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ca
 Adjustments and the Conceptual
Framework
 Adjustments are end-of-year journal entries to
update account balances
 Going-concern and periodicity dictate that
financial statements be prepared periodically
 Faithful representation requires updating account
balances

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 Why Adjusting Entries?
 Accrual basis, not cash basis
 With cash basis, there is no need for adjusting entries
 Timing differences between cash and
performance
 Long-term assets

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he Need for Adjusting Entries: An Example

On March 1, 2013 a company pays $12,000 for

one year’s rent
The Journal Entry:
March 1, 2013
Prepaid Rent 12,000
Cash 12,000

Dr. Prepaid Rent Cr. Dr. Cash Cr.

3/1 12,000 3/1 12,000

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Why Adjusting Entries?

By December 31, 2013, the firm would

have occupied the property for 10
months. Also, there are only two months
left in Prepaid Rent:
Monthly rent = 12,000 / 12 = $1,000
Rent expense for 2013 = 1,000 x 10 =
$10,000
Prepaid rent as of 12/31/2013 = 1,000 x 2
= $2,000
But so far, prepaid rent has a balance of
$12,000 and rent expense is not recorded
yet
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 Why Adjusting Entries?
T-accounts of prepaid rent and rent expense should have
ending balances of $2,000 and $10,000, respectively

Dr. Prepaid Rent Cr. Dr. Rent exp Cr.

3/1 12,000 12/31 10,000
12/31 10,000
Bal. 2,000
Bal. 10,000

Thus, the adjusting entry would be:

12/31/2013
Rent expense 10,000
Prepaid rent 10,000
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 Graphically
$12,000 March 1, 2013 Dec. 31, 2013
$10,000

$2,000

Prepaid Rent
Rent Expense
Prepaid Rent Before Adj.
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 Types of adjusting entries
 Timing differences between cash and
performance give rise to the need for adjusting
entries
 Prepayments (deferrals): result when cash is received or
paid before services are provided or received
 Accruals: result when services are provided or received
before cash is received or paid

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 Prepayments

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 Prepayments- Example 1

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 Example 1- 2012
03/01/2012 Prepaid insurance 2,400
Cash
2,400
On December 31:
Insurance Expense = 2,400/12 X 10(month) = $2,000
12/31/2012 Insurance Expense 2,000
Prepaid Insurance
2,000
Prepaid
Dr. insurance Cr. Dr. Insurance exp Cr.
03/01 2,400 12/31 2,000
12/31 2,000
Bal. 400 Bal. 2,000

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 Example 1- 2013
03/01/2013 Prepaid insurance 3,000
Cash
3,000
On December 31:
Insurance Expense:
From old policy = 2,400/12 X 2 = $400
From new policy = 3,000 / 12 X 10 = $2,500
Insurance expense = 400 + 2,500 = $2,900
12/31/2013 Insurance Expense 2,900
Prepaid Insurance
2,900
Prepaid
Dr. insurance Cr. Dr. Insurance exp Cr.
Bal. 400 12/31 2,900
03/01 3,000
12/31 2,900
Bal. 500 Bal. 2,900
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 Prepayments- Example 2

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 03/01/2013 Supplies 3,000
Cash 3,000
On December 31
Ending supplies = Beginning Supplies + Purchases – Supplies
Expense
1,200 = 0 + 3,000 – Supplies Expense  Supplies Expense
= $1,800
12/31/2013 Supplies Expense 1,800
Supplies
1,800

Dr. Supplies Cr. Dr. Supplies Expense Cr.

Beg. Bal. 0 12/31 1,800
12/31 1,800
03/01 3,000
Bal. 1,800
Bal. 1,200

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 Prepayments- Example 3

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 Prepayments- Example 4

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06/01/2013 Cash 36,000
Unearned Revenue
36,000
On December 31:
Revenue for 2013 = 36,000/12 X 5 = $15,000
12/31/2013 Unearned Revenue 15,000
Revenue 15,000

Unearned
Dr. Revenue Cr. Dr. Revenue Cr.
Beg. Bal. 0 06/01 36,000 12/31 15,000
12/31 15,000 Bal. 21,000 Bal. 15,000

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 Accruals

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 Accruals- Example 1

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Daily wages expense = 6,000 / 5 = $1,200

Monday Tuesday Wednesday Thursday Friday

$1,200 $1,200 $1,200 $1,200 $1,200

Year-End
On Wednesday: Pay Day
Salaries Expense = 6,000/5 X 3 = $3,600

Salaries Expense 3,600

Salaries Payable 3,600

On Friday:
Salaries Payable 3,600
Salaries Expense 2,400
Cash 6,000

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 Accruals- Example 2

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 Interest Revenue = Principal x Interest Rate x Period
Interest Revenue for 2013 = 10,000 x 12% x (4/12) =
$400

Adjusting entry on 12/31/2013

Interest Receivable 400

Interest Revenue 400

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 Ethical Issues in
Accrual Accounting

“Managing” earnings to
meet or beat Bay Street
forecasts.
Questionable timing of
recognizing
revenues, and expenses; affects
quality of earnings.

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 Ethical Issues in
Accrual Accounting

Failure to accrue expenses

Cookie jar reserves for

discretionary expenses
and liabilities

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 Quality of Earnings
 “True” earnings can be measured only
when business is liquidated.
 Since users of financial information
need more timely disclosure, reported
earnings are based on estimates
 Some estimates are straightforward, but
many are too subjective
 Management has incentives to exploit
these estimates
 Compensation, debt covenants, and political
scrutiny
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 Closing the Books

 Prepares the accounts for next period

 Sets revenues, expenses, and dividends to zero

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 Closing the Books

Temporary Permanent
Accounts Accounts
• Closed • Not closed
• Revenues, • Assets,
expenses, liabilities,
and and equity
dividends
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 Closing Entries

Close
Debit each revenue Revenues
Credit Retained earnings
account

Close Expenses
Credit each expense
Debit Retained earnings
account

Close Dividends
Debit Retained earnings Credit Dividends

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 Closing the Books- Example
Cash 400
Dividends 80
Service revenue 1,000
Accounts receivable 50
Common stock 250
Salary expense 200
Rent expense 280
Accounts payable 180
Retained earnings (beg.) 100
Utilities expense 320
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 Closing the Books- Example
Closing Revenues: Income Summary 200
Service Revenue 1,000 RE 200
Income Summary 1,000 Closing dividends:
Closing Expenses: RE 80
Income Summary 800 Dividends 80
Salary Expense 200
Rent Expense 280
Utilities Expense 320
Closing Income Summary:
Balance of Income Summary =
1,000 Cr – 800 Dr. = $200 Cr.

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 Balance Sheet Formats

Report Format Account Format

 Assets listed at the top  Assets on the left
 Liabilities and equity  Liabilities and equity on
beneath the right

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 Income Statement Formats

Single-Step Multi-Step
 All revenues grouped  Shows subtotals to
together emphasize relationships
 All expenses grouped  Includes
together  Gross profit

 Income from operations

 Income before taxes

 Net income

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 Net Working Capital

Current
Current
liabilitie
assets
s

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 Current Ratio
>1

Current assets

Current
liabilities

Measures ability to pay current

liabilities
Strong current ratio =
1.50
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 Debt Ratio

Total liabilities

Total assets

Measures ability to pay all liabilities

Low debt ratio is safer than high debt
ratio
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 Transactions Affect on Ratios
 Increase revenue and decrease costs
 Results in increase in current assets and net income
 Sell stock
 Increases cash and equity
 Borrow less money
 Decreases liabilities

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