Study Objectives-: Chapter 3-The Basics of Adjusting Entries
Study Objectives-: Chapter 3-The Basics of Adjusting Entries
Study Objectives-: Chapter 3-The Basics of Adjusting Entries
3. T or F: All adjustments affect both the Balance Sheet and the Income
Statement.
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1. Cash basis—an accounting method in which an expense is recorded when
cash is paid and revenue is recorded when cash is received. Cash-basis
accounting is NOT in accordance with GAAP.
2. Accrual basis—an accounting method in which an expense is recorded
when it is incurred and revenue is recorded when it is earned. It is the basis
of accounting in which transactions that change a company’s financial
statements are recorded in the periods in which the events occur.
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2. Identify the performance obligations in the contract which are
contractual promises with a customer to transfer a good or service.
3. Determine the transaction price (amount entity expects to be entitled).
4. Allocate the transaction price to the performance obligations in the
contract.
5. Recognize revenue when (or as) the entity satisfies each performance
obligation by transferring a good or service to a customer which is when
customer obtains control of the good or service and amount recognized is
amount allocated to the satisfied performance obligation.
F. Define accruals and deferrals .
1. Accruals—Expenses incurred and revenue earned in the current
accounting period but not recorded as of the end of the period. To accrue
means to build up or to accumulate. Thus, an accrual is a buildup or
accumulation of revenue or an expense that has not been recorded by a
routine journal entry.
2. Deferrals—Expenses and revenues that have been recorded in the
current accounting period but are not incurred or earned until a future
period. To defer means to put off or to postpone. Thus a deferral is a putting
off or a postponement of revenue or an expense that has been recorded by a
routine journal entry but belongs to the future.
G. Define the Going Concern Concept —financial reports of a business are
prepared with the expectation that the business will remain in operation
indefinitely. Since this concept assumes that a business will continue indefinitely
into the future, by accruing expenses and revenues, it is understood that the
business has a future.
H. The Basics of Adjusting Entries:
1. Adjusting entries are entries made at the end of an accounting period
to ensure that the revenue recognition and matching principles are
followed.
2. Adjusting entries are required every time financial statements are
prepared and are dated as of the balance sheet date.
3. Adjusting entries are needed because:
a) Some events are not journalized daily because it is
inexpedient to do so. Examples are the consumption of supplies and
the earning of wages by employees.
b) Some costs are not journalized during the accounting period
because they expire with the passage of time rather than through
recurring daily transactions. Examples are equipment deterioration,
and rent and insurance expiring.
c) Some items may be unrecorded. An example of a utility bill
that will not be received and/or paid until the next accounting period.
I. Types of Adjusting Entries:
1. Prepayments:
a) Prepaid Expenses—expenses paid in cash and recorded as assets
(or expenses as shown in the chapter appendix—alternative treatment of
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prepaid expenses) before they are used or consumed. Depreciation of
plant assets falls into this category.
b) Unearned Revenues—cash received and recorded as liabilities
(or revenues as shown in the chapter appendix—alternative treatment of
unearned revenues) before revenue is earned.
2. Accruals:
a) Accrued Revenues—revenues earned but not yet received in
cash or recorded.
b) Accrued Expenses—expenses incurred but not yet paid in cash
or recorded.
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2014 Adjusting Entries
Dec. 31 Salaries Expense 12,000.00
Salaries Payable 12,000.00
3. An adjusting entry, such as one for an accrued expense, affects both the
income statement and the balance sheet) as it results in an increase (debit)
to an expense account and an increase (credit) to a liability account. In the
case of an accrued expense such as accrued salaries, the income statement is
affected because an expense account (Salaries Expense) is debited; a
balance sheet account is affected because a liability account (Salaries
Payable) is credited.
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revenues. Thus with accrued interest, additional interest will be added to the
interest expense account.
1. How to calculate the due date of a note:
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General Journal Page 1
Date Account Title P.R. Debit Credit
20-- Adjusting Entries
Dec. 31 Interest Expense 280.00
Interest Payable 280.00
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III. Accounting for Accrued Revenue . The accrual of revenue creates
assets. Accrued revenue has been earned in the current accounting period but the
cash will NOT BE RECEIVED until the next period. Accrued revenue is also called
an Accrued Asset as the debit will be to a Receivable (an asset) account when
accrued revenue is credited). Helpful hint to remember what is done with Accruals:
The “A” in Accrual means add to expense or revenue as the adjusting entry will be
adding to expenses or to revenues in this case. Remember that the goal is to adhere to
the revenue recognition principle—a business earns (realizes) revenue when goods or
services are sold to customers, even though cash may not be collected until sometime
in the future. Therefore, to make sure that the correct amount of revenue is shown that is
earned each fiscal year for the accrual basis of accounting, some revenue may need to
be accrued that has been earned but not yet recorded. Adjusting entries to accrue
revenue will affect both an income statement (credit to a revenue) and a balance sheet
(debit to a receivable) account ALL adjusting entries effect one Income Statement
account and one Balance Sheet account.
A. Explain accrued rent revenue and the adjustment needed.
1. Accrued rent revenue—revenue earned but not yet received.
2. Steps to prepare the adjusting entry:
a. Calculate the amount of rent earned.
b. Prepare the adjusting entry—an adjusting entry for accrued
revenues results in an increase (debit) to an asset account and an
increase (credit) to a revenue:
General Journal Page 1
Date Account Title P.R. Debit Credit
20-- Adjusting Entries
Dec. 31 Rent Receivable 1,200.00
Rent Income 1,200.00
c. Post to the General Ledger where the Rent Receivable will be
shown under the current asset section on the Balance Sheet and Rent
Income account will be closed and its balance listed as nonoperating
revenue on the income statement:
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3. A good way to understand the concept of accrued revenue is the
mirror image concept—accrued revenue is the mirror image of accrued
expenses. A rent accrual can be shown as follows:
a. From the Lessor perspective, the entry would be:
Debit—Rent Receivable 1,200
Credit—Rent Income 1,200
b. From the Lessee perspective, the entry would be:
Debit—Rent Expense 1,200
Credit—Rent Payable 1,200
4. Affect if the adjusting entry for accrued revenues is OMITTED:
a. Revenues are understated as did not accrue the additional revenue
of Rent Income. Set up the accounting equation with simple balances in
the accounts if fail to do the adjustment: A = L + OE + R – E or 200 =
100 + 50 +100 -50.. Revenues are showing a balance of $100 but the
balance SHOULD BE (S/B) $110 as an additional revenue of $10 should
have been accrued. Therefore revenues are understated by $10 if the
adjusting entry is omitted.
b. Assets are understated as did not accrue the additional receivable
owed to the company of Rent Receivable. The accounting equation is
showing the balances in the accounts if fail to do the adjustment.
Assets are showing a balance of $200 but the balance SHOULD BE (S/B)
$210 as an additional receivable of $10 should have been accrued.
Therefore assets are understated by $10 if the adjusting entry is omitted.
c. Net income is understated as did not accrue the additional revenue
of Rent Income which would increase the amount of net income as
revenues increase income and owner’s equity. The net income shows $50
($100 Revenues - $50 Expenses) if fail to do the adjustment. When the
accrued revenue is made the net income is $60 ($110 Revenues - $50
Expenses). Therefore net income is understated by $10 if the adjusting
entry is omitted.
B. Describe other types of Accrued Revenue:
1. In Chapter 8 Notes Receivable are covered and should be considered
as the mirror image of Notes Payable. Calculations of due date and interest
are identical for notes payable and notes receivable and where one company’s
interest expense is another company’s interest income. To accrue interest
income:
a. Calculate interest earned from the date of the note until the
end of the accounting period—P x R x T.
b. Record the adjusting entry:
Debit—Interest Receivable
Credit—Interest Income
2. Any unbilled revenues such as fees earned or sales made but where
the cash has not yet been received needs to be accrued to accounts
receivable. Normally the name of the receivable account will match the
name of the revenue account as shown in the above examples (i.e. Rent
Receivable/Rent Income; Interest Receivable/Interest Income, etc.) unless
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the revenue is for the regular income for the business. The example of fees
earned, but not yet recorded example:
Debit—Accounts Receivable
Credit—Fees Earned
A. Explain the entries needed when deferred expenses are first recorded as assets.
1. Define deferred expense—advance payment for goods or services that
benefit more than one accounting period. Deferred expenses are actually
Prepaid expenses (supplies, prepaid insurance, prepaid rent, prepaid
advertising, etc.). Deferred expenses have already been paid, but will
benefit future periods. To match (Matching principle) revenue and
expenses properly, a part of the deferred expense must be “put off” into
the future (part that has future benefit) and part must be recognized in the
current period (part that has been used or expired). Be Careful with the
word, “Expense,” as many students get confused thinking that the
account must be an Expense account but the usual transaction is to
record the amounts paid for expenses paid in advance as an asset NOT
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AN EXPENSE. If the prepayment will become an expense in one year or
less, then the prepaid expense account is listed under the “Current
Asset” section of the Balance Sheet. If the prepayment will become an
expense longer than one year, it is shown in the “Other Asset” section
(long-term section) of the Balance Sheet as a Deferred charge.
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purchased advertising supplies costing $2,500 on October 5. A debit
(increase) was made to the asset Advertising Supplies. This account shows
a balance of $2,500 on the October 31 trial balance (T.B.). The adjustment
will be the amount of supplies that have been USED. At October 31st, an
inventory of supplies is taken and it is determined that $1,000 of supplies
is still on hand. In order to determine the amount of supplies used, you
must SUBTRACT. THIS STEP IS OFTEN FORGOTTEN and should be
done as follows:
Balance of account on T.B. 2,500.00
- Inventory count (amount on hand) - 1,000.00
= Amount USED (the adjustment) 1,500.00
Assets = Liabilities + Owner’s Equity + Revenues - Expenses
Adver. Supplies Adver. Supplies Exp.
2,500 1,500 USED 1,500
1,000
Note that after the adjusting entry, the balance of the Advertising Supplies account,
$1,000 reflects the amount shown in the inventory count or the amount of the
supplies still on hand. Every adjusting entry affects both the balance sheet and the
income statement. For example, the adjustment for supplies used, the debit is to
Supplies Expense (an income statement account) and the credit is to supplies (a
balance sheet account). This will always hold true.
5. Illustrate the adjustment needed for depreciation of assets .
a. Define depreciation—an allocation process in which the cost of a long-
term asset (except land as land is considered permanent and is assumed
to last forever, so depreciation is not allowed) is divided over the
periods in which the asset is used (useful life) in the production of the
business’s revenue in a rational and systematic manner. The objective of
depreciation accounting is to spread the cost of a long-term asset over
the assets’ useful life, rather than treating the cost of an asset as an
expense in the year of purchase. TYPICAL STUDENT
MISCONCEPTION: in accounting for depreciation, students often
think of depreciation in the economic sense. That is, they view it as a
valuation process used to record the decline in the value of an asset. In
accounting, depreciation has nothing to do with value. It refers only
to the allocation of an asset’s cost over its estimated useful life. As time
passes, the usefulness of assets will decline, and eventually they will no
longer serve their original purpose so the accounting system, must,
therefore, reflect the fact that the equipment and furniture will
gradually wear out or become obsolete and will have to be replaced.
b. Describe the straight-line method of computing depreciation—a
popular method of calculating depreciation that yields the same
amount of depreciation for each full period an asset is used. When
calculating the amount of the adjustment for straight-line depreciation,
you should always calculate a yearly amount first, then a monthly
amount. See example on page 99 of the textbook.
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c. Describe the contra-account Accumulated Depreciation. The
depreciation adjustment is not reflected directly in the asset account.
Accumulated Depreciation is a contra asset account—an account
whose balance is opposite (offset against) the asset to which it relates.
Since asset accounts have debit balances, contra asset accounts (the
opposite of assets) have credit balances. Contra means opposite or
against like in the words contradiction, contraband, and contrary
(similar to what drawing and expenses do to owner’s equity).
Depreciation is recorded in the Accumulated Depreciation account ,
rather than directly in the asset account, so as to maintain both the
asset account showing the original (or historical) cost of the asset
and the Accumulated Depreciation account showing how much the
asset has depreciated (the total cost that has expired to date). This is
especially needed when the asset is sold to determine any gain or loss
on the sale of the asset. The questions that must be answered on the
tax return are:
1. What was the original cost of the asset? (the amount is
found in the asset account)
2. What is the total depreciation that has been taken on
the asset? (the amount is found in the accumulated
depreciation account)
3. How much was the asset sold for?
4. What is the gain or loss on sale?
The use of a contra account provides disclosure of both the
original cost of the equipment and the total cost that has expired
to date.
The following example illustrates the process of allocating expired (deferred)
prepayments to expenses:
Assets = Liabilities + Owner’s Equity + Revenues - Expenses
Office Supplies Office Supplies Exp.
125 45 USED 45
150
275
230
Prepaid Insur. Insurance Expense
240 20 USED (EXPIRED) 20
220
Office Equip.
3,000
Acc.Dep-Off Eq USED (ALLOCATED) Depr.Exp.-Off. Eq.
50 50
Office Furn.
2,000
Acc.Dep-Off Furn Depr.Exp.-Off.Furn.
USED (ALLOCATED)
30 30
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d. Every adjusting entry affects both the balance sheet and the income
statement. For example, the adjustment for depreciation, the debit is to
Depreciation Expense (an income statement account) and the credit is to
accumulated depreciation (a balance sheet account).
7. Explain the entries needed when deferred expenses are first recorded as
expenses.
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a. There are two ways to initially record deferred or prepaid
expenses (1) as assets or (2) as expenses. Both methods yield the
identical results on the income statement and the balance sheet. A
question usually arises at this point as to WHY would this entry be
initially recorded as an EXPENSE and believe it or not, from an
auditor’s perspective, this is the METHOD that I have observed is
the MORE COMMON method done in practice. Some of the
reasons are:
i. The entry was made by an inexperienced or not
properly educated bookkeeper who believes that any time an
expenditure is made; IT MUST BE AN EXPENSE because
money has been spent and anytime money is spent, it is an
expense with that thinking.
ii. There is actually a conceptual reason for recording this
type of expenditure initially as an expense especially dealing
with the expenditure for supplies. If it is believed that all of
the supplies would be used by the end of the accounting period,
then it would be wise to initially record the amount as an
expense because then it would not be necessary to make an
adjusting entry at the end of the accounting period. This
reasoning does not make sense, though, when paying for an
insurance policy because you would know at the time of the
payment if the policy would totally expire or not by the end of
the accounting period. But if most of the policy will be expired,
then it could be initially recorded as an expense.
b. The adjusting entry that transfers the amount of the
expenditure that is unexpired (insurance in the example) to an
asset account.
c. The closing entry that closes the balance of the expense account
to the income summary which then becomes part of owner’s
equity for the net income or net loss of the company.
d. Consider the concept of whether a reversing entry will be
considered or not. . Recall the RULE TO MASTER: Whenever an
adjusting entry creates a Balance Sheet account (liability or asset)
reversal is possible and desirable as well so that the adjusting entry
into the created account WILL NOT BE FORGOTTEN. Since an
asset account had been created in the adjusting process (prepaid
insurance in the example), a reversing entry is needed to return
the prepayment to an expense in the next accounting period.
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record correct expenses incurred and revenues earned. With deferred
expenses and deferred revenues, not all adjusting entries can be
reversed as can be done with accrued expenses and accrued revenues.
Another liability called unearned (deferred) revenue that does not have the word,
"payable," with the name of the account but it is a liability (a debt owed by the
company) as it originates from receiving cash in advance before a revenue
(income earned from carrying out the activities of a firm) is performed. The
reason that this account is a liability is that a service or sale must be made
requiring a performance in the future (a liability as a debt of performance is
owed) or the money must be refunded (a liability as a debt owed) if the job is
not done.
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a revenue account. The accounting equation shows the balances in the
accounts if fail to do the adjustment. Liabilities are showing a balance
of $100 but the balance SHOULD BE (S/B) $90 as a liability should
have been reduced by $10 for the portion earned. Therefore liabilities
are overstated by $10 if the adjusting entry is omitted.
c. Net income is understated as did not record the additional
revenue that had been earned where revenues increase income and
owner’s equity. A net income shows of $50 ($100 Revenues - $50
Expenses) if fail to do the adjustment. When the additional revenue is
recorded the net income is $60 ($110 Revenues - $50 Expenses).
Therefore net income is understated by $10 if the adjusting entry in
omitted.
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net income or net loss of the company. (Closing entries are covered in
chapter 4 of the textbook).
4. Decide whether a reversing entry will be considered or not. Recall
the RULE TO MASTER: Whenever an adjusting entry creates a Balance
Sheet account (liability or asset) reversal is possible and desirable as well
so that the adjusting entry into the created account WILL NOT BE
FORGOTTEN. When a deferred or unearned revenue is initially
recorded as revenue, the adjusting process will create or increase a
liability account (some unearned revenue account—unearned
subscriptions income in the example) and since a liability account had
been created or increased in the adjusting process, a reversing entry is
needed to return the prepayment to revenue in the next accounting
period.
B. There are always two methods to account for deferrals. However, though
there are two ways of recording deferrals, there is still just ONE CORRECT
RESULT.
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B. General Ledger:
1. The words “Adjusting Entry” are entered into the Explanation
column which again alerts the readers of the general ledger that these
entries were made at the end of the accounting period to bring the
balances of the accounts up-to-date.
2. The date transferred from the general journal shows that the
entries were made the last day of the accounting period.
C. Preparing the Adjusted Trial Balance:
1. It proves the equality of the total debit balances and the total
credit balances in the ledger after all the adjustments have been made.
2. The accounts in the adjusted trial balance contain all the data that
are needed for the preparation of the financial statements except for the
capital account that may have additional investments in which case that
information would show in the general ledger account.
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