Adjusting the Accounts: Major Types and Preparing Deferral Entries

2
Chapter 3
Adjusting the
Accounts
Financial Accounting, IFRS Edition
Weygandt Kimmel Kieso

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1. Explain the time period assumption.
2. Explain the accrual basis of accounting.
3. Explain the reasons for adjusting entries.
4. Identify the major types of adjusting entries.
5. Prepare adjusting entries for deferrals.
6. Prepare adjusting entries for accruals.
7. Describe the nature and purpose of an adjusted trial
balance.
Study Objectives

4
Types of adjusting
entries
Adjusting entries for
deferrals
Adjusting entries for
accruals
Summary of
journalizing and
posting
Timing Issues
Fiscal and calendar
years
Accrual- vs. cash-
basis accounting
Recognizing
revenues and
expenses
Preparing the
adjusted trial balance
Preparing financial
statements
The Basics of
Adjusting Entries
The Adjusted Trial
Balance and
Financial Statements
Adjusting the Accounts

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Generally a month, a quarter, or a year
Fiscal year vs. calendar year
Also known as the “Periodicity Assumption”
Timing Issues
Accountants divide the economic life of a business into
artificial time periods (Time Period Assumption).
SO 1 Explain the time period assumption.
Jan. Feb. Mar. Apr. Dec.
. . . . .

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The time period assumption states that:
a. revenue should be recognized in the accounting
period in which it is earned.
b. expenses should be matched with revenues.
c. the economic life of a business can be divided into
artificial time periods.
d. the fiscal year should correspond with the calendar
year.
Review
Timing Issues
SO 1 Explain the time period assumption.
a. revenue should be recognized in the accounting
b. expenses should be matched with revenues.
c. the economic life of a business can be divided into
artificial time periods.
d. the fiscal year should correspond with the calendar
year.
Solution on
notes page

7
Accrual-Basis Accounting
Transactions recorded in the periods in which the
events occur.
Revenues are recognized when earned, rather than
when cash is received.
Expenses are recognized when incurred, rather than
when paid.
Timing Issues
Accrual- vs. Cash-Basis Accounting
SO 2 Explain the accrual basis of accounting.

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Cash-Basis Accounting
Revenues are recognized when cash is received.
Expenses are recognized when cash is paid.
Cash-basis accounting is not in accordance with
International Financial Reporting Standards (IFRS).
Timing Issues
Accrual- vs. Cash-Basis Accounting

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Revenue Recognition Principle
Timing Issues
Recognizing Revenues and Expenses
Companies recognize
revenue in the accounting
In a service enterprise,
revenue is considered to be
earned at the time the service
is performed.

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Expense Recognition Principle – (Matching Principle)
Timing Issues
Recognizing Revenues and Expenses
Match expenses with
revenues in the period when
the company makes efforts to
generate those revenues.
“Let the expenses follow
the revenues.”

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Timing Issues
IFRS relationships in
revenue and expense
recognition
Illustration 3-1

12 SO 2
Answer on
notes page

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Match the description of the concept to the
concept.
Solution on
notes page
Timing Issues
g
f
c
b

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One of the following statements about the accrual basis of
accounting is false. That statement is:
a. Events that change a company’s financial statements
are recorded in the periods in which the events occur.
b. Revenue is recognized in the period in which it is
earned.
c. The accrual basis of accounting is in accord with
generally accepted accounting principles.
d. Revenue is recorded only when cash is received, and
expenses are recorded only when cash is paid.
Review
Timing Issues
Solution on
notes page
One of the following statements about the accrual basis of
accounting is false. That statement is:
a. Events that change a company’s financial statements
are recorded in the periods in which the events occur.
b. Revenue is recognized in the period in which it is
earned.
c. The accrual basis of accounting is in accord with
generally accepted accounting principles.
d. Revenue is recorded only when cash is received, and
expenses are recorded only when cash is paid.

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Adjusting entries make it possible to report correct
amounts on the statement of financial position
and on the income statement.
A company must make adjusting entries every time
it prepares financial statements.
The Basics of Adjusting Entries
SO 3 Explain the reasons for adjusting entries.

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Revenues - recorded in the period in which they are
earned.
Expenses - recognized in the period in which they
are incurred.
Adjusting entries - needed to ensure that the
revenue recognition and expense recognition are
followed.

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Adjusting entries are made to ensure that:
a. expenses are recognized in the period in
which they are incurred.
b. revenues are recorded in the period in which
they are earned.
c. statement of financial position and income
statement accounts have correct balances at
the end of an accounting period.
d. all of the above.
Review
Adjusting entries are made to ensure that:
a. expenses are recognized in the period in
which they are incurred.
b. revenues are recorded in the period in which
they are earned.
c. statement of financial position and income
statement accounts have correct balances at
the end of an accounting period.
d. all of the above.
Solution on
notes page

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Types of Adjusting Entries
1. Prepaid Expenses.
Expenses paid in cash and
recorded as assets before
they are used or consumed.
Deferrals
3. Accrued Revenues.
Revenues earned but not yet
received in cash or recorded.
4. Accrued Expenses.
Expenses incurred but not
yet paid in cash or recorded.
2. Unearned Revenues.
Revenues received in cash
and recorded as liabilities
before they are earned.
Accruals
SO 4 Identify the major types of adjusting entries.
Illustration 3-2
Categories of adjusting entries

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Trial Balance –
Illustrations are
based on the
October 31, trial
balance of
Pioneer
Advertising
Agency Inc.
Illustration 3-3
SO 4 Identify the major types of adjusting entries.

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Deferrals are either:
Prepaid expenses
OR
Unearned revenues.
SO 5 Prepare adjusting entries for deferrals.
Adjusting Entries for Deferrals

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Payment of cash that is recorded as an asset because
service or benefit will be received in the future.
Adjusting Entries for “Prepaid Expenses”
insurance
supplies
advertising
Cash Payment Expense Recorded
BEFORE
rent
maintenance on equipment
fixed assets (depreciation)
Prepayments often occur in regard to:

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Prepaid Expenses
Costs that expire either with the passage of time or
through use.
Adjusting entries (1) to record the expenses that apply
to the current accounting period, and (2) to show the
unexpired costs in the asset accounts.

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Adjusting entries for prepaid expenses
Increases (debits) an expense account and
Decreases (credits) an asset account.
Illustration 3-4

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Illustration: Pioneer Advertising Agency purchased advertising
supplies costing $2,500 on October 5. Pioneer recorded the
payment by increasing (debiting) the asset Advertising Supplies.
This account shows a balance of $2,500 in the October 31 trial
balance. An inventory count at the close of business on October
31 reveals that $1,000 of supplies are still on hand.
Advertising supplies 1,500
Advertising supplies expense 1,500
Oct. 31
Illustration 3-5

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Illustration: On October 4, Pioneer Advertising Agency paid $600
for a one-year fire insurance policy. Coverage began on October
1. Pioneer recorded the payment by increasing (debiting) Prepaid
Insurance. This account shows a balance of $600 in the
October 31 trial balance. Insurance of $50 ($600 / 12) expires
each month.
Prepaid insurance 50
Insurance expense 50
Oct. 31
Illustration 3-6

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Depreciation
Buildings, equipment, and vehicles (long-lived assets)
are recorded as assets, rather than an expense, in the
year acquired.
Companies report a portion of the cost of a long-lived
asset as an expense (depreciation) during each period
of the asset’s useful life.

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Illustration: Pioneer Advertising estimates depreciation on the
office equipment to be $480 a year, or $40 per month.
Accumulated depreciation 40
Depreciation expense 40
Oct. 31
Illustration 3-7

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Depreciation (Statement Presentation)
Accumulated Depreciation is a contra asset account.
Appears just after the account it offsets (Equipment) on
the statement of financial position.
Illustration 3-8

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Summary Illustration 3-9

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Receipt of cash that is recorded as a liability because the
revenue has not been earned.
Adjusting Entries for “Unearned Revenues”
rent
airline tickets
school tuition
Cash Receipt Revenue Recorded
BEFORE
magazine subscriptions
customer deposits
Unearned revenues often occur in regard to:

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Unearned Revenues
Company makes an adjusting entry to record the revenue
that has been earned and to show the liability that remains.
The adjusting entry for unearned revenues results in a
 decrease (a debit) to a liability account and an
 increase (a credit) to a revenue account.

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Adjusting entries for unearned revenues
Decrease (a debit) to a liability account and
Increase (a credit) to a revenue account.
Illustration 3-10

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Illustration: Pioneer Advertising Agency received $1,200 on
October 2 from R. Knox for advertising services expected to be
completed by December 31. Unearned Service Revenue shows a
balance of $1,200 in the October 31 trial balance. Analysis
reveals that the company earned $400 of those fees in October.
Service revenue 400
Unearned service revenue 400
Oct. 31
Illustration 3-11

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Summary
Illustration 3-12

35 SO 5
Answer on
notes page

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Made to record:
Revenues earned and
OR
Expenses incurred
in the current accounting period that have not been
recognized through daily entries.
SO 6 Prepare adjusting entries for accruals.
Adjusting Entries for Accruals

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Revenues earned but not yet received in cash or
recorded.
Adjusting Entries for “Accrued Revenues”
rent
interest
services performed
BEFORE
Accrued revenues often occur in regard to:
Cash Receipt
Revenue Recorded
Adjusting entry results in:

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Accrued Revenues
An adjusting entry serves two purposes:
(1) It shows the receivable that exists, and
(2) It records the revenues earned.

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Adjusting entries for accrued revenues
Increases (debits) an asset account and
Increases (credits) a revenue account.
Illustration 3-13

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Illustration: In October Pioneer Advertising Agency earned
$200 for advertising services that had not been recorded.
Service Revenue 200
Accounts Receivable 200
Oct. 31
Illustration 3-14

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Summary
Illustration 3-15

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Expenses incurred but not yet paid in cash or recorded.
Adjusting Entries for “Accrued Expenses”
rent
interest
BEFORE
Accrued expenses often occur in regard to:
Cash Payment
Expense Recorded
taxes
salaries
Adjusting entry results in:

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Accrued Expenses
An adjusting entry serves two purposes:
(1) It records the obligations, and
(2) It recognizes the expenses.

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Adjusting entries for accrued expenses
Increases (debits) an expense account and
Increases (credits) a liability account.
Illustration 3-16

45 SO 6 Prepare adjusting entries for accruals.
Illustration: Pioneer Advertising Agency signed a three-month
note payable in the amount of $5,000 on October 1. The note
requires Pioneer to pay interest at an annual rate of 12%.
Interest payable 50
Interest expense 50
Oct. 31
Illustration 3-18
Illustration 3-17

Illustration: Pioneer Advertising Agency last paid salaries on
October 26; the next payment of salaries will not occur until
November 9. The employees receive total salaries of $2,000 for a
five-day work week, or $400 per day. Thus, accrued salaries at
October 31 are $1,200 ($400 x 3 days).
Illustration 3-19

Illustration: Pioneer Advertising Agency last paid salaries on
October 26; the next payment of salaries will not occur until
November 9. The employees receive total salaries of $2,000 for a
five-day work week, or $400 per day. Thus, accrued salaries at
October 31 are $1,200 ($400 x 3 days).
Salaries payable 1,200
Salaries expense 1,200
Oct. 31
Illustration 3-20

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Summary
Illustration 3-21

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After all adjusting entries are journalized and posted the
company prepares another trial balance from the ledger
accounts (Adjusted Trial Balance).
Its purpose is to prove the equality of debit balances and
credit balances in the ledger.
The Adjusted Trial Balance
SO 7 Describe the nature and purpose of an adjusted trial balance.

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SO 7
Illustration 3-24
Adjusted trial balance

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Which of the following statements is incorrect concerning
the adjusted trial balance?
a. An adjusted trial balance proves the equality of the
total debit balances and the total credit balances in
the ledger after all adjustments are made.
b. The adjusted trial balance provides the primary basis
for the preparation of financial statements.
c. The adjusted trial balance lists the account balances
segregated by assets and liabilities.
d. The adjusted trial balance is prepared after the
adjusting entries have been journalized and posted.
Review Question
Which of the following statements is incorrect concerning
the adjusted trial balance?
a. An adjusted trial balance proves the equality of the
total debit balances and the total credit balances in
the ledger after all adjustments are made.
b. The adjusted trial balance provides the primary basis
for the preparation of financial statements.
c. The adjusted trial balance lists the account balances
segregated by assets and liabilities.
d. The adjusted trial balance is prepared after the
adjusting entries have been journalized and posted.

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Financial Statements are prepared directly from the
Adjusted Trial Balance.
Statement
of Financial
Position
Income
Statement
Retained
Earnings
Statement
Preparing Financial Statements

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Illustration 3-25
Preparation of
the income
statement and
retained earnings
statement from
the adjusted trial
balance
SO 7

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Illustration 3-26
SO 7

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Like IFRS, companies applying GAAP use accrual-basis
accounting to ensure that they record transactions that change a
company’s financial statements in the period in which events
occur.
Similar to IFRS, cash-basis accounting is not in accordance with
GAAP.
GAAP also divides the economic life of companies into artificial
time periods. Under both GAAP and IFRS, this is referred to as the
time period assumption. GAAP requires that companies present a
complete set of financial statements, including comparative
information annually.
Understanding U.S. GAAP
Key Differences

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GAAP has more than 100 rules dealing with revenue recognition.
Many of these rules are industry-specific. Revenue recognition
under IFRS is determined primarily by a single standard, IAS 18.
Despite this large disparity in the detailed guidance devoted to
revenue recognition, the general revenue recognition principles
required by IFRS that are used in this textbook are similar to those
under GAAP.
GAAP uses concepts such as realized, realizable, and earned as a
basis for revenue recognition.
Key Differences Adjusting the Accounts

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Internal controls are a system of checks and balances designed to
detect and prevent fraud and errors. The Sarbanes-Oxley Act
requires U.S. companies to enhance their systems of internal
control. However, many foreign companies do not have this
requirement.
Under IFRS, revaluation to fair value of items such as land and
buildings is permitted. This is not permitted under GAAP.
The form and content of financial statements are very similar under
GAAP and IFRS. Any significant differences will be discussed in
those chapters that address specific financial statements.
Key Differences Adjusting the Accounts

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Looking to the Future
The IASB and FASB are now involved in a joint project on revenue
recognition. Presently, the Boards are considering an approach
that focuses on changes in assets and liabilities (rather than on
“when earned”) as the basis for revenue recognition. It is hoped
that this approach will lead to more consistent accounting in this
area. The IASB and the FASB also face a difficult task in attempting
to update, modify, and complete a converged conceptual
framework. For example, how do companies choose between
information that is highly relevant but difficult to verify versus
information that is less relevant but easy to verify? Should a single
measurement method, such as historical cost or fair value, be
used, or does it depend on whether it is an asset or liability that is
being measured?

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Some companies use an alternative treatment for
prepaid expenses and unearned revenues.
When a company prepays an expense, it debits that
amount to an expense account.
When a company receives payment for future services,
it credits the amount to a revenue account.
Alternative Treatment of Prepaid Expenses
and Unearned Revenues
SO 8 Prepare adjusting entries for the alternative treatment of deferrals.
APPENDIX

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Illustration: Pioneer Advertising purchased supplies on
October 5 for $2,500 and debited Advertising
Supplies Expense for the full amount. What if an inventory
of $1,000 of advertising supplies remains on October 31?
Alternative Treatment for “Prepaid Expenses”
Advertising supplies expense 1,000
Advertising supplies 1,000
Oct. 31
Illustration 3A-1

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Alternative Treatment for “Prepaid Expenses”
Adjustment approaches—a comparison
Illustration 3A-2

62
Illustration: Assume that Pioneer Advertising received $1,200
for future services on October 2 and credited the entire amount
to Service Revenue. If at the statement date Pioneer has not
performed $800 of the services, it would make an adjusting
entry.
Alternative Treatment for “Unearned Revenues”
Unearned service revenue 800
Service revenue 800
Oct. 31
Illustration 3A-4

63 SO 8 Prepare adjusting entries for the alternative treatment of deferrals.
Adjustment approaches—a comparison
Illustration 3A-5
Alternative Treatment for “Unearned Revenues”

64 SO 8 Prepare adjusting entries for the alternative treatment of deferrals.
Summary of Additional Adjustment Relationships
Illustration 3A-7

65
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