CHAPTER THREE – ADJUSTING ACCOUNTS FOR FINANCIAL STATEMENTS

Purpose of Adjustments
 The purpose of adjusting accounts at the end of the accounting period is to ensure
the financial records reflect the true financial position of the business at a specific
date.
 The cost of certain assets expire or are used up as time passes and at the month end
or year end date we are concerned the balances reported in the financial statements
reflect assets used up, revenues earned and costs incurred.
 The following accounts often need to be adjusted at the end of the accounting
period:
 Prepaid Insurance
 Supplies
 Prepaid Rent
 Depreciation
 Unearned Revenues
 Interest Expense
 Salaries Expense
 Services Revenue
 Accrued Interest Income

GAAP and the Adjusting Process

 The adjusting process is based on three Generally Accepted Accounting Principles:
the timeliness principle, the matching principle, and the revenue recognition
principle.

The Accounting Period

 The adjusting process is often linked to timeliness of information. Information
must reach decision makers frequently and on a timely basis; therefore,
accounting systems need to prepare periodic reports at regular intervals. This
results in an accounting process impacted by the timeliness principle.
 The timeliness principle assumes that an organization’s activities can be divided
into specific time periods such as a month, a three-month, quarter, or a year.
 Time periods covered by statements are called accounting periods (or reporting
periods). Reports covering a one-year period are known as annual financial
statements.
Recognizing Revenues and Expenses
 Because it is critical for external users to understand how the company performed
financially compared to previous years, accounting standard-setting bodies
developed a set of principles to clarify the appropriate level of revenue and expense
to report.
 The matching principle aims to report or match expenses in the same accounting
period as the revenues they helped to earn.
 Revenue recognition: a major goal of the adjusting process is to have revenue
recognized (reported) in the time period when it is earned regardless of when the
cash is actually received.

Accrual Basis Compared to Cash Basis

 Accrual basis accounting is founded on the revenue recognition principle, where
revenues and expenses are recognized or recorded when earned or incurred
regardless of when cash is received or paid.

Revenue - Earned Versus Collected (Received)

Expenses – Incurred Versus Paid

 Accrual basis accounting, then, is based on the three GAAP of timeliness, matching,
and revenue recognition
 In contrast, cash basis accounting recognizes revenues and expenses when cash is
received or paid.
 Cash basis accounting for the income statement, balance sheet, and statement of
changes in equity is not permitted under Generally Accepted Accounting Principles.
 The cash basis of accounting is not an acceptable method for use in financial
reporting. IFRS and Canadian ASPE standards require companies to use the
accrual basis of accounting.
 CRA (Canadian Revenue Agency) also requires companies to adopt the accrual
basis accounting.

Adjusting Accounts
 An adjusting is recorded at the end of the accounting period to bring asset or
liability account balance to its proper amount. This entry also updates the related
expense or revenue account and is necessary to prepare the financial statements.
Adjustments are journalized in the general journal and then posted to account in
the ledger.
Adjusting Prepaid Expenses (Prepayments)
Prepaid insurance, Prepaid Rent, Supplies

 Recorded as an Asset initially( One has the option of recording it as an expense

initially also)
 After the asset has been depleted through direct usage or usage due to passing of
time then you expensed (report it as expense) it.

Prepaid Insurance:

1.On January 1, 2019 Mrs. X paid $2400 insurance premium for two years period

Initially – record as an asset – Jan 1, 2019

Debit Credit
Prepaid Insurance 2400
Cash 2400
To record the insurance premium of 2 years

On Jan 31, you are going to prepare reports. So you already used one month insurance.

Adjustment – Jan 31, 2019: $2400/24 = $100/per month

Debit Credit Prepaid Ins

Insurance Expense 100
Prepaid Insurance 100 2400 100
To adjust the insurance of the month 2300

Supplies: Daily usage of supplies is not generally recorded for accounting purposes:

 Tracking each miscellaneous item used is difficult

 By recording once, can reduce recordkeeping time and costs

2.On Jan1, 2019 Mrs. X purchased supplies which costs $3600 on cash. During the month it
is reported by the office manager that the supplies on hand counted to be $1800.

Initially record it as an asset: Jan 1, 2019

Debit Credit Supplies

Supplies 3600
Cash 3600 3600 1800
To record the purchase of supplies 1800

Adjustment on Jan 31, 2019: $3600 – 1800 = $1800 – used/consumed

Supplies expense 1800
Supplies 1800
To record the supplies used or consumed during the month

Adjusting for Depreciation

Depreciation: is the process of calculating expenses from matching (allocating)

the cost of plant & equipment assets over their expected useful lives.

 It is the wear & tear or deterioration of an asset.

 We have various methods of calculating depreciation like straight line,
declining method or sum of digits method etc
 Scrap value or salvage value: The amount that businesses estimate for
the asset to be sold at the end of its useful period

Straight line = Cost – salvage value / Estimated useful life

Mrs. X bought a Equipment for an amount of $ 6000 for cash , on Jan 1, 2019.
The estimated useful life of the truck is 5 years. It is expected that it will have
a scrap value of $0 at the end of the 5th year.

On Jan 1
Debit Credit
Equipment 6000
Cash 6000
To record the purchase of the truck

Depreciation expense = 6000 – 0 = 6000/5 = $1200/per annum

One month depreciation = 1200/12 = $100 per month

On January 31, 2019

Debit Credit
Depreciation Expense - Truck 100
Accumulated Depreciation –Truck 100 (Contra – asset)
To allocate the depreciation of the month

Accumulated depreciation is an Asset account which reduces the fixed asset

but unlike asset it has a normal balance of credit side. Because of being an
asset with a balance side of credit, it is called a contra-asset account.
Adjusting Unearned Revenues (Deferred Revenues)

Unearned revenue refers to cash received in advance of providing products

and services in the future. This is a liability.

 When the products or services are provided, the amount on the

unearned revenue becomes earned revenue
 Adjusting entry for unearned revenue involve increasing (credit)
revenues and decreasing (debit) unearned revenue

On January 15, 2019 Mrs. X received cash of $ 4000 for catering services
(food delivery) to be provided on Jan 31, 2019 for the 1st batch which is $1500
and the next delivery will be for the 2nd batch which is $ 2500 on Feb 20, 2019

On Jan 15: Record the initial entry

Debit Credit
Cash 4000
Unearned food revenue 4000 - This is a liability
To record receiving of cash in advance

Adjustment - On Jan 31, 2019 Unearned Revenue

1500 4000
Unearned food revenue 1500 2500 bal
Food Revenue 1500
To adjust the services provided

Adjusting accrued expenses

Accrued expenses refer to costs incurred in a period that are both unpaid and
unrecorded prior to adjustment.

 Generally they relate to expenses incurred for services provided or

products received for which the company has yet to be billed.
 Accrued expenses are part of expenses and reported on income
statement
 Adjusting entries for recording accrued expenses involve increasing
(debiting) expenses and recording the required accounts payable –
crediting liabilities.
 Debit Credit
Expense xxxx
Accounts Payable—Bay co xxxx

Accrued Interest expense

Mrs. X has a loan from her bank which is $12000 at 8% per annum; The
interest is monthly but is deducted from your bank account on the 1st day of
the following month after it is incurred. Record the accrued expense as of Jan
31, 2019

$12000 * 8% = 960 /12 = $80

On Jan 31, 2019

Debit Credit
Interest Expense 80
Interest Payable 80
(Accrued Interest)
To record the accrued interest of the month

Accrued Salaries Expense

On Jan 31, Mrs. X has an accrued salary for the end of the month- pay day is
Jan 27 - which is for (Jan 28 – 31, 2019) and is going to be paid for next pay
day 6th February, 2019. The total amount is $650

On Jan 31, 2019

Debit Credit
Salaries Expense 650
Salaries Payable 650
(Accrued salaries)
To record the accrued salaries of the month

Adjusting Accrued Revenues

Accrued revenues refer to revenues earned in a period that are both

unrecorded and not yet received in cash (or other assets). Accrued revenues
are part of revenues and must be reported on the income statement.
  When products and services are delivered, we expect to receive payment
for them
 The adjusting entries increase (debit) assets and increase (credit)
revenues.
Debit Credit
Accounts Receivable xxxx
Revenue xxxx

Accrued services revenue

On Jan 28, Mrs. X gave catering services for ABC Co. Bill was prepared for
an amount of $900, but not billed (sent) to ABC co.

Debit Credit
Accounts Receivable- ABC Co. 900
Food Services Revenue 900
To record the accrued revenues

Accrued Interest Income

Mrs. X has a saving on the bank which is $30000 at 2% per annum. The
interest is monthly but is added on your bank account on the 1st day of the
following month after it is earned. Record the accrued income as of Jan 31,
2019

$30000*2% = $600 /12 =$50

On Jan 31, 2019

Debit Credit
Interest Receivable 50
Interest revenue 50
To record the accrued interest of the month

Adjusted Trial Balance

An unadjusted trial balance is a listing of accounts and balances prepared

before adjustments are recorded.
An adjusted trial balance is a list of accounts and balances prepared after
adjusting entries are recorded and posted to the ledger.

*Note - Adjusted trial balance is presented in Ch 2 – Excel – sheet 2 (Refer to

that document

Preparing Financial Statements

We prepare financial statements directly from information in the adjusted

trial balance. An adjusted trial balance includes all balances appearing in
financial statements. We know that a trial balance summarizes information on
the ledger by listing accounts and balances. This summary is easier to work
from than the information in the entire ledger when preparing financial
statements.

Asset and liability balances on the adjusted trial balances are transferred to
the balance sheet. The ending equity is determined on the statement of
changes in the equity and transferred to the balance sheet.

There are different formats for the balance sheet.

 The account form balance sheet, which has been demonstrated

previously, lists assets on the left and liabilities and equity on the right
side of the balance sheet.
 The report form balance sheet lists items vertically.

Both forms are widely used and considered equally helpful to users.

*Note: Refer the financial statements in Ch 2 – Excel – Sheet 3

Questions

1) What accounting principles most directly lead to the adjusting process?

Possible Answers: the revenue recognition principle, the timeliness

principle, and the matching principle

2) Explain what a contra account is.

Possible Answers: A contra account is an account that is subtracted from

the balance of a related account.

3) Describe how unearned revenue arises. Give an example

Possible answer: It arises when cash is received from a customer before the
services and products are delivered to the customer

Eg. Megazine subscription receipts in advance

4) What is an accrued expense? Give an example

Possible Answer: It refers to costs incurred to a period that are both unpaid
and unrecorded prior to adjusting entries. Eg. Salaries earned by employees
but not yet paid at the end of the period

5) What types of accounts are taken from the adjusted trial balance to
prepare an income statement?

Possible Answers: Revenue accounts and Expense accounts.

Check point questions

1) If the entry to adjust prepaid insurance was not recorded, what effect
would this have on each of the three components of the accounting
equation (Assets, Liabilities, and Equities)?

Possible Answer: Equity will be overstated & Assets will be overstated

2) AltaCo credited Unearned Revenue for $20,000 on November 3, 2020,

for work to be done just prior to the year end. The work was completed
as scheduled. If Unearned Revenue is not adjusted at the year-end to
reflect the completion of work, which GAAP will be violated and why?

Possible Answer: The revenue recognition principle will be violated. Because

revenues earned have not been recognized; the matching principle has also
been violated because revenues earned will not be assigned to the correct
accounting period.

3) Digitalworld.com, an internet based music store, records $1,000 of

accrued salaries on December 31. Five days later on Jan 5 (the next
payday), salaries of $7,000 are paid. What is the January 5 entry?
Jan 5 Salaries payable 1000
Salaries expense 6000
Cash 7000

4) In preparing financial statements from an adjusted trial balance, what

statement is usually prepared first? second? third? Why?
1 – Income statement
2 – Statement of change in Equity
3- Balance sheet
Quick Study Questions

QS 3-1

For each of the following, identify the primary GAAP that has been violated
and explain why.

a. Delta Company prepared its first set of financial statements for the
three years ended July 31, 2020.

Possible Answer: Accounting period or timeliness principle

b. Allard Consulting purchased $9800 of supplies on September 30, 2020,

and debited Office Supplies Expense. Allard’s year-end is September
30.

Possible answer: Matching principle

c. On May 3, 2020, Nikos Car Wash collected $3,000 in advance from a

new Limousine Company to begin operating June 1, 2020. Niko credited
a revenue account for the $3000.

Possible Answer: Revenue recognition principle

d. On November 20, 2020, Scooter Town rented equipment for $1,500.

Scooter Town is not recording the transaction until it pays (payment is
required 15 days from the rental date)

Possible Answer: Matching principle

QS 3-5

Organic Market, a grocery store, purchased supplies for $12,000 cash on July
1, 2020. As of December 31, 2020, $7,000 had been used and $5,000 of supplies
had not been used. Organic Market prepares financial statements on annual
basis and has a December 31 year-end.

a. Record the journal entry on July 1, 2020

July 1 Debit Credit Supplies
Supplies 12000 12000 7000
Cash 12000 5000 Bal
To record the purchase of supplies

b. In order to prepare the annual financial statements, record the

adjusting journal entry to reflect the amount of supplies used as of
December 31, 2020
December 31 Debit Credit
Supplies Expense 7000
Supplies 7000
To adjust the used part

c. On January 1, 2021, what amount in supplies does Organic Market

have? $5000
QS 3-8

Gold Co. purchased a vehicle on March 1, 2020, for cash of $32,000. It will be
used by the president for business purposes for four years and then sold for
an estimated amount of $8,000. Gold Co’s year-end is December 31.

a. Record the journal entry on March 1, 2020

March 1 Debit Credit
Fixed assets – Vehicle 32000
Cash 32000
To record purchase of the vehicle

b. Using the straight-line method, calculate the depreciation expense for

March 1, 2020 to December 31, 2020
Cost = $32000
Estimated life = 4 years
Scrape value = $ 8,000

Cost – scrap value/Estimated life; 32000 – 8000/4 = $6000/year

$6000/12 = $500/month; $500 * 10 months = $5000

c. To prepare the 2020 annual financial statements, record the adjusting

entry for December 31, 2020
Dece 31, 2020 Debit Credit
Depreciation expense – Vehicle 5000
Accumulated depreciation – Vehicle 5000
To record 10 months depreciation

d. Using the straight-line depreciation method, calculate the depreciation

expense for January 1, 2021 to December 31, 2021

$32000 – 8000/4 = $6000 per year

e. To prepare the 2021 annual financial statements, record the adjusting

entry for December 31, 2021
 Dece 31, 2021 Debit Credit
Depreciation expense – Vehicle 6000
Accumulated depreciation – Vehicle 6000
To record 12 months depreciation

Demonstration Problem

The following information continues with the Cutlery, featured in the Chapter
1 and 2 Demonstration problems. After the first month of business, The
Cutlery’s August 31, 2020, unadjusted trial balance appeared as follows:
The Cutlery
Trial Balance
August 31, 2020
Account Debit Credit
Cash 4950
Accounts Receivable 0
Prepaid Insurance 2400
Furniture 2000
Store Equipment 31000
Accounts Payable 14450
Unearned haircutting services revenue 500
Jonne Cardinal, capital 26000
Jonne Cardinal, withdrawals 500
Haircutting services revenue 3800
Wages expense 250
Rent Expense 3200
Hydro Expense 450
Totals 44750 44750

The following additional information is available for the month just ended:

a. Depreciation of $100 per month will be taken on the furniture

b. It is estimated that the store equipment will have $1000 value at the end
of its estimated five-year (or 60-month) useful life. Jonne Cardinal will
record full month of depreciation for August
c. It was determined that the balance in the unearned haircutting services
require at August 31 should be $420
 d. The prepaid insurance represents six month of insurance beginning
August 1
e. On August 31, The Cutlery provided $130 of services to a client who will
pay in September.
f. On August 31, Jonne Cardinal received the business’s August cell phone
bill totalling $50. It will be paid in September

Required:

1. Prepare the adjusting entries ended on August 31, 2020 to record the
previously unrecorded items.
2. Prepare T-accounts for accounts affected by the adjusting entries. Post
the adjusting entries to the T-accounts
3. Prepare an adjusted trial balance
4. Prepare an income statement, a statement of changes in equity, and a
balance sheet.