chapter three is the adjusting process starting off with some definitions the accrual basis of accounting is when revenues in their related expenses are reported on the income statement in the period in which a service has been performed or a product has been delivered and that is the matching principle that we talked about back in chapter one so under the accrual basis of accounting expenses are recorded when they are incurred not necessarily when cash is paid same with revenue revenue is reported when it is earned not necessarily when cash is received and this is required by gaap the cash basis of accounting on the other hand is when revenues and expenses are reported on the income statement and the period in which cash is received or paid so clearly the accrual basis of accounting and the cash basis of accounting are quite different and that is why we need uh to make adjusting entries okay the adjusting process the adjusting process is an analysis and updating of accounts at the end of the period before the financial statements are prepared and it's important to note that adjusting entries will affect at least one income statement account and at least one balance sheet account so whenever you're making your entries you need to make sure you're including at least one of each of those so why do we need these adjustments these are some examples first revenues and expenses may be unrecorded at the end of the period so the company may not have built customers first services provided or products delivered so they haven't recorded revenue at all yet if it was performed at the end of the period so we need to adjust for that second some expenses are not recorded daily so that could be the amount of supplies or more commonly wages so you're not paying your employees every minute every hour not even every day you're probably paying them weekly or bi-weekly so you need to account for that and then third some revenues and expenses are incurred as time passes rather than as separate transaction so this could be any type of unearned revenue so as the example unearned rent expires and becomes revenue over time so we need to make an adjusting entry for that okay so we'll be talking about two main types of adjustments the first is an accrual so an accrual occurs when revenue has been earned or an expense has been incurred but it has not been recorded so these are called accrued revenues and accrued expenses so the issue here is that basically nothing has been recorded and when we're making our adjusting entry we're going to go in and record something to fix that on the other hand a deferral occurs when cash related to a future revenue or expense has been initially recorded as a liability or an asset so with a deferral something has been recorded but we need to update it so we're updating a previous entry so the two main types of deferrals are unearned revenue and unearned revenue is when a liability is created when cash is received before a service is performed or a product is provided so in that case we need to go in and update it after it's actually earned and then a prepaid expense is an asset created when cash is paid in advance for a future expense so we update that as well so accruals and deferrals main difference an accrual nothing has been recorded so we need to go in and record something a deferral something has already been recorded but over time it's wrong so we need to go in and update it okay so now we're going to go through each of them in an example so accrued revenues is the first one so at the end of the accounting period there may be revenue that has been earned but has not been recorded and that's the issue here within with accrued revenues so how do we fix this the revenue is recorded by debiting an asset account and that's going to be accounts receivable and we're going to credit a revenue account which would be fees earned if it's a service company for example so what we're going to do we're going to debit accounts receivable because uh it's not been recorded at all and we haven't received the revenue for it yet but we performed the service or we provided the product we know we earned it so that means we're going to be receiving payment for in the future uh that is an accounts receivable uh cash that we will get in the future and then we're crediting a revenue account to reflect the fact that we did earn revenue so in this example it says as of december 31st abc company provided 25 hours of service to the customer worth 500 but it will not be billed until january 1st however abc company earned the revenue in december and this kind of goes along with accurately effect for reflecting profit so we earned that money in december but it's not going to be billed and paid for until january but if we want our periodic or our yearly statements to be correct we need to record that revenue in december so how do we fix this this is accrued revenues we are going to debit an asset account so accounts receivable is going to be debited for 500 and revenue is going to be credited for 500 so accounts receivable is debited for 500 that means it's increasing revenue is credited for 500 that means it's increasing as well and this would be our adjusting entry for december 31st okay accrued expenses so some types of services used in earning revenues are paid for after the service has been performed and the accrued but unpaid items are an expense and a liability so how do we account for this the expense is recorded by debiting an expense account and creating a liability account so this is easiest to understand in the context of wages so in this example abc company pays its employees bi-weekly wages were just paid on december 27th and december 31st marks the end of the accounting period so during this time four days 250 of wages uh were accrued so from december 27 to december 31st the employees were working they were earning money and we technically owe them wages for that period and we're not going to be paying them for a little bit longer because we pay them bi-weekly but when we're doing our end-of-period statements we need to reflect the fact that we do owe expenses during this time and we need to take that into account when we're calculating our final profit so this is an accrued expense how do we account for it well we know we debit an expense account and we credit a liability account so what we're going to do here this is again going to be december 31st we are debiting an expense account and that is going to be wages expense for 250 dollars to reflect the fact that we owe 250 in wages and we are crediting a liability account and that is going to be wages payable because we haven't paid our employees yet but we do owe them that money so when we do pay them eventually we're going to get rid of this wages payable and we're going to actually pay out cash so in the future you would debit wages payable and credit cash but for now the adjusting entry is just for an accrued expense you debit wages wages expense for 250 dollars and you credit wages payable for 250 dollars to account for this okay now we're moving on to deferrals so for accruals that was there's nothing at all we're creating an entry for deferrals there was an original entry but now we need to update it because it's become incorrect over time so the first type of deferral is unearned revenues so in this case what you're going to do right up front you're going to debit the liability account and you're going to credit revenues because what aren't what unearned revenues means is that it's a liability that becomes revenue as it is earned over time so over time you're decreasing the liability as you pay it off and you're going to transfer it to revenue so that's why we're debiting liability account because we're decreasing it and we're crediting revenue to increase it so in this example it says your tenant pays rent for the year in january amounting to twelve thousand dollars and you create a liability account titled unearned rent at the end of march three months rent has been earned equivalent to three thousand dollars create an adjusting entry so just as a total picture type thing originally what you would do is this your tenant pays rent for the year in january and it's twelve thousand dollars worth and you're creating a liability account titled unearned rent so what's happening at the very beginning of the year so january 1st is your tenant is paying you cash so cash would be debited for 12 000 and unearned rent would be credited for twelve thousand dollars so you're creating that liability account you received cash in advance for something that you have to provide in the future which would be like the actual housing then at after three months which is typically the end of a period you have to go in and update this so march um 31st you go in and you say okay three months rent has been earned equivalent to three thousand dollars so what you're going to do you're going to debit the liability and credit revenue so on march 31st we're going to debit unearned rent for three thousand dollars and we're going to credit revenue for three thousand dollars oops you can't see that three thousand dollars so we're just going to put it over here more okay so what's happening here imagine this is further to the right unearned rent is being debited for three thousand dollars because it's no longer liability we provided three months of housing so the liability decreases and since we provided that service we actually earned the revenue so revenue is being credited and it's increasing so this right here is the actual adjusting entry this on the left was our initial entry okay the second type of deferral is prepaid expenses so the two most common types of prepaid expenses are supplies and prepaid insurance so what you do with prepaid expenses you debit the expense account and you're going to credit the asset which means you are increasing expense and decreasing an asset over time so for supplies during the period supplies on hand are used up and an adjusting entry must be made for the amount of supplies used prepaid insurance similarly you usually prepay insurance for a year and it expires after each month and you have to reflect that expense so same thing you're using up an asset and you have to reflect it as an expense there are two examples for this so the amount of supplies at the beginning of december was five thousand dollars and at the end of december it was one thousand dollars so over the course of december you used up four thousand dollars worth of supplies so we're going to account for this so looking back up quickly we know that for prepaid expenses our little formula is always going to be debit and expense account credit and asset so here what we're going to do we're going to debit supplies expense for four thousand dollars and we're going to credit supplies for four thousand dollars and this would have occurred on december 31st end of the period so supplies expense is being debited to four thousand dollars which means it's increasing we incurred that expense and then supplies is being credited for four thousand dollars so supplies is decreasing and that makes sense because originally the amount of supplies we had at the beginning of december was five thousand dollars that would have been a debit balance we're crediting supplies for four thousand dollars so that means at the end of december it would have only a one thousand dollar uh balance in the supplies account so that checks out similar situation with prepaid insurance on december first uh it was worth two thousand four hundred dollars and on december 31st 200 had been used of that so one month of insurance was used up so we do a similar thing so on december 31st we have insurance expense being debited for two hundred dollars and prepaid insurance which is an asset account being credited for 200 so insurance expenses being debited for 200 that means it's increasing and prepaid insurance is being credited for 200 that means it's decreasing because we used up that insurance over the course of december so that handles prepaid expenses another adjusting entry that we'll talk about in a lot more detail in later chapters is depreciation so depreciation is associated with fixed assets and fixed assets are physical resources that have a long life used to generate revenue so as time passes the equipment loses its ability to provide useful services and this decline in usefulness is known as depreciation so as fixed assets depreciate a portion of its cost is recorded as a debit to depreciation expense and accumulated depreciation is credited so what you see here down at the bottom we always debit depreciation expense and credit accumulated depreciation that's the formula for the adjusting entry for depreciation so depreciation expense is pretty straightforward it's just an expense account but accumulated depreciation is what's known as a contra asset so a contra asset is an account that is subtracted from its related fixed asset account or just any related account in general so accumulated depreciation is a contra asset account accumulated depreciation is subtracted from the fixed asset account to get the book value of the account so down here we have book value of something equals the cost of the asset minus accumulated depreciation on the asset so book value is basically what is it worth now so it's worth what you originally paid for it minus the amount that has been lost due to depreciation so uh any contra asset account will have the opposite signs of its related account so since it's a contra asset account assets normally have the signs debit to increase credit to decrease accumulated accumulated depreciation is debit to decrease credit to increase so that's why we debit depreciation expense to increase it and we credit accumulated depreciation to increase it again we'll talk about this a lot more in the future but this is just in case it comes up very briefly on this first exam okay the adjusted trial balance i told you before that there are three types of trial balances uh if you want to look into this one in more detail you can look at exhibit six on page 127 basically the adjusted trial balance is prepared after the adjusting entries are all posted to again verify that the total debits and total credits are equal and we do this before the financial statements are prepared to make sure everything is in order you would check for errors the same way as you did with the unadjusted trial balance okay so that handles all the content for chapter three now we're going to do some practice problems so in this first one we have abc company pays weekly salaries of 35 000 on friday for a five day week ending on that day so the adjusting entry necessary at the end of the fiscal period ending on a tuesday is so first thing you do is figure out okay how much are they getting per day so it's 35 000 for a five day week that is seven thousand dollars per day and wages so if the fiscal period is ending on a tuesday and it's a five day work week that means you owe money for monday and tuesday so that's two days so automatically you know the answer is going to include something with a 14 000 and that eliminates nothing because all of them have 14 000 but that's how you'd figure out your first step so 14 000 are going to be owed to the employees and then you have to think okay well what is the proper adjusting entry so here what i'm doing uh this is an accrued expense so the formula for accrued expense is you debit the expense account and you credit a liability account so what are they well we're going to be debiting salary expense for 14 000 and we're going to be crediting salaries payable for fourteen thousand dollars because this is an accrued expense and that is our formula so we debit salary expense for fourteen thousand dollars and we credit salaries payable for fourteen thousand dollars and that is c okay second problem silverstone inc made a prepaid rent payment of three thousand six hundred dollars on january first so we're going to underline that first and we have the company's monthly rent is 900 so the amount of prepaid rent that would appear on the january 31st balance sheet after adjustment is so here what it's basically asking you is what would appear in the prepaid rent account on the balance sheet at the end of the month so we know at the very beginning of the month it was worth 3 600 and over the course of the month we use up nine hundred dollars so the answer here is that original three thousand six hundred minus nine hundred because that's how much we use up in the month is two thousand seven hundred dollars would be the balance of the account and that is a okay this is a definition so the net book value of fixed asset is determined by the original cost and then you have to know what the formula is so here we know that book value equals the cost of assa minus accumulated depreciation on that asset so the answer here then would be b less accumulated depreciation book value is always cost of the asset minus accumulated depreciation for a fixed asset okay and the last problem is the adjusting entry to the entry to adjust for the cost of supplies used during the accounting period this is a prepaid expense problem so we know that we're going to be debiting an expense account and crediting supplies well basically you would credit an asset account but the asset we're working with here supplies um so we know that based on that the answer is going to be debit supplies expense and credit supplies and that is a okay that is all i have for you if you have any questions please feel free to reach out and i hope you have a great rest of your day