CH 03

3-1
CHAPTER3
Adjusting the
Accounts
3-2
3-3
Timing Issues
Accountants divide the economic life of a business into
artificial time periods (Time Period Assumption).
Jan.
3-4
Feb.
Mar.
Apr.
.....
Dec.
Generally a month, a quarter, or a year.
Also known as the Periodicity Assumption
SO 1 Explain the time period assumption.
Timing Issues
Fiscal and Calendar Years
3-5
Monthly and quarterly time periods are called interim

periods.
Public 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.
Timing Issues
Review
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.
3-6
Timing Issues
Accrual- vs. Cash-Basis Accounting
Accrual-Basis Accounting
3-7
Transactions recorded in the periods in which the

events occur.
Revenues are recognized when earned, rather than

when cash is received.
Expenses are recognized when incurred, rather

than when paid.
SO 2 Explain the accrual basis of accounting.
Timing Issues
Accrual- vs. Cash-Basis Accounting
Cash-Basis Accounting
3-8
Revenues recognized when cash is received.
Expenses recognized when cash is paid.
Cash-basis accounting is not in accordance with

generally accepted accounting principles (GAAP).
Timing Issues
Recognizing Revenues and Expenses
Revenue Recognition Principle
Recognize revenue in the
accounting period in which it
is earned.
In a service enterprise,
revenue is considered to be
earned at the time the
service is performed.
3-9
Timing Issues
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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Timing Issues
Illustration 3-1
GAAP relationships in revenue
and expense recognition
3-11
3-12
Timing Issues
Review
One of the following statements about the accrual basis of
accounting is false. That statement is:
a. Events that change a companys financial statements
are recorded in the periods in which the events occur.
b. Revenue is recognized in the period in which it is
earned.
c. The accrual basis of accounting is in accord with
generally accepted accounting principles.
d. Revenue is recorded only when cash is received, and
expenses are recorded only when cash is paid.
3-13
The Basics of Adjusting Entries
3-14
Adjusting entries are necessary because the trial

balance may not contain up-to-date and complete
data.
Ensure that the revenue recognition and expense

recognition principles are followed.
Required every time a company prepares financial

statements.
Will include one income statement account and

one balance sheet account.
SO 3 Explain the reasons for adjusting entries.

Review
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 they
are earned.
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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SO 3 Explain the reasons for adjusting entries.

Types of Adjusting Entries
Illustration 3-2
Categories of adjusting entries
3-16
Deferrals
Accruals
1. Prepaid Expenses.
Expenses paid in cash and
recorded as assets before
they are used or consumed.
3. Accrued Revenues.
Revenues earned but not yet
received in cash or
recorded.
2. Unearned Revenues.
Cash received and recorded
as liabilities before revenue
is earned.
4. Accrued Expenses.
Expenses incurred but not
yet paid in cash or recorded.
SO 4 Identify the major types of adjusting entries.

Types of Adjusting Entries
Trial Balance
Each account is
analyzed to
determine
whether it is
complete and upto-date.
Illustration 3-3
3-17
SO 4 Identify the major types of adjusting entries.

Adjusting Entries for Deferrals
Deferrals are either:
Prepaid expenses
OR
3-18
Unearned revenues.
SO 5 Prepare adjusting entries for deferrals.

Prepaid Expenses
Payment of cash, that is recorded as an asset because
service or benefit will be received in the future.
Cash Payment
BEFORE
Expense Recorded
Prepayments often occur in regard to:
3-19
insurance
rent
supplies
equipment
advertising
buildings

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
3-20

Illustration: Pioneer Advertising Agency
purchased supplies costing $2,500 on
October 5. Pioneer recorded the payment
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
Supplies
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1,500
1,500

Illustration 3-5
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SO 5

Illustration: On October 4, Pioneer
Advertising Agency paid $600 for a oneyear 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
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50

Illustration 3-6
3-24
SO 5

Depreciation
3-25
Buildings, equipment, and vehicles (assets with long

lives) are recorded as assets, rather than an expense,
in the year acquired.
Companies report a portion of the cost of the asset as

an expense (depreciation expense) during each period
of the assets useful life.
Depreciation does not attempt to report the actual

change in the value of the asset.

Illustration: For Pioneer Advertising,
assume that depreciation on the
equipment is $480 a year, or $40 per
month.
Oct. 31
Depreciation expense
Accumulated depreciation
40
40
Accumulated Depreciation is called a contra asset account.
3-26

Illustration 3-7
3-27
SO 5

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

on the balance sheet.
Normal balance of a contra asset account is a credit.

Illustration 3-8
3-28
Illustration 3-9
3-29

Unearned Revenues
Receipt of cash that is recorded as a liability because the
revenue has not been earned.
Cash Receipt
BEFORE
Revenue Recorded
Unearned revenues often occur in regard to:
3-30
Rent
Magazine subscriptions
Airline tickets
Customer deposits

Unearned Revenues
Adjusting entry is made to record the revenue that

has been earned and to show the liability that remains.
Results in a decrease (debit) to a liability account

and an increase (credit) to a revenue account.
Illustration 3-10
3-31

Illustration: Pioneer Advertising Agency 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 earned $400 of those fees in October.
Oct. 31
Unearned service revenue

Service revenue
3-32
400
400

Illustration 3-11
3-33
SO 5
Illustration 3-12
3-34
3-35

Adjusting Entries for Accruals
Accruals are made to record
Revenues earned
OR
Expenses incurred
in the current accounting period that have not been

recognized through daily entries.
3-36
SO 6 Prepare adjusting entries for accruals.

Accrued Revenues
Revenues earned but not yet received in cash or recorded.
Revenue Recorded
BEFORE
Cash Receipt
Accrued revenues often occur in regard to:
3-37
Rent
Interest
Services performed

Accrued Revenues
Adjusting entry shows the receivable that exists and

records the revenues earned.
Adjusting entry:
Increases (debits) an asset account and
Increases (credits) a revenue account.

Illustration 3-13
3-38
SO 6

Illustration: In October Pioneer Advertising
Agency earned $200 for advertising services
that had not been recorded.
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
3-39
200

Illustration 3-14
3-40
SO 6

Illustration 3-15
3-41

Accrued Expenses
Expenses incurred but not yet paid in cash or recorded.
Expense Recorded
BEFORE
Cash Payment
Accrued expenses often occur in regard to:
3-42
Rent
Taxes
Interest
Salaries

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
3-43
SO 6

Illustration: Pioneer Advertising Agency 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%.
Oct. 31
Interest expense
Interest payable
3-44
50
50

Illustration 3-18
3-45
SO 6
3-46

Illustration: Pioneer Advertising Agency last paid salaries 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
3-47

Illustration 3-20
3-48
SO 6
Illustration 3-21
3-49

Summary of Basic Relationships
Illustration 3-22
3-50
The Adjusted Trial Balance

Adjusted Trial Balance
3-51
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.
SO 7 Describe the nature and purpose of the adjusted trial balance.
Illustration 3-25
3-52
The Adjusted Trial Balance

Review
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.
3-53
The Financial Statements

Financial
FinancialStatements
Statementsare
areprepared
prepareddirectly
directlyfrom
fromthe
the
Adjusted
AdjustedTrial
TrialBalance.
Balance.
Balance
Sheet
3-54
Income
Statement
Owners
Equity
Statement
Illustration 3-26
3-55
SO 7
Illustration 3-27
3-56
SO 7
APPENDIX3A
Alternative Treatment of Prepaid Expenses
and Unearned Revenues
3-57
When a company prepays an expense, it debits that

amount to an expense account.
When a company receives payment for future

services, it credits the amount to a revenue account.
SO 8 Prepare adjusting entries for the alternative treatment of deferrals.
APPENDIX3A
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
3-58
APPENDIX3A
Unearned Revenues
Company may credit (increase) a revenue account when
they receive cash for future services.
Illustration 3A-5
3-59
APPENDIX3A
Summary of Additional Adjustment Relationships
Illustration 3A-7
3-60
IFRS
A Look at IFRS
Key Points
3-61
Companies applying IFRS also use accrual-basis accounting to

ensure that they record transactions that change a companys
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.
IFRS requires that companies present a complete set of financial

statements, including comparative information annually.
IFRS
A Look at IFRS
Key Points
3-62
GAAP has more than 100 rules dealing with revenue recognition.
Many of these rules are industry specific. In contrast, revenue
recognition under IFRS is determined primarily by a single
standard. Despite this large disparity in the amount of detailed
guidance devoted to revenue recognition, the general revenue
recognition principles required by GAAP that are used in this
textbook are similar to those under IFRS.
As the Feature Story illustrates, 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.
IFRS
A Look at IFRS
Key Points
3-63
A specific standard exists for revenue recognition under IFRS (IAS

18). In general, the standard is based on the probability that the
economic benefits associated with the transaction will flow to the
company selling the goods, providing the service, or receiving
investment income. In addition, the revenues and costs must be
capable of being measured reliably. GAAP uses concepts such as
realized, realizable (that is, it is received, or expected to be
received), and earned as a basis for revenue recognition.
Under IFRS, revaluation of items such as land and buildings is

permitted. IFRS allows depreciation based on revaluation of
assets, which is not permitted under GAAP.
IFRS
A Look at IFRS
Key Points
The terminology used for revenues and gains, and expenses and
losses, differs somewhat between IFRS and GAAP. For example,
income is defined as:
Increases in economic benefits during the accounting period in
the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those
relating to contributions from shareholders.
Expenses are defined as:
Decreases in economic benefits during the accounting period in
the form of outflows or depletions of assets or incurrences of
liabilities that result in decreases in equity other than those r
elating to distributions to shareholders.
3-64
IFRS
A Look at IFRS
Looking into the Future

The IASB and FASB are now involved in a joint project on revenue
recognition. The purpose of this project is to develop
comprehensive guidance on when to recognize revenue.
Presently, the Boards are considering an approach that focuses
on changes in assets and liabilities (rather than on earned and
realized) as the basis for revenue recognition.
3-65
IFRS
A Look at IFRS
GAAP:
a. provides very detailed, industry-specific guidance on
revenue recognition, compared to the general
guidance provided by IFRS.
b. provides only general guidance on revenue
recognition, compared to the detailed guidance
provided by IFRS.
c. allows revenue to be recognized when a customer
makes an order.
d. requires that revenue not be recognized until cash is
received.
3-66
IFRS
A Look at IFRS
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.
3-67
IFRS
A Look at IFRS
As a result of the revenue recognition project being

undertaken by the FASB and IASB:
a. revenue recognition will place more emphasis on
when revenue is earned.
b. revenue recognition will place more emphasis on
when revenue is realized.
c. revenue recognition will place more emphasis on
when changes occur in assets and liabilities.
d. revenue will no longer be recorded unless cash has
been received
3-68
Copyright
Copyright 2011 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written permission of the copyright owner is unlawful.
Request for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The purchaser
may make back-up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no responsibility for
errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.
3-69

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3-1

Generally a month, a quarter, or a year.

Also known as the Periodicity Assumption

SO 1 Explain the time period assumption.

Monthly and quarterly time periods are called interim

Public companies must prepare both quarterly and

Fiscal Year = Accounting time period that is one year

Calendar Year = January 1 to December 31.

SO 1 Explain the time period assumption.

SO 1 Explain the time period assumption.

Transactions recorded in the periods in which the

Revenues are recognized when earned, rather than

Expenses are recognized when incurred, rather

SO 2 Explain the accrual basis of accounting.

Revenues recognized when cash is received.

Expenses recognized when cash is paid.

Cash-basis accounting is not in accordance with

SO 2 Explain the accrual basis of accounting.

SO 2 Explain the accrual basis of accounting.

SO 2 Explain the accrual basis of accounting.

SO 2 Explain the accrual basis of accounting.

SO 2 Explain the accrual basis of accounting.

SO 2 Explain the accrual basis of accounting.

The Basics of Adjusting Entries

Adjusting entries are necessary because the trial

Ensure that the revenue recognition and expense

Required every time a company prepares financial

Will include one income statement account and

SO 3 Explain the reasons for adjusting entries.

The Basics of Adjusting Entries

SO 3 Explain the reasons for adjusting entries.

The Basics of Adjusting Entries

SO 4 Identify the major types of adjusting entries.

The Basics of Adjusting Entries

SO 4 Identify the major types of adjusting entries.

The Basics of Adjusting Entries

SO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Prepayments often occur in regard to:

SO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Expire either with the passage of time or through use.

Increase (debit) to an expense account and

Decrease (credit) to an asset account.

SO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

The Basics of Adjusting Entries

The Basics of Adjusting Entries

SO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

The Basics of Adjusting Entries

Buildings, equipment, and vehicles (assets with long

Companies report a portion of the cost of the asset as

Depreciation does not attempt to report the actual

SO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

Accumulated Depreciation is called a contra asset account.

SO 5 Prepare adjusting entries for deferrals.

The Basics of Adjusting Entries

The Basics of Adjusting Entries

Accumulated Depreciation is a contra asset account.

Appears just after the account it offsets (Equipment)

Normal balance of a contra asset account is a credit.