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.