ACCOUNTING
PRINCIPLES
SIXTH CANADIAN EDITION
Chapter 3
Adjusting the Accounts
Prepared by:
Debbie Musil
Kwantlen Polytechnic University
CHAPTER 3:
Adjusting the Accounts
STUDY OBJECTIVE:
1. Explain accrual basis accounting, and when to
recognize revenues and expenses.
2. Prepare adjusting entries for prepayments.
3. Prepare adjusting entries for accruals.
4. Describe the nature and purpose of an adjusted
trial balance, and prepare one.
5. Prepare adjusting journal entries for the
alternative treatment of prepayments.
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Adjusting the Accounts
• Timing issues
– Selecting an accounting time period
– Accrual versus cash basis of accounting
– Revenue and expense recognition
• Basics of adjusting entries
– Types of adjusting entries
– Prepayments and accruals
• Adjusted trial balance and financial
statements
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Time Periods
• The economic life of a business can
be divided into time periods
– Generally a month, quarter, or year
• Periods of less than one year are
called interim periods
• Period of one year is called a fiscal
year
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Accrual Versus Cash Basis
Accounting
• Accrual basis:
– Events are recorded in the period when
they occur
– Not when the cash is paid or received
• Cash basis:
– Revenue recorded when cash is
received
– Expenses recorded when cash is paid
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Revenue Recognition
• Revenue is recognized when there is
an increase in assets or a decrease in
liabilities as a result of business
activities with customers
• Revenue recognition criteria provides
guidance:
– Generally when the service is performed
or when goods are sold and delivered
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Expense Recognition
• Expenses are decreases in assets or
increases in liabilities from business
activities
• Expense recognition criteria provides
guidance:
– Tied to revenue recognition when a
direct association exists between costs
incurred and earning of revenue
– For long-lived assets, expenses are
recognized over the life of the asset
– Otherwise expenses are reported in
period incurred
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The Accounting Cycle
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Adjusting Entries - Basics
• Required for the preparation of
financial statements
– To ensure that revenue and expense
recognition criteria are followed
– Make it possible to accurately report
assets, liabilities and owner’s equity
• Part of the accounting cycle
• Classified as prepayments or accruals
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CHAPTER 3:
Adjusting the Accounts
STUDY OBJECTIVE:
1. Explain accrual basis accounting, and when to
recognize revenues and expenses.
2. Prepare adjusting entries for prepayments.
3. Prepare adjusting entries for accruals.
4. Describe the nature and purpose of an adjusted
trial balance, and prepare one.
5. Prepare adjusting journal entries for the
alternative treatment of prepayments.
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10
Adjusting Entries – Prepayments
• Prepaid Expenses:
– Expenses paid in cash and recorded as
assets before they are used or
consumed
• Unearned Revenues:
– Cash received and recorded as a liability
before revenue earned
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11
Prepaid Expenses
• Expire through the passage of time or as
an asset is used up
– Portion used up is an expense of the period
• Prior to adjustment, assets are overstated
and expenses are understated
• Adjusting entry:
Dr. An expense account (to increase)
Cr. An asset account (to decrease)
• Examples: supplies, rent, insurance
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Depreciation
• The allocation of the cost of long-lived
assets to expense over their useful
lives
– The portion of the asset that is used up
(or expires) in each period is reported as
an expense
• Straight-line depreciation:
Annual depreciation expense =
Cost ÷ Estimated useful life
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Depreciation – Recording
• Adjusting entry:
Dr. Depreciation expense (to increase)
Cr. Accumulated depreciation (to
increase)
• Contra asset account: An account
with the opposite balance (credit)
compared to its related asset account
– Deducted from its related asset on the
balance sheet
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Depreciation – Presentation
• Accumulated depreciation is deducted from the
cost of the asset on the balance sheet
• This difference is called the Carrying Amount
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Unearned Revenues
• Cash received before revenue is earned is
recorded as a liability
• Subsequently earned by performing a
service or providing a good
• Prior to adjustment, liabilities are
overstated and revenues are understated
• Adjusting entry:
Dr. A liability account (to decrease)
Cr. A revenue account (to increase)
• Examples: subscriptions, customer
deposits
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Adjusting Entries for Prepayments
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CHAPTER 3:
Adjusting the Accounts
STUDY OBJECTIVE:
1. Explain accrual basis accounting, and when to
recognize revenues and expenses.
2. Prepare adjusting entries for prepayments.
3. Prepare adjusting entries for accruals.
4. Describe the nature and purpose of an adjusted
trial balance, and prepare one.
5. Prepare adjusting journal entries for the
alternative treatment of prepayments.
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18
Adjusting Entries - Accruals
• Required where items are not yet
recorded in the accounts
• Accrued Revenues:
– Revenues earned but not yet received in
cash or recorded
• Accrued Expenses:
– Expenses incurred but not yet paid in
cash or recorded
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Accrued Revenues
• Accrue with the passage of time or result
from services performed but not billed or
collected
• Prior to adjustment, assets and revenues
are understated
• Adjusting entry:
Dr. An asset account (to increase)
Cr. A revenue account (to increase)
• Examples: accounts receivable, rent
receivable, and interest receivable
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Accrued Expenses
• Expenses incurred but not yet paid or
recorded
• Prior to adjustment, liabilities and expenses
are understated
• Adjusting entry:
Dr. An expense account (to increase)
Cr. A liability account (to increase)
• Examples: accounts payable, rent payable,
salaries payable, and interest payable
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Adjusting Entries for Accruals
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CHAPTER 3:
Adjusting the Accounts
STUDY OBJECTIVE:
1. Explain accrual basis accounting, and when to
recognize revenues and expenses.
2. Prepare adjusting entries for prepayments.
3. Prepare adjusting entries for accruals.
4. Describe the nature and purpose of an adjusted
trial balance, and prepare one.
5. Prepare adjusting journal entries for the
alternative treatment of prepayments.
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23
Preparing the Adjusted Trial
Balance
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Adjusted Trial Balance
• Prepared after adjusting
entries have been
journalized and posted
• Proves that total debit
and credit balances are
equal after all
adjustments have been
made
• Provides all data needed
for preparing financial
statements
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Preparing the Income Statement
and Statement of Owner’s Equity
The income statement is prepared from the revenue and expense accounts.
The statement of owner’s equity is prepared from the owner’s capital and drawing accounts and Profit
from the Income statement.
To: Balance Sheet – Owner’s equity
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Preparing the Balance Sheet
The balance sheet is prepared from the asset and liability accounts and
the Statement of owner’s equity
From: Statement of Owner’s Equity – Capital
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CHAPTER 3:
Adjusting the Accounts
STUDY OBJECTIVE:
1. Explain accrual basis accounting, and when to
recognize revenues and expenses.
2. Prepare adjusting entries for prepayments.
3. Prepare adjusting entries for accruals.
4. Describe the nature and purpose of an adjusted
trial balance, and prepare one.
5. Prepare adjusting journal entries for the
alternative treatment of prepayments.
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28
Appendix 3A: Alternative
Treatment of Prepayments
• Prepaid Expenses:
– Record initial transaction as an expense
– Adjust at end of period for amount that
has not been used up
• Unearned Revenues:
– Record initial transaction as revenue
– Adjust at end of period for services not
yet provided or goods not yet delivered
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29
COPYRIGHT
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