ADJUSTING THE ACCOUNTS
STUDY OBJECTIVES
After studying this chapter, you should understand:
Time period assumption
Accrual basis of accounting
Adjusting entries for
prepayments
Adjusting entries for accruals
Why adjusting entries are
necessary
Purpose of an adjusted
trial balance
Major types of adjusting
entries
STUDY OBJECTIVE 1
TIME PERIOD ASSUMPTION
• The time period 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 (fiscal year)
STUDY OBJECTIVE 2
ACCRUAL vs. CASH-BASIS ACCOUNTING
Accrual Basis
Revenue recognized when earned
Expenses are matched against revenues
Required by GAAP
Cash-Basis
Revenues and expenses
recorded when cash is paid or received
Not GAAP
REVENUE RECOGNITION PRINCIPLE
• The revenue recognition principle dictates
that revenue be recognized in the accounting
period in which it is earned.
• In a service business, revenue is considered
to be earned when the service is performed.
MATCHING PRINCIPLE
• 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
GAAP RELATIONSHIPS IN
REVENUE & 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
STUDY OBJECTIVE 3
WHY ADJUSTING ENTRIES ARE NECESSARY
Adjusting entries are needed to ensure that revenue
recognition and matching principles are followed
1 Revenues are recorded in the period earned, and......
2 Expenses are recognized in the period incurred.
STUDY OBJECTIVE 4
TYPES OF ADJUSTING ENTRIES
Adjusting entries are required each time financial statements are prepared.
Two main categories of adjustments are:
PREPAYMENTS
ACCRUALS
ADJUSTING ENTRIES:
PREPAYMENTS
Prepaid Expenses
Unearned Revenues
Expenses are paid
and recorded as assets
before they are
used or consumed
Cash received and
recorded as liabilities
before revenue is earned
Example:
Prepaid Insurance
Example:
Cash received for
services provided in future
ADJUSTING ENTRIES:
ACCRUALS
Accrued Revenues
Accrued Expenses
Revenues earned but
Not yet received
In cash or recorded
Expenses incurred
but not yet paid
in cash or recorded
Example:
Sales of merchandise
On account
Example:
Utilities used but
not yet paid for
TRIAL BALANCE
PIONEER ADVERTISING AGENCY
Trial Balance
October 31, 2006
Cash
Advertising Supplies
Prepaid Insurance
Office Equipment
Notes Payable
Accounts Payable
Unearned Revenue
Common Stock
Retained Earnings
Dividends
Service Revenue
Salaries Expense
Rent Expense
The Trial Balance is
the starting place
for adjusting
entries.
Debit
$ 15,200
2,500
600
5,000
Credit
$ 5,000
2,500
1,200
10,000
0
500
10,000
4,000
900
$ 28,700
$ 28,700
STUDY OBJECTIVE 5
ADJUSTING ENTRIES FOR PREPAYMENTS
Adjusting entries for prepayments are
required to
record the portion of the prepayment
representing:
1 the expense incurred, or
2 the revenue earned in the current period.
ADJUSTING ENTRIES
FOR PREPAYMENTS
Adjusting Entries
Prepaid Expenses
Asset
Expense
Unadjusted Credit
Balance
Adjusting
Entry (-)
Debit
Adjusting
Entry (+)
Unearned Revenues
Liability
Debit
Adjusting
Entry (-)
Unadjusted
Balance
Revenue
Credit
Adjusting
Entry (+)
ADJUSTING ENTRIES FOR PREPAYMENTS
SUPPLIES
ADJUSTMENT
October 31, an inventory count reveals that $1,000
of $2,500 of supplies are still on hand.
JOURNAL ENTRY
Date
Oct. 31
Account Titles and Explanation
Advertising Supplies Expense
Advertising Supplies
(To record supplies used)
Debit Credit
1,500
1,500
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
October 31, an analysis of the policy reveals
that $50 of insurance expires each month.
JOURNAL ENTRY
Date
Oct. 31
Account Titles and Explanation
Insurance Expense
Prepaid Insurance
(To record insurance
expired)
Debit Credit
50
50
POSTING
Prepaid Insurance
Oct. 4
600 Oct. 31
31
550
10
50
Insurance Expense
Oct. 31
50
63
REVIEW QUESTION
ADJUSTING ENTRY-SUPPLIES
The trial balance shows supplies of $1,350 and supplies
expense of $0. If $750 of supplies are on hand at
the end of the period, what is the adjusting entry?
Account
Debit
Supplies Expense
Credit
$600
Supplies
$600
The balance in supplies after adjustment
is $750, the amount remaining unused.
The amount used is transferred to expense.
ADJUSTING ENTRIES FOR PREPAYMENTS
DEPRECIATION
• Depreciation is the allocation of the cost of an asset to
expense over its useful life.
• Depreciation is an estimate of expired cost.
• Depreciation Expense is debited and a contra-asset
account, Accumulated Depreciation, is credited
• Cost – accumulated depreciation = Book value
Depreciation Expense
XXX
Accumulated Depreciation
XXX
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
Date
Oct. 31
Account Titles and Explanation
Depreciation Expense
Accumulated Depreciation - Office Equipment
(To record monthly depreciation)
Debit Credit
40
40
POSTING
Accumulated Depreciation Office Equipment
Oct. 31
40
Depreciation Expense
Oct. 31
40
ADJUSTING ENTRIES FOR PREPAYMENTS
UNEARNED REVENUES
ADJUSTMENT
October 31, analysis reveals that, of $1,200 in fees
received in advance of performance, $400 has been
earned in October.
JOURNAL ENTRY
Date
Oct. 31
Account Titles and Explanation
Unearned Revenue
Service Revenue
(To record revenue for services provided)
Debit Credit
400
400
POSTING
Unearned Revenue
Oct. 31
400 Oct. 2
31
1,200
800
Service Revenue
Oct. 31
31
10,000
400
STUDY OBJECTIVE 6
ADJUSTING ENTRIES FOR 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.
ADJUSTING ENTRIES
FOR ACCRUALS
Adjusting Entries
Accrued Revenues
Asset
Revenue
Debit
Adjusting
Entry (+)
Credit
Adjusting
Entry (+)
Accrued Expenses
Expense
Debit
Adjusting
Entry (+)
Liability
Credit
Adjusting
Entry (+)
ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED REVENUE
ADJUSTMENT
October 31, the agency earned $200
for advertising services that were not
billed to clients before October 31.
JOURNAL ENTRY
Date
Oct. 31
Account Titles and Explanation
Accounts Receivable
Service Revenue
(To accrue revenue for services provided)
Debit Credit
200
200
POSTING
Accounts Receivable
Oct. 31
200
Service Revenue
Oct. 31
31
31
31
10,000
400
200
10,600
ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED INTEREST
ADJUSTMENT
October 31, the portion of the interest to be accrued
on a 3-month note payable is calculated to be $50.
JOURNAL ENTRY
Date
Oct. 31
Account Titles and Explanation
Interest Expense
Interest Payable
(To accrue interest on notes payable)
Debit Credit
50
50
POSTING
Interest Expense
Oct. 31
50
Interest Payable
Oct. 31
50
ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED SALARIES
ADJUSTMENT
October 31, accrued salaries
are calculated to be $1,200.
JOURNAL ENTRY
Date
Oct. 31
Account Titles and Explanation
Salaries Expense
Salaries Payable
(To record accrued salaries)
Debit Credit
1,200
1,200
POSTING
Salaries Expense
Oct. 26
4,000
31
1,200
31
5,200
Salaries Payable
Oct. 31
1,200
REVIEW QUESTION
ADJUSTING ENTRY-SALARIES
Kathy Siska earned a salary of $400 for the last week of
September. She will be paid on October 1.
What is the required adjusting entry?
Account
Salaries Expense
Debit
Credit
$400
Salaries Payable
This entry recognizes an expense for the salary
earned by Kathy in the last week of September, and a
liability for the amount due to Kathy at September 30th.
$400
STUDY OBJECTIVE 7
ADJUSTED TRIAL BALANCE
• An Adjusted Trial Balance is prepared after all
adjusting entries have been journalized and posted.
• Its purpose is to prove 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.
PREPARING THE INCOME STATEMENT FROM
THE ADJUSTED TRIAL BALANCE
PIONEER ADVERTISING AGENCY
Adjusted Trial Balance
October 31, 2006
Cash
Accounts Receivable
Advertising Supplies
Prepaid Insurance
Office Equipment
Accumulated Depreciation
Notes Payable
Accounts Payable
Interest Payable
Unearned Revenue
Salaries Payable
Common Stock
Retained Earnings
Dividends
Service Revenue
Salaries Expense
Ad vertising Supplies Expense
Rent Expense
Insurance Expense
Interest Expense
Depreciation Expense
Debit
$ 15,200
200
1,000
550
5,000
- Office Equpment
Credit
$
40
5,000
2,500
50
800
1,200
10,000
0
500
10,600
5,200
1,500
900
50
50
40
$ 30,190
INCOME
STATEMENT
ACCOUNTS
$ 30,190
INCOME STATEMENT
PIONEER ADVERTISING AGENCY
Income Statement
For the Month Ended October 31, 200 6
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.
PREPARING THE
RETAINED EARNINGS STATEMENT
FROM THE ADJUSTED TRIAL BALANCE
PIONEER ADVERTISING AGENCY
Adjusted Trial Balance
October 31, 2006
BALANCE
SHEET
ACCOUNTS
Cash
Accounts Receivable
Advertising Supplies
Prepaid Insurance
Office Equipment
Accumulated Depreciation
Notes Payable
Accounts Payable
Interest Payable
Unearned Revenue
Salaries Payable
C.ommon Stock
Retained Earnings
Dividends
Service Revenue
Salaries Expense
A dvertising Supplies Expense
Rent Expense
Insurance Expense
Interest Expense
Depreciation Expense
Debit
$ 15,200
200
1,000
550
5,000
- Office Equpt.
Credit
$
40
5,000
2,500
50
800
1,200
10,000
0
500
10,600
5,200
1,500
900
50
50
40
$ 30,190
$ 30,190
RETAINED
EARNINGS
STATEMENT
ACCOUNTS
RETAINED EARNINGS STATEMENT
PIONEER ADVERTISING AGENCY
Retained Earnings Statement
For the Month Ended October 31, 2006
Retained earnings, October 1
Add: Net income
Less: Dividends
Retained earnings, October 31
$
2,860
-02,860
2,860
500
$ 2,360
The retained earnings statement is prepared from the revenue, expense,
dividends, and retained earnings accounts.
BALANCE SHEET
PIONEER ADVERTISING AGENCY
Balance Sheet
October 31, 2006
Liabilities and Stockholders’ Equity
Assets
Cash
Accounts receivable
Advertising supplies
Prepaid insurance
Office equipment
Less: Accumulated
depreciation
Total assets
$ 15,200
200
1,000
550
$ 5,000
40
4,960
$ 21,910
Liabilities
Notes payable
Accounts payable
Interest payable
Unearned fees
Salaries payable
Total liabilities
Stockholders’ Equity
Common Stock
Retained Earnings
Total liabilities and owner’s
equity
$ 5,000
2,500
50
800
1,200
9,550
10,000
2,360
$ 21,910
The balance sheet is prepared from asset and liability and stockholders equity accounts.