Adjusting the Accounts — Chapter 3 Study Guide
Adjusting entries update account balances at period-end so revenues and expenses land in the right accounting
period before financial statements are prepared. This guide follows the chapter’s four learning objectives.
1. Key Concepts
Time Period Assumption
• Time Period (Periodicity) Assumption — a company’s economic life can be divided into artificial time
periods (month, quarter, year) so results can be reported regularly.
• Fiscal year: any 12-month accounting period. Calendar year: January 1 – December 31.
Accrual-Basis vs. Cash-Basis Accounting
Accrual-basis accounting is required under GAAP:
Accrual Basis (GAAP) Cash Basis (not GAAP)
Revenue recorded when… the performance obligation is satisfied cash is received
(earned)
Expense recorded when… incurred, matched to the revenue it cash is paid
helped earn
Revenue & Expense Recognition
• Revenue Recognition Principle — recognize revenue in the period the performance obligation is satisfied.
• Expense Recognition Principle (Matching) — match expenses to the period whose revenue they helped
generate. "Let the expenses follow the revenues."
2. Why We Need Adjusting Entries
• Some events (supplies used, rent earned, interest accruing) aren’t recorded day to day.
• The unadjusted trial balance isn’t complete or up to date.
• Required every time financial statements are prepared.
• Key fact: every adjusting entry affects one income statement account and one balance sheet account —
and never touches Cash.
3. The Four Types of Adjusting Entries
Quick sort: did cash move before the revenue/expense should be recognized, or after?
• Cash moved first → Deferral (Prepaid Expense or Unearned Revenue)
• Cash moves later → Accrual (Accrued Revenue or Accrued Expense)
A. Prepaid Expenses (Deferral)
• Cash paid in advance for something not yet used or consumed — insurance, supplies, rent, advertising,
depreciation.
• Before adjustment: Assets overstated, Expenses understated.
• Entry: Dr. Expense / Cr. Asset (or Contra-Asset for depreciation).
• Example: Paid $600 for a 1-year policy; $50 expires per month → Dr. Insurance Expense 50 / Cr. Prepaid
Insurance 50.
B. Unearned Revenues (Deferral)
• Cash received in advance for services not yet performed — rent, subscriptions, customer deposits, tickets.
• Before adjustment: Liabilities overstated, Revenues understated.
• Entry: Dr. Liability / Cr. Revenue.
• Example: Received $1,200 in advance; $400 of work completed this month → Dr. Unearned Service
Revenue 400 / Cr. Service Revenue 400.
C. Accrued Revenues (Accrual)
• Revenue earned but not yet billed or received in cash — interest, rent, services performed.
• Before adjustment: Assets understated, Revenues understated.
• Entry: Dr. Accounts Receivable / Cr. Revenue.
• Example: $200 of services performed but not yet billed → Dr. Accounts Receivable 200 / Cr. Service
Revenue 200.
D. Accrued Expenses (Accrual)
• Expense incurred but not yet paid or recorded — interest, salaries, taxes, rent.
• Before adjustment: Expenses understated, Liabilities understated.
• Entry: Dr. Expense / Cr. Liability.
• Example: 1 month’s interest on a $5,000 note at 12% annual = $5,000 × 12% × 1/12 = $50 → Dr. Interest
Expense 50 / Cr. Interest Payable 50.
4. Depreciation — Quick Notes
• Depreciation allocates an asset’s cost to expense over its useful life — it’s an allocation, not a valuation (it
doesn’t track market value).
• Accumulated Depreciation is a contra-asset account (credit balance) that offsets the related asset on the
balance sheet.
• Book Value = Cost − Accumulated Depreciation
5. Master Summary Table (Memorize This)
If you memorize one table for the exam, make it this one:
Type Before Adjustment Adjusting Entry
Prepaid Expenses Assets overstated; Expenses understated Dr. Expenses / Cr. Assets
Unearned Revenues Liabilities overstated; Revenues understated Dr. Liabilities / Cr. Revenues
Accrued Revenues Assets understated; Revenues understated Dr. Assets / Cr. Revenues
Accrued Expenses Expenses understated; Liabilities Dr. Expenses / Cr. Liabilities
understated
6. The Adjusted Trial Balance
• Prepared after all adjusting entries are journalized and posted.
• Purpose: proves total debits = total credits after adjustments.
• It’s the primary basis for preparing the financial statements.
• Prep order: Income Statement → Owner’s Equity Statement → Balance Sheet (net income flows into the
equity statement; ending capital flows into the balance sheet).
7. Self-Check Questions
Q1. A company pays $2,400 for a 1-year insurance policy on July 1. What’s the Dec 31 year-end adjusting
entry?
Q2. Unearned Rent Revenue has a $3,000 balance; $1,000 has been earned by month-end. What’s the adjusting
entry?
Q3. Employees are owed $900 in unpaid wages at year-end. What’s the adjusting entry?
Q4. A company performed $500 of services that haven’t been billed yet. What’s the adjusting entry?
Q5. True or False: Adjusting entries can involve the Cash account.
Answer Key
• A1. Dr. Insurance Expense 1,200 / Cr. Prepaid Insurance 1,200 (6 months × $200/mo)
• A2. Dr. Unearned Rent Revenue 1,000 / Cr. Rent Revenue 1,000
• A3. Dr. Salaries and Wages Expense 900 / Cr. Salaries and Wages Payable 900
• A4. Dr. Accounts Receivable 500 / Cr. Service Revenue 500
• A5. False — adjusting entries never include Cash.
Appendix — Only If Your Syllabus Covers It
• Alternative treatment: some companies debit prepayments directly to an Expense account (instead of an
Asset), or credit advance receipts directly to Revenue (instead of a Liability), for convenience — the year-
end adjustment then simply works in reverse.
• Qualitative characteristics: Relevance and Faithful Representation (fundamental); Comparability,
Consistency, Verifiability, Timeliness, Understandability (enhancing).
• Assumptions & principles: Monetary Unit, Economic Entity, Going Concern, Time Period; Historical Cost
vs. Fair Value measurement; Cost Constraint (benefit of information should exceed the cost of providing
it).