Chapter 3: The Adjusting Process – Financial Accounting Study Notes

Chapter 3: The Adjusting Process

Overview

This chapter focuses on the essential concepts and procedures involved in the adjusting process in financial accounting. It covers the differences between cash basis and accrual basis accounting, the application of key accounting principles, and the preparation and impact of adjusting entries.

Chapter 3 Learning Objectives

• Differentiate between cash basis accounting and accrual basis accounting

• Define and apply the time period concept, revenue recognition, and matching principles

• Explain the purpose of and journalize/post adjusting entries for deferrals and accruals

• Explain the purpose of and prepare an adjusted trial balance

• Identify the impact of adjusting entries on financial statements

• Describe the accounting cycle

• Explain the purpose of a worksheet and use it to prepare adjusting entries and the adjusted trial balance

Cash Basis vs. Accrual Basis Accounting

Definitions and Key Differences

Understanding the distinction between cash basis and accrual basis accounting is fundamental for accurate financial reporting.

• Cash Basis Accounting:

  • Revenues are recorded when cash is received.

  • Expenses are recorded when cash is paid.

  • Not allowed under GAAP (Generally Accepted Accounting Principles).

  • Easier to follow; requires less knowledge of accounting concepts and principles.

• Accrual Basis Accounting:

  • Revenues are recorded when earned, regardless of when cash is received.

  • Expenses are recorded when incurred, regardless of when cash is paid.

  • Used by most businesses and required under GAAP.

  • Provides a better picture of a business’s revenues and expenses.

Example: Revenue Recognition under Cash vs. Accrual Basis

Consider Smart Touch Learning receiving $600 on April 30 for services to be performed over six months (May–October):

	Cash Basis	Accrual Basis
Cash Received	April 30: $600	April 30: $600
Revenue Recorded	April 30: $600	May 31: $100 June 30: $100 July 31: $100 August 31: $100 September 30: $100 October 31: $100
Total Revenue Recorded	$600	$600

Key Point: Under cash basis, all revenue is recognized when cash is received. Under accrual basis, revenue is recognized as it is earned over the service period.

Additional info:

• Accrual accounting provides more accurate financial statements and is required for external reporting by most organizations.

• Adjusting entries are necessary to ensure that revenues and expenses are recognized in the correct accounting period.