BA 99.

1 – CHAPTER 3
Accrual-basis Accounting and Adjusting
Entries
- Accountants need to divide the economic
life of a business into artificial time
periods to see how well businesses
perform: time period The Need for Adjusting Entries
assumption/periodicity assumption - Adjusting entries ensure that the
Fiscal and Calendar Years revenue recognition and expense
- Fiscal year: one year in length recognition principles are followed
o Usually begins with the first day of a - Reasons why adjusting entries are
month and ends 12 months later on necessary:
the last day of a month o Some events are not recorded daily
- Interim periods: monthly and quarterly because it is not efficient to do so
time periods  Use of supplies, earning of wages
- Calendar year: Jan 1-Dec 31, many by employees
businesses use this as their accounting o Some costs are not recorded during
period the accounting period because these
Accrual- versus Cash-Basis Accounting costs expire over time rather than
- Accrual-basis accounting: companies because of recurring daily
record transactions that change a transactions
company’s financial statements in the  Changes related to the use of
periods in which the events occur buildings and equipment, rent,
o Companies recognize revenues when and insurance
they perform services (rather than o Some items may be unrecorded
when they receive the cash)  Utility service bill that will be
o Recognizing expenses when incurred received in the next accounting
(rather than paid) period
o In accordance with GAAP - Adjusting entries are required every
- Cash-basis accounting: companies time a company prepares financial
record revenue at the time they receive statements
cash - Every adjusting entry will include
o Record an expense when they pay it one income statement account and
o Often produces misleading financial one balance sheet account
Types of Adjusting Entries
statements
- Classified as either deferrals or accruals
 Fails to record revenue when
services have been performed but
o Deferrals:
no cash was received yet
Recognizing Revenues and Expenses  Prepaid expenses: expenses
- Revenue Recognition Principle paid in cash before they are used
o Performance obligation: when a or consumed
 Unearned revenues: cash
company agrees to perform a service
received before services are
or sell a product to a customer
performed
 The company recognizes
o Accruals:
revenue when it meets this
performance obligation  Accrued revenues: revenues for
o Revenue recognition principle: services performed but not yet
received in cash or recorded
requires that companies recognize
 Accrued expenses: expenses
revenue in the accounting period in
incurred but not yet paid in cash
which the performance obligation is
or recorded
satisfied
Adjusting Entries for Deferrals
- Expense Recognition Principle
- Deferrals: expenses or revenues that are
o “Let the expenses follow the
recognized at a date later than the
revenues”
point when cash was originally
o Expense recognition principle is
exchanged
tied to revenue recognition
Prepaid Expenses
 Requires that companies
- Prepaid expenses or prepayments:
recognize expenses in the period
when companies record payments of
in which they make efforts
expenses that will benefit more than one
(consume assets or liabilities) to
accounting period
generate revenue
 o Recorded as an asset by increasing  Both assets and owner’s equity
(debit) prepaid expenses will be overstated on balance
 to show the service or benefit that sheet
the company will receive in the
future
- costs that expire either with the passage
of time (rent, insurance) or through use
(supplies)
o do not require daily entries because it
would be impractical and unnecessary
- an adjusting entry for prepaid expenses
results in an increase (debit) to an
expense account and a decrease
(credit) to an asset account

- Depreciation
o Useful life: the period of service of
- Supplies
assets such as buildings, equipment,
o Companies record supplies expense
and motor vehicles
at the end of the accounting
o Depreciation: the process of
period
allocating the cost of an asset to
o Companies count the remaining
expense over its useful life
supplies at the end of the accounting
o Does not attempt to report the actual
period
change in the value of the asset
o Results in an increase to assets
o Accumulated Depreciation: contra
(debit)
asset account
o Without adjustment, expenses are
understated, and net income is
 Does not record depreciation as a
overstated
direct credit to the asset account
 both assets and owner’s equity
 Keeps track of the total amount of
will be overstated on the balance
depreciation expense taken over
sheet.
the life of the asset
 Preferable to use because it shows
both the original cost and the
total cost that has been expensed
to date
o In the balance sheet, accumulated
depreciation is deducted from the
related asset account
o Without adjustment, total assets, total
owner’s equity, and net income are
overstated and depreciation expense
is understated

- Insurance
o Insurance must be paid in advance,
often for multiple months
o Prepaid insurance is recorded as an
increase in assets (debit)
o When adjusted, companies
increase insurance expense
(debit) and decrease prepaid
insurance (credit) for the cost of
insurance that has expired during that
period
o Without adjustment, expenses are
understated and net income is
overstated o Book value/carrying value: the
difference between the cost of any
 depreciable asset and its related o May result from services that have
accumulated depreciation been performed but not yet billed nor
collected
 May be unrecorded because only
a portion of the total service has
been performed
- An adjusting entry results to an increase
Unearned Revenues (debit) to an asset account and an
- Unearned revenues: when companies increase (credit) to a revenue
receive cash before services are account
performed - Without the adjusting entry, assets and
o Recorded as a liability by owner’s equity on the balance sheet and
increasing (crediting) unearned revenues and net income on the income
revenues statement are understated
o A company now has a performance
obligation to transfer a service to one
of its customers
- The opposite of prepaid expenses
- An adjusting entry for unearned
revenues results in a decrease (debit)
to a liability account and an increase
(credit) to a revenue account
- Without adjustment, revenues and net
income are understated in the income
statement.
o Liabilities will be overstated and
owner’s equity will be understated by
balance sheet

Accrued Expenses
- Accrued expenses: expenses incurred
but not yet paid or recorded at the
statement date
- An adjusting entry results in an increase
(debit) to an expense account and an
increase (credit) to a liability account

Adjusting Entries for Accruals

- Accruals: increase both a balance sheet
and an income statement account - Accrued Interest
Accrued Revenues o Amount of interest is determined by 3
- Accrued revenues: revenues for factors
services are performed but not yet  Face value of the note
recorded at the statement date  Interest rate (annual rate)
o May accumulate with the passing of  Length of time the note is
time like interest revenue (does not outstanding
involve daily transactions)
 o Without adjustment, liabilities and recognize supplies used should increase
interest expense are understated, and Supplies Expense
net income and owner’s equity are - Double-check all computations
overstated - Each adjusting entry affects one balance
sheet account and one income statement
account

- Accrued Salaries and Wages

o Companies pay for some types of
expenses, like employee salaries and
wages, after the services have been
performed
o Remaining working days after the
latest payment of salaries represent
an accrued expense and a related
liability
o Without the adjustment for salaries
and wages, expenses are
understated, and its liabilities are
understated

Summary of Basic Relationships

Type of Accounts Before Adjustment
Adjustment
Prepaid Assets overstated
Expenses Expenses understated

Unearned Liabilities overstated

revenues Revenues understated
Accrued Assets understated
revenues Revenues understated
Accrued Expenses understated
Expenses Liabilities understated
- Adjusting entries should not involve
debits or credits to Cash
- Evaluate whether the adjustment makes
sense. For example, an adjustment to