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CHAPTER 3
ADJUSTING THE ACCOUNTS
LEARNING OBJECTIVES
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.
*7. PREPARE ADJUSTING ENTRIES FOR THE ALTERNATIVE
TREATMENT OF DEFERRALS.
*8. DISCUSS FINANCIAL REPORTING CONCEPTS.
CHAPTER REVIEW
Timing Issues
- (L.O. 1) The time period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods.
- Accounting time periods are generally a month, a quarter, or a year. An accounting time period that is one year in length is a fiscal year.
Accrual Basis of Accounting
- (L.O. 2) The revenue recognition and expense recognition principles are used under the accrual basis of accounting. Under cash basis accounting, revenue is recorded only when cash is received and expenses are recorded only when paid.
- Generally accepted accounting principles require accrual basis accounting rather than cash basis accounting because the cash basis of accounting often leads to misleading financial statements.
Revenue Recognition Principle
- The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied.
The Expense Recognition Principle
- The expense recognition principle requires that efforts (expenses) be matched with results (revenues).
Adjusting Entries
- (L.O. 3) Adjusting entries are made in order for: a. Revenues to be recorded in the period in which services are performed, and for expenses to be recognized in the period in which they are incurred. b. The revenue recognition and expense recognition principles are followed.
- Adjusting entries are required every time financial statements are prepared. Adjusting entries can be classified as (a) deferrals (prepaid expenses or unearned revenues) or (b) accruals (accrued revenues or accrued expenses).
Deferrals
- (L.O. 4) Prepaid expenses are expenses paid in cash before they are used or consumed. a. Prepaid expenses expire with the passage of time or through use and consumption. b. An asset-expense account relationship exists with prepaid expenses. c. Prior to adjustment, assets are overstated and expenses are understated. d. The adjusting entry results in a debit to an expense account and a credit to an asset account. e. Examples of prepaid expenses include supplies, insurance, and depreciation. f. To illustrate a prepaid adjusting entry, assume on October 1, Kubitz Company pays $2,400 cash to Sandy Insurance Co. for a one-year insurance policy effective October 1. The adjusting entry at October 31 is: Insurance Expense ($2,400 X 1/12) ................................... 200 Prepaid Insurance ...................................................... 200
e. To illustrate an accrued expense adjusting entry, assume Schwenk Company incurs salaries and wages of $4,000 during the last week of October that will be paid in November. The adjusting entry on October 31 is:
Salaries and Wages Expense .................................... 4, Salaries and Wages Payable ............................. 4,
- Each adjusting entry affects one balance sheet account and one income statement account.
Adjusted Trial Balance
- (L.O. 6) After all adjusting entries have been journalized and posted an adjusted trial balance is prepared. This trial balance shows the balances of all accounts, including those that have been adjusted, at the end of the accounting period.
- The purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments have been made.
- The accounts in the adjusted trial balance contain all data that are needed for the preparation of financial statements.
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 3-
(a) Prepaid Insurance — to recognize insurance expired during the period.
(b) Depreciation Expense — to account for the depreciation that has occurred on the asset during the period.
(c) Unearned Service Revenue — to record revenue earned for services performed.
(d) Interest Payable — to recognize interest accrued but unpaid on notes payable.
BRIEF EXERCISE 3-
Item
(a) Type of Adjustment
(b) Account Balances before Adjustment
- Prepaid Expenses Assets Overstated Expenses Understated
- Accrued Revenues Assets Understated Revenues Understated
- Accrued Expenses Expenses Understated Liabilities Understated
- Unearned Revenues Liabilities Overstated Revenues Understated
BRIEF EXERCISE 3-
Dec. 31 Depreciation Expense 4,
Supplies ($6,700 – $2,500) ............................ 4,
Supplies Supplies Expense 6,700 12/31 4,200 12/31 4, 12/31 Bal. 2,
BRIEF EXERCISE 3-
- Dec. 31 Interest Expense ........................................... 400 Interest Payable ..................................... 400
- 31 Accounts Receivable .................................... 1, Service Revenue.................................... 1,
- 31 Salaries and Wages Expense ....................... 900 Salaries and Wages Payable ................ 900
BRIEF EXERCISE 3-
Account
(a) Type of Adjustment
(b) Related Account Accounts Receivable Accrued Revenues Service Revenue Prepaid Insurance Prepaid Expenses Insurance Expense Accum. Depr. — Equipment Prepaid Expenses Depreciation Expense Interest Payable Accrued Expenses Interest Expense
Dec. 31 Unearned Service Revenue 2,
BRIEF EXERCISE 3-
PARSONS COMPANY
Income Statement For the Year Ended December 31, 2014
Revenues Service revenue .................................................... $37, Expenses Salaries and wages expense ............................... $16, Rent expense ........................................................ 4, Insurance expense ............................................... 2, Supplies expense ................................................. 1, Depreciation expense .......................................... 1, Total expenses .............................................. 24, Net income ................................................................... $12,
BRIEF EXERCISE 3-
PARSONS COMPANY
Owner’s Equity Statement For the Year Ended December 31, 2014
Owner’s capital, January 1 ............................................................. $15, Add: Net income ............................................................................ 12, 27, Less: Drawings .............................................................................. 7, Owner’s capital, December 31 ....................................................... $20,
*BRIEF EXERCISE 3-
(a) Apr. 30 Supplies ......................................................... 700 Supplies Expense .................................. 700
(b) 30 Service Revenue ........................................... 3, Unearned Service Revenue................... 3,
BRIEF EXERCISE 3-
(a) Predictive value. (b) Confirmatory value. (c) Materiality. (d) Complete. (e) Free from error. (f) Comparability. (g) Verifiability. (h) Timeliness.
BRIEF EXERCISE 3-
(a) Relevant. (b) Faithful representation. (c) Consistency.
BRIEF EXERCISE 3-
