Chapter 3

The Adjusting
Process

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Learning Objectives

1. Differentiate between cash

basis accounting and
accrual basis accounting
2. Define and apply the time
period concept, revenue
recognition, and matching
principles
3. Explain the purpose of and
journalize and post
adjusting entries

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Learning Objectives

4. Explain the purpose of and

prepare an adjusted trial
balance
5. Identify the impact of
adjusting entries on the
financial statements

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Learning Objectives

6. Explain the purpose of a

worksheet and use it to
prepare adjusting entries
and the adjusted trial
balance
7. Understand the alternative
treatments of recording
deferred expenses and
deferred revenues
(Appendix 3A)

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Learning Objective 1

Differentiate between cash

basis accounting and accrual
basis accounting

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 What is the Difference Between Cash
Basis Accounting and Accrual Basis
Accounting?
Cash basis accounting Accrual basis
• Revenue is recorded accounting
when cash is • Revenue is recorded
received. when earned.
• Expenses are • Expenses are
recorded when cash recorded when
is paid. incurred.
• Not allowed under
• Used by most
GAAP.
businesses.

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 What is the Difference Between Cash
Basis Accounting and Accrual Basis
Accounting?
• On May 1, Smart Touch Learning paid
$1,200 for insurance for the next six
months ($200 per month).

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 What is the Difference Between Cash
Basis Accounting and Accrual Basis
Accounting?
• On April 30, Smart Touch Learning
received $600 for services to be
performed for the next six months.

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Learning Objective 2

Define and apply the time

period concept, revenue
recognition, and matching
principles

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 The Time Period Concept

• Time period concept

• Business activities are sliced into small time
segments.
• Financial statements can be prepared monthly,
quarterly, or annually.
• Fiscal year
• Any 12-month accounting period.
• Often coincides with a calendar year.

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 The Revenue Recognition Principle

• The revenue recognition principle dictates

when to record revenue and the amount of
revenue to record.
– Record revenue when earned.
– May be different from cash collections.
– Revenue is based on the actual selling price of
the item or service.

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The Revenue Recognition Principle

Revenue should be recorded

when it is EARNED.

A good has
The
been delivered
earnings
or a service
process is
has been
complete.
performed.

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 The Matching Principle

• The matching principle guides accounting

for expenses.
– Expenses are recorded when they are incurred
during the period.
– Expenses are matched against the revenue of
the period.
• For example, record rent expense for January against
January revenues, even if the rent was paid in
December.

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Learning Objective 3

Explain the purpose of and

journalize and post adjusting
entries

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 What are Adjusting
Entries, and How
Do We Record
Them?

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 What are Adjusting Entries, and How
Do We Record Them?
Adjusting entries can be divided into two
basic categories:

Deferrals Accruals
1. Deferred expenses 1. Accrued expenses
2. Deferred revenues 2. Accrued revenues

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 Deferred Expenses

• Deferred expenses are:

• Advance payments of future expenses
• Treated as assets until used
• Recognized as an expense by an adjusting
journal entry when the prepayment is used
• Types of deferred expenses:
• Prepaid rent
• Office supplies
• Depreciation

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 Prepaid Rent

Paying $3,000 for rent in advance gives us

the right to use the property for three
months.

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 Prepaid Rent

To adjust the Prepaid Rent account on Dec.

31 , we need to reduce it by 1/3 since the
company has used the space for one month.

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 Office Supplies

On November 3, Smart Touch Learning

purchased $500 of supplies on account. As
of December 31, only $100 of supplies
remain on hand.

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 Depreciation

• Plant assets:
• Long-lived, tangible assets
• Used in the operations of the business
• Value and usefulness decline as the assets are
used
• Similar to deferred expenses:
• Paid for when acquired
• Used up over time
• Usage is recorded as Depreciation Expense

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 Depreciation

On December 2, Smart Touch Learning

received a contribution of furniture with a
market value of $18,000 from a Sheena
Bright, the owner.

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 Depreciation

• Depreciation is the allocation of a plant

asset’s cost over its useful life.
– All plant assets are depreciated, with the
exception of land.
• Residual value is the expected value of a
depreciable asset at the end of its useful
life.
• The straight-line method allocates an
equal amount of depreciation each year.

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 Depreciation

Using the straight-line method, Smart Touch

Learning calculates $300 of depreciation for
December. Assume the residual value of the
asset is zero and the useful life is 5 years.

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 Depreciation

Recording the entry requires the use of two

accounts: Depreciation Expense and
Accumulated Depreciation.

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 Depreciation

• The Accumulated Depreciation account is

the sum of all depreciation expense
recorded for the depreciable asset to date.
– Accumulated Depreciation is a contra account;
therefore, the account balance is the opposite of
the normal balance of the related asset account.
• The cost minus accumulated depreciation
of a plant asset is called its book value.

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Depreciation

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 Deferred Revenue

• Deferred revenue:
– Occurs when a company receives cash before it
does the work or delivers a product
– Is a liability because the business owes the
customer the product, the service, or a refund
• Upon performance or delivery, deferred
revenue is converted to earned revenue.

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 Deferred Revenue

On December 21, a law firm engages Smart

Touch Learning to provide e-learning
services for the next 30 days, paying $600
in advance.

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 Deferred Revenue

During the last 10 days of the month, Smart

Touch Learning performs 1/3 of the
services.

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 Accrued Expenses

• Accrued expenses are expenses a business

has incurred but has not yet paid.
• Examples of accrued expenses:
– Salaries
– Interest
– Utilities

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 Accrued Salaries Expense

Smart Touch
Learning pays its
employee a monthly
salary of $2,400,
half on the 15th and
half on the first day
of the next month.

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 Accrued Salaries Expense

On December 31, Smart Touch Learning owes

its employee $1,200, which won’t be paid until
January 1. Accrue salaries for December.

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 Accrued Interest Expense

Smart Touch Learning borrows $60,000 on

December 1 to purchase a building. As of
December 31, Smart Touch Learning incurs
$100 of interest on the note.

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 Accrued Revenue

• Accrued revenues arise when:

– A company performs a service but has not yet
collected cash.
– A company delivers a product but has not yet
collected cash.
• Record accrued revenues with a:
– Debit to Accounts Receivable.
– Credit to Service Revenue.

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 Accrued Revenue

On December 15, Smart Touch Learning

agrees to perform e-learning services for
$1,600 per month. By the end of December,
it has earned ½ of the monthly fee.

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© 2016 Pearson Education, Ltd. 3-37
• Exhibit 3-4
summarizes the
adjusting entries:

• (a)‒(d) are
deferred expenses

• (e) represents
deferred revenue

• (f) and (g) are

accrued expenses

• (h) is accrued
revenue
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Learning Objective 4

Explain the purpose of and

prepare an adjusted trial
balance

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 What is the Purpose of the Adjusted
Trial Balance, and How Do We Prepare
it?
Journalize Post Prepare
adjusting adjusting adjusted trial
entries entries balance

• At the end of the fiscal period, an adjusted

trial balance is prepared.
– A summary of all accounts with adjusted
balances
– The purpose is to ensure total debits equal
total credits

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 • The adjusted trial
balance includes the
balances after posting
the adjusting journal
entries.

• Prepare the financial

statements from the
adjusted trial balance.

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Learning Objective 5

Identify the impact of

adjusting entries on the
financial statements

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 What is the Impact of Adjusting
Entries on the Financial Statements?
• The adjusted trail balance is used to:
– Confirm debits equal credits after adjusting
entries.
– Ensure balance sheet items are properly
valued.
– Prepare the financial statements.
• Failing to record adjusting entries results
in incorrect financial statements.

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 What is the Impact of Adjusting
Entries on the Financial Statements?

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Learning Objective 6

Explain the purpose of a

worksheet and use it to
prepare adjusting entries and
the adjusted trial balance

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 How Could a Worksheet Help in
Preparing Adjusting Entries and the
Adjusted Trial Balance?
• A worksheet is an internal document that
helps summarize data for the preparation
of the financial statements.
• The worksheet has four sections that we
will work with in the chapter:
– Account names
– Unadjusted trial balance
– Adjustments
– Adjusted trial balance

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How Could a Worksheet Help in Preparing Adjusting
Entries and the Adjusted Trial Balance?

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Learning Objective 7

Understand the alternative

treatment of recording
deferred expenses and
deferred revenues
(Appendix 3A)

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 What is an Alternative Treatment of
Recording Deferred Expenses and
Deferred Revenues?
• An alternative approach to account for
deferred expenses and deferred revenues.
• Deferred expenses:
– The alternative approach records an expense
and adjusts for any unused portion.
• Deferred revenues:
– The alternative approach records Service
Revenue and adjusts for any unearned portion.

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 Deferred Expenses

Rather than record the prepayment of an

expense as a current asset, record the
prepayment as an expense on the date of
payment.

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 Deferred Expenses

At the end of the period, if any of the

expense remains “unused,” then adjust
some of it into the prepaid asset account.

The results are the same as with the

traditional approach.

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 Deferred Revenues

Rather than record the early cash receipt

from a customer as a current liability, record
the cash receipt as a revenue on the date of
receipt.

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 Deferred Revenues

At the end of the period, an adjustment is

made for the portion of revenue not earned
in the period.

The results are the same as with the

traditional approach.

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