Chapter+3+Notes+-+Adjusting+Entries

Homework: SS1, SS2, SS3, SS4, SS5; E3-2(a) Highlights: time period assumption (economic life of business can be divided into artificial time periods); fiscal periods (monthly, quarterly, annually); fiscal year vs. calendar year; revenue recognition principle (recognize revenue when earned, i.e., when service is performed for service firms, or when goods and bill are delivered for merchandising firms); matching principle (recognize expenses when incurred - match efforts [expenses] with accomplishments [revenues]); accrual basis of accounting (record transactions when revenues are earned and expenses are incurred); cash basis of accounting (recognize revenues and expenses only when payment is finally delivered); adjusting entries are necessary to update accounts and financial statements at end of each period; three types of adjusting entries: prepayments (prepaid expenses and unearned revenues), accruals (accrued expenses and accrued revenues) and estimates (amortization/depreciation of fixed assets)
 * __SO 1 - 5__**

Homework: SS6, SS7; BE3-2, BE3-3, BE3-4 (journal entries only); P3-2A Highlights: **adjusting entries for prepayments** (payments made in advance of expenses incurred or revenues earned) include prepaid expenses such as prepaid rent, licenses, insurance and supplies and unearned revenues such as magazine subscriptions, airline ticket purchases, college tuition and customer deposits for future services (click here for a link to the grade 11 accounting summary of adjusting entries)
 * __SO 6__**

__**SO 7**__ Homework: SS8, SS9; BE3-5 Highlights: **adjusting entries for accruals** (accrued revenues and accrued expenses); accruals refer to revenues earned or expenses incurred/accumulated within current fiscal period but not yet recorded or paid as of last day of period, thereby requiring adjusting entry to account for these accumulated revenues or expenses

Homework: SS10; BE3-6 Highlights: **adjusting entries for estimates** includes amortization/depreciation of fixed/capital assets over time and allowance for doubtful accounts (discussed in chapter 9); estimates refer to difficult-to-measure changes in value of certain assets within current fiscal period that have yet to be recorded as of last day of period; amortization/depreciation refers to the estimated allocation of the cost of a capital asset to expense over the course of its useful life using either straight line method (cost - erv/eul) or declining balance method (nbv x CRA fixed rate); depreciation journal entries require debit to Depreciation Expense and credit to contra asset accounts (Accumulated Depreciation - Automobile); net book value or carrying value of depreciable assets can be calculated by subtracting accumulated depreciation from original purchase price (not to be confused with fair market value); adjusted trial balance (a, l, c, d, r, e) contains all accounts after period-ending adjustments; preparation of financial statements using adjusted trial balance - income statement, statement of owner's equity, balance sheet
 * __SO 8 - 9__**

Homework: E3-6, E3-7, E3-8
 * __SO 6 - 8 summary of all adjusting entries for prepayments, accruals and estimates__**

As you recall from grade 11, **adjusting entries** are journal entries recorded on the last day of each fiscal period in order to update the accounts before the financial statements are prepared.
 * __Chapter 3 Additional notes__**

In your textbook, **adjusting entries** are classified as either **prepayments, accruals** or **estimates**.

The textbook assumes that, in most cases, financial statements are prepared (i.e., accounts are updated and adjusting entries are recorded) at the end of each __monthly__ fiscal period.

Additionally, you may note that adjusting entries typically involve both an income statement account (revenue / expense) and a balance sheet account (asset / liability).

Furthermore, please note that interest rates are always expressed as an __annual__ rate in your textbook.


 * In the following examples, assume a fiscal period end of October 31.**

1) **Prepayments** include **prepaid expenses** and **unearned revenues (SO 6)**


 * (a) Prepaid expenses** (aka **prepaid assets** or **deferred expenses** or **future expenses**) refer to expenses prepaid by our firm in full and recorded as __assets__ before they are consumed or expire, e.g. supplies, licenses, insurance, rent

Oct 1 Prepaid Insurance 1200 (asset) - Cash 1200 Purchase of 12-month insurance policy

Oct 31 Insurance Expense 100 -- Prepaid Insurance 100
 * Adjusting entry** to record one month of expired insurance

- or -

Oct 1 Supplies 2500 (asset) - Cash 2500 Purchase of office supplies for cash

Oct 31 Supplies Expense 1400 --- Supplies 1400
 * Adjusting entry** to record $1400 of supplies used during October ($1100 of supplies remain on hand following p.i.c.)


 * (b) Unearned revenues** (aka deferred revenues or future revenues) refer to advance payments received from customers (i.e., prepayments by our customers) but not yet earned and are recorded as __liabilities__

Oct 15 Cash 500 Unearned Revenue 500 (liability) Receipt of unearned revenue

Oct 31 Unearned Revenue 100 -- Fees Earned 100 (revenue)
 * Adjusting entry** to record revenue for services performed during October

2) **Accruals** include **accrued revenues** and **accrued expenses (SO 7)**


 * (a)** **Accrued revenues** (aka accrued receivables) refer to revenues earned (accumulated) but not yet recorded as of the last day of the fiscal period, i.e., the date of preparation of the financial statements. Accordingly, an adjusting entry is necessary as of the last day of the period to account for these accumulated revenues earned but not yet received.

Accrued revenues may accumulate due to the passage of time (e.g., rent revenue, interest revenue) or as a result of partial services performed but not yet billed or collected, (e.g., fees earned, sales revenue)

Oct 31 Accounts Receivable 300 -- Fees Earned 300
 * Adjusting entry** for accrued revenues that have been earned but not yet received as of last day of fiscal period

Nov 10 Cash 300 - Accounts Receivable 300 To record receipt of payment for accrued revenues

- or -

Oct 31 Rent Receivable (asset) 1,800 - Rental Revenue (revenue) 1,800
 * Adjusting entry** for accrued rental income that has been earned but not yet received as of last day of fiscal period

Nov 10 Cash 3,000 --- Rent Receivable 1,800 --- Rental Revenue 1,200 To record receipt of payment of accrued rental revenues up to October 31 plus additional rental revenues received during November


 * (b) Accrued expenses** (aka accrued liabilities) refer to expenses incurred (accumulated) but not yet paid or recorded as of the last day of the fiscal period, i.e., the date of preparation of the financial statements, e.g., interest, rent, taxes, salaries. Accordingly, an adjusting entry is necessary as of the last day of the period to account for these accumulated expenses incurred but not yet paid.

Oct 1 Cash 10,000 -- Notes Payable 10,000 (liability) Borrowed $10,000 from TD Bank; signed three-year note at 6% interest

Oct 31 Interest Expense 50 Interest Payable 50 (liability)
 * Adjusting entry** for interest accrued but not yet paid on note payable ($10,000 x 6% / 12 months) as of last day of fiscal period

Nov 1 Interest Payable 50 - Cash 50 Payment of interest accrued on note payable for month of October

- or -

Oct 31 Salaries Expense 2,400 -- Salaries Payable 2,400 (liability)
 * Adjusting entry** for salaries accrued but not yet paid as of last day of fiscal period

Nov 10 Salaries Payable 2,400 ........... Salaries Expense 1,200 .......................................... Cash 3,600 To record payment of accrued salaries up to October 31 plus additional salaries paid in November

3) **Estimates** include **allowances for doubtful accounts** (discussed later in chapter 9) and **amortization/depreciation (SO 8)**


 * Amortization** (aka **depreciation**) refers to the allocation of the cost of all capital (fixed or long-term) assets except land to expense accounts over their estimated useful lives.

Oct 1 Equipment 55,000 -- Cash 55,000 Purchase of equipment with estimated useful life of 60 months and $5,000 estimated residual value using straight-line method (see below)

Oct 31 Amortization Expense - Equipment 833.33 -- Accumulated Amortization - Equipment (contra asset) 833.33
 * Adjusting entry** for monthly amortization of equipment (55,000 - 5,000/60)

Note: Please note that in many circles (but not in your textbook), the term "amortization" is used to describe the gradual loss in value over time of __intangible__ assets only (e.g., patents, copyright) while the term "depreciation" is used to describe the gradual loss in value over time of __tangible__ assets only (e.g., equipment, furniture).

(a) Annual depreciation expense using **straight-line method** = **original purchase price - estimated residual value / estimated useful life in years**
 * __Notes on calculating annual amortization/depreciation expense:__**

e.g. $10,000 - $1000 / 10 years = $900 annual depreciation expense each year

Please note that with this method, annual depreciation expense will be __identical__ from year to year. Part-year depreciation may apply in year one, however.

(b) Annual depreciation expense using **declining-balance method** = **net book value (undepreciated or remaining value) x CRA fixed annual rate of depreciation**

e.g. $10,000 x 10% = $1000 annual depreciation expense (in year one) e.g. $9,000 x 10% = $900 annual depreciation expense (in year two)

Please note that with this method, annual depreciation expense will __decline__ from year to year. The 50% Rule may apply in year one, however.

Click here for an excellent summary of accruals and deferrals in relation to both revenues and expenses.
 * __Note__:** Sometimes, **adjusting entries** are simply classified as either **accruals** or **deferrals (prepayments)**.