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Lecture 4

Class Notes - WEEK 4 (Sept 30,31, Oct 2,3) - COMM 2AA3

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McMaster University
Aadil Merali Juma

LECTURE 4 COMM 2AA3 Chapter 4: Adjustments, Financial Statements and the Quality of Earnings September 30, 2013 Adjusting Entries  Accounting Cycle: Transaction Analysis – Journal Entries – Post to Ledger – Trial Balance – Adjustments  Conceptual Framework o Adjustments – end-of-year journal entries to update account balances o Going-concern and periodicity dictate that financial statements be prepared periodically o Faithful representation requires updating account balances  Accrual basis, not cash bases; with cash basis; there is no need to adjust entries  Timing differences between cash and performance; require the use of adjusting entries  Adjusting entries are prepared at the end of the accounting period so that accounting information will be faithfully represented  Adjusting entries are needed when we have transactions that span a period of time that includes the accounting period end o Long-term assets; recording depreciation expense is an adjusting entry o Eg/ in September, a university collects tuition for the academic year, which starts from Sep 1 through April 3. The accounting period for the university ends on Dec 31. The transaction spans the period September through April of the following year. The university must prepare an adjusting entry on Dec 31 to record the tuition revenue since September  Cash (Asset)  Unearned Revenue (Liability)  Sept 1 – Unearned Revenue because money collected but no service provided  Dec 31 – half of services provided; recognize that half of unearned revenue is now earned o Eg/ On October 1, 2010, a company pays one years rent in advance. Its accounting period ends on Dec 31. This transaction spans the period of Oct. 1, 2010 to Sept 30, 2011  Prepaid Expense (Asset)  Dec 31 – used property for 3 months; recognize expense for 3 months; prepaid expense decreases  Eg/ Need for Adjusting Entries o On March 1, 2013, a company pays $12,000 for one year’s rent Journal Entry: March 1, 2013 Prepaid Rent 12,000 Cash 12,000 o By December 31, 2013 – the firm occupied the property for 10 months; 2 months left of prepaid rent  Monthly rent = $12,000/12 = $1000  Rent Expense for 2013 = 1,000 x 10 = $10,000  Prepaid rent as of 12/31, 2013 = 1,000 x 2 = $2,000  But so far, prepaid rent has a balance of $12,000 and rent expense is not yet recorded o T-Accounts of prepaid rent and rent expense should have ending balances of $2,000 and $10,000 (respectively) o Adjusting Entry: 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 1. Prepayments (deferrals) – result when cash is received or paid before services are provided or received o Result when:  Cash advance is received to provide future services (unearned revenue)  Adjustment is made when revenue is earned (debit unearned revenue, credit revenue) 1 LECTURE 4 COMM 2AA3  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 special cases of prepayments o Eg 1/ On March 1, 2012, XYZ Co, purchased an insurance policy for one year, effective immediately. The premium of $2,400 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  Ending Prepaid Insurance (PI) = Beginning PI + Purchases of Insurance – Insurance Expense o Eg 2/ On March 1, 2013 XYZ buys office supplies for $3,000; On December 31, 2013, physical counts show supplies on hand of $1,200 o Eg 3/ On April 1, 2013 ABC purchased equipment that cost $80,000. The expected useful life is 4 years and the estimates salvage value at the end of its life is $20,000; the company uses Straight-Line depreciation method; the accounting period en
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