Chapter Three Adjusting the Accounts Accountants divide the economic life of a business into artificial time periods This convenient assumption is referred to as the time period assumption Interim periods monthly and quarterly time periods Fiscal year an accounting time period that is one year in length Calendar year January 1st December 31st Accrual basis accounting accounting basis in which companies record transactions that change a company s financial statements in the periods in which the events occur Cash basis accounting accounting basis in which companies record revenue when they receive cash and an expense when they pay cash Not in accordance with GAAP Revenue recognition principle the principle that companies recognize revenue in the accounting period in which it is earned Expense recognition principle matching principle the principle that companies match efforts expenses with accomplishments revenues Adjusting entries ensure that the revenue recognition and expense recognition principles are followed A company must make adjusting entries every time it prepares financial statements It analyzes each account in the trial balance to determine whether it is complete and up to date 1 Prepaid Expenses Expenses paid in cash and recorded as assets before they 2 Unearned Revenues Cash received and recorded as liabilities before revenue is Deferrals are used or consumed earned Accruals 1 Accrued Revenues Revenues earned but not yet received in cash or recorded 2 Accrued Expenses Expenses incurred but not yet paid in cash or recorded Adjusting Entries for Deferrals Deferrals either prepaid expenses expenses paid in cash that benefit more than one accounting period and that are recorded as assets or unearned revenue cash received and recorded as liabilities before revenue is earned o Prepaid expenses An adjusting entry for prepaid expense increases debits an expense account and decreases credits an asset account Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner estimate rather than factual The difference between the cost of any depreciable asset and its related accumulated depreciation is its book value An adjusting entry for unearned revenues results in a decrease a debit to a liability account and an increase a credit to a revenue account o Unearned revenue ACCOUNTING FOR PREPAID EXPENSES Examples insurance supplies advertising rent depreciation Reason for adjustment prepaid expenses recorded in asset accounts have been used Accounts before adjustment assets overstated Expenses understated Adjusting entry Dr Expenses Cr Assets ACCOUNTING FOR UNEARNED REVENUE Examples rent magazines subscriptions customer deposits for future services Reason for adjustment unearned revenues recorded in liability accounts have been earned Accounts before adjustment liabilities overstates Revenues understated Adjusting entry Dr Liabilities Cr Revenues Adjusting Entries for Accruals Accruals adjusting entries for either accrued revenues revenues earned but not yet received in cash or recorded or accrued expenses expenses incurred but not yet paid in cash or recorded o Accrued revenues o Accrued expenses An adjusting entry for accrued revenues increases debits an asset account and increases credits a revenue account An adjusting entry for accrued expenses increases debits an expense account and increases credits a liability account Interest face value of note x annual interest rate x time terms of one yr ACCOUNTING FOR ACCRUED REVENUES Examples interest rent services performed but not collected Reason for adjustment revenues have been earned but not yet received in cash or recorded Accounts before adjustment assets understated Revenues understated Adjusting entry Dr Assets Cr Revenues ACCOUNTING FOR ACCRUED EXPENSES Examples interest rate salaries Reason for adjustment expenses have been incurred but not yet paid in cash or recorded Accounts before adjustment expenses understated Liabilities understated Adjusting entry Dr Expenses Cr Liabilities The company has journalized and posted all adjusting entries Next it prepares another trial balance form the ledger accounts This is called an adjusted trial balance Its purpose is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments The accounts in the adjusted trial balance contain all data that the company needs to prepare financial statements Chapter Four Completing the Accounting Cycle A worksheet is a multiple column form used in the adjustment process and in preparing financial statements The use of a worksheet is optional Steps 1 Prepare a trial balance on the worksheet 2 Enter the adjustments in the adjustments columns 3 Enter adjusted balances in the adjusted trial balance columns a Enter titles and debit credit columns a Keying debit credit amounts a For each account the amount in the adjusted trial balance columns is the balance that will appear in the ledger after journalizing and posting the adjusting entries 4 Extend adjusted trial balance amounts to appropriate financial statement columns 5 Total the statement columns compute the net income or net loss and complete the worksheet a The debit amount balances the income statement columns the credit amount balances the balance sheet columns Preparing Financial Statements from a Worksheet Once the worksheet is completed the company has all the info needed to prepare a financial statement However the completed worksheet is not a substitute for formal financial statements A worksheet is essentially a working tool of the accountant Preparing Adjusting Entries from a Worksheet A worksheet is not a journal and it cannot be used as a basis for posting to ledger accounts The adjusting entries are prepared from the adjustments columns of the worksheet The journalizing and posting of adjusting entries follows the preparation of financial statements when a worksheet is used Closing the Books At the end of the accounting period the company makes the accounts ready for the next period This is called closing the books In closing the books companies make separate entries to close revenues and expenses to income summary income summary to retained earnings and dividends to retained earnings o Temporary accounts nominal accounts that relate only to a given accounting period Consist of all income statement accounts and the dividends account All temporary accounts are closed