CHAPTER 3: THE ADJUSTING PROCESS

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Chapter’s objectives
After studying this chapter, students should be able to:
ü Describe the nature of the adjusting process: the adjusting process, types
of Accounts Requiring Adjustment
ü Journalize entries for accounts requiring adjustment: Prepaid Expenses,
Unearned Revenues, Accrued Revenues, Accrued Expenses, Depreciation
Expense
ü Summarize the adjustment process
ü Prepare an adjusted trial balance
ü Describe and illustrate the use of vertical analysis in evaluating a
company’s performance and financial condition.
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Chapter 3 3
1. Nature of the Adjusting Process
q Accrual basis and Cash basis

Accrual basis Cash basis

Revenues are recognized when Revenues are recognized when cash

earned and expenses are recognized is received and expenses recorded
when incurred. when cash is paid
GAAP Not GAAP

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1. Nature of the Adjusting Process
q Accrual basis and Cash basis

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1. Nature of the Adjusting Process
q Accrual basis and Cash basis
• The accounting period: Accounting systems prepare periodic reports at regular
intervals
Annually

1 2
Semiannually

1 2 3 4
Quarterly

1 2 3 4 5 6 7 8 9 10 11 12
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Monthly
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1. Nature of the Adjusting Process
q Accrual basis and Cash basis
• The accounting period concept requires revenues and expenses be reported in
the proper period => Accrual basis => Revenue recognition concept
• The accounting concept reporting revenues and related expenses in the same
period is the matching concept.

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1. Nature of the Adjusting Process

The analysis and updating of accounts at the end of the period before
the financial statements are prepared is called the adjusting process

The journal entries that bring the accounts up to date at the end of the
accounting period are called adjusting entries.

• Each adjusting entry will affect an income statement and balance sheet

account
• Adjusting entries are required every time a company prepares financial
statements

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1. Nature of the Adjusting Process
q The need of adjusting process:
- The trial balance - the first pulling together of the transaction data - may
not contain up-to-date and complete data.
- Some events are not recorded daily because it is not efficient to do so.
Examples are the use of supplies and the earning of wages by employees.
- Some costs are not recorded during the accounting period because these
costs expire with the passage of time rather than as a result of recurring
daily transactions.
- Some items may be unrecorded

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1. Nature of the Adjusting Process
q The need of adjusting process
Transaction

Analyze
transactions

Journalize
Prepare
statements
Post

Prepare Prepare
Adjusting
unadjusted POST adjusted
Entries
trial balance trial balance
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2. Adjusting entries

At the end of the period, adjusting entries are needed for prepaid expenses,
unearned revenues, accrued revenues, accrued expenses, and recording
depreciation on fixed assets.

After all the adjusting entries have been posted, the equality of the total debit
balances and total credit balances is verified by an adjusted trial balance.

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2. Adjusting Entries
q Type of accounts requiring adjustment
Four basic types of accounts require adjusting entries as shown below.
1. Prepaid expenses
2. Unearned revenues
3. Accrued revenues
4. Accrued expenses

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2. Adjusting entries
2.1. Prepaid expenses

Prepaid expenses are the advance payment of future expenses and are
recorded as assets when cash is paid.

Prepaid expenses become expenses over time or during normal operations.

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2.1. Prepaid expenses

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2.1. Prepaid expenses

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2.1. Prepaid expenses
Example:

Dec 1. Dr. Prepaid Insurance $2,400

Cr. Cash $2,400

Dec 31. Dr. Insurance expense $200

Cr. Prepaid insurance $200

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2.2. Unearned revenues

Unearned revenues are the advance receipt of future revenues and are
recorded as liabilities when cash is received.

Unearned revenues become earned revenues over time or during normal

operations.

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2.2. Unearned revenues

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2.2. Unearned revenues

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2.2. Unearned revenues
Example:

Dec1. Dr. Cash $360

Cr. Unearned revenues $360
Dec 31. Dr. Unearned revenues $120
Cr. Rent revenues $120

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2.3. Accrued revenues

Accrued revenues are unrecorded revenues

that have been earned and for which cash
has not been received yet.

Fees for services that an attorney or a doctor

has provided but not yet billed are accrued revenues.

Accounting period: Jan 1 – Dec 31, 20x0

Nov 30 Sold stock to customers on time
Jan 5, 20X1 customer paid us on cash

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2.3. Accrued revenues
Example: NetSolutions signed an agreement with Dankner Co. on December
15. The agreement provides that NetSolutions will answer computer
questions and render assistance to Dankner Co.’s employees. The services will
be billed to Dankner Co. on the fifteenth of each month at a rate of $20 per
hour. As of December 31, NetSolutions had provided 25 hours of assistance to
Dankner Co. The revenue of $500 (25 hours * $20) will be billed on January
15.

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2.4. Accrued expenses

Accrued expenses are unrecorded expenses that have been incurred

and for which cash has yet to be paid.

Example: Wages owed to employees at the end of a period but not yet paid
are an accrued expense.

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2.4. Accrued expenses
Example:

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2.4. Accrued expenses
Example:

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Exercise

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2.5. Depreciation expenses

Fixed assets are physical resources that have a long life. As time passes, the
decrease in usefulness of these assets is called depreciation.

• All fixed assets, except land, lose their usefulness and, thus, are said to
depreciate.
• The periodic depreciation portion is called depreciation expense.
• The accumulated depreciation portion is called accumulated depreciation
(contra-asset account)

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2.5. Depreciation expenses
Example: NetSolutions owns two fixed assets: land and office equipment
Land does not depreciate; however, an adjusting entry is recorded for the
depreciation of the office equipment for December. Assume that the office
equipment depreciates $50 during December.

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2.5. Depreciation expenses
Example: NetSolutions owns two fixed assets: land and office equipment
Land does not depreciate; however, an adjusting entry is recorded for the
depreciation of the office equipment for December. Assume that the office
equipment depreciates $50 during December.

Book value of the asset (or net book value) = Cost of the Asset –
Accumulated Depreciation of Asset

Example: NetSolutions bought office equipment of $1,000 on 1 Jan 20XX.

Office equipment depreciates $50 every month. What is the book value of
office equipment on 31 Dec 20XX?

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2.6. Supplies

Supplies/ Office supplies are small items like paper, ink, pen, etc.

Example: On Dec 1, NetSolutions purchased $2,000 of office supplies, paid by

cash. On December 31, the amount of supplies on hand is $760.

At the time the business bought office supplies, it is treated as an asset.

At the end of each month, when the business conducts inventory count
and recognizes the amount of supplies use, it is allocated to Supplies
Expense
Journal Entry:
Dec 1: Dr. Supplies 2,000
Cr. Cash 2,000
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2.6. Supplies

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ADJUSTING ACCOUNTS - SUMMARY

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Chapter 3 34
PRACTICE:

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Example:

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HOMEWORK

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