41
chapter
3
The Adjusting Process
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OPENING COMMENTS
Chapter 3 introduces students to the adjusting process. The beginning of the chapter briefly describes the
cash basis of accounting and includes examples of businesses that use it. The focus of the text is on the
accrual basis accounting. The basic idea of the matching concept was presented in Chapter 1, where
expenses incurred were matched against revenues. Now in Chapter 3, matching is introduced formally
After studying the chapter, your students should be able to:
2. Journalize entries for accounts requiring adjustment.
4. Prepare an adjusted trial balance.
5. Describe and illustrate the use of vertical analysis in evaluating a company’s performance and
financial condition.
KEY TERMS
accounting period concept
accrual basis of accounting
42 Chapter 3 The Adjusting Process
accrued expenses
accrued revenues
Accumulated Depreciation
adjusted trial balance
adjusting entries
adjusting process
book value of the asset (or net book value)
cash basis of accounting
STUDENT FAQS
• Why can’t we just do cash basis accounting?
• Why is unearned revenue a liability instead of a revenue account?
• Adjusting entries give me a headache. Can we just skip them?
• Why are adjusting entries done at the end of the accounting period instead of at the beginning?
• Expired and unexpired give me problems. Is there an easy way to understand them?
• Why is matching revenues and expenses so important?
• How can an expense item temporarily be treated as an asset? I thought an asset was something of
value or worth, not a cost of doing business.
• How can revenue temporarily be treated as a liability? I thought revenue was a good thing, not a debt
or obligation.
• Why can’t you debit depreciation expense and credit equipment? No other adjusting entry uses a
contra account.
Chapter 3 The Adjusting Process 43
• If you are going to deduct the contra account (accumulated depreciation) from the equipment account,
why not show equipment at the net value to start with?
• Now that I know about vertical analysis, what are some examples of when it’s better or more
informative to use one instead of the other or both?
OBJECTIVE 1
Describe the nature of the adjusting process.
SYNOPSIS
Accountants use generally accepted accounting principles called GAAP. The accounting period concept
requires that revenues and expenses be recorded in the proper period. The revenue recognition concept
and the matching concept require that revenue be reported when it is earned and related expenses be
reported in the same time period. Some businesses use the cash basis of accounting; in this method,
revenue is recorded when cash is received and expenses are recorded when the cash is paid. Small service
businesses that have few receivables and payables may use the cash basis.
At the end of the accounting period, a few accounts require updating. Expenses not recorded daily,
revenues and expenses incurred as time passes, and revenues and expenses that are unrecorded are all
accounts that need adjusted. These transactions are recorded at the end of the period prior to the financial
statements being prepared and are called adjusting entries. Prepaid expenses, accrued expenses, unearned
revenues, and accrued revenues are examples of accounts that require adjusting.
Key Terms and Definitions
• Accounting Period Concept – The accounting concept that assumes that the economic life of the
business can be divided into time periods.
• Accrual Basis of Accounting – Under this basis of accounting, all revenues are recognized when
services have been performed or products have been delivered to customers and expenses are reported in
the period in they are incurred.
• Accrued Expenses – Expenses that have been incurred but not recorded in the accounts.
• Accrued Revenues – Revenues that have been earned but not recorded in the accounts.
44 Chapter 3 The Adjusting Process
• Adjusting Entries – The journal entries that bring the accounts up to date at the end of the
accounting period.
• Adjusting Process – An analysis and updating of the accounts when financial statements are
prepared.
• Cash Basis of Accounting – Under this basis of accounting, revenues and expenses are reported
in the income statement in the period in which cash is received or paid.
Relevant Example Exercises and Exhibits
• Example Exercise 3-1 Accounts Requiring Adjustment
• Example Exercise 3-2 Type of Adjustment
• Exhibit 1 – Prepaid Expenses
• Exhibit 2 – Unearned Revenues
• Exhibit 3 – Accrued Revenues
• Exhibit 4 – Accrued Expenses
SUGGESTED APPROACH
Under this objective, you will need to revisit the matching concept from Chapter 1. Emphasize again that
the matching concept is necessary in order to match revenues and expenses in the proper accounting
period. If the concept is violated, the financial statements for the period will not be accurate. The
adjusting process discussed in this chapter is critical to conforming to the matching concept.
To check your students’ understanding of these concepts, pose the following questions:
If rent for May is paid on June 1, in which month will it be reported as an expense under
(a) the cash basis and (b) the accrual basis? Answer: (a) June, (b) May.
GROUP LEARNING ACTIVITY—Introduction to the Matching Concept
TM 3-1 provides financial information about an individual filling out a loan application. The loan
application asks for total monthly expenses. The person applying for the loan has a few expenses that are
Chapter 3 The Adjusting Process 45
paid annually or semiannually. Therefore, your students must “match” expenses to the time period
requested by the loan application: one month. The expenses paid annually and semiannually must be
divided into monthly amounts to properly determine the applicant’s total monthly expenses.
The solution to this exercise is provided in TM 3-2.
LECTURE AID—Matching Concept
Remind your students that, similar to personal expenses, not all business expenses are paid monthly. If a
business wants to know its true expenses for the month, it must consider all expenses incurred, not just
the expenses paid that month.
Likewise, payment for services provided to customers is not always received in the same month that the
service is completed. If a business wants to know how much revenue it has earned, it must determine the
value of services provided, not just the cash received in payment for services rendered.
GROUP LEARNING ACTIVITY—Reviewing the Matching Concept
TM 3-3 asks students to apply the matching concept by determining the profit on a stone patio laid by
Artisan Stone and Brick. TM 3-4 provides the solution to this exercise.
LECTURE AID—Accruals and Deferrals
Deferrals adjust accounts that are already a part of a company’s accounting records.
46 Chapter 3 The Adjusting Process
Deferred expenses occur when an asset that will be used up or will expire is purchased. As this asset is
used, its cost must be recorded as an expense. Therefore, you defer recording the cost of the asset as an
expense until it is used. An example of a deferred expense for a student is tuition paid at the beginning of
each term. Business examples of deferred expenses include the following:
1. Supplies—These are recorded as an asset when they are purchased. As the supplies are used, an
adjusting entry is made to transfer the cost of the supplies to an expense account.
2. Prepaid insurance—When an insurance policy is paid in advance of the period covered, its cost is
recorded as an asset. An adjusting entry must be made to transfer the cost of the insurance policy to
an expense account as the policy expires.
Revenues are deferred when cash is received from a customer before a business completes its service for
the customer or delivers its product. When cash is received under these circumstances, it cannot be
recorded as revenue, since it has not been earned. Instead, it is recorded as a liability, reflecting the
1. Accrued expenses—salaries/wages owed to employees at the end of an accounting period that have
not been paid; interest owed on loans that have not been paid.
TM 3-5 provides a summary of deferrals and accruals. This TM can be used as a handout for students to
review these concepts.
Chapter 3 The Adjusting Process 47
OBJECTIVE 2
Journalize entries for accounts requiring adjustment.
SYNOPSIS
The previous objective showed the overall nature and process of adjusting. This objective shows the
journal entries and how they affect the trial balance. Starting with the unadjusted trial balance for
NetSolutions, this objective shows the how the adjustments change the balances of the accounts while
keeping the debits and credits in the new adjusted trial balance equal. Using supplies and prepaid
insurance as examples of prepaid expenses, this objective demonstrates how to calculate how much of
these assets have been used up and how to journalize this transaction. Without these adjustments,
expenses would be understated. Unearned revenue accounts must be adjusted to account for revenue that
has been earned in this period. Accrued revenues and expenses must also be recorded to update these
accounts. The last type of account to be adjusted is depreciation expense. This involves the use of fixed or
Key Terms and Definitions
• Accumulated Depreciation – The contra asset account credited when recording the depreciation
of a fixed asset.
• Book Value of the Asset (or Net Book Value) – The difference between the cost of a fixed asset
and its accumulated depreciation.
• Contra Accounts (or Contra Asset Accounts) – An account offset against another account.
• Depreciate – To lose usefulness as all fixed assets except land do.
• Depreciation – The systematic periodic transfer of the cost of a fixed asset to an expense account
during its expected useful life.
Relevant Example Exercises and Exhibits
• Example Exercise 3-3 Adjustment for Prepaid Expense
• Example Exercise 3-4 Adjustment for Unearned Revenue
• Example Exercise 3-5 Adjustment for Accrued Revenues
• Example Exercise 3-6 Adjustment for Accrued Expense
48 Chapter 3 The Adjusting Process
• Example Exercise 3-7 Adjustment for Depreciation
• Exhibit 5 – Unadjusted Trial Balance for NetSolutions
• Exhibit 6 – Expanded Chart of Accounts for NetSolutions
• Exhibit 7 – Accrued Wages
SUGGESTED APPROACH
Adjusting entries can be effectively presented to your class by working through an example of each
adjusting entry covered in the text. Or, you may choose to work a problem opposite an assigned
DEMONSTRATION PROBLEM—Adjusting Entry for Prepaid Insurance
An example of an expense that is typically paid in advance is insurance. Insurance policies are paid at the
beginning of a policy period. This outlay of cash is recorded in Prepaid Insurance—an asset account. The
portion of the insurance coverage that has expired by the end of the accounting period must be transferred
Graphically, this can be illustrated as follows:
New Data
Asset: Prepaid Expense: Insurance
Insurance Amount of Insurance Expense
Coverage Expired
For example, on December 1, Atherton Plumbing purchased a six-month insurance policy for $600. As of
December 31, one month (or $100) of that coverage had expired.
Original Prepaid Insurance……… 600
Chapter 3 The Adjusting Process 49
The T accounts follow:
Prepaid Insurance Insurance Expense
12/1 600
Adj. 100 Adj. 100
DEMONSTRATION PROBLEM—Adjusting Entry for Supplies
Another asset that must be adjusted at the end of the accounting period is the supplies account. All
supplies are recorded in the supplies account as they are purchased. By the end of the accounting period,
some of the supplies will have been used. The supplies used must be taken out of the supplies account and
transferred to an expense account.
Graphically, this can be illustrated as follows:
New Data
Asset: Supplies Expense: Supplies
Amount of Supplies Expense
That Have Been Used
For example, on December 5, Atherton Plumbing purchased $250 in supplies. As of December 31, only
$50 worth of those supplies was left.
Original Supplies………….…. 250
Entry: Cash………………… 250
The T accounts follow:
Supplies Supplies Expense
12/5 250 Adj. 200 Adj. 200
Bal. 50
The T accounts show that the balance of the supplies account is $50—the amount of supplies left.
50 Chapter 3 The Adjusting Process
To illustrate why businesses typically count the amount of supplies left at the end of the month and use
that information to determine the cost of supplies used, ask your students the following question:
What is the easiest way to determine how many miles you have driven your car this
month? Answer: Record the beginning and ending odometer readings. This is easier than
DEMONSTRATION PROBLEM—Adjusting Entry for Unearned Revenue
If payment for goods or services is received before the goods are delivered or the service is performed, it
cannot be recognized as revenue. Revenue can be recorded only after it is earned. Therefore, when
payment is received in advance, it is recorded in an unearned revenue account. This is a liability account.
Graphically, this can be illustrated as follows:
New Data
Liability: Unearned Revenue: Fees Earned
Revenue Amount of Revenue (or other revenue
That Has Been Earned earned account
as appropriate)
For example, on November 2, Huber Rental Properties received three months’ rent, totaling $2,400, in
advance for one of its commercial properties. As of December 31, two months’ worth of this rent had
been earned.
Original Cash……………………. 2,400
Entry: Unearned Rent……….. 2,400
Chapter 3 The Adjusting Process 51
The T accounts follow:
Unearned Rent Rent Revenue
Adj. 1,600 11/2 2,400 Adj. 1,600
DEMONSTRATION PROBLEM—Adjusting Entry for Accrued Expenses
Any expenses that a business has incurred must be recorded before preparing financial statements in order
to get a true measure of profitability. The act of recording expenses that have not been paid is called
accruing expenses.
One common example is wages paid to employees. Many organizations pay their employees on Friday.
Graphically, this can be illustrated as follows:
New Data
Expense: Wages Expense
Amount of Wages
That Employees Have Liability: Wages Payable
Earned
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.