Chapter 3

The Adjusting Process

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Under the accrual basis of accounting, revenues are reported in the income statement in the period in which they are earned.

2

The accounting concept supporting the reporting of revenues when they are earned regardless of when cash is received is called the revenue recognition concept.

Revenue Recognition Concept

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The accounting concept supporting reporting revenues and related expenses in the same period is called the matching concept, or matching principle.

Matching Principle

4

Under the cash basis of accounting, revenues and expenses are reported in the income statement in the period in which cash is received or paid.

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The Adjusting Process

Under the accrual basis, at the end of the accounting period some of the accounts need updating for the following reasons:1. Some expenses are not recorded daily.2. Some revenues and expenses are incurred

as time passes rather than as separate transactions.

3. Some revenues and expenses may be unrecorded.

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The analysis and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process.

The Adjusting Process

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Indicate with a Yes or No whether or not each of the following accounts normally requires an adjusting entry.

a. Cash d. Office Equipmentb. Prepaid Rent e. Accounts Receivablec. Wages Expense f. Unearned Rent

Example Exercise 3-1

Accounts Requiring Adjustment

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a. Cash d. Office Equipmentb. Prepaid Rent e. Accounts Receivablec. Wages Expense f. Unearned Rent

NoYes

Yes

NoYes

Yes

Example Exercise 3-1 (continued)

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Prepaid expenses are the advance payment of future expenses and are recorded as assets when cash is paid.

Types of Accounts Requiring Adjustment

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Unearned revenues are the advance receipt of future revenues and are recorded as liabilities when cash is received.

Types of Accounts Requiring Adjustment

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Exhibit 1 Type of Adjustments: Prepaid Expenses and Unearned Revenues

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Accrued revenues are unrecorded revenues that have been earned and for which cash has yet to be received.

Types of Accounts Requiring Adjustment

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Accrued expenses are unrecorded expenses that have been incurred and for which cash has not been paid.

Types of Accounts Requiring Adjustment

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Exhibit 2 Type of Adjustments: Accrued Revenues and Expenses

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Type of Adjustment

Example Exercise 3-2

Classify the following items as (1) prepaid expense, (2) unearned revenue, (3) accrued expense, or (4) accrued revenue.

a. Wages owed but not c. Fees received but not yet paid.earned.

b. Supplies on hand. d. Fees earned but not yet received.

a. Accrued expenseb. Prepaid expense

c. Unearned revenued. Accrued revenue

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NetSolutions’ Supplies account has a balance of $2,000 in the unadjusted trial balance. Some of these supplies have been used. On December 31, a count reveals that $760 of supplies are on hand.

Prepaid Expenses

Supplies (balance on trial balance) $2,000Supplies on hand, December 31 – 760Supplies used $1,240

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Dec. 31 1,240Dec. 31 1,240

Supplies Supplies ExpenseBal. 800

14 55

2,040760

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The debit balance of $2,400 in NetSolutions’ Prepaid Insurance account represents the December 1 prepayment of insurance for 12 months.

Prepaid Expenses

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Dec. 31 200Prepaid InsuranceBal.

2,400

Insurance Expense15 56

2,200 Dec. 31 200

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The prepaid insurance account had a beginning balance of $6,400 and was debited for $3,600 of premiums paid during the year. Journalize the adjusting entry required at the end of the year assuming the amount of unexpired insurance related to future periods is $3,250.

Adjustment for Prepaid Expenses

Example Exercise 3-3

Insurance Expense……………………… 6,750Prepaid Insurance…………………… 6,750

Insurance expired ($6,400 +$3,600 – $3,250).

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Adjustment for Unearned Revenue

Example Exercise 3-4

The balance in the unearned fees account, before adjustment at the end of the year, is $44,900. Journalize the adjusting entry required if the amount of unearned fees at the end of the year is $22,300.

Unearned Fees……………………………. 22,600Fees Earned………………………….. 22,600

Fees earned ($44,900 – $22,300).

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At the end of the current year, $13,680 of fees have been earned but have not been billed to clients. Journalize the adjusting entry to record the accrued fees.

Example Exercise 3-5

Follow My Example 3-5

Accounts Receivable……………………. 13,680Fees Earned………………………….. 13,680 Accrued fees.

Adjustment for Accrued Fees

23

Sanregret Realty Co. pays weekly salaries of $12,500 on Friday for a five-day week ending on that day. Journalize the necessary adjusting entry at the end of the accounting period, assuming that the period ends on Thursday.

Example Exercise 3-6

Adjustment for Accrued Expenses

Salaries Expense……………………….. 10,000Salaries Payable…………………….. 10,000

Accrued salaries [($12,500 ÷ 5 days) × 4 days].

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Fixed assets, or plant assets, are physical resources that are owned and used by a business and are permanent or have a long life.

Fixed Assets

25

As time passes, a fixed asset loses its ability to provide useful services. This decrease in usefulness is called depreciation.

Depreciation

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Normal titles for fixed asset accounts and their related contra asset accounts are as follows:

Fixed Asset Contra AssetLand None—Land is not depreciatedBuildings Accumulated Depreciation—

BuildingsStore Equipment Accumulated Depreciation—Store

EquipmentOffice Equipment Accumulated Depreciation—Office

Equipment

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NetSolutions estimates the depreciation on its office equipment to be $50 for the month of December.

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Dec. 31 50Depreciation Expense Accum. Depr.—Office Equip. 1953

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Dec. 31 50Depreciation Expense

Dec. 31 50Accum. Depr.—Office Equip. 1953

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NetSolutions’ balance sheet would show office equipment at cost, less accumulated depreciation.

Office equipment $1,800 Less accumulated depreciation 50 $1,750

Book value

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The estimated amount of depreciation on equipment for the current year is $4,250. Journalize the adjusting entry to record the depreciation.

Adjustment for Depreciation

Depreciation Expense………...……….. 4,250Accumulated Depreciation— Equipment………………………….. 4,250

Depreciation on equipment.

Example Exercise 3-7

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Exhibit 7 Adjusting Entries—NetSolutions

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Exhibit 7 Adjusting Entries—NetSolutions (continued)

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Example Exercise 3-8

For the year ending December 31, 2010, Mann Medical Co. mistakenly omitted adjusting entries for (1) $8,600 of unearned revenue that was earned, (2) earned revenue of $12,500 that was not billed, and (3) accrued wages of $2,900. Indicate the combined effect of the errors on (a) revenues, (b) expenses, and (c) net income for 2010.

Effect of Omitting Adjustments

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Example Exercise 3-8 (continued)

a. Revenues were understated by $21,100 ($8,600 + $12,500).

c. Net income was understated by $18,200 ($8,600 +12,500 – $2,900).

b. Expenses were understated by $2,900.

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The purpose of the adjusted trial balance is to verify the equality of the total debit and credit balances before the financial statements are prepared.

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Exhibit 9 Adjusted Trial Balance—NetSolutions

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THE END

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