CHAPTER 3
ADJUSTING ACCOUNTS FOR FINANCIAL STATEMENTS
Related Assignment Materials
Student Learning Objectives Questions Quick Studies* Exercises* Problems*
Beyond the
Numbers
Conceptual objectives:
A2. Compute current ratio and
describe what it reveals about a
company’s financial condition.
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Procedural objectives:
P1. Prepare and explain adjusting
entries.
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P2. Explain and prepare an adjusted
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P8. Prepare reversing entries and
explain their purpose (Appendix
3C)
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*See additional information on next page that pertains to these quick studies, exercises and problems.
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Additional Information on Related Assignment Material
Connect (Available on the instructor’s course-specific website) repeats all numerical Quick
Studies, all Exercises and Problems Set A. Connect provides new numbers each time the Quick
Study, Exercise or Problem is worked. It allows instructors to monitor, promote, and assess
student learning. It can be used in practice, homework, or exam mode.
Synopsis of Chapter Revisions
International Princess Project: NEW opener
Enhanced the innovative three-step process for adjusting accounts
Changed selected numbers for FastForward
New multicolor-coded five-step layout for work sheet preparation and use
Updated profit margin and current ratio decision analysis section using Limited Brands
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Chapter Outline Notes
I. Timing and Reporting
A. The Accounting Period
To provide timely information, accounting systems prepare reports
at regular intervals.
1. Time-period principle assumes that an organization’s activities
can be divided into specific time periods such as a month, a
three-month quarter, a six-month interval, or a year for
periodic reporting. Interim and annual financial statements can
then be prepared.
2. Annual reporting period:
a. Calendar year—January 1 to December 31.
b. Fiscal year—any twelve consecutive months on which to
base the annual financial reports.
c. Natural business year—a fiscal year that ends when a
company’s sales activities are at their lowest point.
d. Interim financial statements—statements prepared for any
period less than a fiscal year.
B. Accrual Basis versus Cash Basis
1. Accrual basis—uses the adjusting process to recognize
revenues when earned and expenses when incurred with
revenues (match the expenses with the revenue). This means
the economic effects of revenues and expenses are recorded
when earned or incurred, not when cash is received or paid.
Accrual basis is consistent with GAAP. Improves
comparability of statements.
2. Cash basis—revenues are recognized when cash is received
and expenses are recognized when cash is paid. Cash basis is
not consistent with GAAP.
C. Recognizing Revenues and Expenses
1. The revenue recognition principle requires revenue be
recorded when earned, not before and not after.
2. The expense recognition principle (often called the matching
principle) aims to record expenses in the same period as the
revenues earned as a result of these expenses.
II. Adjusting Accounts—An adjusting entry is recorded to bring an asset
or liability account balance to its proper amount. This entry also
updates the related expense or revenue account. Need to determine the
current account balance; what the balance should equal and record the
adjusting entry to get from step 1 to step 2.
A. Framework for Adjustments
Adjustments are necessary for transactions that extend over more
than one period.
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Chapter Outline Notes
B. Adjusting Prepaid (Deferred) Expenses
1. Prepaid expenses (including depreciation) are items paid for in
advance of receiving their benefits. Prepaid expenses, also
called deferred expenses, are assets. As the assets are used,
their costs become expenses.
2. Common prepaid items are supplies, prepaid insurance,
prepaid rent and depreciation.
3. Adjusting entries for prepaids involve increasing (debiting)
expenses and decreasing (crediting) assets (with the exception
of depreciation on plant and equipment).
C. Adjusting for Depreciation
1. Depreciation is the process of allocating the cost of plant
assets over their expected useful lives.
2. Adjusting entries for depreciation expense involve increasing
(debiting) expenses and increasing (crediting) a special
account called Accumulated Depreciation. This account is
classified as a contra-asset. It is linked to the asset as a
subtraction and thus used to record the declining asset balance.
3. Book value is a term used to describe the asset less its contra-
asset (accumulated-depreciation).
D. Adjusting Unearned (Deferred) Revenues
1. Unearned revenues (also called deferred revenues) are
liabilities created by cash received in advance of providing
products or services. The obligation is to provide the service
or product. As they are provided, unearned revenues
(liabilities) become earned revenues (revenues).
2. Adjusting entries for unearned revenues involve increasing
(crediting) revenues and decreasing (debiting) unearned
revenues.
E. Adjusting Accrued Expenses
1. Accrued expenses are costs or expenses incurred in a period
but are both unpaid and unrecorded.
2. Common accrued expenses are salaries, interest, rent, and
taxes.
3. Adjusting entries for recording accrued expenses involve
increasing (debiting) expenses and increasing (crediting)
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Chapter Outline Notes
F. Adjusting Accrued Revenues
1. Accrued revenues are revenues earned in a period that are both
unrecorded and not yet received in cash.
2. Accrued revenues commonly result from partially completed
jobs or interest earned.
3. Adjusting entries for recording accrued revenues involve
increasing (debit) assets and increasing (credit) revenues. (The
asset is a “receivable.”)
G. Links to Financial Statements
Each adjusting entry affects one or more income statement
accounts and one or more balance sheet accounts. Failure to make
a necessary adjustment will result in misstatements of amounts on
each of these statements. (See textbook Exhibit 3-12 for a
summary of adjustments and financial statement links.)
H. Adjusted Trial Balance
A list of accounts and balances prepared after adjusting entries are
recorded and posted to the ledger.
III. Preparing Financial Statements—Prepare financial statements
directly from information in the adjusted trial balance. The following
preparation order shows the flow of information from one statement to
another:
A. Income Statement
B. Statement of Retained Earnings
Requires use of net income or loss from previous statement.
C. Balance Sheet
Requires use of ending equity from previous statement.
IV. Closing Process—The closing process is an important step at end of
the accounting period after financial statements have been completed.
Prepares accounts for recording transactions and events for the next
period.
A. Steps in closing process:
1. Identify accounts for closing.
2. Record and post-closing entries.
3. Prepare a post-closing trial balance.
B. Purpose of closing process:
1. To reset revenues, expenses, and dividends account balances
to zero at the end of every period to prepare these accounts for
proper measurement in the next period.
2. To update the retained earnings account with the effect of the
period’s net income (revenue minus expenses) and dividends.
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Chapter Outline
C. Temporary and Permanent Accounts
1. Temporary (or nominal) accounts accumulate data related to
2. Permanent (or real) accounts report on activities related to one
or more future accounting periods. They are all balance sheet
accounts.
D. Recording Closing Entries—the purpose is to transfer the end-
of-period balances in revenue, expense, and dividends accounts
to the permanent retained earnings account.
1. Use a new temporary account called Income Summary. The
four closing entries are:
a. Close credit balances in revenue (and gain) accounts by
debiting the accounts and crediting Income Summary.
This transfers revenue balances to the credit side Income
Summary.
b. Close debit balances in expense (and loss) accounts by
crediting the accounts and debiting Income Summary.
This transfers the expense balances to the debit side of
Income Summary.
c. Close the Income Summary account to the retained
earnings account.
Note: The Income Summary account, prior to closing, will
have a credit balance equal to net income or a debit balance
equal to net loss. Therefore this entry will credit retained
earnings for the amount of net income (or debit retained
earnings for a net loss).
d. Close dividends account by crediting the account and
debiting the retained earnings account.
2 After all closing entries are posted, all temporary accounts have
a zero balance and retained earnings is up to date.
E. Post-Closing Trial Balance—a list of permanent accounts and
their balances taken from the ledger.
1. Prepared after closing entries are journalized and posted.
2. Verifies that total debits equal total credits for permanent
accounts and all temporary accounts have zero ending balances.
Notes
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Chapter Outline Notes
V. Accounting Cycle–steps can vary if a worksheet is used (see Visual
#3-1). The ten steps repeated each accounting cycle are as follows:
1. Analyze transactions
2. Journalize
3. Post
4. Prepare unadjusted trial balance
5. Adjust
6. Prepare an adjusted trial balance
7. Prepare statements
8. Close
9. Prepare a post-closing trial balance.
Reverse (optional)
VI. Classified Balance Sheet organizes assets and liabilities into important
subgroups and provides more information for decision makers.
A. Classification Structure
1. One of the more important classifications is the separation
between current and noncurrent assets and liabilities.
2. Current items are expected to come due (both collected and
owed) within the longer of one year or the company’s
operating cycle.
3. An operating cycle is the time span from when cash is used to
acquire goods and services until cash is received from the sale
of those goods and services.
B. Classification Categories
1. Current assets—cash or other resources that are expected to be
sold, collected, or used within one year or the operating cycle,
whichever is longer. Examples: cash, short-term investments,
accounts receivable, short-term notes receivable, merchandise
inventory, and prepaid expenses.
2. Long-term investments—assets held for more than one year,
that are not used in business operations. Examples: stocks,
bonds, promissory notes, and land held for future expansion.
3. Plant assets—tangible, long-lived assets that are used to
produce or sell goods and services. Examples: equipment,
buildings, land.
4. Intangible assets—long-term resources that benefit business
operation. They lack physical form. Their value comes from
the privileges or rights that are granted to or held by the
owner. Examples: goodwill, patents, trademarks, franchises,
copyrights.
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Chapter Outline
5. Current liabilities—obligations due to be paid or settled within
the longer of one year or the operating cycle. Examples:
accounts payable, notes payable, wages payable, taxes payable,
interest payable, unearned revenues, current portions of
long-term liabilities.
6. Long-term liabilities—obligations that are not due to be paid
within one year or the operating cycle of the business.
Examples: notes payable, mortgage payable, bonds payable.
7. Equity—owner’s claim on assets. In a corporation, equity is
divided into two main subsections: capital stock and retained
earnings.
VII. Global View
A. Adjusting accounts—adjustments presented in this chapter are
identical under both systems.
B. Preparing financial statements—the same basic four statements are
presented under both systems but the sequence of account group
presentation varies.
C. Closing process is identical under both system.
VIII. Decision Analysis: Profit Margin and Current Ratio
A. Profit margin is used to evaluate operating results by measuring the
ratio of a company’s net income to sales. Also called return on sales.
B. Calculated as net income divided by net sales revenues.
C. Current ration assesses a company’s ability to pay its debts in the near
future.
D. Calculation: total current assets divided by total current liabilities.
IX. Appendix 3A—Alternative Accounting for Prepayments
Notes
A. Prepaid expenses may originally be recorded with debits to
expense accounts instead of assets. If so, then adjusting entries
must transfer the cost of the unused portions from expense
accounts to prepaid expense (asset) accounts.
B. Prepaid revenues or revenues collected in advance may originally
be recorded with credits to revenue accounts instead of liabilities.
If so, then adjusting entries must transfer the unearned portions
from revenue accounts to unearned revenue (liability) accounts.
C. Note that the financial statements are identical under either
procedure, but the adjusting entries are different.
X. Appendix 3B—Work Sheet as a Tool
A. Benefits of a Work Sheet (Spreadsheet) – aids in the preparation
of financial statements; reduces errors; links accounts and
adjustments to the financial statements; assists in planning an
audit; helps in preparing interim financial statements; and shows
proposed “what-if” transactions.
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Chapter Outline
B. Work sheet Applications and Analysis – does not substitute for
financial statements. It is a tool used at the end of the period to help
organize data and prepare financial statements.
XI. Appendix 3C—Reversing Entries
A. Accounting without reversing entries
1. To construct proper entries when the cash receipt/payment
occurs in the new accounting period, the related accrual or
deferral adjustment must be recalled and considered.
2. With or without reversing entries use, it will yield the same
result.
B. Accounting with reversing entries (an optional step)
1. Linked to asset and liability account balances that arose from
the accrual of revenues and expenses.
2. Purpose is to simplify recordkeeping.
3. They are prepared after closing entries and dated the first day
of the new period.
4. Procedure is to transfer accrued asset and liability account
balances to related revenue and expense accounts creating an
abnormal balance in these accounts.
5. The full subsequent cash receipts (and payments) are recorded
as increases in revenue (and expense) accounts creating a net
balance equal to the amount earned or incurred in that period.
Notes
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