Chapter 3
Adjusting the Accounts
Two accounting methods:
Accrual-basis accounting: the impact of a business event
is recorded as it occurs – whether or not cash has been
received or paid
Cash-basis accounting: the impact of a business event is
only recorded once cash is received or paid
GAAP (The Matching Principle and The Revenue
Recognition Principle) requires that a business use
the accrual basis.
The accrual basis requires adjusting entries at the end
of the period to produce correct balances for the
financial statements.
Adjusting the Accounts
Adjusting entries assign revenues to the period in which they are earned
and expenses to the period in which they are incurred. They also update
the asset and liability accounts.
Adjusting entries can be classified as
1. prepayments (prepaid expenses or
unearned revenues),
2. accruals (accrued revenues or
accrued expenses), or
3. estimates (amortization).
PREPAID EXPENSES
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.
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, rent, insurance, and
property tax.
Ex. Supplies expense
Supplies
200
200
UNEARNED REVENUES
Revenues received and recorded as liabilities before they are earned.
Unearned revenues are earned by performing a service or providing a good
to a customer.
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,
airplane tickets, and tuition.
Ex. Unearned service revenue
Service revenue
3000
3000
AMORTIZATION OF CAPITAL ASSETS
(A.K.A. DEPRECIATION)
The process of allocating the cost of capital assets (except land) to
expense over their useful life.
• Amortization is an estimate rather than a factual
measurement of the cost that has expired.
• The adjusting entry for amortization always debits and
amortization expense and credits an accumulated amortization
account.
Ex. Amortization expense-building
600
Accumulated amortization-building
600
ACCRUED REVENUES
Revenues earned but not yet received in cash nor has the client been
billed.
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.
Examples of accrued revenues include accounts receivable, rent
receivable, and interest receivable.
Ex. Accounts receivable
Service Revenue
2500
2500
ACCRUED EXPENSES
Expenses incurred but not yet paid.
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.
Examples of accrued expenses include accounts payable, rent payable,
salaries payable, and interest payable.
Ex. Salary expense
Salary payable
1000
1000
FORMULA TO CALCULATE INTEREST
Face
Value of
Note
x
Annual
Interest
Rate
Time
x
$5,000 x
6%
x
(in Terms of
One Year)
= Interest
1/12 =
$25
 Each type of adjusting entry affects at least one
income statement account and at least one balance
sheet account.
 No adjusting entry affects the Cash account.
Adjusting entries are non-cash transactions required
by accrual accounting.
 Once adjustments are complete we prepare the
adjusted trial balance which is used to prepare the
financial statements.
In Class Activity