CHAPTER 3: THE ADJUSTING PROCESS

* Learning Objectives:

•  Differentiate between accrual and cash-basis accounting

•  Explain why adjusting entries are needed

•  Journalise and post adjusting entries

•  Explain the purpose of and prepare an adjusted trial balance

•  Prepare the financial statements from the adjusted trial balance

•  Describe the ethical challenges in accrual accounting

3.1 Accrual versus cash-basis accounting

•  Accrual accounting records the effect of each transaction as it occurs

•  Cash-basis accounting records only cash receipts and cash payments. It ignores receivables,
payables and other items

•  In accrual accounting, revenues are recorded when earned, which is not necessarily in the same
accounting period as when the corresponding cash is received

•  Most businesses use the accrual basis as covered in this book

Ex:

1.  Suppose Smart Touch purchases $200 of office supplies on credit on 15 Jun and pays to supplier
on 03 Jul.

2.  Suppose Smart Touch performs services and earns revenue of $1,000 on 20 Jun but collects no
cash (Cash will be collected on 05 Jul)

--> Indicate the difference in recording above transactions on the cash-basic accounting and accrual-
basic accounting.

3.2. Why we adjust the accounts

•  Accrual accounting requires adjusting entries at the end of the period

•  Adjusting entries assign revenues to the period when they are earned and expenses to the period
when they are incurred
•  Adjustments are needed to properly measure two things: (1) profit (loss) in the income statement,
and (2) assets and liabilities in thebalance sheet

3.3 Two categories of adjusting entries

•  The two basic categories of adjusting entries are prepayments (defferals) and accruals

•  In a prepaid adjustment, the cash payment occurs before an expense is recorded or the cash receipt
occurs before the revenue is earned

•  An accrual records an expense before the cash payment or it records the revenue before the cash is
received

•  Adjusting entries fall into five types: prepaid expenses, depreciation of non-current assets, accrued
expenses, accrued revenues, unearned revenues

•  Prepaid expenses are advance payments of expenses

•  Examples include prepaid rent, insurance, supplies

•  Prepaid expenses are considered assets rather than expenses

•  When the prepayment is used up, the used portion of the asset becomes an expense via an adjusting
journal entry

Ex: Smart Touch prepays three months’ office rent of $3,000 ($1,000 per month x 3 months) on 01 June
201N

•  Property, plant and equipment assets are long-lived, non-current, tangible assets used in the
operation of a business

•  As a business uses non-current assets, their value and usefulness decline

•  The decline in usefulness of a non-current asset is an expense, and accountants systematically spread
the asset’s cost over its useful life

•  The allocation of a non-current asset’s value to expense is called depreciation

•  The accumulated depreciation account is the sum of all the depreciation recorded for the asset, and
that total increases (accumulates) over time

•  Accumulated depreciation is a contra asset

Ex: On 01 June, Smart Touch purchased furniture for $18,000. Its expected useful life is five years.
•  The term accrued expense refers to an expense incurred before paying for them

•  Examples include accruing salary expense and accruing interest expense

•  An accrued expense hasn’t been paid for yet and always creates a liability

Ex: Sheena Bright pays its employee a monthly salary of $1,800 – half on the 17th and half on the first
day of next month.

•  Businesses can earn revenue before they receive the cash, which creates accrued revenues

•  Accrued revenue is revenue that has been earned but for which the cash has not yet been collected

Ex: Assume that Smart Touch is hired on 16 June to perform elearning services for the Central
Queensland University. Under this agreement, Smart Touch will earn $800 monthly. During June, for
work performed from 16 June to 30 June, Smart Touch will earn half a month’s fee, $400.

•  Some businesses collect cash from customers in advance of performing work

•  Receiving cash before earning it creates a liability to perform work in the future called unearned
revenue

•  The business owes a product or a service to the customer, or it owes the customer his or her money
back

•  Only after completing the job will the business earn the revenue. Because of this delay, unearned
revenue is also called deferred revenue

•  Ex: A legal firm engages Smart Touch to provide e-learning services, agreeing to pay $600 in advance
monthly, beginning immediately. Sheena Bright collects the first amount on 21 June.
Ex: Information for the adjustments at 30 June 201N of Smart Touch

(a) Prepaid rent expired, $1,000

(b) Supplies used , $100

(c) Depreciation on furniture, $300

(d) Depreciation on building, $200

(e) Accrued salary expense, $900

(f) Accrued interest on loan, $100

(g) Accrued service revenue, $400

(h) Service revenue that was collected in advance and now had been earned, $200

Required: Journalising and posting to T-accounts all the above adjustments.

3.4 The adjusted trial balance

•  Prepared after adjusting entries are posted

•  Useful step in preparing financial statements

•  Often appears on a work sheet

•  The income statement reports revenues and expenses

•  The statement of changes in equity shows why capital changed during the period

•  The balance sheet reports assets, liabilities and owners’ equity

•  The financial statements should be prepared in the following order:

(1) income statement to determine profit or loss;

(2) statement of changes in equity which needs profit or loss from the income statement to calculate
ending capital;

(3) balance sheet which needs the amount of ending capital to achieve its balancing feature
3.6. Ethical issues in accrual accounting

•  Accrual accounting provides opportunities for unethical behaviour

•  For example, a dishonest businessperson could omit depreciation expense at the end of the year

•  Failing to record depreciation would overstate profit as calculated by mandated accrual principles
and disclose a more favourable picture of the business’ financial position than actually existed

SUMMARY: CHAPTER 3

•  Accrual accounting records revenues and expenses when they are earned/incurred

•  Cash-basis accounting records revenues and expenses when cash is received or paid

•  Accrual accounting requires adjusting entries at the end of the period

•  The two basic categories of adjusting entries are prepayments and accruals

•  The adjusted trial balance includes all the transactions captured during the period on the trial balance
plus/minus any adjusting journal entries made at the end of the period

•  The financial statements must be prepared in order