Adjusting Accounts For

Financial Statements
Chapter 3

Wild and Shaw

Financial and Managerial Accounting
8th Edition

Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 Accounting Cycle
Exhibit
3.19

© McGraw-Hill Education  2
Learning Objective C2: Identify steps in the accounting cycle.
Chapter 3 Learning Objectives
CONCEPTUAL
C1 Explain the importance of periodic reporting and the role of accrual accounting.
C2 Identify steps in the accounting cycle.
C3 Explain and prepare a classified balance sheet.

PROCEDURAL
P1 Prepare adjusting entries for deferral of expenses.
P2 Prepare adjusting entries for deferral of revenues.
P3 Prepare adjusting entries for accrued expenses.
P4 Prepare adjusting entries for accrued revenues.
P5 Explain and prepare an adjusted trial balance.
P6 Prepare financial statements from an adjusted trial balance.
P7 Describe and prepare closing entries.
P8 Explain and prepare a post-closing trial balance.

© McGraw-Hill Education  3
 Learning Objective C1

Explain the importance of

periodic reporting and the role
of accrual accounting.

© McGraw-Hill Education  4
 The Accounting Period
Exhibit
3.1

The time period assumption presumes that an organization’s activities

can be divided into specific time periods

© McGraw-Hill Education  5
Learning Objective C1: Explain the importance of periodic reporting and the role of accrual accounting.
Accrual Basis versus Cash Basis
Definitions
Accrual Basis Cash Basis
Recognize revenues Recognize revenue
when they are when cash is
earned and records received and records
expenses when they expenses when cash
are incurred (match is paid.
with revenues). Not GAAP
Accounting

© McGraw-Hill Education  6
Learning Objective C1: Explain the importance of periodic reporting and the role of accrual accounting.
Accrual Basis versus Cash Basis

 Andrew is a dentist. He agrees to perform teeth

positioning treatment for Bryan. The entire procedure
completes in 3 stages over a period of 12 months. Bryan
agrees to pay $3,000 down and $400 for each month.
The treatment is completed in the following manner:
 January 1, 2008 30% 2340
 June 1, 2008 50% 3900
 December 1, 2008 20% 1560
 How should the revenue be recognize by Andrew?

7
Accrual Basis versus Cash Basis
Accrual Basis Example

Exhibit
On the accrual basis, $100 of insurance expense 3.2
is recognized in 2019, $1,200 in 2020, and
$1,100 in 2021.
The expense is matched with the periods
benefited by the insurance coverage.
8
Accrual Basis versus Cash Basis
Cash Basis Example

On December 1, 2019, FastForward paid $2,400 cash for a Exhibit

3.3
twenty-four month business insurance policy.

Using the cash basis, the entire $2,400 would be recognized

as insurance expense in 2019. No insurance expense from
this policy would be recognized in 2020 or 2021, periods
covered by the policy.
© McGraw-Hill Education  9
Learning Objective C1: Explain the importance of periodic reporting and the role of accrual accounting.
 Recognizing Revenues
Revenue Recognition Principle: The revenue recognition requires
that revenue be recorded when the goods or services are provided
to customer and at an amount expected to be received from
customers.

We have delivered the

product to our customer,
so I think we should record
the revenue earned.

10
 Type of Revenue Transactions
Source: HKAS 18 Revenue
Revenues can be from …
• the sale of goods - Goods includes goods produced by the entity for
the purpose of sale and goods purchased for resale, such as
merchandise purchased by a retailer or land and other property held
for resale.

• the rendering of services - The rendering of services typically

involves the performance by the entity of a contractually agreed task
over an agreed period of time.

• The use by others of entity assets yielding interest, royalties and

dividends.

11
 Recognition Criteria-Sale of Goods
Source: HKAS 18 Revenue
Revenue from the sale of goods should be recognized when ALL the
following conditions have been satisfied:
(1) the entity has transferred to the buyer the significant risks and
rewards of ownership of the goods;
(2) the entity retains neither continuing managerial involvement to the
degree usually associated with ownership nor effective control over the
goods sold;
(3) the amount of revenue can be measured reliably;
(4) it is probable that the economic benefits associated with the
transaction will flow to the entity; and
(5) the costs incurred or to be incurred in respect of the transaction can
be measured reliably.
12
 Recognition Criteria- Example1
Sales with right of return
Pesido Company is in the beta-testing stage for new laser equipment
that will help patients who have acid reflex problems. The product that
Pesido is selling has been very successful in trials to date. As a result,
Pesido has received regulatory authority to sell this equipment to
various hospitals. Because of the uncertainty surrounding this product,
Pesido has granted to the participating hospitals the right to return the
device and receive full reimbursement for a period of 9 months.

When should Pesido recognize the revenue

for the sale of the new laser equipment?

13
 Recognition Criteria- Example 2
The firm is working on two projects. Work on both projects is done
continuously over the period of the contract.
Project #1 was started on May 1, 2017 and will be completed on
April 30, 2019. The firm will earn $1,824,000 for this project.
$608,000 was collected in advance for this project and the rest will
be collected when the project is completed.
Project #2 is a 10-month project that began on August 1, 2018. The
entire $840,000 fee for Project #2 will be collected upon completion
of the project.

• Required: Calculate the total amount of revenue earned in 2018

(show your computation) and prepare the adjusting journal entry
required on December 31, 2018 to properly state the accounts.
14
 Recognizing Expenses
The expense recognition (or matching)
requires that expenses be recorded in the
same accounting period as the revenues that
are recognized as a result of those expenses.
This matching of expenses with the revenue
benefits is a major part of the adjusting
process.

© McGraw-Hill Education  15
Learning Objective C1: Explain the importance of periodic reporting and the role of accrual accounting.
 The need for adjusting entries
 The need for adjusting entries does not mean that
transactions are being recorded improperly.

 The purpose of adjusting entries is to ensure that revenue

and expenses are recognized in the right accounting
period under the accrual concept.

 We rely on two principles in the adjusting process:

revenue recognition and matching.

16
 Framework for Adjustments
An adjusting entry is recorded to bring an asset or liability
account balance to its proper amount and at the same
time update revenue and expense accounts.

Adjustments

Paid (or received) cash before Paid (or received) cash after
expense (or revenue) recognized expense (or revenue) recognized

Prepaid Unearned Accrued Accrued

(Deferred) (Deferred) expense revenues
expenses* revenues

© McGraw-Hill Education  17
Learning Objective C1: Explain the importance of periodic reporting and the role of accrual accounting.
 Learning Objective P1

Prepare adjusting entries for

deferral of expenses.

© McGraw-Hill Education  18
 Prepaid (Deferred) Expenses
Prepaid expenses are assets paid for in advance of
receiving their benefits.
Examples: Prepaid Insurance, Prepaid Rent, Supplies

Exhibit
3.5

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  19
 Adjusting for Prepaid Insurance
Step 1
Step 1: Determine current balance:
• FastForward paid $2,400 to cover insurance for 24 months
that began on December 1 of 2019.
• FastForward recorded the expenditure as Prepaid Insurance
on December 1.

PREPAID INSURANCE
24-month policy
Beginning 12/01 $2,400

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  20
 Adjusting for Prepaid Insurance
Step 2
Step 2: Balance in balance in prepaid insurance should equal $2,300.
On 12/31, one month’s worth of insurance has expired.

PREPAID INSURANCE INSURANCE EXPENSE

$2,400 $100
$100
$2,400/24 months = $100

Insurance Expense is debited $100 to recognize the amount of insurance

coverage for Dec. and Prepaid Insurance is credited for $100 to reduce
its balance.

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  21
 Adjusting for Prepaid Insurance
Step 3
(Balance Sheet) (Income Statement)
PREPAID INSURANCE INSURANCE EXPENSE
$2,400 adj. $100
$100 adj.
Bal. $2,300
The Income Statement will
The Balance Sheet will show show $100 (1 month) of
$2,300 (23 months) of insurance expired!
Prepaid Insurance remaining!
Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  22
 Adjusting Entry for
Prepaid Insurance
The general journal adjustment on Dec. 31 and
general ledger account balances are as follows:

128 637

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  23
 Adjusting for Supplies
Steps 1 and 2
Step 1: FastForward purchased $9,720 of supplies in
December. Some of these were used during December.
Step 2: A physical count shows that unused supplies equal
$8,670.

SUPPLIES
Purchases during December $9,720

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  24
 Adjusting for Supplies Step 3
Step 3: Adjusting entry reduces Supplies by $1,050 or the
difference between the beginning balance and the physical
count. (Balance Sheet) (Income Statement)
SUPPLIES SUPPLIES EXPENSE
$9,720 adj. $1,050
$1,050 adj.
Bal. $8,670
The Income Statement will
The Balance Sheet will show show $1,050 (1 month) of
$8,670 of supplies remaining! Supplies expired!

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  25
 Adjusting Entry – Supplies
We’ve seen the adjustment in the T-accounts but
we need to record the adjustment on Dec. 31,
in the General Journal
126 652

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  26
P1 Other Prepaid Expenses
 Other prepaid expenses, such as Prepaid Rent, are
accounted for exactly as Insurance and Supplies.
 We should note that some prepaid expenses are both
paid for and fully used up within a single period.

For example, a company may pay monthly rent on the

first day of each month. This payment creates a prepaid
expense on the first day of the month that fully expires
by the end of the month.

In these special cases, we can record the cash paid with a

debit to the expense account instead of an asset account.
 Depreciation
Instead of expensing the cost of a plant asset
(equipment, building, cars, etc.) in the year it
is purchased we allocate or spread out the
cost over their expected useful lives.
The formula for straight-line depreciation is:
Straight-Line Asset Cost - Salvage Value
Depreciation =
Expense Useful Life

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  28
 Useful Life
 The period of time that an asset is expected
to help produce revenues.
 Useful life expires as a result of wear and
tear, or because it no longer satisfies the
needs of the business.

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  29
 Salvage Value
• The expected market value or selling price
of an asset at the end of its useful life
• Also called:
– Scrap Value or
– Residual Value

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  30
 Adjusting for Depreciation – Step 1
• Step 1: FastForward purchased equipment on Dec 1
for $26,000.
• It has an estimated useful live of 5 years.
• The equipment is expected to be worth about
$8,000 at the end of five years.
• They purchased the equipment on Dec. 1 but it is
now Dec. 31.

Because FastForward expects the equipment to be worth $8,000

when the five years are over, only $18,000 of the cost needs to be
spread over the next 60 months.
Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  31
 Straight-line Depreciation
Step 1: FastForward purchased equipment
on December 1 for $26,000.
Calculate
FORMULA: Net Cost (amount to depreciate).
Original Salvage Net Cost
Cost Value =
Depreciable cost
$26,000 $8,000 = $18,000

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  32
 Adjusting for Depreciation– Step 2
• Step 2: Equipment has an useful live of 5 years. The
equipment is expected to be worth $8,000 at the end
of five years. FastForward using straight-line
depreciation. $18,000 ($26,000 – 8,000) of the cost
needs to be spread over the next 60 months.
One month = $18,000 / 60 = $300.

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 
33
 Adjusting for Depreciation – Step 3
Depreciation adjustment reflected in our
T-accounts looks like this:
Equipment Depreciation Expense
12/1 26,000 12/31 300

Accumulated Depreciation
12/31 300

• Step 3: Record adjusting entry for $300 for one month.

• The depreciation amount of $300 is credited to this
account instead of the asset account.

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  34
 Adjusting Entry for Depreciation
Equipment Depreciation Expense
12/1 26,000 12/31 300

Accumulated Depreciation-Equipment
12/31 300

35
Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 
 Depreciation – Balance Sheet
Exhibit
3.7

After three
months of
depreciation have
been taken, the
Equipment is
shown net of
accumulated
depreciation.

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education  36
 Learning Objective P2

Prepare adjusting entries for

deferral of revenues.

© McGraw-Hill Education  37
 Deferral of Revenue
Unearned revenue is cash received in advance
of providing products or services.

Exhibit
3.8

Learning Objective P2: Prepare adjusting entries for deferral of revenues. © McGraw-Hill Education  38
 Adjusting for Unearned Revenues –
Steps 1 and 2
Step 1: FastForward’s client paid 60-day fee in advance
covering the period from 12/27 – 2/24 and recorded:

Step 2: FastForwards earns payment as time passes. At

12/31, 5 days’ service is earned or 5/60 × $3,000 = $250.
Step 3: Adjusting entry reduces liability, Unearned Consulting
Revenue, by $250 or 5 days’ worth of revenue. Also,
Consulting Revenue of $250 is earned.
Learning Objective P2: Prepare adjusting entries for deferral of revenues. © McGraw-Hill Education  39
 Adjusting for Unearned Revenue –
Step 3
(Balance Sheet) (Income Statement)
UNEARNED CONSULTING
CONSULTING REVENUE
REVENUE
$3,000 $5,800
adj. $250 250
$2,750 Bal.
$6,050 Bal.

The Balance Sheet will show The Income Statement will

$2,750 of Unearned Consulting show $6,050 total Consulting
Revenue unearned. Revenue earned.
Learning Objective P2: Prepare adjusting entries for deferral of revenues. © McGraw-Hill Education  40
 Adjusting Entry for Unearned Revenue
Adjusting entry recorded on Dec. 31 to transfer $250
from unearned to earned consulting revenue.

Learning Objective P2: Prepare adjusting entries for deferral of revenues. © McGraw-Hill Education  41
 Learning Objective P3

Prepare adjusting entries for

accrued expenses.

© McGraw-Hill Education  42
 Accrued Expense
Expense incurred in a period that is
both unpaid and unrecorded.
Exhibit
3.9

Learning Objective P3: Prepare adjusting entries for accrued expenses. © McGraw-Hill Education  43
 Adjusting for Accrued Salaries –
Steps 1, 2 and 3
Step 1: FastForward’s pays its employee $70 per day, or
$350 for a five-day work. Salaries are paid every two
weeks on a Friday.
Step 2: 12/31 is a Wednesday, so three day’s salaries are
owed at year end which equals $70 × 3 = $210.
Step 3: Adjusting entry increases a liability, Salaries
Payable, and increases the Salaries Expense account
for $210 with the following journal entry:

Learning Objective P3: Prepare adjusting entries for accrued expenses. © McGraw-Hill Education  44
 Adjusting for Accrued Salaries -
Financial Statements
(Balance Sheet) (Income Statement)
SALARIES PAYABLE SALARIES EXPENSE

$210 adj $1,400

adj 210
$210 Bal. Bal. $1,610

The Income Statement will

The Balance Sheet will show
show $1,610 total Salaries
$210 of Salaries Payable owed.
Expense.

Learning Objective P3: Prepare adjusting entries for accrued expenses. © McGraw-Hill Education  45
 Future Payment of Accrued Expenses
Accrued expenses at the end of one period result in a
cash payment in a future period.
On 12/31, FastForward recorded accrued salaries of
$210.
On 1/9 of the next year, the following entry will reduce
the accrued liability, salaries payable, and record the
expense for 7 days work in January.

Learning Objective P3: Prepare adjusting entries for accrued expenses. © McGraw-Hill Education  46
 Learning Objective P4

Prepare adjusting entries for

accrued revenues.

© McGraw-Hill Education  47
 Accrued Revenue
Accrued revenues are revenues earned in a period that
are both unrecorded and not yet received in cash or
other assets.

Exhibit
3.11

Learning Objective P4: Prepare adjusting entries for accrued revenues. © McGraw-Hill Education  48
 Adjusting for Accrued Services Revenue –

Steps 1, 2, and 3
Step 1: On 12/12, FastForward’s customer agreed to pay
$2,700 on 1/10 of the next year for future services over
the next 30 days.
Step 2: 12/31, 20 days worth of services have been provided
and earned which totals $1,800 ($2,700 × 20/30 days).
Step 3: Adjusting entry increases an asset, Accounts
Receivable, and increases the Consulting Revenue
account for $1,800 with the following journal entry:

Learning Objective P4: Prepare adjusting entries for accrued revenues. © McGraw-Hill Education  49
 Adjusting for Accrued Services Revenue
– Financial Statements
(Balance Sheet) (Income Statement)
ACCOUNTS RECEIVABLE CONSULTING REVENUE

adj. $1,800 $6,050

1,800 adj.
Bal. $1,800 $7,850 Bal.

The Income Statement will

The Balance Sheet will show
show $7,850 total
$1,800 of Accounts Receivable.
Consulting Revenue

Learning Objective P4: Prepare adjusting entries for accrued revenues. © McGraw-Hill Education  50
 Future Receipt of Accrued Revenues
Accrued revenue at the end of one period results in a cash
receipt in a future period.
On 12/31, FastForward recorded accrued revenue earned of
$1,800.
On 1/10 of the next year, the following entry will reduce the
accounts receivable, record revenue earned for 10 days and
receipt of $2,700 cash.

Learning Objective P4: Prepare adjusting entries for accrued revenues. © McGraw-Hill Education  51
 Links to Financial Statements

© McGraw-Hill Education  52
Learning Objective P4: Prepare adjusting entries for accrued revenues.
 Learning Objective P5

Explain and prepare an

adjusted trial balance.

© McGraw-Hill Education  53
 Adjusted Trial Balance Exhibit
3.13

54
Learning Objective P5: Explain and prepare an adjusted trial balance. © McGraw-Hill Education 
 Learning Objective P6

Prepare financial statements

from an adjusted trial balance.

© McGraw-Hill Education  55
 Financial Statements
The four financial statements and their purposes are:
1. Income statement—reports revenues less expenses incurred by a
business over a period of time.
2. Statement of retained earnings—reports changes in retained earnings
over the reporting period from net income (or loss) and from any
dividends over a period of time.
3. Balance sheet—reports the financial position (types and amounts of
assets, liabilities, and equity) at a point in time.
4. Statement of Cash Flows—lists the cash inflows and cash outflows for
the period.
**For simplicity, we do not show the statement of cash flows for FastForward in this
chapter, but we do return to this statement in the next chapter.**

Learning Objective P3: Prepare financial statements from business transactions. © McGraw-Hill Education  56
 Preparing Financial Statements
from an Adjusted Trial Balance
Step 1— Prepare income statement using revenue and expense
accounts from adjusted trial balance.
Step 2—Prepare statement of retained earnings using retained
earnings and dividends from adjusted trial balance;
and pull net income from step 1.
Step 3—Prepare balance sheet using asset and liability account
from adjusted 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).

Learning Objective P6: Prepare financial statements from an adjusted trial balance.
© McGraw-Hill Education  57
 Preparing Financial Statements from an Adjusted Trial Balance

Exhibit
3.14

58
Learning Objective P6: Prepare financial statements from an adjusted trial balance. © McGraw-Hill Education 
Drafting Notes to the Financial Statements

Examples of Items Disclosed

Notes to the
Two items always disclosed:
Financial Statements
The accounting method (e.g.,
depreciation policies)

The due dates of major liabilities

Drafting Notes to the Financial Statements
Examples of Items Disclosed
Lawsuits pending
Notes to the Scheduled plant closings
Financial Statements Governmental investigations
Significant events occurring
after the balance sheet date
Specific customers that
account for a large portion of
revenue (10%)
Unusual transactions and
related party transactions
Assets pledged as collateral to
secure loans
 Learning Objective P7

Describe and prepare closing

entries. (4 entries)

© McGraw-Hill Education  61
 Temporary Accounts and Permanent Accounts
• (need to be closed)Temporary accounts accumulate
data related to one accounting period.
• All income statement accounts, the withdrawals accounts and
the income summary are referred to as temporary accounts.

• Permanent accounts carry their ending balances into the

next period. The cumulative running balance reflects all
transactions affecting that account since the inception of the
business.
• All accounts which appear on a balance sheet (assets,
liabilities, equity accounts) are permanent accounts.

Learning Objective P6: Prepare financial statements from an adjusted trial balance.
© McGraw-Hill Education  62
 4 - 63

Closing Process
1. Resets revenue,
expense, and Identify accounts
dividends account for closing.
balances to zero at
the end of the period.
Record and post
2. Helps summarize a closing entries.
period’s revenues and
expenses in the
Income Summary
Prepare post-closing
account.
trial balance.
© McGraw-Hill Education  63
Learning Objective P7: Describe and prepare closing entries.
 4 - 64

Temporary and
Permanent Accounts
Revenues Assets

Liabilities
Dividends
Expenses

Equity
Temporary Permanent
Accounts Accounts

Income
Summary The closing process
applies only to
temporary accounts.
© McGraw-Hill Education  64
Learning Objective P7: Describe and prepare closing entries.
 4 - 65

Recording Closing Entries

1. Close Credit Balances in Revenue Accounts to
Income Summary.
2. Close Debit Balances in Expense accounts to
Income Summary.
3. Close Income Summary account to Retained
Earnings
4. Close Dividends to Retained Earnings.

© McGraw-Hill Education  65
Learning Objective P7: Describe and prepare closing entries.
 4 - 66

Recording Closing Entries

Exhibit
3.15

66
 4 - 67

Recording Closing Entries

67
 Learning Objective P8

Explain and prepare a post-

closing trial balance.

© McGraw-Hill Education  68
 Post-Closing Trial Balance

• List of permanent Let’s look at

accounts and their FastForward’s
post-closing trial
balances after posting balance.
closing entries.

• Total debits and

credits must be equal.

© McGraw-Hill Education  69
Learning Objective P8: Explain and prepare a post-closing trial balance.
 Post-Closing Trial Balance
Exhibit
3.18

© McGraw-Hill Education  70
Learning Objective P8: Explain and prepare a post-closing trial balance.
 Learning Objective C2

Identify steps in the accounting

cycle.

© McGraw-Hill Education  71
 4 - 72

Accounting Cycle
Exhibit
3.19

© McGraw-Hill Education  72
Learning Objective C2: Identify steps in the accounting cycle.
 4 - 73

Interim Financial Statement

• When a business closes its accounts only at year-end,
the revenue, expense, and withdrawals accounts have
balances representing the activities of the year-to-
date.

• How might this business prepare interim financial

statements covering only the month of June? Or the
quarter ended June 30?

© McGraw-Hill Education  73
 4 - 74

Ethical Issues in Accrual Accounting

• Accruals require the use of judgment to determine
which period should reflect revenues
earned/expenses incurred.

• Managers should not use accruals to manipulate

income by delaying or accelerating recognition of
either revenues or expenses.

© McGraw-Hill Education  74
 4 - 75

P4 Appendix 3A: Alternative

Accounting for Prepayments
An alternative method is to record all prepaid expenses
with debits to expense accounts.

The adjusting entry depends on how the original payment

was recorded.
4 - 76
4 - 77
4 - 78
End of Chapter 3

© McGraw-Hill Education  79