3-1

3 Adjusting the Accounts

Learning Objectives
After studying this chapter, you should be able to:
[1] Explain the time period assumption.
[2] Explain the accrual basis of accounting.
[3] Explain the reasons for adjusting entries and Identify the major types of
adjusting entries.
[4] Prepare adjusting entries for deferrals.
[5] Prepare adjusting entries for accruals.
[6] Describe the nature and purpose of an adjusted trial balance.

3-2

2
 Preview of Chapter 3

Accounting Principles
Eleventh Edition
Weygandt Kimmel Kieso
3-3

Timing Issues

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.

3-4 LO 1 Explain the time period assumption.

4
 Timing Issues

Fiscal and Calendar Years

 Monthly and quarterly time periods are called interim
periods.

 Public 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.

3-5 LO 1 Explain the time period assumption.

Timing Issues

Review Question
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.

3-6 LO 1 Explain the time period assumption.

6
 Timing Issues

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 cash is received).

 Expenses are recognized when incurred (rather than

when paid).

3-7 LO 2 Explain the accrual basis of accounting.

Timing Issues

Accrual- vs. 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

generally accepted accounting principles (GAAP).

3-8 LO 2 Explain the accrual basis of accounting.

8
 Timing Issues

Recognizing Revenues and Expenses

REVENUE RECOGNITION PRINCIPLE
Recognize revenue in the
accounting period in which the
performance obligation is
satisfied.

3-9 LO 2

Timing Issues

Recognizing Revenues and Expenses

EXPENSE RECOGNITION PRINCIPLE
Match expenses with
revenues in the period when
the expense makes its
contribution to revenue.

“Let the expenses follow

the revenues.”

3-10 LO 2

10
 Timing Issues
Illustration 3-1
GAAP relationships in revenue
and expense recognition

3-11 LO 2

11

Timing Issues

Review Question
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 the performance
obligation is satisfied.
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 paid.
3-12 LO 2 Explain the accrual basis of accounting.

12
 > DO IT!
A list of concepts is provided in the left column below, with a description of the
concept in the right column below. There are more descriptions provided than
concepts. Match the description of the concept to the concept.

1. ___ Accrual-basis accounting. (a) Monthly and quarterly time periods.

(b) Efforts (expenses) should be matched
2. ___ Calendar year.
with results (revenues).
3. ___ Time period assumption. (c) Accountants divide the economic life of
4. ___ Expense recognition a business into artificial time periods.
principle. (d) Companies record revenues when they
receive cash and record expenses
when they pay out cash.
(e) An accounting time period that starts on
January 1 and ends on December 31.
(f) Companies record transactions in the
period in which the events occur.

3-13 LO 2

13

The Basics of 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

balance sheet account.

LO 3 Explain the reasons for adjusting entries and

3-14 Identify the major types of adjusting entries.

14
 The Basics of Adjusting Entries

Review Question
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
services are performed.
c. balance sheet and income statement accounts
have correct balances at the end of an accounting
period.
d. all of the above.
LO 3 Explain the reasons for adjusting entries and
3-15 Identify the major types of adjusting entries.

15

The Basics of Adjusting Entries

Types of Adjusting Entries

Illustration 3-2
Categories of adjusting entries

Deferrals Accruals

1. Prepaid Expenses. 1. Accrued Revenues.

Expenses paid in cash before Revenues for services
they are used or consumed. performed but not yet
received in cash or recorded.

2. Unearned Revenues. 2. Accrued Expenses.

Cash received before services Expenses incurred but not yet
are performed. paid in cash or recorded.

LO 3 Explain the reasons for adjusting entries and

3-16 Identify the major types of adjusting entries.

16
 The Basics of Adjusting Entries

Types of Adjusting Entries

Trial Balance –
Each account is
analyzed to
determine whether
it is complete and
up-to-date.

Illustration 3-3

LO 3 Explain the reasons for adjusting entries and

3-17 Identify the major types of adjusting entries.

17

The Basics of Adjusting Entries

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 and

 Unearned revenues.

3-18 LO 4 Prepare adjusting entries for deferrals.

18
 The Basics of Adjusting Entries

PREPAID 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  equipment
 advertising  buildings

3-19 LO 4 Prepare adjusting entries for deferrals.

19

The Basics of Adjusting Entries

PREPAID EXPENSES
 Expire either with the passage of time or through use.

 Adjusting entry:
► Increase (debit) to an expense account and

► Decrease (credit) to an asset account.

Illustration 3-4

3-20 LO 4 Prepare adjusting entries for deferrals.

20
 The Basics of Adjusting Entries

Illustration: Pioneer Advertising Agency

purchased supplies costing $2,500 on
October 5. Pioneer 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

3-21 LO 4 Prepare adjusting entries for deferrals.

21

The Basics of Adjusting Entries

Illustration 3-5

3-22 LO 4

22
 The Basics of Adjusting Entries

Illustration: On October 4, Pioneer

Advertising Agency 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.

Oct. 31 Insurance expense 50

Prepaid insurance 50

3-23 LO 4 Prepare adjusting entries for deferrals.

23

The Basics of Adjusting Entries

Illustration 3-6

3-24 LO 4

24
 The Basics of Adjusting Entries

Depreciation
 Buildings, equipment, and motor vehicles (assets that
provide service for many years) are recorded as assets,
rather than an expense, in the year 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.

3-25 LO 4 Prepare adjusting entries for deferrals.

25

The Basics of Adjusting Entries

Illustration: For Pioneer 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.

3-26 LO 4 Prepare adjusting entries for deferrals.

26
 The Basics of Adjusting Entries
Illustration 3-7

3-27 LO 4

27

The Basics of Adjusting Entries

Statement Presentation
 Accumulated Depreciation is a contra asset account
(credit).
 Appears just after the account it offsets (Equipment) on
the balance sheet.
 Book value is the difference between the cost of any
depreciable asset and its accumulated depreciation.
Illustration 3-8

3-28 LO 4 Prepare adjusting entries for deferrals.

28
 The Basics of Adjusting Entries

Illustration 3-9

3-29 LO 4 Prepare adjusting entries for deferrals.

29

The Basics of Adjusting Entries

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

3-30 LO 4 Prepare adjusting entries for deferrals.

30
 The Basics of Adjusting Entries

UNEARNED REVENUES
 Adjusting entry is made to record the revenue for
services performed during the period and to show the
liability that remains at the end of the period.

 Results in a decrease (debit) to a liability account and

an increase (credit) to a revenue account.

Illustration 3-10

3-31 LO 4

31

The Basics of Adjusting Entries

Illustration: Pioneer Advertising Agency 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

3-32 LO 4 Prepare adjusting entries for deferrals.

32
 The Basics of Adjusting Entries
Illustration 3-11

3-33 LO 4

33

The Basics of Adjusting Entries

Illustration 3-12

3-34 LO 4 Prepare adjusting entries for deferrals.

34
 The Basics of Adjusting Entries

Adjusting Entries for Accruals

Accruals are made to record

 Revenues for services performed

OR

 Expenses incurred

in the current accounting period that have not been

recognized through daily entries.

3-35 LO 5 Prepare adjusting entries for accruals.

35

The Basics of Adjusting Entries

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  Services performed
 Interest

3-36 LO 5 Prepare adjusting entries for accruals.

36
 The Basics of Adjusting Entries

ACCRUED REVENUES
 Adjusting entry shows the receivable that exists and records
the revenues for services performed.

 Adjusting entry:
► Increases (debits) an asset account and
► Increases (credits) a revenue account.

Illustration 3-13

3-37 LO 5

37

The Basics of Adjusting Entries

Illustration: In October Pioneer Advertising

Agency earned $200 for advertising services
that had not been recorded.

Oct. 31
Accounts receivable 200
Service revenue 200

On November 10, Pioneer receives cash of

$200 for the services performed.

Nov. 10 Cash 200

Accounts receivable 200
3-38 LO 5 Prepare adjusting entries for accruals.

38
 The Basics of Adjusting Entries
Illustration 3-14

3-39 LO 5

39

The Basics of Adjusting Entries

Illustration 3-15

3-40 LO 5 Prepare adjusting entries for accruals.

40
 The Basics of Adjusting Entries

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

3-41 LO 5 Prepare adjusting entries for accruals.

41

The Basics of Adjusting Entries

ACCRUED EXPENSES
 Adjusting entry records the obligation and recognizes the
expense.

 Adjusting entry:
► Increase (debit) an expense account and
► Increase (credit) a liability account.

Illustration 3-16

3-42 LO 5

42
 The Basics of Adjusting Entries

Illustration: Pioneer Advertising Agency 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%.
Illustration 3-17

Oct. 31 Interest expense 50

Interest payable 50

3-43 LO 5 Prepare adjusting entries for accruals.

43

The Basics of Adjusting Entries

Illustration 3-18

3-44 LO 5

44
 The Basics of Adjusting Entries

Illustration: Pioneer Advertising Agency last paid salaries 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. Thus, accrued salaries at
October 31 are $1,200 ($400 x 3 days).
Illustration 3-19

3-45 LO 5 Prepare adjusting entries for accruals.

45

The Basics of Adjusting Entries

Illustration 3-20

3-46 LO 5

46
 The Basics of Adjusting Entries

Illustration 3-21

3-47 LO 5 Prepare adjusting entries for accruals.

47

The Basics of Adjusting Entries

Summary of Basic Relationships

Illustration 3-22

3-48 LO 5 Prepare adjusting entries for accruals.

48
 The Adjusted Trial Balance

Adjusted Trial Balance

 Prepared after all adjusting entries are journalized and
posted.

 Purpose is to prove the equality of debit balances and

credit balances in the ledger.

 Is the primary basis for the preparation of financial

statements.

3-49 LO 6 Describe the nature and purpose of the adjusted trial balance.

49

Illustration 3-25

3-50 LO 6

50
 The Adjusted Trial Balance

Review Question
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 posted.

3-51 LO 6

51

The Financial Statements

Financial Statements are prepared directly from the

Adjusted Trial Balance.

Owner’s
Income Balance
Equity
Statement Sheet
Statement

3-52 LO 6 Describe the nature and purpose of the adjusted trial balance.

52
 Illustration 3-26
Preparation of the income statement and owner’s
equity statement from the adjusted trial balance
3-53 LO 6

53

Illustration 3-27
Preparation of the balance sheet from
the adjusted trial balance
3-54 LO 6

54
 APPENDIX 3B Concepts in Action

Qualities of Useful Information

According to the FASB, useful information should possess two
fundamental qualities, relevance and faithful representation.
 Relevance Accounting information has relevance if it would
make a difference in a business decision. Information is
considered relevant if it provides information that has predictive
value, that is, helps provide accurate expectations about the
future, and has confirmatory value, that is, confirms or corrects
prior expectations. Materiality is a company-specific aspect of
relevance. An item is material when its size makes it likely to
influence the decision of an investor or creditor.

3-55 LO 8 Discuss financial reporting concepts.

55

APPENDIX 3B Concepts in Action

Qualities of Useful Information

According to the FASB, useful information should possess two
fundamental qualities, relevance and faithful representation.
 Faithful Representation Faithful representation means that
information accurately depicts what really happened. To provide
a faithful representation, information must be complete (nothing
important has been omitted), neutral (is not biased toward one
position or another), and free from error.

3-56 LO 8 Discuss financial reporting concepts.

56
 APPENDIX 3B Concepts in Action

Qualities of Useful Information

ENHANCING QUALITIES

Comparability results Information is Information has the

when different verifiable if quality of
companies use the independent understandability
same accounting observers, using the if it is presented in a
principles. same methods, obtain clear and concise
similar results. fashion.

Consistency means that

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

3-57 LO 8 Discuss financial reporting concepts.

57

APPENDIX 3B Concepts in Action

Assumptions in Financial Reporting Illustration 3B-2

Monetary Unit Economic Entity

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

3-58 LO 8 Discuss financial reporting concepts.

58
 APPENDIX 3B Concepts in Action

Assumptions in Financial Reporting Illustration 3B-2

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.

3-59 LO 8 Discuss financial reporting concepts.

59

APPENDIX 3B Concepts in Action

Principles in Financial Reporting

MEASUREMENT PRINCIPLES

HISTORICAL FAIR VALUE

COST Indicates that
Or cost principle, assets and
dictates that liabilities should be
companies record reported at fair
assets at their value (the price
cost. received to sell an
asset or settle
a liability).

3-60 LO 8 Discuss financial reporting concepts.

60
 APPENDIX 3B Concepts in Action

Principles in Financial Reporting

REVENUE EXPENSE FULL
RECOGNITION RECOGNITION DISCLOSURE
PRINCIPLE PRINCIPLE PRINCIPLE
Requires that Dictates that Requires that
companies efforts (expenses) companies disclose
recognize revenue be matched with all circumstances
in the accounting results (revenues). and events that
period in which the Thus, expenses would make a
performance follow revenues. difference to
obligation is financial statement
satisfied. users.

3-61 LO 8 Discuss financial reporting concepts.

61

APPENDIX 3B Concepts in Action

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.

3-62 LO 8 Discuss financial reporting concepts.

62