MCD2010

Accounting 1

Topic 4
Adjusting the Accounts
Reference: Principles of Accounting and Finance (Second edition)
(Carey 2010). Chapter 4
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 Review of previous week
• Revising the recording process
• Trading firms
• Recording purchases and sales under the
perpetual inventory system
• Other issues
– Special journals
– Manual vs computerised systems
– GST / VAT
 Learning Objectives
1. Explain the time period assumption
2. Explain the revenue recognition principle
3. Explain the expense recognition principle
4. Explain why adjusting entries are needed
5. Identify the major types of adjusting entries
6. Prepare adjusting entries for prepayments
7. Prepare adjusting entries for accruals
8. Describe the nature and purpose of an adjusted trial balance
9. Prepare adjusting entries for the alternative treatment of
prepayments.
 Lecture Overview
• Timing issues
• Revenue and expense recognition
• Adjusting entries:
– Prepaid expenses
– Unearned revenue
– Accrued revenue
– Accrued expenses
• The adjusted trial balance
 Timing Issues
• The time period assumption assumes the economic
life of a business can be divided into artificial time
periods.

• Accounting time periods are usually a month, a

quarter, semi-annual or a year.

• A time period less than a year is called an interim

period.

• The annual reporting period often coincides with the

financial year rather than the calendar year.
 Timing Issues (continued)
• Entities prepare financial statements every accounting
period.

• Under accrual accounting, some amounts are paid

before or after they are actually due.

• These entries, and others, require adjustment at the

end of a period to ensure the information presented in
the financial statements is relevant and faithfully
represents the transactions or events that it claims to
represent.
 Recognising revenue and expenses
• Determining the amount of revenue and expenses to be
reported in a given accounting period can be difficult.

• However, it is important that the correct amount of

revenues and expenses are reported as users rely on
this information for decision making.

• To help in this task, accountants have developed the

‘revenue recognition principle’ and the expense
recognition principle.
 Revenue and expense recognition
• The revenue recognition principle specifies that
revenue should be recognised in the accounting
period when an increase in future economic
benefits has occurred.

• The expense recognition principle states that an

expense should be recognised in the accounting
period when a decrease in future economic benefits
has occurred.
 Relationships between Principles
Time Period Assumption

Economic life of business

can be divided into artificial
time periods.

Revenue Recognition Principle Matching Principle

Expenses matched with

Revenue recognized in revenues in same period
the accounting period in when efforts are expended to
which it is earned. generate revenues.
10
 Adjusting entries
• Businesses use the assumption of “going concern”
GAAP
– i.e. the entity will continue indefinitely in the absence
of evidence to the contrary.
• The problem is, owners cannot wait until the end of
the business life cycle to determine activity or
performance.
• The use of the “accounting time period” GAAP
arbitrarily splits the business into smaller time
periods for recording & reporting.
• Some transactions impact more than 1 accounting
period.
– e.g. Insurance paid of $30,000 for the 12 months’
January - December, with balance day falling on
30 June. 11
 Adjusting entries
• Financial Statements are prepared to assist users in
making informed decisions about the allocation of
scarce resources.
• Information must be Relevant & Reliable (Faithful
Representation).
– There is a likely trade-off between increased
Relevance and reduced Reliability with increases
in the use of estimates.
– Examples include:
Depreciation (life, residual, pattern of use)
• Values relating to these events are derived from
– estimates and
– by the use of professional judgement and
– the application of GAAP’s. 12
 Adjusting entries
• Adjusting entries are made in order to:
– Record revenues in the period they are earned.
– Recognise expenses in the period they are incurred.

• Adjusting entries are required each time financial

statements are prepared.

• Adjusting entries can also be made to record events

that may not have otherwise been recorded that need
to be recorded.
 Adjusting entries (continued)
• Adjusting entries are made in order to:
Ensure the correct amount of profit or loss is reported
for the particular accounting period.

• Ensure the correct balance of asset, liability and equity

accounts are reported in the financial statements.

• Adjusting entries can be classified as:

– Prepayments
– Accruals
 Adjusting entries
• Trial balance is the starting point.
– Identify adjustments required
– Obtain information needed
– Make informed judgements or estimates
– Determine the general journal entries
– Record Balance Date Adjustments
( BDA’s )in the General Journal
– Post entries in GJ to ledger accounts
– Prepare the adjusted trial balance
– Prepare the financial statements
15
 Types of Adjusting Entries

Prepaid Expenses
Prepayments
Unearned Revenue

Accrued Revenue
Accruals
Accrued Expenses
 Prepaid Expenses (Prepayments)
• Expenses that are paid in cash before they are
used or consumed.

• Initially recorded in an asset account to show the

benefits yet to be received.

• Examples: insurance, supplies, advertising, rent

 Prepaid expenses (continued)
• Expire either with the passage of time or through use
and consumption.
• An adjusting entry is made at financial statement
(balance) date to record the expense consumed and
show the value of the asset remaining.
• Adjusting entry:

Asset Expense
Unadjusted Credit Debit
balance adjusting adjusting
entry (-) entry (+)
 Example – prepaid insurance
Insurance of $600 was paid on 1 October for one year in advance.
Adjustment is needed at the end of October to record the expense
consumed ($600/12 = $50)
Journal entry:

Oct. 31 Insurance Expense 50

Prepaid Insurance
50
To record insurance expired.
General ledger:
Prepaid Insurance Insurance Expense
1/10 600 31/10 Ins Exp 50 31/10 PP Ins 50

31/10 Bal. 550

 Example - stationery
Stationery supplies of $500 were recorded as an asset when
purchased on 5 October.
Stationery supplies on hand at 31 October totalled $200.
Journal entry:

Oct. 31 Stationery supplies expense 300

Stationery supplies on hand
300
To record
General Ledger : supplies used.

Supplies on hand(A) Supplies Expense

5/10 500 31/10 Supp Exp 300 31/10 Supplies 300

31/10 Bal. 200

 Depreciation
• Entities have non-current assets such as equipment,
computers, vehicles and premises to assist them in
business operations.

• These items are recorded in asset accounts, then

‘depreciated’ over their business life.

• Depreciation can be seen as a prepaid adjustment, as

the assets are initially acquired, then expensed over
time.
 Depreciation (continued)
• Depreciation is the allocation of the cost of a non-current
asset over its useful life.

• The acquisition of the non-current assets is viewed as a

long-term payment for services.

• This payment needs to be recognised in a consistent

manner to other prepaid expenses.

• Note that Land is NOT normally a depreciable asset.

 Methods for recording depreciation

Two main methods of recording

• Straight Line Depreciation (Prime cost)-
benefits are used/consumed equally over
the asset’s useful life.
• Reducing Balance (Diminishing value) -
benefits are greater at first in the early stage
of an asset’s life but reduce/diminish over
time.
23
 Straight Line Depreciation
• The formula to calculate straight line depreciation is:

(Cost - Residual Value)

Estimated Useful Life (in years)
• Residual value is the estimated scrap (salvage) value (if
any)

Straight line depreciation is based on:

• Original cost supported by documentary evidence
• Estimated residual value and useful life
Estimates need to be reviewed regularly
24
 Straight Line Depreciation
• If Oracle Consultancy Service purchased
a Motor Vehicle for $30,000 on 1 January
2008.
• If the useful life was estimated at three
years with a residual value of $3,750

Depreciation Calculation :
( Cost $30,000 - scrap value $3,750 ) / life 3
years
= $8,750 per year (or per annum) 25
 Reducing Balance Depreciation
(also known as “diminishing value”)

• The formula to calculate reducing

balance depreciation is:

(Original Cost - Accum Depn) x

Reducing Balance % Rate

26
 Reducing Balance Depreciation
• If Oracle Consultancy Service purchased a Motor
Vehicle for $30,000 on 1 January 2008. If the reducing
balance rate was estimated at 50%
End of Year 1, 31 Dec 2008 depn calculation:
= (Cost $30,000 - accum dep’n 0 ) X 50%
= $15,000
End of Year 2, 31 Dec 2009 depn calculation:
= (Cost $30,000 - accum dep’n $15,000 ) X 50%
= $7,500
End of Year 3, 31 Dec 2010 depn calculation:
= (Cost $30,000 - accum dep’n $22,500 ) X 50%
= $3,750
27
 Recording Depreciation
Depreciation of office equipment is $480 p.a. or $40 monthly.
Record depreciation for the month of October.
Journal entry:
Oct. 31 Depreciation Expense 40
Accumulated Depreciation - Office Equipment
40
To record monthly depreciation.
General Ledger:
Office Equipment
1/10 5 800

Accumulated Depreciation
- Office Equipment Depreciation Expense
31/10 Dep’n Exp 40 31/10 Acc dep’n 40
 Recording Depreciation (continued)
– The carrying amount or book value is the
difference between the cost of any depreciable
asset and its related accumulated depreciation.

– It appears in the Balance Sheet (Statement of

Financial Position) and is usually different from the
asset’s fair value (market value).

– Balance Sheet:
Office Equipment $5 800
Less: Accumulated Depreciation
(40)
Carrying Value $5 760
 Unearned revenue
• Cash received for revenue before it has been
earned.

• Also known as ‘prepaid’ revenue.

• Examples: pre-booked airline tickets, rent received

in advance, magazine subscriptions.
 Unearned revenue (continued)
• It can be initially recorded as a liability to recognise the
obligation to be provided in the future.

• An adjustment is needed at the end of the period to

record the revenue earned and remaining obligation.

• Adjusting entry:
Liability Revenue
Debit Unadjusted Credit
adjusting balance
entry (-) adjusting
entry (+)
 Example – advertising fees
A newspaper business received $1,200 on 2nd October for
advertising services for Oct, Nov and Dec.
Assume the accounting period ends on 31 October.
Adjusting entry:

Oct. 31 Unearned Revenue 400

Service Revenue
400
To record revenue for services provided.
General Ledger:
Unearned Revenue Service Revenue
31/10 Service Rev 400 2/10 1 200 31/10 Bal. 10
000

31/10 Bal. 800 31/10 Unearn R

 Accrued Revenue
• Revenue earned but not yet received in cash
(receivable) nor recorded.

• Examples: interest ,dividends

• Adjusting entry is required to:

– Show that a receivable exists at balance date.
– Record income earned in the period.
 Accrued Revenue (continued)
• An adjusting entry is required to show the asset
(receivable) at the end of the accounting period and
to record the revenue earned.

• Adjusting entry:

Asset Revenue
Debit Credit
adjusting
entry (+) adjusting
entry
(+)
 Example – accrued interest revenue
Interest revenue of $200 has been earned for the month of
October, but not yet recorded.
Journal entry:
Oct. 31 Interest Receivable 200
Interest Revenue
200
To record revenue for interest earned, not received
General Ledger:

Interest Receivable Interest Revenue

31/10 Int rev 200 31/10 Int Receiv 200

31/10 Bal.
200
 Accrued Expenses
• Expenses incurred but not yet paid or recorded at
statement date.

• Examples: wages owing to employees, interest owing

on loan borrowings, outstanding electricity and gas
accounts
 Accrued expenses (continued)
• An adjusting entry is required to record the obligation
(liability) at reporting date and recognise the expense
incurred during the current period.

• Adjusting entry:

Expenses Liability
Debit Credit
adjusting
entry (+) adjusting
entry
(+)
 Example – accrued interest
A business took out a loan, and interest owing on the
loan for the month of October is $50.
Adjusting entry:

Oct. 31 Interest Expense 50

Interest Payable
50
To accrue interest on loan payable.
General ledger:
Interest Expense Interest Payable
31/10 Int Pay 50 31/10 Int Exp
50
 Example – accrued salaries (wages)

• At balance date, most businesses will have accrued

salaries as a liability.

• Employees usually work for several days before being

paid weekly, fortnightly or possibly monthly.

• If the end of period occurs before a ‘pay day’, salaries or

wages will be owing to staff at that time and need to be
recorded.
Example – accrued salaries (continued)
End of period is 31 October. Salaries outstanding for
the last pay period in October total $1,200 (assuming 3
days x $400 per day)

40
 Example – accrued salaries (continued)
Journal entry:
Oct. 31 Salaries Expense 1200
Salaries Payable
1200
To record accrued salaries
General Ledger:

Salaries Expense Salaries Payable

26/10 4000 31/10 Sal Exp
1200
31/10 Sal Pay1200

31/10 Bal. 5200

 The Adjusted Trial Balance
• The adjusted trial balance is prepared after all
adjusting entries have been posted from the general
journal to ledger accounts.

• Its purpose is to prove equality of the total debit and

credit balances in the general ledger after adjustments
have been made.

• The adjusted trial balance is the main basis for

preparation of the financial statements.
Example – adjusted trial balance
 APPENDIX - Alternative Treatment
of Prepayments
• Some firms initially use Income Statement accounts for
adjusting entries rather than Asset or Liability Accounts.
• This would involve a:
– Debit to the expense account for prepaid expenses
when cash is paid.
– Credit to the revenue account at the time cash is
received.
• After adjustments, the two treatments will result in the
same effect on the financial statements as the initial
entries to the balance sheet accounts.
 Alternative Treatment
(1) Prepaid Expenses
$500 recorded as Stationery Expense on 5 Oct.
Stationery Supplies at 31 October: $200
Journal entry:

Oct. 31 Stationery supplies (A) 200

Stationery expense
200
To record supplies inventory on hand.

General Ledger:
Stationery supplies on hand Stationery expense
31/10 St Exp 200 5/10 500 31/10 St Sup
200
31/10 Bal. 300
 Alternative treatment (continued)
(2) Unearned Income
$1,200 received 2 October for advertising services to be
completed by 31 December. Services incomplete in October.
Journal entry at end of October:

Oct. 31 Service Revenue 800

Unearned Income
800
To record unearned income.
General Ledger:
Unearned Income Service Revenue
31/10 Rev 800 31/10 Unearn 800 2/10 1200

31/10 Bal.
400