Chapter 03 – Adjusting Accounts and Preparing Financial Statements
CHAPTER 3
ADJUSTING ACCOUNTS AND PREPARING FINANCIAL
STATEMENTS
Related Assignment Materials
Student Learning Objectives Questions
Quick
Studies* Exercises* Problems*
Beyond the
Numbers
Conceptual objectives:
C1. Explain the importance of periodic
reporting and the time period
principle.
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C2. Explain accrual accounting and
how it improves financial
statements.
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C3. Identify the types of adjustments
and their purpose.
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Analytical objectives:
A1. Explain how accounting
adjustments link to financial
statements.
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11, 12
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3-2, 3-3,
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A2. Compute profit margin and
describe its use in analyzing
company performance.
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3-4, 3-5,
3-7, 3-9
Procedural objectives:
P1. Prepare and explain adjusting
entries.
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P2. Explain and prepare an adjusted
trial balance.
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P3. Prepare financial statements from
an adjusted trial balance.
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P4A. Explain the alternatives in
accounting for prepaids. (appendix
3A)
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*See additional information on next page that pertains to these quick studies, exercises and problems.
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Chapter 03 – Adjusting Accounts and Preparing Financial Statements
Additional Information on Related Assignment Material
The Serial Problem for Success Systems continues in this chapter and it can be completed with Sage 50
Software or QuickBooks. Problems 3-3A and 3-4A can be completed using Excel.
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 with new entrepreneurial assignment
Enhanced the innovative 3-step process for adjusting accounts
Changed selected numbers for FastForward
Updated profit margin section using Limited Brands
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Chapter 03 – Adjusting Accounts and Preparing Financial Statements
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.
A. Framework for Adjustments
Adjustments are necessary for transactions that extend over more than
one period.
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Chapter 03 – Adjusting Accounts and Preparing Financial Statements
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
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) liabilities. (The
liability is a “payable.”)
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Chapter 03 – Adjusting Accounts and Preparing Financial Statements
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
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 Owner’s Equity
Requires use of net income or loss from previous statement.
C. Balance Sheet
Requires use of ending equity from previous statement.
IV. Global View—Compares U.S. GAAP to IFRS
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.
V. Decision Analysis—Profit Margin
A. 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. Interpreted as reflecting the portion of profit in each dollar of revenue.
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Chapter 03 – Adjusting Accounts and Preparing Financial Statements
Chapter Outline Notes
VI. Appendix 3A—Alternative Accounting for Prepayments
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.
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