The Adjusting Process

Accounting
27e

human/iStock/360/Getty Images
Warren
Reeve
Duchac
Accrual and Cash Basis of Accounting
(slide 1 of 2)

• Under the accrual basis of accounting,

revenues are reported on the income
statement in the period in which a service
has been performed or a product has been
delivered.
o Cash may or may not be received from
customers during this period.
• The accrual basis of accounting also
requires expenses to be recorded when
they are incurred, not necessarily when
cash is paid.
• Generally accepted accounting principles
(GAAP) require the accrual basis of
©2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Accrual and Cash Basis of Accounting
(slide 2 of 2)

• Under the cash basis of accounting,

revenues and expenses are reported on
the income statement in the period in
which cash is received or paid.
• Most individuals and small service
businesses may use the cash basis of
accounting. For most large businesses,
however, the cash basis will not provide
accurate financial statements for user
needs.

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Revenue and Expense Recognition
(slide 1 of 2)

• Under the revenue recognition

principle, revenues are recorded when
services have been performed or products
have been delivered to customers.
o Revenue is normally measured as the assets
received, such as cash or accounts receivable.
o The process of recognizing revenues is called
revenue recognition.

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Revenue and Expense Recognition
(slide 2 of 2)

• Under the expense recognition

principle, the expenses incurred in
generating revenue must be reported in
the same period as the related revenue.
o This is also called the matching principle.
 By matching revenues and expenses, net income or
loss for the period is properly reported on the income
statement.
 Adjusting entries are required to properly match
revenues and expenses.

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The Adjusting Process
(slide 1 of 3)

• At the end of an accounting period, an

unadjusted trial balance is prepared to
verify that the total debit balances equal
the total credit balances.
• Many of these account balances are
reported in the financial statements
without change.

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The Adjusting Process
(slide 2 of 3)

• Some accounts on the unadjusted trial balance,

however, require adjustments for the following
reasons:
o Some expenses are not recorded daily.
 For example, the daily use of supplies would require many
entries with small amounts.
o Some revenues and expenses are incurred as time
passes rather than as separate transactions.
 For example, rent received in advance (unearned rent)
expires and becomes revenue with the passage of time.
o Some revenues and expenses may be unrecorded at the
end of the accounting period.
 For example, a company may have provided services to
customers that it has not billed or recorded at the end of
the accounting period.

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The Adjusting Process
(slide 3 of 3)

• The analysis and updating of accounts at

the end of the period before the financial
statements are prepared is called the
adjusting process.
• The journal entries that bring the accounts
up to date at the end of the accounting
period are called adjusting entries.
o All adjusting entries affect at least one income
statement account and one balance sheet
account.
 Thus, an adjusting entry will always involve a
revenue or an expense account and an asset or a
liability account.
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Types of Accounts Requiring Adjustment

• The two general classifications of accounts

requiring adjustment are as follows:
o Accruals
o Deferrals

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Types of Accounts Requiring Adjustment:
Accruals

• An accrual occurs when revenue has been

earned or an expense has been incurred
but has not been recorded.
o If the accrual is for revenue, the adjusting
entry debits an asset (Accounts Receivable)
and credits a revenue account.
o If the accrual is for an expense, the adjusting
entry debits an expense account and credits a
related liability account such as Accounts
Payable or Wages Payable.

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Types of Accounts Requiring Adjustment:
Deferrals

• A deferral occurs when cash related to a

future revenue or expense has been
initially recorded as a liability or an asset.
o If the cash received is related to future
revenue, it is initially recorded as a liability
called unearned revenue.
 The adjusting entry in the period when the revenue is
earned debits an unearned revenue account and
credits a revenue account.
o If the cash paid is related to a future expense,
it is initially recorded as an asset called
prepaid expense.
 The adjusting entry in the period when the expense is
incurred debits an expense account and credits a
prepaid
©2018 Cengage Learning. expense
All Rights Reserved. (asset)
May not be scanned, account.
copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Depreciation Expense
(slide 1 of 6)

• Fixed assets, or plant assets, are

physical resources that are owned and
used by a business and are permanent or
have a long life.
o Examples of fixed assets include land,
buildings, and equipment.
• As time passes, a fixed asset loses its
ability to provide useful services.
o This decrease in usefulness is called
depreciation.

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Depreciation Expense
(slide 2 of 6)

• All fixed assets, except land, lose their

usefulness and, thus, are said to
depreciate.
o As a fixed asset depreciates, a portion of its
cost should be recorded as an expense.
 This periodic expense is called depreciation
expense.

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Depreciation Expense
(slide 3 of 6)

• The adjusting entry to record depreciation

expense is similar to the adjusting entry
for supplies used.
o The depreciation expense account is increased
(debited) for the amount of depreciation.
o However, the fixed asset account is not
decreased (credited).
 This is because both the original cost of a fixed asset
and the depreciation recorded since its purchase are
reported on the balance sheet.
 Instead, an account entitled Accumulated
Depreciation is increased (credited).

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Depreciation Expense
(slide 4 of 6)

• Accumulated depreciation accounts are

called contra accounts, or contra asset
accounts.
o This is because accumulated depreciation
accounts are deducted from their related fixed
asset accounts on the balance sheet.
o The normal balance of a contra account is
opposite to the account from which it is
deducted.
o Because the normal balance of a fixed asset
account is a debit, the normal balance of an
accumulated depreciation account is a credit.

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Depreciation Expense
(slide 5 of 6)

• The normal titles for fixed asset accounts

and their related contra asset accounts are
as follows:

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Depreciation Expense
(slide 6 of 6)

• The difference between the original cost of

the office equipment and the balance in
the accumulated depreciation—office
equipment account is called the book
value of the asset (or net book value).
• It is computed as follows:

Book Value of Asset = Cost of the Asset – Accumulated

Depreciation of Asset

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Adjusted Trial Balance

• After the adjusting entries are posted, an

adjusted trial balance is prepared.
• The adjusted trial balance verifies the
equality of the total debit and credit
balances before the financial statements
are prepared.

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Analysis for Decision Making:
Vertical Analysis

• Comparing each item in a financial

statement with a total amount from the
same statement is referred to as vertical
analysis.
o In vertical analysis of a balance sheet, each
asset item is stated as a percent of the total
assets. Each liability and stockholders’ equity
item is stated as a percent of total liabilities
and stockholders’ equity.
o In vertical analysis of an income statement,
each item is stated as a percent of revenues or
fees earned.

©2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.