Chapter 3: The Adjusting Process

Key Definitions

• Accrual Basis of Accounting: Revenues and related expenses are reported when a service is performed or a product is delivered.

  • Matching Principle: Aligns revenue with expenses in the same period.
  • Revenues are recorded when earned, and expenses when incurred, not necessarily when cash is paid.
  • Required by GAAP (Generally Accepted Accounting Principles).

• Cash Basis of Accounting: Revenues and expenses are reported when cash is received or paid.

The Adjusting Process

• Purpose: Analyze and update accounts at the end of the period before preparing financial statements.
  • Adjusting entries will affect at least one income statement account and one balance sheet account.

Reasons for Adjustments

1. Unrecorded Revenues/Expenses: Company may not have billed customers for services/products provided.
2. Irregular Expense Recording: Some expenses (like wages) are not recorded daily.
3. Time-Passed Revenues/Expenses: Some items (like unearned revenue) need adjustment over time.

Types of Adjustments

1. Accruals

• Definition: When revenue has been earned or an expense incurred but not recorded.

  • Accrued Revenues: Recorded by debiting an asset (Accounts Receivable) and crediting a revenue account (e.g., Fees Earned).
  • Example: ABC Company provided $500 worth of services in December but will bill in January. Adjusting entry:
    • Debit Accounts Receivable: $500
    • Credit Revenue: $500

• Accrued Expenses: Recorded by debiting an expense account and crediting a liability account (e.g., Wages Payable).

  • Example: ABC Company owes $250 in wages for four days worked (not yet paid). Adjusting entry:
    • Debit Wages Expense: $250
    • Credit Wages Payable: $250

2. Deferrals

• Definition: When cash related to future revenue/expense has been initially recorded but needs updating.

Types of Deferrals:

• Unearned Revenue:

  • Adjust by debiting the liability account and crediting revenues.
  • Example: Tenant pays $12,000 rent in advance. After three months, adjusting entry:
    • Debit Unearned Rent: $3,000
    • Credit Revenue: $3,000

• Prepaid Expenses:

  • Adjust by debiting the expense account and crediting the asset.
  • Example: Supplies worth $5,000 at the beginning, $1,000 at the end. Used $4,000:
    • Debit Supplies Expense: $4,000
    • Credit Supplies: $4,000
  • Example: Prepaid insurance of $2,400, $200 used:
    • Debit Insurance Expense: $200
    • Credit Prepaid Insurance: $200

3. Depreciation

• Associated with fixed assets which lose value over time.
  • Adjusting entry: Debit Depreciation Expense, Credit Accumulated Depreciation (contra asset).
  • Book Value = Cost of Asset - Accumulated Depreciation.

Adjusted Trial Balance

• Prepared after all adjusting entries to ensure total debits and credits are equal.
• Used to check for errors before financial statements are prepared.

Practice Problems Summary

1. ABC Company Salaries: Adjusting entry for accrued salaries of $14,000 (Debit Salary Expense, Credit Salaries Payable).
2. Prepaid Rent: After adjustment, prepaid rent balance is $2,700.
3. Net Book Value: Book value formula equals cost of asset minus accumulated depreciation.
4. Supplies Used: Adjusting entry is Debit Supplies Expense and Credit Supplies.

Conclusion

• Understanding adjusting entries is crucial for accurate financial reporting.
• Feel free to reach out with questions!