Chapter 3
Adjusting the Accounts
Learning Objectives
1. Dene net income and explain the concepts underlying income measurement.
2. Distinguish cash basis of accounting from accrual accounting, and explain how accrual
accounting is accomplished.
3. Identify four situations that require adjusting entries, and illustrate typical adjusting
entries.
4. Prepare nancial statements from an adjusted trial balance.
5. Explain the importance of ethical measurement of net income and the relation of net
income to cash &ows.
Section 1: Concepts
Concepts
Net income
Revenues
Expenses
Continuity
Periodicity
Accrual accounting (matching rule)
Revenue recognition
Lecture Outline
I. Net income is the excess of revenues over expenses; net loss is the reverse.
II. Revenues are increases in owner’s equity resulting from selling goods, rendering
services, or performing other business activities.
III. Expenses are the decreases in owner’s equity resulting from the cost of selling goods or
rendering services in the course of earning revenue.
IV. The continuity assumption states that when measuring income, in the absence of
evidence to the contrary, the accountant should assume that a business will continue to
operate indenitely.
V. The periodicity assumption recognizes that the measurement of net income for a given
period is at best an estimate.
VI. A scal year is any 12-month period; it may or may not correspond to the calendar
year.
VII. Under accrual accounting (the matching rule), revenues are recorded in the accounting
period in which they are earned, and expenses are recorded in the same accounting
period as the revenue generated by the particular expense; the timing of cash receipts
and payments is irrelevant.
VIII. Under the cash basis of accounting, revenues and expenses are recognized (recorded)
when cash is received or paid.
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Chapter 3: Adjusting the Accounts Instructor’s Manual, p. 2
IX. Earnings management is the manipulation of revenues and expenses to achieve a
specic outcome. While not illegal within small ranges, larger variations can mislead
the user and lead to fraudulent nancial reporting.
X. A scal year is any 12-month period; it may or may not correspond to the calendar
year.
XI. Under the cash basis of accounting, revenues and expenses are recognized (recorded)
when cash is received or paid.
XII. According to the matching rule, revenues are recorded in the accounting period in
which they are earned, and expenses are recorded in the same accounting period as
the revenue generated by the particular expense; the timing of cash receipts and
payments is irrelevant.
XIII. Accrual accounting consists of all the techniques used to apply the matching rule.
A. When revenue is recorded before cash is received, a receivable is also recorded.
B. When an expense is recorded before cash is paid, a payable is also recorded.
C. Adjusting entries are required when (1) recorded costs have to be allocated
between two or more accounting periods, (2) unrecorded expenses exist, (3)
recorded unearned revenues must be allocated between two or more accounting
periods, and (4) unrecorded revenues exist.
XIV. Determining when revenue is earned is known as revenue recognition.
VIIIV. The SEC stated that all the following conditions must exist before revenue is
recognized:
A. Persuasive evidence of an arrangement exists.
B. A product or service has been delivered.
C. The seller’s price to the buyer is xed or determinable.
D. Collectibility is reasonably assured.
Summary
Earning a prot is an important goal of most businesses. One of the major functions of
accounting is to measure and report a company’s success or failure in achieving this goal.
This is done by means of an income statement.
Net income is the net increase in owner’s equity resulting from a company’s operations.
Net income results when revenues exceed expenses; a net loss results when expenses
exceed revenues.
Revenues are increases in owner’s equity resulting from selling goods, rendering services, or
performing other business activities. Examples of revenue accounts are Sales (the account used
when merchandise is sold), Commissions Earned, and Fees Earned.
Expenses also described as the cost of doing business or as expired costs, are the
decreases in owner’s equity resulting from the cost of selling goods or rendering services
used in the course of earning revenues. Examples of expense accounts are Telephone
Expense, Wages Expense, and Advertising Expense.
Users of nancial reports should be aware that assumptions play a major role in the
measurement of net income and other key indicators of performance. The major
assumptions made in measuring business income relate to continuity, periodicity, and
accrual accounting (matching).
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or posted to a publicly accessible website, in whole or in part.
Chapter 3: Adjusting the Accounts Instructor’s Manual, p. 3
The issue of continuity arises as the diAculty associated with not knowing how long a
business will survive. Because the majority of companies present their nancial statements
on the assumption that a company will continue to operate indenitely, it is assumed that a
company is a going concern. The continuity assumption is that unless there is evidence to
the contrary, the accountant assumes that the business will continue to operate indenitely.
The assumption about periodicity states that although the lifetime of a business is
uncertain, it is still useful to estimate the business’s net income in terms of accounting
periods. Comparison of nancial statements is made possible through the use of accounting
periods of equal length. A !scal year is any 12-month period used by a company. Many
companies’ scal years correspond to the calendar year, which is the 12-month period from
January 1 through December 31. Accounting periods of less than one year are called
interim periods.
Under accrual accounting (the matching rule), revenues must be recorded in the
accounting period in which they are actually earned, and expenses must be recorded in the
accounting period in which they are incurred (i.e., in the same period as the revenue
generated by an expense); the timing of cash payments or receipts is irrelevant.
When the cash basis of accounting is used, revenues are recorded in the period in which
cash is received, and expenses are recorded in the period in which cash is paid. This
method, however, can lead to a distortion of net income for the period.
Accrual accounting consists of all the techniques used to apply the matching rule.
Specically, it involves (1) recording revenues when earned (revenue recognition), (2)
recording expenses when incurred, and (3) adjusting the accounts at the end of the period.
The SEC has stated that all the following conditions must exist before revenue is recognized:
(1) persuasive evidence of an arrangement exists; (2) a product or service has been
delivered; (3) the seller’s price to the buyer is xed or determinable; and (4) collectibility is
reasonably assured.
Relevant Examples and Exhibits
Exhibit 1 Concepts Underlying Net Income
Teaching Strategy
The explanations required for this section provide an opportunity to reiterate that revenues
are not necessarily cash in&ows and that expenses do not have to be cash out&ows (that is,
the concept of accrual accounting). It should be pointed out that the main purpose of an
expense is to generate revenue, whether directly or indirectly.
At this point, students probably will not fully understand the diCerences between revenues
and assets, expenses and assets, and expenses and liabilities. The use of carefully chosen
accounts (such as OAce Supplies and OAce Supplies Expense) to explain the diCerence
between assets and expenses will help to clear the confusion.
The necessity for timely nancial reports must be emphasized. The periods of time chosen
must be of equal length to provide comparability from one accounting period to the next.
Students will have an easier time understanding the importance of this concept if examples
are used that illustrate situations in which monthly, quarterly, or annual nancial statements
would be most appropriate.
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or posted to a publicly accessible website, in whole or in part.
Chapter 3: Adjusting the Accounts Instructor’s Manual, p. 4
To illustrate the continuity problem, it is helpful to demonstrate, by a simple income statement,
the diCerence in net income for two periods in which everything is equal except that an asset is
put into service and “expensed” immediately in the rst period. In this discussion, the
opportunity then exists to introduce the concept of understatement and overstatement of net
income.
Explain that the most accurate way to measure performance (income) is to place revenues
and related expenses in the same accounting period.
Students are familiar with the cash basis of accounting through their personal experience. As
a result, it may be helpful to illustrate the matching rule by using examples from students’
own experiences (e.g., Did prepaying a meal ticket for the fall semester at college mean that
they had no food expense during October and November?). The illustration can then be
expanded to the business setting.
The distortion that results in net income under the cash basis can be demonstrated with a
simple example. Compute cash basis net income for three or four periods for a company
that buys and sells on account. This example can be expanded to include the accrual basis.
Once students are prepared to accept that cash &ow is not necessarily a determinant of revenue
and expense recognition, simple illustrations that draw on students’ personal experiences can be
used to further explain accruals. Particular attention should be paid to showing the &ow of
accounting information, including the cash transactions, in examples of an accrual for revenues
and an accrual for expenses. Continuing the example, compute net income under the accrual
basis and show how it gives a more realistic picture of business performance for those
periods.
Given that adjusting entries are required because of the passage of time, with no “incident” to
record, students often ask how they know what amounts to use and which accounts need to be
adjusted. This is an opportunity to discuss schedules, tables, and other supporting information
that may be kept with accounting records. At the least, students should be reassured that they
will be given the appropriate information when they are required to do a practice problem.
Section 2: Accounting Applications
Accounting Applications
Prepare adjusting entries
Prepare nancial statements from an adjusted trial balance
Lecture Outline
I. Adjusting entries are made at the end of the period.
A. A deferral is the postponement of the recognition of revenue received in advance
or of an expense already paid (cash has already changed hands).
1. Allocate recorded costs between two or more accounting periods.
2. Allocate recorded, unearned revenues between two or more accounting
periods.
B. An accrual is the recognition of a revenue or expense that has arisen but has not
yet been recorded (cash has not yet changed hands).
1. Recognize unrecorded expenses.
2. Recognize unrecorded, earned revenues.
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or posted to a publicly accessible website, in whole or in part.
Chapter 3: Adjusting the Accounts Instructor’s Manual, p. 5
II. Prepaid rent and prepaid insurance are transferred (at least in part) to expense
accounts.
III. OAce supplies used are recorded as OAce Supplies Expense. Usually an inventory of
oAce supplies is taken to calculate the cost of supplies used.
IV. Depreciation on buildings and equipment must be recorded.
A. Depreciation is the logical allocation of asset cost to the accounting periods
beneted.
B. Depreciation Expense is a temporary account used to record depreciation during a
given accounting period. Accumulated Depreciation is a permanent account that
shows the total depreciation recorded in all prior periods.
C. Show the balance sheet presentation of the Accumulated Depreciation account.
V. Accrued expenses (expenses incurred but not paid) are recorded. Examples are accrued
interest, wages, and taxes.
VI. Unearned revenues (liabilities) are transferred (portions now earned) to earned
revenues.
VII. Accrued revenues (revenues earned but not received) are recorded.
VIII. An adjusted trial balance is prepared after all the adjusting entries have been posted to
the ledger.
IX. Once the adjusted trial balance is in balance, the nancial statements can be prepared.
Summary
An issue arises when revenues or expenses apply to more than one accounting period. The
issue is resolved by making adjusting entries at the end of the accounting period.
Adjusting entries allocate to the current period the revenues and expenses that apply to that
period, deferring the remainder to future periods. A deferral is the postponement of the
recognition of an expense already paid or of revenue received in advance. An accrual is the
recognition of an expense or revenue that has arisen but has not yet been recorded.
Adjusting entries are required to accomplish the following tasks:
1. To allocate recorded costs (such as the cost of machinery or prepaid rent) between two
or more accounting periods
2. To recognize incurred but unrecorded expenses (such as wages earned by employees
after the last payday in an accounting period)
3. To allocate recorded, unearned revenues (such as cash received for services yet to be
rendered) between two or more accounting periods
4. To recognize unrecorded, earned revenues (such as fees earned but not yet billed to
customers)
When an expenditure is made that will benet more than just the current period, the initial
debit is usually made to an asset account instead of to an expense account. Then, at the end
of the accounting period, the amount that has been used up or that has expired is
transferred from the asset account to an expense account by means of an adjusting entry.
1. The Prepaid Rent and Prepaid Insurance accounts (examples of prepaid expenses) are
debited when rent and insurance, respectively, are paid in advance.
2. The OAce Supplies account is debited when oAce supplies are purchased. At the end of
the accounting period, an inventory of oAce supplies is taken. The diCerence between
oAce supplies available during the period and ending inventory represents the amount
consumed during the period.
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 3: Adjusting the Accounts Instructor’s Manual, p. 6
3. Long-term assets such as machinery, buildings, equipment, or company vehicles are
debited to an asset account when purchased. At the end of each accounting period, an
adjusting entry must be made to transfer a portion of the original cost of each long-term
asset to an expense account. The amount transferred or allocated is called
depreciation. The Accumulated Depreciation account is called a contra account,
because it appears on the balance sheet as a deduction from its associated asset
account. Proper balance sheet presentation will, therefore, disclose the original cost,
the accumulated depreciation as of the balance sheet date, and the undepreciated
balance (called the carrying value).
In the adjusting entry to record depreciation, Depreciation Expense is debited and
Accumulated Depreciation is credited.
When expenses have been incurred but cash has not been paid by the end of the accounting
period, an adjusting entry must nevertheless be made to record these accrued
(accumulated) expenses. For example, interest may have accrued on a loan that does not
require payment until the next period. A debit to Interest Expense and a credit to Interest
Payable will record the current period’s interest expense for the income statement as well as
record the liability for the balance sheet.
When payment is received for goods before they are delivered or for services before they
are rendered, a liability account (an example is unearned revenues) appears on the
balance sheet and represents revenue that must still be earned. This account is credited
when payment is received and debited when goods are delivered or services performed.
When revenues have been earned for which no payment has been received, adjusting
entries must be made to record these accrued (unrecorded) revenues. For example, if
interest that has been earned will not be received until the next period, a debit must be
made to Interest Receivable, and a credit must be made to Interest Income.
The following journal entries are introduced in this section:
Rent Expense XX (amount expired)
Prepaid Rent XX (amount expired)
To record expiration of prepaid rent
OAce Supplies Expense XX (amount consumed)
OAce Supplies XX (amount consumed)
To record supplies used
Depreciation Expense—OAce Equipment XX (amount allocated to period)
Accumulated Depreciation—OAce Equipment XX (amount allocated to
To record depreciation for the period period)
Wages Expense XX (amount incurred)
Wages Payable XX (amount to be paid)
To record wages incurred but not paid
Unearned Design Revenue XX (amount earned)
Design Revenue XX (amount earned)
To record prepaid service revenue earned
Accounts Receivable XX (amount to be received)
Design Revenue XX (amount earned)
To record accrual of unrecorded revenue
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or posted to a publicly accessible website, in whole or in part.
Chapter 3: Adjusting the Accounts Instructor’s Manual, p. 7
After all the adjusting entries have been posted to the ledger accounts and new account
balances have been computed, an adjusted trial balance is prepared. If it is in balance,
the adjusted trial balance is used to prepare the nancial statements.
Relevant Examples and Exhibits
Exhibit 2 Trial Balance for Blue Design Studio
Exhibit 3 The Four Types of Adjustments
Exhibit 4 Adjustment for Prepaid (Deferred) Expenses
Exhibit 5 Adjustment for Unrecorded (Accrued) Expenses
Exhibit 6 Adjustment for Unearned (Deferred) Revenues
Exhibit 7 Adjustment for Unrecorded (Accrued) Revenues
Exhibit 8 Relationship of the Adjusted Trial Balance to the Income Statement,
Statement of Owner’s Equity, and Balance Sheet
Exhibit 9 ECects of Adjusting Entries on the Financial Statements
Teaching Strategy
An example of each of the four situations should be used, identifying which adjustments
pertain to deferrals and which to accruals.
Students may need to be reminded to pay close attention to detail. The wording of an
adjustment explanation makes a signicant diCerence in the amount of the adjustment.
Point out key words (such as used, consumed, expired, earned, unrecorded, unearned) and
which accounts they indicate. Care in calculating the adjustment should be emphasized.
Each illustration of typical adjusting entries in the text is supported by an explanation and a
journal entry. It is helpful to go through a few of these examples with students.
The contra-asset account Accumulated Depreciation is often confusing to students. A
discussion of the nature of a contra account is required.
Students will be confused over the diCerence between Depreciation Expense and
Accumulated Depreciation. Comparing Accumulated Depreciation to an odometer and
Depreciation Expense to a trip odometer should eliminate the confusion.
Students may be concerned that they do not have the expertise to calculate depreciation.
Assurance that they will be learning this in later chapters may help. It is not necessary to
discuss depreciation in detail at this time.
Point out that no adjusting entry includes the Cash account. Finally, state the rule of debit or
credit for each adjusting entry component (e.g., a decrease in an asset requires a credit).
Asking students how omission of each adjusting entry would aCect the nancial statements
will improve their analytical skills.
Short Exercises 2 through 6 and Exercise 9A are excellent for illustrating basic adjusting
entries. Case 1 is a good group activity on adjusting entries, and Case 3 is a business
communication case that applies adjusting entries to a real business.
While learning the adjusting entries, students may have lost sight of the sequence of events
in the accounting cycle to this point. It is helpful to review the accounting cycle step by step.
This leads students to the trial balance, the necessity for adjustments, and the need for a
“new” trial balance—the adjusted trial balance.
Reinforce students’ understanding of adjusting entries by indicating what the balance in
each account represents.
Short Exercise 7 and Exercise 10A may be used to illustrate this topic in class.
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
Chapter 3: Adjusting the Accounts Instructor’s Manual, p. 8
Section 3: Business Applications
Business Applications
Ethics
Cash &ows
Liquidity
Lecture Outline
I. Earnings management is the manipulation of revenues and expenses to achieve a
specic outcome. While not illegal within small ranges, larger variations can mislead
the user and lead to fraudulent nancial reporting.
II. Accrual-based net income indicates whether management has met its protability goal.
III. Cash &ow measures liquidity.
IV. Cash paid (received) equals maximum possible cash payments (or receipts) minus cash
not paid (or received) this period.
Summary
Because adjusting entries never involve the Cash account, they do not aCect cash &ow. They
are, however, necessary for the accurate measurement of performance. Good judgment
must be exercised in the preparation of adjusting entries to avoid the abuse and
misrepresentation that can occur.
Earnings management is the manipulation of revenues and expenses to achieve a specic
outcome. Earnings management within small ranges is not illegal, but earnings management
outside a reasonable range can mislead the user and can constitute fraudulent nancial
reporting. In recent years, most SEC violation investigations have stemmed from
misapplication of the matching rule resulting from improper accrual accounting.
While accrual accounting helps management assess protability, cash &ow analysis helps
management measure liquidity and forecast cash requirements. Cash &ows can be
determined by analyzing the relationship between related income statement and balance
sheet accounts. In general, cash &ows can be computed by determining the maximum
possible amount of cash payments (or receipts) for each expense (revenue) and then
subtracting the amount not paid (or received) in the current period.
Relevant Examples and Exhibits
Exhibit 10 Determination of Cash Flows from Accrual-Based Information
Teaching Strategy
Engage students in a discussion of the ethics of earnings management.
Stress the importance of cash &ow in decision making. Explain to students that instead of
keeping two sets of books—one cash basis, one accrual basis—accountants convert
accrual-based numbers to cash-based numbers.
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or posted to a publicly accessible website, in whole or in part.
Chapter 3: Adjusting the Accounts Instructor’s Manual, p. 9
Students will want to memorize the formulas shown for determining cash payments and
receipts. Explain the logic behind the formulas. Solving cash &ow problems using T accounts
is another approach.
Short Exercises 9 and 10 and Exercise 12A pertain to this topic.
Student Engagement Tactics
1. Divide the class into self-selected small groups and assign Case 2.
2. Either give the groups 15 to 20 minutes to meet in class or have them meet prior to the
next class.
3. Have each group write brief answers to hand in during the next class period.
4. Discuss each example of fraudulent reporting in class and why a company would resort
to such practices.
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.