Chapter 3: The Adjusting Process

1. Introduction to Adjusting Process

• Accrual Basis of Accounting: Revenues and related expenses reported in the period when a service is performed or product is delivered.
  • Matching Principle: Expenses recorded when incurred, not necessarily when cash is paid. Revenue reported when earned, not necessarily when cash is received.
  • Required by GAAP.
• Cash Basis of Accounting: Revenues and expenses reported when cash is received or paid.
• Need for Adjusting Entries: Distinction between accrual and cash basis necessitates adjustments.

2. The Adjusting Process

• Definition: Analysis and updating of accounts at the end of the period before financial statements are prepared.
• Adjusting Entries: Affect at least one income statement account and one balance sheet account.

Reasons for Adjustments

1. Revenues/expenses may be unrecorded at end of period.
2. Some expenses not recorded daily (e.g., wages).
3. Revenues/expenses incurred over time rather than in separate transactions (e.g., unearned revenue).

3. Types of Adjustments

A. Accruals

• Definition: Revenue has been earned or an expense incurred but not recorded.
  • Accrued Revenues: Recorded by debiting an asset account (Accounts Receivable) and crediting a revenue account.
  • Example: ABC company provides 25 hours of service worth $500 that won’t be billed until January 1st. Adjusting entry:
    • Debit Accounts Receivable $500
    • Credit Revenue $500

B. Deferrals

• Definition: Cash related to future revenue/expense has been initially recorded as a liability or asset.
  • Types of Deferrals:
    1. Unearned Revenue: Liability created when cash is received before service/product is provided.
       • Adjusting entry: Debit liability account (Unearned Rent) and credit revenue account.
       • Example: Tenant pays $12,000 rent for the year; 3 months earned is $3,000. Adjusting entry:
         • Debit Unearned Rent $3,000
         • Credit Revenue $3,000
    2. Prepaid Expenses: Asset created when cash is paid in advance for a future expense.
       • Adjusting entry: Debit expense account and credit asset account.
       • Example: Supplies used from $5,000 to $1,000 (used $4,000). Adjusting entry:
         • Debit Supplies Expense $4,000
         • Credit Supplies $4,000
       • Example: Prepaid Insurance of $2,400, $200 used. Adjusting entry:
         • Debit Insurance Expense $200
         • Credit Prepaid Insurance $200

C. Depreciation

• Definition: Decline in usefulness of fixed assets over time.
• Adjusting Entry: Debit Depreciation Expense and credit Accumulated Depreciation (a contra asset).
• Formula: Book Value = Cost of Asset - Accumulated Depreciation.

4. Adjusted Trial Balance

• Definition: Prepared after all adjusting entries to verify total debits and credits are equal before financial statements.

5. Practice Problems

Problem 1: Adjusting Entry for Salaries

• Weekly salaries of $35,000; adjusting entry for fiscal period ending on Tuesday:
  • Daily salary: $7,000; Amount owed for Monday and Tuesday: $14,000.
  • Entry: Debit Salary Expense $14,000; Credit Salaries Payable $14,000.

Problem 2: Prepaid Rent Payment

• Prepaid rent $3,600, monthly rent $900; balance on January 31:
  • $3,600 - $900 = $2,700.

Problem 3: Net Book Value of Fixed Asset

• Book value formula: Cost of asset - Accumulated depreciation.

Problem 4: Adjusting Entry for Supplies Used

• Entry: Debit Supplies Expense and Credit Supplies.

Conclusion

• Questions welcomed. Hope you have a great day!