Lecture Notes 3-Adjusting entries PDF

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18/02/2015

ACCG 611 - PRINCIPLES OF ACCOUNTING Adjusting Entries & Preparing Financial Statements

By Colly He

Revision

• • • • •

Effects of transactions in equation T-account General journal Debit and credit rules The unadjusted trial balance

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Measurement of Profit Income statement Cr Dr

=

Cr

+ Cr

Dr

Revenue

Expense

Assets = Liabilities + Equity Cr

=

Dr

+ Dr

Profit =(R-E)

Cr

Balance sheet Capital

Cr

Drawings Dr Change in equity

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Measurement of Profit continued Profit figure for a period depends on how we recognize & measure Revenues & Expenses for the period Revenues & Expenses can be recognized on either Accrual or Cash basis, within the accrual basis, there are two underlying accounting assumptions: - 1. How the period is defined ( ) - 2. Whether or not the accounting entity is a goingconcern ( )

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Cash Basis Profit = Cash inflows - Cash outflows Income (incl. Revenue) -recorded in the period in which cash is Expenses -Recorded in the period in which cash is Regardless of whether underlying business transaction relates to the current accounting period or not Cash basis would be more appropriate if the entity were to liquidate in the near future

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Accrual Basis Profit = Revenues earned – Expenses incurred Income (incl. Revenue) - recorded in the period it is earned (i.e. at the time goods are delivered/services are performed). Expenses - recorded in the period that they are incurred (i.e. When assets are consumed or liabilities incurred) Regardless of whether the related cash inflow/outflow takes place in the current accounting period or not 7

Cash Basis vs. Accrual Basis Cash basis = cash transactions (only) that occurred during the period Accrual basis = cash transactions + non-cash transactions + adjusting entries all transactions that occurred during the period

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Expanded Accounting Cycle 1. Recognise & record transactions

Source documents

2. Journalise transaction

General journal

3. Post to ledger accounts

General ledger

4. Prepare unadjusted trial balance of general ledger

Trial balance (unadjusted)

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Expanded Accounting Cycle General journal

5. Determine adjusting entries and journalise

General ledger (Accounts Adjusted)

6. Post adjusting entries to general ledger

Trial balance (Adjusted)

7. Prepare adjusted trial balance 8. Prepare financial statements

Work sheet

Financial Statements

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The Need for Adjusting Entries • The operating cycle - the average period of time it takes for the entity to complete its operating activities – i.e. purchase inventory, sell it to customers and receive money. • However, in practice the life of the entity is divided arbitrarily into time intervals for periodic reporting. Usually the reporting period is 12 months.

Operating cycle

reporting period

• Some activities are started and completed within an accounting period, but many remain incomplete at the end of the reporting period. 11

The Need for Adjusting Entries • Therefore, at the end of each period, the accountant evaluates the progress of incomplete activities to decide on - the accomplishments (Revenues) - the obligations of future services (Liabilities) - the resources that have been used up (Expenses) - The resources that still remain (Assets) • Consequently, some accounts must be adjusted on balance-day (i.e. the last day of the reporting period) to accurately recognized income and expenses (and thus affected asset and liability accounts) for the reporting period.

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Adjusting Entries • Arise only when accrual basis is adopted • Are journal entries which ensure that: - Revenues & Expenses are recorded (accurately) in the accounting period in which they are earned/incurred - Revenues are matched with related expenses for the same accounting period • Are recorded & posted at the end of the accounting period (on balance-day) Never adjusts cash account !

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Classification of Adjusting Entries

Deferrals (Prepayments) Accruals (Unrecorded)

PrepaidExpense Costs/expensespaid beforetheyare consumed

AccruedExpense Expensesincurredbut notyetpaid

UnearnedRevenue Revenuesthatare collectedorreceived butnotyetearned

AccruedRevenue Revenue earnedbut notyetreceived

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Deferral: prepaid expenses (asset account) • Amounts paid in advance (before the benefit is consumed) • Initially recorded as assets and charged to expenses in subsequent periods as consumed • i.e. Prepaid rent, prepaid insurance, prepaid supplies Example: On 3 June 20X6, a 24 month insurance policy purchased for $960. Initially recorded as: GeneralJournal Date

Account

Post Ref

Prepaid insurance

xxx

Cashatbank

xxx

Debit

Credit

20x6 Jun3

960 960

(prepaid insurance)

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Deferral: Prepaid Expenses Continued By 30 June 20X6, the period end, we need to adjust prepaid insurance account to reflect the consumption GeneralJournal 20x6

40

Jun 30

40 (consumption of1monthinsurance) Insurance Expense

Prepaid Insurance Initial cost 960

Adjusting entry 40

cost used up, incurred or expired

Adjusting entry 40 16

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Prepaid Expense continued Depreciation Expense • Property, plant and equipment (PPE) are usually acquired for use (to earn revenue) rather than for resale (inventory) • The useful life of a PPE over a number of accounting period • The total economic benefits embodied in a PPE is partially used up in each accounting period over its useful life. The portion of expired economic benefits (reflecting the use of the PPE) is recorded as an expense (i.e. necessary cost of running the business) • Depreciation = the process of allocating the determined cost of the PPE to expense over the asset’s useful life. • Depreciation, therefore, is an allocation process, not a valuation process • Purchasing a PPE can be considered as a prepaid expense 17

Prepaid Expense continued Depreciation Expense

ASSET ACCOUNT Initial cost Debit

CONTRA ASSET ACCOUNT Accumulated Depreciation Adjusting entry Credit

EXPENSE ACCOUNT Adjusting entry Debit

cost used up & allocated to current period

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Prepaid Expense continued Depreciation Expense On 1 July 20X6, Office furniture was purchased on credit for $15,000. Depreciation is to be allocated over 10 years (i.e. $1,500 per year) Ignore GST. GeneralJournal 20x6

Office furniture

Jul 1

Cash atbank

15000 15000

(Purchase ofofficefurniture) 20x7

1500

Jun 30

1500

Balance sheet as at June 30, 20x7 Office furniture (original value) Less: Accumulated Depreciation Carrying Amount

15 000 (1 500) 13 500

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Deferral: Unearned Revenues (Liabilities) Amounts received before services are provided Recorded as liability until the obligation is fulfilled i.e. Unearned magazine subscription revenue, Rent received in advance LIABILITY ACCOUNT Unearned Revenue Adjusting entry Debit

Cash receipt

INCOME ACCOUNT Revenue Adjusting entry Credit

revenue earned during the current period 20

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Deferral: Unearned Revenues continued On 10 June 20X6, $2,000 was received from client to perform consulting service. By 30 June 20X6 (balance date), only half the job was completed GeneralJournal 20x6

Cashatbank

Jun 10

Unearnedrevenue

2000 2000

(Received cashfromclientinadvance) Jun 30

1000 1000

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Accrued Expenses Arises when expenses are incurred by balance date but not yet: a) recorded; nor b) paid for. thus are unrecorded expenses Need to record: a) Expense; and b) Payable (Accrual) i.e. Wages expense, Utilities expense, Interest expense 22

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EXAMPLE: ACCRUED SALARIES

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Accrued Expenses continued Wages expense GeneralJournal Jun22

Wages expense

7600

Cash

7600

(Salarypaidtoemployees) Jun 30

3980 3980

Jul 6

Wagesexpense

3420

Wages payable

3980

Cash

7400

(Salarypaidtoemployees) 24

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Accrued Revenues Arises when revenue is earned by balance date but not yet: a) recorded; nor b) payment received. thus are unrecorded revenues Need to record: a) Revenue; and b) Receivable. i.e. Interest Revenue, Rent revenue and Commission revenue

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Accrued Revenues continued Interest of $1200 was earned from a term deposit for the month of March but not yet received or recorded. GeneralJournal Mar31

Interestreceivable

1200

Interestrevenue

1200

(Adjustingentrytorecordaccruedinterest)

When interest is received in a subsequent month GeneralJournal Apr x

Cash atbank Interest receivable

1200 1200

(Received interestincash) 26

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Adjusting Entries - Revenue Unearnedrevenue

Accruedrevenue

Revenuescollectedin advance,butnotyetearned e.g.magazinesubscription receivedinadvance

Revenuesearned,butnotyet receivedincashorentered e.g.interestearnedonabank termdepositbutnotpaid

$$$

Revenue

LastYear

Revenue

$$$ NextYear

CurrentYear

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Adjusting Entries - Expenses Prepaidexpenses

Accruedexpenses

Expensespaidforbeforetheyare consumed e.g.Insurancepaid12monthsin advance

Expensesincurred,butnotyet paidfororentered e.g.wagesearnedby employees,butnotyetpaid

$$$ LastYear

Expense

Expense

CurrentYear

$$$ NextYear 28

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Adjusted Trial Balance • Is prepared from the updated ledger accounts – that reflect all posted end-of-period adjusting entries • Provides basis from which to prepare Financial Statements Debit

Credit

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