest will both be paid at maturity.
Accrued Interest
• Pioneer will not pay the interest until the note comes due at the end
of three months.
• Companies use the Interest Payable account, instead of crediting
Notes Payable, to disclose the two different types of obligations—
interest and principal—in the accounts and statements.
Accrued Interest
• This means:
• Income statement: October expenses are understated by
$50, and net income is overstated by $50.
• Balance sheet (as of October 31): liabilities are
understated by $50, and owner’s equity is overstated by
$50.
Accrued Salaries and Wages
• Accrued salaries and wages is the earned but unpaid
salaries and wages the company still owes its
employees.
Accrued Salaries and Wages
Accrued Salaries and Wages
Accrued Salaries and Wages
• This means:
• Income statement: October expenses are understated by
$1,200 and net income is overstated by $1,200.
• Balance sheet (as of October 31): liabilities are
understated by $1,200, and owner’s equity is overstated
by $1,200.
Accrued Salaries and Wages
• Pioneer pays salaries and wages every two weeks.
Consequently, the next payday is November 9, when
the company will again pay total salaries and wages of
$4,000.
• The payment consists of $1,200 of salaries and wages
payable at October 31 plus $2,800 of salaries and
wages expense for November (7 working days, as
shown in the November calendar × $400).
Accrued Salaries and Wages
• Therefore, Pioneer makes the following entry on November 9.

• This entry eliminates the liability for Salaries and Wages Payable that
Pioneer recorded in the October 31 adjusting entry, and it records the
proper amount of Salaries and Wages Expense for the period between
November 1 and November 9.
Summary of Basic Relationships
 Adjusted Trial Balance
and Financial Statements
Adjusted Trial Balance
• After a company has journalized and posted all
adjusting entries, it prepares another trial balance
from the ledger accounts. This trial balance is called
an adjusted trial balance.
• The adjusted trial balance shows the balances of all
accounts, including those adjusted, at the end of the
accounting period.
Adjusted Trial Balance
• 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.
• The adjusted trial balance is the primary basis for the
preparation of financial statements because the
accounts now contain all data needed for financial
statements.
Preparing Financial Statement
• Companies can prepare financial statements directly
from the adjusted trial balance.