Chapter 3

The Adjusting
Process

© 2018 Pearson Education, Inc.

Chapter 3 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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Chapter 3 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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Chapter 3 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 accounting

• Revenues are recorded • Revenues are
when cash is received recorded when earned
• Expenses are recorded • Expenses are recorded
when cash is paid when incurred
• Not allowed under GAAP • Used by most
• Easier method to follow; businesses
requires less knowledge • Provides a better
of accounting concepts picture of a business’s
and principles revenues and
expenses

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 WHAT IS THE DIFFERENCE BETWEEN
CASH BASIS ACCOUNTING AND
ACCRUAL BASIS ACCOUNTING?
Example: 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?
Example: On April 30, Smart Touch Learning received
$600 for services to be performed for the next six
months (May through October).

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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

• The time period concept assumes business

activities are sliced into small time
segments and that financial statements
can be prepared for specific periods, such
as a month, quarter, or year.
• A fiscal year is an accounting year of any
12 consecutive months that may or may
not coincide with the calendar year.

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 The Revenue Recognition Principle

The revenue recognition principle tells accountants

when to record revenue and requires companies
follow a five step process:
• Step 1: Identify the contract with the customer.
– A contract is an agreement between two or more
parties that creates enforceable rights and
obligations.
• Step 2: Identify the performance obligations in
the contract.
– A performance obligation is a contractual promise
with a customer to transfer a distinct good or
service.

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 The Revenue Recognition Principle

• Step 3: Determine the transaction price.

– The transaction price is the amount that the entity
expects to be entitled to as a result of transferring
goods or services to the customer.
• Step 4: Allocate the transaction price to the
performance obligations in the contract.
– If the transaction has multiple performance
obligations, the transaction price will need to be
allocated among the different performance
obligations.

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 The Revenue Recognition Principle

• Step 5: Recognize revenue when (or as) the

entity satisfies each performance obligation.
– The business will recognize revenue when (or as) it
satisfies each performance obligation by
transferring a good or service to a customer.
– A good or service is considered transferred when
the customer obtains control of the good or
service.
– The amount of revenue recognized is the amount
allocated to the satisfied performance obligation.

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 The Matching Principle

• The matching principle guides accounting

for expenses and ensures:
– All expenses are recorded when they are
incurred during the period.
– Expenses are matched against the revenues of
the period.
• The goal is to compute an accurate net income or net
loss for the time period.

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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?

• An unadjusted trial
balance lists the
revenues and expenses,
but these amounts are
incomplete because they
omit various revenue
and expense
transactions.

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WHAT ARE ADJUSTING ENTRIES, AND
HOW DO WE RECORD THEM?
• Adjusting entries are made at the end of
the accounting period to record revenues
to the period in which they are earned and
expenses to the period in which they
occur.
– Adjusting entries also update asset and liability
accounts.
– The two basic categories are deferrals and
accruals.

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WHAT ARE ADJUSTING ENTRIES, AND
HOW DO WE RECORD THEM?

Deferrals Accruals
• Defer the recognition • Record an expense
of revenue or expense before the cash is
to a date after the paid, or records
cash is received or revenue before the
paid cash is received
Two types of deferrals: Two types of 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.
• Also called prepaid 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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 Deferred Expenses
Prepaid Rent
Smart Touch Learning prepaid three months’ office rent
of $3,000 ($1,000 per month x 3 months) on December
1, 2018.

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 Deferred Expenses
Prepaid Rent
• Prepaid Rent has a $3,000 balance on Dec. 1

• As of December 31, Prepaid Rent should be decreased

for the amount that has been used up.

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 Deferred Expenses
Prepaid Rent
• The adjusting entry transfers $1,000 ($3,000 * 1/3)
from Prepaid Rent to Rent Expense.

• After posting:

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 Deferred Expenses

Office Supplies
On November 3, Smart Touch Learning purchased $500
of supplies on account. As of December 31, $100 of
supplies remain on hand.

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 Deferred Expenses

Office Supplies
• The December 31 adjusting entry should be:

• After posting:

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 Depreciation

• Property, plant, and equipment represent

long-lived, tangible assets used in the
operations of the business.
• Examples: Land, Buildings, Equipment
• The allocation of plant asset’s cost over its
useful life is called depreciation.
• The adjusting entry records cost allocation to
Depreciation Expense.
• Accounting for plant assets is similar to
prepaid expenses.
© 2018 Pearson Education, Inc. 3-25
 Depreciation

• The expected value of a depreciable asset

at the end of its useful life is called the
residual value.
• The straight-line method allocates an
equal amount of depreciation each year
and is calculated as:

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 Depreciation

On December 2, Smart Touch Learning received a

contribution of furniture with a market value of $18,000
from Sheena Bright in exchange for shares of stock.

After posting:

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 Depreciation

Smart Touch Learning believes the furniture will remain

useful for five years and will have no value at the end of
its life. The straight-line method is used for depreciation.

Adjusting entry:

© 2018 Pearson Education, Inc. 3-28

 Depreciation

• The Accumulated Depreciation account is

the sum of all depreciation expense
recorded for the depreciable asset to date.
– It is a contra asset.
• A contra account has two main
characteristics:
1. It is paired with and is listed immediately after
its related account in the chart of accounts and
associated financial statement.
2. Its normal balance (debit or credit) is the
opposite of the normal balance of the related
account.
© 2018 Pearson Education, Inc. 3-29
 Depreciation

Example: Accumulated Depreciation—Furniture is

the contra account that follows the Furniture account
on the balance sheet.

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 Depreciation

• Book value is a depreciable asset’s cost

minus accumulated depreciation.
• Book value of Smart Touch Learning’s
furniture on December 31:

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 Depreciation

Suppose that Smart Touch Learning purchased a

building on December 1. The monthly depreciation is
$250. The following adjusting entry would record
depreciation for December:

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Depreciation

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 Deferred Revenues

• 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
– Also called unearned revenue
• Upon performance or delivery, deferred
revenue is converted to earned revenue.

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 Deferred Revenues

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 Revenues

During the last 10 days of the month, Smart Touch

Learning will earn 1/3 of the revenue. Adjusting entry:

After posting:

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 Accrued Expenses

• Accrued expenses are expenses a

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

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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

During December, the company paid the first half-month

salary on Thursday, December 15, and made this entry:

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 Accrued Salaries Expense

• Adjusting entry on December 31:

• After posting:

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 Accrued Salaries Expense

The adjusting entry at December 31 creates a

liability that will be paid on January 1.

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 Accrued Interest Expense

• On December 1, Smart Touch Learning purchased a

$60,000 building in exchange for a one-year loan.

• The formula for computing the interest is as follows:

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 Accrued Interest Expense

The company must record an adjusting entry for the

$100 of interest expense that has been incurred by
December 31.

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 Accrued Interest Expense

After the adjusting entry posts, Interest Expense and

Interest Payable now have the following correct
balances:

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 Accrued Revenues

• 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

© 2018 Pearson Education, Inc. 3-45

 Accrued Revenues

Smart Touch Learning is hired on December 15 to

perform e-learning services, beginning on December 16.
The business will earn $1,600 monthly and receive
payment on January 15. As of December 31, $800 is
earned. Adjusting entry:

© 2018 Pearson Education, Inc. 3-46

 Accrued Revenues

Smart Touch Learning’s account balances after

posting the adjusting entry are:

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 Accrued Revenues

When Smart Touch Learning receives the payment on

January 15, the business will record the following entry:

© 2018 Pearson Education, Inc. 3-48

© 2018 Pearson Education, Inc. 3-49
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

© 2018 Pearson Education, Inc. 3-50

Learning Objective 4

Explain the purpose of

and prepare an adjusted
trial balance

© 2018 Pearson Education, Inc. 3-51

 WHAT IS THE PURPOSE OF THE
ADJUSTED TRIAL BALANCE, AND HOW
DO WE PREPARE IT?
• At the end of the fiscal period, an adjusted
trial balance is prepared.
• An adjusted trial balance is a list of all the
accounts with their adjusted balances.
– The purpose is to ensure total debits equal
total credits

Journalize Post Prepare

adjusting adjusting adjusted trial
entries entries balance

© 2018 Pearson Education, Inc. 3-52

 WHAT IS THE PURPOSE
OF THE ADJUSTED
TRIAL BALANCE, AND
HOW DO WE PREPARE
IT?

• The adjusted trial balance

includes the balances after
posting the adjusting
journal entries.
• Financial statements are
prepared from the adjusted
trial balance.

© 2018 Pearson Education, Inc. 3-53

Learning Objective 5

Identify the impact of

adjusting entries on the
financial statements

© 2018 Pearson Education, Inc. 3-54

 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
• Failing to record adjusting entries results
in incorrect financial statements.
– See Exhibit 3-6 for examples.

© 2018 Pearson Education, Inc. 3-55

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

© 2018 Pearson Education, Inc. 3-57

 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:
– Account names
– Unadjusted trial balance
– Adjustments
– Adjusted trial balance

© 2018 Pearson Education, Inc. 3-58

© 2018 Pearson Education, Inc. 3-59
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?

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 Expense Recorded Initially as
an Expense

• The asset created by a deferred expense my be so

short lived that it will expire in the current period.
• Thus, the accountant may decide to debit the
prepayment to an expense account at the time of
payment.
• The entry could, alternatively, be recorded as follows:

© 2018 Pearson Education, Inc. 3-62

 Deferred Expense Recorded Initially as
an Expense
As of December 31, only one month’s prepayment has
expired, leaving two months of rent still prepaid. In this
case, the accountant must transfer two-thirds of the
original prepayment of $3,000, or $2,000, to the asset
account Prepaid Rent with an adjusting entry:

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Deferred Expense Recorded Initially as
an Expense

After posting, the two accounts appear as follows:

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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.
• For example, Smart Touch Learning is paid $600 in
advance for monthly e-learning services on December
21.

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 Deferred Revenues Recorded Initially
as a Revenue
Another way to account for the receipt of cash is to
credit a revenue account when the business receives
cash:

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 Deferred Revenues Recorded Initially
as a Revenue
• If the business then earns all the revenue within the
same accounting period, no adjusting entry is needed.
• However, if the business earns only part of the
revenue in that period, it must make an adjusting
entry.
• For example, if Smart Touch Learning earned only
$200, by December 31:

© 2018 Pearson Education, Inc. 3-67

 Deferred Revenues Recorded Initially
as a Revenue

After posting, the total amount, $600, is properly

divided between the liability account—$400, and the
revenue account—$200, as follows:

© 2018 Pearson Education, Inc. 3-68

© 2018 Pearson Education, Inc. 3-69