Chapter 3

CHAPTER 3
ADJUSTING THE
ACCOUNTS
Chapter
3-1
Timing Issues
Accountants divide the economic life of a business

into artificial time periods (Time Period
Assumption).
.....
Jan. Feb. Mar. Apr. Dec.
Generally a month, a quarter, or a year.

Fiscal year vs. calendar year
Also known as the “Periodicity Assumption”
Chapter
3-2 LO 1 Explain the time period assumption.
Timing Issues
Review
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.
Chapter
3-3 LO 1 Explain the time period assumption.
Timing Issues
Accrual- vs. Cash-Basis Accounting

Accrual-Basis Accounting
Transactions recorded in the periods in which the events
occur
Revenues are recognized when earned, rather than when
cash is received.
Expenses are recognized when incurred, rather than
when paid.
Chapter
3-4 LO 2 Explain the accrual basis of accounting.
Timing Issues
Accrual- vs. Cash-Basis Accounting

Cash-Basis Accounting
Revenues are recognized when cash is received.
Expenses are recognized when cash is paid.
Cash-basis accounting is not in accordance with
generally accepted accounting principles (GAAP).
Chapter
Timing Issues
Recognizing Revenues and Expenses

Revenue Recognition Principle
Companies recognize revenue
in the accounting period in
which it is earned.
In a service enterprise,
revenue is considered to be
earned at the time the service
is performed.
Chapter
Timing Issues
Recognizing Revenues and Expenses

Matching Principle
Match expenses with
revenues in the period when
the company makes efforts to
generate those revenues.
“Let the expenses follow the

revenues.”
Chapter
Timing Issues
GAAP relationships in
revenue and expense
recognition
Illustration 3-1
Chapter
Timing Issues
Review
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 it is earned.
c. This basis is in accord with generally accepted accounting
principles.
d. Revenue is recorded only when cash is received, and
expense is recorded only when cash is paid.
Chapter
The Basics of Adjusting Entries
Adjusting entries make it possible to report correct

amounts on the balance sheet and on the income
statement.
A company must make adjusting entries every time
it prepares financial statements.
Chapter
3-10 LO 3 Explain the reasons for adjusting entries.
The Basics of Adjusting Entries
Revenues - recorded in the period in which they are

earned.
Expenses - recognized in the period in which they
are incurred.
Adjusting entries - needed to ensure that the revenue
recognition and matching principles are followed.
Chapter
Timing Issues
Review
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 they are
earned.
c. balance sheet and income statement accounts have
correct balances at the end of an accounting period.
d. all of the above.
Chapter
Types of Adjusting Entries
Deferrals Accruals
1. Prepaid Expenses. Expenses 3. Accrued Revenues. Revenues
paid in cash and recorded as earned but not yet received in
assets before they are used or cash or recorded.
consumed.
2. Unearned Revenues. 4. Accrued Expenses. Expenses

Revenues received in cash and incurred but not yet paid in
recorded as liabilities before cash or recorded.
they are earned.
Chapter
3-13 LO 4 Identify the major types of adjusting entries.
Trial Balance
Trial Balance – Each account is analyzed to
determine whether it is complete and up-to-date.
Phoenix Consulting - J an. 31st (before adjusting entries)

Acct. No. Account Debit Credit
100 Cash $ 50,000
105 Accounts receivable 35,000
110 Prepaid insurance 12,000
120 Equipment 24,000
130 I nvestments 300,000
200 Accounts payable $ 20,000
210 Unearned revenue 24,000
220 Note payable 200,000
300 Austin, capital 40,000
400 Sales 137,000
$ 421,000 $ 421,000
Chapter
3-14 LO 4 Identify the major types of adjusting entries.
Adjusting Entries for Deferrals
Deferrals are either:

Prepaid expenses or
Unearned revenues.
Chapter
3-15 LO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
Payment of cash, that is recorded as an asset because service

or benefit will be received in the future.
Cash Payment BEFORE Expense Recorded
Prepayments often occur in regard to:

insurance rent
supplies maintenance on equipment
advertising fixed assets (depreciation)
Chapter
Prepaid Expenses
Costs that expire either with the passage of time or through
use.
Adjusting entries (1) to record the expenses that apply to
the current accounting period, and (2) to show the
unexpired costs in the asset accounts.
Chapter
Illustration 3-4
Adjusting entries for prepaid expenses
Increases (debits) an expense account and

Decreases (credits) an asset account.
Chapter
Example (Insurance): On Jan. 1st, Phoenix Consulting paid $600

for 12 months of insurance coverage. Show the journal entry to
record the payment on Jan. 1st.
Jan. 1 Prepaid insurance 600

Cash 600
Prepaid Insurance Cash

Debit Credit Debit Credit
600 600
Chapter
Example (Insurance): On Jan. 1st, Phoenix Consulting paid $600

for 12 months of insurance coverage. Show the adjusting journal
entry required at Jan. 31st.
Jan. 31 Insurance expense 50

Prepaid insurance 50
Prepaid Insurance Insurance expense

600 50 50
550
Chapter
Depreciation
Buildings, equipment, and vehicles (long-lived assets)
are recorded as assets, rather than an expense, in the year
acquired.
Companies report a portion of the cost of a long-lived
asset as an expense (depreciation) during each period of
the asset’s useful life (Matching Principle).
Chapter
Example (Depreciation): On Jan. 1st, Phoenix Consulting paid

$24,000 for equipment that has an estimated useful life of 20 years.
Show the journal entry to record the purchase of the equipment on
Jan. 1st.
Jan. 1 Equipment 24,00
Cash 0 24,00
0
Equipment Cash
24,000 24,000
Chapter
Example (Depreciation): On Jan. 1st, Phoenix Consulting paid $24,000

for equipment that has an estimated useful life of 20 years. Show the
adjusting journal entry required at Jan. 31st. ($24,000 / 20 yrs. / 12
months = $100)
Jan. 31 Depreciation expense 100

Accumulated depreciation 100
Depreciation expense Accumulated

Debit Credit depreciation
Debit Credit
100 100
100
Chapter
Depreciation (Statement Presentation)

Accumulated Depreciation—is a contra asset account.
Appears just after the account it offsets (Equipment) on the
balance sheet.
Balance Sheet J an. 31

Assets
Equipment 24,000
Accumulated Depreciation (100)
Net Equipment 23,900
Chapter
Adjusting Entries for “Unearned Revenues”
Receipt of cash that is recorded as a liability because the

revenue has not been earned.
Cash Receipt BEFORE Revenue Recorded
Unearned revenues often occur in regard to:

rent magazine subscriptions
airline tickets customer deposits
school tuition
Chapter
Unearned Revenues
Company makes an adjusting entry to record the revenue
that has been earned and to show the liability that remains.
The adjusting entry for unearned revenues results in a
decrease (a debit) to a liability account and an increase (a
credit) to a revenue account.
Chapter
Illustration 3-10
Adjusting entries for unearned revenues
Decrease (a debit) to a liability account and

Increase (a credit) to a revenue account.
Chapter
Adjusting Entries for “Unearned
Revenues”
Example: On Jan. 1st, Phoenix Consulting received
$24,000 from Arcadia High School for 3 months rent in
advance. Show the journal entry to record the receipt
on Jan. 1st.
Jan. 1 Cash 24,00
Unearned rent revenue 0 24,00
0
Cash Unearned Rent
Debit Credit DebitRevenue
Credit
24,000 24,000
Chapter
Adjusting Entries for “Unearned
Revenues”
Example: On Jan. 1st, Phoenix Consulting received
$24,000 from Arcadia High School for 3 months rent in
advance. Show the adjusting journal entry required on
Jan. 31st.
Jan. 31 Unearned rent revenue 8,000
Rent revenue 8,000
Rent Revenue Unearned Rent

Debit Credit DebitRevenue
Credit
8,000 8,000 24,000
16,000
Chapter
Adjusting Entries for Accruals
Made to record:
Revenues earned and
Expenses incurred
in the current accounting period that have not been
recognized through daily entries.
Chapter
3-30 LO 6 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Revenues”
Revenues earned but not yet received in cash or recorded.
Adjusting entry results in:
Revenue Recorded BEFORE Cash Receipt
Accrued revenues often occur in regard to:

rent
interest
services performed
Chapter
Accrued Revenues
An adjusting entry serves two purposes:
(1) It shows the receivable that exists, and
(2) It records the revenues earned.
Chapter
Illustration 3-13
Adjusting entries for accrued revenues
Increases (debits) an asset account and

Increases (credits) a revenue account.
Chapter
Example: On Jan. 1st, Phoenix Consulting invested $300,000 in

securities that return 5% interest per year. Show the journal entry to
record the investment on Jan. 1st.
Jan. 1 Investments 300,00

Cash 0 300,000
Investments Cash
300,000 300,000
Chapter
Example: On Jan. 1st, Phoenix Consulting invested $300,000 in

securities that return 5% interest per year. Show the adjusting journal
entry required on Jan. 31st. ($300,000 x 5% / 12 months = $1,250)
Jan. 31 Interest receivable 1,250

Interest revenue 1,250
Interest Receivable Interest Revenue

1,250 1,250
Chapter
Adjusting Entries for “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
Chapter
Accrued Expenses
(1) It records the obligations, and
(2) It recognizes the expenses.
Chapter
Illustration 3-16
Adjusting entries for accrued expenses
Increases (debits) an expense account and

Increases (credits) a liability account.
Chapter
Example: On Jan. 2nd, Phoenix Consulting borrowed $200,000 at a rate

of 9% per year. Interest is due on first of each month. Show the journal
entry to record the borrowing on Jan. 2 nd.
Jan. 2 Cash 200,00

Notes payable 0 200,000
Cash Notes Payable

200,000 200,000
Chapter
Example: On Jan. 2nd, Phoenix Consulting borrowed $200,000 at a rate

of 9% per year. Interest is due on first of each month. Show the
adjusting journal entry required on Jan. 31st. ($200,000 x 9% / 12 months
= $1,500)
Jan. 31 Interest expense 1,500
Interest payable 1,500
Interest Expense Interest Payable

1,500 1,500
Chapter
Accrued Expenses
(1) It records the obligations, and
(2) it recognizes the expenses.
Chapter
The Adjusted Trial Balance
After all adjusting entries are journalized and posted the

company prepares another trial balance from the ledger
accounts (Adjusted Trial Balance).
Its purpose is to prove the equality of debit balances and

credit balances in the ledger.
Chapter
3-42 LO 7 Describe the nature and purpose of an adjusted trial
Timing Issues
Review
Which of the following statements is incorrect concerning the
adjusted trial balance?
a. An adjusted trial balance proves the equality of the total
debit balances and the total credit balances in the ledger after
all adjustments are made.
b. The adjusted trial balance provides the primary basis for the
preparation of financial statements.
c. The adjusted trial balance lists the account balances
segregated by assets and liabilities.
d. The adjusted trial balance is prepared after the adjusting
entries have been journalized and posted.
Chapter
Preparing Financial Statements
Financial Statements are prepared directly from the Adjusted

Trial Balance.
Statement of
Balance Income Statement of
Retained
Sheet Statement Cash Flows
Earnings
Chapter
Adjusted Trial Balance Debit Credit
Cash $ 50,000 Income
Accounts receivable
I nterest receivable
35,000
1,250 Statement
I ncome Statement
Prepaid insurance 11,000
For the Month Ended J an. 31,
Equipment 24,000
Accumulated depreciation $ 100 Revenues:
I nvestments 300,000 Sales $ 137,000
Accounts payable 20,000 I nterest revenue 1,250
I nterest payable 1,500 Rent revenue 8,000
Unearned revenue 16,000
Total revenue 146,250
Note payable 200,000
Austin, capital 40,000 Expenses:
Sales 137,000 I nterest expense 1,500
I nterest revenue 1,250 Depreciation expense 100
Rent revenue 8,000 I nsurance expense 1,000
I nterest expense 1,500
Total expenses 2,600
Depreciation expense 100
Net income $ 143,650
I nsurance expense 1,000
$ 423,850 $ 423,850
Chapter
Adjusted Trial Balance Debit Credit
Cash $ 50,000
Accounts receivable 35,000
I nterest receivable 1,250
Equipment 24,000
Accumulated depreciation $ 100
I nvestments 300,000
Statement of
Accounts payable 20,000 Owners’ Equity
I nterest payable 1,500
Statement of Owners' Equity
For the Month Ended J an. 31,
Austin, capital 40,000
Sales 137,000 Austin, Capital, J an. 1 $ 40,000
I nterest revenue 1,250 +Net income 143,650
Rent revenue 8,000 - Drawings 0
I nterest expense 1,500 Austin, Capital, J an. 31 $ 183,650
Depreciation expense 100
$ 423,850 $ 423,850
Chapter
Adjusted Trial Balance Debit Credit Balance Sheet J an. 31
Cash $ 50,000 Assets
Cash $ 50,000
I nterest receivable 1,250
Equipment 24,000 I nterest receivable 1,250
Accumulated depreciation $ 100 Prepaid insurance 11,000
I nvestments 300,000 Equipment 24,000
Accounts payable 20,000 Accum. Depreciation (100)
I nterest payable 1,500 I nvestments 300,000
Total assets $ 421,150
Liabilities & Owners' Equity
Austin, capital 40,000
Sales 137,000 Accounts payable $ 20,000
I nterest revenue 1,250 I nterst payable 1,500
Rent revenue 8,000 Unearned revenue 16,000
I nterest expense 1,500 Note payable 200,000
Depreciation expense 100 Austin, capital 183,650
Total liab. & equity $ 421,150
$ 423,850 $ 423,850
Chapter

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CHAPTER 3

Accountants divide the economic life of a business

Generally a month, a quarter, or a year.

Accrual- vs. Cash-Basis Accounting

Accrual- vs. Cash-Basis Accounting

Recognizing Revenues and Expenses

Recognizing Revenues and Expenses

“Let the expenses follow the

Adjusting entries make it possible to report correct

Revenues - recorded in the period in which they are

2. Unearned Revenues. 4. Accrued Expenses. Expenses

Phoenix Consulting - J an. 31st (before adjusting entries)

Deferrals are either:

Payment of cash, that is recorded as an asset because service

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

Increases (debits) an expense account and

Example (Insurance): On Jan. 1st, Phoenix Consulting paid $600

Jan. 1 Prepaid insurance 600

Prepaid Insurance Cash

Example (Insurance): On Jan. 1st, Phoenix Consulting paid $600

Jan. 31 Insurance expense 50

Prepaid Insurance Insurance expense

Example (Depreciation): On Jan. 1st, Phoenix Consulting paid

Example (Depreciation): On Jan. 1st, Phoenix Consulting paid $24,000

Jan. 31 Depreciation expense 100

Depreciation expense Accumulated

Depreciation (Statement Presentation)

Balance Sheet J an. 31

Receipt of cash that is recorded as a liability because the

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

Decrease (a debit) to a liability account and

Rent Revenue Unearned Rent

Revenues earned but not yet received in cash or recorded.

Adjusting entry results in:

Revenue Recorded BEFORE Cash Receipt

Accrued revenues often occur in regard to:

Increases (debits) an asset account and

Example: On Jan. 1st, Phoenix Consulting invested $300,000 in

Jan. 1 Investments 300,00

Example: On Jan. 1st, Phoenix Consulting invested $300,000 in

Jan. 31 Interest receivable 1,250

Interest Receivable Interest Revenue

Expenses incurred but not yet paid in cash or recorded.

Expense Recorded BEFORE Cash Payment

Accrued expenses often occur in regard to:

Increases (debits) an expense account and

Example: On Jan. 2nd, Phoenix Consulting borrowed $200,000 at a rate

Jan. 2 Cash 200,00

Cash Notes Payable

Example: On Jan. 2nd, Phoenix Consulting borrowed $200,000 at a rate

Interest Expense Interest Payable

After all adjusting entries are journalized and posted the

Its purpose is to prove the equality of debit balances and

Financial Statements are prepared directly from the Adjusted

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