Financial Accounting Chapter 4 Adjustments Financial Statements and the Quality of Earnings Adjusting Revenues and Expenses Accounting Cycle o Is the process followed by entities to analyze and record transactions adjust the records at the end of the period prepare financial statements and prepare the records for the next cycle Unadjusted Trial Balance o Before adjusting the accounting records managers normally review an unadjusted trial balance o Trial Balance is a spreadsheet that lists the names of the T accounts in one column usually in financial order with their ending debit or credit balances in the next two columns Provide a check on the equality of the debits and credits Purpose of Adjustments o Adjusting entries are entries necessary at the end of the accounting period to measure all revenues and expenses of that period Revenue is recorded when they are earned the revenue principle Expenses are recorded when they are incurred to generate revenue the matching principle Assets are reported at amounts that represent the probable future benefits at the end of the period Liabilities are reported at amounts that represent the probable future sacrifices of assets or services owed at the end of the period o Companies wait until the end of the Accounting Period to adjust their accounts in this way because adjusting the records daily would be costly and time consuming Types of Adjustments Adjusting entries that increase Revenues 1 Deferred Revenue a Also called Unearned Revenue b Previously recorded liabilities that were created when cash was received in advance and that must be reduced for the amount of revenue actually earned during that period c Customer pays for goods or services before the company delivers them the company records the amount of cash received in a deferred revenue Account 2 Accrued revenue a Revenues that have been earned but not yet recorded because cash will be received after the services are performed or goods are delivered Adjusting entries that increase expenses 3 Deferred Expenses a Previously recorded assets such a prepaid rent supplies and equipment that were created when cash was paid in advance and that must be reduced for the amount of expenses actually incurred during the period through use of asset 4 Accrued Expenses a Expenses that have been incurred but not yet recorded because cash will be paid after the goods or services are used Adjustment Process Deferred Revenues Adjustment 1 Unearned Franchise fees Case Papa John s received cash last period and recorded an increase in Cash and increase in Unearned Franchise Fees a liability to recognize the business s obligation to provide future services to franchisees During January Papa John s performed 1 100 in services for franchisees who had previously paid fees AJE 1 Unearned Franchise Fees L Franchise Fee Revenue R SE Debit 1 100 Credit 1 100 Assets Liabilities Unearned Franchise Fees 1 100 Stockholders Equity Franchise Fee Revenue R 1 100 Accrued Revenues Adjustment 2 Accounts Receivable Case Papa John s franchisees owe Papa John s 830 in royalties for sales the franchisees made in the last week of January The cash will be received in the future AJE 2 Credit Debit Accounts Receivable A Franchise Fee Revenue R SE 830 830 Assets Liabilities Accounts Receivable A 830 Stockholders Equity Franchise Fee Revenue R 830 Adjustment 3 Interest Receivable Case Papa John s loaned 3 000 to franchisees on December 31 one month ago at 6 percent interest per year with interest to be paid at the end of each year There was also 8 000 in notes receivable outstanding all month from prior loans There are two components when lending or borrowing money principal the amount loaned or borrowed and interest the cost of borrowing Notes Receivable the principal was recorded properly when the money was loaned AJE 3 Interest Receivable A Interest Income R SE Debit 70 Credit 70 Assets Liabilities Stockholders Equity Interest Receivable A 70 Interest Income R 70 Deferred Expenses Adjustment 4 Prepaid Rent and Insurance Case Prepaid Expenses includes 2 000 paid on January 1 for insurance coverage for four months January through April and 6 000 paid on January 1 for rental of space at shopping centers over three months January through March Compute the amount of expense incurred One month has expired for each of the prepaid amounts Insurance 2 000 x 1 month 4 months 500 used in January Rent 6 000 x 1 month 3 months 2 000 used in January AJE 4 Interest Expense E SE Rent Expense E SE Prepaid Expenses A Assets Liabilities Cash A 2 500 Credit Debit 500 2 000 2 500 Stockholders Equity Insurance Expense E Rent Expense E 500 2 500 Adjustment 4 Supplies Case Supplies include food and paper products At the end of the month Papa John s counted 12 000 in supplies on hand but the Supplies account indicated a balance of 16 000 We need to determine the supplies used during the current accounting period AJE 5 Supplies Expense E SE Supplies A Debit 4 000 Credit 4 000 Assets Supplies A 4 000 Liabilities Stockholders Equity Supplies Expense E 4 000 Adjustment 6 Property and Equipment Amounts for Accrued Expenses 1 Salaries 500 per day 4 days 2 000 2 Utilities 610 3 Interest 138 000 06 1 12 690 RECALL Property and equipment are assets that have a normal debit balance Depreciation is the allocation of the cost of an asset over its estimated useful life to the company Depreciation is an expense with a normal debit balance When we record depreciation we credit a contra asset account called Accumulated Depreciation Contra accounts are accounts that are directly linked to another account but with an opposite balance We subtract accumulated depreciation from the cost of our property and equipment to arrive at net book value Case Papa John s estimates depreciation to be 30 000 per year 30 000 12 months 2 500 per month depreciation expense AJE 6 Depreciation Expense E SE Accumulated Depreciation AX A Debit 2 500 Credit 2 500 Assets Liabilities Stockholders Equity Accum Depr AX A 2 500 Depreciation Expense E 2 500 Accrued Expenses Adjustment 7 Accrued Expenses Payable Salaries Utilities and Interest Case Papa John s owed 1 its employees salaries for working four days at the end of January at 500 per day 2 610 for utilities used in January and 3 interest on its long term notes payable borrowed at a 6 percent annual rate AJE 7 Salaries Expense E SE Utilities Expense E SE Interest Expense E SE Accrued Expenses Payable L Assets Liabilities Debit 2 000 610 690
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