Accounting 1 Instructor Notes

Accounting 1 Instructor Notes CHAPTER THREE THE ADJUSTING PRINCIPLE Have you ever purchases season tickets, for example to Music Theater of WSU's Basketball games? Have you ever paid in advance for a magazine subscription? Or have you ever purchased concert tickets in advance? Sometimes revenues are earned and expenses occurred at the time of the sale. But in the examples i just mentioned above, you have paid for something in advanced, and therefore the revenue has not been earned yet. The amount of ticket sales should be recorded as revenue earned when the concert takes place, not when the cash is received. What happens if the concert does not take place? I would want my money back! As we learned in chapter 2, that money received in advanced by a company for future revenues is recorded as an unearned. It is then adjusted to become a revenue once it is earned (for example the concert takes place). There are sometimes when cash is received not as a revenue but as a deposit and always remains as a liability. For example, our homeowner's association requires a $50 pool key deposit which an owner can get back if they return the key (maybe they are moving or just don't use the pool). This will always show as an liability. There are five groups of adjusting entry types, we will talk about each group and show the entry to adjust the required accounts. Adjusting entries may be done monthly, quarterly, yearly, but should be done right before the financial statements are prepared. Revenues and expenses may be reported on the income statement by 1. Cash basis -- Revenues are reported when cash is actually received and expenses are actually paid in cash. Ok for a smaller business. 2. Accrual basis -- Usually used. Revenue and expenses are recorded when they are incurred. This may or may not be when they actually receive the cash. Accrual basis requires the use of adjusting entries at the end of the accounting period to match the revenues and expenses so they are reported in the same period (so the Revenue along with the expenses is reported on the same financial Statements for the month, quarter, or year). Prepaid expenses, land, equipment and buildings are recorded at cost, however, some use or depreciation of the asset may occur, requiring an adjustment. When no adjustment is made 1. Asset accounts are overstated because asset goes done in value. 2. Expense accounts are understated because depreciation is an expense. So to record these transactions, accountants use adjusting entries. NATURE OF ADJUSTING PROCESS Journal entries at end of accounting period to bring accounts up to date and to properly match revenue to expenses are adjusting entries. Affect at least one Income statement account and one Balance sheet account. A. Deferrals Record transactions in a way that defers the recognition of an expense or revenue. These transactions have been previously recorded (not necessarily paid in cash, it could have been on account) (1) Deferred Expenses Item's previously recorded as assets and will become expenses (Supplies, prepaid expenses). You want to record the amount used (or with insurance it might say expired), NOT unused or on hand (or with insurance not the unexpired). Supplies Balance 2,000 Supplies on hand - 760 Supplied Used 1,240 Adjusting Entry: Supplies Expense 1,240 Supplies 1,240 If this entry is not done, Supplies (assets) would be overstated by 1,240 (affecting the balance sheet) and Expenses would be understated by 1,240 (affecting net income to be larger than it really is). Prepaid insurance balance 2,400 Insurance Expired - 100 Ending Balance 2,300 Adjusting Entry: Insurance Expense 100 Prepaid Insurance 100 (2) Deferred Revenues Initially recorded as liability (unearned), but are expected to become revenues. Magazine subscriptions paid to you in advanced, rent paid to you in advanced would all be previously recorded as an Liability (Debit to unearned subscriptions or unearned rent and credit to cash). We are renting a building to another company for 120 per month. They paid us three months in advanced. Initial recording: Cash 360 Unearned Rent 360 After one Month: Unearned Rent Balance (liability) 360 Rent Income for month -120 Ending Balance 240 Adjusting Entry (after you earn one month of rent): Unearned Rent 120 Rent Revenue 120 B. Accruals (1) Accrued Expenses (Accrued Liability) Expenses that accrued but have not been recorded (wages, interest on loan). Wages of 250 dollars have accrued for the month that have not been paid yet. Adjusting entry: Wages Expense 250 Wages Payable 250 (2) Accrued Revenues Revenues that have accrued but not yet recorded (fees earned maybe by an attorney or real estate agents who have agreed to not actually bill the customer maybe until their job is done). You basically pretend like you are billing the customer for the Fees or Revenue. You have performed 500 worth of services that you will not bill or collect until next month AR 500 Fees Eared 500 REMEMBER: Deferrals have been pre-recorded while accruals have not. PLANT ASSETS (Depreciation) For plant assets there is a separate account set up to record the depreciation, or decrease in value of an asset, called a contra account. We will call this account Accumulated depreciation (contra account because it is "offset" against that account). Since it is a Contra Asset, instead of having a normal debit balance like most asset accounts, it will have a credit balance. Land -- not normally depreciated Buildings ---------Accumulated Dep. Buildings Equipment----------Accumulated Dep. Equipment Office equipment with a value of 1,800 is depreciated by $50 for the month. The balance in Office equipment stays the same. The entry to adjust is: Depreciation Expense 50 Accumulated Dep. Office Equip 50 Book Value is 1,750 (1,800 less 50) BALANCE SHEET Sample Balance Sheet Follow this format when putting together a Balance Sheet. Notice there is more than one “Property, Plant, and Equipment” asset with each having it’s own accumulated depreciation following it. You then subtract to show “Book Value” in the middle column. Any Company Balance Sheet Dec. 31, 2001 Assets: Current Assets Cash $100,000 AR 50,000 Supplies 5,000 Total Current Assets $155,000 Prop. Plant and Equip . Land 20,000 Equip. $70,000 Less Accum. Dep. 5,000 65,000 Auto 10,000 Less Accum. Dep. 4,000 6,000 Total Prop. Plant & Equip. 91,000 Total Assets $246,000 ========= Liabilites: Current Liabilites AP $10,000 Wages Payable 5,000 Notes Payable (current) 1,000 Total Current Liab. $16,000 Long Term Liabilities Notes Payable 6,000 Mortgage Payable 144,000 Total Long Term Liab. 150,000 Total Liabilities 166,000 Owner’s Equity Smith, Capital 80,000 Total Liab. & Owner’s Equity $246,000 ========= Summary of Adjusting Entries: Matching Principle – to match expenses in the same financial statement period as the revenue. 1. Deferred Expenses – Previously recorded as an Asset a. Supplies Expense Supplies b. Rent Expense Prepaid Rent c. Insurance Expenses Prepaid Insurance 2. Deferred Revenue – Previously recorded as a Liability (Unearned) a. Unearned Rent Rent Revenue 3. Accrued Expense – Not previously recorded a. Wages Expense Wages Payable 4. Accrued Revenue – Not previously recorded. Earned but not billed. a. AR Fees Earned 5, Depreciation a. Depreciation Expense Accumulated depreciation .

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