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Lecture

Week4_LectureNotes_2013.pdf

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Department
Commerce
Course
COMMERCE 1BA3
Professor
Teal Mc Ateer
Semester
Summer

Description
ADJUSTING ENTRIES The next step in the accounting cycle after the trial balance is the adjusting entries. These entries are prepared at the end of the accounting period to bring all accounts balances up to date on an accrual accounting basis so that financial statements can be prepared   W HY D O WE NEED TO PERFOM A DJUSTING E NTRIES ? You learned in the last chapter that accounting records are prepared under the Accrual Basis, which requires the adherence to the revenue recognition principle and the matching principle. Adjusting entries are necessary to achieve appropriate matching of revenues and expenses in determining net income for a period and to obtain a faithfully representative balance sheet at the end of the period. Effectively, the adjusting entries assign revenues to the period in which they are earned, expenses to the period in which they are incurred, and update the asset and liability  ounts.   M AJOR T YPES OF A DJUSTING E NTRIES There is no need for adjusting entries under the cash basis. Also, there is no need for adjusting entries if ALL the transactions were in cash, and the firm did not have long-term assets or long- term liabilities. Obviously, it is nearly impossible in the current business environment to find a business that conducts all its transactions in cash and/or does not have any long-term assets or long- term liabilities. Therefore, ALL businesses need to prepare adjusting entries.   The need for adjusting entries arises from the timing differences between cash and performance. Therefore, adjusting entries can be classified into two major groups: 1. Prepayments: cash is received before the firm provides services, or cash is paid before the firm receives services. 2. Accruals: the firm provides services before receiving cash, or receives services before paying cash.   P REPAYMENTS Prepayments fall into two categories: prepaid expenses and unearned revenues.   1. P REPAID EXPENSES: Refer to expenses for which cash was paid in advance. These payments are recorded as an asset called prepaid expenses. Subsequently, when the firm receives the services, the prepaid expenses will expire. Prepaid expenses expire either with the passage of time (e.g., rent and insurance), or as they are consumed (e.g., supplies).   The adjusting entry for prepaid expenses involves an asset account and an expense account, and usually requires a debit to an expense and a credit to an asset. Omitting the adjusting entry for a prepaid expense results in an understatement of total expenses, an overstatement of net income for the period, an overstatement of owners’ equity, and an overstatement of total assets.   Example 1 On March 1, 2009 XYZ Co. paid $1,800 to purchase an insurance policy that provides   insurance coverage for one year, effective immediately. On March 1, 2010, XYZ Co. renewed the insurance policy for one year, effective immediately. The new premium of $2,400 is paid in full. The accounting period is 12 months ending December 31 of each year. 2009 is the first year of operations for XYZ.   Journal entry on March 1, 2009 Dr. Prepaid Insurance 1,800 Cr. Cash 1,800 Adjusting entry on December 31, 2009 Insurance expense for 2009 = (1,800/12) x 10 = $1,500 The adjusting entry is Dr. Insurance Expense 1,500 Cr. Prepaid Insurance 1,500 The balance in prepaid insurance after the adjusting entry is $300. It can be calculated in two ways: One: Use the following equation Ending prepaid insurance = beginning prepaid insurance + purchase of insurance – insurance expense Ending prepaid insurance = 0 + 1,800 – 1,500 = $300 Two: Use the T-Account for prepaid insurance as follows: Dr. Prepaid Insurance Cr. March 1 1,800 December 31 1,500 Ending Balance 300 Journal entry on March 1, 2010 Dr. Prepaid Insurance 2,400 Cr. Cash 2,400 Adjusting entry on December 31, 2010 Insurance expense for 2010 = 300 + (2,400 /12) x 10 = $2,300 The adjusting entry is: Dr. Insurance Expense 2,300 Cr. Prepaid Insurance 2,300 The balance in prepaid insurance after the adjusting entry is $400. It can be calculated in two ways:   One: Use the following equation Ending prepaid insurance = beginning prepaid insurance + purchase of insurance – insurance expense Ending prepaid insurance = 300 + 2,400 – 2,300 = $400 Two: Use the T-Account for prepaid insurance as follows: Dr. Prepaid Insurance Cr. Beg. Balance 300 December 31 2,300 March 1 2,400 Ending Balance 300   If the accountant omits recording the adjusting entry, then – Expenses will be understated by $2,300 because insurance expense is not recorded – Net income will be overstated by $2,300 because expenses are understated – Owners’ equity will be overstated because income is overstated – Total assets will be overstated because prepaid expenses will be overstated Notice that the accounting equation is still balance despite the omission of a required journal entry!   Example 2: On January 1, 2010 the balance in supplies was $600. On May 11, 2010 the company purchased office supplies of $1,000. On December 31, 2010 a physical count of supplies show a supplies balance on hand of $400. Prepare the adjusting entry on December 31, 2010.   To calculate the supplies expense for 2010, apply the following equation Ending supplies = Beginning supplies + Supplies purchases – Supplies expense 400 = 600 + 1,000 – Supplies expense à Supplies expense = $1,200 The adjusting entry is: Dr. Supplies Expense 1,200 Cr. Supplies 1,200   Alternatively, you can calculate office supplies expense using the T-account as follows: Dr. Office Supplies Cr. Beg. Balance 600 December 31 1,200 May 11 1,000 Ending Balance 400   2. U NEARNED REVENUES : Refer to cash received from customers in advance for goods or services to be delivered in the future. By accepting the cash payment, the firm commits itself to providing the goods or services in the future. That commitment gives rise to a liability called unearned revenues. The company will absolve itself of the liability by providing the services. The adjusting entry for unearned revenues will reduce the liability and recognize the revenue. Omitting the adjusting entry for unearned revenues will result in understatement of total revenues, understatement of net income for the period, understatement of owners’ equity, and overstatement of total Liabilities.   Example: ABC received $600 on December 1, 2010 for services to be rendered in December, January, and February. The journal entry for this transaction is Dr. Cash 600 Cr. Unearned Revenue 600 To record the adjusting entry on December 31, 2010, you must calculate the revenue earned for 2010. Revenue for 2010 = 600 / 3 x 1 = $200 The adjusting entry is: Dr. Unearned Revenues 200 Cr. Revenue 200 The balance in unearned revenue at the end of 2010 is $400. It can be calculated either using the following equation: Ending unearned revenue = beginning unearned revenue + advance cash received – revenue Ending unearned revenue = 0 + 600 – 200 = 400 You can also calculate the same amount using the T-account as follows: Dr. Unearned Revenue Cr. December 31 200 December 1 600 Ending Balance 400   A CCRUALS Accruals fall into two categories: Accrued Expenses and Accrued Revenues   1. A CCRUED E XPENSES (Unrecorded expenses) – Refer to expenses incurred (i.e., resources or benefits that are consumed or used up during the period) but not yet paid in cash or recorded until the end of period. The adjusting entry for accrued expenses involves an expense account and a liability account. All adjusting entries for accrued expenses involve a debit to an expense (because a resource has been used or the benefits of the service has been received) and a credit to a liability (because the expense has not yet been paid or recorded by the end of the period). Omitting the adjusting entry for accrued expense will result in understatement of total expenses, overstatement of net income for the period, overstatement of owners’ equity, and understatement of total liabilities.   Example: ABC’s 5-day weekly payroll is $6,000, and the year ended on a Wednesday. ABC pays and records wages each Friday. To prepare the adjusting entries, we need to calculate the salaries expense from the last time salaries were paid to the fiscal year end. In this case, it is the salaries of Monday, Tuesday, and Wednesday.   Salaries expense = 6,000 / 5 x 3 = $3,600 And the adjusting entry is: Dr. Salaries Expense 3,600 Cr. Salaries Payable 3,600   Salaries payable is credited because ABC owes $3,600 to its employees as of the fiscal year end.   2. A CCRUED REVENUES (unrecorded revenues) - Refer to revenues earned during the period (because goods or services have been delivered), but not yet received in cash or recorded until the end of period. The adjusting entries for accrued revenues involve a debit to a receivable (because cash has not yet been received) and a credit to a revenue (because the revenue has been earned). Omitting the adjusting entry for accrued revenue will result in understatement of revenues, understatement of net income for the period, understatement of owners’ equity, and understatement of total assets.   Example: On September 1, 2010, ABC put $10,000 in a saving account for one year. The interest rate is 12% payable every six months. Preparing the adjusting entry on December 31, 2010 requires the calculation of interest revenue for 2010.   Interest revenue for 2010 = 10,000 x 12% x 4/12 = $400   Dr. Interest Receivable 400 Cr. Interest Revenue 400
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