Principle of Accounting

Chapter 3: Adjusting The Accounts

MSC. NGUYEN BAO QUAN

EMAIL: [email protected]
 Learning Objectives
➢Define net income, and explain the concepts underlying income
measurement.
➢Distinguish cash basis of accounting from accrual accounting, and explain
how accrual accounting is accomplished.
➢Identify four situations that require adjusting entries, and illustrate
typical adjusting entries.
➢Prepare financial statements from an adjusted trial balance .
➢Explain the important of ethical measurement of net income and the
relation of net in come to cash flows.
Concepts Underlying Income Measurement
❑Net Income: is the net increase in owner’s equity that results from a
company’s operations.
➢In its simplest form, net income results when revenues exceed
expenses:

➢ When expenses exceed revenues, a net loss results.

✓Revenues: equal the price of goods sold or services rendered during a
specific period.
✓Expenses: are the costs of goods and services used in the process of
producing revenues.
❑Income Measurement Assumptions
• Continuity:
✓The majority of companies present annual financial statements on
the assumption that the business will continue to operate
indefinitely—that is, that the company is a going concern.
✓The continuity assumption states that unless there is evidence to the
contrary, the accountant assumes that the business is a going concern
and will continue to operate indefinitely.
• The continuity assumption allows certain expense and revenue
transactions to be allocated over several accounting periods
• Periodicity (tính chu kỳ):
✓ The periodicity assumption states that although the lifetime of a
business is uncertain, it is nonetheless useful to estimate the business’s
net income in terms of accounting periods.
✓ A 12-month accounting period is called a fiscal year.
• The fiscal year may be the same as the calendar year or some other
12-month period.
✓ Accounting periods of less than a year are called interim periods (kỳ
giữa niên độ).
❑Accrual Basis of Accounting (Matching Rule)
• Under accrual accounting (often referred to as the matching rule) net
income is measured by assigning:
➢Revenues to the accounting period in which the goods are sold or the
services performed. => Revenue recorded when earned, not only
when cash received.
➢Expenses to the accounting period in which they are used to produce
revenue. => Expense recorded when services or goods are used or
consumed in the generation of revenue, not only when cash paid.
• When there is no direct means of connecting expenses and revenues,
costs are allocated among the accounting periods that benefit from
the costs
➢A vehicle’s cost is expensed over the vehicle’s expected useful life
➢Interest on investments is recorded as income even though it may
not have been received
Quiz !!
 Concepts Underlying Accrual Accounting
❑The Cash basis of accounting
The cash basis of accounting is the practice of accounting for revenues
in the period in which cash is received and for expenses in the period in
which cash is paid
With this method, taxable income is calculated as the difference
between cash receipts from revenues and cash payments for expenses.
❑The Accrual accounting
In accrual accounting, revenues and expenses are recorded when they
are earned or incurred rather than when they are received or paid.
❑Recognizing Revenue: the process of determining when revenue
should be recorded.
❑The Securities and Exchange Commission (SEC) requires that all the
following conditions be met before revenue is recognized:
➢Persuasive evidence of an arrangement exists.
➢A product or service has been delivered.
➢The seller’s price to the buyer is fixed or determinable.
➢Collectability is reasonably ensured
❑Recognizing Expenses: Expenses are recorded when all of the
following conditions are met:
➢There is an agreement to purchase goods or services.
➢The goods have been delivered or the services rendered.
➢A price has been established or can be determined.
➢The goods or services have been used to produce revenue.
Note that recognition of the expense does not depend on the payment
of cash.
 The Adjustment Process
Some of the accounts in Blue Design Studio’s
trial balance as of July 31 do not show the
correct balances for preparing the financial
statements.
The trial balance lists prepaid rent of $3,200
for the months of July and August. So, on
July 31, one-half of the $3,200 represents
rent expense for July, and the remaining
$1,600 represents an asset that will be used
in August. An adjustment is needed to
reflect the $1,600 balance in the Prepaid
Rent account and the $1,600 rent expense.
As you will see, several other accounts in
Blue’s trial balance do not reflect their
correct balances. Like the Prepaid Rent
account, they need to be adjusted.
The four types of adjusting entries
• A deferral is the postponement of the recognition of an expense
already paid (Type 1 adjustment) or of revenue received in advance
(Type 3 adjustment).
➢The cash payment or receipt is recorded before the adjusting entry is
made.
• An accrual is the recognition of expense (Type 2 adjustment) or a
revenue (Type 4 adjustment) that has arisen but not been recorded
during the accounting period
➢The cash payment or receipt occurs in a future accounting period,
after the adjusting entry has been made.
Type 1. Allocating recorded costs between two or more accounting
periods.
Examples of these costs are prepayments of rent, insurance, and
supplies and the depreciation of plant and equipment. The adjusting
entry involves an asset account and an expense account.
• Payment of cash, that is recorded as an asset to show the service or
benefit the company will receive in the future.

• Prepayments often occur in regard to:

❑Prepaid Expenses: Companies customarily pay some expenses,
including those for rent, supplies, and insurance, in advance. These
costs are called prepaid expenses

Adjusting entries for prepaid expenses

❑Adjustment for Prepaid Rent
• Transaction: Blue Design Studio paid two months’ rent in advance at the
beginning of July. The advance payment resulted in an asset – the right to
occupy the office for two months. As each day in the month passed, part
of the asset’s cost expired and became an expense. By July 31, one half of
the asset’s cost ($1,600) had expired
• Analysis: The journal entry to record the expiration of prepaid rent
▼ Decreases the asset account Prepaid Rent with a credit
▲ Increases the expense account Rent Expense with a debit
❑Adjustment for Supplies
• Transaction: Blue Design Studio purchased $5,200 of office supplies in
early July. At the end of July, an inventory shows that office supplies
costing $3,660 are still on hand. This means that of the $5,200 of supplies
originally purchased, $1,540 worth were used (became an expense) by
July 31.
• Analysis The journal entry to record the consumption of office supplies
▼ Decreases the asset account Office Supplies with a credit
▲ Increases the expense account Office Supplies Expense with a debit
 TYPE 1: Allocating recorded costs
(Deferred Expense)
• Companies often make expenditures that benefit more than one
period. These costs are debited to an asset account.
• At the end of an accounting period, the amount of the asset that has
been used is transferred from the asset account to an expense
account.
• Two important adjustments of this type are for prepaid expenses and
the depreciation of plant and equipment
=> Debit Expense account / Credit Accumulated Depreciation
❑Depreciation of Plant and Equipment
➢When a company buys a long-term asset— such as a building, truck,
computer —it is, in effect, prepaying for the usefulness of that asset
for as long as it benefits the company.
➢Because a long-term asset is a deferral of an expense, the accountant
must allocate the cost of the asset over its estimated useful life. The
amount allocated to any one accounting period is called depreciation
(or depreciation expense).
➢To maintain historical costs, separate accounts are used to
accumulate the depreciation on each long-term asset
• These Accumulated Depreciation accounts are called contra accounts.
A contra account is paired with a related account. The balance of a
contra account is shown on a financial statement as a deduction from
its related account.
• The net amount is called the carrying value (or book value) of the
asset.
❑Adjustment for Plant and Equipment
• Transaction: On July 31, Blue Design Studio records $300 of
depreciation of office equipment.
• Analysis: The journal entry to record depreciation
▲ Increases the contra account Accumulated Depreciation—Office
Equipment with a credit
▲ Increases the expense account Depreciation Expense—Office
Equipment with a debit
SUPPLIES
• Illustration: Pioneer Advertising purchased supplies costing $2,500 on
October 2. 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 supplies are still on hand.
INSURANCE
• Illustration: October 3 Pioneer Advertising 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.
DEPRECIATION
• Illustration: Pioneer Advertising, assume that depreciation on the
equipment is $480 a year, or $40 per month.

• Accumulated Depreciation is called a contra asset account

Type 3. Allocating recorded, unearned revenues between two or more
accounting periods.
Examples include payments received in advance and deposits made for
goods or services to be delivered or provided in the future. The
adjusting entry involves a liability account and a revenue account
• Receipts of cash that is recorded as a liability because the service has
not been performed

• Unearned Revenues often occur in regard to:

 TYPE 3: Allocating Recorded, Unearned
Revenues (Deferred Revenues)
• When a company receives revenues in
advance, it has an obligation to deliver
goods or perform services. Unearned
revenues are therefore shown in a liability
account
➢As a company delivers part of the goods or
performs part of the services, it earns a part
of the advance receipts.
➢The earned portion must be transferred
from the liability account to a revenue
account
=> Debit Unearned Revenue / Credit Revenue
❑Adjustment for Unearned Revenue
• Transaction: During July, Blue Design Studio received $1,400 from
another firm as advance payment for a series of brochures. By the end
of the month, it had completed $800 of work on the brochures, and the
other firm had accepted the work. On July 31, Blue Design would record
the performance of services for which $800 cash was received in
advance.
• Analysis: The journal entry to record performing services for which cash
was received in advance
▲Increases the owner’s equity account Design Revenue with a credit
▼Decreases the liability account Unearned Design Revenue with a debit
UNEARNED REVENUE
• Illustration: Pioneer Advertising received $1,200 on October 4 from
KN for advertising services expected to be completed by December
31. Unearned Revenue shows a balance of $1,200 in the October 31
trial balance. Analysis reveals that the company performed $400 of
service in October.
Type 4. Recognizing unrecorded, earned revenues.
An example is revenue that a company has earned for providing a
service but for which it has not billed or collected a fee by the end of
the accounting period. The adjusting entry involves an asset account
and a revenue account
• Revenue for services performed but not yet received in cash or
recorded.

• Accrued Revenues often occur in regard to:

 TYPE 4: Recognizing unrecorded, earned
revenues(Accrued Revenues)
• Accrued revenues are revenues that a
company has earned by performing a
service or delivering goods but for which
no entry has been made in the
accounting records.
• Any revenues earned but not recorded
during an accounting period require an
adjusting entry that debits an asset
account and credits a revenue account
❑Adjustment for Design Revenue
Transaction: During July, Blue Design Studio agrees to create two
advertisements for Maggio’s Pizza Company and to finish the first
advertisement by July 31. By the end of July, Blue has earned $400 for
completing the first advertisement, but it will not bill Maggio’s until the
entire project has been completed. On July 31, Blue records the accrual
of $400 of unrecorded revenue.
Analysis: The journal entry to record the accrual of unrecorded revenue
▲ Increases the owner’s equity account Design Revenue with a credit
▲ Increases the asset account Accounts Receivable with a debit
Accrued Revenues
• Illustration: In October, Pioneer Advertising performed services worth
$200 that were not billed to clients on or before October 31.

• On November 10, Pioneer receives cash of $200 for the services

performed.
• Type 2. Recognizing unrecorded expenses.
Examples of these expenses are wages and interest that have been
incurred but are not recorded during an accounting period. The
adjusting entry involves an expense account and a liability account
• Expenses incurred but not yet paid in cash or recorded.

• Accrued expenses often occur in regard to:

 TYPE 2: Recognizing unrecorded expenses
(Accrued Expense)
• At the end of an accounting period, some
expenses incurred during the period have
not been recorded in the accounts
• These expenses require adjusting entries.
Examples include: –Interest on borrowed
money –Wages –Utilities
• As the expense and the corresponding
liability accumulate, they are said to
accrue—hence the term accrued
expenses.
=> Debit Expense Account / Credit Account
Payable
❑Adjustment for Unrecorded (Accrued) Wages
• Transaction: Suppose Blue Design Studio has two pay periods a month
rather than one. In July, its pay periods end on the 12th and the 26th,
as indicated in the calendar below:

By the end of business on July 31, The assistant will have worked three
days (Monday, Tuesday, and Wednesday) beyond the last pay period.
The employee has earned the wages for those days but will not be paid
until the first payday in August. The wages for these three days are
rightfully an expense for July, and the liabilities should reflect that the
company owes the assistant for those days. Because the assistant’s wage
rate is $2,400 every two weeks, or $240 per day ($2,400 410 working
days), the expense is $720 ($240 3 3 days). On July 31, Blue would
record the $720 accrual of unrecorded wages
• Analysis: The journal entry to record the accrual of wages
▲ Increases the owner’s equity account Wages Expense with a debit
▲ Increases the liability account Wages Payable with a credit
ACCRUED SALARIES AND WAGES
• Illustration: Pioneer Advertising paid S&W 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.
Using the Adjusted Trial Balance to Prepare 4
Financial Statements
➢ An adjusted trial balance is prepared after adjusting entries have been
posted to the accounts .
➢ Once the adjusted trial balance is in balance, the financial statements can
be prepared.
➢ Its purpose is to test whether total debits equal total credits after the
adjusting entries have been post and before the financial statements are
prepared.
➢ The balances in the revenue and expense accounts in the adjusted trial
balance are used to prepare the income statement.
➢ The balances in the asset and liability accounts in the adjusted trial
balance and in the statement of owner’s equity are used to prepare the
balance sheet.
Practice !!