Chapter 3

Adjusting the Accounts

Chapter Outline
Learning Objectives
LO 1 Explain the accrual basis of accounting and the
reasons for adjusting entries.
LO 2 Prepare adjusting entries for deferrals.
LO 3 Prepare adjusting entries for accruals.
LO 4 Describe the nature and purpose of an adjusted
trial balance.

Copyright ©2019 John Wiley & Son, Inc. 2

 Accrual-Basis and Adjusting Entries
Accountants divide the economic life of a business into
artificial time periods (Time Period Assumption).
.....
Jan. Feb. Mar. Apr. Dec.

Generally a
ALTERNATIVE TERMINOLOGY
• month, The time period assumption
is also called the
• quarter, or periodicity assumption.
• year.
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 Fiscal and Calendar Years
• Monthly and quarterly time periods are called interim
periods
• Most large companies must prepare both quarterly
and annual financial statements
• Fiscal Year = Accounting time period that is one year
in length
• Calendar Year = January 1 to December 31

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 Accrual- versus Cash-Basis Accounting
Accrual-Basis Accounting
• Transactions recorded in the periods in which the
events occur
• Companies recognize revenues when they perform
services (rather than when they receive cash)
• Expenses are recognized when incurred (rather than
when paid)
• In accordance with International Financial Reporting
Standards (IFRS)
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 Accrual- versus Cash-Basis Accounting
Cash-Basis Accounting
• Revenues recognized when cash is received
• Expenses recognized when cash is paid
• Cash-basis accounting is not in accordance with
International Financial Reporting Standards (IFRS)

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 Recognizing Revenues and Expenses
Revenue Recognition Principle
Recognize revenue in the
accounting period in which the
performance obligation is
satisfied.

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 Recognizing Revenues and Expenses
Expense Recognition Principle
Companies recognize expenses in the
period in which they make efforts
(consume assets or incur liabilities)
to generate revenue.

“Let the expenses follow

the revenues.”

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 The Need for Adjusting Entries
Adjusting Entries
• Ensure that the revenue recognition and expense
recognition principles are followed.
• Necessary because the trial balance may not contain
up-to-date and complete data.
• Required every time a company prepares financial
statements.
• Will include one income statement account and one
statement of financial position account.
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 Types of Adjusting Entries
Deferrals Accruals
1. Prepaid Expenses. Expenses 1. Accrued Revenues.
paid in cash before they are Revenues for services
used or consumed. performed but not yet
received in cash or recorded.
2. Unearned Revenues. 2. Accrued Expenses.
Cash received before Expenses incurred but not
services are performed. yet paid in cash or recorded.

ILLUSTRATION 3.2
Categories of adjusting entries

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 Adjusting Entries for Deferrals
Deferrals are expenses or revenues that are recognized
at a date later than the point when cash was originally
exchanged. There are two types:
• Prepaid expenses
• Unearned revenues
Journalize and post
Trial
Analyze Journalize Post adjusting entries:
Balance
deferrals/accruals

Adjusted
Financial Closing Post-Closing
Trial
Balance Statements Entries Trial Balance

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 Prepaid Expenses
Payments of expenses that are recorded as an asset to
show the service or benefit the company will receive in
the future.

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

• insurance • rent
• supplies • equipment
• advertising • buildings

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 Yazici Advertising
Trial Balance
October 31, 2020
Debit Credit
Cash ₺15,200
Supplies 2,500
Prepaid Insurance Subsequent 600
Equipment examples are 5,000
Notes Payable based on the ₺ 5,000
Accounts Payable October 31 trial 2,500
Unearned Revenue balance from 1,200
Owner’s Capital Chapter 2. 10,000
Owner’s Drawings 500
Service Revenue 10,000
Salaries and Wages Expense 4,000
Rent Expense 900
ILLUSTRATION 2.31 ₺28,700 ₺28,700
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 Supplies
Illustration: Yazici Advertising purchased
supplies costing ₺2,500 on October 5.
Yazici recorded the payment 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.
Oct. 31
Supplies Expense 1,500
Supplies 1,500
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 Supplies ILLUSTRATION 3.5
Adjustment for supplies

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 Insurance
Illustration: 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.

Oct. 4 Prepaid Insurance 600

Cash 600
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 Insurance
Illustration: 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.

Oct. 31 Insurance Expense 50

Prepaid Insurance 50
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 Insurance ILLUSTRATION 3.6
Adjustment for insurance

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 Depreciation
• Buildings, equipment, and motor vehicles (assets
that provide service for many years) are recorded as
assets, rather than an expense, on the date acquired
• Depreciation is the process of allocating the cost of
an asset to expense over its useful life
• Depreciation does not attempt to report the actual
change in the value of the asset
 Allocation concept, not a valuation concept

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 Depreciation
Illustration: For Yazici Advertising, assume
that depreciation on the equipment is ₺480
a year, or ₺40 per month.
Oct. 31
Depreciation Expense 40
Accumulated Depreciation 40

Accumulated Depreciation is called a

contra asset account.

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 ILLUSTRATION 3.7
Adjustment for depreciation

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 Depreciation
Statement Presentation
• Accumulated Depreciation is a contra asset account
(credit)
• Offsets related asset account on the statement of
financial position
• Book value is the difference between the cost of any
depreciable asset and its accumulated depreciation
Equipment ₺5,000
Less: Accumulated depreciation—equipment 40
ILLUSTRATION 3.8 ₺4,960
Statement of financial position presentation of accumulated depreciation

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 Unearned Revenues
Receipt of cash that is recorded as a liability because the
service has not been performed.

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

• Rent • Magazine subscriptions
• Airline tickets • Customer deposits

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 Unearned Revenues
Illustration: Yazici Advertising received
₺1,200 on October 2 from R. Knox for
advertising services expected to be
completed by December 31. Unearned
Service Revenue shows a balance of
₺1,200 in the October 31 trial balance.
Analysis reveals that the company
performed ₺400 of services in October.

Oct. 2 Cash 1,200

Unearned Service Revenue 1,200
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 Unearned Revenues
Illustration: Yazici Advertising received
₺1,200 on October 2 from R. Knox for
advertising services expected to be
completed by December 31. Unearned
Service Revenue shows a balance of
₺1,200 in the October 31 trial balance.
Analysis reveals that the company
performed ₺400 of services in October.

Oct. 31 Unearned Service Revenue 400

Service Revenue 400
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 Unearned Revenues ILLUSTRATION 3.11
Service revenue accounts
after adjustment

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 Adjusting Entries for Accruals
Accruals are made to record,
• Revenues for services performed but not yet
recorded at the statement date
• Expenses incurred but not yet paid or recorded at the
statement date
Journalize and post
Trial
Analyze Journalize Post adjusting entries:
Balance
deferrals/accruals

Adjusted
Financial Closing Post-Closing
Trial
Balance Statements Entries Trial Balance

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 Accrued Revenues
Revenues for services performed but not yet received in
cash or recorded.

Revenue Recorded BEFORE Cash Receipt

Accrued revenues often occur in regard to:

• Rent
• Interest
• Services

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 Accrued Revenues
Illustration: In October Yazici Advertising
performed services worth ₺200 that were
not billed to clients on or before October 31.
Oct. 31
Accounts Receivable200
Service Revenue 200
On November 10, Pioneer receives cash of ₺200 for the
services performed. The journal entry on the 10 th is:
Cash 200
Accounts Receivable 200
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 Accrued Revenues ILLUSTRATION 3.14
Adjustments for accrued revenue

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 Accrued Expenses
Expenses incurred but not yet paid in cash or recorded.

Expense Recorded BEFORE Cash Payment

Accrued expenses often occur in regard to:

• Rent • Taxes
• Interest • Salaries

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 Accrued Expenses
Accrued Interest
Illustration: 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%.

Face Value Annual Time in Terms

of Note x Interest Rate x of One Year = Interest
₺5,000 x 12% x 1/12 = ₺50
ILLUSTRATION 3.17
Oct. 31 Interest Expense 50
Interest Payable 50
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 Accrued Expenses ILLUSTRATION 3.18
Adjustment for accrued interest

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 Accrued Expenses
Accrued Salaries and Wages
Illustration: Yazici Advertising paid salaries and wages on
October 26; the next payment of salaries will not occur until
November 9. The employees receive total salaries of ₺2,000
for a five-day work week, or ₺400 per day. ILLUSTRATION 3.19

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 Accrued Expenses ILLUSTRATION 3.20
Adjustment for accrued salaries
and wages

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 Adjusted Trial Balance
• Prepared after adjusting entries are journalized and
posted
• Proves equality of debit and credit balances
• Basis for the preparation of financial statements

Trial Adjusting
Analyze Journalize Post
Balance Entries

Adjusted Prepare Journalize and

Post-Closing
Trial Financial Post Closing Trial Balance
Balance Statements Entries

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 Yazici Advertising
Adjusted Trial Balance
October 31, 2020
Debit Credit
Cash ₺15,200
Accounts Receivable 200
Supplies 1,000
Prepaid Insurance 550
Equipment 5,000
Accumulated Depreciation ₺ 40
Notes Payable 5,000
Accounts Payable 2,500
Unearned Service Revenue 800
Salaries and Wages Payable 1,200
Interest Payable 50
Owner’s Capital 10,000
Owner’s Drawings 500
Service Revenue 10,600
Salaries and Wages Expense 5,200
Supplies Expense 1,500
Rent Expense 900
Insurance Expense 50
Interest Expense 50
Depreciation Expense 40
₺30,190 ₺30,190
ILLUSTRATION 3.25
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 Preparing Financial Statements
Financial
FinancialStatements
Statementsare
areprepared
prepareddirectly
directlyfrom
fromthe
the
Adjusted
AdjustedTrial
TrialBalance.
Balance.

Statement
Owner’s
Income of
Equity
Statement Financial
Statement
Position

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 ILLUSTRATION 3.26
Preparation of the income statement and owner’s equity
statement from the adjusted trial balance
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 ILLUSTRATION 3.27
Preparation of the statement of financial position
from the adjusted trial balance

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 Appendix 3B Financial Reporting Concepts
Qualities of Useful Information
Two fundamental qualities
1. Relevance
Make a difference in a business decision
Provides information that has predictive value and
confirmatory value
Materiality is a company-specific aspect of
relevance
 An item is material when its size makes it likely to
LO 6
influence theCopyright
decision of an investor or creditor 41
©2019 John Wiley & Son, Inc.
 Appendix 3B Financial Reporting Concepts
Two fundamental qualities
2. Faithful Representation
Information accurately depicts what really
happened.
Information must be
 complete (nothing important has been omitted)
 neutral (is not biased toward one position or
another)
 free from error
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 Qualities of Useful Information
Enhancing Qualities
Comparability Information is Information has the
results when verifiable if quality of
different companies independent understandability
use the same observers, using the if it is presented in a
accounting same methods, clear and concise
principles. obtain similar results. fashion.

Consistency means that a For accounting

company uses the same information to have
accounting relevance, it must be
principles and methods timely.
from year to year.

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 Assumptions in Financial Reporting

Monetary Unit Economic Entity

Requires that only those States that every economic
things that can be expressed entity can be separately
in money are included in the identified and accounted for.
accounting records.
ILLUSTRATION 3B.2

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 Assumptions in Financial Reporting

Time Period Going Concern

States that the life of a The business will remain in
business can be divided into operation for the
artificial time periods. foreseeable future.

ILLUSTRATION 3B.2

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 Assumptions in Financial Reporting
Measurement Principles
Historical Cost Fair Value
Or cost principle, Indicates that assets
dictates that and liabilities should
companies be reported at fair
record assets at value (the price
their cost. received to sell an
asset or settle
a liability).

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 Principles of Financial Reporting
Revenue Expense Full
Recognition Recognition Disclosure
Principle Principle Principle
Requires that Dictates that efforts Requires that
companies recognize (expenses) be companies disclose
revenue in the matched with results all circumstances
accounting period in (revenues). Thus, and events that
which the expenses follow would make a
performance revenues. difference to
obligation is financial statement
satisfied. users.

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 Cost Constraint
Cost Constraint
Accounting standard-setters
weigh the cost that companies
will incur to provide the
information against the benefit
that financial statement users will
gain from having the information
available.

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Copyright
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Copyright ©2019 John Wiley & Son, Inc. 49