CHAPTER THREE

Adjusting the Accounts

Learning Objectives
1- Explain the Types of Adjusting Entries

2- Prepare adjusting entries for deferrals.

3- Prepare adjusting entries for accruals.
4- Describe the nature and purpose of an adjusted trail balance

Types of Adjusting Entries

Adjusting entries are classified as either deferrals or accruals.

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.

Prepare 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.
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 insurance, supplies, advertising, and rent.
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 expirations 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, as
shown in Illustration below, 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
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.
Pioneer Advertising purchased supplies costing $2,500 on October 5. Pioneer 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 owner’s equity by increasing an expense account, Supplies Expense.

Oct.31 Supplies Expense 1,500

Supplies 1,500
(To record supplies used)
INSURANCE
Companies purchase insurance to protect themselves from losses due to fire, 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, 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 owner’s equity by increasing an
expense account, Insurance Expense.

Oct.31 Insurance Expense 50

Prepaid Insurance 50
(To record insurance expired)

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.
For Pioneer Advertising, assume that depreciation on the equipment is $480 a year, or
$40 per month.
Oct.31 Depreciation Expense 40
Accumulated Depreciation—Equipment 40
(To record monthly depreciation)
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. Airlines such as United, Southwest, and Delta, for instance, treat receipts from
the sale of tickets as unearned revenue until the flight service is provided.
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. The
liability (Unearned Service Revenue) is therefore decreased, and owner’s equity (Service
Revenue) is increased.
Oct.31 Unearned Service Revenue 400
Service Revenue 400
(To record revenue for services performed)

Prepare adjusting entries for accruals.

Accrued Revenues
Revenues for services performed but not yet recorded at the statement date are accrued
revenues.
Accrued revenues may accumulate (accrue) with the passing of time, as in the case of
interest revenue.
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. An adjusting entry records
the receivable that exists at the balance sheet date and the revenue for the services
performed during the period.
In October, Pioneer Advertising performed services worth $200 that were not billed to
clients on or before October 31.
Oct.31 Accounts Receivable 200
Service Revenue 200
(To record revenue for services performed)

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.
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.
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%. 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 Pioneer, the total interest due on the $5,000 note at its
maturity date three months in the future is $150 ($5,000 x 12% x 3/12), or $50 for one
month (150/3 = 50).
Interest = Face value x Annual rate of Interest x Time
Oct.31 Interest Expense 50
Interest Payable 50
(To record interest on notes payable)
ACCRUED SALARIES AND WAGES
Companies pay for some types of expenses, such as employee salaries and wages, after
the services have been performed. Pioneer Advertising 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.
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 x 3).
Oct.31 Salaries and Wages Expense 1,200
Salaries and Wages Payable 1,200
(To record accrued salaries and wages)

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
balance sheet account and one income statement account.

Type of Adjustment Accounts Before Adjusting Entry

Adjustment
Prepaid expenses Assets overstated. Dr. Expenses
Expenses understated. Cr. Assets or Contra Assets

Unearned revenues Liabilities overstated. Dr. Liabilities

Revenues understated. Cr. Revenues

Accrued revenues Assets understated. Dr. Assets

Revenues understated. Cr. Revenues
Accrued expenses
Expenses understated. Dr. Expenses
Liabilities understated. Cr. Liabilities
journalizing and posting of adjusting entries for Pioneer Advertising on October 31.
 GENERAL JOURNAL J2
Date Account titles and explanation Ref Debit Credit
2017 Adjusting Entries
Oct 31 Supplies Expense 631 1,500
Supplies 126 1,500
(To record supplies used)

31 Insurance Expense 722 50

Prepaid Insurance 130 50
(To record insurance expired)

31 Depreciation Expense 711 40

Accumulated Depreciation—Equipment 158 40
(To record monthly depreciation)

31 Unearned Service Revenue 209 400

Service Revenue 400 400
(To record revenue for services
performed)

31 Accounts Receivable 112 200

Service Revenue 400 200
(To record revenue for services
performed)

31 Interest Expense 905 50

Interest Payable 230 50
(To record interest on notes payable)

31 Salaries and Wages Expense 726 1,200

Salaries and Wages Payable 212 1,200
(To record accrued salaries and wages)

Describe the nature and purpose of an adjusted trail balance

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.

Preparing the Adjusted Trial Balance

Pioneer advertising
Adjusted Trail Balance
October 31,2007

Debit Credit
Cash $ 15,200
Account Receivable 200
Supplies 1,000
Prepaid Insurance 550
Equipment 5,000
Accumulated Depreciation – Equipment $ 40
Notes Payable $ 5,000
Accounts Payable 2,500
Interest Payable 50
Unearned Service Revenue 800
Salaries and Wages Payable 1,200
Owner’s Capital 10,000
Owner’s Drawings 500
Service Revenue 10,600
Salaries and Wages Expenses 5,200
Supplies Expenses 1,500
Rent Expense 900
Insurance Expenses 50
Interest Expenses 50
Depreciation Expenses 40
$30,190 $30,190
Preparing Financial Statements
Companies can prepare financial statements directly from the adjusted trial
balance.
companies prepare the income statement from the revenue and expense accounts. Next,
they use the owner’s capital and drawings accounts and the net income (or net loss) from
the income statement to prepare the owner’s equity statement.

Pioneer Advertising
Income Statement
For the Month Ended October 31,2007
Revenues
Service revenue 10,600

Expenses
Salaries and wages expense $ 5,200
Supplies expense 1,500
Rent expense 900
Insurance expense 50
Interest expense 50
Depreciation expense 40
Total expenses 7,740
Net income 2,860

Pioneer Advertising
Owner’s Equity Statement
For the Month Ended October 31, 2017

Owner’s capital, October 1 $ –0–

Add: Investments 10,000
10,000
Net income 2,860
12,860
Owner’s drawings 500
Owner’s capital, October 31 12,360
 PIONEER ADVERTISING
Balance Sheet
October 31, 2017
Assets
Cash $ 15,200
Account Receivable 200
Supplies 1,000
Prepaid Insurance 550
Equipment 5,000
Less: Accumulated Depreciation
– Equipment 40 4,960
Total Assets 21,910
Liabilities and Owner’s Equity
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

Owner’s equity
Owner’s capital 12,360
Total liabilities and owner’s equity 21,910