Chapter 9

1. Chapter 9 Completing the Accounting Cycle

2. The Adjustment Process

3. The Adjusting Process • We now know that financial statements are used extensively to assist in making business decisions. • It is the accountants responsibility to ensure that these financial statements are accurate, up-to-date, and consistent from year to year.

4. The Adjusting Process • When preparing the financial statements, the accountant must ensure: • All accounts are brought up to date; • All late transactions are taken into account; • All calculations have been made correctly; and • All GAAPs have been complied with.

5. The Adjusting Process • Bringing the account data up-to-date at statement time is known as “making the adjustments”. • The accounting entries produced by this process are known as adjusting entries. • In most cases adjusting entries assign amounts of revenue or expense to the appropriate accounting period before the books are finalized for the fiscal period.

6. The Adjusting Process • Adjusting entries are necessary because the books of account are allowed to become inaccurate between statements dates. • Some accounts do not need to be perfectly accurate at the end of each business day BUT do need to be adjusted in order to determine the correct net income of net loss for the period.

7. The Adjusting Process • The first three adjusting entries are: • Adjusting entries for Supplies; • Adjusting entries for Prepaid Expenses; and • Adjusting entries for Late-Arriving Purchase Invoices.

8. Adjusting Entries for Supplies • When supplies are purchased, their cost is debited correctly to the Supplies account. • As supplies are used, which is usually daily, no accounting entries are made to record this usage. • During the accounting period, the balance of the Supplies account represents the balance at the beginning of the period plus any new supplies purchased.

9. Adjusting Entries for Supplies • The balance of Supplies Expense is zero. • In order to satisfy the Matching Principle, both of these accounts must be adjusted to reflect the usage (i.e. expense) during the fiscal period. • To book the adjusting entry, you must first determine the supplies inventory (by counting the remaining supplies). • You then determine the cost of the supplies used (i.e. difference between the inventory count and the balance of the supplies account).

10. 2007 2007 6,514 6,514 6,514 6,514 6,514 1,386 2007 Adjusting Entries for Supplies Assume the Supplies on hand at December 31, 2007 are $1,386 (i.e. the supplies inventory).

11. Adjusting Entries for Prepaid Expense • There are times in business when expense items are paid for in advance. • This presents no problem if the expense item falls entirely within the fiscal period . • If the expense item affects more than the current fiscal period, then it must be treated as a prepaid expense. • A prepaid expense is an item paid for in advance, but one where the benefits extend into the future.

12. Adjusting Entries for Prepaid Expense • Insurance is the most common prepaid expense. • A business can purchase insurance to cover possible losses on automobiles, buildings, contents, crops, etc. • When you purchase insurance, you usually pay for one year’s coverage in advance. ( Note: occasionally, the period can be greater than one year.)‏

13. Adjusting Entries for Prepaid Expense • When prepaid expenses are purchased, they are usually debited to a prepaid expense account. • Prepaid expenses accounts have value and are therefore classified as assets. • If, for example you were to cancel an insurance policy, all (or a portion) of the prepaid insurance expense would be refunded by the insurance broker / company.

14. 2007 2007 600 600 600 600 600 1,200 Adjusting Entries for Prepaid Expense Prepaid annual insurance premium on September 1, 2007. $1,800 x 4/12

15. Adjusting Entries for Late-Arriving Purchase Invoices • Goods and services are often bought and received toward the end of an accounting period. • The invoices for these items may not arrive until the subsequent fiscal period. • The Matching Principle states that expenses are to be recognized in the same period as the revenue that they help to earn.

16. Adjusting Entries for Late-Arriving Purchase Invoices • The financial statements are not “typically” prepared until two or three weeks after the fiscal year end. • During this waiting period, the accounting department must analyze all purchase invoices in order to find those that affect the fiscal period that just ended.

17. Adjusting Entries for Late-Arriving Purchase Invoices Prior to financial statement preparation, the accountant discovers there were two late-arriving invoices: telephone $212 and utilities $315.

18. Class / Homework • p. 308, Exercises 1 & 3 • p. 309, Exercises 4, 5 & 6

19. Adjusting Entries and the Work Sheet

20. Adjusting Entries and the Work Sheet • The first place that adjusting entries are recorded is on the work sheet. • As the work sheet is prepared, adjusting entries are calculated and recorded in a section headed Adjustments.

21. The physical inventory of supplies at Dec. 31 totaled $526. What adjusting entry is required? An analysis of prepaid insurance determined that the balance at Dec. 31 should be $4,070. What adjusting entry is required? 496.00 626.00 954.90 3 3 1 2494.00 2 85.00 45.00 3 3 Supplies Expense 954.90 1 Insurance Expense 2 2494.00 A clerk discovered three “late” purchase invoices belonging to 2007…telephone $45, truck repair $496 & printer repair $85.

22. Balance the Adjustments Columns. Balancing the Work Sheet … total each of the last four columns Balancing the Work Sheet … determine the diff. between the two income statement columns the two balance sheet columns Extending the Work Sheet … add or subtract the adjustments from the trial balance and record in the last four columns. 1 1 1 1 2 2 2 2 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 1 1 1 1 2 2 2 2 526.00 4,070.00 3,136.00 Net Income

23. Journalize Adjusting Entries • So far, the adjusting entries have been recorded only on the work sheet • Once the work sheet is complete / balanced, the adjusting entries must be recorded in the books of accounts. • Journalize and post all entries that appear in the adjustments section of the work sheet.

24. Journalize Adjusting Entries

25. Class / Homework • p. 321, Exercises 2

26. Closing Entries

27. Closing Entries Concepts • The Time Period Concept states that financial reporting, or net income in particular, is done in equal period of time. • After you do your adjusting entries and prepare your formal income statements, the accounts must be made ready for the next accounting cycle.

28. Closing Entries Concepts • Determine which accounts have balances that continue from one period to the next and which do not. • There are two types of accounts … real accounts and nominal accounts. • All asset and liability accounts, as well as the owner’s capital account, are considered to be real accounts.

29. Closing Entries Concepts • Real accounts have balances that continue into the next fiscal period. • Nominal accounts (revenue, expense and drawings accounts) have balances that do not continue into the next fiscal period. • Nominal accounts, with the exception of drawings, are related to the income statement.

30. Closing Entries Concepts • A special nominal account, called the Income Summary account, is used only during the closing entry process. • Once the income statement for a period has been completed, the balances in the nominal accounts are no longer useful … their balance must be taken to zero in preparation for the next accounting cycle.

31. Closing Entries Concepts • Closing an account means to cause it to have no balance. • Any changes in equity during the period are contained in the Revenue, Expense, and Drawings accounts. • Closing these nominal accounts moves the values collected in these accounts into the one real equity account, the Capital account.

32. Performed daily Accounting entries recorded in the journal. Performed by accounting clerks Performed monthly Ledger balanced by means of a trial balance. Journal entries posted to the ledger accounts. Work sheet prepared. Formal income stmt. & balance sheet prepared. Performed by accountants Performed at end of each fiscal period Closing entries journalized & posted. Adjusting entries journalized & posted. Post-closing trial balance. Transactions occur. Source documents. Complete Accounting Cycle

33. Class / Homework • p. 324, Exercises 1 • p. 326, Exercises 4

34. Journalizing and Posting the Closing Entries

35. Closing Entry 1: transfer the balances in the revenue account(s) to a new nominal account called Income Summary. Closing Entry 2: transfer the balances in the expense accounts to the Income Summary account. Closing Entry 3: transfer the balances in Income Summary Account to the owner’s Capital account. Closing Entry 4: transfer the balances in Drawings account to the owner’s Capital account. 1 2 3 3 3 3 1 2 Net Income

36. Summary of Closing Entries

37. Post-Closing Trial Balance

38. Balance the Adjustments Columns. Extending the Work Sheet … add or subtract the adjustments from the trial balance and record in the last four columns. Post-Closing Trial Balance Balancing the Work Sheet … total each of the last four columns 1 1 1 1 2 2 2 2 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 1 1 1 1 2 2 2 2 526.00 4,070.00 3,136.00

39. Capital Account Calculating your Post-Closing Balance P. Marshall, Capital $42,000.00 4 66,836.09 3 $42,000.00 $95,731.51 $53,731.51 $28,895.42

40. Post-Closing Trial Balance P. Marshall, Capital $42,000.00 $42,000.00 $28,895.42 66,836.09 $95,731.51 $53,731.81

41. Class / Homework • p. 334, Exercises 1 • p. 335, Exercises 2 – A, B & D • p. 335-6, Exercises 3

42. Adjusting for Depreciation

43. Adjusting for Depreciation • Assets that are used to produce revenue over several fiscal periods are known as fixed assets. • Fixed assets are also known as “long-lived assets”, “capital equipment”, and “plant and equipment”. • Except for land, all fixed assets will be used up in the course of time and activity.

44. Adjusting for Depreciation • Fixed assets decrease or depreciate in value. • Depreciationrefers to an allowance made for the decrease in value of an asset over time. • It is not possible to calculate depreciation until the end of the asset’s life … only then, can you say how many years it was used and determine its final worth.

45. Adjusting for Depreciation • The matching principle dictates that depreciation must be included on every year-end income statement. • To do this, accountants must estimate depreciation while the asset is still in use. • The two most common methods of calculating depreciation are the: Straight-Line method and Declining-balance method.

46. Straight-Line Depreciation Original Cost of Asset Estimated Salvage Value Straight-Line Depreciation for one year - = Estimated Number of Periods in the Life of the Asset • The simplest way to estimate depreciation. • The Straight-Line method of depreciation divides up the net cost of the asset equally over the years of the asset’s life.

47. Straight-Line Depreciation Original Cost of Asset Estimated Salvage Value Straight-Line Depreciation for one year - = Estimated Number of Periods in the Life of the Asset - $78,000 $7,800 = 6 = $11,700 • You purchased a truck for $78,000 on January 1, 2007. It is estimated that the truck will be used for six years, and at the end of that time, could be sold for $7,800. What is the annual depreciation?

48. Straight-Line Depreciation Original Cost of Asset Estimated Salvage Value Straight-Line Depreciation for one year - = Estimated Number of Periods in the Life of the Asset - $5,120 $500 = 10 = $462 • You purchased furniture for $5,120 on January 1, 2007. It is estimated that the furniture will be used for 10 years, and at the end of that time, could be sold for $500. What is the annual depreciation?

49. Adjusting Depreciation • When adjusting for depreciation you would expect to DR Depreciation Expense CR Asset • In order to show the value of the Asset at cost, you would not CR Asset for the depreciation … rather you CR Accumulated Depreciation.

50. Accumulated Depreciation • Accumulated depreciation is a valuation or contra account. • A contra account is one that is displayed alongside an associated account and has a balance that is opposite to the account it is associated with. • Accumulated depreciation is also known as a valuation account … an account that is used, together with an asset account, to show the true net value (or net book value) of the asset.