adjusting accounts for financial statements

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Adjusting Accounts for
Financial Statements
CHAPTER 3
Electronic Presentations in Microsoft® PowerPoint® to accompany
Fundamental Accounting Principles, 17ce
Prepared by
Regula Lewis
© 2022 McGraw Hill Ltd.

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© McGraw Hill Ltd. 3-2
© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No
reproduction or further distribution permitted without the prior written consent of McGraw-Hill
Education.
Learning Objectives 1
1. Describe the purpose of adjusting accounts at the end of the period. (LO1)
2. Explain how the timeliness, matching, and revenue recognition principles
affect the adjusting process. (LO2)
3. Explain accrual accounting and cash basis accounting and how accrual
accounting adds to the usefulness of financial statements.
(LO3)
4. Prepare and explain adjusting entries for prepaid expenses, depreciation,
unearned revenues, accrued expenses, and accrued revenues. (LO4)

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Learning Objectives2
5. Explain how accounting adjustments link to financial statements. (LO5)
6. Explain and prepare an adjusted trial balance. (LO6)
7. Prepare financial statements from an adjusted trial balance. (LO7)
8. Explain and prepare correcting entries. (Appendix 3A) (LO8) NOT
REQUIRED
9. Identify and explain an alternative in recording prepaid and unearned
revenues. (Appendix 3B) (LO9) NOT REQUIRED

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Education.
LO1: Purpose of Adjusting 1
The following accounts often need to be adjusted at the end of an accounting
period:
1. Prepaid Insurance
2. Supplies
3. Prepaid Rent
4. Depreciation
5. Unearned Revenues
6. Interest Expense
7. Salaries Expense
8. Services Revenue
9. Accrued Interest Income

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Education.
Trial Balance
Organico Trial Balance March 31, 2023
Debit Credit
Cash $8,070
Accounts Receivable -0-
Prepaid Insurance 2,400
Supplies 3,600
Equipment 6,000
Accounts Payable $200
Unearned food services revenue 3,000
Notes payable 6,000
Hailey Walker, capital 600
Food Services revenue 3,800
Teaching revenue 300
Rent expense 1,000
Salaries expense 1,400
Utilities expense 230
Totals $23,300 $23,300

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Education.
LO2: GAAP and the Adjusting Process
Adjustments are based on three generally accepted accounting principles:
• Timeliness principle
• Matching principle
• Revenue recognition principle

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Education.
The Accounting Period 1
• Information must reach decision makers frequently and on a timely
basis.
• The timeliness principle assumes that an organization’s activities can be
divided into specific time periods such as a month, a three-month
quarter, or a year.
EXHIBIT 3.3

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Education.
The Accounting Period 2
• Reports covering a one-year period are known as annual financial
statements.
• A company can adopt a fiscal year based on the calendar year or its natural
business year.
• Many organizations also prepare interim financial reports covering one, three
(quarterly), or six (semi-annual) months of activity.
• The annual reporting period is not always a calendar year ending on
December 31.
• Companies with little seasonal variation in sales often choose the calendar
year as their fiscal year.

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Education.
Recognizing Revenues and Expenses
• Accounting standard-setting bodies developed a set of principles to clarify the
appropriate level of revenue and expense to report.
• Two main generally accepted accounting principles are used in the adjusting
process:
• Matching Principle: Expenses are to be matched in the same accounting period as the
revenues they helped to earn.
• Revenue Recognition Principle: Revenue is recognized (reported) in the time period
when it is earned regardless when the cash is received.

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Education.
LO3: Accrual Basis Compared to Cash Basis 1
Accrual Basis:
• Revenues and expenses are recognized when earned or incurred regardless
of when cash is received or paid.
• Consistent with GAAP.
Cash Basis:
• Revenues and expenses are recognized when cash is received or paid.
• Not consistent with GAAP.

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Education.
Accrual Basis Compared to Cash Basis 2

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IMPORTANT TIP
The cash basis of accounting is not an acceptable method for use in
financial reporting.
IFRS and Canadian ASPE standards require companies to use the
accrual basis of accounting.
CRA also requires companies to adopt the accrual basis of
accounting.

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Education.
ETHICAL IMPACT GOOD …. I SAW THIS IN REAL
LIFE 1…PHARMA COMPANY
MagnaChip is a South Korea–based semiconductor company that has been
publicly traded in the United States since its initial public offering in 2011.
The company was recently under investigation by the United States
Securities and Exchange Commission (SEC) for engaging in
unethical/improper conduct over the period from 2011 to December
2013. These practices included artificially increasing revenue, delaying or
avoiding expenses, avoiding reductions in revenue, smoothing gross
margins, and hiding delays in receivables collections. MagnaChip also
engaged in a practice called “channel stuffing,” which means they
negotiated side agreements with distributors, offering incentives to take
products earlier than needed to enable the company to meet sales targets.
The company’s falsified records misled investors and resulted in increasing
their stock price by 69% over the period.

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Education.
ETHICAL IMPACT 2
A red flag that signaled the Board and Audit Committee that a problem
existed occurred when they recognized accounts receivable balances were
increasing. These prudent board members pursued an investigation into
the company’s accounting practices that resulted in a subsequent
restatement of their financial statements in 2015, reducing previously
recognized revenue by $121 million. Consequently, the company’s 2011
reported net profit was changed to a net loss and a correction to its
previously recognized increasing trend of more than 5% revenue growth
each quarter, “when in fact it was declining.” After the restatement
announcement, MagnaChip’s stock price dropped by 50%. The SEC
imposed monetary fines of $3 million for the company, and the chief
financial officer was ordered to pay a fine of $135,000. The CFO was a CPA
(US), and is no longer able to work for a public company in an accounting
capacity or as an officer or director.

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Education.
ETHICAL IMPACT 3
MagnaChip’s executives were known to set aggressive revenue and gross
margin targets and insisted employees meet their prescribed targets. This
resulted in employees throughout the sales, finance, and manufacturing
organizations engaging in improper acts leading to fraudulent financial
reporting. If you were hired as a junior accountant into a company that
was engaging in similar practices, what would you do?

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Education.
Adjusting Accounts
• Process of adjusting accounts is similar to process of analyzing and
recording transactions.
• An adjusting entry is recorded at the end of the accounting period to
bring an asset or liability account balance to its proper amount.
• Adjustments are journalized in the general journal and then posted to
accounts in the ledger.

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Education.
LO4: Framework for Adjustments …KEY SLIDE
EXHIBIT 3.4

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Education.
Adjusting Prepaid Expenses
• Costs paid for in advance of receiving their benefits.
• They are recorded as assets.
• As these assets are used, their costs become expenses.
• Common prepaid expenses are insurance, rent payments made in
advance, and supplies purchased for use in the business.
• Benefits of prepaid expenses are utilized within a year, thus they are
classified as current assets.
• The adjusting entry comes into effect at period-end when these assets
have been depleted through direct usage or usage due to the passing of
time.

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Education.
Adjusting for Prepaid Expenses
Adjusting entries for prepaids involve increasing (debiting) expenses and
decreasing (crediting) prepaid assets.
EXHIBIT 3.5

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Education.
Prepaid Insurance 1
We illustrate prepaid insurance using Organico’s payment of $2,400 for
two years of insurance protection beginning on March 1, 2023.
The following entry records the purchase of the insurance:
Mar. 1 Prepaid Insurance 2,400
Cash 2,400
To record purchase of insurance for 24
months

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Education.
Prepaid Insurance 2
By March 31 one month’s insurance coverage is used, causing a portion of
the asset Prepaid Insurance to become an expense. This expense is $100
($2,400 × 1/24).
Our adjusting entry to record this expense and reduce the asset is:
Adjustment (a)
Mar. 31 Insurance Expense 100
Prepaid Insurance 100
To record expired insurance.

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Education.
Prepaid Insurance 3
• After posting, the $100 balance in Insurance Expense and the $2,300
balance in Prepaid Insurance are ready for reporting in the financial
statements.
• If the adjustment is not made at March 31, then (a) expenses are
understated by $100 and profit is overstated by $100 for the March
income statement, and (b) both Prepaid Insurance and equity are
overstated by $100 in the March 31 balance sheet.
Prepaid Insurance
Mar. 1 2,400 100 Mar. 31
Balance 2,300
Insurance Expense
Mar. 31 100
EXHIBIT 3.6

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Education.
Supplies 1
Organico has $2,550 of supplies remaining out of the $3,600 ($2,500 +
$1,100) purchased in March. The $1,050 difference between these two
amounts is the cost of the supplies used. This amount is March’s Supplies
Expense.
Our adjusting entry to record this expense and reduce the Supplies asset
account is:
Adjustment (b)
Mar. 31 Supplies Expense 1,050
Supplies 1,050
To record supplies used.

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Education.
Supplies 2
• The balance of the Supplies account is $2,550 after posting and equals
the cost of remaining unused supplies.
• If the adjustment is not made at March 31, then (a) expenses are
understated by $1,050 and profit is overstated by $1,050 for the March
income statement, and (b) both Supplies and equity are overstated by
$1,050 in the March 31 balance sheet.
Supplies
Mar. 1 2,500 1,050 Mar. 31
1 1,100
Balance 2,500
Supplies Expense
Mar. 31 1,050

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Education.
Adjusting For Depreciation 1
• Depreciation is the process of calculating expense from matching (or
allocating) the cost of plant and equipment assets over their expected
useful lives.
• Businesses that have significant dollars invested in plant and equipment
can have large amounts of depreciation appearing on the income
statement.

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Education.
Organico purchased its food truck for $6,000 on March 1. Hailey Walker
expects the equipment to have a useful life (benefit period) of two years.
Hailey expects to sell the truck for about $1,200 at the end of two years.
This means that the net cost expected to expire over the estimated useful
life is
$4,800 = $6,000 − $1,200

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Education.
There are several methods that we can use to allocate this $4,800 net cost
to expense.
Organico uses straight-line depreciation.When the $4,800 net cost is
divided by the asset’s useful life of 24 months (2 years × 12 months per
year), we get an average monthly cost of $200 $4,800/24.
Our adjusting entry to record monthly depreciation expense is:
Adjustment (c)
Mar. 31 Depreciation Expense, Equipment 200
Accumulated Depreciation,
Equipment
200
To record monthly depreciation on equipment.

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Education.
Accounts After Depreciation Adjustments:
Equipment
Mar 1 6,000
Bal. 6,000
Accumulated Depreciation,
Equipment
200 Mar. 31
Depreciation Expense, Equipment
Mar. 31 200
EXHBIT 3.8

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Education.
• A contra account is an account that is linked with another account and
has an opposite normal balance to its counterpart.
• It is reported at the net amount, after subtracting the contra account
from the normal account balance.
• On Organico’s balance sheet, the balance in the contra asset account,
Accumulated Depreciation, Equipment, will be subtracted from the
Equipment account balance.
• The cost of an asset less its accumulated depreciation is the net book
value of an asset.
• The fair value of an asset, also known as the market value of an asset, is
the amount it can be sold for.

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Education.
• After posting the adjustment, the Equipment account less its
Accumulated Depreciation, Equipment account equals the March 31
balance sheet amount for this asset.
• The balance in the Depreciation Expense, Equipment account is the
expense reported in the March income statement.
• If the adjustment is not made at March 31, then (1) expenses are
understated by $200 and profit is overstated by $200 for the March
income statement, and (2) both assets and equity are overstated by
$200 in the March 31 balance sheet.

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Education.
EXHIBIT 3.9

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Education.
IMPORTANT TIP
Adjusting for Partial Month Depreciation.
When calculating depreciation for partial periods when an item is
acquired during the month, we use a policy referred to as "the nearest
whole month". Under the "nearest whole month" depreciation for a
month is calculated if the asset was in use for more than half of that
month.
Otherwise it is not recorded until the subsequent month.
Depreciation is not calculated by the number of days (such as in the
case of prepaid insurance) because that would imply depreciation is
precise, when in fact it is based on an estimate.

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Education.
Adjusting Unearned Revenues 1
• Cash received in advance of providing products and services.
• Also known as deferred revenues, are a liability.
• When cash is accepted, an obligation to provide products and services is
also accepted.
• As products and services are provided, the amount of unearned
revenues becomes earned revenues.
• Adjusting entries for unearned revenues involve increasing (crediting)
revenues and decreasing (debiting) unearned revenues.

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Education.
Adjusting for Unearned Revenues 2
EXHIBIT 3.11

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Education.
On March 26, Organico agreed to cater a series of Tuesday night
ski/snowboard instructor training events over the next two months for a
local ski hill called Mount Mundy. When the contract was signed, the ski
hill paid Organico $3,000 for the series.
The entry to record the cash received in advance is:
Mar. 26 Cash 3,000
Unearned Food Services Revenue 3,000
Received advance payment for future
ski/snowboard catering services for
Mount Mundy

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Education.
By March 31, Organico provided food services in the amount of $250 for
the first “Tuesday Train the Trainer” event. The revenue recognition
principle requires that $250 of unearned revenue is reported as food
services revenue on the March income statement.
The adjusting entry to reduce the liability account and recognize earned
revenue is:
Adjustment (d)
Mar. 31 Unearned Food Services Revenue 250
Food Services Revenue 250
To record the earned portion of revenue
received in advance.

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Education.
Unearned Revenue and Revenue Accounts After Adjustments:
Unearned Food Services Revenue
Mar. 31 250 3,000 Mar. 26
2,750 Balance
Food Services Revenue
2,200 Mar. 10
1,600 15
250 31
4,050 Total
EXHIBIT 3.12

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Education.
Adjusting Accrued Expenses 1
• Costs incurred in a period that are both unpaid and unrecorded prior to
adjustment.
• Generally relate to expenses incurred for services provided or products
received for which the company has yet to be billed.

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Education.
Adjusting for Accrued Expenses 2
EXHIBIT 3.13

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Accrued Interest Expenses 3
Interest of $35 has accrued on Organico’s $6,000, 7%, six-month note
payable for the month of March.
The journal entry is:
Adjustment (e)
Mar. 31 Interest Expense 35
Interest Payable 35
To record accrued interest.

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Education.
After the adjusting entry is posted, the expense and liability accounts
appear as follows:
Notes Payable
6,000 Mar. 1
Interest Payable
35 Mar. 31
Interest Expense
35 Mar. 31
EXHIBIT 3.14

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Education.
The $6,000 principal and total interest of $210 $6,000 × 7% × 6/12 =
$210 will be paid six months from March 1, the date the note was issued.
Calculated as:
Interest = Principal of the note × Annual interest rate × Time expressed
years OR i = Prt
Where the term of the note is in days,
Interest = Principal x Rate x
𝐄𝐱𝐚𝐜𝐭 𝐝𝐚𝐲𝐬
𝟑𝟔𝟓

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Education.
Accrued Salaries Expenses 1
Organico’s only employee earns $70 per day or $350 for a five-day
workweek beginning on Monday and ending on Friday. This employee
gets paid every two weeks on Friday. On the 13th and the 27th of March,
the wages are paid, recorded in the journal, and posted to the ledger.
The unadjusted Salaries Expense and Cash paid for salaries appear as
follows:
Cash
700 Mar. 13
700 27
Salaries Expense
Mar. 13 700
27 700
EXHIBIT 3.15

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Education.
The calendar shows two working days after the March 27 payday (March
30 and 31).
EXHIBIT 3.16

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Education.
This means that the employee earns two days’ salary by the close of
business on Tuesday, March 31. While this salary expense is incurred, it is
not yet paid or recorded by the company.
The period-end adjusting entry to account for accrued salaries is:
Adjustment (f)
Mar. 31 Salaries Expense 140
Salaries Payable 140
To record two day’s accrued salary; 2 x $70.

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Education.
After the adjusting entry is posted, the expense and liability accounts
appear as follows:
Salaries Expense
Mar. 13 700
27 700
31 140
Total 1,540
Salaries Payable
140 Mar. 31
EXHIBIT 3.17

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Education.
The accrued salaries are paid on the first payday of the next biweekly
period, which occurs on Friday, April 10.
The entry includes the added salaries expense for the eight days worked
in April:
Apr. 10 Salaries Payable 140
Salaries Expense 560
Cash 700
Paid two weeks’ salary incl. two days accrued
in March (1 day at $70; 8 days at $140 =
$560).

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Education.
Adjusting Accrued Revenues 1
• Revenues earned in a period that are both unrecorded and not yet
received in cash (or other assets).
• Accrued revenues are part of revenues and must be reported on the
income statement.

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Education.
Adjusting Accrued Revenues 2
EXHIBIT 3.18

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Education.
Accrued Services Revenues 3
Organico has earned $1,800 = $2,700 × 20/30 . The revenue recognition
principle requires that we report the $1,800 on the March income
statement because it is earned in March. The balance sheet also must
report that this client owes Organico $1,800.
The adjusting entry to account for accrued teaching services revenue is:
Adjustment (g)
Mar. 31 Accounts Receivable 1,800
Food Services Revenue 1,800
To record 20 days’ accrued revenue.

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Education.
After the adjusting entry is posted, the affected accounts look as follows:
Accounts Receivable
Mar. 15 1,900 1,900 Mar. 25
31 1,800
Balance 1,800
Food Services Revenue
2,200 Mar. 10
1,600 15
250 31
1,800 31
5,850 Total
EXHIBIT 3.19

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Education.
When the catering fee is received from the builder on April 10, Organico
makes the following entry to remove the accrued asset (accounts
receivable) and recognize the added 10 days of revenue earned in April:
Apr. 10 Cash 2,700
Accounts Receivable 1,800
Food Services Revenue 900
Received cash for accrued asset and earned
teaching revenue; $900 = $2,700 x 10/30

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Education.
LO5: Adjustments and Financial
Statements..KEY
• Adjustments are only made when financial statements are prepared.
• Affect both the income statement and the balance sheet.
• Never affect cash.

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Summary of Adjustments & Financial
Statement Impact
EXHIBIT 3.20

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LO6: Adjusting Trial Balance
Unadjusted Trial Balance:
• A listing of accounts and balances that is prepared before adjustments
are recorded.
Adjusted Trial Balance:
• A listing of accounts and balances that is prepared after adjustments are
recorded and posted to the ledger.
• It is used to prepare financial statements.

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Education.
Unadjusted and Adjusted Trial Balance
EXHIBIT 3.22

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LO7: Preparing Financial Statements 1
• An adjusted trial balance includes all balances appearing in financial
statements.
• We know that a trial balance summarizes information in the ledger by
listing accounts and their balances.
• This summary is easier to work from than the entire ledger when
preparing financial statements.

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Education.
Preparing Financial Statements 3
The following are the steps to prepare financial statements:
• Step 1: Prepare income statement using revenue and expense accounts
from adjusted trial balance.
• Step 2: Prepare statement of owner’s equity using capital and
withdrawals accounts from the trial balance; pull profit from Step 1.
• Step 3: Prepare balance sheet using asset and liability accounts from
trial balance; pull updated capital balance from Step 2.

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Education.
Organico’s revenue and expense balances are transferred from the
adjusted trial balance to (1) the income statement, and (2) the statement
of changes in equity.
Note how we use the profit as reported on the income statement and the
end-of-year balance in the withdrawals account to prepare the statement
of changes in equity.
Finally the balance sheet (3) can be prepared.

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Education.
EXHIBIT 3.23

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Education.
IMPORTANT TIP
Determining the Opening Balance for the Owner’s Capital Account.
Notice how the balance in the capital account on the trial balance in
Exhibit 3.23 cannot be used as the opening capital balance in the
statement of changes in equity.
You always need to deduct owner investments made during the year from
the balance in the Capital account to determine the owner’s capital
account balance at the beginning of the period.

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CHECKPOINT
18. On March 14, Accounts Receivable was debited for $4,100 and
Service Revenue was credited for $4,100. At the end of the month, it
was discovered that the March 14 entry should have been credited to
Rent Revenue. What correcting entry is required?

adjusting accounts for financial statements

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