1. John Wiley & Sons, Inc.
Financial Accounting, 4e
Weygandt, Kieso, & Kimmel
Prepared by
Gregory K. Lowry
Mercer University
Marianne Bradford
The University of Tennessee
2. After studying this chapter, you should be able to:
CHAPTER 3
ADJUSTING THE ACCOUNTS
1 Explain the time period assumption.
2 Explain the accrual basis of accounting.
3 Explain why adjusting entries are needed.
4 Identify the major types of adjusting
entries.
5 Prepare adjusting entries for prepayments.
6 Prepare adjusting entries for accruals.
7 Describe the nature and purpose of an
adjusted trial balance.
3. PREVIEW OF CHAPTER 3
ADJUSTING THE
ACCOUNTS
The Adjusted Trial
Balance and
Financial Statements
The Basics of
Adjusting Entries
Types of
adjusting entries
Adjusting entries
for prepayments
Adjusting entries
for accruals
Summary
Preparing the
adjusted trial
balance
Preparing
financial
statements
Time Period
assumption
Fiscal and calendar
years
Recognizing
revenues and
expenses
Accrual vs. Cash
basis accounting
Timing Issues
4. The time period (or periodicity) assumption assumes that the
economic life of a business can be divided into artificial time
periods.
Accounting time periods are generally a month, a quarter, or
a year.
The accounting time period of one year in length is
usually known as a fiscal year.
The accounting period used by most businesses
coincides with the calendar year (January 1 to
December 31).
TIME-PERIOD ASSUMPTION
5. ACCRUAL BASIS OF
ACCOUNTING
The revenue recognition and matching
principles are used under the accrual basis of
accounting.
Under cash-basis accounting, revenue is
recorded only when cash is received, and
expenses are recorded only when paid.
Generally accepted accounting principles
require accrual basis accounting because the
cash basis often causes misleading financial
statements.
6. REVENUE RECOGNITION
PRINCIPLE
The revenue recognition principle states
that revenue should be recognized in the
accounting period in which it is earned.
In a service business, revenue is considered
to be earned at the time the service is
performed.
7. The practice of expense recognition is
referred to as the matching principle.
The matching principle dictates that efforts
(expenses) be matched with
accomplishments (revenues).
Revenues
earned
this month
are offset
against....
expenses
incurred in
earning the
revenue
THE MATCHING PRINCIPLE
8. Time-Period Assumption
Revenue-Recognition Principle Matching Principle
Economic life of business
can be divided into
artificial time periods
Revenue recognized in
the accounting period in
which it is earned
Expenses matched with revenues
in the period when efforts are
expended to generate revenues
ILLUSTRATION 3-1
GAAP RELATIONSHIPS IN REVENUE AND
EXPENSE RECOGNITION
9. ADJUSTING ENTRIES
Adjusting entries are made in order for:
1 Revenues to be recorded in the period in
which they are earned, and for......
2 Expenses to be recognized in the period in
which they are incurred.
10. Adjusting entries are required each time
financial statements are prepared.
Adjusting entries can be classified as
1 prepayments (prepaid expenses or
unearned revenues) or
2 accruals (accrued revenues or accrued
expenses)
ADJUSTING ENTRIES
11. TYPES OF
ADJUSTING ENTRIES
Prepayments
1 Prepaid Expenses - expenses paid in cash
and recorded as assets before they are used
or consumed
2 Unearned Revenues - revenues received in
cash and recorded as liabilities before they
are earned
12. Accruals
1 Accrued Revenues - revenues earned but not
yet received in cash or recorded
2 Accrued Expenses - expenses incurred but
not yet paid in cash or recorded
TYPES OF
ADJUSTING ENTRIES
13. PIONEER ADVERTISING AGENCY, INC.
Trial Balance
October 31, 2002
Debit Credit
Cash $ 15,200
Advertising Supplies 2,500
Prepaid Insurance 600
Office Equipment 5,000
Notes Payable $ 5,000
Accounts Payable 2,500
Unearned Revenue 1,200
Common Stock 10,000
Retained Earnings -0-
Dividends 500
Service Revenue 10,000
Salaries Expense 4,000
Rent Expense 900
$ 28,700 $ 28,700
ILLUSTRATION 3-3
TRIAL BALANCE
The Trial Balance
is the starting
place for adjusting
entries.
14. PREPAYMENTS
Prepayments are either prepaid expenses
or unearned revenues.
Adjusting entries for prepayments are
required to record the portion of the
prepayment that represents
1 the expense incurred or
2 the revenue earned in the current
accounting period.
16. Prepaid expenses are expenses paid in
cash and recorded as assets before they
are used or consumed.
Prepaid expenses expire with the
passage of time or through use and
consumption.
An asset-expense account relationship
exists with prepaid expenses.
PREPAID EXPENSES
17. Prior to adjustment, assets are overstated
and expenses are understated.
The adjusting entry results in a debit to an
expense account and a credit to an asset
account.
Examples of prepaid expenses include
supplies, insurance, and depreciation.
PREPAID EXPENSES
19. ADJUSTING ENTRIES FOR PREPAYMENTS
INSURANCE
Journal
Entry
Posting
October 31, an analysis of the policy reveals that $50 of
insurance expires each month.
Adjustment
20. Depreciation is the process of allocating
the cost of an asset to expense over its
useful life in a rational and systematic
manner.
The purchase of equipment or a building
is viewed as a long-term prepayment of
services and, therefore, is allocated in
the same manner as other prepaid
expenses.
DEPRECIATION
21. Depreciation Expense
Depreciation is an estimate rather than a
factual measurement of the cost that has
expired.
In recording depreciation, Depreciation
Expense is debited and a contra asset
account, Accumulated Depreciation, is
credited
DEPRECIATION
xxx
xxx
22. In the balance sheet, Accumulated
Depreciation is offset against the asset
account.
The difference between the cost of the
asset and its related accumulated
depreciation is referred to as the
book value of the asset.
DEPRECIATION
23. ADJUSTING ENTRIES FOR PREPAYMENTS
DEPRECIATION
Journal
Entry
Posting
Adjustment
October 31, depreciation on the office equipment is estimated
to be $480 a year, or $40 per month.
24. Unearned revenues are revenues
received in cash and recorded as
liabilities before they are earned.
Unearned revenues are subsequently
earned by rendering a service to a
customer.
A liability-revenue account relationship
exists with unearned revenues.
UNEARNED REVENUES
25. Prior to adjustment, liabilities are
overstated and revenues are understated.
The adjusting entry results in a debit to a
liability account and a credit to a revenue
account.
Examples of unearned revenues include
rent, magazine subscriptions, and customer
deposits for future services.
UNEARNED REVENUES
26. Adjustment
Unearned Revenue
Oct. 31 400 Oct. 2 1,200
31 800
Service Revenue
Oct. 31 10,000
31 400
Journal
Entry
Posting
October 31, analysis reveals that, of $1,200 in fees, $400 has
been earned in October.
Date Account Titles and Explanation Debit Credit
Oct. 31 Unearned Revenue 400
Service Revenue 400
ADJUSTING ENTRIES FOR PREPAYMENTS
UNEARNED REVENUES
(To record revenue for services
provided
27. ACCRUALS
The second category of adjusting entries
is accruals.
Adjusting entries for accruals are
required to record revenues earned and
expenses incurred in the current period.
The adjusting entry for accruals will
increase both a balance sheet and an
income statement account.
29. Accrued revenues may accumulate with the
passing of time or through services
performed but not billed or collected.
An asset-revenue account relationship
exists with accrued revenues.
Prior to adjustment, assets and revenues
are understated.
The adjusting entry requires a debit to an
asset account and a credit to a revenue
account.
ACCRUED REVENUES
30. Date Account Titles and Explanation Debit Credit
Oct. 31 Accounts Receivable 200
Service Revenue 200
(To accrue fees earned but
not billed or collected)
ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED REVENUES
Adjustment
Journal
Entry
Posting
Service Revenue
Oct. 31 10,000
31 400
31 200
31 10,600
October 31, the agency earned $200 in fees for advertising
services that were not billed to clients before October 31.
31. Accrued expenses are expenses incurred
but not yet paid or recorded.
A liability-expense account relationship
exists
Prior to adjustment, liabilities and
expenses are understated
The adjusting entry results in a debit to an
expense account and a credit to a liability
account
ACCRUED EXPENSES
32. ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED INTEREST
Adjustment
Journal
Entry
Posting
October 31, the portion of the interest to be accrued on a
3-month note payable is calculated to be $50.
33. ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED SALARIES
Adjustment
Journal
Entry
Posting
October 31, accrued salaries are calculated to be $1,200.
34. ILLUSTRATION 3-16
SUMMARY OF ADJUSTING ENTRIES
1 Prepaid Assets
andAssets overstatedDr. Expenses expenses expenses Expenses understated Cr.
Assets
2 Unearned Liabilities and Liabilities overstatedDr. Liabilities revenues
revenues Revenues understated Cr. Revenues
3 Accrued Assets and Assets understated Dr. Assets revenues revenues
Revenues understated Cr. Revenues
4 Accrued Expenses and Expenses understated Dr. Expenses expenses
liabilities Liabilities understated Cr. Liabilities
35. ADJUSTED TRIAL BALANCE
An Adjusted Trial Balance is prepared after all
adjusting entries have been journalized and
posted.
It shows the balances of all accounts at the end of
the accounting period and the effects of all
financial events that have occurred during the
period.
It proves the equality of the total debit and credit
balances in the ledger after all adjustments have
been made.
Financial statements can be prepared directly
from the adjusted trial balance.
37. Appendix:Alternative
Treatment
Some businesses use an alternative treatment for
prepaids and unearned revenues.
Instead of debiting an asset at the time an expense
is prepaid, the amount is charged to an expense
account.
Instead of crediting a liability at the time cash is
received in advance of earning it, the amount is
credited to a revenue account.
This treatment of prepaid expenses and unearned
revenues will ultimately result in the same effect on
the financial statements as initial entries to balance
sheet accounts and then adjusting entries.
38. ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS
SUPPLIES
Adjustment
Journal
Entry
Posting
October 31, an inventory count reveals that $1,000 of
$2,500 of supplies are still on hand.
39. ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS
UNEARNED REVENUES
Journal
Entry
Unearned Revenue
Oct. 31 800
Posting
Service Revenue
Oct. 31 800 Oct. 2 1,200
31 400
Date Account Titles and Explanation Debit Credit
Oct. 31 Service Revenue 800
Unearned Revenue 800
(To record unearned revenue)
Adjustment
October 31, analysis reveals that, of $1,200 in revenue, $400
has been earned in October.
40. ILLUSTRATION 3A-7
SUMMARY OF BASIC RELATIONSHIPS FOR PREPAYMENTS
1 Prepaid Assets and a Prepaid expenses
Assets overstatedDr Expenses Expenses Expensesinitially recorded in Expenses
understated Cr Assets asset accounts have
been used.
b Prepaid expensesAssets understated Dr Assets
initially recorded in Expenses overstated Cr Expenses
expense accounts
have not been used.
2 Unearned Liabilities and a Unearned revenues Liabilities overstated Dr Liabilities Revenues
Revenues initially recorded in Revenues understated Cr Revenues
liability accounts
have been earned.
b Unearned revenues Liabilities understated Dr Revenues
initially recorded in Revenues understated Cr Liabilities
revenue accounts
have not been earned.
