Financial Accounting, 4e

Weygandt, Kieso, & Kimmel

Prepared by
Gregory K. Lowry
Mercer University
Marianne Bradford
The University of Tennessee

John Wiley & Sons, Inc.

 CHAPTER 3
ADJUSTING THE ACCOUNTS
After studying this chapter, you should be able to:
1 Explain the time period assumption.
2 Explain the accrual basis of accounting.
3 Explain why adjusting entries are needed.
4 Identify the major types of adjusting
entries.
5 Prepare adjusting entries for prepayments.
6 Prepare adjusting entries for accruals.
7 Describe the nature and purpose of an
adjusted trial balance.
 PREVIEW OF CHAPTER 3
ADJUSTING THE
ACCOUNTS

The Adjusted Trial

The Basics of Balance and
Timing Issues
Adjusting Entries Financial Statements

 Time Period  Types of  Preparing the

assumption adjusted trial
adjusting entries
 Fiscal and calendar balance
years

Adjusting entries
for prepayments  Preparing
Recognizing

financial
revenues and Adjusting entries statements
expenses for accruals
Accrual vs. Cash 
Summary
basis accounting
 TIME-PERIOD ASSUMPTION

 The time period (or periodicity) assumption assumes that the

economic life of a business can be divided into artificial time
periods.
 Accounting time periods are generally a month, a quarter, or
a year.
 The accounting time period of one year in length is
usually known as a fiscal year.
 The accounting period used by most businesses
coincides with the calendar year (January 1 to
December 31).
 ACCRUAL BASIS OF
ACCOUNTING
 The revenue recognition and matching
principles are used under the accrual basis of
accounting.
 Under cash-basis accounting, revenue is
recorded only when cash is received, and
expenses are recorded only when paid.
 Generally accepted accounting principles
require accrual basis accounting because the
cash basis often causes misleading financial
statements.
 REVENUE RECOGNITION
PRINCIPLE
 The revenue recognition principle states that
revenue should be recognized in the
accounting period in which it is earned.
 In a service business, revenue is considered
to be earned at the time the service is
performed.
 THE MATCHING PRINCIPLE

 The practice of expense recognition is

referred to as the matching principle.
 The matching principle dictates that efforts
(expenses) be matched with
accomplishments (revenues).

Revenues expenses
earned are offset incurred in
this month against.... earning the
revenue
 ILLUSTRATION 3-1
GAAP RELATIONSHIPS IN REVENUE AND
EXPENSE RECOGNITION

Time-Period Assumption

Economic life of business

can be divided into
artificial time periods

Revenue-Recognition Principle Matching Principle

Revenue recognized in Expenses matched with revenues

the accounting period in in the period when efforts are
which it is earned expended to generate revenues
 ADJUSTING ENTRIES

Adjusting entries are made in order for:

1 Revenues to be recorded in the period in
which they are earned, and for......
2 Expenses to be recognized in the period in
which they are incurred.
 ADJUSTING ENTRIES

 Adjusting entries are required each time

financial statements are prepared.
 Adjusting entries can be classified as
1 prepayments (prepaid expenses or
unearned revenues) or
2 accruals (accrued revenues or accrued
expenses)
 TYPES OF
ADJUSTING ENTRIES

Prepayments
1 Prepaid Expenses - expenses paid in cash
and recorded as assets before they are used
or consumed
2 Unearned Revenues - revenues received in
cash and recorded as liabilities before they
are earned
 TYPES OF
ADJUSTING ENTRIES

Accruals
1 Accrued Revenues - revenues earned but not
yet received in cash or recorded
2 Accrued Expenses - expenses incurred but
not yet paid in cash or recorded
 ILLUSTRATION 3-3
TRIAL BALANCE
PIONEER ADVERTISING AGENCY, INC.
Trial Balance
October 31, 2002
Debit Credit
Cash $ 15,200
Advertising Supplies The Trial Balance 2,500
Prepaid Insurance
Office Equipment
is the starting 600
5,000
Notes Payable place for adjusting $ 5,000
Accounts Payable 2,500
Unearned Revenue entries. 1,200
Common Stock 10,000
Retained Earnings -0-
Dividends 500
Service Revenue 10,000
Salaries Expense 4,000
Rent Expense 900
$ 28,700 $ 28,700
 PREPAYMENTS

 Prepayments are either prepaid expenses

or unearned revenues.
 Adjusting entries for prepayments are
required to record the portion of the
prepayment that represents
1 the expense incurred or
2 the revenue earned in the current
accounting period.
 ILLUSTRATION 3-4
ADJUSTING ENTRIES FOR PREPAYMENTS

Adjusting Entries
Prepaid Expenses
Asset Expense
Unadjusted Credit Debit
Balance Adjusting Adjusting
Entry (-) Entry (+)
Unearned Revenues
Liability Revenue
Debit Unadjusted Credit
Adjusting Balance Adjusting
Entry (-) Entry (+)
 PREPAID EXPENSES

 Prepaid expenses are expenses paid in

cash and recorded as assets before they
are used or consumed.
 Prepaid expenses expire with the
passage of time or through use and
consumption.
 An asset-expense account relationship
exists with prepaid expenses.
 PREPAID EXPENSES

 Prior to adjustment, assets are overstated

and expenses are understated.
 The adjusting entry results in a debit to an
expense account and a credit to an asset
account.
 Examples of prepaid expenses include
supplies, insurance, and depreciation.
 ADJUSTING ENTRIES FOR PREPAYMENTS
SUPPLIES

October 31, an inventory count reveals that $1,000 of

Adjustment $2,500 of supplies are still on hand.

Journal
Entry

Posting
 ADJUSTING ENTRIES FOR PREPAYMENTS
INSURANCE

October 31, an analysis of the policy reveals that $50 of

Adjustment insurance expires each month.

Journal
Entry

Posting
 DEPRECIATION

 Depreciation is the process of allocating

the cost of an asset to expense over its
useful life in a rational and systematic
manner.
 The purchase of equipment or a building
is viewed as a long-term prepayment of
services and, therefore, is allocated in
the same manner as other prepaid
expenses.
 DEPRECIATION
 Depreciation is an estimate rather than a
factual measurement of the cost that has
expired.
 In recording depreciation, Depreciation
Expense is debited and a contra asset
account, Accumulated Depreciation, is
credited
Depreciation Expense
xxx xxx
 DEPRECIATION

 In the balance sheet, Accumulated

Depreciation is offset against the asset
account.
 The difference between the cost of the
asset and its related accumulated
depreciation is referred to as the
book value of the asset.
 ADJUSTING ENTRIES FOR PREPAYMENTS
DEPRECIATION

October 31, depreciation on the office equipment is estimated

Adjustment to be $480 a year, or $40 per month.

Journal
Entry

Posting
 UNEARNED REVENUES

 Unearned revenues are revenues

received in cash and recorded as
liabilities before they are earned.
 Unearned revenues are subsequently
earned by rendering a service to a
customer.
 A liability-revenue account relationship
exists with unearned revenues.
 UNEARNED REVENUES

 Prior to adjustment, liabilities are

overstated and revenues are understated.
 The adjusting entry results in a debit to a
liability account and a credit to a revenue
account.
 Examples of unearned revenues include
rent, magazine subscriptions, and customer
deposits for future services.
 ADJUSTING
ADJUSTING ENTRIES
ENTRIES FOR
FOR PREPAYMENTS
PREPAYMENTS
UNEARNED REVENUES

October 31, analysis reveals that, of $1,200 in fees, $400 has

Adjustment been earned in October.

Date Account Titles and Explanation Debit Credit

Journal Oct. 31 Unearned Revenue 400
Service Revenue 400
Entry (To record revenue for services
provided

Unearned Revenue Service Revenue

Posting Oct. 31 400 Oct. 2 1,200 Oct. 31 10,000
31 800 31 400
 ACCRUALS

 The second category of adjusting entries

is accruals.
 Adjusting entries for accruals are
required to record revenues earned and
expenses incurred in the current period.
 The adjusting entry for accruals will
increase both a balance sheet and an
income statement account.
 ILLUSTRATION 3-10
ADJUSTING ENTRIES FOR ACCRUALS

Adjusting Entries
Accrued Revenues
Asset Revenue
Debit Credit
Adjusting Adjusting
Entry (+) Entry (+)
Accrued Expenses
Expense Liability
Debit Credit
Adjusting Adjusting
Entry (+) Entry (+)
 ACCRUED REVENUES

 Accrued revenues may accumulate with the

passing of time or through services
performed but not billed or collected.
 An asset-revenue account relationship exists
with accrued revenues.
 Prior to adjustment, assets and revenues
are understated.
 The adjusting entry requires a debit to an
asset account and a credit to a revenue
account.
 ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED REVENUES

October 31, the agency earned $200 in fees for advertising

Adjustment services that were not billed to clients before October 31.

Date Account Titles and Explanation Debit Credit

Journal Oct. 31 Accounts Receivable
Service Revenue
200
200
Entry (To accrue fees earned but
not billed or collected)

Service Revenue
Oct. 31 10,000
Posting 31
31
400
200
31 10,600
 ACCRUED EXPENSES

 Accrued expenses are expenses incurred

but not yet paid or recorded.
 A liability-expense account relationship
exists
 Prior to adjustment, liabilities and expenses
are understated
 The adjusting entry results in a debit to an
expense account and a credit to a liability
account
 ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED INTEREST

October 31, the portion of the interest to be accrued on a

Adjustment 3-month note payable is calculated to be $50.

Journal
Entry

Posting
 ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED SALARIES

Adjustment October 31, accrued salaries are calculated to be $1,200.

Journal
Entry

Posting
 ILLUSTRATION 3-16
SUMMARY OF ADJUSTING ENTRIES

1 Prepaid Assets
andAssets overstatedDr. Expenses expenses expenses Expenses understated Cr.
Assets
2 Unearned Liabilities and Liabilities overstated Dr. Liabilities revenues
revenues Revenues understated Cr. Revenues
3 Accrued Assets and Assets understated Dr. Assets revenues revenues
Revenues understated Cr. Revenues
4 Accrued Expenses and Expenses understated Dr. Expenses expenses
liabilities Liabilities understated Cr. Liabilities
 ADJUSTED TRIAL BALANCE

 An Adjusted Trial Balance is prepared after all

adjusting entries have been journalized and
posted.
 It shows the balances of all accounts at the end of
the accounting period and the effects of all
financial events that have occurred during the
period.
 It proves the equality of the total debit and credit
balances in the ledger after all adjustments have
been made.
 Financial statements can be prepared directly
from the adjusted trial balance.
 ILLUSTRATION 3-19
TRIAL BALANCE AND ADJUSTED TRIAL BALANCE COMPARED

PIONEER ADVERTISING AGENCY, INC.

Trial Balances
October 31, 2002
Before After
Adjustment Adjustment
Debit Credit Debit Credit
Cash $ 15,200 $ 15,200
Accounts Receivable 200
Advertising Supplies 2,500 1,000
Prepaid Insurance 600 550
Office Equipment 5,000 5,000
Accumulated Depreciation - Office Equipment $ 40
Notes Payable $ 5,000 5,000
Accounts Payable 2,500 2,500
Interest Payable 50
Unearned Revenue 1,200 800
Salaries Payable 1,200
Common Stock 10,000 10,000
Retained Earnings –0– –0–
Dividends 500 500
Service Revenue 10,000 10,600
Salaries Expense 4,000 5,200
Advertising Supplies Expense 1,500
Rent Expense 900 900
Insurance Expense 50
Interest Expense 50
Depreciation Expense 40
$ 28,700 $ 28,700 $ 30,190 $ 30,190
 Appendix:Alternative
Treatment
 Some businesses use an alternative treatment for
prepaids and unearned revenues.
 Instead of debiting an asset at the time an expense
is prepaid, the amount is charged to an expense
account.
 Instead of crediting a liability at the time cash is
received in advance of earning it, the amount is
credited to a revenue account.
 This treatment of prepaid expenses and unearned
revenues will ultimately result in the same effect on
the financial statements as initial entries to balance
sheet accounts and then adjusting entries.
 ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS

SUPPLIES

October 31, an inventory count reveals that $1,000 of

Adjustment $2,500 of supplies are still on hand.

Journal
Entry

Posting
 ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS

UNEARNED REVENUES

October 31, analysis reveals that, of $1,200 in revenue, $400

Adjustment has been earned in October.

Date Account Titles and Explanation Debit Credit

Journal Oct. 31 Service Revenue 800
Unearned Revenue 800
Entry (To record unearned revenue)

Unearned Revenue Service Revenue

Oct. 31 800 Oct. 31 800 Oct. 2 1,200
Posting 31 400
 ILLUSTRATION 3A-7
SUMMARY OF BASIC RELATIONSHIPS FOR PREPAYMENTS

1 Prepaid Assets and a Prepaid expenses

Assets overstated Dr Expenses Expenses Expensesinitially recorded in Expenses
understated Cr Assets asset accounts have
been used.
b Prepaid expensesAssets understated Dr Assets
initially recorded in Expenses overstated Cr Expenses
expense accounts
have not been used.
2 Unearned Liabilities and a Unearned revenues Liabilities overstated Dr Liabilities Revenues
Revenues initially recorded in Revenues understated Cr Revenues
liability accounts
have been earned.
b Unearned revenues Liabilities understated Dr Revenues
initially recorded in Revenues understated Cr Liabilities
revenue accounts
have not been earned.
 COPYRIGHT

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CHAPTER 3
ADJUSTING THE ACCOUNTS