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Lecture 7

COMMERCE 1AA3 Lecture Notes - Lecture 7: Deferral, Accrual, Faithful Representation


Department
Commerce
Course Code
COMMERCE 1AA3
Professor
Aadil Merali Juma
Lecture
7

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Saturday, September 16, 2017
Areej Raza
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Chapter 3- Accrual Accounting and the Financial Statements
Adjustments and the Conceptual Framework
Adjustments are end-of-year journal entries to update account balances
Going concern principle and periodicity dictate that financial statements be prepared
periodically
Faithful representation requires updating account balances therefore HAVE TO DO
ADJUSTMENT ENTRIES.
Why Adjusting Entries?
Accrual basis, not cash basis
o With cash basis, there is no need for adjusting entries
Cash basis accounting- record only business transactions involving the receipt or
payment of cash. All other business transactions are ignored. Cash basis
accounting is not permitted by IFRS or ASPE, both of which provide extensive
guidance on how to apply the accrual basis of accounting to prepare financial
statements that present a relevant and faithful representation of a company’s
business activities.
Accrual accounting- the receipt or payment of cash is irrelevant to deciding
whether a business transaction should be recorded. What matters is whether the
business has acquired an asset, earned revenue, taken on a liability, or incurred
an expense. This also includes deferrals and accruals.
Timing differences between cash and performance
Long-term assets
The Need for Adjusting Entries: An Example
On March 1, 2013 a company pays $12000 for one year’s rent.
Journal Entry:
By December 31, 2013, the firm would have occupied the property for 10 months. Also, there
are only two months left in Prepaid Rent:
Monthly Rent = 12,000/12 = $1000
o Rent Expense for 2013 = 1000 x 10 = #10,000
o Prepaid rent as of 12/31/2013 = 1000 x 2 = $2000
But so far, prepaid rent has a balance of $12,000 and rent expense is not recorded yet
T-accounts of prepaid rent and rent expense should have ending balances of $2000 and
$10,000, respectively

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Thus, the adjusting entry would be:
12/31/2013
Rent expense 10,000
Prepaid rent 10,000
Types of Adjusting Entries
Timing differences between cash and performance give rise to the need for adjusting entries
o Prepayments (deferrals): result when cash is received or paid before services are
provided or received
o Accruals: results when services are provided or received before cash is received or paid
Prepayments (Deferrals)
Result when:
o Cash advance is received to provide future services (unearned revenue)
Adjustment is made when revenue is earned
o Cash advance is paid to receive future services (prepaid expenses)
Adjustment is made when the services are received
Amortizing long term assets and expensing supplies are a special case of
prepayments
Prepayments- Example 1
On March 1, 2012, XYZ Co. purchased an insurance policy for one year effective immediately.
The premium of $2400 is paid in advance. The accounting period is 12 months, ending
December 31 of each year. 2012 is the first year of operation for XYZ.
In March 1, 2013 XYZ renewed the insurance policy. The new premium of $3000 is paid in
advance.
Solution:
Prepayments- Example 2
On March 1, 2013 XYZ buys office supplies for $3000. On December 31, 2013 physical counts
shows supplies on hand of $1200.
Solution:

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Prepayments- Example 3
On April 1, 2013 ABC purchased equipment that cost $80000. The expected useful life is 4 years
and the estimated salvage value at the end of its life is $20,000. The company uses Straight-Line
depreciation method. The accounting period ends Dec. 31 each year.
Solution:
Prepayments- Example 4
On June 1, 2013 ABC Publishers Inc., receives $36,000 in newspaper subscriptions for the
next year, effective August 1, 2013. Prepare the adjusting entry as of December 31, 2013.
Solution:
Accruals
Accrued expenses (unrecorded expenses): Expenses incurred but not yet paid in cash or
recorded until the end of period
Accrued revenues (unrecorded revenues): Revenues earned during the period but not yet
received in cash or recorded until the end of period
Accruals- Example 1
ABC’s 5 day weekly payroll was $6000, and the year ended on a Wednesday. ABC pays and
records wages each Friday. Prepare the adjusting entry as of fiscal year end.
Solution:
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