3-1

3 Adjusting the Accounts

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

2 Prepare adjusting entries for deferrals.

3 Prepare adjusting entries for accruals.

Describe the nature and purpose of an adjusted trial

4 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
Alternative Terminology
 a month, The time period assumption
is also called the
 a quarter, or periodicity assumption.
 a 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).

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 Accrual- versus Cash-Basis Accounting

Cash-Basis Accounting
 Revenues are recorded when cash is received.
 Expenses are recorded 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 to
generate those revenues.
“Let the expenses follow
the revenues.”

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 Recognizing Revenues and Expenses
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 accordance 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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3-12 LO 1
 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

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.

Illustration 3-2
Categories of adjusting entries

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 Types of Adjusting Entries

Trial Balance
Each account
is analyzed to
determine
whether it is
complete and
up-to-date for
financial
statement
purposes.

Illustration 3-3

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 DO IT!
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 and
 Unearned revenues.

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 Prepaid Expenses

Payments of expenses that will benefit more than one

accounting period.

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

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

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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
Adjusting entries for prepaid
expenses
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 Prepaid Expenses

Illustration: Pioneer Advertising Inc. Inc.

purchased supplies costing $2,500 on
October 5. Pioneer recorded the
purchase 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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 Prepaid Expenses
Illustration 3-5

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 Prepaid Expenses

Illustration: On October 4, Pioneer

Advertising Inc. 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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 Prepaid Expenses
Illustration 3-6

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 Prepaid Expenses

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.

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 Prepaid Expenses

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.

Helpful Hint
All contra accounts have increases,
decreases, and normal balances opposite
to the account to which they relate.
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 Prepaid Expenses
Illustration 3-7

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 Prepaid Expenses

Statement Presentation
 Accumulated Depreciation is a contra asset account
(credit).
 Appears just after the account it offsets (Equipment) 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

Illustration 3-9

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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 accounting 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 Inc. 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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3-33
 Unearned Revenues
Illustration 3-11

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 Unearned Revenues
Illustration 3-12

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3-36 LO 2
 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond Inc., on March 31, 2017, includes these

selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
An analysis of the accounts shows the following.
1. Insurance expires at the rate of $100 per month.
2. Supplies on hand total $800.
3. The equipment depreciates $200 a month.
4. During March, services were performed for one-half of the unearned
service revenue.
Prepare the adjusting entries for the month of March.

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 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond Inc., on March 31, 2017, includes these

selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.

1. Insurance expires at the rate of $100 per month.

Insurance Expense 100

Prepaid Insurance 100

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 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond Inc., on March 31, 2017, includes these

selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.

2. Supplies on hand total $800.

Supplies Expense 2,000

Supplies 2,000

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 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond Inc., on March 31, 2017, includes these

selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.

3. The equipment depreciates $200 a month.

Depreciation Expense 200

Accumulated Depreciation—Equipment 200

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 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond Inc., on March 31, 2017, includes these

selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.

4. During March, services were performed for one-half of the unearned

service revenue.

Unearned Service Revenue 4,600

Service Revenue 4,600

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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 (accrued revenues).
OR
 Expenses incurred but not yet paid or recorded at the
statement date (accrued expenses).

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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  Services performed
 Interest

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 Accrued Revenues

 Adjusting entry records 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

Inc. performed services worth $200 that were
not billed to clients in October.

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

3-46 LO 3
 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:

 Interest
 Taxes
 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

Illustration: Pioneer Advertising Inc. 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

Illustration: Pioneer 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. Thus, accrued salaries at October 31 are
$1,200 ($400 x 3 days).
Illustration 3-19

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 Accrued Expenses
Illustration 3-20

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 Accrued Expenses

Illustration 3-21

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3-55 LO 3
 Summary of Basic Relationships

Illustration 3-22

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 DO IT! 3 Adjusting Entries for Accruals

Micro Computer Services began operations on August 1, 2017. At the

end of August 2017, management prepares monthly financial
statements. The following information relates to August.
1. At August 31, the company owed its employees $800 in
salaries and wages that will be paid on September 1.
2. On August 1, the company borrowed $30,000 from a local
bank on a 15-year mortgage. The annual interest rate is 10%.
3. Revenue for services performed but unrecorded for August
totaled $1,100.
Prepare the adjusting entries needed at August 31, 2017.

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 DO IT! 3 Adjusting Entries for Accruals

Prepare the adjusting entries needed at August 31, 2017.

1. At August 31, the company owed its employees $800 in
salaries and wages that will be paid on September 1.
Salaries and Wages Expense 800
Salaries and Wages Payable 800

2. On August 1, the company borrowed $30,000 from a local

bank on a 15-year mortgage. The annual interest rate is 10%.
Interest Expense 250
Interest Payable 250

3. Revenue for services performed but unrecorded for August

totaled $1,100.
Accounts Receivable 1,100
Service Revenue 1,100
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 LEARNING Describe the nature and purpose of an
4
OBJECTIVE adjusted trial balance.

Preparing the Adjusted Trial Balance

 Prepared after all adjusting entries are journalized and
posted.
 Purpose is to prove the equality of debit balances and
credit balances in the ledger.
 Is the primary basis for the preparation of financial
statements.

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 Illustration 3-25

3-60 LO 4
 The Adjusted Trail Balance

Question
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.

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 Preparing Financial Statements

Financial
FinancialStatements
Statementsare
areprepared
prepareddirectly
directlyfrom
fromthe
the
Adjusted
AdjustedTrial
TrialBalance.
Balance.

Retained
Income Balance
Earnings
Statement Sheet
Statement

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 Illustration 3-26
Preparation of the income statement and retained
earnings statement from the adjusted trial balance

3-63 LO 4
 Illustration 3-27
Preparation of the balance sheet from
the adjusted trial balance

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 DO IT! 4 Trial Balance

(a) Determine the net income for the quarter April 1 to June 30.
(b) Determine the total assets and total liabilities at June 30, 2017, for Skolnick Co.
(c) Determine the amount of retained earnings at June 30, 2017. LO 4
3-65
 DO IT! 4 Trial Balance
Solution

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 DO IT! 4 Trial Balance
Solution

3-67 LO 4
 DO IT! 4 Trial Balance
Solution

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 LEARNING APPENDIX 3A: Prepare adjusting entries
5
OBJECTIVE for the alternative treatment of deferrals.

Alternate Treatment
 When a company prepays an expense, it debits that
amount to an expense account.
 When it receives payment for future services, it credits
the amount to a revenue account.

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 Prepaid Expenses

Company may choose to debit (increase) an expense account

rather than an asset account. This alternative treatment is simply
more convenient.
Illustration 3A-2

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 Unearned Revenues

Company may credit (increase) a revenue account when they

receive cash for future services.
Illustration 3A-5

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 Summary of Additional Adjustments
Relationships
Illustration 3A-7

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 LEARNING APPENDIX 3B: Discuss financial
6
OBJECTIVE reporting concepts.

Qualities of Useful Information

Two fundamental qualities, relevance and faithful representation.

Relevance
 Make a difference in a business decision.
 Provides information that has predictive value and
confirmatory value.
 Materiality is a company-specific aspect of relevance.
► An item is material when its size makes it likely to influence
the decision of an investor or creditor.

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 Qualities of Useful Information

Two fundamental qualities, relevance and faithful representation.

Faithful Representation
 Information accurately depicts what really happened.
 Information must be
► complete (nothing important has been omitted),

► neutral (is not biased toward one position or another), and

► free from error.

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 Qualities of Useful Information

ENHANCING QUALITIES

Comparability Information is Information has the

results when different verifiable if quality of
companies use the independent understandability
same accounting observers, using the if it is presented in a
principles. same methods, obtain clear and concise
similar results. fashion.

Consistency means
that a company uses For accounting information
the same accounting to have relevance, it must
principles and methods be timely.
from year to year.

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 Assumptions in Financial Reporting
Illustration 3B-2

Monetary Unit Economic Entity

Requires that only those things States that every economic
that can be expressed in entity can be separately
money are included in the identified and accounted for.
accounting records.

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 Assumptions in Financial Reporting
Illustration 3B-2

Time Period Going Concern

States that the life of a The business will remain in
business can be divided into operation for the
artificial time periods. foreseeable future.

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 Principles of Financial Reporting

MEASUREMENT PRINCIPLES

Historical Cost Fair Value

Or cost principle, Indicates that
dictates that assets and
companies record liabilities should be
assets at their reported at fair
cost. value (the price
received to sell an
asset or settle
a liability).

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 Principles of Financial Reporting

Revenue Expense
Full Disclosure
Recognition Recognition
Principle
Principle Principle
Requires that Dictates that Requires that
companies efforts (expenses) companies disclose
recognize revenue be matched with all circumstances
in the accounting results (revenues). and events that
period in which the Thus, expenses would make a
performance follow revenues. difference to
obligation is financial statement
satisfied. users.

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 Cost Constraint

Cost Constraint
Accounting standard-setters weigh
the cost that companies will incur to
provide the information against the
benefit that financial statement
users will gain from having the
information available.

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 LEARNING Compare the procedures for adjusting
7
OBJECTIVE entries under GAAP and IFRS.

Key Points
Similarities
 Companies applying IFRS also use accrual-basis accounting to
ensure that they record transactions that change a company’s
financial statements in the period in which events occur.
 Similar to GAAP, cash-basis accounting is not in accordance with
IFRS.
 IFRS also divides the economic life of companies into artificial time
periods. Under both GAAP and IFRS, this is referred to as the time
period assumption.
3-81 LO 7
 A Look at IFRS

Key Points
Similarities
 The general revenue recognition principle required by GAAP that is
used in this textbook is similar to that used under IFRS.
 Revenue recognition fraud is a major issue in U.S. financial reporting.
The same situation occurs in other countries, as evidenced by
revenue recognition breakdowns at Dutch software company Baan
NV, Japanese electronics giant NEC, and Dutch grocer AHold NV.

Differences
 Under IFRS, revaluation (using fair value) of items such as land and
buildings is permitted. IFRS allows depreciation based on revaluation
of assets, which is not permitted under GAAP.

3-82 LO 7
 A Look at IFRS

Key Points
Differences
 The terminology used for revenues and gains, and expenses and
losses, differs somewhat between IFRS and GAAP. For example,
income under IFRS includes both revenues, which arise during the
normal course of operating activities, and gains, which arise from
activities outside of the normal sales of goods and services. The term
income is not used this way under GAAP. Instead, under GAAP income
refers to the net difference between revenues and expenses.
 Under IFRS, expenses include both those costs incurred in the normal
course of operations as well as losses that are not part of normal
operations. This is in contrast to GAAP, which defines each separately.

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 A Look at IFRS

Looking to the Future

The IASB and FASB are completing a joint project on revenue recognition.
The purpose of this project is to develop comprehensive guidance on when
to recognize revenue.
It is hoped that this approach will lead to more consistent accounting in this
area. For more on this topic, see
www.fasb.org/project/revenue_recognition.shtml .

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 IFRS Practice
IFRS:

a. uses accrual accounting.

b. uses cash-basis accounting.

c. allows revenue to be recognized when a customer makes an

order.

d. requires that revenue not be recognized until cash is

received.

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 Look at IFRS

IFRS Practice
Which of the following statements is false?
a. IFRS employs the periodicity assumption.
b. IFRS employs accrual accounting.
c. IFRS requires that revenues and costs must be capable of
being measured reliably.
d. IFRS uses the cash basis of accounting.

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 A Look at IFRS

IFRS Practice
As a result of the revenue recognition project being undertaken by
the FASB and IASB:
a. revenue recognition places more emphasis on when the
performance obligation is satisfied.
b. revenue recognition places more emphasis on when revenue
is realized.
c. revenue recognition places more emphasis on when
expenses are incurred.
d. revenue is no longer recorded unless cash has been
received.

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 Copyright

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