Financial Accounting, 3e
Weygandt, Kieso, & Kimmel
Prepared by
Gregory K. Lowry
Mercer University
Marianne Bradford
The University of Tennessee
John Wiley & Sons, Inc.
CHAPTER 3
ADJUSTING THE ACCOUNTS
After studying this chapter, you should be able to:
1 Explain the time period assumption.
2 Distinguish between the revenue recognition
principle and the matching principle.
3 Explain why adjusting entries are needed.
4 Identify the major types of adjusting entries.
5 Prepare adjusting entries for prepayments.
6 Prepare adjusting entries for accruals.
7 Describe the nature and purpose of an adjusted
trial balance.
8 Explain the accrual basis of accounting.
PREVIEW OF CHAPTER 3
ADJUSTING THE
ACCOUNTS
Timing Issues



The Basics of
Adjusting Entries
Time Period
assumption

Types of
adjusting entries
Fiscal and
calendar years

Adjusting entries
for prepayments
Recognizing
revenues and
expenses

Adjusting entries
for accruals

Summary
The Adjusted Trial
Balance and
Financial Statements

Preparing the
adjusted trial
balance

Preparing
financial
statements
Accrual vs. Cash
Basis of
Accounting
TIME-PERIOD ASSUMPTION
 The time period (or periodicity) assumption assumes
that the economic life of a business can be divided into
artificial time periods.
 Accounting time periods are generally a month, a
quarter, or a year.
 The accounting time period of one year in
length is usually known as a fiscal year.
 The accounting period used by most
businesses coincides with the calendar
year (January 1 to December 31).
REVENUE RECOGNITION
PRINCIPLE
 The revenue recognition principle states
that revenue should be recognized in the
accounting period in which it is earned.
 In a service business, revenue is considered
to be earned at the time the service is
performed.
THE MATCHING PRINCIPLE
 The practice of expense recognition is
referred to as the matching principle.
 The matching principle dictates that efforts
(expenses) be matched with accomplishments
(revenues).
Revenues
earned
this month
are offset
against....
expenses
incurred in
earning the
revenue
ILLUSTRATION 3-1
GAAP RELATIONSHIPS IN REVENUE AND
EXPENSE RECOGNITION
Time-Period Assumption
Economic life of business
can be divided into
artificial time periods
Matching Principle
Revenue-Recognition Principle
Revenue recognized in
the accounting period in
which it is earned
Expenses matched with revenues
in the period when efforts are
expended to generate revenues
Revenue and Expense Recognition
In accordance with generally
accepted accounting
principles (GAAP)
ADJUSTING ENTRIES
Adjusting entries are made in order for:
1 Revenues to be recorded in the period in
which they are earned, and for......
2 Expenses to be recognized in the period in
which they are incurred.
ADJUSTING ENTRIES
Adjusting entries are required each time
financial statements are prepared.
Adjusting entries can be classified as
1 prepayments (prepaid expenses or
unearned revenues) or
2 accruals (accrued revenues or accrued
expenses)
TYPES OF
ADJUSTING ENTRIES
Prepayments
1 Prepaid Expenses - expenses paid in cash
and recorded as assets before they are used
or consumed
2 Unearned Revenues - revenues received in
cash and recorded as liabilities before they
are earned
TYPES OF
ADJUSTING ENTRIES
Accruals
1 Accrued Revenues - revenues earned but not
yet received in cash or recorded
2 Accrued Expenses - expenses incurred but
not yet paid in cash or recorded
ILLUSTRATION 3-3
TRIAL BALANCE
PIONEER ADVERTISING AGENCY, INC.
Trial Balance
October 31, 2001
Cash
Advertising Supplies
Prepaid Insurance
Office Equipment
Notes Payable
Accounts Payable
Unearned Revenue
Common Stock
Retained Earnings
Dividends
Service Revenue
Salaries Expense
Rent Expense
The Trial Balance
is the starting place
for adjusting
entries.
Debit
$ 15,200
2,500
600
5,000
Credit
$ 5,000
2,500
1,200
10,000
-0500
10,000
4,000
900
$ 28,700 $ 28,700
PREPAYMENTS
 Prepayments are either prepaid expenses
or unearned revenues.
 Adjusting entries for prepayments are
required to record the portion of the
prepayment that represents
1 the expense incurred or
2 the revenue earned in the current
accounting period.
ILLUSTRATION 3-4
ADJUSTING ENTRIES FOR PREPAYMENTS
Adjusting Entries
Prepaid Expenses
Asset
Expense
Unadjusted Credit
Balance
Adjusting
Entry (-)
Debit
Adjusting
Entry (+)
Unearned Revenues
Liability
Debit
Adjusting
Entry (-)
Unadjusted
Balance
Revenue
Credit
Adjusting
Entry (+)
PREPAID EXPENSES
 Prepaid expenses are 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.
 An asset-expense account relationship
exists with prepaid expenses.
PREPAID EXPENSES
 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, insurance, and depreciation.
ADJUSTING ENTRIES FOR PREPAYMENTS
SUPPLIES
Adjustment
Journal
Entry
Posting
October 31, an inventory count reveals that $1,000 of
$2,500 of supplies arestill on hand.
Date
Oct. 31
Account Titles and Explanation
Advertising Supplies Expense
Advertising Supplies
(To record supplies used)
Advertising Supplies
Oct. 5
2,500 Oct. 31
1,500
31
1,000
Debit Credit
1,500
1,500
Advertising Supplies Expense
Oct. 31
1,500
ADJUSTING ENTRIES FOR PREPAYMENTS
INSURANCE
Adjustment
Journal
Entry
Posting
October 31, an analysis of the policy reveals that $50 of
insurance expires each month.
Date
Oct. 31
Account Titles and Explanation
Insurance Expense
Prepaid Insurance
(To record insurance
expired)
Prepaid Insurance
Oct. 4
600 Oct. 31
31
550
10
50
Debit
50
Insurance Expense
Oct. 31
50
Credit
50
63
DEPRECIATION
 Depreciation is the process of allocating
the cost of an asset to expense over its
useful life in a rational and systematic
manner.
 The purchase of equipment or a building
is viewed as a long-term prepayment of
services and, therefore, is allocated in
the same manner as other prepaid
expenses.
DEPRECIATION
Depreciation is an estimate rather than a
factual measurement of the cost that has
expired.
In recording depreciation, Depreciation
Expense is debited and a contra asset
account, Accumulated Depreciation, is
credited
xxx Depreciation Expense
Accumulatedxxx
Depreciation
DEPRECIATION
In the balance sheet, Accumulated
Depreciation is offset against the asset
account.
The difference between the cost of the
asset and its related accumulated
depreciation is referred to as the
book value of the asset.
ADJUSTING ENTRIES FOR PREPAYMENTS
DEPRECIATION
Adjustment
Journal
Entry
Posting
October 31, depreciation on the office equipment is
estimated to be $480 a year, or $40 per month.
Date
Oct. 31
Account Titles and Explanation
Depreciation Expense
Accumulated Depreciation - Office Equipment
(To record monthly depreciation)
Accumulated Depreciation Office Equipment
Oct. 31
40
Debit Credit
40
40
Depreciation Expense
Oct. 31
40
UNEARNED REVENUES
Unearned revenues are revenues
received and recorded as liabilities
before they are earned.
Unearned revenues are subsequently
earned by rendering a service to a
customer.
A liability-revenue account relationship
exists with unearned revenues.
UNEARNED REVENUES
 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, and customer
deposits for future services.
ADJUSTING ENTRIES FOR PREPAYMENTS
UNEARNED REVENUES
Adjustment
Journal
Entry
Posting
October 31, analysis reveals that, of $1,200 in fees, $400
has been earned in October.
Date
Oct. 31
Account Titles and Explanation
Unearned Revenue
Service Revenue
(To record revenue for services
provided
Unearned Revenue
Oct. 31
400 Oct. 2
1,200
31
800
Debit Credit
400
400
Service Revenue
Oct. 31 10,000
31
400
ACCRUALS
The second category of adjusting entries
is accruals.
Adjusting entries for accruals are
required to record revenues earned and
expenses incurred in the current period.
The adjusting entry for accruals will
increase both a balance sheet and an
income statement account.
ILLUSTRATION 3-10
ADJUSTING ENTRIES FOR ACCRUALS
Adjusting Entries
Accrued Revenues
Asset
Revenue
Debit
Adjusting
Entry (+)
Credit
Adjusting
Entry (+)
Accrued Expenses
Expense
Debit
Adjusting
Entry (+)
Liability
Credit
Adjusting
Entry (+)
ACCRUED REVENUES
 Accrued revenues may accumulate with the
passing of time or through services
performed but not billed or collected.
 An asset-revenue account relationship
exists with accrued revenues.
 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.
ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED REVENUES
Adjustment
Journal
Entry
Posting
October 31, the agency earned $200 in fees for
advertising services that were not billed to clients before
October 31.
Date
Oct. 31
Account Titles and Explanation
Accounts Receivable
Service Revenue
(To accrue fees earned but
not billed or collected)
Accounts Receivable
Oct. 31
200
Debit Credit
200
200
Service Revenue
Oct. 31 10,000
31
400
31
200
31 10,600
ACCRUED EXPENSES
 Accrued expenses are expenses incurred
but not paid yet.
 A liability-expense account relationship
exists
 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
ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED INTEREST
Adjustment
Journal
Entry
Posting
October 31, the portion of the interest to be accrued on a
3-month note payable is calculated to be $50.
Date
Oct. 31
Account Titles and Explanation
Interest Expense
Interest Payable
(To accrue interest on notes
payable)
Interest Expense
Oct. 31
50
Debit Credit
50
50
Interest Payable
Oct. 31
50
ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED SALARIES
Adjustment
Journal
Entry
Posting
October 31, accrued salaries are calculated to be $1,200.
Date
Oct. 31
Account Titles and Explanation
Salaries Expense
Salaries Payable
(To record accrued salaries)
Salaries Expense
Oct. 26
4,000
31
1,200
31
5,200
Debit Credit
1,200
1,200
Salaries Payable
Oct. 31
1,200
ILLUSTRATION 3-14
SUMMARY OF ADJUSTING ENTRIES
Type of
1Adjustment
Prepaid
expenses
2 Unearned
revenues
3 Accrued
revenues
4 Accrued
expenses
Account
Relationship
Assets
and
expenses
Liabilities and
revenues
Assets and
revenues
Expenses and
liabilities
Accounts before
Adjusting
Adjustment
Entry
Assets
overstated
Dr. Expenses
Expenses understated Cr. Assets
Liabilities overstated Dr. Liabilities
Revenues understated Cr. Revenues
Assets understated
Dr. Assets
Revenues understated Cr. Revenues
Expenses understated Dr. Expenses
Liabilities understated Cr. Liabilities
ADJUSTED TRIAL BALANCE
 An Adjusted Trial Balance is prepared after all
adjusting entries have been journalized and posted.
 It shows the balances of all accounts at the end of
the accounting period and the effects of all financial
events that have occurred during the period.
 It proves the equality of the total debit and credit
balances in the ledger after all adjustments have
been made.
 Financial statements can be prepared directly from
the adjusted trial balance.
ILLUSTRATION 3-18
TRIAL BALANCE AND ADJUSTED TRIAL BALANCE COMPARED
PIONEER ADVERTISING AGENCY, INC.
Trial Balances
October 31, 2001
Cash
Accounts Receivable
Advertising Supplies
Prepaid Insurance
Office Equipment
Accumulated Depreciation - Office Equipment
Notes Payable
Accounts Payable
Interest Payable
Unearned Revenue
Salaries Payable
Common Stock
Retained Earnings
Dividends
Service Revenue
Salaries Expense
Advertising Supplies Expense
Rent Expense
Insurance Expense
Interest Expense
Depreciation Expense
Before
Adjustment
Debit
Credit
$ 15,200
2,500
600
5,000
$ 5,000
2,500
1,200
10,000
–0–
500
10,000
4,000
900
$ 28,700
$ 28,700
After
Adjustment
Debit
Credit
$ 15,200
200
1,000
550
5,000
$
40
5,000
2,500
50
800
1,200
10,000
–0–
500
10,600
5,200
1,500
900
50
50
40
$ 30,190 $ 30,190
ACCRUAL BASIS OF
ACCOUNTING
 The revenue recognition and matching
principles are used under the accrual basis
of accounting.
 Under cash-basis accounting, revenue is
recorded only when cash is received, and
expenses are recorded only when paid.
 Generally accepted accounting principles
require accrual basis accounting because
the cash basis often causes misleading
financial statements.
ALTERNATIVE TREATMENT
 Some businesses use an alternative treatment for
prepaids and unearned revenues.
 Instead of debiting an asset at the time an expense
is prepaid, the amount is charged to an expense
account.
 Instead of crediting a liability at the time cash is
received in advance of earning it, the amount is
credited to a revenue account.
 This treatment of prepaid expenses and unearned
revenues will ultimately result in the same effect on
the financial statements as initial entries to balance
sheet accounts and then adjusting entries.
ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS
SUPPLIES
Adjustment
Journal
Entry
Posting
October 31, an inventory count reveals that $1,000 of
$2,500 of supplies are still on hand.
Date
Oct. 31
Account Titles and Explanation
Advertising Supplies
Advertising Supplies Expense
(To record supplies
inventory)
Advertising Supplies
Oct. 31
1,000
Debit Credit
1,000
1,000
Advertising Supplies Expense
Oct. 5
2,500 Oct. 31
1,000
31
1,500
ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS
UNEARNED REVENUES
Adjustment
Journal
Entry
Posting
October 31, analysis reveals that, of $1,200 in revenue,
$400 has been earned in October.
Date
Account Titles and Explanation
Oct. 31 Service Revenue
Unearned Revenue
(To record unearned revenue)
Unearned Revenue
Oct. 31
800
Debit Credit
800
800
Service Revenue
Oct. 31
800 Oct. 2
31
1,200
400
ILLUSTRATION 3A-7
SUMMARY OF BASIC RELATIONSHIPS FOR PREPAYMENTS
Type of
1Adjustment
Prepaid
Account
Relationship
Assets
and
Expenses
Expenses
2 Unearned
Revenues
Liabilities and
Revenues
Reason for
Adjustment
a Prepaid
expenses
Account Balances
before overstated
Adjustment
Assets
initially recorded in
asset accounts have
been used.
b Prepaid expenses
initially recorded in
expense accounts
have not been used.
a Unearned revenues
initially recorded in
liability accounts
have been earned.
b Unearned revenues
initially recorded in
revenue accounts
have not been earned.
Expenses understated Cr Assets
Assets understated
Expenses overstated
Adjusting
Entry
Dr
Expenses
Dr Assets
Cr Expenses
Liabilities overstated Dr Liabilities
Revenues understated Cr Revenues
Liabilities understated Dr Revenues
Revenues understated Cr Liabilities
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CHAPTER 3
ADJUSTING THE ACCOUNTS