CHAPTER

3 Adjusting the Accounts

CHAPTER 3 LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Explain the time period assumption.

2. Explain the accrual basis of accounting.
3. Explain the reasons for adjusting entries.
4. Identify the major types of adjusting entries.
5. Prepare adjusting entries for deferrals.
6. Prepare adjusting entries for accruals.
7. Describe the nature and purpose of an adjusted trial balance.

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Timing Issues
PREVIEW OF CHAPTER 3 Learning
Objective 1 Accountants divide the economic life of a
Explain the time
period assumption. business into artificial time periods (Time
Period Assumption).

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

 Generally a month, a quarter, or a year.

 Also known as the “Periodicity Assumption”

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 Fiscal and Calendar Years Fiscal and Calendar Years

 Monthly and quarterly time periods are called interim periods. Question
 Most large companies must prepare both quarterly and annual The time period assumption states that:
financial statements.
a. companies must wait until the calendar year is completed
 Fiscal Year = Accounting time period that is one year in to prepare financial statements.
length.
b. companies use the fiscal year to report financial
 Calendar Year = January 1 to December 31. information.

c. the economic life of a business can be divided into

artificial time periods.

d. companies record information in the time period in which

the events occur.
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Accrual- versus Cash-Basis Accounting Accrual- versus Cash-Basis Accounting

Learning
Accrual-Basis Accounting Objective 2 Cash-Basis Accounting
Explain the accrual
basis of accounting.
 Transactions recorded in the periods in  Revenues are recorded when cash is received.
which the events occur.
 Expenses are recorded when cash is paid.
 Companies recognize revenues when they perform services
 Cash-basis accounting is not in accordance with International
(rather than when they receive cash).
Financial Reporting Standards (IFRS).
 Expenses are recognized when incurred (rather than when
paid).

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 Recognizing Revenues and Expenses Recognizing Revenues and Expenses

REVENUE RECOGNITION PRINCIPLE EXPENSE RECOGNITION PRINCIPLE

Recognize revenue in the Match expenses with revenues
accounting period in which the in the period when the
performance obligation is company makes efforts to
satisfied. generate those revenues.

“Let the expenses follow the

revenues.”

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Illustration 3-1
IFRS relationships in Recognizing Revenues and Expenses
revenue and expense
recognition

Question
The revenue recognition principle states that:

a. revenue should be recognized in the accounting period in which a

performance obligation is satisfied.

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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 > DO IT! The Basics of Adjusting Entries
Learning Objective
A list of concepts is provided in the left column below, with a description of the concept 3 Explain the
in the right column below. There are more descriptions provided than concepts. Match the
Adjusting Entries reasons for adjusting
description of the concept to the concept. entries.
 Ensure that the revenue recognition and
1. ___ Accrual-basis accounting. (a) Monthly and quarterly time periods. expense recognition principles are followed.
(b) Efforts (expenses) should be matched with
2. ___ Calendar year.
results (revenues).  Necessary because the trial balance may not contain up-to-
3. ___ Time period assumption. (c) Accountants divide the economic life of a date and complete data.
4. ___ Expense recognition business into artificial time periods.
principle. (d) Companies record revenues when they  Required every time a company prepares financial statements.
receive cash and record expenses when
they pay out cash.  Will include one income statement account and one statement
(e) An accounting time period that starts on of financial position account.
January 1 and ends on December 31.
(f) Companies record transactions in the period
in which the events occur.
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Adjusting Entries E3-1/p.140

Nish Patel has prepared the following list of statements about the time
Question period assumption.
1. Adjusting entries would not be necessary if a company’s life were
Adjusting entries are made to ensure that: not divided into artificial time periods.
a. expenses are recognized in the period in which they are incurred. 2. The tax authorities require companies to file annual tax returns.
3. Accountants divide the economic life of a business into artificial time
b. revenues are recorded in the period in which services are periods, but each transaction affects only one of these periods.
performed. 4. Accounting time periods are generally a month, a quarter, or a year.
5. A time period lasting one year is called an interim period.
c. statement of financial position and income statement accounts have
6. All fiscal years are calendar years, but not all calendar years are
correct balances at the end of an accounting period. fiscal years.
d. All the responses above are correct. Instructions
Identify each statement as true or false. If false, indicate how to correct
the statement.

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 Types of Adjusting Entries Learning Objective
4 Identify the major
types of adjusting
entries.

Deferrals Accruals

1. Prepaid Expenses. Expenses 1. Accrued Revenues. Revenues

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

2. Unearned Revenues. 2. Accrued Expenses. Expenses

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

Illustration 3-2
Categories of adjusting entries Illustration 3-3
Trial balance Each account is analyzed to determine whether it is complete
and up-to-date for financial statement purposes.
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Adjusting Entries for Deferrals PREPAID EXPENSES

Learning Objective
Deferrals are expenses or revenues that are 5 Prepare adjusting Payments of expenses that will benefit more than one accounting
entries for deferrals. period.
recognized at a date later than the point when
cash was originally exchanged. There are two
Cash Payment BEFORE Expense Recorded
types:
 Prepaid expenses and Prepayments often occur in regard to:
 Unearned revenues.  insurance  rent
 supplies  buildings and equipment
 advertising

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 PREPAID EXPENSES 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: Yazici Advertising Inc. Inc.
purchased supplies costing ₺2,500 on October
5. Yazici 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.

Illustration 3-4
Adjusting entries for prepaid
expenses
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PREPAID EXPENSES

Illustration: On October 4, Yazici Advertising Inc.

paid ₺600 for a one-year fire insurance policy.
Coverage began on October 1. Yazici 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.

Illustration 3-5
Adjustment for supplies

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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.
Illustration 3-6
Adjustment for insurance

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PREPAID EXPENSES

Illustration: For Yazici Advertising, assume that

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

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.
Illustration 3-7
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 PREPAID EXPENSES 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 3-9
Accounting for prepaid expenses

Illustration 3-8
3-29 Statement of financial position presentation of accumulated depreciation LO 5 3-30 LO 5

UNEARNED REVENUES UNEARNED REVENUES

Receipt of cash that is recorded as a liability because the service  Adjusting entry is made to record the revenue for services
has not been performed. performed during the period and to show the liability that
remains at the end of the accounting period.
Cash Receipt BEFORE Revenue Recorded  Results in a decrease (debit) to a liability account and an
increase (credit) to a revenue account.
Unearned revenues often occur in regard to: Illustration 3-10
Adjusting entries for
 Rent  Magazine subscriptions unearned
revenues

 Airline tickets  Customer deposits

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 UNEARNED REVENUES

Illustration: Yazici 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.

Illustration 3-11
Service revenue accounts after adjustment

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UNEARNED REVENUES > DO IT!

The ledger of Zhu Company on March 31, 2017, includes these selected accounts
before adjusting entries are prepared.
(amounts in thousands) 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.
Illustration 3-12
Accounting for unearned revenues
1. Insurance expires at the rate of ¥100 per month.
2. Supplies on hand total ¥800.
3. The equipment depreciates ¥200 a month.
4. One-half of the unearned service revenue was performed in March.
Prepare the adjusting entries for the month of March.

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 Adjusting Entries for Accruals ACCRUED REVENUES
Learning Objective
Accruals are made to record 6 Prepare adjusting Revenues for services performed but not yet received in cash or
entries for accruals. recorded.
 Revenues for services performed but not
yet recorded at the statement date Revenue Recorded BEFORE Cash Receipt
(accrued revenues).

OR Accrued revenues often occur in regard to:

 Rent  Services performed
 Expenses incurred but not yet paid or recorded at the
statement date (accrued expenses).  Interest

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ACCRUED REVENUES ACCRUED REVENUES

 Adjusting entry records the receivable that exists and records Illustration: In October, Yazici Advertising Inc.
the revenues for services performed. performed services worth ₺200 that were not
billed to clients in October.
 Adjusting entry:
► Increases (debits) an asset account and Oct. 31

► Increases (credits) a revenue account.

Illustration 3-13
Adjusting entries for
accrued
revenues On November 10, Yazici receives cash of ₺200 for the services
performed.

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 ACCRUED REVENUES

Illustration 3-15
Accounting for accrued revenues

Illustration 3-14
Adjustment for accrued revenue

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ACCRUED EXPENSES ACCRUED EXPENSES

Expenses incurred but not yet paid in cash or recorded.  Adjusting entry records the obligation and recognizes the expense.

 Adjusting entry:
Expense Recorded BEFORE Cash Payment ► Increase (debit) an expense account and
► Increase (credit) a liability account.
Accrued expenses often occur in regard to:
Illustration 3-16
 Interest Adjusting entries for
accrued expenses
 Taxes
 Salaries

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 ACCRUED INTEREST

Illustration: Yazici Advertising Inc. signed a three-month note payable in

the amount of ₺5,000 on October 1. The note requires Yazici to pay
interest at an annual rate of 12%. Illustration 3-17
Formula for
computing interest

Illustration 3-18
Adjustment for accrued interest

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ACCRUED SALARIES AND WAGES

Illustration: Yazici 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
Calendar showing
Yazici’s pay
periods

Illustration 3-20
Adjustment for accrued salaries and wages

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 ACCRUED EXPENSES > DO IT!

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 ¥8,000 in salaries
and wages that will be paid on September 1.
2. On August 1, the company borrowed ¥300,000 from a local bank on
Illustration 3-21
Accounting for accrued expenses a 15-year mortgage. The annual interest rate is 10%.
3. Revenue for services performed but unrecorded for August
totaled ¥11,000.
Prepare the adjusting entries needed at August 31, 2017.

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Summary of Basic Relationships E3-5/p.141

Hwang Ltd. has the following balances in selected
accounts on December 31, 2017.

Illustration 3-22
Summary of adjusting entries

All the accounts have normal balances. The information

below has been gathered at December 31, 2017.
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 E3-5/p.141 E3-5/p.141

1. Hwang borrowed NT$240,000 by signing a 6%, 1-year
note on October 1, 2017.
2. A count of supplies on December 31, 2017, indicates
that supplies of NT$23,400 are on hand.
3. Depreciation on the equipment for 2017 is NT$30,000.
4. Hwang paid NT$63,000 for 12 months of insurance
coverage on June 1, 2017.
5. On December 1, 2017, Hwang collected NT$900,000 for
consulting services to be performed from December 1,
2017, through March 31, 2018.
6. Hwang performed consulting services for a client in
December 2017. The client will be billed NT$117,000.
7. Hwang pays its employees total salaries of NT$270,000
every Monday for the preceding 5-day week (Monday
through Friday). On Monday, December 29, employees
were paid for the week ending December 26. All
employees worked the last 3 days of 2017.
Instructions
Prepare annual adjusting entries for the seven items
described above.

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The Adjusted Trial Balance and Financial

Statements
Learning
Preparing the Adjusted Trial Balance Objective 7
Describe the
nature and
 Prepared after all adjusting entries are purpose of an
adjusted trial
journalized and posted. balance.

 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.

Illustration 3-25
LO 7 Adjusted trial balance LO 7
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 Preparing the Adjusted Trail Balance Preparing Financial Statements

Question Financial Statements are prepared directly from the Adjusted

Which of the following statements is incorrect concerning the adjusted trial Trial Balance.
balance?
a. (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.
Retained Statement of
b. The adjusted trial balance provides the primary basis for the Income
Earnings Financial
preparation of financial statements. Statement
Statement Position
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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Illustration 3-26 Illustration 3-27

Preparation of the income statement and retained Preparation of the statement of financial
earnings statement from the adjusted trial balance position from the adjusted trial balance
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 > DO IT! > DO IT!
(a) Determine the net income for the quarter April 1 to June 30.

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> DO IT! > DO IT!

(b) Determine the total assets and total liabilities at June 30, 2017, for (c) Determine the amount that appears for retained earnings at June 30,
Skolnick Co. 2017.

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 E3-13, E3-14/p.143 E3-13, E3-14/p.144
The trial balances before and after adjustment for Matusiak Instructions
Company OAO at the end of its fiscal year are presented below.
E3-13. Prepare the adjusting entries that were
made.
E3-14. Prepare the income and retained earnings
statements for the year and the statement of
financial position at August 31.

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Alternative Treatment of Prepaid Expenses and Prepaid Expenses

APPENDIX 3A
Unearned Revenues
Learning Company may choose to debit (increase) an expense account rather than
Alternate Treatment Objective 8
an asset account. This alternative treatment is simply more convenient.
Prepare adjusting
entries for the
 When a company prepays an expense, it debits alternative
that amount to an expense account. treatment of
deferrals.
 When it receives payment for future services, it
credits the amount to a revenue account.

Illustration 3A-2
Adjustment approaches—a comparison

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 Unearned Revenues Summary of Additional Adjustments Relationships

Company may credit (increase) a revenue account when they receive cash
for future services.

Illustration 3A-7
Summary of basic relationships for deferrals

Illustration 3A-5
Adjustment approaches—a comparison

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APPENDIX 3B Concepts in Action Qualities of Useful Information

Learning
Qualities of Useful Information Objective 9 Two fundamental qualities, relevance and faithful representation.
Discuss financial
reporting Faithful Representation
Two fundamental qualities, relevance and concepts.
faithful representation.  Information accurately depicts what really happened.

Relevance  Information must be

 Make a difference in a business decision. ► complete (nothing important has been omitted),

 Provides information that has predictive value and confirmatory value. ► neutral (is not biased toward one position or another), and

 Materiality is a company-specific aspect of relevance. ► free from error.

► 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 Assumptions in Financial Reporting

ENHANCING QUALITIES

Comparability results Information is verifiable Information has the

when different if independent quality of
companies use the observers, using the understandability
same accounting same methods, obtain if it is presented in a
principles. similar results. clear and concise
fashion.
Monetary Unit Economic Entity
Consistency means that a Requires that only those things States that every economic
company uses the same For accounting information to
that can be expressed in money entity can be separately
accounting have relevance, it must be
are included in the accounting identified and accounted for.
principles and methods timely.
records.
from year to year.
Illustration 3B-2
Key assumptions in financial
reporting
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Assumptions in Financial Reporting Principles of Financial Reporting

MEASUREMENT PRINCIPLES

Historical Cost Fair Value

Or cost principle, Indicates that assets
dictates that and liabilities should
companies record be reported at fair
Time Period Going Concern assets at their cost. value (the price
The business will remain in
received to sell an
States that the life of a
operation for the foreseeable asset or settle
business can be divided into
artificial time periods. future. a liability).

Illustration 3B-2
Key assumptions in financial
reporting
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 Principles of Financial Reporting Cost Constraint

REVENUE EXPENSE Cost Constraint

FULL DISCLOSURE
RECOGNITION RECOGNITION Accounting standard-setters weigh the
PRINCIPLE
PRINCIPLE PRINCIPLE cost that companies will incur to
Requires that Dictates that efforts Requires that provide the information against the
companies recognize (expenses) be companies disclose all benefit that financial statement users
revenue in the matched with results circumstances will gain from having the information
accounting period in (revenues). Thus, and events that available.
which the expenses follow would make a
performance revenues. difference to financial
obligation is statement users.
satisfied.

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