Prepared by Kurt M. Hull, MBA CPA California State University, Los AngelesFinancial Accounting, 5eJohn Wiley & Sons, Inc.Weygandt, Kieso, & KimmelSTUDY OBJECTIVESAfter studying this chapter, you should understand: Time period assumptionAdjusting entries for prepayments Accrual basis of accountingAdjusting entries for accrualsWhy adjusting entries are necessaryPurpose of an adjusted trial balanceMajor types of adjusting entriesAlternate treatment of prepayments & accrualsCHAPTER 3ADJUSTING THE ACCOUNTS The time period assumption assumes that the economic life of a business can be divided into artificial time periods. Accounting time periods are generally a month, a quarter, or a year (fiscal year)STUDY OBJECTIVE 1TIME PERIOD ASSUMPTIONSTUDY OBJECTIVE 2ACCRUAL vs. CASH-BASIS ACCOUNTINGAccrual Basis Revenue recognized when earned Expenses are matched against revenues Required by GAAPCash-Basis Revenues and expenses recorded when cash is paid or received Not GAAP The revenue recognition principle dictates that revenue be recognized in the accounting period in which it is earned. In a service business, revenue is considered to be earned when the service is performed.REVENUE RECOGNITION PRINCIPLE The practice of expense recognition is referred to as the matching principle. The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues).Revenues earned this monthare offset againstexpenses incurred in earning the revenueMATCHING PRINCIPLETime-Period AssumptionEconomic life of business can be divided into artificial time periodsRevenue-Recognition Principle Revenue recognized in the accounting period in which it is earnedMatching PrincipleExpenses matched with revenues in the same period when efforts are expended to generate revenuesGAAP RELATIONSHIPS IN REVENUE & EXPENSE RECOGNITIONAdjusting entries are needed to ensure that revenue recognition and matching principles are followed1 Revenues are recorded in the period earned, and 2 Expenses are recognized in the period incurred.STUDY OBJECTIVE 3WHY ADJUSTING ENTRIES ARE NECESSARYSTUDY OBJECTIVE 4TYPES OF ADJUSTING ENTRIESAdjusting entries are required each time financial statements are prepared. Two main categories of adjustments are: PREPAYMENTSACCRUALSADJUSTING ENTRIES: PREPAYMENTSPrepaid ExpensesExpenses are paid and recorded as assets before they are used or consumedExample: Prepaid InsuranceUnearned RevenuesCash received and recorded as liabilities before revenue is earnedExample: Cash received for services provided in future ADJUSTING ENTRIES: ACCRUALSAccrued RevenuesRevenues earned but Not yet received In cash or recordedExample: Sales of merchandise On accountAccrued ExpensesExpenses incurred but not yet paid in cash or recordedExample: Utilities used but not yet paid forPIONEER ADVERTISING AGENCY Trial Balance October 31, 2006 Debit Credit Cash $ 15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable $ 5,000 Accounts Payable 2,500 Unearned Revenue 1,200 Common Stock Retained Earnings 10,000 0 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 $ 28,700 $ 28,700 The Trial Balance is the starting place for adjusting entries.TRIAL BALANCEAdjusting entries for prepayments are required to record the portion of the prepayment representing: 1 the expense incurred, or 2 the revenue earned in the current period.The adjusting entry results in a debit to an expense account and a credit to an asset account.STUDY OBJECTIVE 5ADJUSTING ENTRIES FOR PREPAYMENTSAdjusting EntriesAssetUnadjusted BalanceCredit Adjusting Entry (-)ExpenseDebit Adjusting Entry (+)Prepaid ExpensesLiabilityUnadjusted BalanceDebit Adjusting Entry (-)RevenueCredit Adjusting Entry (+)Unearned RevenuesADJUSTING ENTRIES FOR PREPAYMENTSAdvertising Supplies Expense Oct. 311,500Advertising SuppliesOct. 52,500 Oct. 311,500311,000Date Account Titles and Explanation Debit Credit Oct. 31 Advertising Supplies Expense 1,500 Advertising Supplies 1,500 (To record supplies used) JOURNAL ENTRYPOSTINGADJUSTMENTOctober 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand.ADJUSTING ENTRIES FOR PREPAYMENTSSUPPLIESInsurance Expense63 Oct. 3150Prepaid Insurance10Oct. 4600 Oct. 315031550DateAccount Titles and ExplanationDebitCreditOct. 31Insurance Expense50Prepaid Insurance50(To record insuranceexpired)JOURNAL ENTRYPOSTINGADJUSTMENTOctober 31, an analysis of the policy reveals that $50 of insurance expires each month.ADJUSTING ENTRIES FOR PREPAYMENTSINSURANCEREVIEW QUESTIONADJUSTING ENTRY-SUPPLIESThe trial balance shows supplies of $1,350 and suppliesexpense of $0. If $750 of supplies are on hand at the end of the period, what is the adjusting entry? $600 Supplies$600Supplies ExpenseCreditDebit AccountThe balance in supplies after adjustment is $750, the amount remain