CHAPTER 3
ADJUSTING ACCOUNTS AND PREPARING FINANCIAL
3-2
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
• ash&dans: NEW opener with new entrepreneurial assignment
• New layout for the types of adjustments
• New example of unearned revenues using USA Today
• Enhanced and emphasized the innovative three-step process for adjusting accounts
• Updated IFRS and FASB revenue recognition convergence
• Added six new Quick Studies to directly apply the three-step adjustment process
Learning Objective
Slides
C1
2
C2
3-8
C3
9
P1
10–28
A1
29
P2
30
P3
31–34
A2
36
P4
37–40
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 used to base
annual financial reports on.
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 match expenses when incurred with
revenues. 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.
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)
liabilities. (The liability is a “payable.”)
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, p.102 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 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. 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.
V. 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.
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.
VISUAL #3-1
ACCRUAL BASIS ACCOUNTING
(Follows GAAP)
requires that the
Income Statement
ALL REVENUES EARNED in period (Collected or Not)
Minus ALL EXPENSES INCURRED in period (Paid or Not)
Equals Net Income or Net Loss for the period
ACCOUNTS MUST BE ADJUSTED TO FOLLOW PRINCIPLES
Revenue
Recognition
GAAP
Periodicity
GAAP
Recognition
(or Matching)
GAAP
Recognition
or Matching
3-8
A REVENUE not earned cannot be shown, even if collected.
An EXPENSE not incurred cannot be shown, even if paid.
PREPAID = ASSET *
*We defer or postpone the reporting of the collected revenues
(as revenues) and prepaid expenses (as expenses) until the
3-9
VISUAL #3-3
ADJUSTMENTS
TYPE
GENERALIZED*
ENTRY
AMOUNT
1A. Prepaid (deferred)
expenses—initially recorded as
assets
Dr. _________ Expense
Cr. the Asset* acct.
Amount used, or
consumed, or expired
1B. Prepaid (deferred)
expenses—that are depreciable
(plant assets)
Dr. Depreciation Expense
Cr. Accumulated
Depreciation
Portion of cost
allocated to this period
as depreciation
1C. Prepaid (deferred)
expenses—initially recorded as
expenses (alternate treatment—
appendix)
Dr. the Asset** acct.
Cr. ________ Expense
Amount left, or
not consumed, or
unexpired
2A. Unearned revenues—
(revenue received in advance)
initially record as liability
(unearned account)
Dr. Unearned ________
Cr. the Revenue** acct.
Amount earned to date
2B. Unearned revenues—
(revenue received in advance)
initially recorded as a revenue
(alternate treatment—
appendix)
Dr. the Revenue** acct.
Cr. Unearned________
Amount still not
earned
3. Accrued expenses—
(expenses incurred but not yet
recorded)
Dr. _________ Expense
Cr. _________ Payable
Amount accrued
4. Accrued revenues
(revenues earned but not
yet recorded)
Dr. ________ Receivable
Cr. the Revenue** acct.
Amount accrued
3-10
Alternate Demonstration Problem
Chapter Three
On July 1, 2013, Howard M. Tenant, Inc., rents office space from John Q.
Landlord for two years, starting immediately, at a rate of $100 per month, or
$2,400 in total. The full $2,400 was paid on this date. Record the original
transaction and the appropriate adjusting entries in 2013, 2014, and 2015
from the point of view of Tenant and Landlord .
3-11
Solution: Alternate Demonstration Problem
Chapter 3
Tenant
Landlord
7/1/13
Prepaid Rent …………….
2,400
Cash ………………………..
2,400
Cash
2,400
Unearned Rent
Rev. ………………..
2,400
12/31/13
Rent Expense …………..
600
Unearned Rent Rev.
600
Prepaid Rent ……..
600
Rent Revenue
600
12/31/14
Rent Expense …………..
1,200
Unearned Rent Rev.
1,200
*Prepaid Rent …….
1,200
Rent Revenue
1,200
12/31/15
*Rent Expense ………….
600
Unearned Rent Rev.
600
Prepaid Rent ……..
600
Rent Revenue
600
An Alternative Solution (Based on the Appendix)
Tenant
Landlord
7/1/13
Rent Expense …………..
2,400
Cash ………………………..
2,400
Cash ………………….
2,400
Rent Rev. ………….
2,400
12/31/13
Prepaid Rent ……………
1,800
Rent Rev.
1,800
Rent Expense …….
1,800
Unearned Rent
Revenue ………….
1,800
*12/31/14
Rent Expense …………..
1,200
Unearned Rent Rev.
1,200
Prepaid Rent ……..
1,200
Rent Revenue
1,200
*12/31/15
Rent Expense …………..
600
Unearned Rent Rev.
600
Prepaid Rent ……..
600
Rent Revenue
600
*Notice the adjustment is the same in 2014 and 2015 under both
approaches. This is because the adjustment in the appendix alternative
solution places all remaining unexpired/unearned amounts in the
asset/liability accounts to be considered for future adjustment.
3-12
Another Alternate Demonstration Problem
Chapter Three
The trial balance of Large Company, Inc., at the end of its annual
accounting period is as follows:
LARGE COMPANY, INC.
Trial Balance
December 31, 2013
Cash ………………………………………………………………..
$ 4,000
Prepaid Insurance ……………………………………………
1,600
Supplies …………………………………………………………
2,100
Equipment ………………………………………………………
20,000
Accumulated Depreciation—Equipment ……………
$ 2,000
C. Large, Capital ……………………………………………..
19,000
C. Large, Withdrawals ………………………………………
2,000
Revenue ………………………………………………………….
33,000
Salaries Expense ……………………………………………..
18,300
Rent Expense ………………………………………………….
6,000
______
Totals ………………………………………………………………
$54,000
$54,000
Additional information:
1. Expired insurance, $600.
2. Unused supplies, per inventory, $800.
3. Estimated depreciation, $1,000.
4. Earned but unpaid salaries, $700.
Required:
Prepare adjusting entries.
3-13
Solution: Another Alternate Demonstration Problem
Chapter 3
1.
Insurance Expense …………………………………….
600
Prepaid Insurance ………………………………..
600
Supplies Expense ………………………………………
1,300
Supplies ………………………………………………
1,300
Depreciation Expense Equip. ……………………..
1,000
Accumulated Depreciation Equip. …………
1,000
Salaries Expense ……………………………………….
700
Salaries Payable …………………………………..
700