Chapter 3

The adjusting process

201044 - The adjusting process

 Learning objectives
• Differentiate between accrual and cash-basis accounting
• Explain why adjusting entries are needed
• Journalise and post adjusting entries
• Explain the purpose of and prepare an adjusted trial balance
• 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
accounting
• Accrual accounting records the effect of each transaction as it
occurs
• Cash-basis accounting records only cash receipts and cash
payments. It ignores receivables, payables and other items
• In accrual accounting, revenues are recorded when earned, which
is not necessarily in the same accounting period as when the
corresponding cash is received
• Most businesses use the accrual basis as covered in this book

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 3.1. Accrual versus cash-basis
accounting
Ex:
1. Suppose Smart Touch purchases $200 of office supplies
on credit on 15 Jun and pays to supplier on 03 Jul.
2. Suppose Smart Touch performs services and earns
revenue of $1,000 on 20 Jun but collects no cash
(Cash will be collected on 05 Jul)
 Indicate the difference in recording above transactions on
the cash-basic accounting and accrual-basic accounting.

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 3.2. Why we adjust the accounts
• Accrual accounting requires adjusting entries at the end of the
period
• Adjusting entries assign revenues to the period when they are
earned and expenses to the period when they are incurred
• Adjustments are needed to properly measure two things: (1) profit
(loss) in the income statement, and (2) assets and liabilities in the
balance sheet
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 3.3. Two categories of adjusting entries
• The two basic categories of adjusting entries are prepayments
(defferals) and accruals
• In a prepaid adjustment, the cash payment occurs before an
expense is recorded or the cash receipt occurs before the revenue
is earned
• An accrual records an expense before the cash payment or it
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

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 3.3. Two categories of adjusting entries
Prepaid expenses
• Prepaid expenses are advance payments of expenses
• Examples include prepaid rent, insurance, supplies
• Prepaid expenses are considered assets rather than expenses
• When the prepayment is used up, the used portion of the asset
becomes an expense via an adjusting journal entry
Ex: Smart Touch prepays three months’ office rent of $3,000 ($1,000
per month x 3 months) on 01 June 201N

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 3.3. Two categories of adjusting entries
Depreciation
• Property, plant and equipment assets are long-lived, non-current,
tangible assets used in the operation of a business
• As a business uses non-current assets, their value and usefulness
decline
• The decline in usefulness of a non-current asset is an expense, and
accountants systematically spread the asset’s cost over its useful
life
• The allocation of a non-current asset’s value to expense is called
depreciation

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 3.3. Two categories of adjusting entries
Depreciation
• The accumulated depreciation account is the sum of all the
depreciation recorded for the asset, and that total increases
(accumulates) over time
• Accumulated depreciation is a contra asset
Ex: On 01 June, Smart Touch purchased furniture for $18,000. Its
expected useful life is five years.
Dr. Dep
Cr Acc Dep, Furniture 18,000/12x5 x ???

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 3.3. Two categories of adjusting entries
Accrued expenses
• The term accrued expense refers to an expense incurred before
paying for them
• Examples include accruing salary expense and accruing interest
expense
• An accrued expense hasn’t been paid for yet and always creates a
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.

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 3.3. Two categories of adjusting entries
Accrued revenues
• Businesses can earn revenue before they receive the cash, which
creates accrued revenues
• Accrued revenue is revenue that has been earned but for which the
cash has not yet been collected
Ex: Assume that Smart Touch is hired on 16 June to perform e-
learning services for the Central Queensland University. Under this
agreement, Smart Touch will earn $800 monthly.
During June, for work performed from 16 June to 30 June, Smart
Touch will earn half a month’s fee, $400.

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 3.3. Two categories of adjusting entries
Unearned revenues (Deferred revenue)
• Some businesses collect cash from customers in advance of
performing work
• Receiving cash before earning it creates a liability to perform work in
the future called unearned revenue
• The business owes a product or a service to the customer, or it
owes the customer his or her money back
• Only after completing the job will the business earn the revenue.
Because of this delay, unearned revenue is also called deferred
revenue

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 3.3. Two categories of adjusting entries
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.

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 3.3. Two categories of adjusting entries

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 3.3. Two categories of adjusting entries

Ex: Information for the adjustments at 30 June 201N of Smart

Touch
(a) Prepaid rent expired, $1,000
(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.
 3.4. The adjusted trial balance
• Prepared after adjusting entries are posted
• Useful step in preparing financial statements
• Often appears on a work sheet

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 3.4. The adjusted trial balance

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 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

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 3.5. The financial statements

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 3.5. The financial statements

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 3.5. The financial statements

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 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

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 Summary: Chapter 3
• Accrual accounting records revenues and expenses when they are
earned/incurred
• Cash-basis accounting records revenues and expenses when cash
is received or paid
• Accrual accounting requires adjusting entries at the end of the
period
• 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 in class
Textbook: Chapter 3
• Quick Check
• Starters
• Exercises

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 Tasks at home
1/ Homework:
Textbook: Chapter 3
• Problems
• Apply
2/ Self-study:
Key References [2]: Chapter 4

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The end of Chapter 3
The adjusting process

201044 - The adjusting process