The Basics of Adjusting Entries
Chapter 3
Please show any of your work in bold type.
Overview
Revenue recognition principle means that the company recognizes revenue in the accounting period
(accounting periods can differ but are usually a month, a quarter or a year) that it is earned in. Usually
this means when the service is completed. Matching principle is letting expenses follow revenue.
Expenses that are incurred for a particular sale (revenue) should be recorded in the same accounting
period. Adjusting entries is how accountants make sure these principles are followed, making the
balance sheet and income statement contain correct and factual numbers. There are two types of
adjusting entries, deferrals and accruals. Deferrals consist of two parts, either pre-paid expenses or
unearned revenues. Pre-paid expenses are expenses that are paid in cash and recorded as assets before
they are used or consumed. Unearned revenues is cash received and recorded as liabilities before
revenue is earned (someone else pre-paid expenses). Accruals can be accrued revenues or accrued
expenses. Accrued revenue is revenue earned but not yet received in cash or recorded. Accrued
expenses are expenses incurred but not yet paid in cash or recorded.
Deferrals
Deferrals are either pre-paid expenses or unearned revenues. Companies record the portion of the
deferral that represents the expense that was incurred or revenue earned during that accounting
period.
Pre-paid expenses are recorded as assets until they are used or with the passage of time. Common
examples of pre-paid expenses include insurance, supplies, advertising, rent or purchased buildings and
equipment. Prior to the adjustment entries, assets would be overstated and expenses would be
understated.
Pre-paid Expenses
Unadjusted
Balance
Asset
Credit adjusting
entry (-)
Expense
Debit adjusting
entry (+)
Examples of specific types of pre-paid expenses
Supplies: Supplies are usually bought in “bulk” and stored. Generally supplies are debited to an asset
account when they are purchased. Their use is recognized through the adjustment process.
Pioneer Advertising Agency purchased advertising supplies for $2,500 on October 5. The transaction was
recorded by increasing (debiting) the asset advertising supplies. An inventory count on October 31
shows that there are $1,000 worth of supplies in the supply closet, so the cost of the supplies used was
($2,500 – 1,000) $1,500. The adjusting entries would look as follows.
Supplies
Advertising Supplies (asset)
10/5
2500 10/31 adj (1500)
10/31 bal
1000
Advertising Supplies Expense
10/31 adj (1500)
So what this means is…….on October 5 the company bought 2,500 worth of supplies to be used, after 1
month they still had 1,000 so they used 1,500 worth of supplies during that month. So the accounting
shows a decrease in available supplies by 1,500 and that the company “spent” 1,000 on supplies for the
month of October. Going into the next month they only have 1,500 worth of supplies available for use.
Insurance: Insurance is always paid in advance in payments called premiums. Premiums are usually
listed as an increase in assets (debit). The insurance premiums that are used up or expired during that
accounting period would then be listed as an expense or a decrease (credit). On October 4, Pioneer
Advertising Agency paid $600 for a one-year fire insurance policy beginning on October 1. Complete the
following table (shaded cells require an answer) showing the debit/credit for the adjusting entry.
Insurance
10/4
10/31 bal
10/31 adj
()
10/31 adj
()
Depreciation: Depreciation is the process of allocating the cost of an asset to expense over its useful life
in a rational and systematic manner. Pioneer Advertising estimates depreciation on office equipment to
be $480 per year. Show the adjusting entries in the following table.
Depreciation
10/4
10/31 bal
10/31 adj
()
10/31 adj
()
Check for Comprehension
1. Complete DO IT! Exercise on p. 106. Show the adjusting entries as above and then explain to me
in written sentences why each entry was made the way it was.
2. Complete Self Study Questions on p. 123, SO 6, 7, 10.
3. Complete Brief Exercises on p. 125; BE3 3, 5, 6