FINANCIAL ACCOUNTING COURSE

CHAPTER 03: ADJUSTING THE ACCOUNTS

SUB-UNITS:
▪ Timing Issues
▪ The Basics of Adjusting Entries
▪ The Adjusted Trial Balance and
Financial Statements

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Timing Issues
If we could wait to prepare financial statements until a company ended
its operations, no adjustments would be needed. At that point, we could
easily determine its final statement of financial position and the amount
of lifetime income it earned.
However, most companies need immediate feedback about how well
they are doing. For example, management usually wants monthly
financial statements, and taxing agencies require all businesses to file
annual tax returns. Therefore, accountants divide the economic life of
a business into artificial time periods. This convenient assumption is
referred to as the time period assumption.
Fiscal and Calendar Years
An accounting time period that is one year in length is a fiscal year. A
fiscal year usually begins with the first day of a month and ends 12
months later on the last day of a month.
Many businesses use the calendar year (January 1 to December 31) as
their accounting period.

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Accrual- versus Cash-Basis Accounting

What you will learn in this chapter is accrual-basis accounting. Under
the accrual basis, companies record transactions that change a
company’s financial statements in the periods in which the events
occur. For example, using the accrual basis to determine net income
means companies recognize revenues when they perform the services
(rather than when they receive cash). It also means recognizing
expenses when incurred (rather than when paid).
An alternative to the accrual basis is the cash basis. Under cash-basis
accounting, companies record revenue when they receive cash. They
record an expense when they pay out cash. The cash basis seems
appealing due to its simplicity, but it often produces misleading
financial statements. It fails to record revenue for a company that has
performed services but for which the company has not received the
cash. As a result, the cash basis does not match expenses with revenues.
Accrual-basis accounting is therefore in accordance with
International Financial Reporting Standards (IFRS). Individuals and
some small companies, however, do use cash-basis accounting. The
cash basis is justified for small businesses because they often have few
receivables and payables. Medium and large companies use accrual-
basis accounting.
Recognizing Revenues and Expenses
It can be difficult to determine when to report revenues and expenses.
The revenue recognition principle and the expense recognition
principle help in this task.

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REVENUE RECOGNITION PRINCIPLE

When a company agrees to perform a service or sell a product to a
customer, it has a performance obligation. When the company meets
this performance obligation, it recognizes revenue. The revenue
recognition principle therefore requires that companies recognize
revenue in the accounting period in which the performance obligation
is satisfied.
EXPENSE RECOGNITION PRINCIPLE
Accountants follow a simple rule in recognizing expenses: “Let the
expenses follow the revenues.” Thus, expense recognition is tied to
revenue recognition.

EXERCISE
Several timing concepts are discussed on pervious lesson . Below, a list
of concepts is provided in the left column, with descriptions of the
concepts in the right column. There are more descriptions provided
than concepts. Match the description of the concept to the concept.
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1. ____Accrual-basis accounting. (a) Monthly and quarterly time periods.

2. ____Calendar year. (b) Efforts (expenses) should be matched

3. ____Time period assumption. with results (revenues).

4. ____Expense recognition principle (c) Accountants divide the economic life of

a business into artifi cial time periods.

(d) Companies record revenues when they

receive cash and record expenses when

they pay out cash.

(e) An accounting time period that starts

on January 1 and ends on December 31.

(f) Companies record transactions in the

period in which the events occur.

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The Basics of Adjusting Entries
In order for revenues to be recorded in the period in which services
are performed, and for expenses to be recognized in the period in
which they are incurred, companies make adjusting entries. Adjusting
entries ensure that the revenue recognition and expense recognition
principles are followed.
Adjusting entries are necessary because the trial balance—the first
pulling together of the transaction data—may not contain up-to-date
and complete data.
This is true for several reasons:
1. Some events are not recorded daily because it is not efficient to do
so. Examples are the use of supplies and the earning of wages by
employees.
2. Some costs are not recorded during the accounting period because
these costs expire with the passage of time rather than as a result of
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recurring daily transactions. Examples are charges related to the use of

buildings and equipment, rent, and insurance.
3. Some items may be unrecorded. An example is a utility service bill
that will not be received until the next accounting period.
Adjusting entries are required every time a company prepares financial
statements. The company analyzes each account in the trial balance to
determine whether it is complete and up-to-date for financial statement
purposes. Every adjusting entry will include one income statement
account and one statement of financial position account.
Types of Adjusting Entries
Adjusting entries are classified as either deferrals or accruals, and each
of these classes has two subcategories.
Deferrals:
1. Prepaid expenses: Expenses paid in cash before they are used or
consumed.
2. Unearned revenues: Cash received before services are performed.
Accruals:
1. Accrued revenues: Revenues for services performed but not yet
received in cash or recorded.
2. Accrued expenses: Expenses incurred but not yet paid in cash or
recorded.
Subsequent sections give examples of each type of adjustment. Each
example is based on the October 31 trial balance of Yazici Advertising
A.S¸. from Chapter 2.

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We assume that Yazici uses an accounting period of one month. Thus,

monthly adjusting entries are made. The entries are dated October 31.
Adjusting Entries for Deferrals
To defer means to postpone or delay. Deferrals are expenses or
revenues that are recognized at a date later than the point when cash
was originally exchanged. Companies make adjusting entries for
deferrals to record the portion of the deferred item that was incurred as
an expense or recognized as revenue during the current accounting
period. The two types of deferrals are prepaid expenses and unearned
revenues.
PREPAID EXPENSES
When companies record payments of expenses that will benefit more
than one accounting period, they record an asset called prepaid
expenses or prepayments. When expenses are prepaid, an asset account
is increased (debited) to show the service or benefit that the company
will receive in the future. Examples of common prepayments are

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insurance, supplies, advertising, and rent. In addition, companies make

prepayments when they purchase buildings and equipment.
Let’s look in more detail at some specific types of prepaid expenses,
beginning with supplies.
SUPPLIES The purchase of supplies, such as paper and envelopes,
results in an increase (a debit) to an asset account. During the
accounting period, the company uses supplies. Rather than record
supplies expense as the supplies are used, companies recognize
supplies expense at the end of the accounting period. At the end of the
accounting period, the company counts the remaining supplies. The
difference between the unadjusted balance in the Supplies (asset)
account and the actual cost of supplies on hand represents the supplies
used (an expense) for that period.
Recall from Chapter 2 that Yazici Advertising purchased supplies
costing 2,500 on October 5. Yazici recorded the purchase by increasing
(debiting) the asset Supplies.
This account shows a balance of 2,500 in the October 31 trial balance.
An inventory count at the close of business on October 31 reveals that
1,000 of supplies are still on hand. Thus, the cost of supplies used is
1,500 (2,500 − 1,000). This use of supplies decreases an asset, Supplies.
It also decreases equity by increasing an expense account, Supplies
Expense.

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After adjustment, the asset account Supplies shows a balance of 1,000,

which is equal to the cost of supplies on hand at the statement date. In
addition, Supplies Expense shows a balance of 1,500, which equals the
cost of supplies used in October. If Yazici does not make the adjusting
entry, October expenses are understated and net income is overstated
by 1,500. Moreover, both assets and equity will be overstated by 1,500
on the October 31 statement of financial position.
INSURANCE Companies purchase insurance to protect themselves
from losses due to fi re, theft, and unforeseen events. Insurance must
be paid in advance, often for more than one year. The cost of insurance
(premiums) paid in advance is recorded as an increase (debit) in the
asset account Prepaid Insurance. At the financial statement date,
companies increase (debit) Insurance Expense and decrease (credit)
Prepaid Insurance for the cost of insurance that has expired during the
period.
On October 4, Yazici Advertising paid 600 for a one-year fire insurance
policy. Coverage began on October 1. Yazici recorded the payment by
increasing (debiting) Prepaid Insurance. This account shows a balance
of 600 in the October 31 trial balance. Insurance of 50 (600 ÷ 12)
expires each month. The expiration of prepaid insurance decreases an

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asset, Prepaid Insurance. It also decreases equity by increasing an

expense account, Insurance Expense.

The asset Prepaid Insurance shows a balance of 550, which represents

the unexpired cost for the remaining 11 months of coverage. At the
same time, the balance in Insurance Expense equals the insurance cost
that expired in October. If Yazici does not make this adjustment,
October expenses are understated by 50 and net income is overstated
by 50. Moreover, both assets and equity will be overstated by 50 on the
October 31 statement of financial position.
DEPRECIATION A company typically owns a variety of assets that
have long lives, such as buildings, equipment, and motor vehicles. The
period of service is referred to as the useful life of the asset. Because a
building is expected to be of service for many years, it is recorded as
an asset, rather than an expense, on the date it is acquired. As explained
in Chapter 1, companies record such assets at cost, as required by the
historical cost principle. To follow the expense recognition principle,
companies allocate a portion of this cost as an expense during each
period of the asset’s useful life. Depreciation is the process of allocating
the cost of an asset to expense over its useful life.

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For Yazici Advertising, assume that depreciation on the equipment is

480 a year, or 40 per month.

Statement Presentation
As indicated, Accumulated Depreciation— Equipment is a contra asset
account. It is offset against Equipment on the statement of financial
position. The normal balance of a contra asset account is a credit.
A theoretical alternative to using a contra asset account would be to
decrease (credit) the asset account by the amount of depreciation each
period. But using the contra account is preferable for a simple reason:
It discloses both the original cost of the equipment and the total cost
that has been expensed to date. Thus, in the statement of financial
position, Yazici deducts Accumulated Depreciation— Equipment from
the related asset account.

Book value is the difference between the cost of any depreciable asset
and its related accumulated depreciation.
Depreciation expense identifies the portion of an asset’s cost that
expired during the period (in this case, in October). Without this
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adjusting entry, assets, equity, and net income are overstated by 40 and
depreciation expense is understated by 40.

UNEARNED REVENUES
When companies receive cash before services are performed, they
record a liability by increasing (crediting) a liability account called
unearned revenue. In other words, a company now has a performance
obligation (liability) to perform a service for one of its customers.
Items like rent, magazine subscriptions, and customer deposits for
future service may result in unearned revenues.
Unearned revenues are the opposite of prepaid expenses. Indeed,
unearned revenue on the books of one company is likely to be a prepaid
expense on the books of the company that has made the advance
payment. For example, if identical accounting periods are assumed, a
landlord will have unearned rent revenue when a tenant has prepaid
rent.
When a company receives payment for services to be performed in a
future accounting period, it increases (credits) an unearned revenue (a
liability) account to recognize the liability that exists. Typically, prior
to adjustment, liabilities are overstated and revenues are understated.
The adjusting entry for unearned revenues results in a decrease (a debit)
to a liability account and an increase (a credit) to a revenue account.
Yazici Advertising received 1,200 on October 2 from R. Knox for
advertising services expected to be completed by December 31. Yazici
credited the payment to Unearned Service Revenue. This liability
account shows a balance of 1,200 in the October 31 trial balance. From

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an evaluation of the services Yazici performed for Knox during

October, the company determines that it should recognize 400 of
revenue in October. The liability (Unearned Service Revenue) is
therefore decreased, and equity (Service Revenue) is increased.

Without this adjustment, revenues and net income are understated by

400. Moreover, liabilities are overstated and equity is understated by
400 on the October 31 statement of financial position.

EXERCISE
The ledger of Zhu¯ Company on March 31, 2017, includes these
selected accounts before adjusting entries are prepared.

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An

analysis of the accounts shows the following.

1. Insurance expires at the rate of ¥100,000 per month.
2. Supplies on hand total ¥800,000.
3. The equipment depreciates ¥200,000 a month.
4. One-half of the unearned service revenue was performed in March.
Prepare the adjusting entries for the month of March.

Adjusting Entries for Accruals

The second category of adjusting entries is accruals, Prior to an accrual
adjustment, the revenue account (and the related asset account) or the
expense account (and the related liability account) are understated.
Thus, the adjusting entry for accruals will increase both a statement of
financial position and an income statement account.

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ACCRUED REVENUES
Revenues for services performed but not yet recorded at the statement
date are accrued revenues.
An adjusting entry records the receivable that exists at the statement of
financial position date and the revenue for the services performed
during the period. Prior to adjustment, both assets and revenues are
understated., an adjusting entry for accrued revenues results in an
increase (a debit) to an asset account and an increase (a credit) to a
revenue account.
In October, Yazici Advertising performed services worth 200 that were
not billed to clients on or before October 31. Because these services are
not billed, they are not recorded. The accrual of unrecorded service
revenue increases an asset account, Accounts Receivable. It also
increases equity by increasing a revenue account, Service Revenue.

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On November 10, Yazici receives cash of 200 for the services

performed in October and makes the following entry.
Nov. 10 Cash 200
Accounts Receivable 200
(To record cash collected on account)
The company records the collection of the receivables by a debit
(increase) to Cash and a credit (decrease) to Accounts Receivable.

ACCRUED EXPENSES
Expenses incurred but not yet paid or recorded at the statement date are
called accrued expenses. Interest, taxes, and salaries are common
examples of accrued expenses.
Companies make adjustments for accrued expenses to record the
obligations that exist at the statement of financial position date and to
recognize the expenses that apply to the current accounting period.
Prior to adjustment, both liabilities and expenses are understated.
Therefore, an adjusting entry for accrued expenses results in an
increase (a debit) to an expense account and an increase (a credit) to a
liability account.

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Let’s look in more detail at some specific types of accrued expenses,

beginning with accrued interest.
ACCRUED INTEREST Yazici Advertising signed a three-month note
payable in the amount of 5,000 on October 1. The note requires Yazici
to pay interest at an annual rate of 12%.
The amount of the interest recorded is determined by three factors:
(1) the face value of the note;
(2) the interest rate, which is always expressed as an annual rate; and
(3) the length of time the note is outstanding.
For Yazici, the total interest due on the 5,000 note at its maturity date
three months in the future is 150 (5,000 × 12% × 3/12), or 50 for one
month.
Formula for computing interest

Interest Expense shows the interest charges for the month of October.
Interest Payable shows the amount of interest the company owes at the
statement date.
Yazici will not pay the interest until the note comes due at the end of
three months. Companies use the Interest Payable account, instead of
crediting Notes Payable, to disclose the two different types of
obligations—interest and principal—in the accounts and statements.
Without this adjusting entry, liabilities and interest expense are
understated, and net income and equity are overstated.

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ACCRUED SALARIES AND WAGES Companies pay for some

types of expenses, such as employee salaries and wages, after the
services have been performed. Yazici paid salaries and wages on
October 26 for its employees’ first two weeks of work. The next
payment of salaries will not occur until November 9.
Three working days remain in October (October 29–31). At October
31, the salaries and wages for these three days represent an accrued
expense and a related liability to Yazici. The employees receive total
salaries and wages of 2,000 for a five-day work week, or 400 per day.
Thus, accrued salaries and wages at October 31 are 1,200 ( 400 × 3).
This accrual increases a liability, Salaries and Wages Payable. It also
decreases equity by increasing an expense account, Salaries and Wages
Expense.

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In Salaries and Wages Payable of 1,200 is the amount of the liability

for salaries and wages Yazici owes as of October 31. Without the 1,200
adjustments for salaries and wages, Yazici’s expenses are understated
1,200 and its liabilities are understated 1,200.
Yazici pays salaries and wages every two weeks. Consequently, the
next payday is November 9, when the company will again pay total
salaries and wages of 4,000. The payment consists of 1,200 of salaries
and wages payable at October 31 plus 2,800 of salaries and wages
expense for November (7 working days, as shown in the November
calendar × 400). Therefore, Yazici makes the following entry on
November 9.
Nov. 9 Salaries and Wages Payable 1,200
Salaries and Wages Expense 2,800
Cash 4,000
(To record November 9 payroll)

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This entry eliminates the liability for Salaries and Wages Payable that
Yazici recorded in the October 31 adjusting entry, and it records the
proper amount of Salaries and Wages Expense for the period between
November 1 and November 9.

EXERCISE
Micro Computer Services began operations on August 1, 2017. At the
end of August 2017, management attempted to prepare monthly
financial statements. The following information relates to August.
(Amounts are in Chinese yuan.)
1. At August 31, the company owed its employees ¥8,000 in salaries
and wages that will be paid on September 1.
2. On August 1, the company borrowed ¥300,000 from a local bank on
a 15-year mortgage. The annual interest rate is 10%.
3. Revenue for services performed but unrecorded for August totaled
¥11,000.
Prepare the adjusting entries needed at August 31, 2017.

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Summary of Basic Relationships

General journal showing adjusting entries

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General ledger after adjustment

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The Adjusted Trial Balance and Financial Statements

After a company has journalized and posted all adjusting entries, it
prepares another trial balance from the ledger accounts. This trial
balance is called an adjusted trial balance. It shows the balances of all
accounts, including those adjusted, at the end of the accounting period.
The purpose of an adjusted trial balance is to prove the equality of the
total debit balances and the total credit balances in the ledger after all
adjustments. Because the accounts contain all data needed for financial
statements, the adjusted trial balance is the primary basis for the
preparation of financial statements.

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Companies can prepare financial statements directly from the adjusted

trial balance.

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EXERCISE

(a)
Determine the net income for the quarter April 1 to June 30.
(b) Determine the total assets and total liabilities at June 30, 2017, for
Kang Company.
(c) Determine the amount that appears for retained earnings at June
30, 2017.

END OF CHAPTER 03

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