3 Adjusting The Accounts

Learning Objectives
Explain the accrual basis of accounting and the
1 reasons for adjusting entries.

2 Prepare adjusting entries for deferrals.

3 Prepare adjusting entries for accruals.

Describe the nature and purpose of an adjusted

4 trial balance.
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LEARNING Explain the accrual basis of accounting
1
OBJECTIVE and the reasons for adjusting entries.

Accountants divide the economic life of a business into

artificial time periods (Time Period Assumption).

.....
Jan. Feb. Mar. Apr. Dec.

Generally a
Alternative Terminology
 month, The time period assumption
is also called the
 quarter, or periodicity assumption.
 year.

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 Fiscal and Calendar Years

 Monthly and quarterly time periods are called interim

periods.
 Most large companies must prepare both quarterly and
annual financial statements.
 Fiscal Year = Accounting time period that is one year
in length.
 Calendar Year = January 1 to December 31.

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 Fiscal and Calendar Years

Question
The time period assumption states that:
a. revenue should be recognized in the accounting
period in which it is earned.

b. expenses should be matched with revenues.

c. the economic life of a business can be divided into
artificial time periods.
d. the fiscal year should correspond with the calendar
year.

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 Accrual- versus Cash-Basis Accounting

Accrual-Basis Accounting
 Transactions recorded in the periods in which the
events occur.
 Companies recognize revenues when they perform
services (rather than when they receive cash).
 Expenses are recognized when incurred (rather than
when paid).
 In accordance with generally accepted accounting
principles (GAAP).

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 Accrual- versus Cash-Basis Accounting

Cash-Basis Accounting
 Revenues recognized when cash is received.
 Expenses recognized when cash is paid.
 Cash-basis accounting is not in accordance with
generally accepted accounting principles (GAAP).

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 Recognizing Revenues and Expenses

REVENUE RECOGNITION PRINCIPLE

Recognize revenue in the
accounting period in which the
performance obligation is
satisfied.

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 Recognizing Revenues and Expenses

EXPENSE RECOGNITION PRINCIPLE

Match expenses with revenues
in the period when the company
makes efforts that generate those
revenues.

“Let the expenses

follow the revenues.”

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 Illustration 3-1
GAAP relationships in
revenue and expense
recognition

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 Recognizing Revenues and Expenses

Question
One of the following statements about the accrual basis of
accounting is false? That statement is:
a. Events that change a company’s financial statements are
recorded in the periods in which the events occur.
b. Revenue is recognized in the period in which the performance
obligation is satisfied.
c. The accrual basis of accounting is in accord with generally
accepted accounting principles.
d. Revenue is recorded only when cash is received, and
expenses are recorded only when cash is paid.

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 The Need for Adjusting Entries

Adjusting Entries
 Ensure that the revenue recognition and expense
recognition principles are followed.
 Necessary because the trial balance may not contain
up-to-date and complete data.
 Required every time a company prepares financial
statements.
 Will include one income statement account and one
balance sheet account.

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 The Need for Adjusting Entries

Question
Adjusting entries are made to ensure that:
a. expenses are recognized in the period in which
they are incurred.
b. revenues are recorded in the period in which
services are performed.
c. balance sheet and income statement accounts
have correct balances at the end of an accounting
period.
d. all of the above.

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 Types of Adjusting Entries
Illustration 3-2
Categories of adjusting entries

Deferrals Accruals

1. Prepaid Expenses. 1. Accrued Revenues.

Expenses paid in cash before Revenues for services
they are used or consumed. performed but not yet received
in cash or recorded.

2. Unearned Revenues. 2. Accrued Expenses.

Cash received before services Expenses incurred but not yet
are performed. paid in cash or recorded.

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 Types of Adjusting Entries

Trial Balance – Each account is analyzed to determine

whether it is complete and up-to-date.
Illustration 3-3

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 DO IT! 1 Timing Concepts

A list of concepts is provided in the left column below, with a description of the
concept in the right column below. There are more descriptions provided than
concepts. Match the description of the concept to the concept.

f Accrual-basis accounting.
1. ___ (a) Monthly and quarterly time periods.
e Calendar year. (b) Efforts (expenses) should be matched
2. ___
with results (revenues).
c Time period assumption.
3. ___ (c) Accountants divide the economic life of
4. ___
b Expense recognition a business into artificial time periods.
principle. (d) Companies record revenues when they
receive cash and record expenses
when they pay out cash.
(e) An accounting time period that starts on
January 1 and ends on December 31.
(f) Companies record transactions in the
period in which the events occur.
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 LEARNING
OBJECTIVE
2 Prepare adjusting entries for deferrals.

Deferrals are expenses or revenues that are recognized

at a date later than the point when cash was originally
exchanged. There are two types:
 Prepaid expenses

 Unearned revenues

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 Prepaid Expenses

Payment of cash, that is recorded as an asset to show

the service or benefit the company will receive in the
future.

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

 insurance  rent
 supplies  equipment
 advertising  buildings

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 Prepaid Expenses

 Expire either with the passage of time or through use.

 Adjusting entry:
► Increase (debit) to an expense account and
► Decrease (credit) to an asset account.

Illustration 3-4

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 Supplies

Illustration: Pioneer Advertising

purchased supplies costing $2,500 on
October 5. Pioneer recorded the payment
by increasing (debiting) the asset
Supplies. This account shows a balance
of $2,500 in the October 31 trial balance.
An inventory count at the close of
business on October 31 reveals that
$1,000 of supplies are still on hand.

Oct. 31 Supplies Expense 1,500

Supplies 1,500

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 Supplies
Illustration 3-5

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 Insurance

Illustration: On October 4, Pioneer

Advertising paid $600 for a one-year fire
insurance policy. Coverage began on October
1. Pioneer recorded the payment by
increasing (debiting) Prepaid Insurance. This
account shows a balance of $600 in the
October 31 trial balance. Insurance of $50
($600 ÷ 12) expires each month.

Oct. 31 Insurance Expense 50

Prepaid Insurance 50

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 Insurance
Illustration 3-6

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 Depreciation

 Buildings, equipment, and motor vehicles

(assets that provide service for many years) are
recorded as assets, rather than an expense, on
the date acquired.

 Depreciation is the process of allocating the cost

of an asset to expense over its useful life.

 Depreciation does not attempt to report the actual

change in the value of the asset.

► Allocation concept, not a valuation concept.

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 Depreciation

Illustration: For Pioneer Advertising, assume

that depreciation on the equipment is $480 a
year, or $40 per month.

Oct. 31
Depreciation expense 40
Accumulated depreciation 40

Accumulated Depreciation is called

a contra asset account.

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 Illustration 3-7

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 Depreciation

STATEMENT PRESENTATION
 Accumulated Depreciation is a contra asset account
(credit).
 Offsets related asset account on the balance sheet.
 Book value is the difference between the cost of any
depreciable asset and its accumulated depreciation.
Illustration 3-8

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 Prepaid Expenses

Summary of the accounting for prepaid expenses.

Illustration 3-9
Accounting for prepaid expenses

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 Unearned Revenues

Receipt of cash that is recorded as a liability because

the service has not been performed.

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

 Rent  Magazine subscriptions
 Airline tickets  Customer deposits

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 Unearned Revenues

 Adjusting entry is made to record the revenue for

services performed during the period and to show
the liability that remains at the end of the period.

 Results in a decrease (debit) to a liability account

and an increase (credit) to a revenue account.
Illustration 3-10

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 Unearned Revenues

Illustration: Pioneer Advertising received

$1,200 on October 2 from R. Knox for
advertising services expected to be
completed by December 31. Unearned
Service Revenue shows a balance of $1,200
in the October 31 trial balance. Analysis
reveals that the company performed $400 of
services in October.

Oct. 31 Unearned Service Revenue 400

Service Revenue 400

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 Unearned Revenues
Illustration 3-11

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 Unearned Revenues

Summary of the accounting for unearned revenues.

Illustration 3-12

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 LEARNING
OBJECTIVE
3 Prepare adjusting entries for accruals.

Accruals are made to record

 Revenues for services performed but not yet
recorded at the statement date.
 Expenses incurred but not yet paid or recorded at
the statement date.

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 Accrued Revenues

Revenues for services performed but not yet received

in cash or recorded.

Revenue Recorded BEFORE Cash Receipt

Accrued revenues often occur in regard to:

 Rent
 Interest
 Services

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 Accrued Revenues

 Adjusting entry shows the receivable that exists and

records the revenues for services performed.
 Adjusting entry:
► Increases (debits) an asset account and
► Increases (credits) a revenue account.

Illustration 3-13

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 Accrued Revenues

Illustration: In October Pioneer Advertising

performed services worth $200 that were not
billed to clients on or before October 31.

Oct. 31

Accounts Receivable 200

Service Revenue 200

On November 10, Pioneer receives cash of $200 for the services

performed.

Nov. 10 Cash 200

Accounts Receivable 200
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 Accrued Revenues
Illustration 3-14

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 Accrued Revenues

Summary of the accounting for accrued revenues.

Illustration 3-15

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 Accrued Expenses

Expenses incurred but not yet paid in cash or recorded.

Expense Recorded BEFORE Cash Payment

Accrued expenses often occur in regard to:

 Rent  Taxes
 Interest  Salaries

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 Accrued Expenses

 Adjusting entry records the obligation and recognizes

the expense.
 Adjusting entry:
► Increase (debit) an expense account and
► Increase (credit) a liability account.

Illustration 3-16

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 Accrued Expenses

ACCRUED INTEREST
Illustration: Pioneer Advertising signed a three-month note
payable in the amount of $5,000 on October 1. The note requires
Pioneer to pay interest at an annual rate of 12%.
Illustration 3-17

Oct. 31 Interest expense 50

Interest payable 50

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 Accrued Expenses
Illustration 3-18

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 Accrued Expenses

ACCRUED INTEREST
Illustration: Pioneer Advertising paid salaries and wages on
October 26; the next payment of salaries will not occur until
November 9. The employees receive total salaries of $2,000 for a
five-day work week, or $400 per day.
Illustration 3-19

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 Accrued Expenses
Illustration 3-20

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 Accrued Expenses

Summary of the accounting for accrued expenses.

Illustration 3-21

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 Summary of Basic Relationships
Illustration 3-22

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