GOLIS UNIVERSITY

Faculty Of Business and Economics

Chapter four (part two)

Accounting Information System

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 Adjusting Entries
• In order for revenues to be recorded in the period in which
services are performed and for expenses to be recognized in the
period in which they are incurred, companies make adjusting
entries.
• In short, adjustments ensure that a company like McDonald’s
follows the revenue recognition and expense recognition
principles.
• The use of adjusting entries makes it possible to report on the
balance sheet the appropriate assets, liabilities, and owners’ equity
at the statement date
• Adjusting entries also make it possible to report on the income
statement the proper revenues and expenses for the period.

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• However, the trial balance—the first pulling together of the
transaction data—may not contain up-to-date and complete data.
This occurs for the following reasons.
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. Examples of such
costs are building and equipment depreciation and rent and
insurance.
Some items may be unrecorded. An example is a utility service
bill that will not be received until the next accounting period.

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• Adjusting entries are required every time a
company, such as Coca-Cola, prepares
financial statements. At that time, Coca-Cola
must analyze each account in the trial balance
to determine whether it is complete and up-
to-date for financial statement purposes.

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 Types of Adjusting Entries
• Adjusting entries are classified as either deferrals or accruals. Each
of these classes has two subcategories,
Deferrals:
 Prepaid expenses: Expenses paid in cash before they are used or
consumed.
 Unearned revenues: Cash received before services are performed.
Accruals:
 Accrued revenues: Revenues for services performed but not yet
received in cash or recorded.
 Accrued expenses: Expenses incurred but not yet paid in cash or
recorded.

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• We base each example on the October 31 trial
balance of Pioneer Advertising Agency Inc.
(Illustration 3-19). We assume that Pioneer
uses an accounting period of one month. Thus,
Pioneer will make monthly adjusting entries,
dated October 31.

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 Adjusting Entries for Deferrals
• To defer means to postpone or delay.
Deferrals are expenses or revenues that are
recognized at a date later than the point when
cash was originally exchanged. The two types
of deferrals are prepaid expenses and
unearned revenues.

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• If a company does not make an adjustment for these
deferrals, the asset and liability are overstated, and the
related expense and revenue are understated.
• For example, in Pioneer’s trial balance, the balance in the
asset Supplies shows only supplies purchased. This balance
is overstated; the related expense account, Supplies
Expense, is understated because the cost of supplies used
has not been recognized.
• Thus, the adjusting entry for deferrals will decrease a
balance sheet account and increase an income statement
account.
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 Supplies
• For example, Pioneer Advertising purchased
advertising supplies costing $25,000 on
October 5. Pioneer therefore debited the asset
Supplies. This account shows a balance of
$25,000 in the October 31 trial balance.
• An inventory count at the close of business on
October 31 reveals that $10,000 of supplies are
still on hand. Thus, the cost of supplies used is
$15,000 ($25,000-$10,000).
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 Without an adjusting entry, October expenses are understated and net income
overstated by $15,000. Moreover, both assets and stockholders’ equity are
overstated by $15,000 on the October 31 balance sheet.

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 Prepaid insurance
• For example, on October 4, Pioneer
Advertising paid $6,000 for a one-year fire
insurance policy. Coverage began on October
1. Pioneer debited the cost of the premium to
Prepaid Insurance at that time. This account
still shows a balance of $6,000 in the October
31 trial balance.
• The analysis and adjustment for insurance is
summarized on the next slide.
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 Without an adjusting entry, October expenses are understated by $500 and net
income overstated by $500. Moreover, both assets and stockholders’ equity also
are overstated by $500 on the October 31 balance sheet.

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 Depreciation expense
• In the case of Pioneer Advertising, it estimates
depreciation on its office equipment to be
$4,800 a year (cost $50,000 less salvage value
$2,000 divided by useful life of10 years), or
$400 per month. The analysis and adjustment
for depreciation is summarized on the next
slide

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 Accumulated Depreciation—Equipment is a contra asset account. A contra asset
account offsets an asset account on the balance sheet. This means that the
Accumulated Depreciation—Equipment account offsets the Equipment account
on the balance sheet.
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 Unearned Revenues.
• For example, Pioneer Advertising received
$12,000 on October 2 from R. Knox for
advertising services expected to be completed by
December 31. Pioneer credited the payment to
Unearned Service Revenue. This liability account
shows a balance of $12,000 in the October 31 trial
balance. Based on an evaluation of the service
Pioneer performed for Knox during October, the
company determines that it should recognize
$4,000 of revenue in October.
• The liability (Unearned Service Revenue) is
therefore decreased and stockholders’ equity
(Service Revenue) is increased, as shown on the
next slide.
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Without this adjustment, revenues and net income are understated by $4,000
in the income statement. Moreover, liabilities will be overstated and
stockholders’ equity will be understated by $4,000 on the October 31 balance
sheet.
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 Adjusting Entries for Accruals
• The second category of adjusting entries is accruals.
• Companies make adjusting entries for accruals to
record revenues for services performed and
expenses incurred in the current accounting
period.
• Without an accrual adjustment, the revenue account
(and the related asset account) or the expense
account (and the related liability account) are
understated.

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 Accrued Revenues.
• Revenues for services performed but not yet recorded at the
statement date are accrued revenues. Accrued revenues may
accumulate (accrue) with the passing of time, as in the case of
interest revenue. These are unrecorded because the earning of
interest does not involve daily transactions.
• In October, Pioneer Advertising performed services worth
$2,000 that were not billed to clients on or before October 31.
Because these services are not billed, they are not recorded. The
accrual of unrecorded service revenue increases an asset
account, Accounts Receivable. It also increases stockholders’
equity by increasing a revenue account, Service Revenue, as
shown on the next slide.

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Without an adjusting entry, assets and stockholders’ equity on the balance sheet, and
revenues and net income on the income statement, are understated.

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 Accrued Expenses
• Expenses incurred but not yet paid or recorded at the
statement date are called accrued expenses. Interest,
rent, taxes, and salaries are common examples.
• Accrued expenses result from the same causes as
accrued revenues. In fact, an accrued expense on the
books of one company is an accrued revenue to
another company.
• For example, the $2,000 accrual of service revenue
by Pioneer is an accrued expense to the client that
received the service.
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 Accrued interest
Pioneer Advertising signed a three-month note payable in the amount
of $50,000 on October 1. The note requires interest at an annual rate
of 12 percent.
Three factors determine the amount of the interest accumulation:
1. the face value of the note;
2. the interest rate, which is always expressed as an annual rate; and
3. the length of time the note is outstanding.

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Without this adjusting entry, liabilities and interest expense are understated, and
both net income and stockholders’ equity are overstated.

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 Accrued salaries and wages.
• Companies pay for some types of expenses, such as employee
salaries and wages, after the services have been performed. For
example, Pioneer Advertising last paid salaries and wages on
October 26. It will not pay salaries and wages again until
November 23. However, three working days remain in October
(October 29–31).
• At October 31, the salaries and wages for these days represent
an accrued expense and a related liability to Pioneer. The
employees receive total salaries and wages of $10,000 for a
five-day work week, or $2,000 per day. Thus, accrued salaries
and wages at October 31 are $6,000 ($2,000*3). The analysis
and adjustment process is summarized below.

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 Without the $6,000 adjustment for salaries, both Pioneer’s expenses and
liabilities are understated by $6,000.

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 Bad debts.
To illustrate, assume that, based on past experience,
Pioneer Advertising reasonably estimates a bad debt
expense for the month of $1,600. The analysis and
adjustment process for bad debts is summarized below

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 ADJUSTED TRIAL BALANCE

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 Preparing Financial Statements

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 Closing Entries Journalized

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 FINANCIAL STATEMENTS
FOR A MERCHANDISING COMPANY

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