Chapter 3

The Adjusting Process

Chapter Overview
This chapter introduces you to the adjusting process. Cash and accrual accounting are illustrated and
differentiated. The accounting period concept, the revenue, and matching principles and the time-period
concept are explained. Adjusting entries are defined. Prepaids and accruals are compared. The five
categories of adjusting entriesprepaid expenses, depreciation, accrued expenses, accrued revenues, and
unearned revenuesare illustrated and described in detail. The text provides examples of adjusting
entries for prepaid rent, supplies, and depreciation of furniture. Accumulated depreciation and book value
are explained. The text then provides examples of accrued salaries, accrued service revenue, and unearned
service revenue. A comparison of the timing of both prepaids and accruals along with a summary of the
adjusting process concludes the discussion of adjusting entries.
The last part of the chapter focuses on the financial statements. You will learn how to prepare an adjusted
trial balance and then use it to prepare the financial statements. The relationship among the financial
statements is emphasized. Following a discussion of ethical issues in accrual accounting, Decision
Guidelines (page 152) will help you through the adjusting process. Decision Guidelines feature important
questions about measuring business income, the accounting process, and the adjusted trial balance. A
summary problem reviews adjusting entries, the adjusted trial balance, and preparation of the financial
statements. An appendix covers an alternate way to record prepaid expenses and unearned revenues
directly into and income statement account. You will not be tested on the materials covered in the
appendix.

Chapter 3: Summary Handout

1. Accrual versus cash-basis accounting

o

Accrual accounting records the effect of each transaction as it occurs

Revenues are recorded when earned

Expenses are recorded when incurred

Cash-basis accounting records only cash receipts and cash payments

Cash receipts are treated as revenues

Cash payments are treated as expenses

2. Other accounting principles

o

The Accounting Period

The Revenue Recognition Principle

The Matching Principle

The Time-Period Concept

3. Two Categories of Adjusting Entries

o

Prepaid

Depreciation

Allocates a plant's asset costs to an expense

Accumulated depreciation, a contra asset account, holds the sum of all

depreciation recorded for the asset over its useful life

Expenses

Prepaid expenses are assets until used

Unearned Revenue

When the company is paid cash before it does all the work to earn it, a
liability is created

Accrual

Expenses

Incurred costs which haven't been paid for yet

Revenues

Earned revenue for which cash hasn't been collected for

4. Adjusting entries always affects a revenue or an expense, and an asset or a liability

o

Adjusting entries never affect cash

5. The adjusted trial balance gives the adjusted account balances.

o

A worksheet can be used to combine the trial balance amounts plus/minus any adjustments to
made at the end of the period

6. Relationships among financial statements

o

Statements must be prepared in order

Net income (loss) from the Income Statement is carried to the Statement of Owner's Equity

Net income increases capital

Net loss decreases capital

Capital then goes to the Balance Sheet

Lecture Outline Tips: Key Topics

Accountants have several accounting principles or concepts that guide them in recording financial
information. Some of the principles, in addition to accrual accounting versus cash-basis accounting,
include the accounting period concept and the revenue principle. Various businesses have different
accounting period. Generally one accounting period is one year or one fiscal period. A fiscal year may be
the same as a calendar year. It is important to understand the revenue principle for the process of
adjusting entries related to revenue recognition. The revenue principle in accrual accounting system is
that revenue is recognized when services are performed and not necessarily when cash for services are
received. The revenue principle in cash-basis accounting is that revenue is recognized when cash is
received and not necessarily when services are provided. Companies that must follow GAAP must use
accrual accounting system. One of the GAAP principles called matching principle requires using
adjusting entries to make sure revenue earned in one period is matched against the expenses incurred in
the same period that created revenue.
Adjusting entries are simply a kind of journal entry and must balance debits equal credits. Another
good check figure with adjusting entries is that the income statement and the balance sheet are always
affected. Adjusting entries do not affect the cash account. The handout on Chapter Three posted on
Modules is a short, yet comprehensive summary of the adjusting entries.
Some students have difficulty with adjusting the unearned revenue account. Remember the purpose of the
adjusting entry is to record the revenue that was earned during the period, not the amount related to work
to be performed in the future.
It may be helpful to understand that someones accrual is always someone elses deferral. For example, a
tenants rent payment recorded as prepaid rent has been recorded by the landlord as unearned revenue.
Be careful when calculating adjusted trial balance totals. Not every adjustment is an addition or
subtraction - it depends on the account type. Debits are added to debits, but are subtracted from credits,
for example.
The income statement and statement of owner's equity are for the period, but the balance sheet is for one
day. Students may want to report the balance sheet for the period, which is impossible. For example, you
cant compute a cash balance for an entire period, its computed for each day, and will change from day
to day. In addition, point out the statement of owner's equity balance in the balance sheet is for the end of
the period, not the beginning.

Answer Key to Chapter 3 Quiz:

1.
2.
3.
4.
5.

B
B
C
C
A

6. A
7. C
8. C
9. B
10. D

Name

Date

Section

CHAPTER 3
TEN-MINUTE QUIZ
Circle the letter of the best response.
1.

What are the distinctive features of accrual accounting and cash-basis accounting?
A.
Accrual accounting records only receivables, payables, and depreciation.
B.
Accrual accounting is superior because it provides more information.
C.
Cash-basis accounting records all transactions.
D.
All of the above are true.

2.

The revenue recognition principle says

A.
divide time into annual periods to measure revenue properly.
B.
record revenue only after you have earned it.
C.
measure revenues and expenses in order to compute net income.
D.
record revenue after you receive cash.

3.

Adjusting the accounts is the process of

A.
subtracting expenses from revenues to measure net income.
B.
recording transactions as they occur during the period.
C.
updating the accounts at the end of the period.
D.
zeroing out account balances to prepare for the next period.

4.

Which types of adjusting entries are natural opposites?

A.
Net income and net loss
B.
Expenses and revenues
C.
Prepaids and accruals
D.
Prepaids and depreciation

5.

Assume that the weekly payroll of In the Woods Camping Supplies, Inc., is $300. December
31, end of the year, falls on Tuesday, and In the Woods will pay its employee on Friday for the
full week. What adjusting entry will In the Woods make on Tuesday, December 31? (Use five
days as a full workweek.)
A.
B.
C.
D.

Salary expense
120
Salary payable
120
Salary payable
300
Salary expense
300
Salary expense
180
Cash
180
No adjustment is needed because the company will pay the payroll on Friday.

6.

Get Fit Now gains a client who prepays $540 for a package of six physical training sessions.
Get Fit Now collects the $540 in advance and will provide the training later. After four training
sessions, what should Get Fit Now report on its income statement?
A.
B.
C.
D.

7.

Service revenue of $360

Service revenue of $540
Unearned service revenue of $360
Cash of $180

Assume you prepay Get Fit Now for a package of six physical training sessions. Which type
of account should you have in your records?
A.
Accrued revenue
B.
Accrued expense
C.
Prepaid expense
D.
Unearned revenue

8.

Unearned revenue is always

A.
owner's equity because you collected the cash in advance.
B.
revenue.
C.
a liability.
D.
an asset.

9.

The adjusted trial balance shows

A.
amounts that may be out of balance.
B.
amounts ready for the financial statements.
C.
assets, liabilities, and owner's equity only.
D.
revenues and expenses only.

10.

Accounting data flow from

A.
the income statement to the statement of owner's equity.
B.
the statement of owner's equity to the balance sheet.
C.
the balance sheet to the income statement.
D.
both A and B above.