Chapter 3: The Adjusting Process – Financial Accounting Study Notes

Chapter 3: The Adjusting Process

Overview

This chapter introduces the adjusting process in financial accounting, focusing on the distinction between cash basis and accrual basis accounting, the application of key accounting principles, and the preparation and impact of adjusting entries on financial statements.

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

• Prepare an adjusted trial balance

• Identify the impact of adjusting entries on financial statements

• Describe the accounting cycle

• Explain the purpose of a worksheet in preparing adjusting entries and the adjusted trial balance

Cash Basis vs. Accrual Basis Accounting

Definitions and Key Differences

• Cash Basis Accounting:!

  • Revenues are recorded when cash is received.

  • Expenses are recorded when cash is paid.

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

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

• 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.

  • Required by GAAP and used by most businesses.

  • Provides a more accurate picture of a business’s financial performance.

Example: Expense Recognition

	Cash Basis	Accrual Basis
Cash Payment Made	May 1: $1,200	May 1: $1,200
Expense Recorded	May 1: $1,200	May 31: $200 June 30: $200 July 31: $200 August 31: $200 September 30: $200 October 31: $200
Total Expense Recorded	$1,200	$1,200

Explanation: Under cash basis, the entire payment is recorded as an expense when paid. Under accrual basis, the expense is allocated over the period benefited.