CHAPTER 3

Adjusting the Accounts

LECTURE OUTLINE

1. Timing Issues
Accountants divide the life of a business into artificial time periods, such as a month, a three-
month quarter or a year. This is done to satisfy Investor needs and in compliance with CRA. An
accounting period that is one year long is called a fiscal year, time periods of less than a year are
interim periods.

1.1 Accrual vs. Cash Basis of Accounting

A company using the accrual basis of accounting records revenues when services are
performed and records expenses when incurred, regardless of when the cash is received
or paid.
A company using the cash basis of accounting records revenues when cash is received and
records expenses when cash is paid.

1.2 Revenue and Expense Recognition

The revenue recognition principle provides guidance about when revenue is to be
recognized. In general, revenue is recognized when the service has been performed or the
goods have been sold and delivered, that is, when the performance obligation has been
satisfied. Under ASPE we also need to ensure that revenue can be reliably measured and
collection is reasonably certain.

Expenses are recognized when there is a decrease in assets or an increase in liabilities,

excluding transactions from the owner.
Expense recognition is tied to revenue recognition when there is a direct relationship
between costs incurred and revenue. This process is commonly referred to as the
matching concept.
However, sometimes there is no direct relationship between expenses and revenue, such
as with depreciation of long-lived assets where the expense is recognized over the useful
life of the asset.
Sometimes, it is impossible to match expenses with revenues and in these cases expenses
are reported in the period in which they occur.

.
2. Adjusting Entries for Prepayments
2.1. Adjusting entries ensure that revenues are recognized in the period in which the services
are performed, and that expenses are recognized in the period in which they are incurred.
They are needed to ensure that the correct amounts of assets, liabilities and owner’s
equity are reported on the balance sheet.

2.2. The unadjusted trial balance may not contain up-to-date and complete data because:
Some events, wages earned by employees for example, or the consumption of supplies, are
not journalized daily because it is not efficient to do so.
Some costs are not journalized during the period because they expire with the passage of
time rather than through recurring daily transactions. Examples are insurance and rent.
Some items may be unrecorded. A bill for costs incurred may not have been received by
the end of the accounting period, for example.

2.3. Adjusting entries are required every time financial statements are prepared. Each
adjusting entry affects one balance sheet account and one income statement account.
Under IFRS, adjusting entries are required every quarter since companies under IFRS
must report quarterly financial statements. Companies following ASPE need to only
prepare adjusting entries annually.

2.4. Adjusting entries are necessary to prepare financial statements on an accrual basis.

2.5. Adjusting entries can be classified as either prepayments or accruals.

Prepayments exist when cash has been received before the revenue has been recognised
or when cash has been paid before the expense has been incurred. Prepayments are either
prepaid expenses or unearned revenues.
Accruals exist when revenue for services performed has not yet been recorded or collected
or when an expense has been incurred but not yet recorded or paid.

2.6. Prepaid expenses are costs paid in cash and recorded as assets before they are used or
consumed. They expire with the passage of time (insurance, rent) or through use
(supplies). Cash flow precedes expense recognition.
Adjusting entries are required to record as expenses, the portions of the prepayment that
has expired or has been used up in the current accounting period, and to have only the
unexpired portions of the costs in the asset accounts.
Prior to adjustment, assets are overstated and expenses are understated.
The adjusting entry will increase (debit) an expense account and decrease (credit) an
asset account.
Examples of Adjusting Entries:
Oct 31 Supplies Expense 1,500
Supplies 1,500
To record supplies used.

Oct. 31 Insurance Expense 50

Prepaid Insurance 50
To record insurance expired.

.
 2.7 Depreciation is the process of allocating the cost of a long-lived asset to expense over its
useful life in a rational and systematic manner. Long-lived assets such as buildings,
equipment and vehicles provide service for a number of years and depreciation is an
allocation of costs over these years (useful life). The portion of the long-lived asset that is
used up in each period must be reported as an expense (or depreciated). From an
accounting perspective, the purchase of long-lived assets is basically a long-term
prepayment from services.
Only assets with specific useful lives are depreciated. Land is not depreciated, since it has
an unlimited life.
Since the useful life of an asset cannot be known with certainty, depreciation is an estimate
rather than an exact measurement of the cost that has expired.
Depreciation expense can be calculated by dividing the cost of an asset by its useful life.
This is known as the straight-line method of depreciation.

The adjusting entry for prepayments will increase (debit) an expense account and
increase (credit) a contra asset account. A contra asset account is offset against a related
account on the balance sheet or income statement. A contra asset account has an opposite
balance (credit) as compared to its related asset account (debit).
Accumulated Depreciation is a contra asset account and appears as an offset against the
asset account on the balance sheet. Therefore, the balance in the asset account represents
the original cost of the asset, and the balance in the contra account, Accumulated
Depreciation, represents the cumulative sum of the depreciation expense since the asset
was purchased.
The carrying amount of an asset is calculated by subtracting the accumulated depreciation
from the cost of the asset.
The carrying amount is usually not the same as the fair value of the asset. Depreciation is a
process of cost allocation, not asset valuation.
Example of Adjusting Entry to record depreciation:
Oct 31 Depreciation Expense 83
Accumulated Depreciation 83

2.8 Unearned revenues are revenues received in cash and recorded as liabilities before the
services have been provided (rent, magazine subscriptions, customer deposits). Cash flow
precedes revenue recognition. Unearned revenues are the opposite of prepaid expenses.
Adjusting entries are required to record as revenues, the portions of the revenues that
apply to the current period, and to have only the unearned portions of the revenues in the
liability accounts.
Prior to adjustment, liabilities are overstated and revenues are understated.
The adjusting entry will decrease (debit) a liability account and increase (credit) a
revenue account.
Example of Adjusting Entry for Unearned Revenue:
Oct 31 Unearned Revenue 400
Service Revenue 400

.
3. Adjusting Entries for Accruals
3.1. Accrued revenues are revenues for services provided but not yet received in cash or
recorded at the statement date (interest, rent, and commissions). Accrued revenue may
accumulate (accrue) with the passage of time (e.g. interest revenue and rent revenue).
Cash flow follows revenue recognition.
Adjusting entries are required to show the receivables that exist at the balance sheet date,
and to record the revenues for services that have been provided during the period.
Prior to adjustment, assets and revenues are understated.
The adjusting entry will increase (debit) an asset account and increase (credit) a revenue
account.

3.2 Accrued expenses are expenses incurred but not yet paid or recorded at the statement date
(interest, rent, property taxes, and salaries). Cash flow follows expense recognition.
Adjusting entries are required to show the obligations that exist at the balance sheet date,
and to recognize the expenses that apply to the current period.
Prior to adjustment, liabilities and expenses are understated. Profit and owner’s equity are
overstated.
The adjusting entry will increase (debit) an expense account and increase (credit) a
liability account.

Example of Adjusting Entry for Accrued Expenses:

Oct 31 Interest Expense 25
Interest Payable 25

4. The Adjusted Trial Balance and Financial Statements

4.1 Preparing the Adjusted Trial Balance

4.1.1. An adjusted trial balance is prepared after all adjusting entries have been
journalized and posted.

4.1.2. The adjusted trial balance proves the equality of the total debit balances and the
total credit balances in the ledger, after all adjustments have been made. As
discussed in Chapter 2, it does not prove that no errors exist.

4.1.3. Financial statements can be prepared directly from an adjusted trial balance. The
income statement is prepared from the revenue and expense accounts. The
statement of owner’s equity is derived from the capital and drawings accounts,
and from the profit or loss from the income statement. The balance sheet is
prepared from the asset and liability accounts and ending owner’s capital
balance, as reported in the statement of owner’s equity.

.
4.2 Preparing Financial Statements

Financial statements can be prepared directly from the adjusted trial balance.

Comparing IFRS and ASPE

Key Differences International Financial Accounting Standards for
Reporting Standards (IFRS) Private Enterprises (ASPE)
Revenue With IFRS, there are five In ASPE, revenue is
Steps that must be met to recorded when the good
recognize revenue. One of the and services are provided
key steps is that the to the customer, and the
performance obligation is amount is measurable and
satisfied (the goods and collectible.
services have been provided),
and then revenue maybe
recognized.
Timing of preparing Public companies must Private companies must
adjusting journal entries prepare quarterly financial prepare annual financial
statements, so adjusting statements, so adjusting
entries will have to be made at entries are required only
least four times a year. on an annual basis.
Terminology In IFRS, the term In ASPE, the term
“depreciation” is used for the “amortization” is used for
allocation of the cost of long- the allocation of the cost of
lived assets such as buildings buildings and equipment
and equipment and the term and for intangible long-
“amortization” is used for lived assets. But private
intangible long-lived assets. companies are allowed to
use the term “depreciation”
for buildings and
equipment.