Chapter 4

ADJUSTING THE ACCOUNTS

& PREPARING
FINANCIAL STATEMENTS

©2015 John Wiley & Sons Australia Ltd

 LEARNING OBJECTIVES

1. Describe the difference between the cash basis and the

accrual basis of measuring profit
2. Explain the accounting cycle and the need for end-of-
accounting-period adjusting entries
3. Identify and prepare the different types of adjusting entries
4. Prepare an adjusted trial balance and financial statements
5. Describe the difference between current and non-current
assets and liabilities
6. Use a worksheet to prepare the financial statements
7. Explain how financial statements are used in decision
making.
MEASUREMENT OF PROFIT

• Cash Basis
➢Income is recorded when cash is received
➢Expenses are recorded when cash is paid
• Accrual Basis
➢ Income recognised when the anticipated inflow of
economic benefit can be reliably measured
➢Expenses recognised when the consumption of
benefits can be reliably measured

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INCOME (INCLUDING REVENUE)
• Accounting definition
➢increases in economic benefits during the period in
the form of inflows or enhancements of assets or
decreases in liabilities
➢Result in increases in equity
➢Not contributions by the owners
• Income = Revenue + Gains

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EXPENSES

• Accounting definition
➢Decreases in economic benefits during the period in
the form of outflows or depletions of assets or
incurrences of liabilities
➢Result in decreases in equity
➢Not distributions to the owners
• Expenses are recognised in the period in which the
consumption of costs can be measured.

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ACCRUAL vs CASH BASIS

6
ACCRUAL vs CASH BASIS

7
ACCRUAL vs CASH BASIS - conclusion

There are two kinds of accounting – cash accounting and accrual

accounting:
• In cash accounting, the business will only record the transaction
when cash inflow or cash outflow occurs.
• In accrual accounting, on the other hand, income and expenses
are recorded whenever they occur.
• As an example, we can say that cash flow analysis is done by
following cash accounting and income statement is created by
following accrual accounting. But according to the companies
act, only accrual accounting is recognized.
EX 1

QUESTION: Match the description of the

concept to the concept.
f
e
c
b
 2- 47
EX 2

1. Sent out an invoice for $5,000 for a web design

project completed this month
2. Received a bill for $1,000 in developer fees for
work done this month
3. Paid $75 in fees for a bill you received last month
4. Received $1,000 from a client for a project that
was invoiced last month
•Cash basis: The profit for this month?

•Accrual basis:The profit for this month?

TEMPORARY AND PERMANENT ACCOUNTS

• Temporary (Nominal) Accounts

➢Income Statement Accounts
➢Reduced to zero balance at the end
of each accounting period (closed)
➢Reset the business “stopwatch”
• Permanent (Real) Accounts
➢Balance Sheet Accounts
➢Ending balances carried forward to next accounting
period

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EXPANDED ACCOUNTING CYCLE INCLUDING
ADJUSTING ENTRIES

1. Recognise & record Source documents

transactions

2. Journalise transaction General journal

3. Post to ledger accounts General ledger

4. Prepare unadjusted trial Trial balance

balance of general ledger (unadjusted)

Continued Next Slide

EXPANDED ACCOUNTING CYCLE INCLUDING
ADJUSTING ENTRIES

5. Determine adjusting entries General journal

and journalise

6. Post adjusting entries to General ledger

general ledger (Accounts Adjusted)

7. Prepare adjusted trial Trial balance

balance (Adjusted)

8. Prepare financial statements Work Financial Statements

sheet

13
THE NEED FOR ADJUSTING ENTRIES

• In many cases the period in which cash is paid or

received does not coincide with period in which
expense and income are recognised
• Therefore, in order for our statements to reflect
what has actually happened, some accounts must
be adjusted on the last day of the accounting
period to correctly recognise income and expenses
not reflected in cash receipts or payments

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CLASSIFICATION OF
ADJUSTING ENTRIES

Prepaid Expense Unearned Revenue

Deferrals Costs/expenses paid Revenues that are
(Prepayments) before they are
consumed
collected or received but
not yet earned

Accruals Accrued Expense Accrued Revenue

Expenses incurred but Revenue earned but not
(Unrecorded) not yet paid yet received

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THE RULES OF
ADJUSTING ENTRIES
• Attempting to account for the “timing difference” between
receipt/payment of cash, and recognition of
income/expense
• One side of the entry affects an income statement
account
➢That is revenue or expense
• The other side of the entry affects an account reported in
the balance sheet
➢That is asset or liability
• Cash is never adjusted!

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ADJUSTING ENTRIES
Revenue
Unearned revenue Accrued revenue
Revenues collected in Revenues earned, but not yet
advance, but not yet earned received in cash or entered
e.g. magazine subscription e.g. interest earned on a bank
received in advance term deposit but not paid

$$$ Revenue Revenue $$$

Last Year Current Year Next Year

ADJUSTING ENTRIES
Expenses
Prepaid expenses Accrued expenses
Expenses paid for before they are Expenses incurred, but not yet
consumed paid for or entered
e.g. Insurance premium paid 12 e.g. wages earned by
months in advance employees, but not yet paid

$$$ Expense Expense $$$

Last Year Current Year Next Year

DEFERRALS: PREPAID EXPENSES

• Cash paid before benefits are consumed/expire

• Initially recorded as an asset when paid
• At the end of the period the amount consumed/expired is
expensed.

ASSET ACCOUNT EXPENSE ACCOUNT

Prepaid Expense
Initial Cost Adjusting Entry Adjusting Entry
Debit Credit Debit

Costs consumed or expired

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EXAMPLE: PREPAID RENT

• On 1 June the following entry was made to record rent

covering the a period of 3 months:

General Journal
Jun 5 Prepaid Rent 1 200
Cash at Bank 1 200
(Payment of rent for 3 months)

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 EXAMPLE: PREPAID RENT
• On 30 June only one month of rent has expired ($1,200 ÷
3 months = $400)

General Journal
Jun 30 Rent Expense 400
Prepaid Rent 400
(Adjusting entry for rent)

Prepaid Rent Rent Expense

Initial Entry Adjusting Entry Adjusting Entry
1 200 400 400

Costs expired and allocated to current period 21

EXAMPLE: DEPRECIATION

Depreciation = Allocation of the historic cost of an asset

(less any residual) over the useful life of that asset
Non-Current Asset
Initial Cost
Debit

Contra-Asset Account
Accumulated Depreciation Depreciation Expense
Adjusting Entry Adjusting Entry
Credit Debit

Costs consumed and allocated

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to current period
DEFERRALS: UNEARNED REVENUE

• Cash received in advance for services that are to be

preformed in the future
• Initially recorded as liability when received
• Recognised as revenue as earned

LIABILITY ACCOUNT INCOME ACCOUNT

Unearned Revenue
Adjusting Entry Cash Receipt Adjusting Entry
Debit Credit

Revenue earned during the current period

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EXAMPLE: SUBSCRIPTIONS

• On 8 September a monthly magazine publisher received

$264 for a 1 year subscription beginning October

General Journal
Sept 8 Cash at Bank 240
Unearned Subscription Revenue 240
(Receipt of subscriptions in advance)

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 EXAMPLE: SUBSCRIPTIONS
• On 31 December 3 months of revenue has been earned
(3/12 x $240 = $60)

General Journal
Dec 31 Unearned Subscriptions Revenue 60
Subscriptions Revenue 60
(Adjusting entry for subscriptions earned)

Unearned Subscriptions Revenue Subscriptions Revenue

Adjusting Entry Cash Adjusting Entry
60 240 60

Revenue earned during the current period 25

ACCRUALS: ACCRUED EXPENSES

• Expenses that have been consumed but payment has

not yet been made
• Expense must be recognised along with a liability for
future payment

LIABILITY ACCOUNT EXPENSE ACCOUNT

Expense Payable
Adjusting Entry Adjusting Entry
Credit Debit

Expenses Incurred
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EXAMPLE: ACCRUED SALARIES

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 EXAMPLE: ACCRUED SALARIES
• On 30 June an adjusting entry is required to correctly
determine June’s expenses

General Journal
Jun 30 Salaries Expense 3 980
Salaries Payable 3 980
(Adjusting entry for salaries payable)

Salaries Payable Salaries Expense

Adjusting Entry Adjusting Entry
3 980 3 980

Expenses Incurred 28
 EXAMPLE: ACCRUED SALARIES
• The liability is eliminated on 6 July when the next
payment is made to employees

General Journal
Jul 6 Salaries Payable 3 980
Salaries Expense 3 420
Cash at Bank 7 400
(Payment of salaries earned 23 June
to 6 July)

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ACCRUALS: ACCRUED REVENUE

• Usually recorded when service is performed

➢No adjusting entry would be necessary
• Any unrecorded revenue earned needs to be recorded

ASSET ACCOUNT INCOME ACCOUNT

Accounts Receivable Revenue
Adjusting Entry Adjusting Entry
Debit Credit

Revenue earned but not yet received

EXAMPLE: MARKET SERVICES

• On 1 June an agreement was signed to provide

marketing services for a monthly fee of $800. On 30 June
cash is yet to be received and no invoice has been
issued

General Journal
Jun 30 Accounts Receivable 800
Marketing Services Revenue 800
(Marketing services fee receivable for
June)

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EXAMPLE

EX 1 - QUETION:
• Ray spends $5,000 on a new piece of equipment for his
carpentry business. He expects the equipment to last for
5 years, by which point it will likely be of no substantial
value.
• His business uses Straight-Line Depreciation to record
depreciation expense.
• Require: record the transactions.

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EX 2 - QUESTION :
• Eventually, after 5 years, Accumulated Depreciation will
have a credit balance of 5,000 (the original cost of the
asset).
• At this point –net book value of asset is how much? And
how Ray will make the entry for the asset?
EX 3 - QUESTION:
• Lydia spends $11,000 on office furniture, which she plans
to use for the next ten years, after which she believes it
will have a value of approximately $2,000.
• Require: record the journal entry to reflect depreciation
expense
EX 4 - QUESTION:
• After ten years, Accumulated Depreciation will have a
$9,000 credit balance.
• If, at that point, Lydia does in fact sell the furniture for
$2,000.
• Require: record the journal entries.
 QUESTIONS
Record the journal entries for the transactions below:
1) The Prepaid Insurance account has a $5,000 debit
balance to start the year. A review of insurance policies
and payments shows that $1,000 of unexpired insurance
remains at year-end.
2) On October 1 of the current year, the company
prepaid $12,000 for one year of rent for facilities being
occupied from that day forward. The company debited
Prepaid Rent and credited Cash for $12,000. December
31 year-end statements must be prepared.
 QUESTIONS
Record the journal entries for the transactions below:
3) The Supplies account has an $1,000 debit balance to
start the year. Supplies of $2,000 were purchased during
the current year and debited to the Supplies account. A
December 31 physical count shows $500 of supplies
remaining.
4) The company has only one fixed asset (equipment)
that it purchased at the start of this year. That asset had
cost $38,000, had an estimated life of 10 years, and is
expected to be valued at $8,000 at the end of the 10-
year life
EXAMPLES – QUESTIONS
Prepare and explain adjusting entries
1) The company collected $24,000 rent in advance on
September 1, debiting Cash and crediting Unearned Rent
Revenue. The tenant was paying 12 months rent in
advance and occupancy began September 1.
2) The company charges $100 per month to spray a
house for insects. A customer paid $600 on November 1
in advance for six treatments, which was recorded with a
debit to Cash and a credit to Unearned Services
Revenue. At year-end, the company has applied two
treatments for the customer.
ADJUSTED TRIAL BALANCE

• Same accounting process applied

• Unadjusted trial balance used as starting point
• Adjusting entries are posted to the general ledger
• An adjusted trial balance can then be prepared
• Debits must still equal credits
• Adjusting entries always affect an Income Statement and
a Balance Sheet account

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PREPARATION OF
FINANCIAL STATEMENTS
• Income statement
➢ Prepared first to determine profit or loss
➢ Reflects entity’s performance for the period
• Statement of changes in equity
➢ Profit (loss) must be added to (subtracted from)
equity
➢ Capital contributions and Drawings/Dividends also
recorded
➢ Shows details of movements in equity
➢ Equity balance is reported in balance sheet
BALANCE SHEET

• Reflects entity’s financial position as at the end of the

period
• Three major categories of accounts
➢ Assets
➢ Liabilities
➢ Equity
• Statement users find it useful if assets and liabilities are
further classified
BALANCE SHEET

Assets Liabilities
• Current Assets • Current Liabilities
• Non-Current Assets • Non-Current Liabilities
• Investments
• Property, Plant & Equip.
• Intangible Assets
• Other Assets

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CURRENT Vs. NON-CURRENT

• Current assets/liabilities will be used up/paid off within a

single operating cycle (usually 12 months). Examples
include:

ASSETS LIABILITIES
Cash at Bank Bank Overdraft
Accounts Receivable Accounts Payable
Inventory Unearned Revenue
Prepaid Expenses Accrued Expenses
CURRENT Vs. NON-CURRENT

• Non- Current assets/liabilities that will not be used

up/paid off within a single operating cycle (usually 12
months). Examples include:

ASSETS LIABILITIES
Land Mortgage
Buildings Long Term Borrowings
Equipment
Vehicles
THE WORKSHEET

• A useful “One Stop Shop”

• Assembles all information needed to adjust the
accounts and prepare financial statements
• Aids in the preparation of interim financial statements
when adjusting and closing entries are not required
• Contains information needed to close off profit and
loss accounts for the period if required

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PREPARATION OF THE WORKSHEET

1. Enter ledger account titles and balances in the account

title and unadjusted trial balance columns
2. Enter the adjustments in the adjustment column (note:
same principal as a journal – DR and CR appropriate
accounts)
3. Calculate adjusted trial balances
4. Extend adjusted balances to the financial statements
columns

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PREPARATION OF THE WORKSHEET

5. Difference between the two income columns

represents the profit or loss for the period. This
balance is transferred to the balance sheet column to
balance totals.

Financial statements can then be prepared

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Preparing Financial Statements

Step 1 - Prepare income statement using revenue and

expense accounts from trial balance.
Step 2 - Prepare statement of retained earnings using
retained earnings and dividends from trial
balance; and pull net income from step 1.
Step 3 - Prepare balance sheet using asset and liability
account from trial balance; and pull updated
retained earnings balance from step 2.
Step 4 - Prepare statement of cash flows from changes in
cash flows for the period (illustrated later in the
book).
Preparing Financial Statements (1 of 3)

• Ex:
Use the following adjusted trial balance of Magic Company
to prepare its (1) income statement, (2) statement of
retained earnings, and (3) balance sheet (unclassified), for
the year ended, or date of, December 31, 20X2. The
Retained earnings account balance is $45,000 at
December 31, 20X1.
Preparing Financial Statements (2 of 3)
Preparing Financial Statements (3 of 3)
 Trial Balance Example-1
• Suresh Oberoi is in the stage of preparing FS for the quarter
ended March 2019. They have just completed the posting of
general entries and recording all of their transactions. Below are
balances reported at the end of the quarter. You are required to
prepared trial balance.
 Trial Balance Example-2
Gold Gems has reported below transactions for the month of Feb
2019 and the accountant wants to prepare the trial balance for the
month of Feb 2019.
1. Purchase of Raw Material in cash 25,00,000
2. Purchase of Raw Material on credit 25,00,000
3. Selling of Finish product in cash 35,00,000
4. Selling of Finish product on credit 40,00,000
5. Salary paid in cash 1,00,000

• You are required to prepare a trial balance based upon the above
transactions only.
 Trial Balance Example-3
You are required to correct the below trial balance