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52 Chapter 3 The Adjusting Process
For example, assume that December 31 is a Wednesday. On that date, Huber Rental Properties owes $500
in wages to employees. These wages will be paid on Friday, the usual payday.
Original
Entry: None
Adjusting Wages Expense…………. 500
Entry: Wages Payable…........... 500
The T accounts follow:
Wages Expense Wages Payable
Adj. 500 Adj. 500
DEMONSTRATION PROBLEM—Adjusting Entry for Accrued Revenues
Any revenue that a business has earned must be recorded before preparing financial statements in order to
get a true measure of profitability. The act of recording revenues that have not been received is called
accruing revenues.
One example of accrued revenue is interest. Assume that a company charges its customers interest
New Data
Revenue: Interest Income
Amount of Interest
That Has Been Earned Asset: Interest Receivable
For example, Atherton Plumbing granted a customer additional time to pay an invoice; however, the
customer must pay interest at a rate of 10 percent annually. At the end of the accounting period, the interest
that has accumulated totals $80.
Original
Entry: None
Adjusting Interest Receivable………….. 80
Entry: Interest Income………......... 80
Chapter 3 The Adjusting Process 53
The T accounts follow:
Interest Receivable Interest Income
Adj. 80 Adj. 80
Other examples of accrued revenues would be commissions earned by a travel agent but not billed or
cleaning services fees earned by a property management company but not yet billed. You could also
illustrate the concept of accrued revenue by asking your students to estimate any wages they have earned
that have not been paid as of today.
DEMONSTRATION PROBLEM—Adjusting Entry for Depreciation
Read the following scenario to your class:
Assume that your car needs four new tires. One set of tires you are considering costs $200.
The manufacturer estimates that these tires will last 20,000 miles. If you drive about 10,000
miles per year, that equates to two years.
Another set of tires costs $300. These tires should last 40,000 miles or four years.
Assuming that you plan to keep your car at least another four years, which set of tires is the
best deal? Why?
It is common to break the cost of a long-term asset into a cost per year or a cost per month when evaluating
whether or not to purchase the asset. Allocating the cost of an asset (such as the tires) to the years it is used
makes it easier to determine the yearly expense of owning the asset. The cost of owning the $300 set of
tires is $75 per year.
The accrual basis of accounting requires business owners to allocate the cost of fixed assets to the years
they are used. This process is called depreciation.
Consider the following example. A florist purchases a delivery van for $12,000. The van will last three
years. What is the florist’s cost per year for this van? (Answer: $4,000.)
54 Chapter 3 The Adjusting Process
will fall to zero after the third year of depreciation, assuming no residual value is stated in the depreciation
calculations. This topic is discussed in Chapter 10 in detail.
The florist’s accountant is required to record depreciation on the delivery van for the following two reasons:
1. Whenever an asset is used up in running a business, it must be recorded as an expense. Similar to
supplies or prepaid insurance, the florist’s van will not last forever. Its usefulness will eventually expire.
Therefore, a portion of the van will be recorded as an expense in each year the van is used.
Graphically, this can be illustrated as follows:
New Data
Asset: Delivery Expense: Depreciation
Van Portion of the Van’s Expense
Usefulness That Has
Expired
The journal entries to record the purchase of the van and the first year’s depreciation are as follows:
Original Delivery Van………………………… 12,000
Entry: Cash…………………………........... 12,000
Adjusting Depreciation Expense—Delivery Van 4,000
Entry: Accumulated Depreciation
—Delivery Van…………........ 4,000
Note that the account credited by the adjusting entry is Accumulated Depreciation—Delivery Van. This is
a contra-asset account—an account that works “against” another asset account to reduce it. The
accumulated depreciation—delivery van account works against the delivery van account.
The T accounts follow:
Delivery Van Depreciation Expense—Delivery Van
12,000 Adj. 4,000
Bal. 12,000 Bal. 4,000
Accumulated Depreciation—
Chapter 3 The Adjusting Process 55
Delivery Van
Adj. 4,000 The asset and contra-asset accounts are
reported on the balance sheet as follows:
Bal. 4,000 Delivery van $12,000
Less: Accum. depr. 4,000
Net book value of van $ 8,000
Why use a contra account to record the adjusting entry for depreciation? Why not just reduce the delivery
van account directly?
2. Any depreciation recorded on a fixed asset is just an estimate of the asset’s usefulness that has expired.
This estimate is maintained in a separate account. For accounting purposes, we assign this cost over
1. A fixed asset must be owned and used by the business.
3. Depreciation is not related to the value of the asset (i.e., the market value of a fixed asset is not related
to the fixed asset’s book value).
4. The normal balance of the accumulated depreciation account is a credit.
TEACHING SUGGESTION—Use of an Accumulated Depreciation Account
To help students understand the purpose of accumulated depreciation contra-accounts, show the following
example:
Company 1 Company 2
Net book value of Equipment $10,000 $10,000
Without using a contra account, both companies look identical. Now show the following:
Company 1 Company 2
Equipment $100,000 $11,000
Accumulated Depreciation 90,000 1,000
Net book value of Equipment $ 10,000 $10,000
56 Chapter 3 The Adjusting Process
What information does the contra account provide? First, the equipment is 90 percent depreciated in
Company 1 and only about 9 percent depreciated in Company 2. Second, Company 1 originally invested
nearly 10 times as much into its equipment as Company 2. Therefore, Company 1 is probably a much larger
operation. Since Company 2 has recorded a smaller percentage of depreciation, it may be a younger
organization. Conclusion: Companies 1 and 2 are quite different, and reporting only book values does not
reveal the differences.
WRITING EXERCISE—Adjusting Entry for Depreciation
To see how well your students have grasped the concept of depreciation, ask them to write an answer to the
following question (also shown on TM 3-6):
Assume that you are the accountant for Computer Consultants. Prior to this year, Computer
Consultants operated out of a leased office. However, the company purchased its own office
building this year. The building is in an area where real estate values have been increasing
Possible explanation: The response should address the fact that cost, accumulated depreciation, and
ultimately book value are not trying to match the market value of an asset. The market value can go up or
down, depending on the current economic climate. The goal of accounting for fixed assets is to spread the
initial investment cost over a reasonable expected life of the asset. This cost is periodically transferred
through the adjusting process and the accumulated depreciation account. Students should also mention the
Chapter 3 The Adjusting Process 57
OBJECTIVE 3
Summarize the adjustment process.
SYNOPSIS
Exhibit 8 shows a summary of all the adjustments in this chapter. All adjustments must be completed prior
to completing the financial statements for the period. Exhibit 9 shows the journal entry for each adjustment,
and Exhibit 10 shows the result of the adjustments after posting in the general ledger.
Relevant Example Exercises and Exhibits
• Example Exercise 3-8 Effect of Omitting Adjustments
• Exhibit 8 – Summary of Adjustments
• Exhibit 9 – Adjusting Entries—NetSolutions
• Exhibit 10 – Ledger with Adjusting Entries—NetSolutions
SUGGESTED APPROACH
This objective illustrates the posting of adjusting entries.
Handout 3-1 presents two exercises to assess your students’ understanding of adjusting entries. The student
is given the option to track account balances using T accounts or the “Effect on Adjusting Entry” column
58 Chapter 3 The Adjusting Process
The solution to Part 1 of Handout 3-1 is presented below.
Zeller Company Effect of Zeller Company
Unadjusted Trial Balance Adjusting Adjusted Trial Balance
Dec. 31 Entry Dec. 31
DR CR DR CR
Cash 300 Cash 300
Accounts Receivable 20 + 55 Accounts Receivable 75
Supplies 80 – 70 Supplies 10
Equipment 600 Equipment 600
Accumulated Depreciation 30 + 20 Accumulated Depreciation 50
Accounts Payable 240 Accounts Payable 240
Common Stock 120 Common Stock 120
The solution to Part 2 of Handout 3-1 is presented below.
Dec. 31 Supplies Expense 60
Supplies 60
31 Insurance Expense 190
Prepaid Insurance 190
OBJECTIVE 4
Prepare an adjusted trial balance.
SYNOPSIS
Chapter 3 The Adjusting Process 59
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After journalizing and posting the adjusting entries, an adjusted trial balance is prepared. Exhibit 11 shows
the adjusted trial balance for NetSolutions as of December 31, the end of the company’s accounting period
(fiscal year). The next chapter will show how the financial statements are prepared from this information.
Key Terms and Definitions
• Adjusted Trial Balance - The trial balance prepared after all the adjusting entries have been
posted.
Relevant Example Exercises and Exhibits
• Example Exercise 3-9 Effect of Errors on Adjusted Trial Balance
• Exhibit 11 – Adjusted Trial Balance
SUGGESTED APPROACH
This objective introduces the adjusted trial balance. Explain to students that like the unadjusted trial balance,
the trial balance is merely copying information from the general ledger to the trial balance. The titles of
accounts with balances are copied from the general ledger in the order in which they appear, and their
balance is copied to the proper column (debit or credit) on the trial balance. The final step is to “foot” the
columns and compare the debit and credit balances. You may want to point out that in the accounting cycle,
OBJECTIVE 5
Describe and illustrate the use of vertical analysis in evaluating a company’s performance
and financial condition.
SYNOPSIS
Vertical analysis is a comparison of an amount from a financial statement with a total amount from the
same statement. The total amount chosen is identified as being 100%, and each line in the statement is
shown as a percentage of that total. This analysis is useful for analyzing changes over time. As such, at a
60 Chapter 3 The Adjusting Process
minimum, two years of financial data are needed. Vertical analysis is shown for J. Holmes, Attorney-at-
Law and Pandora Media, Inc., using the income statement.
Key Terms and Definitions
• Vertical Analysis - An analysis that compares each item in a current statement with a total
amount within the same statement.
Relevant Example Exercises and Exhibits
• Example Exercise 3-10 Vertical Analysis
SUGGESTED APPROACH
This objective introduces the value of vertical analysis as a tool to indicate relationships within a given
financial statement. It is also often used to examine changes in these relationships between time periods,
which in turn demonstrate how a company is performing.
Handout 3-1
Part 1: Zeller Company needs to record the following adjusting entries:
a) Supplies on hand on Dec. 31 were $10.
b) Fees earned but not billed on Dec. 31 were $55.
c) Depreciation of equipment was estimated to be $20 for the year.
Use T accounts to record the effect of each adjusting entry and then determine the balances on Zeller’s adjusted trial
balance. You may also use the column labeled “Effect of Adjusting Entry” to track changes in account balances.
Zeller Company Effect of Zeller Company
Unadjusted Trial Balance Adjusting Adjusted Trial Balance
Dec. 31 Entry Dec. 31
DR CR DR CR
Cash 300 Cash
Accounts Receivable 20 Accounts Receivable
Supplies 80 Supplies
Equipment 600 Equipment
Matrix Company
Trial Balance
Dec. 31
Unadjusted Adjusted
Fees Earned 14,200 14,270
Depreciation Expense — 800
Wages Expense 7,200 7,330
Rent Expense 1,200 1,200
Supplies Expense — 60
Type Item Description LO(s) Difficulty
Time
Est
BUSPROG AICPA ACBSP - APC Bloom's EE Excel GL SMH FAI Service Real World Writing Ethics Internet Group
DQ 1 1 Easy 5 min. Analytic FN - Measurement Cash vs. Accrual Knowledge
DQ 2 1 Easy 5 min. Analytic FN - Measurement Cash vs. Accrual Knowledge
DQ 3 1 Easy 5 min. Analytic FN - Measurement Adjusting Entries Knowledge
DQ 4 1 Easy 5 min. Analytic FN - Measurement Adjusting Entries Knowledge
DQ 5 2 Easy 5 min. Analytic FN - Measurement Adjusting Entries Knowledge
DQ 6 2 Easy 5 min. Analytic FN - Measurement Adjusting Entries Knowledge
DQ 7 2 Easy 5 min. Analytic FN - Measurement Adjusting Entries Knowledge
DQ 8 3 Easy 5 min. Analytic FN - Measurement Adjusting Entries Knowledge
PE 5B Adjustment for accrued revenues 2 Easy 5 min. Analytic FN - Measurement Adjusting Entries Application x
PE 6A Adjustment for accrued expense 2 Easy 5 min. Analytic FN - Measurement Adjusting Entries Application x
PE 6B Adjustment for accrued expense 2 Easy 5 min. Analytic FN - Measurement Adjusting Entries Application x
PE 7A Adjustment for depreciation 2 Easy 5 min. Analytic FN - Measurement Adjusting Entries Application x
EX 5 Effect of omitting adjusting entry 2,3 Moderate 5 min. Analytic FN - Measurement Adjusting Entries Application
EX 6 Adjusting entries for prepaid insurance 2 Easy 5 min. Analytic FN - Measurement Adjusting Entries Application X
EX 7 Adjusting entries for prepaid insurance 2 Easy 5 min. Analytic FN - Measurement Adjusting Entries Application X
EX 8 Adjusting entries for unearned fees 2 Easy 5 min. Analytic FN - Measurement Adjusting Entries Application X
EX 20 Book value of fixed assets 2 Easy 5 min. Analytic FN - Measurement Adjusting Entries Application x x
EX 21 Effects of errors on financial statements 2,3 Easy 5 min. Analytic FN - Measurement Adjusting Entries Application x
EX 22 Effects of errors on financial statements 2,3 Easy 5 min. Analytic FN - Measurement Adjusting Entries Application x
EX 23 Effects of errors on financial statements 2,3 Moderate 10 min. Analytic FN - Measurement Adjusting Entries Application
PR 6A Adjusting entries and errors 2,3 Challenging 1 hour Analytic FN - Measurement Adjusting Entries Application x
PR 1B Adjusting entries 2 Moderate 30 min. Analytic FN - Measurement Adjusting Entries Application x X x
PR 2B Adjusting entries 2,3 Moderate 45 min. Analytic FN - Measurement Adjusting Entries Application X
PR 3B Adjusting entries 2 Moderate 1 hour Analytic FN - Measurement Adjusting Entries Application x
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