Chapter 03

Chapter
3-1
CHAPTER 3
ADJUSTING THE
ACCOUNTS
Accounting Principles, Eighth Edition

Chapter
3-2
Study
Study Objectives
Objectives
1. Explain the time period assumption.

2. Explain the accrual basis of accounting.
3. Explain the reasons for adjusting entries.
4. Identify the major types of adjusting entries.
5. Prepare adjusting entries for deferrals.
6. Prepare adjusting entries for accruals.
7. Describe the nature and purpose of an adjusted
trial balance.
Chapter
3-3
Adjusting
Adjusting the
the Accounts
Accounts
The
The Adjusted
Adjusted
The
The Basics
Basics of
of Trial
Trial Balance
Balance and
and
Timing
Timing Issues
Issues Adjusting
Adjusting Financial
Financial
Entries
Entries Statements
Statements
Time period Types of Preparing the

assumption adjusting entries adjusted trial
Fiscal and Adjusting entries balance
calendar years for deferrals Preparing
Accrual- vs. cash- Adjusting entries financial
basis accounting for accruals statements
Recognizing Summary of
revenues and journalizing and
expenses posting
Chapter
3-4
Timing
Timing Issues
Issues
Accountants divide the economic life of a

business into artificial time periods
(Time Period Assumption).
.....
Jan. Feb. Mar. Apr. Dec.
Generally a month, a quarter, or a year.

Fiscal year vs. calendar year
Also known as the “Periodicity
Chapter Assumption” LO 1 Explain the time period assumption.
3-5 LO 1 Explain the time period assumption.
Timing
Timing Issues
Issues
Review
The time period assumption states that:
a. revenue should be recognized in the
accounting period in which it is earned.
b. expenses should be matched with revenues.
c. the economic life of a business can be divided
into artificial time periods.
d. the fiscal year should correspond with the
calendar year.
Chapter
3-6 LO 1 Explain the time period assumption.
Timing
Timing Issues
Issues
Accrual- vs. Cash-Basis Accounting

Accrual-Basis Accounting
Transactions recorded in the periods in which
the events occur
Revenues are recognized when earned,
rather than when cash is received.
Expenses are recognized when incurred,
rather than when paid.
Chapter
3-7 LO 2 Explain the accrual basis of accounting.
Timing
Timing Issues
Issues
Accrual- vs. Cash-Basis Accounting

Cash-Basis Accounting
Revenues are recognized when cash is
received.
Expenses are recognized when cash is paid.
Cash-basis accounting is not in accordance
with generally accepted accounting
principles (GAAP).
Chapter
Timing
Timing Issues
Issues
Recognizing Revenues and

Expenses
Revenue Recognition
Principle
Companies recognize
revenue in the
accounting period in
which it is earned.
In a service enterprise,
revenue is considered to
be earned at the time
the service is
Chapter performed.
Timing
Timing Issues
Issues
Recognizing Revenues and

Expenses
Matching Principle
Match expenses with
revenues in the period
when the company
makes efforts to
generate those
revenues.
“Let the expenses

follow the
Chapter
3-10 revenues.” LO 2 Explain the accrual basis of accounting.
Timing
Timing Issues
Issues
GAAP
relationships in
revenue and
expense
recognition
Illustration 3-1
Chapter
Timing
Timing Issues
Issues
Review
One of the following statements about the accrual
basis of accounting is false. That statement is:
a. Events that change a company’s financial
statements are recorded in the periods in which
the events occur.
b. Revenue is recognized in the period in which it is
earned.
c. The accrual basis of accounting is in accord with
generally accepted accounting principles.
d. Revenue is recorded only when cash is received,
and expenses are recorded only when cash is
Chapter paid.
The
The Basics
Basics of
of Adjusting
Adjusting Entries
Entries
Adjusting entries make it possible to

report correct amounts on the balance
sheet and on the income statement.
A company must make adjusting entries

every time it prepares financial
statements.
Chapter
3-13 LO 3 Explain the reasons for adjusting entries.
The
The Basics
Basics of
of Adjusting
Adjusting Entries
Entries
Revenues - recorded in the period in

which they are earned.
earned
Expenses - recognized in the period in
which they are incurred.
incurred
Adjusting entries - needed to ensure
that the revenue recognition and
matching principles are followed.
Chapter
Timing
Timing Issues
Issues
Review
Adjusting entries are made to ensure that:
a. expenses are recognized in the period in
which they are incurred.
b. revenues are recorded in the period in
which they are earned.
c. balance sheet and income statement
accounts have correct balances at the end
of an accounting period.
d. all of the above.
Chapter
Types
Types of
of Adjusting
Adjusting Entries
Entries
Deferrals Accruals
1. Prepaid Expenses. 3. Accrued Revenues.
Expenses paid in cash Revenues earned but not
and recorded as assets yet received in cash or
before they are used or recorded.
consumed.
2. Unearned Revenues. 4. Accrued Expenses.
Revenues received in cash Expenses incurred but
and recorded as liabilities not yet paid in cash or
before they are earned. recorded.
Chapter
3-16 LO 4 Identify the major types of adjusting entries.
Trial
Trial Balance
Balance
Trial Balance – Each account is analyzed to
determine whether it is complete and up-to-date.
Phoenix Consulting - J an. 31st (before adjusting entries)

Acct. No. Account Debit Credit
100 Cash $ 50,000
105 Accounts receivable 35,000
110 Prepaid insurance 12,000
120 Equipment 24,000
130 I nvestments 300,000
200 Accounts payable $ 20,000
210 Unearned revenue 24,000
220 Note payable 200,000
300 Austin, capital 40,000
400 Sales 137,000
$ 421,000 $ 421,000
Chapter
3-17 LO 4 Identify the major types of adjusting entries.
Adjusting
Adjusting Entries
Entries for
for Deferrals
Deferrals
Deferrals are either:

Prepaid expenses
OR
Unearned revenues.
Chapter
3-18 LO 5 Prepare adjusting entries for deferrals.
Adjusting
Adjusting Entries
Entries for
for “Prepaid
“Prepaid
Expenses”
Expenses”
Payment of cash, that is recorded as an asset because
service or benefit will be received in the future.
Cash Payment BEFORE Expense Recorded
Prepayments often occur in regard to:

insurance rent
supplies maintenance on
advertising equipment
fixed assets
(depreciation)
Chapter
Adjusting
Adjusting Entries
Entries for
for “Prepaid
“Prepaid
Expenses”
Expenses”
Prepaid Expenses
Costs that expire either with the passage of
time or through use.
Adjusting entries (1) to record the expenses

that apply to the current accounting period,
and (2) to show the unexpired costs in the
asset accounts.
Chapter
Adjusting
Adjusting Entries Entries for
for “Prepaid
“Prepaid
Expenses”
Expenses”
Illustration 3-4
Adjusting entries for prepaid

expenses
Increases (debits) an expense account and

Decreases (credits) an asset account.
Chapter
Adjusting
Adjusting Entries
Entries for
for “Prepaid
“Prepaid
Expenses”
Expenses”
Example (Insurance): On Jan. 1 , Phoenix
st
Consulting paid $12,000 for 12 months of insurance

coverage. Show the journal entry to record the
payment on Jan. 1st.
Jan. 1 Prepaid Insurance 12,00
Cash 0 12,00
0
Prepaid Insurance Cash
Debit Credit Debit Credit
12,000 12,000
Chapter
Adjusting
Adjusting Entries
Entries for
for “Prepaid
“Prepaid
Expenses”
Expenses”
Example (Insurance): On Jan. 1 , Phoenix
st

coverage. Show the adjusting journal entry required at
Jan. 31st.
Jan. 31 Insurance Expense 1,000
Prepaid Insurance 1,000
Prepaid Insurance Insurance Expense

12,000 1,000 1,000
11,000
Chapter
Adjusting
Adjusting Entries
Entries for
for “Prepaid
“Prepaid
Expenses”
Expenses”
Depreciation
Buildings, equipment, and vehicles (long-
lived assets) are recorded as assets, rather
than an expense, in the year acquired.
Companies report a portion of the cost of a
long-lived asset as an expense (depreciation)
during each period of the asset’s useful life
(Matching Principle).
Chapter
Adjusting
Adjusting Entries
Entries for
for “Prepaid
“Prepaid
Expenses”
Expenses”
Example (Depreciation): On Jan. 1 , Phoenix
st
Consulting paid $24,000 for equipment that has an

estimated useful life of 20 years. Show the journal
entry to record the purchase of the equipment on Jan.
1st.
Jan. 1 Equipment 24,00
Cash 0 24,00
0
Equipment Cash
24,000 24,000
Chapter
Adjusting
Adjusting Entries
Entries for
for “Prepaid
“Prepaid
Expenses”
Expenses”
Example (Depreciation): On Jan. 1 , Phoenix
st
Consulting paid $24,000 for equipment that has an

estimated useful life of 20 years. Show the adjusting
journal entry required at Jan. 31st. ($24,000 / 20
yrs. / 12 months = $100)
Jan. 31 Depreciation Expense 100
Accumulated Depreciation 100
Depreciation Expense Accumulated

Debit Credit Depreciation
Debit Credit
100 100
Chapter
Adjusting
Adjusting Entries
Entries for
for “Prepaid
“Prepaid
Expenses”
Expenses”
Depreciation (Statement Presentation)
Accumulated Depreciation is a contra asset
account.
Appears just after the account it offsets
(Equipment) on the balance sheet.
Balance Sheet J an. 31

Assets
Equipment 24,000
Accumulated Depreciation (100)
Net Equipment 23,900
Chapter
Adjusting
Adjusting Entries
Entries for
for “Unearned
“Unearned
Revenues”
Revenues”
Receipt of cash that is recorded as a liability
because the revenue has not been earned.
Cash Receipt BEFORE Revenue Recorded
Unearned revenues often occur in regard to:

rent magazine subscriptions
airline tickets customer deposits
school tuition
Chapter
Adjusting
Adjusting Entries
Entries for
for “Unearned
“Unearned
Revenues”
Revenues”
Unearned Revenues
Company makes an adjusting entry to record
the revenue that has been earned and to show
the liability that remains.
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.
Chapter
Adjusting
for “Unearned
“Unearned
Revenues”
Revenues”
Illustration 3-10
Adjusting entries for unearned revenues
Decrease (a debit) to a liability account and

Increase (a credit) to a revenue account.
Chapter
Adjusting
Adjusting Entries
Entries for
for “Unearned
“Unearned
Revenues”
Revenues”
Example: On Jan. 1 , Phoenix Consulting received
st
$24,000 from Arcadia High School for 3 months rent in

advance. Show the journal entry to record the receipt
on Jan. 1st.
Jan. 1 Cash 24,00
Unearned Rent 0 24,00
Revenue 0
Cash Unearned Rent
Debit Credit DebitRevenue
Credit
24,000 24,000
Chapter
Adjusting
Adjusting Entries
Entries for
for “Unearned
“Unearned
Revenues”
Revenues”
Example: On Jan. 1 , Phoenix Consulting received
st

advance. Show the adjusting journal entry required on
Jan. 31st.
Jan. 31 Unearned Rent 8,000
Revenue
Rent Revenue 8,000
Rent Revenue Unearned Rent

Debit Credit DebitRevenue
Credit
8,000 8,000 24,000
16,000
Chapter
Adjusting
Adjusting Entries
Entries for
for Accruals
Accruals
Made to record:
Revenues earned and
OR
Expenses incurred
in the current accounting period that have not

been recognized through daily entries.
Chapter
3-33 LO 6 Prepare adjusting entries for accruals.
Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued
Revenues”
Revenues”
Revenues earned but not yet received in cash or
recorded.
Adjusting entry results in:
Revenue Recorded BEFORE Cash Receipt
Accrued revenues often occur in regard to:

rent
interest
services performed
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued
Revenues”
Revenues”
Accrued Revenues
An adjusting entry serves two purposes:
(1) It shows the receivable that exists, and
(2) It records the revenues earned.
Chapter
Adjusting
for “Accrued
“Accrued
Revenues”
Revenues”
Illustration 3-13
Adjusting entries for accrued revenues
Increases (debits) an asset account and

Increases (credits) a revenue account.
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued
Revenues”
Revenues” st
Example: On Jan. 1 , Phoenix Consulting invested
$300,000 in securities that return 5% interest per year.
Show the journal entry to record the investment on Jan.
1st.
Jan. 1 Investments 300,00
Cash 0 300,000
Investments Cash
300,000 300,000
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued
Revenues”
Revenues” st
Example: On Jan. 1 , Phoenix Consulting invested
$300,000 in securities that return 5% interest per year.
Show the adjusting journal entry required on Jan. 31st.
($300,000 x 5% / 12 months = $1,250)
Jan. 31 Interest Receivable 1,250
Interest Revenue 1,250
Interest Receivable Interest Revenue

1,250 1,250
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued
Expenses”
Expenses”
Expenses incurred but not yet paid in cash or
recorded.
Adjusting entry results in:
Expense Recorded BEFORE Cash Payment
Accrued expenses often occur in regard to:

rent taxes
interest salaries
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued
Expenses”
Expenses”
Accrued Expenses
(1) It records the obligations, and
(2) It recognizes the expenses.
Chapter
Adjusting
for “Accrued
“Accrued
Expenses”
Expenses”
Illustration 3-16
Adjusting entries for accrued expenses
Increases (debits) an expense account and

Increases (credits) a liability account.
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued
Expenses”
Expenses” nd
Example: On Jan. 2 , Phoenix Consulting borrowed
$200,000 at a rate of 9% per year. Interest is due on first
of each month. Show the journal entry to record the
borrowing on Jan. 2nd.
Jan. 2 Cash 200,00
Notes Payable 0 200,000
Cash Notes Payable

200,000 200,000
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued
Expenses”
Expenses” nd
Example: On Jan. 2 , Phoenix Consulting borrowed
$200,000 at a rate of 9% per year. Interest is due on first
of each month. Show the adjusting journal entry required
on Jan. 31st. ($200,000 x 9% / 12 months = $1,500)
Jan. 31 Interest Expense 1,500
Interest Payable 1,500
Interest Expense Interest Payable

1,500 1,500
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued
Expenses”
Expenses”
Accrued Expenses
(1) It records the obligations, and
(2) it recognizes the expenses.
Chapter
The
The Adjusted
Adjusted Trial
Trial Balance
Balance
After all adjusting entries are journalized and

posted the company prepares another trial
balance from the ledger accounts (Adjusted
Trial Balance).
Its purpose is to prove the equality of debit

balances and credit balances in the ledger.
Chapter
3-45 LO 7 Describe the nature and purpose of an adjusted trial
Timing
Timing Issues
Issues
Review
Which of the following statements is incorrect
concerning the adjusted trial balance?
a. An adjusted trial balance proves the equality of the
total debit balances and the total credit balances
in the ledger after all adjustments are made.
b. The adjusted trial balance provides the primary
basis for the preparation of financial statements.
c. The adjusted trial balance lists the account
balances segregated by assets and liabilities.
d. The adjusted trial balance is prepared after the
adjusting entries have been journalized and
Chapter posted.
Preparing
Preparing Financial
Financial Statements
Statements
Financial
Statements areare prepared
prepared directly
directly from
from
the
the Adjusted
Adjusted Trial
Trial Balance.
Balance.
Owner’s
Income Statemen
Balance Equity
Statemen t of Cash
Sheet Statemen
t Flows
t
Chapter
Preparing
Preparing Financial
Statements
Adjusted Trial Balance Debit Credit
Cash $ 50,000 Income
Accounts receivable
I nterest receivable
35,000
1,250 Statement
I ncome Statement
Prepaid insurance 11,000 For the Month Ended J an. 31, 2008
Equipment 24,000
Revenues:
Accumulated depreciation $ 100
I nvestments 300,000 S ales $ 137,000
Accounts payable 20,000 I nter est r evenue 1,250
I nterest payable 1,500 Rent r evenue 8,000
Unearned revenue 16,000
T otal r evenue 146,250
Note payable 200,000
Austin, capital 40,000 Expenses:
Sales 137,000 I nter est expense 1,500
I nterest revenue 1,250 Depr eciation expense 100
Rent revenue 8,000
I nsur ance expense 1,000
I nterest expense 1,500
Depreciation expense 100 T otal expenses 2,600
I nsurance expense 1,000 Net income $ 143,650
$ 423,850 $ 423,850
Chapter
Preparing
Preparing Financial
Statements
Cash $ 50,000
Accounts receivable 35,000
I nterest receivable 1,250
Prepaid insurance 11,000
Equipment 24,000
I nvestments 300,000
Statement of
Accounts payable 20,000 Owner’s Equity
I nterest payable 1,500 Statement of Owner' s Equity
For the Month Ended J an. 31, 2008
Austin, capital 40,000
Sales 137,000 A ustin, Capital, J an. 1 $ 40,000
I nterest revenue 1,250 + N et income 143,650
Rent revenue 8,000 - Dr awings 0
A ustin, Capital, J an. 31 $ 183,650
Depreciation expense 100
I nsurance expense 1,000
$ 423,850 $ 423,850
Chapter
Preparing
Preparing Financial
Statements
Balance Sheet J an. 31, 2008
Cash $ 50,000 Assets
Accounts receivable 35,000 Cash $ 50,000
I nterest receivable 1,250 A ccounts r eceivable 35,000
Prepaid insurance 11,000
I nter est r eceivable 1,250
Equipment 24,000
Pr epaid insur ance 11,000
I nvestments 300,000 Equipment 24,000
Accounts payable 20,000 A ccum. Depr eciation (100)
I nterest payable 1,500 I nvestments 300,000
T otal assets $ 421,150
Austin, capital 40,000 Liabilities & Owner' s Equity
Sales 137,000 A ccounts payable $ 20,000
I nterest revenue 1,250 I nter st payable 1,500
Rent revenue 8,000
U near ned r evenue 16,000
Depreciation expense 100
N ote payable 200,000
I nsurance expense 1,000 A ustin, capital 183,650
$ 423,850 $ 423,850 T otal liab. & equity $ 421,150
Chapter
Alternative Treatment of Prepaid
Expenses and Unearned Revenues
Some companies use an alternative

treatment for prepaid expenses and
unearned revenues.
When a company prepays an expense, it

debits that amount to an expense
account.
When a company receives payment for

future services, it credits the amount to a
revenue account.
LO 8 Prepare adjusting entries for the alternative treatment of
Chapter deferrals.
3-51
Alternative Treatment for “Prepaid
Expenses”
Example (Insurance): On Dec. 1st, Phoenix
coverage. Show the journal entry to record the
payment on Dec. 1st.
Dec. 1 Insurance Expense 12,00
Cash 0 12,00
0
Insurance Expense Cash
12,000 12,000
Chapter
3-52 LO 8 Prepare adjusting entries for the alternative treatment of deferra
Alternative Treatment for “Prepaid
Expenses”
Example (Insurance): On Dec. 1st, Phoenix
coverage. Show the adjusting journal entry required at
Dec. 31st.
Dec. 31 Prepaid Insurance 11,00
Insurance Expense 0 11,00
0
Insurance Expense Prepaid Insurance
12,000 11,000 11,000
1,000
Chapter
3-53 LO 8 Prepare adjusting entries for the alternative treatment of
Alternative Treatment
Alternative Treatment for
for “Unearned
“Unearned
Revenues”
Revenues”
Example: On Dec. 1st, Phoenix Consulting received
advance. Show the journal entry to record the receipt
on Dec. 1st.
Dec. 1 Cash 24,00
Rent Revenue 0 24,00
0
Cash Rent Revenue
24,000 24,000
Chapter
Alternative
Alternative Treatment
Treatment for for “Unearned
“Unearned
Revenues”
Revenues”
Example: On Dec. 1st, Phoenix Consulting received
advance. Show the adjusting journal entry required on
Dec. 31st.
Dec. 31 Rent Revenue 16,00
Unearned Rent 0 16,00
Revenue 0
Unearned Rent Rent Revenue
DebitRevenue
Credit Debit Credit
16,000 16,000 24,000
8,000
Chapter
Summary of Basic Relationships for
Deferrals
Illustration 3A-7
Chapter
Chapter
3-57
Chapter
3-58
Chapter
3-59
Chapter
3-60
Chapter
3-61
Chapter
3-62

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Chapter

Accounting Principles, Eighth Edition

1. Explain the time period assumption.

Time period Types of Preparing the

Accountants divide the economic life of a

Generally a month, a quarter, or a year.

Accrual- vs. Cash-Basis Accounting

Accrual- vs. Cash-Basis Accounting

Recognizing Revenues and

Recognizing Revenues and

“Let the expenses

Adjusting entries make it possible to

A company must make adjusting entries

Revenues - recorded in the period in

Phoenix Consulting - J an. 31st (before adjusting entries)

Deferrals are either:

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

Adjusting entries (1) to record the expenses

Adjusting entries for prepaid

Increases (debits) an expense account and

Consulting paid $12,000 for 12 months of insurance

Consulting paid $12,000 for 12 months of insurance

Prepaid Insurance Insurance Expense

Consulting paid $24,000 for equipment that has an

Consulting paid $24,000 for equipment that has an

Depreciation Expense Accumulated

Balance Sheet J an. 31

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

The adjusting entry for unearned revenues

Adjusting entries for unearned revenues

Decrease (a debit) to a liability account and

$24,000 from Arcadia High School for 3 months rent in

$24,000 from Arcadia High School for 3 months rent in

Rent Revenue Unearned Rent

in the current accounting period that have not

Adjusting entry results in:

Revenue Recorded BEFORE Cash Receipt

Accrued revenues often occur in regard to:

(1) It shows the receivable that exists, and

(2) It records the revenues earned.

Adjusting entries for accrued revenues

Increases (debits) an asset account and

Interest Receivable Interest Revenue

Adjusting entry results in:

Expense Recorded BEFORE Cash Payment

Accrued expenses often occur in regard to:

(1) It records the obligations, and

(2) It recognizes the expenses.

Adjusting entries for accrued expenses

Increases (debits) an expense account and

Cash Notes Payable

Interest Expense Interest Payable

(1) It records the obligations, and

(2) it recognizes the expenses.

After all adjusting entries are journalized and

Its purpose is to prove the equality of debit

Some companies use an alternative