CHAPTER 4

THE RECORDING PROCESS

Accounting Principle
 Learning Objectives

LEARNING OBJECTIVES DETAIL DO IT

LO1: Describe how accounts, debits and Account DO IT 2.1
credits are used to record business Nomal account balances
transaction. Debit and credit
Double-entry accounting

LO2: State how a journal is used in the Analyzing and recording transactions DO IT 2.2
recording process and journalize The accounting cycle and steps in the record Recording businesss activities
transactions. process
The journal

LO3: Explain how a ledger helps in the The Ledger DO IT 2.3

recording process and post transaction. Posting Posting
The recording process illustrated
Summary illustration of journalizing and posting

LO4: Prepare a trial balance The trial balance DO IT 2.4

Limitations of a trial balance Trial balance
Locating errors
Some process explanations
 Learning Objective 1: Describe how accounts, debits,
and credits are used to record business transaction

The Account
An account is an individual accounting record of increases and decreases in a specific asset,
liabilities, or owner’s equity item.
Ex. Softbyte has separate account called Cash, Account Receivable, Account Payable,
Service revenue, Salaries expense, and so on.
In its simplest form, an account has three parts: (1) the title of the account, (2) a left or a debit
side, and (3) a right or a credit side. Because these parts of an account are positioned like the
letter T, it is called a T account.
Title of Account

Left or debit side Right or credit side

 Debits and Credits
The term debit means left. The term credit means right. These terms are often abbreviated as
“Dr” for debit and “Cr” for credit.
Debit and credit are simply directional signals that describe where entries are made in the
accounts.
Entering an amount on the left side of an account is called debiting the account
Entering an amount on the right side is called crediting the account.
When the totals of the two sides are compares, an account will have a debit balance if the
total of the debit amounts exceeds the credits. On the other hand, an account will have a
credit balance if the credit amounts are more than the debits.
Cash
Account Payable
15,000 7,000
1,200 600 1,600
1,500 900 250 250
200
600
250
1,300
Balance: 1,600
Balance: 8,050
 Debits and Credits procedure

It is very important to understand that debit does not mean increase nor does it mean
decrease. Sometimes we use a debit to increase an account and sometimes we use a debit to
decrease an account. Credit are the same.
The system of using debits and credits is based on the accounting equation, and the
definitions of debit and credit.
Assets = Liabilities + Owner’s Equity
Debit or left side Credit or right side

Title of Account

Left or debit side Right or credit side

 Assets and Liabilities

Assets Liabilities
All accounts have a normal balance, which is Because liabilities are on the right or
the side that increases the account balance. credit side of the accounting equation, the
Because assets are on the left or debit side of normal balance of a liability account is on
the accounting equation, the normal balance the right or credit side. This means
of an asset is also on the left or debit side of increases in liabilities are entered on the
the account. Logically, then, increases to right or credit side, and decreases in
asset accounts need to be recorded on the liabilities are entered on the left or debit
debit side and decreases in assets must be side.
entered on the right of the credit side.
Debits Credits

Increase assets Increase liabilities

Decrease liabilities Decrease assets
 Debits and Credits procedure

To summarize, because assets are on the left side of the accounting equation and this is the
opposite of liabilities, increases and decreases in assets are recorded opposite from increase
and decreases in liabilities.

Assets Liabilities

Debit for Credit for Debit for Credit for

increase decrease decrease increase
Normal balance Normal balance

Knowing the normal balance in an account may be help you find errors.
 Owner’s Equity

As liabilities and owner’s equity are on the same side of the accounting equation, the rules of
debit and credit are the same for these two types of accounts. Credits increase owner’s equity
and debits decrease owner’s equity.

Owner’s Capital: The normal balance of the Owner’s Capital account is a credit
balance. Therefore, investments by owners are credited to the owner’s capital account
and this increases owner’s equity.

Ex. When cash is invested in the business, the Cash account is debited and Owner’s
Capital is credited.

Debits Credits

Decrease Owner’s Equity Increase Owner’s Equity

 Owner’s Equity

Owner’s Drawings: An owner may withdraw cash or other assets for personal use.
Withdrawals are recorded as debits because withdrawals decrease owner’s equity.
Withdrawals could be debited directly to Owner’s Capital.

Debits Credits

Increase Owner’s Drawings Decrease Owner’s Drawing

 Owner’s Capital

The rules of debit and credit for the owner’s Capital and Drawings account

Drawings Owner’s Capital

Debit for Credit for Debit for Credit for

increase decrease decrease increase
Normal balance Normal balance

Knowing the normal balance in an account may be help you find errors.
 Revenues and Expenses

Revenues normally have a credit balance; therefore, increases to revenues are credits. This is
because when revenues are recognized this benefits the owners of the business, and so
owner’s equity increases. Like the Owner’s Capital account, revenue account are increased
by credits and decreased by debits. Credits to revenue account should exceed the debits.

Expenses normally have a debit balance; therefore, increases to expenses are debits. This is
because as expenses are incurred, owner’s equity decreases. Like the Owner’s Drawing
account, expense accounts are increased by debits and decreased by credits. Debits to
expense accounts should exceed the credits

Debits Credits

Decrease revenues Increase revenues

Increase expenses Decrease expenses
 Revenues and Expenses

The effect of debit and credit on revenues and expenses and the normal balance

Expenses Revenues

Debit for Credit for Debit for Credit for

increase decrease decrease increase
Normal balance Normal balance
 Summary of debit/credit rules and effects for the
expanded accounting equation

Assets = Liabilities + Owner’s Equity

Owner’s
Capital _ Drawings + Revenues _ Expenses
Assets Liabilities +
= Dr Cr Dr Cr Dr Cr Dr Cr
Dr Cr Dr Cr +
+ - - + -
+ - - + - +

Remember, the normal balance of each account is on its increase side. So assets,
drawings, and expense accounts have a normal debit balance, while liabilities, owner’s
capital, and revenue accounts have a normal credits balance.
 DO IT 2.1. Normal Account Balances

Brooke Schwenke has just rented space in a shooping mall where she will open a salon and
spa called the Oasis Spa. Brooke had detenmined that the company will need the following
accounts:
1. Account payable
2. Cash
3. B.Schwenke, Capital
4. B.Schwenke, Drawings
5. Equipment
6. Rent Expense
7. Service Revenue
8. Supplies
a. Indicate whether each of these accounts is an asset, liabilities, or owner’s equity account.
If it is an owner’s equity account, indicate what type it is.
b. What is the normal balance of these account?
c. Will a debit increase or decrease these accounts?.
 Double – Entry Accounting

In chapter 2, you learned that each transaction must affect two or more accounts to keep the
basic accounting equation in balance. This means that, when we record transactions, debits
must equal credits. This is known as the double – entry accounting system in which the dual
(two – sided) effect of each transaction is recorded in the appropriate accounts.

 Total amount of debits = Total amount of credits

 This provides a logical method for recording transactions and ensuring the amount are
recorded accurately.

The debit and credit conventions are the building blocks for understanding the double-entry
accounting system and the accounting cycle.
 Analyzing and Recording Transactions

The
accounting
cycle is a
series of
steps
followed by
accountants
in preparing
financial
statements.
There are
nine steps in
this cycle.

Illustration 2.13. The accounting cycle

Analyzing and Recording Transactions
The proceduces used in analyzing and recording transaction information are the first
two steps, shown in Illustration 2.14. These two steps along with posting are also
known as the recording process.

Illustration 2.14. The accounting cycle – Steps1 and 2

 The Journal

We are all familiar with the term “Journal”. It usually refers to a book where personal events
are recorded in chronological other. Similarly, accounting transactions are also recorded in a
journal in chronological (date) other. For this reason, the journal is referred to as the book of
original entry. As transaction are sequentially recorded, the debit and credit effects can be
seen on specific accounts.
Every company has a general journal. It makes some important contributions to the recording
process:
+ It discloses the complete effect of a transaction in one place.
+ It provides a chronological record of transactions.
+ It help to prevent and locate errors, because the debit and credit amounts for each entry can
be easily compared.
 Journalizing Transactions

Entering transaction data in the journal is known as journalizing. A separate journal entry is
made for each transaction. A complete entry consists of the following:
(1) The date of the transaction
(2) The accounts and amounts to be debited and credited, and
(3) A brief explanation of the transaction.
 Journalizing Transactions

Example.
September 1, Andrew Leonid invested $15,000 cash in the business, and
Computer equipment was purchased for $7,000 cash.
Illustration 2.15 Journalizing transactions tabular form
Assets = Liabilities + Owner’s Equity
Cash Equipment A.Leonid Capital
(1) +15,000 + 15,000
(2) - 7,000 + 7,000
Illustration2.16 Shows the standard form of journal entries for these two transactions.
GENERAL JOURNAL
Date Account Title and Explanation Ref Debit Credit
Sept.1 Cash 15,000
A.Leonid, Capital (Invested cash in the business) 15,000
Equipment 7,000
Cash 7,000
 Journalizing Transactions
LO.3
A = L + OE
+1,500 + 3,500
+2,000

GENERAL JOURNAL
Date Account Title and Explanation Ref Debit Credit
Sept.1 Cash 1,500
Account Receivable 2,000
Services Revenue 3,500

Illustration 2.17 Compound journal entry

 The Ledger
LO.3

The entire group of accounts maintained by the company is called the Ledger. The ledger
provides the balance in each account and keeps track of changes in these balances.

Companies can use different kinds of ledgers, but every company has a general ledger.
A general ledger contains accounts for all the asset, liability, equity, revenue, and expense
accounts.

Illustration 2.17 Compound journal entry

 Summary of transactions
Illustration 1.24. Tabular summary of Softbyte transactions
Tr Accounting Aquation

Assets = Liabilities + Owner’s Equity

Cash + Account Receivable + Supplies + Equipment = Accounts payable + A.Leonid,Capital+ revenues – expenses

1 +$15,000 + $15,000

2 - $7,000 + $7,000

3 +$1,600 +$1,600

4 + $1,200 + $1,200

5 +$250 -$250

6 +$1,500 +$2,000 + $3,500

7 -$1,700 -$1,700

8 -$250 -$250

9 +$600 -$600

10 No Entry

11 -$1,300 -$1,300

Sum $8,050 + $1,400 + $1,600 + $7,000 $1,600 + $13.700 + $ 4,700 - $ 1,950

Sum $ 18,050 = $ 18,050

 GENERAL JOURNAL
Date Account Title and Explanation Ref Debit Credit
Sept.1 Cash 15,000
A.Leonid, Capital (Invested cash in the business) 15,000
Sept.1 Equipment 7,000
Cash 7,000
Sept.2 Supplies 1,600
Account Payable 1,600
Sept.3 Cash 1,200
Revenues 1,200
Sept.5 Advertising Expenses 250
Account Payable 250
Sept.9 Cash 1,500
Account Receivable 2,000
Revenues 3,500
Sept.17 Rent expense 600
Salaries expense 900
Utility expenses 200
Cash 1,700
Sept.20 Account Payable 250
Cash 250
Sept.25 Cash 600
Account Receivable 600
Sept.30 Drawings 1,300
Cash 1,300
TOTAL
Beginning balance 0

Total Arising 18,300 10,250

Closing balance 8,050
 Closing Entries

Let’s prepare the

Close Revenue closing entries for
accounts to Income Dress Right.
Summary.

Close Expense
accounts to Income
Summary.

Close Income Summary

account to Retained
Earnings.
  Close Revenue Accounts to Income Summary

GENERAL JOURNAL Page 34

Post.
Date Description Ref. Debit Credit
July 31 Sales Revenue 38,500
Rent Revenue 250
Income Summary 38,750

Now, let’s look at the ledger accounts after

posting this closing entry.
 Close Revenue Accounts to Income Summary
Sales Revenue
38,500 38,500

-
Income Summary
38,750

38,750 Rent Revenue

250 250

-
  Close Expense Accounts to Income Summary

GENERAL JOURNAL Page 34

Post.
Date Description Ref. Debit Credit
July 31 Income Summary 36,333
Cost of goods sold 22,000
Salaries expense 10,500
Supplies expense 800
Rent expense 2,000
Depreciation expense 200
Interest expense 333
Bad debts expense 500

Now, let’s look at the ledger accounts after

posting this closing entry.
  Close Expense Accounts to Income Summary
Bad Debts Exp.
500 500
-
Rent Expense
2,000 2,000
Depreciation Exp.
-
200 200
-
Supplies Expense Income Summary
Salaries Expense 36,333 38,750
800 800
10,500 10,500 - 2,417
-

Interest Expense Net Income

Cost of Goods Sold
333 333 22,000 22,000
- -
  Close Income Summary to Retained Earnings

GENERAL JOURNAL Page 34

Post.
Date Description Ref. Debit Credit
July 31 Income Summary 2,417
Retained Earnings 2,417

Now, let’s look at the ledger accounts after

posting this closing entry.
 Close Income Summary to Retained Earnings

Retained Earnings Income Summary

1,000 2,417 36,333 38,750
2,417
1,417 -
 Post-Closing Trial Balance

DRESS RIGHT CLOTHING CORPORATION

Post-Closing Trial Balance
July 31, 2006
Account Title Debits Credits
Cash $ 68,500
Accounts receivable 2,000 Lists permanent
Allowance for uncollectible accounts $ 500 accounts and their
Supplies 1,200
Prepaid rent 22,000
balances.
Inventory 38,000
Furniture and fixtures 12,000
Accumulated depr.-furniture & fixtures 200
Accounts payable 35,000
Note payable 40,000
Unearned rent revenue 750
Salaries payable 5,500
Interest payable 333
Common stock 60,000 Total debits equal
Retained earnings 1,417
Totals $ 143,700 $ 143,700
total credits.
 ACCOUNTING
ADJUSTING THE ACCOUNTS PRINCIPLE
 Learning Objectives

LEARNING OBJECTIVES DETAIL DO IT

LO1: Explain the accrual basis Timing issues DO IT 3.1
accounting, and when to the recognize Accrual versus cash basis accounting Accrual accounting
revenues and expenses Revenues and expenses recognition

LO2: Describe adjusting entries and Adjusting entries and prepayments DO IT 3.2
prepared adjusting entries for The basics of the adjusting entries Adjusting entries for
prepayments. Adjusting entries for prepayments prepayments

LO3: Prepare adjusting entries for Adjusting entries for accruals DO IT 3.3
accruals Adjusting entries for accruals

LO4: Describe the nature and purpose The adjusted trial balance and financial DO IT 3.4
of an adjusted trial balance and prepare statements Trial balance
one. Preparing the adjusted trial balance
Preparing financial statements
 Timing isues

Learning Objective 1: Explain accrual basis accounting, and when to recognized revenues and expenses

Accountants divide the life of a business into artificial time periods, such as a month, a three-
month (a quarter), or a year. This is permitted by the periodicity concept explained in Chapter
1. Recall that this concept allows organizations to divide up their economic activities into
distinct time periods.
Accrual basis accounting

Accrual basis accounting means that transactions and other events are recorded in the period
when they occur, and not when the cash is paid or received.
Example.
Service revenue is recognized when services are performed, rather than when the cash is
received.
Expenses are recognized when services (salaries…) of goods (supplies…) are use or
consumed, rather than when the cash is paid.
Cash basis accounting
Cash basis accounting, revenue is recorded when cash is received, and expenses are recorded
when cash is paid. This sounds appealing due to its simplicity; however, it often leads to
misleading financial statements. If a company fails to record revenue when it has performed
the service because it has not yes received the cash, the company will not match expenses
with revenues and therefore profits will be misrepresented.
Example.
Suppose you own a painting company and you paint a large building during year 1. In year 1,
you pay $50,000 cash for the cost of the paint and your employees’ salaries. Assume that you
bill your customer $80,000 at the end of year 1, and that you receive the cash from your
customer in year 2.
Compare the Accrual basis accounting and the Cash basis accoungting

On an accrual basis On an cash basis

The revenue is reported during the Company would reported expenses of
period when the service is performed – $50,000 in year 1 because company
year 1. Expenses, such as employee’s paid for them in year 1. Revenues of
salaries and the paint use, are recorded $80,000 would be recorded in year 2
in the period in which the employees because company received cash from
provide their services and the paint is the customer in year 2. For year 1, you
used – year 1. Thus, company’s profit would report a loss of $50,000. For
for year 1 is $30,000. No revenue or year 2, you would report a profit of
expenses from this project is reported $80,000
in year 2.
 Compare the Accrual basis accounting and the Cash
basis accoungting

Illustration 3.2. Year 1 Year 2

Accrual versus Activity Purchase paint, paited Received payment for work
building, paid employees done in year 1
cash basis
accounting Accrual basis Revenue $80,000 Revenue $ 0
Expenses $50,000 Expenses $ 0
Profit $30,000 Profit $ 0
Cumulative profit $30,000
Cash basis Revenue $0 Revenues $80,000
Expenses $(50,000) Expenses $ 0
Loss $ (50,000) Profit $80,000
Note that: Cumulative profit $30,000
The total profit for years 1 and 2 is $30,000 for both method above. However, the difference
in when the revenues and expenses are recognized causes a difference in the amount of
profit or loss each year. Which basis provides better information about how profitable your
efforts were each year? It’s the accrual basis, beause it shows the profit recognized on the
job in the same year as when the work was performed.
 Revenue and Expense Recognition

Revenue is recognized Recall from chapter 1 that we introduced the

when the service has matching concept. The matching concept often
been performed or the determines when we recognize expenses. Generally,
goods have been sold and accounting attempts to match these costs and
delivered, regardless of revenues, so expense recognition is tied to revenue
when cash is collected. recognition.
Example.
As we saw with the painting business, under accrual basis accounting, the salaries and cost of
the paint for the painting in year 1 are reported in the income statement for the same period in
which the service revenue is recognized.
Sometimes, however, there is no direct relationship between expenses and revenue. For
example, we will see in the next section that long – lived assets may be used to help generate
revenue over many years, but the use of the asset is not directly related to earning specific
revenue. In these cases, we will see that expenses are recognized in the income statement over
the life of the asset.
 DO IT 3.1

On January 1,2021, customers owed Joma Company $30,000 for services provides in 2020.
During 2021, Joma Co.received $125,000 cash from customers. On December 31, 2021,
customers owed Joma $19,500 for services provides in 2021. Calculate revenue using (a)
cash basis accounting, and (b) accrual basis accounting.

Solution
a. Revenue for 2021, using cash basis accounting $125,000
b. Cash received from customers in 2021 $125,000
Deduct: Collection of 2020 receivables $(30,000)
Add: Amounts receivable at December 31,2021 $19,000
=> Revenue for 2021, using accrual basis accounting $114,500
 Adjusting entries and Prepayments

Learning Objective 2: Describe adjusting entries and prepare entries for prepayments
The Basis of Adjusting Entries
For revenues and expenses to be recorded in the correct period, adjusting entries are made at
the end of the accouting period. Adjusting entries are needed to ensure that revenue is
recorded when services are performed or goods are provided, and expenses are recorded as
incurred and that the correct amounts for assets, liabilities, and owner’s equity are reported on
the balance sheet.
 Adjusting entries

There are some common reasons why the trial balance – from step 4 in the accounting cycle
– may not contain complete and up – to – date data.
1. Somes events are not 2. Some costs are not 3. Some items may be
recorded daily recorded during the unrecorded. An
because it would not accounting period example is a utility bill
be efficient to do so. because they expire for services in the
For example, with the passage of current accounting
company do not time rather than period that will not be
record the daily use through daily received until the next
of supplies or the transactions. Example accounting period.
earning of wages by are rent and insurance.
employees.
 Adjusting entries

Illustration 3.4. Categories of adjusting entries

PREPAYMENTS ACCRUALS
1. Prepaid Expenses 1. Accrual Expenses
Expenses paid in cash and recorded as Expenses incurred but not yet paid in
assets before they are used. cash or record.
2. Unearned Revenues
Cash received and recorded as a liability 2. Accrued Revenues
before services are performed. Revenues for services performed but not
yet received in cash or recorded.
 Adjusting entries
DEBIT CREDIT
Cash $14,250
Accounts receivable $1,000
Supplies $2,500
LYNK Prepaid insurance $600
SOFTWARE Equipment $5,000
SERVICES Notes payable $5,000
Trial Balance Accounts payable $1,750
October 31,2021 Unearned reenue $1,200
T.Jcobs, capital $10,000
T.Jacobs, drawings $500
Service revenue $10,800
Rent expense $900
Salaries expense $4,000
Illustration 3.5.
Totals $28,750 $28,750
Trial balance
 Adjusting Entries for prepayments

Prepayments are prepaid For unearned revenues, the adjusting

expenses. Adjusting entries are entry records the revenue to be
used to record the portion of the recognized in the current period and
prepayment used in the current reduces the liability account where the
accouting period and to reduce unearned revenue was originally
the asset account where the recorded. This type of adjustment is
prepaid expense was originally necessary because the unearned
recorded. This type of revenue is no longer owed and so is
adjustment is necessary because no longer a liability – the service has
the prepayment has provided the been provided and the revenue should
economic benefit and be recognized.
consequently is no longer an
asset – it has been used.
 Adjusting Entries for prepayments

Prepaid expenses are assets that expire

Prepaid Expenses either with the passage of time (rent,
When prepaid expense is insurance…). It is not practical to
incurred, an assets (prepaid) record the use of these assets daily.
account is debited to show the Instead, companies record these
service or benefit that will be entries when the financial statements
received in the future and cash is are prepared. At each statement date,
credited. Therefore, prepaid they make adjusting entries:
items such as prepaid expenses (1) To expense the cost of an asset
and supplies are assets on the that has been used up in that
balance sheet. period, and
(2) To show an asset for the remaining
amount (unexpired costs).
 Adjusting entries

Before the prepaid expenses are adjusted, assets are overstated and expenses are understated.
Therefore, an adjusting entry is required to reduce the amount of the asset used and to reflect
the expense incurred.
Prepaid Expenses Expense
Asset

Unadjusted Credit Adjusting Debit Adjusting

Balance Entry (-) Entry (+)

ILLUSTRATION 3.6
Adjusting entries for prepaid expenses
 Adjusting entries

Example.
1. Supplies
Lynk Software Services purchased supplies costing $2,500 on October 4. The following
journal entry way prepared:

Oct.4 Supplies 2,500

A = L + OE
+2,500 2,500 Accounts Payable 2,500

Now the Supplies account shows a balance of $2,500 in October 31 trial balance. At the en
of the accouting period, Tyler Jacobs, the proprietor, counts the supplies left at the end of
the day October 31. He determines that only $1,000 of supplies remain. This means that over
the accounting period $1,500 (2,500 - $1,000) of supplies were used and $1,000 of supplies
remain on hand.
 Adjusting entries

An adjusting entry must now be prepared to reflect this usage. The adjusting entry will
reduce the asset account (Supplies) and decrease the owner’s equity as the Supplies Expense
account increases by $1,500.

The use of the supplies decreases the asset account Supplies by

Basic Analysis $1,500 and increases the expense account Supplies Expensse by
$1,500

Assets = Liabilities + Owner’ Equity

Equation Supplies = Supplies Expense
Analysis - 1,500 - 1,500

ILLUSTRATION 3.7
Journal entry for prepaid expenses: Supplies
 Adjusting entries
ILLUSTRATION 3.7
Journal entry for prepaid expenses: Supplies

Debit – Credit Debits is increase expenses: Debit Suppliers Expense $1,500

Analysis Credits decrease assets: Credit Supplies $1,500

Oct.31 Supplies Expense 1,500

Adjust Journal
Supplies 1,500
Entry
To record supplies used
Supplies Supplies Expense

Posting Oct.4 2,500 Oct.31 Adj. 1.500 Oct.31 Adj. 1.500

Oct.31 Bal 1,000

 Adjusting Entries for prepayments

If the adjusting entry is not made, October expenses will be understated and profit
overstated by $1,500. Also, both assets and owner’s equity will be overstated by $1,500 on
October 31 balance sheet
 Adjusting Entries for prepayments

2. Insurance
Companies purchase insurance to protect themselves from losses caused by fire, theft, and
unforeseen accidents. Insurance must be paid in advance, often for one year.
Premiums made in advance are normally charge to the asset account prepaid insurance
when they are paid. At the financial statement date, it is necessary to make an adjustment
to debit (increase) insurance Expense and credit (decrease) prepaid insurance for the cost
of insurance that has expired during the period.
 Adjusting Entries for prepayments

2. Insurance
Companies purchase insurance to protect themselves from losses caused by fire, theft, and
On October 3, Lynk Software services paid $600 for a one year fire insurance policy. The
starting date for the coverage was October 1. The premium was charged to prepaid
insurance when it was paid. The following journal entry was prepared:

Oct.3 Prepaid Insurance 600

Cash 600

This account shows a balance of $600 in October 31 trial balance. An analysis of the
policy reveals that $50 ($600:12 months) expires each month.
An adjusting entry must now be prepared to reflec this expiration over time.
 Adjusting Entries for prepayments

The adjusting entry will reduce the asset account (prepaid insurance) and decrease
the owner’s equity by increasing the Insurnace Expense account by $50.

One month of insurance ($50) has expired. This decreases the

Basic Analysis assets account prepaid insurance by $50 and increases the expense
account insurance expense by $50.

Assets = Liabilities + Owner’s Equity

Equation Prepaid Insurance Insurance Expense
Analysis - 50 - 50

ILLUSTRATION 3.8
Adjustment for insurance
 Adjusting Entries for prepayments

Debit – Credit Debits increase expense: Debit Insurance Expense $50

Analysis Credits decrease assets: Credit prepaid Insurance $50
Oct.31 Insurance Expense 50
Adjusting
Prepaid Insurance 50
journal Entry
To record insurance expired

Prepaid Insurance Insurance Expense

Posting Oct.3 600 Oct.31 Adj. 50 Adj. 50

Oct.31 Bal 550 ILLUSTRATION 3.8

Adjustment for insurance

After the adjustment, the asset Prepaid Insurance shows a balance of $550. This amount
represents the unexpired cost for the remaining 11 months of coverage (11 x $50)
 Adjusting Entries for prepayments

Depreciation
A business usually owns a variety of assets that have long lives, such as land, buidings, and
equipment. These long – lived assets provide service for a number of years. The length of
service is called the useful life. Companies record these assets at cost, as required by the
historical cost principle.
A portion of the cost of a long – lived asset is recognized each period over the useful life of
the asset. The process of allocating the cost of a long – lived asset over its useful life is
called depreciation.
Calculation of Depreciation: A common method of calculation depreciation expense is to
dicvide the cost of the asset by its useful life. This is called the straight – line depreciation
method.
 Adjusting Entries for prepayments

Example. Lynk Software services purchase equipment that cost $5,000 on October 2. If its
useful life is expected to be five years, annual depreciation is $1,000 ($5,000:5).

Cost
Annual Depreciation expense =
Useful life (in years)

ILLUSTRATION 3.9
Formula for straight-line depreciation

If we want to determine the depreciation for one month, we would multiply the annual
expense by 1/12 as there are 12 months in a year.
 Adjusting Entries for prepayments

Depreciation
We report both the original cost of long – lived assets and amount of Accumulated
Depreciation in the financial statements.
Accumulated Depreciation account is a contra asset account because it has the opposite
(credit) balance to its related asset Equipment, which has debit balance. Thus it is offset
against the value of the asset account on the balance sheet.
 Adjusting Entries for prepayments

For Lynk Software Services, depreciation on the equipment is estimated to be $83 per
month (1,000x1/12). The adjusting entry to record the depreciation on the equipment for
the month of Octorber is made as shown in Illustration 3.10

Once month of depreciation increase the amount of Accumulated

Basic Analysic Depreciation – Equipment by $83 and increases the expense account
Depreciation Expense by $83.

Assets = Liabilities + Owner’s Equity

Equation Accumulated Depreciation Expense
Analysis Depreciation – Equipment
- 83 - 83

Illustration 3.10. Adjustment for Depreciation

 Adjusting Entries for prepayments

Debit Depreciation Expense $83

Debit – Credit Credits Accumulated Depreciation-Equipment $83
Analysis

Oct.31 Depreciation Expense 83

Adjusting
Accumulated Depreciation – Equipment 83
journal entry
To record monthly depreciation

Equipment Depreciation Expense

Posting Oct.2 5,000 Oct.31 Adj. 83

Illustration 3.10. Accumulated Depreciation - Equipment

Adjustment for 83 Adj. Oct.31
Depreciation
 Adjusting Entries for prepayments

The balance in the Accumulated If the adjusting entry is not

Depreciation account will increase by made, expenses will be
$83 each month and the balance in the understated by $83. Total assets,
Equipment account will remain total owner’s equity, aand profit
unchanged until the asset is sold. will be overstated $83.

Statement presentation
Otc. Nov. Dec.
Equipment $5,000 $5,000 $5,000
Less: Accumulated depreciation – equipment 83 166 249
Carrying amount $4,917 $4,834 $4,751

Illustration 3.11. Financial statement presentation

 Adjusting Entries for prepayments

If a company owns both equipment and buildings, it calculates and records depreciation
expense on each category. It can use one depreciation expense account but it must create
separate accumulated depreciation accounts for each category.

Accounting for prepaid Expenses

Reason for Accounts before Adjusting Entry
Adjustment Adjustment
Insurance, supplies, Prepaid expenses Assets overstated. Dr. Expenses
advertising, rent, recorded in asset Expense Cr. Assets or
depreciation accounts have been understated. Contra Assets
used

Illustration 3.12. Summarizes the accounting for prepaid expensse

 Adjusting Entries for Unearned Revenues

When companies receive cash before the services are performed, they record a liability by
increasing (crediting) a liability account called Unearned Revenue. In other words, the
company now has an obligation to provide one of its customers with a services.

Example. Airlines such as Air Canada treat receipts from the sale of ticket as unearned
revenue until the flight service is provided

Unearned revenue are the opposite of prepaid expenses. When a payment is received for
services that will be provided in a future accounting period, Cash is debited (increased)
and an unearned revenue account (a liability) should be credited (increased) to recognize
the obligation that exists. The company subsequently recognizes revenues when the service
is provided to the customer.
 Adjusting Entries for Unearned Revenues
Unearned Revenue
Liability Revenue
Debit Adjusting Unadjustted Credit Adjusting
Entry (-) Balance Entry (+)

Illustration 3.13. Adjusting for unearned revenue

Example. Lynk Software received $1,200 on October 3 from R.Knox for consulting
services that will be completed by December 31. The following journal entry was
prepared:
Oct.3 Cash 1,200
Unearned Revenue 1,200

Now the Unearned Revenue account shows a credit balance of $1,200 in the October 31
trial balance. An evaluation of work performed by Lynk for Knox during October shows
that $400 of work was done.
 Adjusting Entries for Unearned Revenues

The liability account Unearned Revenue is decreased by $400 for the

Basic Analysic services provided and the revenue account Service Revenue is increase
by $400.

Assets = Liabilities + Owner’s Equity

Equation
Unearned Revenue Service Revenue
Analysis
- 400 + 400

Debit – Credit Debits decrease liabilities: Debit Unearned Revenue $400

Analysis Credits increase revenues: Credit Service Revenue $400

Illustration 3.14. Sevice Revenue accounts after Adjustment

 Adjusting Entries for Unearned Revenues

Oct.31 Unearned Revenue 400

Adjusting
Service Revenue 400
journal entry
To record revenue for services provides in October

Unearned Revenue Service revenue

Posting
Oct.31 Adj. 400 Oct.4 1,200 Oct.21. 10,000
25 800
Oct.31 Bal. 800 31 Adj. 400

Oct.31 Bal. 11,200

Illustration 3.14. Sevice Revenue accounts after Adjustment

 Adjusting Entries for Unearned Revenues

If this adjustment is not made, revenues and profit will be understated by $400 in the
income statement. As well, liabilities will be overstated by $400 and oener’s equity
understated by that amount on the October 31 balance sheet..

Accounting for Unearned Revenues

Reason for Adjustment Accounts before Adjusting Entry
Adjustment
Rent, maganize Unearned revenues Liabilities Dr. Liabilities
subscriptions, recorded in liability overstated. Cr. Revenues
customer deposits accounts are now Revenues
for future service recognized as revenue understated
for services performed.

Illustration 3.15. Summarizes the accounting for unearned revenues

 DO IT ! 3.2
The trial balance of panos Co. on March 31, 2021, includes the following
selected accounts before adjusting entries:
Debit Credit
Prepaid insurance $ 1,200
Supplies 2,800
Equipment 24,000
Accumulated depreciation – equipment $2,200
Unearned revenue 9,300
An analysis of the accounts shows the following:
1. A once-year insurance policy for $1,200 was purchased on March 1, 2021.
2. Supplies on hand at March 31,2021, total $800
3. Equipment was purchased on April 1, 2020, and has an estimated useful life of 10
years.
4. Once-third of services related to the unearned revenue was performed in March 2021.
Prepare the adjusting entries for the month of March.
 DO IT ! 3.2
Solution

1. Mar. Describe Debit Credit

1. Mar.31 Insurance Expense 100
Prepaid Insurance 100
To record insurance expired: $1,200:12
2. 31 Supplies Expense 2,000
Supplies 2,000
To record supplies used: $2,800 previously on hand - $800
currently on hand = $2,000 used.
3. 31 Depreciation Expense 200
Accumulated Depreciation – Equipment 200
To record monthly depreciation: ($24,000/10)*1/12
4. 31 Unearned Revenue 3,100
Service Revenue 3,100
To record revenue for services performed: $9,300*1/3=$3,100
 Learning Objective 3: Prepare Adjusting Entries for Accruals

The second category of adjusting entries is accruals. Unlike prepayments, which have
already been recorded in the accounts, accruals are not recognized through transaction
journal entries and thus are not included in the accounts. Accruals are required in situations
where cash will be paid or received after the end of the accounting period.
 Accrued Revenues

Revenues for services performed but not yet recorded at the financial statement date are
accrued revenues. Accrued revenues may accumulate with the passage of time, as happens
with interest revenue and rent revenue. There are unrecorded because the earning of
interest does not involve daily transactions. Companies do not record interest revenue daily
because this is often impractical.
 An adjusting entry is required for two purposes:
1. To show the receivable that exixts at the balance sheet date, and
2. 2. To record the revenue for services performed during the period.
Before the adjustment is recorded, both assest and revenues are understated.
 Accrued Revenues

Example: In October, Lynk Software Services worth $200 that were not billed to clients
until November. Because these services have not been billed, they have not been recorded.
Andjusting entry on October 31 is required as shown in Illustration 3.17.

Basic Analysis The asset account Accounts Receivable is increased by $200 for the
services provided and the revenue account Service Revenue is
increased by $200.

Assets = Liabilities + Owner’s Equity

Equation
Accounts Receivable Service Revenue
Analysis
+200 + 200

Debit – Credit Debits increase assets: Debit Account Receivable $200

Analysis Credits increase revenues: Credit Service Revenue $200
 Adjusting Entries for Unearned Revenues

Oct.31 Accounts Receivable 200

Adjusting
Service Revenue 200
journal entry
To accrue revenue for services performed but
not billed or collected.
Account Receivable Service Revenue
Posting
Oct.21 10,000 Oct.31 9,000 Oct.21. 10,000
31 Adj. 200 25 800
31 Adj. 400
31 Adj. 200

Oct.31 Bal. 11,400

Illustration 3.17. Sevice Revenue accounts after Adjustment

 Accrued Revenues

The asset Accounts Receivable shows that $1,200 is owed by clients at the balance sheet
date. The balance of $11,400 ($10,000+$800+$400+$200) in service Revenue represents
the total revenue for services performed during the month.
=> Without the adjusting entry, assets and owner’s equity on the balance sheet, and
revenues and profit on the income statement, will all be understated.
 Adjusting Entries for Unearned Revenues

On November 10, Lynk receives $200 cash for the services performed in October. The
following entry is made:

Nov.10 Cash 200

Accounts Receivable 200
To record cash collected on account.

Examples Reason for Adjustment Accounts Before

Adjustment Adjusting Entry
Interest, rent, Services performed but Assets understated. Dr. Assets
services not yet paid for in cash or Revenues understated. Cr. Revenues
recorded.
 Accrued Expenses

Expenses incurred but not yet paid or recorded at the statement date are called accrued
expenses.
Example: Interest, rent, property taxes, and salaries can be accrued expenses.
Companies make adjustments for accrued expenses to record the obligations that exist at
the end of the current accounting period.
In fact, accrued expenses result from the same causes as accrued revenue for another
company.
For example, the $200 accrual of revenue by Lynk is an accrued expense for the client that
received the service.
Adjustments for accrued expenses are needed for two purposes:
(1) To record the obligations that exist at the balance sheet date, and
(2) To regconized the expenses that apply to the current accounting period.
Before adjustment, both liabilities and expenses are understated. Profit and owner’s equity
are overstated. Therefore, an adjusting entry for accrued expenses results in an increase
(debit) to an expense account and an increase (credit) to a liability account.
 Adjusting Entries for Unearned Revenues

Accrued Expenses

Expense Liability

Debit Adjusting Credit Adjusting

Entry (+) Entry (+)

Illustration 3.19. Adjusting entry for accrued expenses

 Accrued Expenses - Interest

On October 2, Lynk Software Services signed a $5,000, three-month note payable, due
January 2,2022. The note requires interest to be paid at an annual rate of 65. The amount of
interest recorded is determined by three factors:
(1) The principal amount of the note;
(2) The interest rate, which is always expressed as an annual rate; and
(3) The length of time that the note is outstanding (unpaid).
The principle amount iss the amount is the amount borrowed or the amount still owed on a
loan, separate from interest.
Interest is sometimes due montly, and sometimes when the principal is due. For Lynk, the
total interest due on the $5,000 note at its due date three months later is $75
($5,000x6%x3/12 months). Again note, interest rates are always expressed as an annual
rate. Because the interest rate is for one year, the time period must be adjusted for the
fraction of the year that the note is outstanding.
 Accrued Expenses - Interest

The formula for calculating interest and how it applies to Lynk Software Services for the
month of Octorber are shown in Illustration 3.20

Principal Amount X Annual Interest Rate X Time in Terms of One Year

Interest
$5,000 X 6% X 1/12. = 25%
 THE END.
Thank you for your attention.