Chapter 3

ADJUSTING THE ACCOUNTS

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CHAPTER LEARNING OBJECTIVES

After studying this chapter, you should be able to:

  1. Explain the time period assumption.

  2. Explain the accrual basis of accounting.

  3. Explain the reasons for adjusting entries and identify the major types of adjusting entries.

  4. Prepare adjusting entries for deferrals.

  5. Prepare adjusting entries for accruals.

  6. Describe the nature and purpose of an adjusted trial balance.

*7. Prepare adjusting entries for the alternative treatment of prepayments.

*8. Discuss financial reporting concepts.

*9. Compare the procedures for revenue recognition under GAAP and IFRS.

*Note: All asterisked (*) items relate to material contained in the Appendix to the chapter.

PREVIEW OF CHAPTER 3

In Chapter 2 we examined the recording process through the preparation of the trial balance. Before we will be ready to prepare financial statements from the trial balance, additional steps need to be taken. Before financial statements can be prepared, questions relating to the recognition of revenues and expenses must be answered. With the answers in hand, the relevant account balances can then be adjusted. The organization and content of the chapter are as follows:

CHAPTER REVIEW

Time-Period Assumption

1. (L.O. 1) The time period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods.
2. Accounting time periods are generally a month, a quarter, or a year. The accounting time period of one year in length is usually known as a fiscal year.

Accrual Basis of Accounting

3. (L.O. 2) The revenue recognition and matching principles are used under the accrual basis of accounting. Under cash basis accounting, revenue is recorded only when cash is received and expenses are recorded only when paid.

4. Generally accepted accounting principles require accrual basis accounting rather than cash basis accounting because the cash basis of accounting often leads to misleading financial statements.

Revenue Recognition Principle

5. The revenue recognition principle states that revenue should be recognized in the accounting period in which the performance obligation is satisfied.

Expense Recognition Principle

6. The expense recognition principle (also referred to as the matching principle) dictates that efforts (expenses) be matched with accomplishments (revenues).

Adjusting Entries

7. (L.O. 3) Adjusting entries are made in order for:

a. Revenues to be recorded in the period in which services are performed, and for expenses to be recognized in the period in which they are incurred.

b. The revenue recognition and expense recognition principles to be followed.

8. Adjusting entries are required every time a company prepares expense recognition financial statements. Adjusting entries can be classified as (a) deferrals (prepaid expenses or unearned revenues) or (b) accruals (accrued revenues or accrued expenses).

Deferrals

9. (L.O. 4) Prepaid expenses are expenses paid in cash before they are used or consumed.

a. Prepaid expenses expire with the passage of time or through use and consumption.

b. An asset-expense account relationship exists with prepaid expenses.

c. Prior to adjustment, assets are overstated and expenses are understated.

d. The adjusting entry results in a debit to an expense account and a credit to an asset account.

e. Examples of prepaid expenses include supplies, insurance, and depreciation.

f. To illustrate a prepaid adjusting entry, assume on October 1, Kubitz Company pays $2,400 cash to Sandy Insurance Co. for a one-year insurance policy effective October 1. The adjusting entry at October 31 is:

10. Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner.

a. The purchase of equipment or a building is viewed as a long-term prepayment of services and, therefore, is allocated in the same manner as other prepaid expenses.

b. Depreciation is an estimate rather than a factual measurement of the cost that has expired.

c. In recording depreciation, Depreciation Expense is debited and a contra asset account, Accumulated Depreciation, is credited.

d. In the balance sheet, Accumulated Depreciation is offset against the asset account. The difference between the cost of the asset and its related accumulated depreciation is referred to as the book value of the asset.

e. To illustrate an adjusting entry for depreciation, assume Resch Co. purchases a machine for $6,000 cash on January 1, 2014. Assuming that annual depreciation is $1,200, the adjusting entry at December 31, 2014 is:

11. Unearned revenues are revenues received before services are performed.

a. Unearned revenues are subsequently earned by rendering service to a customer.

b. A liability-revenue account relationship exists with unearned revenues.

c. Prior to adjustment, liabilities are overstated and revenues are understated.

d. The adjusting entry results in a debit to a liability account and a credit to a revenue account.

e. Examples of unearned revenues include rent, magazine subscriptions, and customer deposits for future service.

f. To illustrate an unearned revenue adjusting entry, assume on October 1, Schoen Co. receives $3,000 cash from a renter in payment of monthly rent for the period October through December. At October 31, the adjusting entry to record the rent earned in October is:

Accruals

12. (L.O. 5) Accrued revenues are revenues for services performed but not yet recorded at the statement date.

a. Accrued revenues may accumulate with the passing of time as in the case of interest and rent, or through services performed but for which payment has not been collected.

b. An asset-revenue account relationship exists with accrued revenues.

c. Prior to adjustment, both assets and revenues are understated.

d. The adjusting entry results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account.

e. To illustrate an accrued revenue adjusting entry, assume in October, Mayer, a dentist, performs $800 of services for patients for which payment has not been collected. The adjusting entry at October 31 is:

13. Accrued expenses are expenses incurred but not yet paid or recorded at the statement date.

a. Accrued expenses result from the same causes as accrued revenues and include interest, rent, taxes, and salaries.

b. A liability-expense account relationship exists with accrued expenses.

c. Prior to adjustment, both liabilities and expenses are understated.

d. The adjusting entry results in an increase (a debit) to an expense account and an increase (a credit) to a liability account.

e. To illustrate an accrued expense adjusting entry, assume Schwenk Company incurs salaries of $4,000 during the last week of October that will be paid in November. The adjusting entry on October 31 is:

14. Each adjusting entry affects one balance sheet account and one income statement account.

Adjusted Trial Balance

15. (L.O. 6) After all adjusting entries have been journalized and posted an adjusted trial balance is prepared. This trial balance shows the balances of all accounts, including those that have been adjusted, at the end of the accounting period.

16. The purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments have been made.

17. The accounts in the adjusted trial balance contain all data that are needed for the preparation of financial statements.

Alternative Treatment

*18. (L.O. 7) Under the alternative treatment, at the time an expense is prepaid, an expense account is debited, and when unearned revenues are received a revenue account is credited.

*19. The alternative treatment of prepaid expenses and unearned revenues has the same effect on the financial statements as the procedures described in the chapter.

*20. When a prepaid expense is initially debited to an expense account,

a. No adjusting entry will be required if the prepayment is fully expired or consumed before the next financial statement date.

b. If the prepayment is not fully expired or consumed, an adjusting entry is required.

c. Prior to adjustment an expense account is overstated and an asset account is understated.

d. The adjusting entry results in a debit (increase) to an asset account and a credit (decrease) to an expense account.

e. To illustrate the adjusting entry, assume Gonzalez Company purchases $1,200 of supplies and debits Supplies Expense. At the next financial statement date, $300 of supplies are on hand. The adjusting entry is:

*21. When an unearned revenue is initially credited to a revenue account, the procedures are similar to those described above for prepaid expenses. In this case, however,

a. Prior to adjustment, a revenue account is overstated and a liability account is understated.

b. The adjusting entry results in a debit to a revenue account and a credit to a liability account.

Financial Reporting Concepts

*22. (L.O. 8) Recently the FASB completed the first phase of a project in which it developed a conceptual framework to serve as the basis for future accounting standards. The framework states that the primary objective of financial reporting is to provide financial information that is useful to investors and creditors for making decisions about providing capital. Useful information should possess two fundamental qualities, relevance and faithful representation.

*23. Accounting information has relevance if it would make a difference in a business decision. Information is considered relevant if it provides predictive value and confirmatory value. Materiality is a company-specific aspect of relevance.

*24. Faithful representation means that information accurately depicts what really happened. To provide a faithful representation, information must be complete, neutral and free from error.

*25. The FASB also describes a number of enhancing qualities of useful information. These include comparability, consistency, verifiability, timeliness, and understandability.

*26. The FASB relies on some key assumptions, such as the monetary unit assumption, the economic entity assumption, time period assumption, and the going concern assumption.

*27. The FASB uses one of two measurement principles: the historical cost principle or the fair value principal. The historical cost principle dictates that companies record assets at their cost, and the fair value principle indicates that assets and liabilities should be reported at fair value.

*28. The FASB also uses the revenue recognition principle, the expense recognition principle and the full disclosure principle. In addition, the FASB recognizes that there are cost constraints in providing information.

A Look at IFRS

*29. (L.O. 9) Accural – basis accounting applies to both GAAP and IFRS.

*30. GAAP has more than 100 rules dealing with revenue recognition. In contrast, IFRS is determined primarily by a single standard (IAS 18) which is based on the probability that the economic benefits associated with the transaction will flow to the company selling the goods, providing the service, or receiving investment income. In addition, the revenues and costs must be capable of being measured reliably.

*31. Under IFRS, revaluation of items such as land and buildings is permitted. IFRS allows depreciation based on revaluation of assets, which is not permitted under GAAP.

*32. The terminology used for revenues and gains, and expenses and losses, differs somewhat between IFRS and GAAP. Under IFRS income includes both revenues, which arise during the course of operating activities; and gains, which arise from activities outside the normal sales of goods and services. Under GAAP income refers to the net difference between revenues and expenses. Also, under IFRS expenses include both those costs incurred in the normal course of operations, as well as losses that are not part of normal operations.

REVIEW QUESTIONS AND EXERCISES

TRUE—FALSE

Indicate whether each of the following is true (T) or false (F) in the space provided.

_____ 1.	(L.O. 1) The time-period assumption assumes that the economic life of a business can be divided into artificial time periods.
_____ 2.	(L.O. 1) A calendar year and a fiscal year must be the same.
_____ 3.	(L.O. 2) The revenue recognition principle states that revenue should be recognized in the accounting period cash is received.
_____ 4.	(L.O. 2) The expense recognition principle requires that expenses be matched with revenues.
_____ 5.	(L.O. 3) Adjusting entries are journalized throughout the accounting period.
_____ 6.	(L.O. 3) In general, adjusting entries are required each time financial statements are prepared.
_____ 7.	(L.O. 3) In general, adjusting entries are necessary even if the records are free of errors.
_____ 8.	(L.O. 3) Every adjusting entry affects one balance sheet account and one income statement account.
_____ 9.	(L.O. 3) Adjusting entries are journalized but need not be posted.
_____ 10.	(L.O. 4) Prepaid expenses are expenses paid in cash and recorded in an asset account before they are used or consumed.
_____ 11.	(L.O. 4) Depreciation is a process of valuation.
_____ 12.	(L.O. 4) The Accumulated Depreciation account is a contra asset account that is reported on the balance sheet.
_____ 13.	(L.O. 4) The difference between the cost of an asset and its related accumulated depreciation is referred to as the asset's book value.
_____ 14.	(L.O. 4) Revenues received in advance of the accounting period in which they are earned are liabilities.
_____ 15.	(L.O. 5) Accrued revenues are amounts recorded and received but the services are not yet performed.
_____ 16.	(L.O. 5) Prior to an adjustment for accrued revenues, assets and revenues are both understated.
_____ 17.	(L.O. 5) Accrued expenses are prepayments of expenses that will benefit more than one accounting period.
_____ 18.	(L.O. 5) An adjusting entry for accrued expenses results in an increase (a debit) to an expense account and an increase (a credit) to a liability account.
_____ 19.	(L.O. 6) An adjusted trial balance should be prepared before the adjusting entries are made.
_____ 20.	(L.O. 6) The accounts in the adjusted trial balance contain all data that are needed for the preparation of financial statements.
_____ *21.	(L.O. 7) When a prepaid expense is initially debited to an expense account, expenses and assets are both overstated prior to adjustment.
_____ *22.	(L.O. 7) When an unearned revenue is initially credited to a revenue account, the adjusting entry will result in a debit to a revenue account and a credit to a liability account.

MULTIPLE CHOICE

Circle the letter that best answers each of the following statements.

1. (L.O. 2) Which of the following statements concerning the accrual basis of accounting is incorrect?
   1. The accrual basis of accounting follows the revenue recognition principle.
   2. The accrual basis of accounting is the method required by generally accepted accounting principles.
   3. The accrual basis of accounting recognizes expenses when they are paid.
   4. The accrual basis of accounting follows the matching principle.
2. (L.O. 2) The revenue recognition principle recognizes that:
   1. revenue should be recognized in the accounting period in which the services are performed.
   2. the economic life of a business can be divided into artificial time periods.
   3. expenses should be matched with revenues.
   4. the fiscal year should correspond with the calendar year.
3. (L.O. 2) The expense recognition principle dictates that:
   1. each debit be matched with an equal credit.
   2. revenue should be recognized in the accounting period in which the services are performed.
   3. expenses should be matched with revenues.
   4. the fiscal year should match the calendar year.
4. (L.O. 4) For prepaid expense adjusting entries:
   1. an expense-liability account relationship exists.
   2. prior to adjustment, expenses are overstated and assets are understated.
   3. the adjusting entry results in a debit to an expense account and a credit to an asset account.
   4. none of the above.
5. (L.O. 4) The beginning balance of Supplies for Lu Inc. was $900. During the year additional supplies were purchased for $450. At the end of the year an inventory count indicates $700 of supplies on hand. The adjusting entry at December 31, is:

   

6. (L.O. 4) Demaet Cruise Lines purchased a five-year insurance policy for its ships on April 1, 2014 for $100,000. Assuming that April 1 is the effective date of the policy, the adjusting entry on December 31, 2014 is:

   

7. (L.O. 4) Cost less accumulated depreciation for a plant asset is often called:
   1. book value.
   2. market value.
   3. original value.
   4. none of the above answer choices are correct.
8. (L.O. 4) Accumulated depreciation plus book value will equal the asset's:
   1. cost.
   2. market value.
   3. depreciable cost.
   4. none of the above answer choices are correct.
9. (L.O. 4) Tamara Company purchased a machine on January 1, 2014. Annual depreciation is $800. At December 31, 2016, the balance in the accumulated depreciation account, after adjustment, should be:
   1. $800.
   2. $1,600.
   3. $2,400.
   4. $3,200.
10. (L.O. 4) For unearned revenue adjusting entries, the incorrect statement is:
    1. a liability-revenue account relationship exists.
    2. prior to adjustment, revenues are overstated and liabilities are understated.
    3. the adjusting entry results in a debit to a liability account and a credit to a revenue account.
    4. if the adjustment is not made, revenues will be understated.
11. (L.O. 4) On May 1, 2014, Maricel Advertising Company received $3,000 from Kathy Siska for advertising services to be completed April 30, 2015. At December 31, 2014, $2,000 of the fees have been earned. The adjusting entry on December 31, 2014 by Maricel will include a:
    1. $1,000 credit to Unearned Fees.
    2. $1,000 debit to Fees Earned.
    3. $2,000 credit to Unearned Fees.
    4. $2,000 debit to Unearned Fees.
12. (L.O. 4) The account Unearned Revenues is a(n):
    1. revenue account.
    2. contra revenue account.
    3. liability account.
    4. asset account.
13. (L.O. 5) For accrued revenue adjusting entries,
    1. an asset-revenue account relationship exists.
    2. prior to adjustment, assets and revenues are both overstated.
    3. the adjusting entry results in an increase (a debit) to a revenue account and an increase (a credit) to an asset account.
    4. none of the above.
14. (L.O. 5) On June 30, Wian Marketing Services is preparing its financial statements. $600 of fees were earned in June for which payment had not been recorded on prior to June 30. The adjusting entry at June 30 is:

    

15. (L.O. 5) For accrued expense adjusting entries, the incorrect statement is:
    1. a liability-expense account relationship exists.
    2. prior to adjustment, both expenses and liabilities are understated.
    3. if the adjusting entry is not made, expenses will be overstated in the income statement.
    4. the adjusting entry results in an increase (a debit) to an expense account and an increase (a credit) to a liability account.
16. (L.O. 5) Gardner Company purchased a truck from Kutner Co. by issuing a 6-month 10% note payable for $30,000 on November 1. On December 31, the accrued expense adjusting entry is:

    

17. (L.O. 5) Cathy Cline, an employee of the Wheeler Company, will not receive her paycheck until April 2. Based on services performed from March 15 to March 30 her salary was $800. The adjusting entry for Wheeler Company on March 31 is:

    

18. (L.O. 6) Financial statements are prepared directly from the:
    1. general journal.
    2. ledger.
    3. trial balance.
    4. adjusted trial balance.

*19. (L.O. 7) On January 2, Van Alstyne Food Services pays $3,000 cash for office supplies. Supplies Expense is debited because the supplies are expected to be used before financial statements are prepared on June 30. At June 30, there are $300 of office supplies on hand. The adjusting entry is:

*20. (L.O. 7) On May 1, Walsh Inc. credited Service Revenue when $4,000 cash was received for future services. On June 30, the next date financial statements are prepared, $600 of the services have not been rendered. The June 30 adjusting entry will include a:

credit to Service Revenue of $600.

debit to Service Revenue of $600.

debit to Unearned Service Revenue of $3,400.

credit to Unearned Service Revenue of $3,400.

MATCHING

Match each term with its definition by writing the appropriate letter in the space provided.

EXERCISES

EX. 3-1 (L.O. 4 and 5) McDaniels Painting Company is at the end of its fiscal year December 31, 2014 and needs to record its adjusting entries. Adjustment data are as follows:

1. Four months ago, Judy Bernstein made a $8,000 prepayment for the painting of her house. McDaniels recorded the original entry as Unearned Revenue. At December 31, one-fourth of the painting of the house remains to be done.
2. McDaniels purchased a truck from Donnelly Vehicles on January 1, 2013 at a cost of $20,000. Annual depreciation is $4,000. Depreciation was correctly recorded for 2013.
3. An employee, Pam Travis had earned wages of $500 for the last week in December. She will not be paid until January 5.
4. McDaniels purchased a $24,000, four-year insurance policy from Heinsen Insurance four months ago. The effective date of the policy was September 1, 2014.
5. McDaniels began painting Peggy Thompson's clubhouse in November at a price of $32,000. McDaniels determines that $20,000 of the revenue has been earned at December 31. Thompson has not made any payment to McDaniels, and McDaniels has not billed Thompson for services rendered.

Instructions

Prepare the adjusting entries at December 31, 2014.

EX. 3-2 (L.O. 6) The adjusted trial balance of the Susan Dey Company at November 30, 2014, is as follows:

Instructions

(a) Prepare an income statement and an owner's equity statement for the year ended November 30, 2014.

(b) Prepare a balance sheet at November 30, 2014.

SOLUTIONS TO REVIEW QUESTIONS AND EXERCISES

TRUE-FALSE

1. (T)
2. (F)	The calendar year begins January 1 and ends December 31. Fiscal years usually begin with the first day of any month and end on the last day of a month, twelve months later. Of course, the fiscal year could coincide with the calendar year.
3. (F)	The revenue recognition principle states that revenue should be recognized in the accounting period in which the services are performed. Sometimes the receipt of cash does not coincide with the period in which the service is performed.
4. (T)
5. (F)	Adjusting entries are only prepared at the end of an accounting period.
6. (T)
7. (T)
8. (T)
9. (F)	Adjusting entries must be both journalized and posted.
10. (T)
11. (F)	Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner.
12. (T)
13. (T)
14. (T)
15. (F)	Accrued revenues are revenues earned but not yet received in cash.
16. (T)
17. (F)	Accrued expenses are expenses incurred but not yet paid or recorded.
18. (T)
19. (F)	The adjusted trial balance can only be prepared after the adjusting entries are made.
20. (T)
*21. (F)	Prior to adjustment, expenses are overstated and assets are understated.
*22 (T)

MULTIPLE CHOICE

1. (c)	The accrual basis of accounting recognizes expenses when they are incurred. Choices (a), (b), and (d) are all correct statements concerning the accrual basis of accounting.
2. (a)	Choice (b) is the time-period assumption. Choice (c) is the expense recognition principle. Answer (d) pertains to the time-period assumption. Also, the fiscal year does not have to correspond with the calendar year.
3. (c)	Choice (a) is the dual effect of the double-entry system discussed in Chapter 2. Choice (b) is the revenue recognition principle. Choice (d) is an incorrect statement because the fiscal year does not necessarily have to be the calendar year.
4. (c)	Answer (a) is incorrect because an asset-expense account relationship exists. Answer (b) is incorrect because prior to adjustment, assets are overstated and expenses are understated.
5. (d)	The total cost of supplies is $1,350 ($900 + $450). Since the ending inventory is $700, the supplies expense for the period is $650 ($1,350 − $700).
6. (b)	Because the effective date of the policy is April 1, only 3/4 of one year is expensed ($100,000 × 1/5 × 3/4 = $15,000). Insurance Expense is debited and Prepaid Insurance is credited because the $100,000 payment was debited to Prepaid Insurance.
7. (a)	The market value (b) is the current exchange value of the asset. The original value (c) would refer to the cost.
8. (a)	Cost less the related accumulated depreciation is equal to book value; therefore, changing the equation, accumulated depreciation plus book value equals the cost of the asset.
9. (c)	The balance should be the accumulated depreciation for three years which is $2,400 ($800 × 3).
10. (b)	Prior to adjustment liabilities are overstated and revenues are understated. The other answer choices are correct.
11. (d)	The account balances should be Unearned Service Revenue $1,000 credit, and Service Revenue $2,000 credit. Thus, the adjusting entry is:
12. (c)	Unearned Revenue is the receipt of cash before the service has been performed. The obligation to perform this service is indicated in the records by crediting a liability account.
13. (a)	Answer (b) is incorrect because prior to adjustment both assets and revenues are understated. Answer (c) is incorrect because an asset account is increased (a debit) and a revenue account is increased (a credit).
14. (b)	The amount owed by the clients is a receivable that is debited to an asset account. The services concerning this receivable have been performed and thus, earned; therefore, a revenue account is credited.
15. (c)	In an accrued expense adjusting entry, expenses are understated prior to adjustment (b). Therefore, if the adjusting entry is not made, expenses will be understated.
16. (d)	The accrued interest is $500 ($30,000 × 10% × 2/12).
17. (a)	The accrued expense is recognized by debiting Salaries and Wages Expense and crediting Salaries and Wages Payable.
18. (d)	The adjusted trial balance is prepared after all adjusting entries have been posted. Accordingly, the financial statements can be prepared directly from it.
*19. (a)	At June 30, $300 of office supplies is on hand, which is the balance that should be in the asset account, Supplies. Since the unadjusted balance in this account is zero, Supplies must be debited for $300. Given the inventory on hand, office supplies expense for the period is $2,700 ($3,000 − $300). The unadjusted balance in Supplies Expense is $3,000. Therefore, this account must be credited for $300.
*20. (b)	At June 30, $600 of the $4,000 of future services have not been rendered and $3,400 has been earned ($4,000 − $600). Prior to adjustment, the balances are Unearned Service Revenue $0 and Service Revenue $4,000. Thus, the adjusting entry is a debit to Service Revenue $600 and a credit to Unearned Service Revenue $600.

MATCHING

1. k
2. i
3. e
4. n
5. d
6. a
7. h
8. b
9. l
10. m
11. c
12. g
13. f
14. j

EX. 3-1

EX. 3-2