Adjusting Entries

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Chapter 3: The Adjusting Process

Corporate Financial Accounting, 16e

Warren/Jones, Corporate Financial Accounting, 16th Edition. © 2022 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter Objectives

By the end of this chapter, you should be able to: Obj. 1 Describe the nature of the adjusting process. Obj. 2 Journalize adjusting entries for accruals. Obj. 3 Journalize adjusting entries for deferrals. Obj. 4 Journalize adjusting entries for depreciation. Obj. 5 Summarize the adjusting process. Obj. 6 Prepare an adjusted trial balance. Obj. 7 Describe and illustrate the use of vertical analysis in evaluating a

company's performance and financial condition.

Nature of the Adjusting Process (Learning Objective 1)

• Before financial statements can be prepared, some accounts on the unadjusted trial balance must be adjusted.

• These adjustments are necessary because the transactions were recorded using the accrual basis of accounting.

Accrual and Cash Bases of Accounting

• Under the accrual basis of accounting, revenues are reported on the income statement in the period in which a service has been performed or a product has been delivered. • Cash may or may not be received from customers during this

period. • The accrual basis of accounting also requires expenses to be

recorded when they are incurred, not necessarily when cash is paid. • Under the cash basis of accounting, revenues and expenses are

reported on the income statement in the period in which cash is received or paid.

Revenue and Expense Recognition (1 of 2)

• To be useful for decision making, financial statements must be provided on a periodic basis.

• As a result, the economic life of a business is divided into time periods such as a month, quarter of a year, or full year.

• Under the revenue recognition principle, revenues are recorded when earned, which is when the services have been performed or products have been delivered to customers. • Revenue is normally measured as the assets are received, such

as cash or accounts receivable.

Revenue and Expense Recognition (2 of 2)

• Under the expense recognition principle, the expenses incurred in generating revenue must be reported in the same period as the related revenue.

• This is also called the matching principle. • By matching revenues and expenses, net income or loss for the

period is properly reported on the income statement. • Adjusting entries are required to properly match revenues and

expenses.

The Adjusting Process (1 of 2)

• At the end of an accounting period, an unadjusted trial balance is prepared to verify that the total debit balances equal the total credit balances.

• Some accounts on the unadjusted trial balance, however, require adjustments for the following reasons: • Some expenses are not recorded daily.

• For example, the daily use of supplies would require many entries with small amounts.

• Some revenues and expenses are incurred as time passes rather than as separate transactions.

• For example, rent received in advance (unearned rent) expires and becomes revenue with the passage of time.

• Some revenues and expenses may be unrecorded at the end of the accounting period. • For example, a company may have provided services to customers that it has not

billed or recorded at the end of the accounting period.

The Adjusting Process (2 of 2)

• The analysis and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process.

• The journal entries that bring the accounts up to date at the end of the accounting period are called adjusting entries. • All adjusting entries affect at least one income statement account

and one balance sheet account. • Thus, an adjusting entry will always involve a revenue or an

expense account and an asset or a liability account.

Types of Accounts Requiring Adjustment (1 of 2)

• An accrual occurs when revenue has been earned or an expense has been incurred but has not been recorded. • If the accrual is for revenue, the adjusting entry debits an asset

(Accounts Receivable) and credits a revenue account. • If the accrual is for an expense, the adjusting entry debits an

expense account and credits a related liability account such as Accounts Payable or Wages Payable.

Exhibit 1 – Accruals

Types of Accounts Requiring Adjustment (2 of 2)

• A deferral occurs when cash related to a future revenue or expense has been initially recorded as a liability or an asset. • If the cash received is related to future revenue, it is initially

recorded as a liability called unearned revenue. • The adjusting entry in the period when the revenue is earned

debits an unearned revenue account and credits a revenue account.

• If the cash paid is related to a future expense, it is initially recorded as an asset called prepaid expense.

• The adjusting entry in the period when the expense is incurred debits an expense account and credits a prepaid expense (asset) account.

Exhibit 2 – Deferrals

Discussion Activity 1

The expense recognition principle states that the expenses incurred in generating revenue must be reported in the same period as the related revenue. In groups of 2-3 students, discuss how this principle applies to the following situation, and state if you agree with the principle: A company takes a 3-year loan on June 1 of the current fiscal year, which ends on December 31. The loan is to buy materials to manufacture a new product, which will be sold over the next three years. The bank requires all of the interest on the 3-year loan be prepaid in advance on June 1 of the current fiscal year.

Discussion Activity 1 Debrief

Because the expense recognition principle states that the expenses incurred in generating revenue must be reported in the same period as the related revenue, the prepaid interest on the loan must be amortized (expensed) over the 3-year period in which the company is using the cash to buy materials for the product which will be sold over the 3 years. Thus, the prepaid interest is an asset that will be divided out over the 3-year period, based on the number of months in each year (the first year will only have seven months of interest, June – December, for example). It can be argued that since the interest was paid out in cash (or the loan proceeds were reduced by the interest), they should be allowed to expense all of the interest in the first year. However, this is not proper accounting procedure per generally accepted accounting principles.

Adjusting Entries for Accruals (Learning Objective 2)

Exhibit 3 – Unadjusted Trial Balance for NetSolutions

Exhibit 4 – Expanded Chart of Accounts for NetSolutions Balance Sheet Accounts

1. Assets 11 Cash 12 Accounts Receivable 14 Supplies 15 Prepaid Insurance 17 Land 18 Office Equipment 19 Accumulated Depreciation—Office Equipment

2. Liabilities 21 Accounts Payable 22 Wages Payable 23 Unearned Rent

3. Stockholders’ Equity 31 Common Stock 32 Retained Earnings 33 Dividends

Income Statement Accounts 4. Revenue

41 Fees Earned 42 Rent Revenue

5. Expenses 51 Wages Expense 52 Supplies Expense 53 Rent Expense 54 Utilities Expense 55 Insurance Expense 56 Depreciation Expense 59 Miscellaneous Expense

Accrued Revenues (1 of 3)

• During an accounting period, some revenues are recorded only when cash is received.

• At the end of an accounting period, there may be revenue that has been earned but has not been recorded.

• In such cases, the revenue is recorded by increasing (debiting) an asset account and increasing (crediting) a revenue account.

Accrued Revenues (2 of 3)

• Assume that NetSolutions signed an agreement with Dankner Co. on December 15 to provide services at a rate of $20 per hour.

• As of December 31, NetSolutions had provided 25 hours of services. The revenue will be billed on January 15.

Accrued Revenues (3 of 3)

• If the adjustment for the accrued revenue ($500) is not recorded, Fees Earned and the net income will be understated by $500 on the income statement.

• On the balance sheet, assets (Accounts Receivable) and stockholders’ equity (Retained Earnings) will be understated by $500.

• The effects of omitting this adjusting entry are as follows:

Accrued Expenses (1 of 5)

• Some types of services used in earning revenues are paid for after the service has been performed.

• At the end of the accounting period, the amount of such accrued but unpaid items is an expense and a liability.

• This adjusting entry is necessary so that expenses are properly matched to the period in which they were incurred in earning revenue.

Accrued Expenses (2 of 5)

• NetSolutions pays its employees biweekly. • During December, NetSolutions paid wages of $950 on December

13 and $1,200 on December 27. • These payments covered pay periods ending on those days.

• As of December 31, NetSolutions owes $250 of wages to employees for Monday and Tuesday, December 30 and 31. • Thus, the wages expense account is increased (debited) by $250,

and the wages payable account is increased (credited) by $250. • The adjusting journal entry and T accounts are shown in Exhibit 5.

Exhibit 5 – Accrued Wages

Accrued Expenses (3 of 5)

• The adjusting journal entry and T accounts are as follows:

Accrued Expenses (4 of 5)

• As shown in Exhibit 5, NetSolutions paid wages of $1,275 on January 10. • This payment includes the $250 of accrued wages recorded on December 31. • Thus, on January 10, the wages payable account is decreased (debited) by

$250. • The journal entry for the payment of wages on January 10 follows:

Accrued Expenses (5 of 5)

• If the adjustment for wages ($250) is not recorded, Wages Expense will be understated by $250, and the net income will be overstated by $250 on the income statement.

• On the balance sheet, liabilities (Wages Payable) will be understated by $250, and stockholders’ equity (Retained Earnings) will be overstated by $250.

• The effects of omitting this adjusting entry are as follows:

Knowledge Check Activity 1

At the end of an accounting period, an adjusting entry to record revenue that has been earned but not yet recorded would include which of the following? a. debit an asset account; debit a revenue account b. debit an asset account; credit a revenue account c. credit an asset account; debit a revenue account d. credit an asset account; credit a revenue account

Knowledge Check Activity 1: Answer

At the end of an accounting period, an adjusting entry to record revenue that has been earned but not yet recorded would include which of the following?

Answer: b. debit an asset account; credit a revenue account

At the end of an accounting period, when there may be revenue that has been earned but has not been recorded, the revenue is recorded by increasing (debiting) an asset account and increasing (crediting) a revenue account.

Adjusting Entries for Deferrals (LO3) Unearned Revenues

(1 of 2) • The December 31 unadjusted trial balance of NetSolutions indicates a balance in

the unearned rent account of $360. • This balance represents the receipt of three months’ rent on December 1 for

December, January, and February. • At the end of December, one month’s rent has been earned. • The adjusting journal entry and T accounts are as follows:

Unearned Revenues (2 of 2)

• If the preceding adjustment of unearned rent and rent revenue is not recorded, the financial statements prepared on December 31 will be misstated.

• The effects of omitting this adjusting entry are as follows:

Prepaid Expenses (1 of 3)

• The December 31, 20Y3, unadjusted trial balance of NetSolutions indicates a balance in the supplies account of $2,000.

• In addition, the prepaid insurance account has a balance of $2,400. • Each of these accounts requires an adjusting entry.

Prepaid Expenses – Supplies

Prepaid Insurance

• The debit balance of $2,400 in NetSolutions’ prepaid insurance account represents a December 1 prepayment of insurance for 12 months.

• At the end of December, the insurance expense account is increased (debited), and the prepaid insurance account is decreased (credited) by $200, the insurance for one month.

• The adjusting journal entry and T accounts for Prepaid Insurance and Insurance Expense are as follows:

Prepaid Expenses (2 of 3)

• If the preceding adjustments for supplies ($1,240) and insurance ($200) are not recorded, the financial statements prepared as of December 31 will be misstated.

• The effects of omitting these adjusting entries on the income statement and balance sheet are as follows:

Prepaid Expenses (3 of 3)

• Payments for prepaid expenses are sometimes made at the beginning of the period in which they will be entirely used or consumed.

• To illustrate, the following December 1 transaction of NetSolutions is used: • Dec. 1 NetSolutions paid rent of $800 for the month.

• On December 1, the rent payment of $800 represents Prepaid Rent. • However, the Prepaid Rent expires daily, and at the end of December

there will be no asset left. • In such cases, the payment of $800 is recorded as Rent Expense

rather than as Prepaid Rent. • In this way, no adjusting entry is needed at the end of the period.

Knowledge Check Activity 2

On November 20, Cassie purchases a $200 ticket on Delta Airlines to fly to Orlando on January 28 of the next year. Assuming Delta Airlines has a fiscal year end of December 31, which account would they credit to record the sale of this airline ticket on November 20? a. Sales b. Cash c. Unearned Revenue d. Accounts Receivable

Knowledge Check Activity 2: Answer

Answer: c. Unearned Revenue

Even though Delta has collected the cash from the customer for the sale of the ticket on November 20, at the end of the fiscal year on December 31, they have not yet provided the service for this sale (the flight has not yet occurred). They cannot claim the $200 sale until after the flight has taken place on January 28. The Unearned Revenue account, which is a liability, can “hold” the revenue until it is actually earned.

Adjusting Entries for Depreciation (1 of 8) (Learning Objective 4)

• Fixed assets, or plant assets, are physical resources that are owned and used by a business and are permanent or have a long life. • Examples of fixed assets include land, buildings, and equipment. • In a sense, fixed assets are a type of long-term prepaid expense.

• Fixed assets, such as office equipment, are used to generate revenue much like supplies are used to generate revenue. • Unlike supplies, however, there is no visible reduction in the quantity of

the equipment. • Instead, as time passes, the equipment loses its ability to provide useful

services. • This decrease in usefulness is called depreciation.

Adjusting Entries for Depreciation (2 of 8)

• All fixed assets, except land, lose their usefulness and, thus, are said to depreciate. • As a fixed asset depreciates, a portion of its cost should be recorded as an

expense. • This periodic expense is called depreciation expense.

• The adjusting entry to record depreciation expense is similar to the adjusting entry for supplies used. • The depreciation expense account is increased (debited) for the amount of

depreciation. • However, the fixed asset account is not decreased (credited).

• This is because both the original cost of a fixed asset and the depreciation recorded since its purchase are reported on the balance sheet.

• Instead, an account entitled Accumulated Depreciation is increased (credited).

Adjusting Entries for Depreciation (3 of 8)

• Accumulated depreciation accounts are called contra accounts, or contra asset accounts. • This is because accumulated depreciation accounts are deducted

from their related fixed asset accounts on the balance sheet. • The normal balance of a contra account is opposite to the account

from which it is deducted. • Because the normal balance of a fixed asset account is a debit, the

normal balance of an accumulated depreciation account is a credit.

Adjusting Entries for Depreciation (4 of 8)

• The normal titles for fixed asset accounts and their related contra asset accounts are as follows:

Fixed Asset Account Contra Asset Account Land None—Land is not depreciated. Buildings Accumulated Depreciation—Buildings Store Equipment Accumulated Depreciation—Store Equipment Office Equipment Accumulated Depreciation—Office Equipment

Adjusting Entries for Depreciation (5 of 8)

• The December 31, 20Y3, unadjusted trial balance of NetSolutions indicates that NetSolutions owns two fixed assets: land and office equipment. • Land does not depreciate; however, an adjusting entry is recorded for the

depreciation of the office equipment for December. • Assume that the office equipment depreciates $50 during December. • The adjusting journal entry and T accounts are as follows:

Adjusting Entries for Depreciation (6 of 8)

• After the adjusting journal entry is recorded and posted, the office equipment account still has a debit balance of $1,800.

• The difference between these two balances is the cost of the office equipment that has not yet been depreciated.

• This amount, called the book value of the asset (or net book value), is computed as follows:

Book Value of Asset = Cost of the Asset − Accumulated Depreciation of Asset

Book Value of Office Equipment = Cost of Office Equipment − Accumulated Depr. of Office Equipment = $ 1,800 − $ 50 = $ 1,750

Adjusting Entries for Depreciation (7 of 8)

• The office equipment and its related accumulated depreciation are reported on the December 31, 20Y3, balance sheet as follows:

Office Equipment $ 1,800 Accumulated depreciation (50) $ 1,750

Adjusting Entries for Depreciation (8 of 8)

• The market value of a fixed asset usually differs from its book value. • This is because depreciation is an allocation method, not a valuation method.

• The effects of omitting the adjustment for depreciation are as follows:

Knowledge Check Activity 3

Miller Cement Works, Inc. paid $120,000 for a used cement mixer truck. It has an estimated life of 10 years. After six years, the truck has accumulated depreciation of $72,000, and its net book value is: a. $48,000 b. $0 c. $72,000 d. $120,000

Knowledge Check Activity 3: Answer

Answer: a. $48,000

The net book value of the truck after six years will be its purchase price less accumulated depreciation: $120,000 - $72,000 = $48,000.

Summary of Adjusting Process (Learning Objective 5)

• Adjusting entries are dated as of the last day of the period. • Because collecting the adjustment data requires time, the entries are

usually recorded at a later date. • An explanation is normally included with each adjusting entry.

Exhibit 6 – Summary of Adjustments (1 of 5)

Accrued Revenues

Examples Reason for Adjustment

Adjusting Entry

Examples from NetSolutions

Impact if Adjusting Entry

Is Omitted Services performed but not billed, interest to be received

Services have been provided to the customer but not billed or recorded. Interest has been earned but not received or recorded.

Asset Dr. Revenue Cr.

Accts. Receivable 500 Fees Earned 500

Income Statement:

Revenues Expenses Net income

Balance Sheet: Assets Liabilities Stockholders’

equity (Retained earnings)

Understated No effect Understated

Exhibit 6 – Summary of Adjustments (2 of 5)

Accrued Expenses

Examples Reason for Adjustment

Adjusting Entry

Examples from NetSolutions

Impact if Adjusting Entry

Is Omitted Wages or salaried incurred but not paid, interest incurred but not paid.

Expenses have been incurred but have not been not paid or recorded.

Expense Dr. Liability Cr.

Wage Expense 250 Wages Payable 250

Income Statement:

Revenues Expenses Net income

Balance Sheet: Assets Liabilities Stockholders’

equity (Retained earnings)

No effect Understated Overstated

Exhibit 6 – Summary of Adjustments (3 of 5)

Unearned Revenues

Examples Reason for Adjustment

Adjusting Entry

Examples from NetSolutions

Impact if Adjusting Entry

Is Omitted Unearned rent, magazine subscripts. received in advance, fees received in advance of services

Cash received before services provided is recorded as a liability. Some services have been provided to customer before end of accounting period.

Liability Dr. Revenue Cr.

Unearned Rent 120 Rent Revenue 120

Income Statement:

Revenues Expenses Net income

Balance Sheet: Assets Liabilities Stockholders’

equity (Retained earnings)

Understated No effect Understated

No effect Overstated Understated

Exhibit 6 – Summary of Adjustments (4 of 5)

Prepaid Expenses

Examples Reason for Adjustment

Adjusting Entry

Examples from NetSolutions

Impact if Adjusting Entry

Is Omitted Supplies, prepaid insurance

Prepaid expenses (assets) have been used or consumed in the business operations.

Expense Dr. Asset Cr.

Supplies Exp. 1,240 Supplies 1,240

Insurance Exp. 200 Prepaid Ins. 200

Income Statement:

Revenues Expenses Net income

Balance Sheet: Assets Liabilities Stockholders’

equity (Retained earnings)

No effect Understated Overstated

Overstated No effect Overstated

Exhibit 6 – Summary of Adjustments (5 of 5)

Depreciation

Examples Reason for Adjustment Adjusting Entry

Examples from NetSolutions

Impact if Adjusting Entry

Is Omitted Depreciation of equipment and buildings

Fixed assets depreciate as they are used or consumed in the business operations.

Expense Dr. Contra Asset Cr.

Depr. Expense 50 Accum. Depr.— Office Equ. 50

Income Statement:

Revenues Expenses Net income

Balance Sheet: Assets Liabilities Stockholders’ equity (Retained earnings)

No effect Understated Overstated

Overstated No effect Overstated

Exhibit 7 – Adjusting Entries—NetSolutions

Exhibit 8 – Ledger with Adjusting Entries—NetSolutions (1 of 4)

Exhibit 8 – Ledger with Adjusting Entries—NetSolutions (2 of 4)

Exhibit 8 – Ledger with Adjusting Entries—NetSolutions (3 of 4)

Exhibit 8 – Ledger with Adjusting Entries—NetSolutions (4 of 4)

Discussion Activity 2

Adjusting entries are dated as of the last date of the reporting period, but recorded at a later time. Why do you think adjusting entries are recorded at a later time and not actually on the last date of the reporting period? Discuss potential reasons with 2-3 other students and share your thoughts with the class.

Discussion Activity 2 Debrief

Depending upon the business activities of a company, the process of recording adjusting entries could be time consuming for multiple reasons. First, extra care must be taken to capture all potential adjustments necessary, as well as determining the proper amounts and accounts to be used. Also, in some cases, there may be a large volume of adjusting entries to record. Trying to record all possible adjusting entries at the exact end of the accounting period could lead to unnecessary errors. What are some of the reasons you and your classmates found?

Adjusted Trial Balance (Learning Objective 6)

• After the adjusting entries are posted, an adjusted trial balance is prepared.

• The adjusted trial balance verifies the equality of the total debit and credit balances before the financial statements are prepared.

• If the adjusted trial balance does not balance, an error has occurred.

Exhibit 9 – Adjusted Trial Balance

Analysis for Decision Making: Vertical Analysis (1 of 2) (Learning Objective 7)

• Comparing each item on a financial statement with a total amount from the same statement is useful in analyzing relationships within the financial statement.

• Vertical analysis is the term used to describe such comparisons. • In vertical analysis of a balance sheet, each asset item is stated as a

percent of the total assets. • Each liability and stockholders’ equity item is stated as a percent of total

liabilities and stockholders’ equity. • In vertical analysis of an income statement, each item is stated as a

percent of revenues or fees earned. • Vertical analysis is also useful for analyzing changes in financial

statements over time.

Analysis for Decision Making: Vertical Analysis (2 of 2)

Summary

Now that the lesson has ended, you should have learned how to: • Describe the nature of the adjusting process. • Journalize adjusting entries for accruals. • Journalize adjusting entries for deferrals. • Journalize adjusting entries for depreciation. • Summarize the adjusting process. • Prepare an adjusted trial balance. • Describe and illustrate the use of vertical analysis in evaluating a

company’s performance and financial condition.

Chapter 3: The Adjusting Process
Chapter Objectives
Nature of the Adjusting Process�(Learning Objective 1)
Accrual and Cash Bases of Accounting
Revenue and Expense Recognition�(1 of 2)
Revenue and Expense Recognition�(2 of 2)
The Adjusting Process�(1 of 2)
The Adjusting Process�(2 of 2)
Types of Accounts Requiring Adjustment�(1 of 2)
Exhibit 1 – Accruals��
Types of Accounts Requiring Adjustment�(2 of 2)
Exhibit 2 – Deferrals��
Discussion Activity 1
Discussion Activity 1 Debrief
Adjusting Entries for Accruals�(Learning Objective 2)��Exhibit 3 – Unadjusted Trial Balance for NetSolutions
Exhibit 4 – Expanded Chart of Accounts for NetSolutions
Accrued Revenues�(1 of 3)
Accrued Revenues�(2 of 3)
Accrued Revenues�(3 of 3)
Accrued Expenses�(1 of 5)
Accrued Expenses�(2 of 5)
Exhibit 5 – Accrued Wages
Accrued Expenses�(3 of 5)
Accrued Expenses�(4 of 5)
Accrued Expenses�(5 of 5)
Knowledge Check Activity 1
Knowledge Check Activity 1: Answer
Adjusting Entries for Deferrals (LO3) �Unearned Revenues�(1 of 2)
Unearned Revenues�(2 of 2)
Prepaid Expenses�(1 of 3)
Prepaid Expenses – Supplies�
Prepaid Insurance�
Prepaid Expenses�(2 of 3)
Prepaid Expenses�(3 of 3)
Knowledge Check Activity 2
Knowledge Check Activity 2: Answer
Adjusting Entries for Depreciation�(1 of 8) (Learning Objective 4)
Adjusting Entries for Depreciation�(2 of 8)
Adjusting Entries for Depreciation�(3 of 8)
Adjusting Entries for Depreciation�(4 of 8)
Adjusting Entries for Depreciation�(5 of 8)
Adjusting Entries for Depreciation�(6 of 8)
Adjusting Entries for Depreciation�(7 of 8)
Adjusting Entries for Depreciation�(8 of 8)
Knowledge Check Activity 3
Knowledge Check Activity 3: Answer
Summary of Adjusting Process�(Learning Objective 5)
Exhibit 6 – Summary of Adjustments �(1 of 5)�Accrued Revenues
Exhibit 6 – Summary of Adjustments �(2 of 5)�Accrued Expenses��
Exhibit 6 – Summary of Adjustments �(3 of 5)�Unearned Revenues�
Exhibit 6 – Summary of Adjustments �(4 of 5)�Prepaid Expenses
Exhibit 6 – Summary of Adjustments �(5 of 5)�Depreciation
Exhibit 7 – Adjusting Entries—NetSolutions
Exhibit 8 – Ledger with Adjusting Entries—NetSolutions�(1 of 4)
Exhibit 8 – Ledger with Adjusting Entries—NetSolutions�(2 of 4)
Exhibit 8 – Ledger with Adjusting Entries—NetSolutions�(3 of 4)
Exhibit 8 – Ledger with Adjusting Entries—NetSolutions�(4 of 4)
Discussion Activity 2
Discussion Activity 2 Debrief
Adjusted Trial Balance�(Learning Objective 6)
Exhibit 9 – Adjusted Trial Balance
Analysis for Decision Making: Vertical Analysis�(1 of 2) (Learning Objective 7)
Analysis for Decision Making: Vertical Analysis�(2 of 2)
Summary