Accounting Principles, Ch.

Faculty of Business Administration and business trade

Principles of Accounting
ACT 101

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Accounting Principles, Ch.3

CHAPTER 3
Adjusting the Accounts

LEARNING OBJECTIVE 1:
Explain the accrual basis of accounting and the reasons for adjusting entries.

1.1.Time Period Assumption:

➢ 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 feedback about how well they are performing during a
period of time. For example, management usually wants monthly financial statements.
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 and also called the periodicity
assumption.

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1.2.Fiscal and Calendar Years:

➢ Both small and large companies prepare financial statements periodically in order to
assess their financial condition and results of operations. Accounting time periods are
generally a month, a quarter, or a year. Monthly and quarterly time periods are called
interim periods. Most large companies must prepare both quarterly and annual
financial statements.

➢ 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.

1.3. 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 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 at the time 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. For example, it fails to record revenue
for a company that has performed services but has not yet received payment. As a
result, the cash basis may not recognize revenue in the period that a performance
obligation is satisfied.

➢ 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.

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Accounting Principles, Ch.3

➢ 1.4.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.

➢ 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. A company satisfies its performance obligation by performing a
service or providing a good to a customer.

➢ 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.This practice of
expense recognition is referred to as the expense recognition principle. It requires that
companies recognize expenses in the period in which they make efforts (consume
assets or incur liabilities) to generate revenue.

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1.5. The Need for 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:

➢ 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.

➢ Some costs are not recorded during the accounting period because these costs expire
with the passage of time rather than as a result of recurring daily transactions.
Examples are charges related to the use of buildings and equipment, rent, and
insurance.

➢ 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.

➢ 1.6.Types of adjusting entries:

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Accounting Principles, Ch.3

LEARNING OBJECTIVE 2:
Prepare adjusting entries for deferrals.

2.1 Deferrals: are expenses or revenues that are recognized at a date later than the
point when cash was originally exchanged.

We will discuss the two types of Deferrals which are prepaid expenses and
unearned revenues.

2.1.1.Prepaid Expenses ( include Insurance, Supplies and Depreciation)

➢ 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 insurance, advertising, rent, Supplies and

Depreciation. In addition, companies make prepayments when they purchase
buildings and equipment.

➢ Prepaid expenses are costs that expire either with the passage of time (e.g., rent and
insurance) or through use (e.g., supplies). The expiration of these costs does not
require daily entries, which would be impractical and unnecessary.

➢ Accordingly, companies postpone the recognition of such cost expiration until they
prepare financial statements. At each statement date, they make adjusting entries to
record the expenses applicable to the current accounting period and to show the
remaining amounts in the asset accounts.

➢ Prior to adjustment, assets are overstated and expenses are understated. Therefore,
an adjusting entry for prepaid expenses results in an increase (a debit) to an expense
account and a decrease (a credit) to an asset account.

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Let's look in more detail at some specific Types of prepaid expenses

(Insurance, Supplies and Depreciation)

Example 1: Insurance

➢ On October 4, Pioneer Advertising paid $600 for a one-year fire insurance policy.
Coverage began on October 1. Pioneer 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 asset, Prepaid Insurance. It also

decreases equity by increasing an expense account, Insurance Expense.

➢ As shown in Illustration below , 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 Pioneer 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.

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Example 2: Supplies

➢ If Pioneer Advertising company purchased supplies costing $2,500 on October 5.

Then,Pioneer recorded the purchase by increasing (debiting) the 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.

➢ If Pioneer 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. Moreover, both assets and equity will be overstated by $1,500
on the October 31 statement of financial position.

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Example 3: Depreciation

➢ A company typically owns a variety of assets that have long lives, such as buildings,
equipment, and motor vehicles. The period of service (benefit) of these assets 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.

➢ The acquisition of long-lived assets is essentially a long-term prepayment for the use of
an asset. An adjusting entry for depreciation is needed to recognize the cost that has
been used (an expense) during the period and to report the unused cost (an asset) at
the end of the period.

➢ One very important point to understand: Depreciation is an allocation concept, not a

valuation concept. That is, depreciation allocates an asset's cost to the periods in which
it is used. Depreciation does not attempt to report the actual change in the value of the
asset.

➢ For Pioneer Advertising, assume that depreciation on the equipment is $480 a year, or
$40 per month. As shown in Illustration below, rather than decrease (credit) the asset
account directly, Pioneer instead credits Accumulated Depreciation—Equipment.

➢ Accumulated Depreciation is called a contra asset account. Such an account is offset

against an asset account on the statement of financial position. Thus, the Accumulated
Depreciation—Equipment account off sets the asset Equipment. This account keeps
track of the total amount of depreciation expense taken over the life of the asset. To
keep the accounting equation in balance, Pioneer decreases equity by increasing an
expense account, Depreciation Expense.

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Accounting Principles, Ch.3

➢ Book value is the difference between the cost of any depreciable asset and its related
accumulated depreciation . In the Illustration above, the book value of the equipment
at the statement of financial position date is $4,960. The book value and the fair value
of the asset are generally two different values.

➢ Book value is also referred to as carrying value.

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2.1.2. Unearned Revenues:

➢ When companies receive cash before services are performed, they record a liability by
increasing (crediting) a liability account called unearned revenues. 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.

➢ When a company receives payment for services to be performed in a future accounting

period, it Debits cash account and credits an unearned revenue (a liability) account to
recognize the liability that exists.

➢ Once the service is performed during the accounting period, it is not practical to make
daily entries when the company performs services. Instead, the company delays
recognition of revenue until the adjustment process. Then, the company makes an
adjusting entry to record the revenue for services performed during the period and to
show the liability that remains at the end of the accounting period.

➢ Typically, prior to adjustment, liabilities are overstated and revenues are understated.
Therefore, 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

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Example 4: Unearned Revenue

➢ Pioneer Advertising received $1,200 on October 2 from R. Knox for advertising services
expected to be completed by December 31.

➢ Pioneer credited the payment to Unearned Service Revenue. This liability account
shows a balance of $1,200 in the October 31 trial balance. From an evaluation of the
services Pioneer performed for Knox during October, the company determines that it
should recognize $400 of revenue in October (so the company performed services
valued $400 that should be adjusted). The Unearned Service Revenue is therefore
decreased (Debited), and Service Revenue is increased (credited).

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Exercise 1: DEFERRALS

Solution to Ex.1 :

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LEARNING OBJECTIVE 3
Prepare adjusting entries for Accruals.

The second category of adjusting entries is “Accruals”.

We will discuss in details the two types of Accruals which are

Accrued Revenues and Accrued Expenses.

3.1. Accrued Revenues:

➢ Are revenues for services performed but not yet recorded at the financial statements
date.

➢ Accrued revenues may accumulate (accrue) with the passing of time, as in the case of
interest revenue.These are unrecorded because the earning of interest does not
involve daily transactions. Companies do not record interest revenue on a daily basis
because it is often impractical to do so.

➢ Accrued revenues also may result from services that have been performed but not yet
billed nor collected, as in the case of commissions and fees. These may be unrecorded
because only a portion of the total service has been performed and the clients will not
be billed until the service has been completed.

Example 1: Accrued Revenues

➢ In October, Pioneer Advertising performed services worth $200 that were not billed to
clients on or before October 31. Because these services were not billed, they were 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, as shown in Illustration below

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Without the adjusting entry, assets and equity on the statement of financial position and
revenues and net income on the income statement are understated.

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3.2. Accrued Expenses : (Accrued Interest and Accrued Salaries)

➢ Expenses incurred but not yet paid or recorded at the financial statements 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.

Example 1: Accrued Interest

Pioneer Advertising signed a three-month note payable in the amount of $5,000 on October
1. The note requires Pioneer to pay interest at an annual rate of 12%.

Without this adjusting entry, liabilities and interest expense are understated, and net
income and equity are overstated.

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Example 2: Accrued Salaries and wages

➢ At October 31, the salaries and wages for these three days represent an accrued
expense and a related liability to Pioneer. 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, as shown in Illustration.

Without this adjusting entry, liabilities and salaries expense are understated, and net
income and equity are overstated.

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Illustrations 3.1 and 3.2 show the journalizing and posting of adjusting
entries for Pioneer Advertising on October 31.
Illustration 3.1

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Illustration3.2 :

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➢ 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.

Illustration 3.3 presents the adjusted trial balance for Pioneer Advertising

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Preparing Financial Statements

Companies can prepare financial statements directly from the adjusted
trial balance.

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Pioneer Advertising
Statement of Financial Position
October 31, 2017

Assets
Equipment $5,000
Less: Accumulated depreciation-equip. 40 4,960
Prepaid insurance 550
Supplies 1,000
Accounts receivable 200
Cash 15,200
Total assets 21,910
Liabilities and Equity
Equity
Owner's Capital 12,360
Total Equity 12,360
Liabilities
Notes payable 5,000
Accounts payable 2,500
Unearned service revenue 800
Salaries and wages payable 1,200
Interest payable 50
Total liabilities 9,550
Total equity and liabilities 21,910

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Summary of Basic Relationships:

Illustration below summarizes the four basic types of adjusting entries.

Take some time to study and analyze the adjusting entries. Be sure to note
that each adjusting entry affects one statement of financial position
account and one income statement account.

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Exercise 2: Accruals

Solution to exercise 2:

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References:

Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2018). Accounting

principles: IFRS version (Global edition). Wiley.

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