Additional Learning Material for Chapter 3 part II

Chapter 3 – The Adjusting Process

Part I - Adjusting Entries Overview

Adjusting Entries:
- Required at the end of the cycle.
- Some expenses and/or revenues have accrued but not yet been recorded.
- Others are more efficiently recorded at the end of the cycle (e.g., depreciation - deferrals).
- Others require special analysis to determine the amount used up or expired (e.g., supplies used).
- Non-expense adjustments are also possible (e.g., Unearned Revenue) which calculates the amount of revenue earned.
- All adjustments are made in the General Journal and transposed to the appropriate ledger account.
- A check is made through an Adjusted Trial Balance to ensure all accounts are still in balance.
Adjusting entries are based on the Matching Principle – to match expenses in the same financial statement period as the revenue.
Deferrals:
- The postponement of the recognition of an expense already paid (prepayment) or of revenue received in advance (unearned revenue).
- Examples:
  1. Prepaid Rent
  2. Prepaid Insurance
  3. Prepaid Lease
  4. Depreciation Expense/Accumulated Depreciation
  5. Unearned Revenue
Prepayments (Deferred Expenses):
- When a cost is prepaid, an asset account is debited to show the service or benefit that will be received in the future.
- Once these assets are used or consumed, they become prepaid expenses.
- Prepaid Expenses – Expenses paid in cash and recorded as assets before they are used or consumed.
- These accounts are initially recorded as ASSETS.
Deferred Revenue:
- Cash (Revenues) is received before they are earned.
- When a company receives cash (revenues) in advance, it has an obligation to deliver goods or perform services.
- Therefore, this type of deferral is initially recorded as a Liability.
- Unearned Revenues – Cash received and recorded as liabilities before revenue is actually earned.
- These accounts are initially recorded as LIABILITIES.
Accruals:
- Adjusting entries for accruals are necessary to record revenues earned and expenses incurred in the current accounting period that have not been recognized through daily entries.
- Accrued Revenues – Revenues earned but not yet received in cash or recorded.
- They accrue with the passing of time (example: interest revenue and rent revenue).
- Accrued Expenses – Expenses incurred but not yet paid in cash or recorded.
- Accrued expenses result from the same causes as accrued revenues (example: wages payable, interest payable, taxes payable).

Adjusting Entry Chart

Type of Adjustment: Prepaid Expenses (Deferral)
- Reason for Adjustment: Prepaid expenses originally recorded in asset accounts that have been full or partially used up.
- Accounts before Adjustment: Assets overstated, Expenses understated.
- Adjusting Entry: Dr. Expenses, Cr. Assets (prepaid asset is being used up).
Type of Adjustment: Unearned Revenues (Deferral)
- Reason for Adjustment: Unearned revenues initially recorded in liability accounts have been earned.
- Accounts before Adjustment: Liabilities overstated, Revenues understated.
- Adjusting Entry: Dr. Liabilities, Cr. Revenues (promised services are being performed and earned from which cash was already collected).
Type of Adjustment: Accrued Revenues (Accrual)
- Reason for Adjustment: Revenues have been earned but not yet received in cash or recorded.
- Accounts before Adjustment: Assets understated, Revenues understated.
- Adjusting Entry: Dr. Assets, Cr. Revenues.
Type of Adjustment: Accrued Expenses (Accrual)
- Reason for Adjustment: Expenses have been incurred but not yet paid in cash or recorded.
- Accounts before Adjustment: Expenses understated, Liabilities understated.
- Adjusting Entry: Dr. Expenses, Cr. Liabilities.

Part II - Summary of adjusting Journal Entries

Rent Expense (OE) XX (amount expired) Prepaid Rent (A) XX (amount expired)
- (Expiration of prepaid rent – previously recorded as an asset) – Deferral
- + (DR.) Rent Expense - (CR.)
- + (DR.) Prepaid Rent - (CR.)
- XX (amt. purchased) XXX
- XX (amount expired/used up) XX
- XX (amount expired/used up) XXX (amount remaining/un-used)
Insurance Expense (OE) XX (amount expired) Prepaid Insurance (A) XX (amount expired)
- (Expiration of prepaid insurance – previously recorded as an asset) – Deferral
Supplies Expense (OE) XX (amount consumed) Supplies (A) XX (amount consumed)
- (Consumption of supplies - previously recorded as an asset) – Deferral
Depreciation Expense, Equipment (OE) XX (amount allocated to period) Accumulated Depreciation, Equipment (A) XX (amount allocated)
- (Depreciation recorded for period) – Deferral
- + (DR.) Depreciation Expense - (CR.)
- - (DR.) Accumulated Depreciation+ (CR.)
- XX
- (amt. of allocated cost) (amt. of allocated cost)
Wages Expense (OE) XX (amount incurred) Wages Payable (L) XX (amount to be paid)
- (Accrual of unrecorded wages) – Accrual
- + (DR.) Wage Expense - (CR.)
- - (DR.) Wages Payable + (CR.)
- XX
- (amt. of accrued expense) (amt. of wages owed)
Unearned Art Fees (L) XX (amount earned) Art Fees Earned (OE) XX (amount earned)
- (Performance of services paid for in advance) – Deferral
- - (DR.) Unearned Art Fees + (CR.)
- - (DR.) Art Fees Earned + (CR.)
- XX XXX XX
- (amt. of earned revenue) (amt. collected in advance of services earned) (amt. of earned revenue)
- XXX (amount of obligation remaining)
Accounts Receivable (A) XX (amount to be received) Advertising Fees Earned (OE) XX (amount earned)
- (Accrual of unrecorded revenue) - Accrual
- + (DR.) Accounts Receivable - (CR.)
- - (DR.) Advertising Fees Earned + (CR.)
- XX
- (amt. owed from earning revenue on account) (amt. of revenue earned on account)

Chapter 3 Key Points To Remember

The accrual basis of accounting requires that revenues are reported in the period in which they are Earned.
The accrual basis of accounting requires that expenses are reported in the period in which they are Incurred.
Expenses must be Matched to the revenues they generated (Matching Rule)
12 Months is referred to as a Fiscal Year.
A time period of less than 12 months is referred to as the Interim Time Period
GAAP assumes a business is a Going Concern meaning it will Continue Indefinitely.
The updating of accounts at the end of the accounting period is referred to as Adjusting Entries
Cash is Never used in an adjusting entry.
Steps in the adjusting Process:
1. Determine the current account balance.
2. Determine what the current account balance should be.
3. Record an adjusting entry to get from step 1 to step 2.
There are two types of adjusting entries:
- Deferrals
- Accruals
Each adjusting entry must include an(a):
- Income Statement Account
- Balance Sheet Account
Deferral Adjusting Entries are the postponement of a revenue and/or expense to the accounting period(s) where the revenue has been earned and the expense has been incurred.
Accrual Adjusting Entries always increase both the income statement and balance sheet account.
Deferral adjusting entries always decrease the balance sheet account.
After all the adjusting entries have been posted an Adjusted Trial Balance is prepared to verify the equality of Debits and Credits.
Accumulated Depreciation is a contra asset, has a credit normal balance, and is communicated on the balance sheet.
Only Long-Term Plant Assets need an accumulated Depreciation Account
Book (Carrying) Value = Cost – Accumulated Depreciation
Cash Basis accounting involves only recording revenues and expenses when the cash is either collected or paid.
Unearned Revenue is a Liability.
Recording Depreciation Expense is an example of a Deferral Expense Adjusting Entry.
Recording Interest Expense is an example of an Accrual Expense Adjusting Entry.
Prior to recording Deferral Expense Adjusting Entries – Assets are Overstated and Expenses are Understated.
Prior to recording Deferral Revenue Adjusting Entries – Liabilities are Overstated and Revenues are Understated.
Prior to recording Accrual Expense Adjusting Entries – Liabilities are Understated and Expenses are Understated.
Prior to recording Accrual Revenue Adjusting Entries – Assets are Understated and Revenues are Understated.