Chapter 4

Accounting Adjustments

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The Accounting Cycle

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 The Purpose of Adjustments

• Revenues are recorded when earned (the revenue recognition principle).

• Expenses are recorded when they are incurred to generate revenue (the
expense recognition principle).

• Assets are reported at amounts that represent the probable future

benefits remaining at the end of the period.

• Liabilities are reported at amounts that represent the probable future

sacrifices of assets or services owed at the end of the period.

Companies wait until the end

of the accounting period to Adjusting entries are
adjust their accounts because required every time a
doing so daily or weekly company prepares
would be very costly and financial statements
time-consuming.

4-3
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Exhibit 4.2
Types of Adjustments

4-4
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 Adjusting Journal Entries
- Four types of adjustments

Revenues Expenses
1. Unearned 3. Prepaid
Revenues. Expenses.
2. Accrued 4. Accrued
Revenues. Expenses.

---------------------- Chapter 4 ---------------------- 5

 Adjusting Journal Entries
- Four types of adjustments

Unearned (Deferred) revenue (L): Cash received

before revenue earned
Accrued revenue (A): Cash received after revenue
earned
Prepaid expenses (A): Cash paid before expense
incurred
Accrued expenses (L): Cash paid after expense
incurred

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 AJE for Unearned (Deferred) Revenue
– Cash is received before revenue is earned
 If cash is received before the company delivers goods or services,
the liability account Unearned Revenue is recorded (e.g. magazine
subscriptions, season tickets to concerts, airplane tickets).
 When the company delivers the goods or services, Unearned
Revenue is reduced and Revenue is recorded.

AJE by the end of

Cash Received the period

Cash (+A) xxx

Unearned Revenue (+L) xxx

Revenue will be recorded when earned.

Unearned Revenue (-L) xxx

Service Revenue (+R) xxx

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 AJE for Accrued Revenue
– Cash is received after revenue is earned
 If cash is received after the company delivers goods or services, an
asset Account Receivable is recorded.
 When the company received the cash, Account Receivable is
reduced and cash is recorded.

AJE by the end Cash received

of the period in the future

Account Receivable (+A) xxx

Revenue (+R) xxx

Cash will be collected in the future.

Cash (+A) xxx
Account Receivable (+A) xxx

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 AJE for prepaid expenses
– Cash is paid before expense is incurred
 If cash is paid before expenses incurred, an asset account Prepaid
Expense is recorded (e.g. prepaid insurance, prepaid rent, supplies,
equipment).
 When the expense is incurred, Prepaid Expense is reduced and
Expense is recorded.

AJE by the end

Cash Paid of the year

Prepaid Expense (+A) xxx

Cash (-A) xxx

Expense will be recorded when incurred

Expense (+E) xxx

Prepaid Expense (-A) xxx

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 AJE for Accrued Expenses
– Cash is paid after expense is incurred
 If cash is paid after expenses incurred, a liability account Payable is
recorded (e.g. wages payable, utilities payable, interest payable,
income tax payable).
 When cash is paid, Payable is reduced.

AJE by the end Cash Paid

of the period

Expense (+E) xxx

Account Payable (+L) xxx

Cash will be paid.

Account Payable (-L) xxx

Cash (-A) xxx

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3-10
 The Adjustment Process
Three steps: (TAR)

1) Type: Identify the type of adjustment (one of the

four types).
2) Amount: Determine the amount of the adjustment.
3) Record: Record the adjusting journal entry and post
it to the ledger (t-account).

---------------------- Chapter 4 ---------------------- 11

Adjusted Journal Entries - Examples

Well, it is now June 30 and the accounting period has

come to an end. We need to close Jaz’s books and
generate the financial statements. Before we do that,
we need to determine if we need to record any
adjusting entries.

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 Debit-Credit Framework – A Review

A = L + OE
ASSETS LIABILITIES EQUITIES
Debit Credit Debit Credit Debit Credit
for for for for for for
Increase Decrease Decrease Increase Decrease Increase

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 Debit-Credit Framework - Expanded
Dividends decrease RETAINED EARNINGS
Retained Earnings.
Net Income increases
Debit for Credit for Retained Earnings.
Decrease Increase

REVENUES EXPENSES
Debit for Credit Debit for Credit for
Decrease for Increase Decrease
Increase

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Example #1
 Recall Jaz Pizzeria Inc. It is now June 30 and the accounting
period has come to an end. We need to close Jaz’s books and
generate the financial statements. Before we do that, we need to
determine if we need to record any adjusting entries.

(1) When we look at our prepaid account we realize that

on April 30, 2021, Jaz’s paid $8,000 in rent for the
occupancy of its building for the month of June. Well, we
need to recognize that expense now since we have passed
June and we are in the building. To do this, we just
recognize the expense and chip off the $8,000 from the
prepaid account.

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 Example #1
Step 1: Type of account
Prepaid expenses
Step 2: Amount
$8,000
Step 3: Prepare journal entry (ICDV. A = L + SE)

Date Account Debit Credit

6/30 Rent Expense (+E, -SE) 8,000
Prepaid expense (-A) 8,000
June rent expense

---------------------- Chapter 4 ---------------------- 16

Example #2
(2) Next, we look at our supplies and notice that they are
much lower now then they were at the beginning of
June. In fact, supplies started at $60,000 at the
beginning of June, we added $420, and when we count
now, we find that they have decreased to $24,420. That
must mean that we have used some supplies for our
restaurant. Certainly these are expenses that should be
matched with the revenues of the period. We need to
reduce supplies.

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Example #2
Step 1: Type of account
Prepaid expenses
Step 2: Amount Supplies used = Beg. Supplies + Purchase – Amount still in hand
$36,000 [60,000 + 420 – 24,420]
Step 3: Prepare journal entry (ICDV. A=L+SE)

Date Account Debit Credit

6/30 Supplies Expense (+E, -SE) 36,000
Supplies (-A) 36,000
Use of supplies to generate revenue

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Example #3

(3) What about that contract we have with Albertson's? On

February 15, 2021, Jaz’s Inc. received $1,200 from
Albertson’s for a one-year retail food contract for the
period March 1, 2021 to February 29, 2022. It is already
the end of June. Four months of this contract have already
past. We certainly need to recognize four months of
revenue and reduce the unearned revenue liability account
by the same amount.

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Example #3
Step 1: Type of account
Unearned revenue
Step 2: Amount
$400 [(1,200 / 12) * 4 months]
Step 3: Prepare journal entry (ICDV. A=L+SE)

Date Account Debit Credit

6/30 Unearned revenue (-L) 400
Revenue (+R, +SE) 400
Record revenue on Albertson’s contract

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 Example #4

(4) As we do our analysis, we realize that the accounting

period ends before we will actually pay employees for
work they did in June. Our employees worked the entire
month of June, but we will not issue payroll checks until
the first week of July. Since we pay employees once a
month, we must accrue all of June's $12,000 worth of
payroll expenses.

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Example #4
Step 1: Type of account
Accrued expenses
Step 2: Amount
$12,000
Step 3: Prepare journal entry (ICDV. A = L + SE)

Date Account Debit Credit

6/30 Wage Expense (+E, -SE) 12,000
Wages Payable (+L) 12,000
June payroll expense

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 Example #5

(5) Finally, we remember that we own some debt securities.

Since we earn interest on these securities every month, we
need to record the $100 of interest revenue for June even
though we have not received the cash interest payment yet.

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 Example #5
Step 1: Type of account
Accrued revenues
Step 2: Amount
$100
Step 3: Prepare journal entry (ICDV. A = L + SE)

Date Account Debit Credit

6/30 Interest receivable (+A) 100
Interest Revenue (+R, +SE) 100
Accrue interest revenue

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 Accounting Estimates

Certain
Certaincircumstances
circumstancesrequire
requireadjusting
adjustingentries
entriesto
to
record
recordaccounting
accountingestimates.
estimates.


Examples
Examplesinclude
include......

Depreciation
Depreciation

Bad
Baddebts
debts

$$$
---------------------- Chapter 4 ---------------------- 25
In Summary

• You may have noticed that the Cash account was never
adjusted. The cash has already been received or paid by the
end of the period, or it will be received or paid in the next
period.

• Adjustments are required to record revenues and expenses in

the proper period because the cash part of the transaction is
at a different point in time.

• In addition, each adjusting entry always included at least

one income statement account and at least one balance
sheet account.

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Closing the Books

After the financial statements are prepared and disseminated to users, a

closing process is needed as the last step in the accounting cycle to mark
the end of the current period and the beginning of the next.

The final step in the accounting cycle is closing the books.

The closing entry has two purposes:
1. To transfer the balances in the temporary accounts (income statement
accounts) to Retained Earnings.
2. To establish a zero balance in each of the temporary accounts to start
the next period.

• The closing entry is dated the last day of the accounting period and is
posted to the ledger (or T-accounts).
• The income statement (temporary) accounts with debit balances are
credited and the income statement (temporary) accounts with credit
balances are debited.
• The net amount, equal to net income, affects Retained Earnings.

4-27
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*The Closing Process – Revenue/Expense
Date Account Debit Credit
Revenue/Gain XXX
Retained Earnings XXX
Close revenue/gain to retained earnings

Date Account Debit Credit

Retained Earnings XXX
Expense/Loss XXX
Close expense/loss to retained earnings

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*The Closing Process - Dividends

Date Account Debit Credit

Retained Earnings XXX
Dividends XXX
Close dividends to retained earnings

---------------------- Chapter 4 ---------------------- 29

Total Asset Turnover Ratio

How efficient is management in using its resources to generate sales?

The higher the asset turnover is, the more efficient assets are being
utilized to generate revenues.

Total Asset Net Sales (or Operating Revenues)

=
Turnover Ratio Average Total Assets*

*Average is computed as: (Beginning balance + Ending balance) ÷ 2

4-30
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Let’s practice!
Burress Company's annual accounting year ends on December 31. It is
December 31, 2021, and all of the 2021 entries except the following
adjusting entries have been made.
Required: Perform the adjustment process (all three steps) for each of
the transactions below. Indicate the effect of each adjusting entry and the
amount of the effect.

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(a) On September 1, 2021, Burress collected 6 months' rent of S7,200 on storage space. At
that date, Burress debited cash and credited Unearned Rent Revenue for $7,200.
 (b) At December 31, 2021, wages earned by employees totaled $14,000. The employees will
be paid on the next payroll date, January 15, 2022.
 (c) The company earned service revenue of $3,000 on a special job that was completed
December 19, 2021.Collection will be made during January 2022. No entry has been
recorded.
 (d) On October 1, 2021, the company borrowed $18,000 from a local bank and signed a 12
percent note for that amount. The principal and interest are payable on the maturity date,
September 30, 2022.
 (e) On November 1, 2021, Burress paid a one-year premium for property insurance, $7,000,
for coverage starting on that date. Cash was credited and Prepaid Insurance was debited
for this amount.
 (F) Depreciation of $2,000 must be recognized on a service truck purchased on July 1, 2021,
at a cost of $15,000.
 (g) Cash of $3,000 was collected on November 1, 2021, for services to be rendered evenly
over the next year beginning on November 1. Unearned Service Revenue was credited
when the cash was received.
 (h) On December 31, 2021, the company estimated it owed $500 for 2021 property taxes on
land. The tax will be paid when the bill is received in January 2022.

---------------------- Chapter 4 ---------------------- 32

Let’s practice!
Req. 1

a. Unearned revenue e. Prepaid expense

b. Accrued expense f. Prepaid expense
c. Accrued revenue g. Unearned revenue
d. Accrued expense h. Accrued expense

Req. 2

a. Unearned rent revenue (L) ........................................ 4,800

Rent revenue (+R, +SE) .................................... 4,800
($7,200 ÷ 6 months = $1,200 per month x 4 months)

b. Wage expense (+E, SE) ............................................ 14,000

Wages payable (+L) .......................................... 14,000

c. Accounts receivable (+A)............................................. 3,000

Service revenue (+R, +SE) ................................ 3,000

d. Interest expense (+E, SE) .......................................... 540

Interest payable (+L) ............................................ 540
($18,000 x 12% x 3/12 = $540)

e. Insurance expense (+E, SE)...................................... 1,167

Prepaid insurance (A) ..................................... 1,167
($7,000 ÷ 12 months = $583 per month x 2 months of coverage)

f. Depreciation expense (+E, SE) .................................. 2,000

Accumulated depreciation, service truck (+XA, A) 2,000

g. Unearned service revenue (L).................................... 500

Service revenue (+R, +SE) ................................. 500
($3,000 x 2/12)

h. Property tax expense (+E, SE)................................... 500

Property tax payable (+L) ..................................... 500

---------------------- Chapter 4 ---------------------- 33

Let’s practice!
Balance Sheet Income Statement
Stockholders’ Net
Transaction Assets Liabilities Equity Revenues Expenses Income
a. NE –4,800 +4,800 +4,800 NE +4,800
b. NE +14,000 –14,000 NE +14,000 –14,000
c. +3,000 NE +3,000 +3,000 NE +3,000
d. NE +540 –540 NE +540 –540
e. –1,167 NE –1,167 NE +1,167 –1,167
f. –2,000 NE –2,000 NE +2,000 –2,000
g. NE –500 +500 +500 NE +500
h. NE +500 –500 NE +500 –500

Chapter 4 34