CH 03

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Learning objectives
• Differentiate between accrual and cash-basis accounting
• Explain why adjusting entries are needed
Chapter 3 • Journalise and post adjusting entries
• Explain the purpose of and prepare an adjusted trial balance
The adjusting process • Prepare the financial statements from the adjusted trial balance
• Describe the ethical challenges in accrual accounting
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3.1. Accrual versus cash-basis 3.1. Accrual versus cash-basis

accounting accounting
• Accrual accounting records the effect of each transaction as it Ex:
occurs
1. Suppose Smart Touch purchases $200 of office supplies
• Cash-basis accounting records only cash receipts and cash on credit on 15 Jun and pays to supplier on 03 Jul.
payments. It ignores receivables, payables and other items
2. Suppose Smart Touch performs services and earns
• In accrual accounting, revenues are recorded when earned, which
revenue of $1,000 on 20 Jun but collects no cash (Cash
is not necessarily in the same accounting period as when the
corresponding cash is received
will be collected on 05 Jul)
• Most businesses use the accrual basis as covered in this book  Indicate the difference in recording above transactions on
the cash-basic accounting and accrual-basic accounting.
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Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442551923/Horngren, Best, Fraser,
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3.2. Why we adjust the accounts

3.3. Two categories of adjusting entries
• Accrual accounting requires adjusting entries at the end of the • The two basic categories of adjusting entries are prepayments
period (defferals) and accruals
• Adjusting entries assign revenues to the period when they are • In a prepaid adjustment, the cash payment occurs before an
earned and expenses to the period when they are incurred expense is recorded or the cash receipt occurs before the revenue
• Adjustments are needed to properly measure two things: (1) profit is earned
(loss) in the income statement, and (2) assets and liabilities in the • An accrual records an expense before the cash payment or it
balance sheet records the revenue before the cash is received
• Adjusting entries fall into five types: prepaid expenses, depreciation
of non-current assets, accrued expenses, accrued revenues,
unearned revenues
3.3. Two categories of adjusting entries 3.3. Two categories of adjusting entries
Prepaid expenses Depreciation
• Prepaid expenses are advance payments of expenses • Property, plant and equipment assets are long-lived, non-current,
• Examples include prepaid rent, insurance, supplies tangible assets used in the operation of a business
• Prepaid expenses are considered assets rather than expenses • As a business uses non-current assets, their value and usefulness
decline
• When the prepayment is used up, the used portion of the asset
becomes an expense via an adjusting journal entry • The decline in usefulness of a non-current asset is an expense, and
accountants systematically spread the asset’s cost over its useful
Ex: Smart Touch prepays three months’ office rent of $3,000 ($1,000 life
per month x 3 months) on 01 June 201N
• The allocation of a non-current asset’s value to expense is called
1. When should accountant do the adjustment? depreciation
2. How much for the rent expense for the adjustment?
3. How much for the prepaid201044
rent at the adjustment entry date?
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Depreciation Accrued expenses
• The accumulated depreciation account is the sum of all the • The term accrued expense refers to an expense incurred before
depreciation recorded for the asset, and that total increases paying for them
(accumulates) over time • Examples include accruing salary expense and accruing interest
• Accumulated depreciation is a contra asset expense
Ex: On 01 June, Smart Touch purchased furniture for $18,000. Its • An accrued expense hasn’t been paid for yet and always creates a
expected useful life is five years. liability
Ex: Sheena Bright pays its employee a monthly salary of $1,800 - half
on the 17th and half on the first day of next month.
Accrued revenues
Unearned revenues (Deferred revenue)
• Businesses can earn revenue before they receive the cash, which • Some businesses collect cash from customers in advance of
creates accrued revenues performing work
• Accrued revenue is revenue that has been earned but for which the • Receiving cash before earning it creates a liability to perform work in
cash has not yet been collected the future called unearned revenue
Ex: Assume that Smart Touch is hired on 16 June to perform e- • The business owes a product or a service to the customer, or it
learning services for the Central Queensland University. Under this owes the customer his or her money back
agreement, Smart Touch will earn $800 monthly.
• Only after completing the job will the business earn the revenue.
During June, for work performed from 16 June to 30 June, Smart Because of this delay, unearned revenue is also called deferred
Touch will earn half a month’s fee, $400. revenue
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Unearned revenues (Deferred revenue)
• Ex: A legal firm engages Smart Touch to provide e-learning
services, agreeing to pay $600 in advance monthly, beginning
immediately. Sheena Bright collects the first amount on 21 June.
3.3. Two categories of adjusting entries 3.4. The adjusted trial balance
• Prepared after adjusting entries are posted
Ex: Information for the adjustments at 30 June 201N of Smart Touch • Useful step in preparing financial statements
(a) Prepaid rent expired, $1,000 • Often appears on a work sheet
(b) Supplies used , $100
(c) Depreciation on furniture, $300
(d) Depreciation on building, $200
(e) Accrued salary expense, $900
(f) Accrued interest on loan, $100
(g) Accrued service revenue, $400
(h) Service revenue that was collected in advance and now had been
earned, $200
Required: Journalising and posting to T-accounts all the above
adjustments.
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3.4. The adjusted trial balance

3.5. The financial statements
• The income statement reports revenues and expenses
• The statement of changes in equity shows why capital changed
during the period
• The balance sheet reports assets, liabilities and owners’ equity
• The financial statements should be prepared in the following order:
(1) income statement to determine profit or loss;
(2) statement of changes in equity which needs profit or loss from the
income statement to calculate ending capital;
(3) balance sheet which needs the amount of ending capital to
achieve its balancing feature
3.5. The financial statements 3.5. The financial statements
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3.5. The financial statements

3.6. Ethical issues in accrual accounting
• Accrual accounting provides opportunities for unethical behaviour
• For example, a dishonest businessperson could omit depreciation
expense at the end of the year
• Failing to record depreciation would overstate profit as calculated by
mandated accrual principles and disclose a more favourable picture
of the business’ financial position than actually existed
Summary: Chapter 3 Tasks in class

• Accrual accounting records revenues and expenses when they are Textbook: Chapter 3
earned/incurred
• Cash-basis accounting records revenues and expenses when cash • Quick Check
is received or paid
• Starters
• Accrual accounting requires adjusting entries at the end of the
period • Exercises
• The two basic categories of adjusting entries are prepayments and
accruals
• The adjusted trial balance includes all the transactions captured
during the period on the trial balance plus/minus any adjusting
journal entries made at the end of the period
• The financial statements must be prepared in order
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Tasks at home
1/ Homework:
Textbook: Chapter 3
• Problems The end of Chapter 3
• Apply
The adjusting process
2/ Self-study:
Key References [2]: Chapter 4
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1/29/2024

201044 - The adjusting process 1/29/2024 201044 - The adjusting process 2

3.1. Accrual versus cash-basis 3.1. Accrual versus cash-basis

3.2. Why we adjust the accounts

3.3. Two categories of adjusting entries

3.4. The adjusted trial balance

3.5. The financial statements 3.5. The financial statements

3.5. The financial statements

Summary: Chapter 3 Tasks in class

1/29/2024 201044 - The adjusting process 25 201044 - The adjusting process

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