Chapter-3: Adjusting the Accounts

Timing Issues

The Basics of Adjusting

Entries

The Adjusted Trial Balance

and Financial Statements

NSU ACT 201: Adnan Habib (Anb)

Timing Issues
 Accountants divide the economic life of a business
into artificial time periods (Time Period
Assumption)

.....
Jan. Feb. Mar. Apr. Dec.

 Generally a month, a quarter, or a year.

 Also known as the “Periodicity Assumption”

NSU ACT 201: Adnan Habib (Anb)

 Timing Issues

Fiscal and Calendar Years

 Monthly and quarterly time periods are called interim
periods.

 Public companies must prepare both quarterly and

annual financial statements.

 Fiscal Year = Accounting time period that is one year

in length.

 Calendar Year = January 1 to December 31.

NSU ACT 201: Adnan Habib (Anb)

 Timing Issues
Accrual- vs. Cash-Basis Accounting
Cash-Basis Accounting
 Revenues recognized when cash is received.

 Expenses recognized when cash is paid.

 Cash-basis accounting is not in accordance with

generally accepted accounting principles (GAAP).

NSU ACT 201: Adnan Habib (Anb)

 Timing Issues
Accrual- vs. Cash-Basis Accounting
Accrual-Basis Accounting
 Transactions recorded in the periods in which the
events occur.

 Revenues are recognized when earned, rather than

when cash is received.

 Expenses are recognized when incurred, rather than

when paid.

NSU ACT 201: Adnan Habib (Anb)

 Timing Issues
Recognizing Revenues and Matching Expenses Principles

 Revenue is recognized in the accounting

period in which it is earned.
 Match expenses with revenues when the
company makes efforts to generate those
revenues.

 “Let expenses follow the revenues”

NSU ACT 201: Adnan Habib (Anb)
The basics of Adjusting Entries
 Adjusting entries are necessary
because the trial balance may not
contain up-to-date and complete
data.
◦ Some expenses (like use of office supplies) are
not recorded daily as it becomes inefficient
◦ Some costs (like rent) are not recorded
during accounting period as it incurs with
time rather than with daily transaction
◦ Some items may remain unrecorded since the
bill is yet to be received.
NSU ACT 201: Adnan Habib (Anb)
The basics of Adjusting Entries
 Ensure that the revenue recognition
and matching expense principles are
followed.

 Required every time a company

prepares financial statements.

 Make it possible to report correct

amounts on the financial statements.
NSU ACT 201: Adnan Habib (Anb)
 The basics of Adjusting Entries
Types of Adjusting Entries
Deferrals Accruals

1. Prepaid Expenses. 3. Accrued Revenues.

Expenses paid in cash and Revenues earned but not yet
recorded as assets before received in cash or recorded.
they are used or consumed
because service or benefit will
be received in the future.
2. Unearned Revenues. 4. Accrued Expenses.
Cash received and recorded Expenses incurred but not
as liabilities before revenue yet paid in cash or recorded.
is earned.

NSU ACT 201: Adnan Habib (Anb)

 The basics of Adjusting Entries
 Each account in a Trial Balance is
analyzed to determine whether it is
complete and up-to-date
Adjusting Entries for Deferrals
Prepayments often occur in regard to:
 insurance  rent
 supplies  equipment
 advertising  buildings

NSU ACT 201: Adnan Habib (Anb)

 The basics of Adjusting Entries
Prepaid Expenses
 Expire either with the passage of time or through use.

 Adjusting entry:

► Increase (debit) to an expense account and

► Decrease (credit) to an asset account.

NSU ACT 201: Adnan Habib (Anb)

 The basics of Adjusting Entries
Example: Pioneer Advertising Agency
purchased supplies costing $2,500 on
October 5. Pioneer recorded the payment
by increasing (debiting) the asset
Supplies. This account shows a balance
of $2,500 in the October 31 trial balance.
An inventory count at the close of
business on October 31 reveals that
$1,000 of supplies are still on hand.

Oct. 31 Supplies expense 1,500

Supplies 1,500
NSU ACT 201: Adnan Habib (Anb)
 The basics of Adjusting Entries
Example: On October 4, Pioneer
Advertising Agency paid $600 for a one-
year fire insurance policy. Coverage
began on October 1. Pioneer recorded
the payment by increasing (debiting)
Prepaid Insurance. This account shows a
balance of $600 in the October 31 trial
balance. Insurance of $50 ($600 / 12)
expires each month.

Oct. 31 Insurance expense 50

Prepaid insurance 50
NSU ACT 201: Adnan Habib (Anb)
The basics of Adjusting Entries
Depreciation
 Companies record long-term assets (buildings,
equipments, vehicles) at cost, as required by the
cost principle (Chapter 1).
 As time passes these assets wear out and their
usefulness reduces, which leads to its value getting
decreased.
 Companies report an estimated portion of the cost
of an asset, which has been reduced with time, as
an expense (depreciation expense) during each
period of the asset’s useful life.
 It is an estimate and not the factual measurement
of the expired cost.

NSU ACT 201: Adnan Habib (Anb)

The basics of Adjusting Entries
Depreciation
 Purchasing long-term assets is essentially a long-
term prepayment of services offered by the asset.
 Recording depreciation expense periodically in
the journal is recognizing that a portion of that
prepayment has been used.
 Thus entries of Depreciation expense are
adjustment entries
 Instead of writing off depreciation directly from
the asset account, a contra-asset account called
Accumulated Depreciation is made.

NSU ACT 201: Adnan Habib (Anb)

 The basics of Adjusting Entries

Example: For Pioneer Advertising,

assume that depreciation on the
equipment is $480 a year, or $40 per
month.

Oct. 31 Depreciation expense 40

Accumulated depreciation 40

Accumulated Depreciation is called a contra asset account.

NSU ACT 201: Adnan Habib (Anb)
 The basics of Adjusting Entries
Accumulated Depreciation: Statement Presentation

 Accumulated Depreciation is a contra asset account.

 Appears just after the account it offsets (Equipment)

on the balance sheet.

 Normal balance of a contra asset account is a credit.

NSU ACT 201: Adnan Habib (Anb)

The basics of Adjusting Entries
Unearned Revenues
 Receipt of cash that is recorded as a liability because
the revenue has not been earned.

 Adjusting entry is made to record the portion of

unearned revenue that has been earned.

 Results in a decrease (debit) to a liability account

and an increase (credit) to a revenue account.

NSU ACT 201: Adnan Habib (Anb)

 The basics of Adjusting Entries
Example: Pioneer Advertising Agency received $1,200 on October
2 from R. Knox for advertising services expected to be completed
by December 31. Unearned Service Revenue shows a balance of
$1,200 in the October 31 trial balance. Analysis reveals that the
company earned $400 of those fees in October.

Oct. 02 Cash 1200

Unearned service revenue 1200

Oct. 31 Unearned service revenue 400

Service revenue 400

NSU ACT 201: Adnan Habib (Anb)

The basics of Adjusting Entries

NSU ACT 201: Adnan Habib (Anb)

 The basics of Adjusting Entries
Adjusting Entries for Accruals
Accrued Revenues
 Revenues earned but not yet received in cash or recorded.

 Adjusting entry shows the receivable that exists and records

the revenues earned.

 Adjusting entry:
► Increases (debits) an asset account and

► Increases (credits) a revenue account.

NSU ACT 201: Adnan Habib (Anb)

 The basics of Adjusting Entries
Example: In October Pioneer Advertising
Agency earned $200 for advertising services
that had not been billed or recorded.

Oct. 31 Accounts receivable 200

Service revenue 200

On November 10, Pioneer receives cash of

$200 for the services performed.

Nov. 10 Cash 200

Accounts receivable 200

NSU ACT 201: Adnan Habib (Anb)

 The basics of Adjusting Entries
Accrued Expenses
 Expenses incurred but not yet paid in cash or recorded.

 Adjusting entry records the obligation and recognizes the expense.

 Adjusting entry:
► Increase (debit) an expense account and
► Increase (credit) a liability account.

NSU ACT 201: Adnan Habib (Anb)

 The basics of Adjusting Entries
Example: Pioneer Advertising Agency signed a three-month note
payable in the amount of $5,000 on October 1. The note requires
Pioneer to pay interest at an annual rate of 12%.

Oct. 31 Interest expense 50

Interest payable 50

NSU ACT 201: Adnan Habib (Anb)

 The basics of Adjusting Entries
Example: An employee who joined Pioneer Advertising Agency
on the 20th October, is paid $8000 salary after one month, which is
($8000/20 working days) = $400 per day. At the end of the month
($400 X 7 remaining working days) = $2800 of his salary expense
has incurred.

Oct. 31 Salary expense 2800

Salary payable 2800

Nov. 20 Salary expense 5200

Salary payable 2800

Cash 8000
NSU ACT 201: Adnan Habib (Anb)
The basics of Adjusting Entries

NSU ACT 201: Adnan Habib (Anb)

 The Adjusted Trial Balance
Adjusted Trial Balance

 Prepared after all adjusting entries are journalized

and posted.

 Purpose is to prove the equality of debit balances

and credit balances in the ledger.

 Is the primary basis for the preparation of financial

statements.

NSU ACT 201: Adnan Habib (Anb)

The Adjusted Trial Balance

NSU ACT 201: Adnan Habib (Anb)

NSU ACT 201: Adnan Habib (Anb)
NSU ACT 201: Adnan Habib (Anb)