CH 3: Adjusting accounts for Financial statements

Purpose of adjusting entries

To ensure revenues and expenses are recorded in the correct accounting period so financial statements show accurate financial position and performance

When adjusting entries are recorded

At the end of the accounting period, before financial statements are prepared

GAAP principles requiring adjusting entries

Timeliness principle

Matching principle

Revenue recognition principle

Timeliness (accounting period) principle

Assumes business activities can be divided into specific time periods for regular reporting

ex. quarterly, monthly, yearly, ect.

Matching principle

Expenses must be recorded in the same period as the revenues they help generate

Revenue recognition principle

Revenue is recognized when earned, regardless of when cash is received

Accrual basis accounting

Revenues and expenses are recorded when earned or incurred, regardless of cash timing

Cash basis accounting

Revenues and expenses are recorded only when cash is received or paid

this is not GAAP compliant !

Adjusting entry

A journal entry made at period-end to update asset or liability balances and record related revenues or expenses

Adjustments include..

prepaid expenses

depreciation

unearned rev.

accrued expenses

accrued rev.

Accounts affected by adjusting entries

Income statement and balance sheet; cash is never affected

Prepaid expenses

Costs paid in advance that provide future benefits and are recorded as current assets ( as they are used within the year) until used.

Adjusting prepaid expenses

Increase expense and decrease prepaid asset

Depreciation

The allocation of the cost of a long-term asset over its useful life

Accumulated depreciation

A contra asset account that records total depreciation expense to date

Contra asset account

An account linked to an asset that has an opposite normal balance and reduces the asset’s book value

Net book value

Cost of an asset minus accumulated depreciation

Does depreciation affect cash?

No, depreciation is a non-cash expense

Unearned revenue

Cash received before goods or services are provided; recorded as a liability

Adjusting unearned revenue

Decrease unearned revenue and increase revenue

GAAP issue if unearned revenue is not adjusted

Revenue recognition principle is violated

Accrued expenses

Expenses incurred but not yet paid or recorded

Adjusting accrued expenses

Increase expense and increase liability

Examples of accrued expenses

Salaries payable, interest payable, utilities payable, taxes payable

Accrued revenues

Revenues earned but not yet received or billed

Adjusting accrued revenues

Increase accounts receivable and increase revenue

Purpose of recording accrued revenues

To properly report earned revenue on the income statement

Unadjusted trial balance

A list of account balances before adjusting entries are recorded

Adjusted trial balance

A list of account balances after adjusting entries are recorded and used to prepare financial statements

Order of preparing financial statements

Income statement, statement of owner’s equity, balance sheet

Key rule about adjusting entries

Adjusting entries never involve cash