The revenue recognition principle requires that revenue be recorded

Chapter 4 THE ADJUSTMENT PROCESS

Principles of Accounting, Volume 1: Financial Accounting

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Chapter Outline

4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries

4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries

4.3 Record and Post the Common Types of Adjusting Entries

4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance

4.5 Prepare Financial Statements Using the Adjusted Trial Balance

Module 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries

Public companies use either US generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS), as allowed by the Securities and Exchange Commission (SEC) regulations.

Companies, public or private, using US GAAP or IFRS prepare their financial statements using the rules of accrual accounting.

With accrual basis accounting, revenues and expenses are recorded in the accounting period in which they were earned or incurred, no matter when cash receipts or payments occur. Individually, these are the revenue recognition principle and the expense recognition principle. Collectively they are known as the matching principle.

The accrual method standardizes reporting information for comparability purposes.

Comparable information is important to external users of information trying to make investment or lending decisions, and to internal users trying to make decisions about company performance, budgeting, and growth strategies.

Some nonpublic companies may choose to use cash basis accounting rather than accrual basis accounting to report financial information.

Teacher Notes: In this chapter, we look at Steps 5, 6, and 7 of the accounting cycle, but to understand why these stages occur, it is first necessary to understand the following concepts: accrual accounting, accounting period, and calendar versus fiscal year.

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An accounting period breaks down company financial information into specific time spans and can cover a month, a quarter, a half-year, or a full year.

Public companies governed by GAAP are required to present quarterly (three-month) accounting period financial statements called 10-Qs.

Most public and private companies keep monthly, quarterly, and yearly (annual) period information. This is helpful for users needing up-to-date financial data to make decisions about company investment and growth.

Accounting Period

A company may choose its yearly reporting period to be based on a calendar or fiscal year.

A calendar year shows financial data from January 1 to December 31 of a specific year.

A fiscal year is a twelve-month reporting cycle that can begin in any month and records financial data for that consecutive twelve-month period.

An interim period is any reporting period shorter than a full year (fiscal or calendar). They can be monthly, quarterly, or half-year statements. The information contained on these statements is timelier than waiting for a yearly accounting period to end. The most common interim period is three months, or a quarter. For companies whose common stock is traded on a major stock exchange, meaning these are publicly traded companies, quarterly statements must be filed with the SEC on a Form 10-Q. The companies must file a Form 10-K for their annual statements.

Fiscal Year versus Calendar Year

Figure 4.2

The Basic Accounting Cycle. In this chapter, we examine the next three steps in the accounting cycle—5, 6, and 7—which cover adjusting entries (journalize and post), preparing an adjusted trial balance, and preparing the financial statements. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Teacher Notes: You can use this as a reminder of the ten stages of the accounting cycle. This cycle must be repeated for each reporting period.

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Figure 4.3

Steps 5, 6, and 7 in the Accounting Cycle. Modified for PPT. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Adjusting entries update accounting records at the end of a period for any transactions that have not yet been recorded.

An adjusted trial balance is a list of all accounts in the general ledger, including adjusting entries, which have nonzero balances.

Based on the adjusted trial balance, the company will prepare an income statement, a statement of retained earnings, a balance sheet, and a statement of cash flows.

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Module 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries

Suppose in January you prepaid your rent for six months. The total you paid was $6,000. Obviously you spent $6,000, but what did that $6,000 get you? You have the right to use your apartment for the next six months. That “right to use” is considered an asset to you. But if you are creating a monthly expense report, what would you say your rent expense is for January? February? March?

Your rent expense is $1,000 per month. Your landlord does not send you an email at the beginning of each month to say “you’ve used up part of your asset (prepaid rent) and your rent expense for the month is $1,000.” You simply know this is the case. For businesses, this type of situation requires adjusting entries to make the accounts correct.

Teacher Notes: Start off with a conceptual example of adjusting entries.

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Adjusting Entries

Adjusting entries update accounting records at the end of a period for any transactions that have not yet been recorded.

These entries are necessary to ensure the income statement and balance sheet present the correct, up-to-date numbers. Adjusting entries are also necessary because the initial trial balance may not contain complete and current data due to several factors:

It is inefficient to record every single day-to-day event, such as the use of supplies.

Some costs are not recorded during the period but must be recognized at the end of the period, such as depreciation, rent, and insurance.

Some items are forthcoming for which original source documents have not yet been received, such as a utility bill.

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Several guidelines support the need for adjusting entries:

Revenue recognition principle: Adjusting entries are necessary because the revenue recognition principle requires revenue recognition when earned, thus the need for an update to unearned revenues.

Expense recognition (matching) principle: This requires matching expenses incurred to generate the revenues earned, which affects accounts such as insurance expense and supplies expense.

Time period assumption: This requires useful information be presented in shorter time periods, such as years, quarters, or months. This means a company must recognize revenues and expenses in the proper period, requiring adjustment to certain accounts to meet these criteria.

Adjusting Entries (continued)

Adjusting entries requires updates to specific account types at the end of the period. Not all accounts require updates—only those not naturally triggered by an original source document. There are two main types of adjusting entries that we explore further: deferrals and accruals.

Types of Adjusting Entries

Deferrals are prepaid expenses and revenue accounts that have delayed recognition until they have been used or earned. This recognition may not occur until the end of a period or future periods.

Prepaid expenses (prepayments) are assets for which advanced payment has occurred, before the company can benefit from use. A company has prepaid for an expense but has not “used” the asset yet, such as paying six months rent expense in advance. That prepaid rent is not an expense until it is used—in other words, until each month passes. The prepaid asset becomes an expense once it is used (appropriate time has passed). Some common examples of prepaid expenses are supplies, depreciation, insurance, and rent.

Unearned revenues represent a customer’s advanced payment for a product or service that the company has yet to provide. Because the company has not yet provided the product or service, it cannot recognize the customer’s payment as revenue. At the end of a period, the company will review the account to see if any of the unearned revenue has been earned—that is, if the company did the work or delivered the goods during that period. If so, this amount will be recorded as revenue in the current period.

Deferrals

Teacher Notes: Examples and numerical explanations will be presented after the definitions/theory for deferrals and accruals.

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Accruals are types of adjusting entries that accumulate during a period when amounts were previously unrecorded. The two specific types of adjustments are accrued revenues and accrued expenses.

Accrued revenues are revenues earned in a period but have yet to be recorded, and no money has been collected. Some examples include interest and services completed where a bill has yet to be sent to the customer.

Accrued expenses are expenses incurred in a period but have yet to be recorded, and no money has been paid. Some examples include interest, tax, and salary expenses.

Accruals

The unadjusted trial balance from Step 4 of the accounting cycle:

Figure 4.4

Unadjusted Trial Balance for Printing Plus. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Figure F04_02_UTB01

Teacher Notes: Chapter 3 ended on this step of the accounting cycle.

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Think It Through: Keep Calm and Adjust . . .

Elliot Simmons owns a small law firm. He does the accounting himself and uses an accrual basis for accounting. At the end of his first month, he reviews his records and realizes there are a few inaccuracies on this unadjusted trial balance.

One difference is the supplies account; the figure on paper does not match the value of the supplies inventory still available. Another difference was interest earned from his bank account. He did not have anything recognizing these earnings.

Why did his unadjusted trial balance have these errors? What can be attributed to the differences in supply figures? What can be attributed to the differences in interest earned?

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A company paid for supplies with cash in the amount of $400. The following entry occurs for the initial payment.

At the end of the month, the company took an inventory of supplies used and determined the value of those supplies used during the period to be $150. The following adjusting entry is made:

Prepaid Expenses Example

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In T-account form, the general ledger postings would be:

Balance Sheet Account

Income Statement Account

Modified for PPT.

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A contra account to the Equipment account

Depreciation Example

Depreciation is the systematic method to record the allocation of cost over a given period of certain assets.

A company pays $2,000 for equipment that is supposed to last four years. The company wants to depreciate the asset over those four years equally. This means the asset will lose $500 in value each year ($2,000/four years). In the first year, the company would record the following adjusting entry to show depreciation of the equipment.

Modified for PPT.

Teacher Notes: More detail about depreciation is covered in another chapter. For now, the original entry would have been DR Equipment and CR Cash (or whatever the payment source is). Contra accounts are accounts that are paired with another account (asset or liability) and will have a normal balance that is the opposite of the account with which they are paired. The purpose is to show a decrease in the original account value without actually adjusting the original account. This way, the historical value of the original account is known, but the net of the original account and the contra account provide the book value of the original asset or liability. Technically, depreciation is a type of prepaid adjustment. The equipment was paid for in advance, but as a cost of the business, it should be allocated or recognized over the periods it benefits the company. Thus, we prepaid for the equipment and will recognize the cost (expense) of that equipment over time.

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In T-account form, the general ledger postings would be:

Balance Sheet Account

Income Statement Account

Modified for PPT.

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A company pays $4,500 for an insurance policy covering six months. It is the end of the first month and the company needs to record an adjusting entry to recognize the insurance used during the month. The following entries show the initial payment for the policy and the subsequent adjusting entry for one month of insurance usage.

Prepaid Account Example 1

Teacher Notes: We just saw that depreciation is a form of prepaid entry, but in accounting we usually do not refer to deprecation as a prepaid adjustment because there is no asset account created called prepaid equipment; it is merely recorded as equipment. However, other prepaid items are labeled as prepaid assets as in the case here.

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In T-account form, the general ledger postings would be:

Balance Sheet Account

Income Statement Account

Modified for PPT.

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A company pays $8,000 in advance for four months of rent. After the first month, the company records an adjusting entry for the rent used. The following entries show initial payment for four months of rent and the adjusting entry for one month’s usage.

Prepaid Account Example 2

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In T-account form, the general ledger postings would be:

Balance Sheet Account

Income Statement Account

Modified for PPT.

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During the year, a law firm collected retainer fees totaling $48,000 from clients. Retainer fees are money lawyers collect in advance of starting work on a case. When the company collects this money from its clients, it will debit cash and credit unearned fees.

At the end of the year after analyzing the unearned fees account, 40% of the unearned fees have been earned. This 40% can now be recorded as revenue. Total revenue recorded is $19,200 ($48,000 × 40%).

Unearned Revenue Account Example

Unearned revenue represents a customer’s advanced payment for a product or service that has yet to be provided by the company. Since the company has not yet provided the product or service, it cannot recognize the customer’s payment as revenue. At the end of a period, the company will review the account to see if any of the unearned revenue has been earned. If so, this amount will be recorded as revenue in the current period.

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In T-account form, the general ledger postings would be:

Balance Sheet Account

Income Statement Account

Modified for PPT.

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A company has one outstanding note receivable in the amount of $100,000. Interest on this note is 5% per year. Three months have passed, and the company needs to record interest earned on this outstanding loan. The calculation for the interest revenue earned is $100,000 × 5% × 3/12 = $1,250. The following adjusting entry occurs.

Interest Revenue Account Example

Teacher Notes: The interest revenue must record that the company is owed the interest for three months but has not been paid that amount because the interest is not yet legally due.

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In T-account form, the general ledger postings would be:

Balance Sheet Account

Income Statement Account

Modified for PPT.

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A company performs landscaping services in the amount of $1,500. However, they have not yet received payment. At the period end, the company would record the following adjusting entry.

Unpaid Service Revenue Account Example

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In T-account form, the general ledger postings would be:

Balance Sheet Account

Income Statement Account

Modified for PPT.

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A company accrued $300 of interest during the period. The following entry occurs at the end of the period.

Interest Expense Account Example

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In T-account form, the general ledger postings would be:

Balance Sheet Account

Income Statement Account

Modified for PPT.

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A company has accrued income taxes for the month for $9,000. The company would record the following adjusting entry.

Income Tax Expense Account Example

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In T-account form, the general ledger postings would be:

Balance Sheet Account

Income Statement Account

Modified for PPT.

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A company has five salaried employees, each earning $2,500 per month. In our example, assume that they do not get paid for this work until the first of the next month. The following is the adjusting journal entry for salaries.

Salaries Expense Account Example

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In T-account form, the general ledger postings would be:

Balance Sheet Account

Income Statement Account

Modified for PPT.

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Your Turn: Adjusting Entries

On a sheet of paper, draw the following:

Table 4.1

Review the three adjusting entries that follow. For each entry write down the income statement account and balance sheet account used in the adjusting entry in the appropriate column. Then in the last column answer yes or no.

Example Income Statement Account Balance Sheet Account Cash in Entry?
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Your Turn: Adjusting Entries Take Two

Did we continue to follow the rules of adjusting entries in these two examples? Explain.

Table 4.3

Example Income Statement Account Balance Sheet Account Cash in Entry?
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Sample Exercise

EA8. Supplies were purchased on January 1, to be used throughout the year, in the amount of $8,500. On December 31, a physical count revealed that the remaining supplies totaled $1,200. There was no beginning of the year balance in the Supplies account. Based on the information provided:

Create journal entries for the original transaction

Create journal entries for the December 31 adjustment needed to bring the balances to correct

Show the activity, with ending balance

Recall the journal entries recorded for Printing Plus and that resulted in this unadjusted trial balance.

Jan. 3, 2019 issues $20,000 shares of common stock for cash
Jan. 5, 2019 purchases equipment on account for $3,500, payment due within the month
Jan. 9, 2019 receives $4,000 cash in advance from a customer for services not yet rendered
Jan. 10, 2019 provides $5,500 in services to a customer who asks to be billed for the services
Jan. 12, 2019 pays a $300 utility bill with cash
Jan, 14, 2019 distributed $100 cash in dividends to stockholders
Jan. 17, 2019 receives $2,800 cash from a customer for services rendered
Jan. 18, 2019 paid in full, with cash, for the equipment purchase on January 5
Jan. 20, 2019 paid $3,600 cash in salaries expense to employees
Jan. 23, 2019 received cash payment in full from the customer on the January 10 transaction
Jan. 27, 2019 provides $1,200 in services to a customer who asks to be billed for the services
Jan. 30, 2019 purchases supplies on account for $500, payment due within three months
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Think It Through: Cash or Accrual Basis Accounting?

You are a new accountant at a salon. The salon had previously used cash basis accounting to prepare its financial records but now considers switching to an accrual basis method. You have been tasked with determining if this transition is appropriate.

When you go through the records you notice that this transition will greatly impact how the salon reports revenues and expenses. The salon will now report some revenues and expenses before it receives or pays cash.

How will change positively impact its business reporting? How will it negatively impact its business reporting? If you were the accountant, would you recommend the salon transition from cash basis to accrual basis?

Transaction 13: On January 31, Printing Plus took an inventory of its supplies and discovered that $100 of supplies had been used during the month.

Analysis: Supplies is an asset that is decreasing (credit). Supplies Expense would increase (debit) for the $100 of supplies used during January.

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Transaction 14: The equipment purchased on January 5 depreciated $75 during the month of January.

Analysis: Accumulated Depreciation–Equipment is a contra asset account (contrary to Equipment) and increases (credit) for $75. Depreciation Expense–Equipment is an expense account that is increasing (debit) for $75.

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Transaction 15: Printing Plus performed $600 of services during January for the customer from the January 9 transaction.

Analysis: On January 9, a customer paid the company $4,000 in advanced payment for services. During January the company did $600 of the work. Unearned Revenue, a liability, will decrease. The company can now recognize the $600 as earned revenue.

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Transaction 16: Reviewing the company bank statement, Printing Plus discovers $140 of interest earned during the month of January that was previously uncollected and unrecorded.

Analysis: Interest Revenue is a revenue account that increases (credit) for $140. Since Printing Plus has yet to collect this interest revenue, it is considered a receivable. Interest Receivable increases (debit) for $140.

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Transaction 17: Employees earned $1,500 in salaries for the period of January 21–January 31 that had been previously unpaid and unrecorded.

Analysis: Salaries have accumulated since January 21 and will not be paid in the current period. Since the salaries expense occurred in January, the expense should be recorded in January. Salaries Expense increases $1,500. The company has not yet paid salaries for this time period. This creates a liability, and Salaries Payable increases $1,500.

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Your Turn: Deferrals versus Accruals

Label each of the following as a deferral or an accrual, and explain your answer.

The company recorded supplies usage for the month.

A customer paid in advance for services, and the company recorded revenue earned after providing service to that customer.

The company recorded salaries that had been earned by employees but were previously unrecorded and have not yet been paid.

Determining Account Balance Using T-Accounts

Using the same transactions:

Transaction 13: On January 31, Printing Plus took an inventory of its supplies and discovered that $100 of supplies had been used during the month.

Modified for PPT.

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Transaction 14: The equipment purchased on January 5 depreciated $75 during the month of January.

Modified for PPT.

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Transaction 15: Printing Plus performed $600 of services during January for the customer from the January 9 transaction.

Modified for PPT.

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Transaction 16: Reviewing the company bank statement, Printing Plus discovers $140 of interest earned during the month of January that was previously uncollected and unrecorded.

Modified for PPT.

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Transaction 17: Employees earned $1,500 in salaries for the period of January 21–January 31 that had been previously unpaid and unrecorded.

Modified for PPT.

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Figure 4.5

Printing Plus summary of T-accounts with Adjusting Entries. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

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Module 4.3 Record and Post the Common Types of Adjusting Entries

Step 5: Prepare adjusting entries

The preceding 12 transactions were recorded as the occurred. On January 31, 2019, Printing Plus makes adjusting entries for the following transactions.

On January 31, Printing Plus took an inventory of its supplies and discovered that $100 of supplies had been used during the month.

The equipment purchased on January 5 depreciated $75 during the month of January.

Printing Plus performed $600 of services during January for the customer from the January 9 transaction.

Reviewing the company bank statement, Printing Plus discovers $140 of interest earned during the month of January that was previously uncollected and unrecorded.

Employees earned $1,500 in salaries for the period of January 21–January 31 that had been previously unpaid and unrecorded.

Module 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance

Step 6: Use the ledger balances to prepare an adjusted trial balance

Once all of the adjusting entries have been posted to the general ledger, step 6 of the accounting cycle takes place

An adjusted trial balance is a list of all accounts in the general ledger, including adjusting entries, which have nonzero balances

The trial balance is an important step in the accounting process because it helps identify any computational errors from prior steps

The adjusted trial balance leads to the formation of the financial statements.

Connection between Adjusting Entries and the Trial Balance

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The Final Unadjusted Trial Balance

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Module 4.5 Prepare Financial Statements Using the Adjusted Trial Balance

Income statement

Statement of retained earnings

Balance sheet

Ten-column worksheets

Your Turn: Magnificent Adjusted Trial Balance

Go over the adjusted trial balance for Magnificent Landscaping Service. Identify which account each will go on: Balance Sheet, Statement of Retained Earnings, or Income Statement.

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Final Income Statement

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Connection between Adjusted Trial Balance and Income Statement

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Final Statement of Retained Earnings

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Connection between Income Statement and Statement of Retained Earnings

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Final Statement of Balance Sheet

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Connection between Adjusted Trial Balance and the Balance Sheet

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Trial balance entered

Adjusting entries posted

Adjusted trial balance computed

Income statement

Balance sheet

Teacher Notes: The 10-column worksheet is used to facilitate putting together the financial statements.

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1. Trial Balance Accounts Entered

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Trial Balance

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2. Adjusting Entries Posted

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3. Adjusted Trial Balance Computed

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Adjusted Trial Balance

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4. Income Statement

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Formal Income Statement

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5. Balance Sheet

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Formal Statement of Retained Earnings and Balance Sheet

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Your Turn: Frank’s Net Income and Loss

What amount of net income/loss does Frank have? What will be the company’s ending retained earnings balance?

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Your Turn: Income Statement and Balance Sheet

Take a couple of minutes and fill in the income statement and balance sheet columns. Total them when you are done. Do not panic when they do not balance. They will not balance at this time.

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Sample Problem

PA2. To demonstrate the difference between cash account activity and accrual basis profits (net income), note the amount each transaction affects cash and the amount each transaction affects net income.

paid balance due for accounts payable $6,900

charged clients for legal services provided $5,200

purchased supplies on account $1,750

collected legal service fees from clients for current month $3,700

issued stock in exchange for a note payable $10,000

Summary

The next three steps in the accounting cycle are adjusting entries (journalizing and posting), preparing an adjusted trial balance, and preparing the financial statements.

Accrual requires revenues and expenses to be recorded in the accounting period in which they occur, not necessarily where an associated cash event happened. This is unlike cash basis accounting that will delay reporting revenues and expenses until a cash event occurs.

Accounting periods help companies by breaking down information into months, quarters, half-years, and full years.

Need for adjustments: Some account adjustments are needed to update records that may not have original source documents or those that do not reflect change on a daily basis.

Rules for adjusting entries: The rules for recording adjusting entries are as follows: every adjusting entry will have one income statement account and one balance sheet account, cash will never be in an adjusting entry, and the adjusting entry records the change in amount that occurred during the period.

Summary (continued)

Posting adjusting entries: Posting adjusting entries is the same process as posting general journal entries. The additional adjustments may add accounts to the end of the period or may change account balances from the earlier journal entry step in the accounting cycle.

Income statement: The income statement shows the net income or loss as a result of revenue and expense activities occurring in a period.

Statement of retained earnings: The statement of retained earnings shows the effects of net income (loss) and dividends on the earnings the company maintains.

Balance sheet: The balance sheet visually represents the accounting equation, showing that assets balance with liabilities and equity.

10-column worksheet: The 10-column worksheet organizes data from the trial balance all the way through the financial statements.