The Adjusting Process

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1 Chapter 03.qxd 5/21/08 7:07 PM Page 99 C H A P T E R 3 AP Photo/Jeff Kravitz Fo r Sa le The Adjusting Process M A R V E L D E N T E R T A I N M E N T, N ot o you subscribe to any magazines? Most of us subscribe to one or more magazines such as Cosmopolitan, Sports Illustrated, Golf Digest, Newsweek, or Rolling Stone. Magazines usually require you to prepay the yearly subscription price before you receive any issues. When should the magazine company record revenue from the subscriptions? As we discussed in Chapter 2, sometimes revenues are earned and expenses are incurred at the point cash is received or paid. For transactions such as magazine subscriptions, the revenue is earned when the magazine is delivered, not when the cash is received. Most companies are required to account for revenues and expenses when the benefit is substantially provided or consumed, which may not be when cash is received or paid. One company that records revenue from subscriptions is Marvel Entertainment, Inc. Marvel began in 1939 as a I N C. comic book publishing company, establishing such popular comic book characters as Spider-Man, X-Men, Fantastic Four, and the Avengers. From these humble beginnings, Marvel has grown into a full-line, multi-billion-dollar entertainment company. Marvel not only publishes comic books, but it has also added feature films, such as the Spider-Man movies, video games, and toys to its product offerings. Most companies, like Marvel Entertainment, are required to update their accounting records for items such as revenues earned from magazine subscriptions before preparing their financial statements. In this chapter, we describe and illustrate this updating process.

2 Chapter 03.qxd 5/21/08 7:08 PM Page Chapter 3 The Adjusting Process After studying this chapter, you should be able to: 1 Describe the nature of the adjusting process Journalize entries for accounts requiring adjustment. Summarize the adjustment process. Prepare an adjusted trial balance. Nature of the Adjusting Process The Adjusting Process EE 3-1 (page 101) Types of Accounts Requiring Adjustment EE 3-2 (page 104) 1 Describe the nature of the adjusting process. American Airlines uses the accrual basis of accounting. Revenues are recognized when passengers take flights, not when the passenger makes the reservation or pays for the ticket. Recording Adjusting Entries Prepaid Expenses EE 3-3 (page 107) Unearned Revenues EE 3-4 (page 108) Accrued Revenues EE 3-5 (page 109) Accrued Expenses EE 3-6 (page 111) Depreciation Expense EE 3-7 (page 113) Summary of Adjustment Process EE 3-8 (page 113) Adjusted Trial Balance EE 3-9 (page 119) At a Glance Menu Turn to pg 121 Nature of the Adjusting Process When preparing financial statements, the economic life of the business is divided into time periods. This accounting period concept requires that revenues and expenses be reported in the proper period. To determine the proper period, accountants use generally accepted accounting principles (GAAP). The use of the accrual basis of accounting is required by GAAP. Under the accrual basis of accounting, revenues are reported in the income statement in the period in which they are earned. For example, revenue is reported when the services are provided to customers. Cash may or may not be received from customers during this period. The accounting concept supporting this reporting of revenues is called the revenue recognition concept. Under the accrual basis, expenses are reported in the same period as the revenues to which they relate. For example, utility expenses incurred in December are reported as an expense and matched against December s revenues even though the utility bill may not be paid until January. The accounting concept supporting reporting revenues and related expenses in the same period is called the matching concept, or matching principle. By matching revenues and expenses, net income or loss for the period is properly reported on the income statement. Although GAAP requires the accrual basis of accounting, some businesses use the cash basis of accounting. Under the cash basis of accounting, revenues and expenses are

3 Chapter 03.qxd 5/21/08 7:08 PM Page 101 Chapter 3 The Adjusting Process 101 The matching concept supports reporting revenues and related expenses in the same period. Example Exercise 3-1 reported in the income statement in the period in which cash is received or paid. For example, fees are recorded when cash is received from clients; likewise, wages are recorded when cash is paid to employees. The net income (or net loss) is the difference between the cash receipts (revenues) and the cash payments (expenses). Small service businesses may use the cash basis, because The Adjusting Process they have few receivables and payables. For example, attorneys, physicians, and real estate agents often use the cash basis. For them, the cash basis provides financial statements similar to those of the accrual basis. For most large businesses, however, the cash basis will not provide accurate financial statements for user needs. For this reason, we use the accrual basis in this text. At the end of the accounting period, many of the account balances in the ledger can be reported in the financial statements without change. For example, the balances of the cash and land accounts are normally the amount reported on the balance sheet. Under the accrual basis, however, some accounts in the ledger require updating. 1 This updating is required for the following reasons: 1. Some expenses are not recorded daily. For example, the daily use of supplies would require many entries with small amounts. Also, managers usually do not need to know the amount of supplies on hand on a day-to-day basis. 2. Some revenues and expenses are incurred as time passes rather than as separate transactions. For example, rent received in advance (unearned rent) expires and becomes revenue with the passage of time. Likewise, prepaid insurance expires and becomes an expense with the passage of time. 3. Some revenues and expenses may be unrecorded. For example, a company may have provided services to customers that it has not billed or recorded at the end of the accounting period. Likewise, a company may not pay its employees until the next accounting period even though the employees have earned their wages in the current period. All adjusting entries affect at least one income statement account and one balance sheet account. The analysis and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process. The journal entries that bring the accounts up to date at the end of the accounting period are called adjusting entries. All adjusting entries affect at least one income statement account and one balance sheet account. Thus, an adjusting entry will always involve a revenue or an expense account and an asset or a liability account. Accounts Requiring Adjustment Indicate with a Yes or No whether or not each of the following accounts normally requires an adjusting entry. a. Cash c. Wages Expense e. Accounts Receivable b. Prepaid Rent d. Office Equipment f. Unearned Rent Follow My Example 3-1 a. No c. Yes e. Yes b. Yes d. No f. Yes 1 For Practice: PE 3-1A, PE 3-1B 1 Under the cash basis of accounting, accounts do not require adjusting. This is because transactions are recorded only when cash is received or paid. Thus, the matching concept is not used under the cash basis.

4 Chapter 03.qxd 5/21/08 7:08 PM Page Chapter 3 The Adjusting Process Types of Accounts Requiring Adjustment Four basic types of accounts require adjusting entries as shown below. 1. Prepaid expenses 3. Accrued revenues 2. Unearned revenues 4. Accrued expenses Prepaid expenses are the advance payment of future expenses and are recorded as assets when cash is paid. Prepaid expenses become expenses over time or during normal operations. To illustrate, the following transaction of NetSolutions from Chapter 2 is used. Dec. 1 NetSolutions paid $2,400 as a premium on a one-year insurance policy. The tuition you pay at the beginning of each term is an example of a prepaid expense to you, as a student. Exhibit 1 On December 1, the cash payment of $2,400 was recorded as a debit to Prepaid Insurance and credit to Cash for $2,400. At the end of December, only $200 ($2,400 divided by 12 months) of the insurance premium is expired and has become an expense. The remaining $2,200 of prepaid insurance will become an expense in future months. Thus, the $200 is insurance expense of December and should be recorded with an adjusting entry. Other examples of prepaid expenses include supplies, prepaid advertising, and prepaid interest. Unearned revenues are the advance receipt of future revenues and are recorded as liabilities when cash is received. Unearned revenues become earned revenues over time or during normal operations. To illustrate, we use the following December 1 transaction of NetSolutions. Dec. 1 NetSolutions received $360from a local retailer to rent land for three months. On December 1, the cash receipt of $360 was recorded as a debit to Cash and a credit to Unearned Rent for $360. At the end of December, $120 ($360 divided by 3 months) of the unearned rent has been earned. The remaining $240 will become rent revenue in future months. Thus, the $120 is rent revenue of December and should be recorded with an adjusting entry. Other examples of unearned revenues include tuition received in advance by a school, an annual retainer fee received by an attorney, premiums received in advance by an insurance company, and magazine subscriptions received in advance by a publisher. Exhibit 1 illustrates the nature of prepaid expenses and unearned revenues. Type of Adjustments: Prepaid Expenses and Unearned Revenues

5 Chapter 03.qxd 5/21/08 7:08 PM Page 103 Chapter 3 The Adjusting Process 103 Exhibit 2 Accrued revenues are unrecorded revenues that have been earned and for which cash has yet to be received. Fees for services that an attorney or a doctor has provided but not yet billed are accrued revenues. To illustrate, we use the following example involving NetSolutions and one of its customers. Dec. 15 NetSolutions signed an agreement with Dankner Co. on December 15 under which NetSolutions will bill Dankner Co. on the fifteenth of each month for services rendered at the rate of $20 per hour. From December 16, NetSolutions provided 25 hours of service to Dankner Co. Although the revenue of $500 (25 hours $20) has been earned, it will not be billed until January 15. Likewise, cash of $500 will not be received until Dankner pays its bill. Thus, the $500 of accrued revenue and the $500 of fees earned should be recorded with an adjusting entry on December. Other examples of accrued revenues include accrued interest on notes receivable and accrued rent on property rented to others. Accrued expenses are unrecorded expenses that have been incurred and for which cash has yet to be paid. Wages owed to employees at the end of a period but not yet paid is an accrued expense. To illustrate, the following example involving NetSolutions and its employees is used: Dec. Type of Adjustments: Accrued Revenues and Expenses NetSolutions owes its employees wages of $250 for Monday and Tuesday, December 30 and. NetSolutions paid wages of $950 on December 13 and $1,200 on December 27,. These payments covered the biweekly pay periods that ended on those days. As of December,, NetSolutions owes its employees wages of $250 for Monday and Tuesday, December 30 and. The wages of $250 will be paid on January 10, 2010, however, they are an expense of December. Thus, $250 of accrued wages should be recorded with an adjusting entry on December. Other examples of accrued expenses include accrued interest on notes payable and accrued taxes. As illustrated above, accrued revenues are earned revenues that are unrecorded. The cash receipts for accrued revenues are normally received in the next accounting period. Accrued expenses are expenses that have been incurred, but are unrecorded. The cash payments for accrued expenses are normally paid in the next accounting period. Exhibit 2 illustrates the nature of accrued revenues and accrued expenses.

6 Chapter 03.qxd 5/21/08 7:08 PM Page Chapter 3 The Adjusting Process Prepaid expenses and unearned revenues are sometimes referred to as deferrals. This is because the recording of the related expense or revenue is deferred to a future period. Accrued revenues and accrued expenses are sometimes referred to as accruals. This is because the related revenue or expense should be recorded or accrued in the current period. Example Exercise 3-2 Type of Adjustment 1 Classify the following items as (1) prepaid expense, (2) unearned revenue, (3) accrued expense, or (4) accrued revenue. a. Wages owed but not yet paid. c. Fees received but not yet earned. b. Supplies on hand. d. Fees earned but not yet received. 1 Follow My Example 3-2 a. Accrued expense c. Unearned revenue b. Prepaid expense d. Accrued revenue 2 Journalize entries for accounts requiring adjustment. Exhibit 3 Unadjusted Trial Balance for NetSolutions Recording Adjusting Entries For Practice: PE 3-2A, PE 3-2B To illustrate adjusting entries, we use the December,, unadjusted trial balance of NetSolutions shown in Exhibit 3. An expanded chart of accounts for NetSolutions is shown in Exhibit 4. The additional accounts used in this chapter are shown in color. The rules of debit and credit shown in Exhibit 3 of Chapter 2 are used to record the adjusting entries. Cash Accounts Receivable Supplies Prepaid Insurance Land Office Equipment Accounts Payable Unearned Rent Chris Clark, Capital Chris Clark, Drawing Fees Earned Wages Expense Rent Expense Utilities Expense Supplies Expense Miscellaneous Expense NetSolutions Unadjusted Trial Balance December, Debit Balances 2,065 2,220 2,000 2,400 20,000 1,800 4,000 4,275 1, ,600 Credit Balances ,000 16,340 42,600

7 Chapter 03.qxd 5/21/08 7:08 PM Page 105 Chapter 3 The Adjusting Process 105 Exhibit 4 Expanded Chart of Accounts for NetSolutions Balance Sheet Accounts Prepaid Expenses Income Statement Accounts 1. Assets 4. Revenue 11 Cash 41 Fees Earned 12 Accounts Receivable 42 Rent Revenue 14 Supplies 5. Expenses 15 Prepaid Insurance 51 Wages Expense 17 Land 52 Rent Expense 18 Office Equipment 53 Depreciation Expense 19 Accumulated Depreciation Office Equipment 54 Utilities Expense 2. Liabilities 55 Supplies Expense 21 Accounts Payable 56 Insurance Expense 22 Wages Payable 59 Miscellaneous Expense 23 Unearned Rent 3. Owner s Equity Chris Clark, Capital 32 Chris Clark, Drawing The balance in NetSolutions supplies account on December is $2,000. Some of these supplies (CDs, paper, envelopes, etc.) were used during December, and some are still on hand (not used). If either amount is known, the other can be determined. It is normally easier to determine the cost of the supplies on hand at the end of the month than to record daily supplies used. Assuming that on December the amount of supplies on hand is $760, the amount to be transferred from the asset account to the expense account is $1,240, computed as follows: Supplies available during December (balance of account) $2,000 Supplies on hand, December 760 Supplies used (amount of adjustment) $1,240 At the end of December, the supplies expense account should be increased (debited) for $1,240, and the supplies account should be decreased (credited) for $1,240 to record the supplies used during December. The adjusting journal entry and T accounts for Supplies and Supplies Expense are as follows: Dec. Supplies Expense Supplies Description Supplies used ($2,000 $760). Journal Page 5 Ref. Debit Credit ,240 1,240 Supplies Bal. 2,000 Dec. 1,240 Bal. 800 Adj. Bal. 760 Dec. 1,240 Adj. Bal. 2,040 Supplies Expense The adjusting entry is shown in color in the T accounts to separate it from other transactions. After the adjusting entry is recorded and posted, the supplies account has a debit balance of $760. This balance is an asset that will become an expense in a future period.

8 Chapter 03.qxd 5/21/08 7:08 PM Page Chapter 3 The Adjusting Process The debit balance of $2,400 in NetSolutions prepaid insurance account represents a December 1 prepayment of insurance for 12 months. At the end of December, the insurance expense account should be increased (debited), and the prepaid insurance account should be decreased (credited) by $200, the insurance for one month. The adjusting journal entry and T accounts for Prepaid Insurance and Insurance Expense are as follows: Insurance Expense 56 Prepaid Insurance 15 Insurance expired ($2,400/12) The adjusted balance of a prepaid expense is an asset that will become an expense in a future period. Prepaid Insurance Bal. 2,400 Dec. 200 Dec. 200 Adj. Bal. 2,200 Insurance Expense After the adjusting entry is recorded and posted, the prepaid insurance account has a debit balance of $2,200. This balance is an asset that will become an expense in future periods. The insurance expense account has a debit balance of $200, which is an expense of the current period. What is the effect of omitting adjusting entries? If the preceding adjustments for supplies ($1,240) and insurance ($200) are not recorded, the financial statements prepared as of December will be misstated. On the income statement, Supplies Expense and Insurance Expense will be understated by a total of $1,440 ($1,240 + $200), and net income will be overstated by $1,440. On the balance sheet, Supplies and Prepaid Insurance will be overstated by a total of $1,440. Since net income increases owner s equity, Chris Clark, Capital will also be overstated by $1,440 on the balance sheet. The effects of omitting these adjusting entries on the income statement and balance sheet are as follows: Amount of Misstatement Income Statement Revenues correctly stated $ XXX Expenses understated by (1,440) Net income overstated by (1) $ 1,440 Balance Sheet Assets overstated by $ 1,440 Liabilities correctly stated $ XXX Owner s equity overstated by 1,440 Total liabilities and owner s equity overstated by $ 1,440 Arrow (1) indicates the effect of the understated expenses on assets. Arrow (2) indicates the effect of the overstated net income on owner s equity. (2) FREE ISSUE Office supplies are often available to employees on a free issue basis. This means that employees do not have to sign for the release of office supplies but merely obtain the necessary supplies from a local storage area as needed. Just because supplies are easily available, however, doesn t mean they can be taken for personal use. There are many instances where employees have been terminated for taking supplies home for personal use.

9 Chapter 03.qxd 5/21/08 7:08 PM Page 107 Chapter 3 The Adjusting Process 107 Payments for prepaid expenses are sometimes made at the beginning of the period in which they will be entirely used or consumed. To illustrate, we use the following December 1 transaction of NetSolutions: Dec. 1 NetSolutions paid rent of $800 for the month. Example Exercise 3-3 Adjustment for Prepaid Expense The prepaid insurance account had a beginning balance of $6,400 and was debited for $3,600 of premiums paid during the year. Journalize the adjusting entry required at the end of the year assuming the amount of unexpired insurance related to future periods is $3,250. Follow My Example 3-3 Best Buy sells extended warranty contracts with terms between 12 and 36 months. The receipts from sales of these contracts are reported as unearned revenue on Best Buy s balance sheet. Revenue is recorded as the contracts expire. On December 1, the rent payment of $800 represents Prepaid Rent. However, the Prepaid Rent expires daily, and at the end of December there will be no asset left. In such cases, the payment of $800 is recorded as Rent Expense rather than as Prepaid Rent. In this way, no adjusting entry is needed at the end of the period. 2 Insurance Expense ,750 Prepaid Insurance ,750 Insurance expired ($6,400 $3,600 $3,250). Unearned Revenues For Practice: PE 3-3A, PE 3-3B The December unadjusted trial balance of NetSolutions indicates a balance in the unearned rent account of $360. This balance represents the receipt of three months rent on December 1 for December, January, and February. At the end of December, one month s rent has been earned. Thus, the unearned rent account should be decreased (debited) by $120, and the rent revenue account should be increased (credited) by $120. The $120 represents the rental revenue for one month ($360/3). The adjusting journal entry and T accounts are shown below. Unearned Rent 23 Rent Revenue 42 Rent earned ($360/3 months). Unearned Rent 2 An alternative treatment of recording the cost of supplies, rent, and other prepayments of expenses is discussed in an appendix that can be downloaded from the book s companion Web site (academic.cengage.com/accounting/warren) 3 An alternative treatment of recording revenues received in advance of their being earned is discussed in an appendix that can be downloaded from the book s companion Web site (academic.cengage.com/accounting/warren). 120 Rent Revenue Dec. 120 Bal. 360 Dec. 120 Adj. Bal. 240 After the adjusting entry is recorded and posted, the unearned rent account has a credit balance of $240. This balance is a liability that will become revenue in a future period. Rent Revenue has a balance of $120, which is revenue of the current period. 3 If the preceding adjustment of unearned rent and rent revenue is not recorded, the financial statements prepared on December will be misstated. On the income statement, Rent Revenue and the net income will be understated by $120. On the balance sheet, Unearned Rent will be overstated by $120, and Chris Clark, Capital will be understated by $120. The effects of omitting this adjusting entry are shown at the top of the next page

10 Chapter 03.qxd 5/21/08 7:08 PM Page Chapter 3 The Adjusting Process Amount of Misstatement Income Statement Revenues understated by $(120) Expenses correctly stated XXX Net income understated by $(120) Balance Sheet Assets correctly stated $XXX Example Exercise 3-4 Liabilities overstated by $ 120 Owner s equity understated by (120) Total liabilities and owner s equity correctly stated $XXX Adjustment for Unearned Revenue The balance in the unearned fees account, before adjustment at the end of the year, is $44,900. Journalize the adjusting entry required if the amount of unearned fees at the end of the year is $22,300. Follow My Example 3-4 RadioShack Corporation is engaged in consumer electronics retailing. RadioShack accrues revenue for finance charges, late charges, and returned check fees related to its credit operations. Unearned Fees ,600 Fees Earned ,600 Fees earned ($44,900 $22,300). Accrued Revenues 2 For Practice: PE 3-4A, PE 3-4B During an accounting period, some revenues are recorded only when cash is received. Thus, at the end of an accounting period, there may be revenue that has been earned but has not been recorded. In such cases, the revenue should be recorded by increasing (debiting) an asset account and increasing (crediting) a revenue account. To illustrate, assume that NetSolutions signed an agreement with Dankner Co. on December 15. The agreement provides that NetSolutions will answer computer questions and render assistance to Dankner Co. s employees. The services will be billed to Dankner Co. on the fifteenth of each month at a rate of $20 per hour. As of December, NetSolutions had provided 25 hours of assistance to Dankner Co. The revenue of $500 (25 hours $20) will be billed on January 15. However, NetSolutions earned the revenue in December. The claim against the customer for payment of the $500 is an account receivable (an asset). Thus, the accounts receivable account should be increased (debited) by $500 and the fees earned account should be increased (credited) by $500. The adjusting journal entry and T accounts are shown below. Accounts Receivable 12 Fees Earned 41 Accrued fees (25 hrs. $20) Accounts Receivable Fees Earned Bal. 2,220 Bal. 16,340 Dec. 500 Dec. 500 Adj. Bal. 2,720 Adj. Bal. 16,840

11 Chapter 03.qxd 5/21/08 7:08 PM Page 109 Chapter 3 The Adjusting Process 109 Example Exercise 3-5 If the adjustment for the accrued revenue ($500) is not recorded, Fees Earned and the net income will be understated by $500 on the income statement. On the balance sheet, Accounts Receivable and Chris Clark, Capital will be understated by $500. The effects of omitting this adjusting entry are shown below. Amount of Misstatement Income Statement Revenues understated by $ (500) Expenses correctly stated XXX Net income understated by $ (500) Balance Sheet Assets understated by $ (500) Liabilities correctly stated $ XXX Owner s equity understated by (500) Total liabilities and owner s equity understated by $ (500) Adjustment for Accrued Revenues At the end of the current year, $13,680 of fees have been earned but have not been billed to clients. Journalize the adjusting entry to record the accrued fees. Follow My Example 3-5 Accounts Receivable ,680 Fees Earned ,680 Accrued fees. Accrued Expenses 2 For Practice: PE 3-5A, PE 3-5B Some types of services used in earning revenues are paid for after the service has been performed. For example, wages expense is used hour by hour, but is paid only daily, weekly, biweekly, or monthly. At the end of the accounting period, the amount of such accrued but unpaid items is an expense and a liability. For example, if the last day of the employees pay period is not the last day of the accounting period, an accrued expense (wages expense) and the related liability (wages payable) must be recorded by an adjusting entry. This adjusting entry is necessary so that expenses are properly matched to the period in which they were incurred in earning revenue. To illustrate, NetSolutions pays its employees biweekly. During December, NetSolutions paid wages of $950 on December 13 and $1,200 on December 27. These payments covered pay periods ending on those days as shown in Exhibit 5. As of December, NetSolutions owes $250 of wages to employees for Monday and Tuesday, December 30 and. Thus, the wages expense account should be increased (debited) by $250 and the wages payable account should be increased (credited) by $250. The adjusting journal entry and T accounts are shown below. Wages Expense 51 Wages Payable 22 Accrued wages

12 Chapter 03.qxd 5/21/08 7:08 PM Page Chapter 3 The Adjusting Process Callaway Golf Company, a manufacturer of such innovative golf clubs as the Big Bertha driver, reports accrued warranty expense on its balance sheet. Exhibit 5 Accrued Wages Wages Expense Wages Payable Bal. 4,275 Dec. 250 Dec. 250 Adj. Bal. 4,525 After the adjusting entry is recorded and posted, the debit balance of the wages expense account is $4,525. This balance of $4,525 is the wages expense for two months, November and December. The credit balance of $250 in Wages Payable is the liability for wages owed on December. As shown in Exhibit 5, NetSolutions paid wages of $1,275 on January 10. This payment includes the $250 of accrued wages recorded on December. Thus, on January 10, the wages payable account should be decreased (debited) by $250. Also, the wages expense account should be increased (debited) by $1,025 ($1,275 $250), which is the wages expense for January Finally, the cash account is decreased (credited) by $1,275. The journal entry for the payment of wages on January 10 is shown below. 4 Jan. 10 Wages Expense 51 1,025 Wages Payable Cash 11 1,275 What would be the effect on the financial statements if the adjustment for wages ($250) is not recorded? On the income statement, Wages Expense will be understated by $250, and the net income will be overstated by $250. On the balance sheet, Wages Wages are paid on the second and fourth Fridays for the two-week periods ending on those Fridays. The payments were $950 on December 13 and $1,200 on December 27. The wages accrued for Monday and Tuesday, December 30 and, are $250. Wages paid on Friday, January 10, total $1, Wages expense, January 1 10, $1,025. Wages expense (accrued), $250 December S M T W T F S January Wages expense (paid), $950 Wages expense (paid), $1,200 Wages paid, $1, Wages expense (Jan.1 10), $1,025 4 To simplify the subsequent recording of the following period s transactions, some accountants use what is known as reversing entries for certain types of adjustments. Reversing entries are discussed and illustrated in Appendix B at the end of the textbook.

13 Chapter 03.qxd 5/21/08 7:08 PM Page 111 Chapter 3 The Adjusting Process 111 Example Exercise 3-6 Payable will be understated by $250, and Chris Clark, Capital will be overstated by $250. The effects of omitting this adjusting entry are shown as follows: Amount of Misstatement Income Statement Revenues correctly stated $XXX Expenses understated by (250) Net income overstated by $ 250 Balance Sheet Assets correctly stated $XXX Liabilities understated by $ (250) Owner s equity overstated by 250 Total liabilities and owner s equity correctly stated $XXX Adjustment for Accrued Expense Sanregret Realty Co. pays weekly salaries of $12,500 on Friday for a five-day week ending on that day. Journalize the necessary adjusting entry at the end of the accounting period, assuming that the period ends on Thursday. Follow My Example 3-6 Lowe s Companies, Inc., reported land, buildings, and store equipment at a cost of over $18 billion and accumulated depreciation of over $4.1 billion. Salaries Expense ,000 Salaries Payable ,000 Accrued salaries [($12,500/5 days) 4 days]. Depreciation Expense 2 For Practice: PE 3-6A, PE 3-6B Fixed assets, or plant assets, are physical resources that are owned and used by a business and are permanent or have a long life. Examples of fixed assets include land, buildings, and equipment. In a sense, fixed assets are a type of long-term prepaid expense. Because of their unique nature and long life, they are discussed separately from other prepaid expenses, such as supplies and prepaid insurance. Fixed assets such as office equipment are used to generate revenue much like supplies are used to generate revenue. Unlike supplies, however, there is no visible reduction in the quantity of the equipment. Instead, as time passes, the equipment loses its ability to provide useful services. This decrease in usefulness is called depreciation. All fixed assets, except land, lose their usefulness and, thus, are said to depreciate. As a fixed asset depreciates while being used to generate revenue, a portion of its cost should be recorded as an expense. This periodic expense is called depreciation expense. The adjusting entry to record depreciation expense is similar to the adjusting entry for supplies used. The depreciation expense account is increased (debited) for the amount of depreciation. However, the fixed asset account is not decreased (credited). This is because both the original cost of a fixed asset and the depreciation recorded since its purchase are normally reported on the balance sheet. Instead, an account entitled Accumulated Depreciation is increased (credited). Accumulated depreciation accounts are called contra accounts, or contra asset accounts. This is because accumulated depreciation accounts are deducted from their related fixed asset accounts on the balance sheet. The normal balance of a contra account is opposite to the account from which it is deducted. Since the normal balance of a fixed asset account is a debit, the normal balance of an accumulated depreciation account is a credit.

14 Chapter 03.qxd 5/21/08 7:08 PM Page Chapter 3 The Adjusting Process The normal titles for fixed asset accounts and their related contra asset accounts are as follows: Fixed Asset Account Land Buildings Store Equipment Office Equipment Contra Asset Account None Land is not depreciated. Accumulated Depreciation Buildings Accumulated Depreciation Store Equipment Accumulated Depreciation Office Equipment The December,, unadjusted trial balance of NetSolutions (Exhibit 3) indicates that NetSolutions owns two fixed assets: land and office equipment. Land does not depreciate; however, an adjusting entry should be recorded for the depreciation of the office equipment for December. We assume that the office equipment has depreciated $50 during December. 5 Thus, the depreciation expense account should be increased (debited) by $50 and the accumulated depreciation office equipment account should be increased (credited) by $50. The adjusting journal entry and T accounts are shown below. Depreciation Expense 53 Accumulated Depreciation Office Equip. 19 Depreciation on office equipment. Office Equipment Accumulated Depr. Office Equip. Bal. 1,800 Dec. 50 Depreciation Expense Dec. 50 After the adjusting journal entry is recorded and posted, the office equipment account still has a debit balance of $1,800. This is the original cost of the office equipment that was purchased on December 4. The accumulated depreciation office equipment account has a credit balance of $50. The difference between these two balances of $1,750 ($1,800 $50) is the cost of the office equipment that has not yet been depreciated. This amount of $1,750 is called the book value of the asset (or net book value). The office equipment and its related accumulated depreciation are reported on the December, balance sheet as follows: Office equipment $1,800 Less accumulated depreciation 50 $1,750 The market value of a fixed asset usually differs from its book value. This is because depreciation is an allocation method, not a valuation method. That is, depreciation allocates the cost of a fixed asset to expense over its estimated life. Depreciation does not measure changes in market values, which vary from year to year. Thus, on December,, the market value of NetSolutions office equipment could be more or less than $1,750. If the adjustment for depreciation ($50) is not recorded, Depreciation Expense on the income statement will be understated by $50, and the net income will be overstated by $50. On the balance sheet, the book value of Office Equipment and Chris Clark, Capital will be overstated by $50. The effects of omitting the adjustment for depreciation are shown at the top of the next page We describe and illustrate methods of computing depreciation expense in Chapter 10.

15 Chapter 03.qxd 5/21/08 7:08 PM Page 113 Chapter 3 The Adjusting Process 113 Example Exercise 3-7 Amount of Misstatement Income Statement Revenues correctly stated $XX Expenses understated by (50) Net income overstated by $ 50 Balance Sheet Assets overstated by $ 50 Liabilities correctly stated $XX Owner s equity overstated by 50 Total liabilities and owner s equity overstated by $ 50 Adjustment for Depreciation The estimated amount of depreciation on equipment for the current year is $4,250. Journalize the adjusting entry to record the depreciation. Follow My Example Summarize the adjustment process. Depreciation Expense ,250 Accumulated Depreciation Equipment ,250 Depreciation on equipment. Example Exercise For Practice: PE 3-7A, PE 3-7B Summary of Adjustment Process 3 objective Effect of Omitting Adjustments For the year ending December, 2010, Mann Medical Co. mistakenly omitted adjusting entries for (1) $8,600 of unearned revenue that was earned, (2) earned revenue that was not billed of $12,500, and (3) accrued wages of $2,900. Indicate the combined effect of the errors on (a) revenues, (b) expenses, and (c) net income for the year ended December, Follow My Example 3-8 We have described and illustrated the basic types of adjusting entries. A summary of these basic adjustments is shown in Exhibit 6 on pages The adjusting entries for NetSolutions are shown in Exhibit 7 on page 116. The adjusting entries are dated as of the last day of the period. However, because collecting the adjustment data requires time, the entries are usually recorded at a later date. An explanation is included with each adjusting entry. NetSolutions adjusting entries have been posted to the ledger shown in Exhibit 8 on pages The adjustments are shown in color in Exhibit 8 to distinguish them from other transactions. a. Revenues were understated by $21,100 ($8,600 $12,500). b. Expenses were understated by $2,900. c. Net income was understated by $18,200 ($8,600 $12,500 $2,900). 3 For Practice: PE 3-8A, PE 3-8B

16 Chapter 03.qxd 5/21/08 7:08 PM Page 114 Exhibit 6 Summary of Adjustments PREPAID EXPENSES Financial Statement Impact if Examples Reason for Adjustment Adjusting Entry Examples from NetSolutions Adjusting Entry Is Omitted Supplies, Prepaid Prepaid expenses Expense Dr. Supplies Expense 1,240 Income Statement: Insurance (assets) have been Asset Cr. Supplies 1,240 Revenues No effect used or consumed in Expenses Understated the business operations. Insurance Expense 200 Net income Overstated Prepaid Insurance 200 Balance Sheet: Assets Overstated Liabilities No effect Owner s Equity Overstated (Capital) UNEARNED REVENUES Unearned rent, Cash received before the Liability Dr. Unearned Rent 120 Income Statement: magazine services have been Revenue Cr. Rent Revenue 120 Revenues Understated subscriptions provided is recorded as Expenses No effect received in a liability. Some services Net income Understated advance, fees have been provided to Balance Sheet: received in customer before the end Assets No effect advance of of the accounting period. Liabilities Overstated services Owner s Equity Understated (Capital) ACCRUED REVENUES Services Services have been Asset Dr. Accounts Receivable 500 Income Statement: performed but provided to the Revenue Cr. Fees Earned 500 Revenues Understated not billed, interest customer, but have not Expenses No effect to be received been billed or recorded. Net income Understated Interest has been Balance Sheet: earned, but has not Assets Understated been received or Liabilities No effect recorded. Owner s Equity Understated (Capital) 114

17 Chapter 03.qxd 5/21/08 7:08 PM Page 115 ACCRUED EXPENSES Financial Statement Impact if Examples Reason for Adjustment Adjusting Entry Examples from NetSolutions Adjusting Entry Is Omitted Wages or salaries Expenses have been Expense Dr. Wages Expense 250 Income Statement: incurred but not incurred, but have not Liability Cr. Wages Payable 250 Revenues No effect paid, interest been paid or recorded. Expenses Understated incurred but not Net income Overstated paid Balance Sheet: Assets No effect Liabilities Understated Owner s Equity Overstated (Capital) DEPRECIATION Depreciation of Fixed assets depreciate Expense Dr. Depreciation Expense Income Statement: equipment and as they are used or Contra Asset Cr. Office Equipment 50 Revenues No effect buildings consumed in the Accumulated Depr. Expenses Understated business operations. Office Equipment 50 Net income Overstated Balance Sheet: Assets Overstated Liabilities No effect Owner s Equity Overstated (Capital) 115

18 Chapter 03.qxd 5/21/08 7:08 PM Page Chapter 3 The Adjusting Process Exhibit 7 Adjusting Entries NetSolutions Description Journal Page 5 Ref. Debit Credit Dec. Adjusting Entries Supplies Expense Supplies Supplies used ($2,000 $760) ,240 1,240 One way for an accountant to check whether all adjustments have been made is to compare the current period s adjustments with those of the prior period. MICROSOFT CORPORATION Insurance Expense Prepaid Insurance Insurance expired ($2,400/12 months). Unearned Rent Rent Revenue Rent earned ($360/3 months). Accounts Receivable Fees Earned Accrued fees (25 hrs. $20). Wages Expense Wages Payable Accrued wages. Depreciation Expense Accum. Depreciation Office Equipment Depreciation on office equipment. Microsoft Corporation develops, manufactures, licenses, and supports a wide range of computer software products, including Windows Vista, Windows XP, Word, Excel, and the Xbox gaming system. When Microsoft sells its products, it incurs an obligation to support its software with technical support and periodic updates. As a result, not all the revenue is earned on the date of sale; some of the revenue on the date of sale is unearned. The portion of revenue related to support services, such as updates and technical support, is earned as time passes and support is provided to customers. Thus, each year Microsoft makes adjusting entries transferring some of its unearned revenue to revenue. The following excerpts were taken from Microsoft s 2007 financial statements: The percentage of revenue recorded as unearned... ranges from approximately 15% to 25% of the sales price for Windows XP Home, approximately 5% to 15% of the sales price for Windows XP Professional,... Unearned Revenue: June 30, 2007 June 30, 2006 Unearned revenue (in millions) $12,646 $10, During the year ending June 30, 2008, Microsoft expects to record over $10,779 million of unearned revenue as revenue. Source: Taken from Microsoft s June 30, 2007, annual report. At the same time, Microsoft will record additional unearned revenue from current period sales.

19 Chapter 03.qxd 5/21/08 7:08 PM Page 117 Chapter 3 The Adjusting Process 117 Exhibit 8 Ledger with Adjusting Entries NetSolutions Account Cash Account No. 11 Account Land Account No. 17 Nov Dec Item Ref. Debit Credit ,000 7, , ,870 1,750 1, ,000 3, ,000 2, ,450 1, ,000 Balance Debit 25,000 5,000 12,500 8,850 7,900 5,900 3,500 2,700 3,060 2,880 2,480 1,530 4,630 3,730 4,380 2,930 1,730 1,420 1,195 4,065 2,065 Credit Account Accounts Receivable Account No. 12 Dec Item Adjusting Ref. Debit Credit ,350 1, Balance Debit 1,750 1,100 2,220 2,720 Credit Account Supplies Account No. 14 Nov Dec. 23 Item Adjusting Ref. Debit Credit 800 1,240 Balance Debit Credit 1, , Nov. 5 Item Ref. Debit Credit 1 20, ,800 Balance Debit 20,000 Credit Account Office Equipment Account No. 18 Dec. 4 Item Ref. Debit Credit Balance Debit 1,800 Credit Account Acc. Depr. Office Equip. Account No. 19 Dec. Account Accounts Payable Account No. 21 Nov Dec Item Ref. Debit Credit 1,350 1, Balance Debit Credit Account Wages Payable Account No. 22 Dec. Item Adjusting Item Adjusting Ref. Debit Credit 5 50 Ref. Debit Credit Balance Debit Balance Debit Credit 50 1, ,200 1, Credit Account Unearned Rent Account No. 23 Dec. 1 Item Ref. Debit Credit 2 Adjusting Balance Debit 250 Credit Account Prepaid Insurance Account No. 15 Dec. 1 Item Adjusting Ref. Debit Credit 2 5 2, Balance Debit 2,400 2,200 Credit Account Chris Clark, Capital Account No. Nov. 1 Item Ref. Debit Credit 1 25,000 Balance Debit Credit 25,000 (continued)

20 Chapter 03.qxd 5/21/08 7:08 PM Page Chapter 3 The Adjusting Process Exhibit 8 Ledger with Adjusting Entries NetSolutions (concluded) Account Chris Clark, Drawing Account No. 32 Account Depreciation Expense Account No. 53 Nov. 30 Dec. Item Balance Ref. Debit Credit Debit Credit 2 4 2,000 2,000 2,000 4,000 Dec. Item Adjusting Balance Ref. Debit Credit Debit Credit Account Fees Earned Account No. 41 Nov. 18 Dec Nov. 30 Dec. 1 Adjusting ,500 3,100 1,750 2,870 1, ,600 7,500 10,600 12,350 15,220 16,340 16,840 Account Rent Revenue Account No. 42 Dec. Nov. 30 Dec Item Item Adjusting Adjusting Balance Ref. Debit Credit Debit Credit Balance Ref. Debit Credit Debit Credit Account Wages Expense Account No. 51 Item , , ,125 3,075 4,275 4, Balance Ref. Debit Credit Debit Credit Account Rent Expense Account No. 52 Item Balance Ref. Debit Credit Debit Credit Account Utilities Expense Account No. 54 Nov. 30 Dec. Nov. 30 Dec. Dec. Nov. 30 Dec. 6 Item Adjusting Adjusting Balance Ref. Debit Credit Debit Credit , Account Supplies Expense Account No. 55 Item Balance Ref. Debit Credit Debit Credit 800 2,040 Account Insurance Expense Account No. 56 Item Balance Ref. Debit Credit Debit Credit 200 Account Miscellaneous Expense Account No. 59 Item Balance Ref. Debit Credit Debit Credit Prepare an adjusted trial balance. Adjusted Trial Balance 4 Objective After the adjusting entries have been posted, an adjusted trial balance is prepared. The adjusted trial balance verifies the equality of the total debit and credit balances before the financial statements are prepared. If the adjusted trial balance does not balance, an error has occurred. However, as we discussed in Chapter 2, errors may occur even though the adjusted trial balance totals agree. For example, if an adjusting entry were omitted, the adjusted trial balance totals would still agree.

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