Chapter 3

Adjusting the Accounts

Chapter Summary

The Time Period Assumption (Periodicity Assumption):

The time period assumption indicates that the economic life of
a business is divided into artificial time periods. The time period
could be a month, a quarter, or a year.

Accrual- vs. Cash Basis Accounting:

 Accrual-Basis Accounting:
1. Transactions are recorded in the period in which the
events occur not in the period in which the company
receives or pays cash.
2. Revenues are recognized (recorded) when earned,
rather than when cash is received.
3. Expenses are recognized (recorded) when incurred,
rather than when paid.

 Cash-Basis Accounting:
1. Revenues are recognized (recorded) when cash is
received.
2. Expenses are recognized (recorded) when cash is paid.
3. Cash-basis accounting is not in accordance with
(GAAP).

Recognizing Revenues and Expenses:

 In order to measure net income (or net loss) for the period, the
company must determine the amount of revenues and expenses
to report in a given accounting period. Two principles help in
that task: the revenue recognition principle, and the matching
principle.

The Revenue Recognition Principle:

1. Companies recognize revenue in the accounting period in
which it is earned.
2. In a service enterprise, revenue is considered to be earned at
the time the service is performed (completed).

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The Matching Principle:
Expenses are recorded in the period in which they help
generate revenues. That is, expenses follow the revenues.

The Reasons for Adjusting Entries:

 Adjusting entries are made at the end of the accounting period
before preparation of the financial statements.

 Adjusting entries are made to ensure that the revenue

recognition principle and the matching principle are followed.

 That is, to ensure that revenues are recorded in the period

in which they are earned and that expenses are recorded in the
period in which they are incurred.

 Adjusting entries make it possible to report the correct

amounts on the balance sheet and on the income statement.

Types of Adjusting Entries:

A. Deferrals:
1. Prepaid Expenses: Expenses paid in cash and
recorded as assets before they are used up or
consumed.
2. Unearned Revenue: Revenues received in cash and
recorded as liabilities before they are earned.

B. Accruals:
1. Accrued Revenue: Revenues earned but not yet
received in cash or recorded.
2. Accrued Expenses: Expenses incurred but not yet
paid in cash or recorded.

Examples and explanations of each type of adjustment will be

based on the October 31 trial balance of Pioneer Advertising Agency
in illustration 3-3 page 85. This trial balance is provided below:

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 Pioneer Advertising Agency
Trial Balance
October 31, 2010
Account Title Dr. Cr.
Cash $15200
Advertising Supplies 2500
Prepaid Insurance 600
Office Equipment 5000
Notes Payable $5000
Accounts payable 2500
Unearned Revenue 1200
C. R. Byrd, Capital 10000
C. R. Byrd, Drawing 500
Service Revenue 10000
Salaries Expense 4000
Rent Expense 900
$28700 $28700

A. Adjusting Entries for Deferrals:

* Deferrals are either:
1. Prepaid expenses, or
2. Unearned revenues.

*Adjusting Entries for deferrals are required to:

1. Record (as an expense) the portion of the asset that is
used up or consumed, or
2. Record (as a revenue) the portion of the liability
(unearned revenue) that has been earned in the
current accounting period.

1. Prepaid Expenses:
* Prepaid expenses are expenses paid in cash and recorded as
assets before they are used up or consumed.

* Prepaid expenses expire with the passage of time such as

prepaid insurance or prepaid rent, or through use and
consumption such as supplies.

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 * The expiration of the assets occurs daily, however, the
recognition of asset expiration is postponed until the end of
the accounting period when there is a need to prepare
financial statements.

* At this point, an adjusting entry is made to recognize the

portion of the asset that has expired which should be
recorded as an expense, an in the meantime to correct
(reduce) the asset.

* An asset-expense account relationship exists with prepaid

expenses.

* Before the adjustment, assets are overstated and expenses are

understated. Therefore, we need to transfer the portion
of the asset that has expired into an expense. That is, we need
to increase the expense by the amount of the asset that has
expired and decrease the asset by the same amount.

* The adjusting entry that accomplishes that is to debit the

expense and to credit the asset.

* If the adjusting entry for prepaid expenses is not made:

1. Expenses will be understated,
2. Net income will be overstated,
3. Owner’s equity will be overstated, and
4. Assets will be overstated.

Examples:
Supplies:
 On October 5, Pioneer Advertising Agency purchased
advertising supplies costing $2500.
 The trial balance for Pioneer Advertising Agency on October
31, shows a balance of $2500 for supplies before adjustment.
 An inventory count on October 31, reveals that $1000 of
supplies are still on hand.
 Required: prepare the necessary adjusting entry on October 31.

Answer:
 Supplies expense represents the portion of the asset (supplies)
that has been used up (consumed) during the period (during
October). Supplies expense is computed as follows:

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 Supplies Expense = $2500 supplies before adjustment - $1000
remaining supplies at the end of October =
$1500.

 The adjusting entry to record supplies expense on October 31

is:

Date Accounts and Explanation Dr. Cr.

Adjusting Entry
Oct. 31 Advertising Supplies Expense 1500
Advertising Supplies 1500
To record supplies used.

 After posting the adjusting entry, the asset “Advertising

Supplies” shows a balance of $1000 which represents the
actual supplies remaining at the end of October, and
“Supplies Expense” shows a balance of $1500 which
represents the supplies used during October.

 If this adjusting entry is not made:

1. Expenses will be understated by $1500.
2. Net income will be overstated by $1500.
3. Owner’s equity will be overstated by $1500.
4. Assets will be overstated by $1500.

Insurance:
 On October 4, Pioneer Advertising Agency purchased a one-
year insurance policy for $600. Coverage began on October
1.

 The trial balance for Pioneer Advertising Agency on

October 31, shows a balance of $600 for prepaid insurance
before adjustment.

 A portion of the asset “Prepaid Insurance” expires every

month (with the passage of time). This portion should be
recorded as “Insurance Expense”. Insurance expense is
computed as follows:

 Insurance Expense = $600 prepaid Insurance ÷ 12 months =

$50 per month.

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 The adjusting entry to record insurance expense on
October 31 is:

Date Accounts and Explanation Dr. Cr.

Adjusting Entry
Oct. 31 Insurance Expense 50
Prepaid Insurance 50
To record insurance expired.

 After posting the adjusting entry, the asset “Prepaid

Insurance” shows a balance of $550 which represents the
unexpired portion of the asset at the end of October, and
“Insurance Expense” shows a balance of $50 which
represents the insurance expired during October.

 If this adjusting entry is not made:

1. Expenses will be understated by $50.
2. Net income will be overstated by $50.
3. Owner’s equity will be overstated by $50.
4. Assets will be overstated by $50.

Depreciation:
 Any business owns a variety of assets such as equipment,
building, trucks,….etc., These long-lived assets provide
services for a number of years called the useful life of the
asset.

 According to the matching principle, a portion of the cost of

the long-lived asset should be reported as an expense during
each period of the asset’s useful life.

 Depreciation is the process of allocating the cost of the long-

lived asset to expense over its useful life in a systematic
manner.

 From an accounting standpoint, the purchase of equipment

or a building is viewed as a long –term prepayment for
services.

 Companies need to make periodic adjusting entries for

depreciation. These entries record the portion of the asset
that has been used (an expense) during the period, and

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 report the unexpired portion (an asset) at the end of the
period.

 A common procedure in computing depreciation is to divide

the cost of the asset by its useful life.

 Pioneer Advertising Agency estimates depreciation on the

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

 The adjusting entry to record insurance expense on October

31 is:

Date Accounts and Explanation Dr. Cr.

Adjusting Entry
Oct. 31 Depreciation Expense 50
Accumulated Depreciation- Off. Eq 50
To record monthly depreciation on
office equipment.

 Accumulated Depreciation-Office Equipment is a contra

asset account. That means that it is offset against an asset
account (Office Equipment) on the balance sheet. Its
normal balance is a credit.

 The contra account is used because it discloses (shows) the

original cost of the equipment and the total cost that has
expired to date (the accumulated depreciation account holds
the sum of all the depreciation recorded for the asset).

 In the balance sheet Pioneer deducts Accumulated

Depreciation-Office Equipment from the related asset
account : Office Equipment) as follows:

Office Equipment $5000

Less: Accumulated Depreciation-Off. Eq. 40
$4960

 The difference between the cost of any depreciable asset and

its related accumulated depreciation is called the book
value.

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2. Unearned Revenues:
 When cash is received in advance from customers for
services to be provided in a future accounting period, a
liability account called “Unearned Revenue” is credited to
recognize the obligation that exists.

 Unearned revenues are subsequently earned by providing

the services to the customer. However, the recognition of
that revenue is delayed until the end of the period and is
done through an adjusting entry.

 A liability-revenue account relationship exists with

unearned revenues.

 Before the adjustment, liabilities (the Unearned Revenue)

are overstated and revenues are understated. Therefore, we
need to decrease the liability “Unearned Revenue” by the
amount of services provided to the customer, and increase
revenues by the same amount.

 The adjusting entry that accomplishes that is to debit the

Unearned Revenue account by the amount of services
provided to the customer, and to credit the Service Revenue
account by the same amount.

 If the adjusting entry for unearned revenues is not made:

1. Revenues will be understated,
2. Net income will be understated,
3. Owner’s equity will be understated, and
4. Liabilities will be overstated.

Example:
 On October 2, Pioneer Advertising Agency received $1200
from a client for advertising services that are expected to be
completed by December 31.
 The trial balance for Pioneer Advertising Agency on October
31, shows a balance of $1200 for unearned revenue before
adjustment.
 Analysis reveals that the company earned $400 of those fees in
October
 Required: prepare the necessary adjusting entry on October 31.

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 Answer:
 Pioneer Advertising Agency should increase Service Revenue
by $400 for the amount of services completed during October,
and decrease the liability “Unearned Revenue” by the same
amount.

 The necessary adjusting entry on October 31, to record the

portion of the unearned revenue that has been earned during
October is shown below:

Date Accounts and Explanation Dr. Cr.

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

 After posting the adjusting entry, the liability “Unearned

Revenue” shows a balance of $800 which represents the
remaining liability at the end of October. At the same time,
Service Revenue is increased by $400 to show a total of
$10400 earned during October.

 If this adjusting entry is not made:

1. Revenues will be understated by $400.
2. Net income will be understated by $400.
3. Owner’s equity will be understated by $400.
4. Liabilities will be overstated by $400.

B. Adjusting Entries for Accruals:

* Adjusting entries for accruals are required to:
1. Record revenues earned in the current accounting
period that have not been recognized.
2. Record expenses incurred in the current accounting
period that have not been recognized.

1. Accrued Revenues:
 Accrued revenue may accumulate (accrue) with the
passage of time as in the case of interest revenue, or may
result from services that have been performed but neither
billed nor collected in cash.

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  An Adjusting entry is required at the end of the period to:
1. To record the receivables that exist at the balance
sheet date, and
2. To record the revenue that has been earned during
the period.

 An asset-revenue account relationship exists with accrued

revenues.

 Before the adjustment, assets are understated and revenues

are understated.

 The adjusting entry must increase the asset by debiting the

asset account, and increase the revenues by crediting the
revenue account.

 If the adjusting entry for accrued revenues are not made:

1. Revenues will be understated,
2. Net income will be understated,
3. Owner’s equity will be understated, and
4. Assets will be understated.

Example:
 In October, Pioneer Advertising Agency earned $200 for
advertising services that have not been recorded.

 Required: prepare the necessary adjusting entry on October

31.

Answer:
 Pioneer Advertising Agency should increase the asset
“Accounts Receivable” by $200 for amount of services
provided but has not been collected yet in October, and
increase “Service Revenue” by the same amount.
 The necessary adjusting entry on October 31, is shown
below:

Date Accounts and Explanation Dr. Cr.

Adjusting Entry
Oct. 31 Accounts Receivable 200
Service Revenue 200
To record revenue for services provided.

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  If this adjusting entry is not made:
1. Revenues will be understated by $200.
2. Net income will be understated by $200.
3. Owner’s equity will be understated by $200.
4. Assets (A/R) will be understated by $200.

2. Accrued Expenses:
 Accrued expenses are expenses incurred but not paid yet in
cash.

 An adjusting entry is needed to record the expense that has

not been recorded, and also to record the liability that exists
at the balance sheet date.

 A liability-expense account relationship exists with accrued

expenses.

 Before the adjustment, both expenses and liabilities are

understated. Therefore, we need to increase the expense
and increase the liability.

 The adjusting entry that accomplishes that is to debit the

expense account, and to credit the liability account.

 If the adjusting entry for accrued expenses is not made:

1. Expenses will be understated,
2. Net income will be overstated,
3. Owner’s equity will be overstated,
4. Liabilities will be understated.

Examples:
Accrued Interest:
 On October 1, Pioneer Advertising Agency signed a $5000,
3-month, 12% note payable.

 Three factors determine the amount of interest

accumulated:
1. The face value of the note ($5000).
2. The interest rate, which is expressed as an annual rate
(12%).
3. The length of the time is outstanding (one month:
October 1 to October 31).

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  Required: prepare the necessary adjusting entry on October
31 to record accrued interest.

Answer:
 Interest Expense = $5000 × 12% × 1/12 = $50

 The adjusting entry should increase interest expense by $50

by debiting the “Interest Expense” account, and increase the
liability “Interest Payable” by the same amount (since this
interest is accrued, at the end of October, the interest is paid
at the end of the three months).

 The necessary adjusting entry on October 31, is shown

below:

Date Accounts and Explanation Dr. Cr.

Adjusting Entry
Oct. 31 Interest Expense 50
Interest Payable 50
To record interest on notes payable.

 After posting this entry, the “Interest Expense” account will

show a balance of $50, and the liability account “Interest
Payable will show a balance of $50.

 If this adjusting entry is not made:

1. Expenses will be understated by $50,
2. Net income will be overstated $50,
3. Owner’s equity will be overstated, $50, and
4. Liabilities will be understated $50.

Accrued Salaries:
 Accrued salaries for Pioneer Advertising Agency at October
31 amounted to $1200.

 Required: prepare the necessary adjusting entry on October

31 to record accrued salaries.

 The necessary adjusting entry on October 31, is shown

below:

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 Date Accounts and Explanation Dr. Cr.
Adjusting Entry
Oct. 31 Salaries Expense 1200
Salaries Payable 1200
To record accrued salaries.

 After posting this entry, the “Salaries Expense” account will

show a balance of $5200 ($4000 paid during October, and
$1200 accrued salaries), and the liability account “Salaries
Payable will show a balance of $1200.

 If this adjusting entry is not made:

1. Expenses will be understated by $1200,
2. Net income will be overstated $1200,
3. Owner’s equity will be overstated, $1200, and
4. Liabilities will be understated $1200.

* All the adjusting entries for Pioneer Advertising Agency at

October 31 are presented below:

Date Accounts and Explanation Dr. Cr.

Adjusting Entries
Oct. 31 Advertising Supplies Expense 1500
Advertising Supplies 1500
To record supplies used.
Oct. 31 Insurance Expense 50
Prepaid Insurance 50
To record insurance expired.
Oct. 31 Depreciation Expense-Off. Equip 40
Accumulated Dep-Off. Equip 40
To record monthly depreciation.
Oct. 31 Unearned Revenue 400
Service Revenue 400
To record revenue for services
provided.
Oct. 31 Accounts Receivable 200
Service Revenue 200
To record revenue for services
provided.
Oct. 31 Interest Expense 50
Interest Payable 50
To record interest on notes payable.

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 Oct. 31 Salaries Expense 1200
Salaries Payable 1200
To record accrued salaries.

* The adjusting entries presented above are then posted to the

appropriate ledger accounts, and then an adjusted trial balance is
prepared.

The Adjusted Trial Balance:

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

 The adjusted trial balance shows the balances of all

accounts at the end of the accounting period and the effects
of all the 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.

 The adjusted trial balance for Pioneer Advertising Agency

at October 31 is Shown below (also on page 99 of the text):

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 Pioneer Advertising Agency
Adjusted Trial Balance
October 3130, 2008
Account Title Dr. Cr.
Cash $15200
Accounts receivable 200
Advertising Supplies 1000
Prepaid Insurance 550
Office Equipment 5000
Accumulated Depreciation-Off. Equip $40
Notes Payable 5000
Accounts Payable 2500
Unearned Revenue 800
Salaries Payable 1200
Interest Payable 50
C. R. Byrd, capital 10000
C. R. Byrd, Drawing 500
Service Revenue 10600
Salaries Expense 5200
Advertising Supplies Expense 1500
Rent Expense 900
Insurance Expense 50
Interest Expense 50
Depreciation Expense 40
$30190 $30190

The Financial Statements:

The financial statements can be prepared directly from the
adjusted trial balance, see textbook pages 100 - 101.

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