CHAPTER
3
The Adjusting Process
Warren
Reeve
Duchac
human/iStock/360/Getty Images
Accounting
26e
Learning Objectives
•
•
•
•
•
LO1: Describe the nature of the adjusting process.
LO2: Journalize entries for accounts requiring
adjustment.
LO3: Summarize the adjustment process.
LO4: Prepare an adjusted trial balance.
LO5: Describe and illustrate the use of vertical analysis
in evaluating a company’s performance and financial
condition.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Nature of the Adjusting Process
(slide 1 of 2)
•
•
The accounting period concept requires that revenues
and expenses be reported in the proper period.
Under the accrual basis of accounting, revenues are
reported on the income statement in the period in
which they are earned.
o
o
•
For example, revenue is reported when the services are
provided to customers.
Cash may or may not be received from customers during
this period.
The accounting concept supporting this reporting of
revenues is called the revenue recognition concept.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Nature of the Adjusting Process
(slide 2 of 2)
•
•
•
Under accrual accounting, revenues are recognized when
services have been performed or products have been delivered
to customers. Revenue is measured as assets received, such as
cash or accounts receivable, in exchange for a service or
product. This process of recording revenues is called revenue
recognition.
The accounting concept supporting reporting revenues and
related expenses in the same period is called the matching
concept.
Under the cash basis of accounting, revenues and expenses
are reported on the income statement in the period in which
cash is received or paid.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Adjusting Process
(slide 1 of 2)
•
Under the accrual basis, some of the accounts need
updating at the end of the accounting period for the
following reasons:
o
o
o
Some expenses are not recorded daily.
Some revenues and expenses are incurred as time passes
rather than as separate transactions.
Some revenues and expenses may be unrecorded.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Adjusting Process
(slide 2 of 2)
•
•
The analysis and updating of accounts at the end of
the period before the financial statements are
prepared is called the adjusting process.
The journal entries that bring the accounts up to date
at the end of the accounting period are called
adjusting entries.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Example Exercise
Accounts Requiring Adjustment
Indicate with a Yes or No whether or not each of the
following accounts normally requires an adjusting
entry:
a.
b.
c.
d.
e.
f.
Cash
Prepaid Rent
Wages Expense
Land
Accounts Receivable
Unearned Rent
a.
b.
c.
d.
e.
f.
No
Yes
Yes
No
Yes
Yes
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Types of Accounts Requiring Adjustment
•
The following basic types of accounts require
adjusting entries:
o
o
o
o
Prepaid expenses
Unearned revenues
Accrued revenues
Accrued expenses
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Prepaid Expenses
(slide 1 of 2)
•
Prepaid expenses are the advance payment of future
expenses and are recorded as assets when cash is
paid.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Prepaid Expenses
(slide 2 of 2)
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Unearned Revenues
(slide 1 of 2)
•
Unearned revenues are the advance receipt of future
revenues and are recorded as liabilities when cash is
received.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Unearned Revenues
(slide 2 of 2)
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accrued Revenues
(slide 1 of 2)
•
Accrued revenues are unrecorded revenues that have
been earned and for which cash has yet to be
received.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accrued Revenues
(slide 2 of 2)
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accrued Expenses
(slide 1 of 2)
•
Accrued expenses are unrecorded expenses that
have been incurred and for which cash has yet to be
paid.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accrued Expenses
(slide 2 of 2)
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Example Exercise
Type of Adjustment
Classify the following items as (1) prepaid expense, (2)
unearned revenue, (3) accrued expense, or (4) accrued
revenue:
a. Wages owed but not yet
paid.
b. Supplies on hand.
c. Fees received but not
yet earned.
d. Fees earned but not yet
received.
a. Accrued expense
b. Prepaid expense
c. Unearned revenue
d. Accrued revenue
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Unadjusted Trial Balance for NetSolutions
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Expanded Chart of Accounts for NetSolutions
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Prepaid Expenses
(slide 1 of 2)
•
NetSolutions’ supplies account has a balance of
$2,000 on the unadjusted trial balance. Some of
these supplies have been used. Assuming that on
December 31 the amount of supplies on hand is $760,
the amount to be transferred from the asset account
to the expense account is computed as follows:
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Prepaid Expenses
(slide 2 of 2)
Accounting Equation Impact
Assets
=
Liabilities
+
Owner’s Equity (Expense)
increase
decrease
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Prepaid Insurance
•
The debit balance of $2,400 in NetSolutions’ prepaid
insurance account represents the December 1
prepayment of insurance for 12 months.
Accounting Equation Impact
Assets
=
Liabilities
+
Owner’s Equity (Expense)
increase
decrease
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Impact of Omitting Adjusting Entries
for Prepaid Expenses
•
•
Arrow (1) indicates the effect of the understated expenses on
assets.
Arrow (2) indicates the effect of the overstated net income on
owner’s equity.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Example Exercise
Adjustment for Prepaid Expense
The prepaid insurance account had a beginning balance
of $6,400 and was debited for $3,600 of premiums paid
during the year. Journalize the adjusting entry required
at the end of the year, assuming the amount of
unexpired insurance related to future periods is $3,250.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Unearned Revenues
•
The credit balance of $360 in NetSolutions’ unearned rent account represents the
receipt of three months’ rent on December 1 for December, January, and February.
At the end of December, one month’s rent has been earned.
Accounting Equation Impact
Assets
=
Liabilities
decrease
+
Owner’s Equity (Revenue)
increase
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Impact of Omitting Adjusting Entry
for Unearned Revenues
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Example Exercise
Adjustment for Unearned Revenue
The balance in the unearned fees account, before
adjustment at the end of the year, is $44,900.
Journalize the adjusting entry required if the amount of
unearned fees at the end of the year is $22,300.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accrued Revenues
•
NetSolutions signed an agreement with Danker Co. on December 15 to provide
services at a rate of $20 per hour. As of December 31, NetSolutions had provided
25 hours of services. The revenue will be billed on January 15.
Accounting Equation Impact
Assets
increase
=
Liabilities
+
Owner’s Equity (Revenue)
increase
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Impact of Omitting Adjusting Entry
for Accrued Revenues
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Example Exercise
Adjustment for Accrued Revenues
At the end of the current year, $13,680 of fees have
been earned but have not been billed to clients.
Journalize the adjusting entry to record the accrued
fees.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accrued Wages
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accrued Expenses
(slide 1 of 2)
•
NetSolutions pays it employees biweekly. During December, NetSolutions paid
wages of $950 on December 13 and $1,200 on December 27. As of December 31,
NetSolutions owes $250 of wages to employees for Monday and Tuesday,
December 30 and 31.
Accounting Equation Impact
Assets
=
Liabilities
+
increase
Owner’s Equity (Expense)
increase
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accrued Expenses
(slide 2 of 2)
•
NetSolutions paid wages of $1,275 on January 10.
This payment includes the $250 of accrued wages
recorded on December 31.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Impact of Omitting Adjusting Entry
for Accrued Expenses
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Example Exercise
Adjustment for Accrued Expense
Sanregret Realty Co. pays weekly salaries of $12,500 on
Friday for a five-day week ending on that day.
Journalize the necessary adjusting entry at the end of
the accounting period, assuming that the period ends
on Thursday.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Depreciation Expense
(slide 1 of 5)
•
•
•
•
Fixed assets, or plant assets, are physical resources
that are owned and used by a business and are
permanent or have a long life.
As time passes, a fixed asset loses its ability to
provide useful services. This decrease in usefulness is
called depreciation.
All fixed assets, except land, lose their usefulness and,
thus, are said to depreciate.
As a fixed asset depreciates, a portion of its cost
should be recorded as an expense. This periodic
expense is called depreciation expense.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Depreciation Expense
(slide 2 of 5)
•
•
The fixed asset account is not decreased (credited)
when making the related adjusting entry. This is
because both the original cost of a fixed asset and
the depreciation recorded since its purchase are
reported on the balance sheet. Instead, an account
entitled Accumulated Depreciation is increased
(credited).
Accumulated depreciation accounts are called contra
accounts, or contra asset accounts.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Depreciation Expense
(slide 3 of 5)
•
Normal titles for fixed asset accounts and their
related contra asset accounts are as follows:
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Depreciation Expense
(slide 4 of 5)
•
NetSolutions estimates the depreciation on its office
equipment to be $50 for the month of December.
Accounting Equation Impact
Assets
=
Liabilities
+
Owner’s Equity (Expense)
increase
increase
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Depreciation Expense
(slide 5 of 5)
•
•
The difference between the original cost of the office
equipment and the balance in the accumulated
depreciation—office equipment account is called the
book value of the asset (or net book value).
It is computed as follows:
Book Value of Asset = Cost of the Asset – Accumulated Depreciation of Asset
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Impact of Omitting Adjusting Entry
for Depreciation
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Example Exercise
Adjustment for Depreciation
The estimated amount of depreciation on equipment
for the current year is $4,250. Journalize the adjusting
entry to record the depreciation.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Summary of Adjustments
(slide 1 of 3)
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Summary of Adjustments
(slide 2 of 3)
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Summary of Adjustments
(slide 3 of 3)
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Adjusting Entries—NetSolutions
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Ledger with Adjusting Entries—NetSolutions
(slide 1 of 5)
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Ledger with Adjusting Entries—NetSolutions
(slide 2 of 5)
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Ledger with Adjusting Entries—NetSolutions
(slide 3 of 5)
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Ledger with Adjusting Entries—NetSolutions
(slide 4 of 5)
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Ledger with Adjusting Entries—NetSolutions
(slide 5 of 5)
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Example Exercise
Effect of Omitting Adjustments
For the year ending December 31, 2016, Mann Medical
Co. mistakenly omitted adjusting entries for (1) $8,600
of unearned revenue that was earned, (2) earned
revenue of $12,500 that was not billed, and (3) accrued
wages of $2,900. Indicate the combined effect of the
errors on (a) revenues, (b) expenses, and (c) net income
for the year ended December 31, 2016.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Adjusted Trial Balance
•
The purpose of the adjusted trial balance is to verify
the equality of the total debit and credit balances
before the financial statements are prepared.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Adjusted Trial Balance
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Example Exercise
Effect of Errors on
Adjusted Trial Balance
For each of the following errors, considered individually, indicate
whether the error would cause the adjusted trial balance totals
to be unequal. If the error would cause the adjusted trial balance
totals to be unequal, indicate whether the debit or credit total is
higher and by how much.
a. The adjustment for accrued fees of $5,340 was journalized as
a debit to Accounts Payable for $5,340 and a credit to Fees
Earned of $5,340.
b. The adjustment for depreciation of $3,260 was journalized as
a debit to Depreciation Expense for $3,620 and a credit to
Accumulated Depreciation for $3,260
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Financial Analysis and Interpretation:
Vertical Analysis
(slide 1 of 3)
•
Comparing each item in a financial statement with a
total amount from the same statement is referred to
as vertical analysis.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Financial Analysis and Interpretation:
Vertical Analysis
(slide 2 of 3)
$12,500
$187,500
= .067 or 6.7%
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Financial Analysis and Interpretation:
Vertical Analysis
(slide 3 of 3)
$36,250
$137,764
= 0.263 or 26.3%
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Example Exercise
Vertical Analysis
(slide 1 of 2)
Two income statements for Fortson Company follow:
a. Prepare a vertical analysis of Fortson Company’s
income statements.
b. Does the vertical analysis indicate a favorable or an
unfavorable trend?
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Example Exercise
Vertical Analysis
(slide 2 of 2)
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.