Note for Chapter 3
1. Nature of Adjusting process
GAAP requires accrual basis of accounting. Revenue and expense needs to be reported in proper
period.
Revenue Recognition Concept requires recognition of revenue in the period when earned.
Matching principle requires expense be reported in the same period as revenue.
Cash basis of accounting only will be used in small business.
Purpose of adjusting: To show the truth of financial situation. Don’t overstate asset and revenue,
don’t understand liabilities and expense.
2. Adjusting Entries (5 types)
Prepaid expense (supposed to turn into expense in period but wasn’t recorded), examples, supplies,
prepaid insurance, prepaid rent. If not recorded, it will lead to overstate of asset and understate of
expense, then overstate of Net Income and Owner’s Equities
Unearned/prepaid revenue (supposed to recognize revenue but wasn’t recorded), examples,
expiration of unearned rent. If not recorded, it will lead to overstate of liabilities and understate of
revenue, then understate of Net Income and Owner’s Equities
Accrued revenue (revenue not received and not recorded), examples, provide service but didn’t
receive cash. If not recorded, it will lead to understate of assets and understate of revenue, then
understate of Net Income and Owner’s Equities
Accrued expense (expense incurred but not recorded), examples, accrued wage at year end. If not
recorded, it will lead to understate of liabilities and understate of expense, then overstate of Net
Income and Owner’s Equities
Depreciation expense (decrease of usefulness of fixed assets), periodic expense called depreciation
expense, accumulated depreciation is a contra assets. If not recorded, it will lead to overstate of
assets and understate of expense, then overstate of Net Income and Owner’s Equities
How to do adjusted entries for each type of transaction
3. Summary of Adjusting process (See page 120-121)
4. Adjusted Trial Balance (Similar function as unadjusted trial balance in Chapter 2)
5. Financial Analysis and Interpretations
Vertical Analysis: each item as percentage of total. I/S, revenue as 100%, B/S asset as 100%