Task Team of FUNDAMENTAL ACCOUNTING
Business School, Sun Yat-sen University
Lesson Notes
Lesson 4
Adjusting Accounts for Financial Statement
Learning objectives
1. Describe the purpose of adjusting accounts at the end of the period.
2. Prepare and explain adjusting entries for prepaid expenses, amortization,
unearned revenues, accrued expenses, and accrued revenues.
3. Explain how accounting adjustments link to financial statements.
4. Explain and prepare an adjusted trial balance.
Teaching hours
Students major in accounting:
3 hours
Others:
3 hours
Teaching contents:
Need for adjustments at the end of an accounting period
Some events are not evidenced by the obvious documents. They may not recorded
and related accounts will not be up-to-date and therefore do not provide a fair
presentation of the accounts on the financial statements. Adjustment are necessary
to record internal economic events such as the expiration of cost.
Before financial statements are prepared at the end of an accounting period, it is
necessary to adjust the account balances that are not up-to-date. The purpose of
making adjustments is to ensure that the information on the accounting statement is
comparable from period to period.
Related GAAPs
Adjustments are based on three generally accepted accounting principles:
Time period principle: The continued life of a business is divided into time
periods of equal length. Annual Financial reports are prepared at the end of each
fiscal period.
Revenue recognition principle: The revenue is recognized in the period in which
it is earned regardless the cash is received or not.
Matching principle: Matching principle requires that revenues and expenses be
matched. All expenses incurred in earning revenues must be deducted from the
revenues in determining net income.
So, Adjustments are required to match:
Associated revenues with their related costs
Revenues and expenses to their appropriate time periods
Task Team of FUNDAMENTAL ACCOUNTING
Business School, Sun Yat-sen University
Accrual and cash basis of accounting
The accrual basis of accounting matches revenues earned with expenses incurred.
The cash basis matches revenues received with expenses paid. It is not satisfactory
for most businesses because it results in financial statements that are not
comparable from period to period, except when the amounts of prepaid, unearned,
and accrued items are not material.
Cash basis accounting does not make adjustments for prepaid expenses, accrued
expenses, unearned revenues, and accrued revenues. Only accrual accounting,
with its emphasis on matching, and hence the need for adjustments, is acceptable
under GAAP.
Type of Adjusting Entries
There are four types of adjustment:
Accruing unrecorded revenues
Converting liabilities to revenues
Accruing unrecorded expenses
Converting assets to expenses
Accruing unrecorded revenues is to accrue revenues and record the related
assets. Since the revenues are earned in one period and cash received in the
other period so adjustment is necessary.
Example: On Jun 1, 2011, Smith Inc. invests $100,000 for a bonds which pays
5% interest per year. Smith Inc. will not receive the interest until March 31,
2012. On December 31, 2011, Smith, Inc. need to make the following entry for
the interest earned already
The adjusting try for the adjustment will be:
Dr. Interest Receivable
2916.67
Cr. Interest Revenue
2916.67
Accruing unrecorded expenses is to accrue incurred expenses and record the
related liabilities.
Example: On the year-end, Dec. 31, 2011, Smith Inc.’s employees have
earned total wages of $35,000 for the Monday, but Smith Inc. will not pay the
wages until 5th of next month. So at the end of the accounting period, Smith
need to make the following entries to accrued the wage expenses.
The adjusting entry will be :
Dr. Wages Expense
35000
Cr. Wages Payable
35000
Converting liabilities to revenues is to recognize as revenues the earned portion of
unearned revenue liabilities.
Task Team of FUNDAMENTAL ACCOUNTING
Business School, Sun Yat-sen University
Example: On Oct. 1, 2011, Smith Inc. signed a contract for providing a special
service to Cone. Smith received $50000 for the service to be provided. At the end of
2012 half of the services have been proved to Cone. Smith should make the following
entries to record earned revenue .
The adjusting entry will be:
Dr. Unearned Revenue
25000
Cr. Service Revenue
25000
Converting assets to expenses is to charge the expired portion of prepaid
expenses to expense.
Example: On July 1, 2011, Smith Inc. paid $20000 for whole year’s rent covered
from 1st of July to 30th of June. At the end of 2011, $10000 of rent expenses have
occurred so Smith Inc. need to make the following entries to transfer the deferrals to
expenses.
The adjusting entry will be:
Dr. Rent Expense 10000
Cr. Prepaid Rent
10000
Amortization is also belongs to this type of adjustment, because Amortization is to
convert the cost of fix asset to amortization expense.
Example: On January 1, 2011, a company purchased a piece of equipment for
$100,000. The equipment is expected to have a useful life of five years and have a
salvage value of $5000.Asume the company use the straight-line method.
We can calculated that the annual amortization value is 19000. [(100000-5000)/5],
the adjusting entry will be :
Dr. Amortization Expense
19000
Cr. Accumulated Amortization
19000
Adjusted Trial Balance
The adjusted trial balance is used to check if there are any mistakes in preparing and
posting the adjusted accounts and it is used for the financial statement.
Adjustments & Financial Statements
Adjusting entries bring the accounts up-to-date.
Adjustments are only made when financial statements are prepared.
Adjust entries will affect both the income statement and the balance sheet.
Adjustment will not affect the cash flow of the company.
Key points
1. Identify and analyze the events needed to adjust;
2. The preparation of adjusting entries.
Task Team of FUNDAMENTAL ACCOUNTING
Business School, Sun Yat-sen University
Reference
1. Philip E. Fess and Carl S. Warren, Accounting Principles, South-Western Publishing Co.,
1987.
2. Burrowes, Ashley W. Core Concepts of Accounting Information Systems. Issues in
Accounting Education, May2005, Vol. 20 Issue 2.
3. Sutton, Steve G., The role of AIS research in guiding practice.,International Journal of
Accounting Information Systems, Mar2005, Vol. 6 Issue 1.
4. Hutchison, Paul D., White, Craig G., and Daigle, Ronald J., Advances in Accounting
Information Systems and International Journal of Accounting Information Systems: first ten
volumes (1992–2003)., International Journal of Accounting Information Systems, Oct2004,
Vol. 5 Issue 3.
5. Lin, Fengyi, A Unified Accounting Information Framework To Modeling Bank Accounting
Systems, Journal of Applied Business Research, Fall2004, Vol. 20 Issue