CHAPTER 3

ADJUSTING THE ACCOUNTS

After studying this chapter, you should be able to: 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.

TIME-PERIOD ASSUMPTION
y The time period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods. y Accounting time periods are generally a month, a quarter, or a year. y The accounting time period of one year in length is referred to as a fiscal year.

ACCRUAL BASIS OF ACCOUNTING

y The revenue recognition and matching

principles are used under the accrual basis of accounting. y Under cash basis accounting, revenue is recorded when cash is received, and expenses are recorded when cash is paid. y Generally accepted accounting principles require accrual basis accounting because the cash basis often causes misleading financial statements.

REVE E RE RI I LE

I I

y The revenue recognition principle dictates that revenue be recognized in the accounting period in which it is earned. y In a service business, revenue is considered to be earned at the time the service is performed.

THE MATCHING PRINCIPLE

y The practice of expense recognition is referred to as the matching principle. y The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues).
Revenues earned this month expenses incurred in earning the revenue

are offset against....

ILLUSTRATION 3-1
GAAP RELATIONSHIPS IN REVENUE AND EXPENSE RECOGNITION
Time-Period Assumption Economic life of business can be divided into artificial time periods Revenue-Recognition Principle Revenue recognized in the accounting period in which it is earned Matching Principle
Expenses matched with revenues in the same period when efforts are expended to generate revenues

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.
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ADJUSTING ENTRIES
y Adjusting entries are required each time financial

statements are prepared. y Adjusting entries can be classified as 1 prepayments (prepaid expenses or unearned revenues) OR 2 accruals (accrued revenues or accrued expenses)

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 cash received and recorded as liabilities before revenue is earned

TYPES OF ADJUSTING ENTRIES

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

ILLUSTRATION 3-3

TRIAL BALANCE
PIONEER ADVER ISING AGENCY rial Balance October 31, 2002
C A S I Eq y b b $ 5,200 2,500 600 5,000 C

O N A y b U R C R By , C C R By , w S R S E R E

The Trial Balance he rial is the starting place for adjusting entries.

$ 5,000 2,500 ,200 0,000 500 0,000 4,000 900 $ 28,700 $ 28,700

PREPAYMENTS
y Prepayments are either prepaid expenses or

unearned revenues. y 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.

ILLUSTRATION 3ADJUSTING ENTRIES FOR PREPAYMENTS

Adjusting Entries Prepaid Expenses
Asset Unadjusted Credit Balance Adjusting Entry (-) Expense Debit Adjusting Entry (+)

Unearned Revenues
Liability Debit Adjusting Entry (-) Unadjusted Balance Revenue Credit Adjusting Entry (+)

PREPAID EXPENSES
y Prepaid expenses are expenses paid in cash and

recorded as assets before they are used or consumed. y Prepaid expenses expire with the passage of time or through use and consumption. y An asset-expense account relationship exists with prepaid expenses.

PREPAID EXPENSES
y Prior to adjustment, assets are overstated and expenses

are understated. y The adjusting entry results in a debit to an expense account and a credit to an asset account. y Examples of prepaid expenses include supplies, insurance, and depreciation.

ADJUSTING ENTRIES FOR PREPAYMENTS

SUPPLIES
ADJUSTMENT JOURNAL ENTRY
Date Oct. 31 Account Titles and Explanation Advertising Supplies Expense Advertising Supplies (To record supplies used) Debit Credit 1,500 1,500
October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand.

POSTING
Advertising Supplies Oct. 5 2,500 Oct. 31 1,500 31 1,000

Advertising Supplies Expense Oct. 31 1,500

ADJUSTING ENTRIES FOR PREPAYMENTS

INSURANCE
ADJUSTMENT JOURNAL ENTRY
D O A I P (T ) T E I E D C October 31, an analysis of the policy reveals that $50 of insurance expires each month.

POSTING
P O I O O I E

DEPRECIATION
y Depreciation is the allocation of the cost of an asset

to expense over its useful life in a rational and systematic manner. y 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
y Depreciation is an estimate rather than a factual

measurement of the cost that has expired. y In recording depreciation, Depreciation Expense is debited and a contra asset account, Accumulated Depreciation, is credited

Depreciation Expense
XXX

ccumulated Depreciation
XXX

DEPRECIATION
y In the balance sheet, Accumulated Depreciation is

offset against the asset account. y The difference between the cost of any depreciable asset and its related accumulated depreciation is referred to as the book value of the asset.

ADJUSTING ENTRIES FOR PREPAYMENTS

DEPRECIATION
ADJUSTMENT
October 31, depreciation on the office equipment is estimated to be $480 a year, or $40 per month.

JOURNAL ENTRY
D O A D A (T E D O E ) T E D C

POSTING
A O E O D

D O

UNEARNED RE ENUES
y Unearned revenues are revenues received and

recorded as liabilities before they are earned. y Unearned revenues are subsequently earned by rendering a service to a customer. y A liability-revenue account relationship exists with unearned revenues.

UNEARNED RE ENUES
y Prior to adjustment, liabilities are overstated and revenues are understated. y The adjusting entry results in a debit to a liability account and a credit to a revenue account. y Examples of unearned revenues include rent, magazine subscriptions, and customer deposits for future services.

ADJUSTING ENTRIES FOR PREPAYMENTS

UNEARNED REVENUES
ADJUSTMENT JOURNAL ENTRY
D O U S T A R R T E D

October 31, analysis reveals that, of $1,200 in fees, $400 has been earned in October.

POSTING
U O R O

R O

ACCRUALS
y The second category of adjusting entries is accruals. y Adjusting entries for accruals are required to record

revenues earned and expenses incurred in the current period. y The adjusting entry for accruals will increase both a balance sheet and an income statement account.

ILLUSTRATION 3-1
ADJUSTING ENTRIES FOR ACCRUALS
Adjusting Entries Accrued Revenues
Asset Debit Adjusting Entry (+) Revenue Credit Adjusting Entry (+)

Accrued Expenses
Expense Debit Adjusting Entry (+) Liability Credit Adjusting Entry (+)

ACCRUED RE ENUES
y Accrued revenues may accumulate with the passing of time or through services performed but not billed or collected. y An asset-revenue account relationship exists with accrued revenues. y Prior to adjustment, assets and revenues are understated. y The adjusting entry requires a debit to an asset account and a credit to a revenue account.

ADJUSTING ENTRIES FOR ACCRUALS

ACCRUED REVENUES
ADJUSTMENT JOURNAL ENTRY
D O A S T A R R T E D C

October 31, the agency earned $200 for advertising services that were not billed to clients before October 31.

POSTING
A O R

R O

ACCRUED EXPENSES
y Accrued expenses are expenses incurred but not paid yet. y A liability-expense account relationship exists y Prior to adjustment, liabilities and expenses are understated y The Adjusting Entry results in a debit to an expense account and a credit to a liability account

ADJUSTING ENTRIES FOR ACCRUALS

ACCRUED INTEREST
ADJUSTMENT JOURNAL ENTRY
D O I I T A E T E D C

October 31, the portion of the interest to be accrued on a 3-month note payable is calculated to be $50.

POSTING
I O E I O

ADJUSTING ENTRIES FOR ACCRUALS

ACCRUED SALARIES
ADJUSTMENT JOURNAL ENTRY
D O S S r A E r T r r T E D 2 2 r r Cr

October 31, accrued salaries are calculated to be $1,200.

POSTING
S O 26 4 2 2 r E

r O 2

ILLUSTRATION 3-1 SUMMARY OF ADJUSTING ENTRIES

pe o Ad ust ent
1 Prepaid expenses 2 Unearned revenues 3 Accrued revenues 4 Accrued expenses
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Account Relations ip
Assets and expenses Liabilities and revenues Assets and revenues Expenses and liabilities

Accounts be ore Ad ust ent

Ad ustin Entr

Assets overstated Dr. Expenses Expenses understated Cr. Assets Liabilities overstated Dr. Liabilities Revenues understated Cr. Revenues Assets understated Dr. Assets Revenues understated Cr. Revenues Expenses understated Dr. Expenses Liabilities understated Cr. Liabilities

ADJUSTED TRIAL BALANCE

y An Adjusted Trial Balance is prepared after all

adjusting entries have been journalized and posted. y Its purpose is to prove the equality of the total debit and credit balances in the ledger after all adjustments have been made. y Financial statements can be prepared directly from the adjusted trial balance.

ILLUSTRATION 3-19
TRIAL BALANCE AND ADJUSTED TRIAL BALANCE COMPARED
PI EE E TI I djus ed Tri l B l c er E ce
After Adjustment Debit Credit $ 15, 200 1,000 550 5,000 $ 40 5,000 2,500 50 800 1,200 10,000 500 10,600 5,200 1,500 900 50 50 40 $ 30,190 $ 30,190

Cash Accounts Receivable Advertising Supplies Prepaid Insurance Office Equipment Accumulated Depreciation - Office Equipment Notes Payable Accounts Payable Interest Payable Unearned Revenue Salaries Payable C. R. Byrd, Capital C. R. Byrd, Drawing Service Revenue Salaries Expense Advertising Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense

Before Adjustment Debit Credit $ 15, 2,500 600 5,000 $ 5,000 2,500 1,200 10,000 500 10,000 4,000 900

$ 28, 00

$ 28, 00

PREPARING FINANCIAL STATEMENTS

Financial statements can be prepared directly from the adjusted trial balance. 1 The income statement is prepared from the revenue and expense accounts. 2 The owners equity statement is derived from the owners capital and drawing accounts and the net income (or net loss) from the income statement. 3 The balance sheet is then prepared from the asset and liability accounts and the ending owners capital balance as reported in the owners equity statement.

ILLUSTRATION 3-20
PREPARATION OF THE INCOME STATEMENT AND THE OWNERS EQUITY STATEMENT FROM THE ADJUSTED TRIAL BALANCE
PIONEER ERTISING GENCY Adjusted Trial alance October ,
Cash Accounts Receivable Advertising Supplies Prepaid Insurance Office Equipment Accumulated Depreciation - Office Equipment Notes Payable Accounts Payable Interest Payable Unearned Revenue Salaries Payable C. R. Byrd, Capital C. R. Byrd, Drawing Service Revenue Salaries Expense Advertising Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense Debit $ 15,200 200 1,000 550 5,000 Credit

40 5,000 2,500 50 800 1,200 10,000 10,600

500 5,200 1,500 900 50 50 40 $ 30,190

$ 30,190

ILLUSTRATION 3PREPARATION OF THE INCOME STATEMENT AND THE OWNERS EQUITY STATEMENT FROM THE ADJUSTED TRIAL BALANCE
PIONEER ADVERTISING AGENCY Income Statement For the Month Ended October 31, 2002
Revenues Fees earned Expenses Salaries expense Advertising supplies expense Rent expense Insurance expense Interest expense Depreciation expense Total expenses Net income $ 10,600

$ 5,200 1,500 900 50 50 40 7,740 $ 2,860

The income statement is prepared from the revenue and expense accounts.

ILLUSTRATION 3-20
PREPARATION OF THE INCOME STATEMENT AND THE OWNERS EQUITY STATEMENT FROM THE ADJUSTED TRIAL BALANCE
PIONEER ADVERTISING AGENCY Adjusted Trial Balance October 31, 2002
Cash Accounts Receivable Advertising Supplies Prepaid Insurance Office Equipment Accumulated Depreciation - Office Equipment Notes Payable Accounts Payable Interest Payable Unearned Revenue Salaries Payable C. R. Byrd, Capital C. R. Byrd, Drawing Service Revenue Salaries Expense Advertising Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense Debit $ 15,200 200 1,000 550 5,000 Credit

40 5,000 2,500 50 800 1,200 10,000 10,600

500 5,200 1,500 900 50 50 40 $ 30,190

$ 30,190

ILLUSTRATION 3PREPARATION OF THE INCOME STATEMENT AND THE OWNERS EQUITY STATEMENT FROM THE ADJUSTED TRIAL BALANCE

PIONEER ADVERTISING AGENCY Owners Equity Statement For the Month Ended October 31, 2002
C.R. Byrd, Capital, October 1 Add: Investments Net income Less: Drawings C.R. Byrd, Capital, October 31 $ $ 10,000 2,860 -0-

12,860 12,860 500 $ 12,360

The owner s equity statement is prepared from the owner s capital and drawing accounts and the net income (or net loss) shown in the income statement.

ILLUSTRATION 3-21
PREPARATION OF THE BALANCE SHEET FROM THE ADJUSTED TRIAL BALANCE
PI j st t I I ,
Debit t eceivable Advertising Supplies Prepaid Insurance Office Equipment Accumulated Depreciation - Office Equipment Notes Payable Accounts Payable Interest Payable Unearned Revenue Salaries Payable C. R. Byrd, Capital C. R. Byrd, Drawing Service Revenue Salaries Expense Advertising Supplies Expense Rent Expense Insurance Expense Interest Expense Depreciation Expense 200 1,000 550 5,000 40 5,000 2,500 50 800 1,200 10,000 500 10,600 5,200 1,500 900 50 50 40 $ 30,190 redit

$ 30,190

ILLUSTRATION 3- 1
PREPARATION OF THE BALANCE SHEET FROM THE ADJUSTED TRIAL BALANCE
PIONEER ADVERTISING AGENCY Balance Sheet October 31, 2002
Assets Cash Accounts receivable Advertising supplies Prepaid insurance Office equipment Less: Accumulated depreciation $ 15,200 200 1,000 550 $ 5,000 40 4,960 Liabilities and Owners Equity Liabilities Notes payable Accounts payable Interest payable Unearned fees Salaries payable Total liabilities Owners equity C.R. Byrd, Capital Total liabilities and owners equity

$ 5,000 2,500 50 800 1,200 9,550 12,360 $ 21,910

Total assets

$ 21,910

The balance sheet is then prepared from the asset and liability accounts and the ending owner s capital balance as reported in the owner s equity statement.

ILLUSTRATION 3ASUMMARY OF BASIC RELATIONSHIPS FOR PREPAYMENTS

ype of Ad ust ent 1 Prepaid Expenses Account Relationship Reason for Ad ust ent Account alances before Ad ust ent Ad ustin Entry

Assets and Expenses

2 Unearned Revenues

Liabilities and Revenues

a Prepaid expenses Assets overstated Dr Expenses initially recorded in Expenses understated Cr Assets asset accounts have been used. b Prepaid expenses Assets understated Dr Assets initially recorded in Expenses overstated Cr Expenses expense accounts have not been used. a Unearned revenues Liabilities overstated Dr Liabilities initially recorded in Revenues understated Cr Revenues liability accounts have been earned. b Unearned revenues Liabilities understated Dr Revenues initially recorded in Revenues overstated Cr Liabilities revenue accounts have not been earned.