Chapter 3 – Adjusting Accounts for Financial Statements

We need to continue with our study of the accounting cycle. To date, we have analyzed
transactions, journalized transactions, posted transactions and prepared a trial balance (which is
technically the first of three trial balances we will prepare). The next step is the adjusting
process.
Why adjust? Because at the end of the period, there are accounts that do not reflect the accurate
totals.
For example, let’s look at office supplies. We purchased them and they sat on the shelf. Do you
think we have used any Office Supplies over the course of the month/year? Yes! Of course we
did. So, how do we adjust the Office Supply account to correctly reflect the amount of Office
Supplies remaining? We adjust it. If we don’t adjust these accounts, the expenses, revenues and
liabilities are often understated and the assets overstated. More on that later.
Cash vs Accrual Accounting
Cash Basis Accounting – only records transactions when cash is received, or cash is paid (you
will never have a journal entry without the Cash account being used).
 Used for small businesses
 Not acceptable under GAAP
Accrual Basis Accounting – records each transaction as it occurs (whether cash is impacted or
not). Revenues are recorded when earned, Expenses are recorded when incurred.
 Most businesses use Accrual Basis Accounting
 This is what we are studying
Under both methods, the total amount recorded is the same over time – the major difference is
the timing of the recognition of revenues and expenses.
When adjusting the accounts, we use the following steps:
1. Determine what the current account balance equals
2. Determine what the current account balance should equal
3. Record an adjusting entry to get from step 1 to step 2
Adjusting Entry – made at the end of the accounting period used to capture unrecorded
revenues or expenses and the update the asset and liability accounts
 Deferrals – cash payment occurs before the expense is incurred (prepaid expenses) or
cash receipt before revenue is earned (unearned revenue)
 Accruals – expense is recorded before cash is paid (salary expense) or revenue is
recorded before the cash is received (account receivable)
Start Book Demo

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Deferred Expenses – prepaid expenses or advanced payment of future expenses. Expense is not
recognized at the time of the payment and are considered assets until they are “used up”.
 Prepaid Rent
 Prepaid Insurance – How much of the $2,400 in prepaid insurance have we used by the
end of December?
 Office Supplies – How many of the $9,720 in office supplies were used in December?
o We are looking for what is USED UP and we can get it two ways
 They can tell us what is used directly ($400 of office supplies were used
over the month)
 They can tell us what is left over ($100 of office supplies remain to be
used at year end)
 Balance before Adjustment – Office Supplies Used = Office Supplies on
Hand
 Depreciation – if the $26,000 in equipment purchased is expected to have a useful life of
5 years and is estimated to have a value of $8,000 at the end of the 5 years, how much of
the equipment was “used up” during December?
o Plant Assets or Property, Plant and Equipment (PPE) – long-term, tangible
used to produce and sell products and services (land, buildings, equipment,
furniture, automobiles).
o As time passes, their value and usefulness declines, so the cost of these assets
should be spread over the period they are used.
o Depreciation is the allocation of the cost of these assets over their useful lives.
 Accumulated Depreciation – the sum of all the depreciation expense
recorded for the asset to date. It’s a Contra-Asset account. depreciation.
o Contra Account – account that is paired with and listed immediately after its
related account on the financial statements. A contra-account’s normal balance is
OPPOSITE that of its related account
o Book Value – the depreciable asset’s cost – accumulated depreciation
o All PPE depreciate with the exception of Land. Land tends to increase in value
rather than decrease so it is maintained on the books at original cost until it is
disposed of.
*If a deferred expense is not adjusted, assets will be overstated and expenses will be
understated.
Deferred Revenue – liability created when a business collects cash from a customer before it
has completed the service or delivered the product. Has a portion of that revenue been earned at
year end? If so, we need to record it.
 Unearned Revenue – what portion of the $3,000 in unearned consulting revenue has
been earned by the end of December?
*If a deferred revenue is not adjusted, the liability will be overstated and the revenue
understated.

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Accrued Expenses – and expense that a business has incurred but has not yet paid. Always
creates a liability account.
 Accrued salaries expense – FastForward pays its employees every two weeks on Friday.
December 31st lands on a Wednesday. How much salary expense does FastForward owe
at the end of December?
o Don’t forget the follow through (debit the liability and credit cash)
 Accrued interest expense – if a company took a $6,000 loan from the bank at an annual
interest rate of 5%, what would the interest expense be for a single month
o Interest is incurred with the passing of time.
o Interest = principal x rate x time
 Rate is assumed to be annual unless stated otherwise
 Make sure your rate and your time are being expressed same way
 Why divide by 360 instead of 365?
o Don’t forget the follow through (debit the liability and credit cash)
*If an accrued expense is not adjusted, the liabilities and expenses will be understated.
Accrued Revenues – a revenue that is earned but for which cash has not yet been collected (or
billed for). Revenues in one period that result in cash receipts in a future period.
 Accounts Receivable -remember the account receivable for $2,700 that will be paid in
January? Has any of that revenue been earned by the end of December?
 Don’t’ forget the follow through (debit cash and record revenue)
*If an accrued revenue is not adjusted, assets and revenues will be understated.
The Two Rules of Adjusting Entries
1. They will NEVER involve the Cash account
2. They will either
a. Increase a revenue (credit revenue)
b. Increase an expense (debit expense)
QS3-7, 9, 12, 13(b), 14, 15 (a & b)
E3-6, 7
P2-2B
Adjusted Trial Balance – the second trial balance we prepare. List of all the accounts with their
balances adjusted.
Profit Margin – is calculated by dividing Net Income by Net Sales. It shows the percentage of
profit in each dollar of sales. The bigger the better.
E3-18