Chapter 3: The Adjusting Process – Financial Accounting Study Notes

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Chapter 3: The Adjusting Process

Learning Objectives

Differentiate between cash basis and accrual basis accounting
Define and apply the time period concept, revenue recognition, and matching principles
Explain the purpose of and journalize and post adjusting entries for deferrals and accruals
Prepare an adjusted trial balance and identify the impact of adjusting entries on financial statements
Describe the accounting cycle and the use of a worksheet in preparing adjusting entries

Cash Basis vs. Accrual Basis Accounting

Definitions and Key Differences

Cash Basis Accounting: Records revenues when cash is received and expenses when cash is paid. Not permitted under GAAP. Simpler but less accurate for depicting financial performance.
Accrual Basis Accounting: Records revenues when earned and expenses when incurred, regardless of cash flow. Required by GAAP and provides a more accurate picture of financial position.

Example: If $1,200 is paid for six months of insurance on May 1:

Cash basis: Records $1,200 expense on May 1.
Accrual basis: Records $200 expense each month from May to October.

Comparison table of cash basis and accrual basis for expense recognition

Example: If $600 is received on April 30 for services to be performed over six months:

Cash basis: Records $600 revenue on April 30.
Accrual basis: Records $100 revenue each month from May to October.

Comparison table of cash basis and accrual basis for revenue recognition

The Time Period Concept, Revenue Recognition, and Matching Principles

The Time Period Concept

Assumes business activities can be divided into specific periods (month, quarter, year).
A fiscal year is any 12 consecutive months, not necessarily the calendar year.

The Revenue Recognition Principle

Determines when revenue should be recorded. Follows a five-step process:
1. Identify the contract with the customer.
2. Identify the performance obligations.
3. Determine the transaction price.
4. Allocate the transaction price to performance obligations.
5. Recognize revenue when (or as) each obligation is satisfied.

The Matching Principle

Requires expenses to be recorded in the same period as the revenues they help generate.
Ensures accurate measurement of net income or loss for the period.

Adjusting Entries: Purpose and Types

What Are Adjusting Entries?

Entries made at the end of the accounting period to assign revenues and expenses to the correct period.
Update asset and liability accounts to reflect correct balances.
Two main categories: Deferrals and Accruals.

Unadjusted trial balance example

Deferrals

Deferred Expenses (Prepaid Expenses): Advance payments for future expenses, recorded as assets until used.
Deferred Revenues (Unearned Revenues): Cash received before services are performed, recorded as liabilities until earned.

Accruals

Accrued Expenses: Expenses incurred but not yet paid or recorded.
Accrued Revenues: Revenues earned but not yet received or recorded.

Deferral Adjustments: Examples and Journal Entries

Prepaid Rent Example

On Dec 1, $3,000 prepaid for three months' rent.
At Dec 31, one month ($1,000) has been used; adjusting entry transfers $1,000 from Prepaid Rent to Rent Expense.

Prepaid Rent T-account before adjustment Timeline showing rent expense allocation T-accounts showing adjustment from Prepaid Rent to Rent Expense

Office Supplies Example

Purchased $500 of supplies; $100 remains at period end.
Adjusting entry: Supplies Expense $400, Office Supplies $400.

Office Supplies T-account before adjustment T-accounts showing adjustment for office supplies used

Depreciation

Allocation of a plant asset's cost over its useful life.
Recorded as Depreciation Expense; Accumulated Depreciation is a contra asset account.
Straight-line method formula:
Example: $18,000 furniture, 5-year life, $0 residual value: $300/month depreciation.

Furniture T-account for asset acquisition T-accounts for depreciation expense and accumulated depreciation Related and contra account T-accounts Partial balance sheet showing property, plant, and equipment

Deferred Revenues (Unearned Revenue)

Cash received before service is performed; recorded as a liability.
When service is performed, liability is reduced and revenue is recognized.
Example: $600 received in advance; $200 earned by period end.

Unearned Revenue T-account for cash received T-accounts showing adjustment from Unearned Revenue to Service Revenue

Accrual Adjustments: Examples and Journal Entries

Accrued Expenses

Expenses incurred but not yet paid (e.g., salaries, interest, utilities).
Example: $2,400 monthly salary, paid half on 15th and half on 1st of next month. At Dec 31, $1,200 accrued.

December calendar showing paydays T-accounts for Salaries Payable and Salaries Expense

Accrued Interest Expense

Interest on a loan is accrued at period end.
Formula:
Example: $60,000 loan, 2% annual rate, 1 month: $100 interest accrued.

T-accounts for Interest Payable and Interest Expense

Accrued Revenues

Revenue earned but not yet received or recorded.
Example: $1,600 monthly service, $800 earned by Dec 31, payment to be received Jan 15.

T-accounts for Accounts Receivable and Service Revenue Journal entry for cash received and revenue recognition

Summary of Deferral and Accrual Adjustments

The following table summarizes the types of adjustments and their impact:

Type of Adjusting Entry	Description	Adjusting Entry	Impact if Not Made
Deferred Expenses	Advance cash payments of future expenses	Expense DR, Asset CR	Expenses understated, assets overstated, net income overstated
Deferred Revenues	Advance cash receipts of future revenues	Liability DR, Revenue CR	Revenues understated, liabilities overstated, net income understated
Accrued Expenses	Expense incurred but not paid	Expense DR, Liability CR	Expenses understated, liabilities understated, net income overstated
Accrued Revenues	Revenue earned but not received	Asset DR, Revenue CR	Revenues understated, assets understated, net income understated

Summary table of deferral and accrual adjustments

Adjusted Trial Balance

Purpose and Preparation

Prepared at the end of the period after all adjusting entries are posted.
Ensures total debits equal total credits.
Financial statements are prepared from the adjusted trial balance.

Adjusted trial balance example

Impact of Adjusting Entries on Financial Statements

Adjusting entries ensure that income statement and balance sheet accounts are properly valued.
Failure to record adjustments leads to misstated financial statements (e.g., overstated assets or net income).

The Accounting Cycle

Steps in the Accounting Cycle

1. Start with beginning account balances
2. Analyze and journalize transactions
3. Post journal entries to the ledger
4. Prepare the unadjusted trial balance
5. Journalize and post adjusting entries
6. Prepare the adjusted trial balance

Diagram of the accounting cycle steps

Worksheets in the Adjusting Process

Purpose and Structure

A worksheet is an internal tool to organize and summarize data for preparing financial statements.
Sections include: account names, unadjusted trial balance, adjustments, adjusted trial balance, income statement, and balance sheet columns.

Partially completed worksheet example

Key Formulas

Straight-line Depreciation:
Interest Calculation:

Summary Table: Adjusting Entries

Type	Original Entry	Adjusting Entry
Prepaid Expenses	Prepaid Rent / Cash	Rent Expense / Prepaid Rent
Depreciation	Furniture / Cash	Depreciation Expense / Accumulated Depreciation
Unearned Revenue	Cash / Unearned Revenue	Unearned Revenue / Service Revenue
Accrued Expenses	None	Salaries Expense / Salaries Payable
Accrued Revenues	None	Accounts Receivable / Service Revenue

Summary of adjusting entries table