Adjustments

Introduction
In this module:

You'll look at:

• The influence of time on accounting records.

You'll be introduced to:

• Time Period assumption
• Adjusting entries; specifically prepayments, accruals, and estimates.

You'll work with the:

• Revenue Recognition and Matching GAAP
• General Journal, general ledger, trial balance and financial statements.

Learning Outcomes
Upon successful completion of Module 3 you will be able to:
1. Understand the Time Period Assumption and why general ledger accounts must always be
adjusted prior to the preparation of financial statements.
2. Differentiate between the Accrual and Cash basis of accounting.
3. Apply the Generally Accepted Accounting Principles (GAAP) of Realization (Revenue
Recognition) and Matching which support the Accrual Basis of accounting.
4. Prepare adjusting entries for:
• Prepayments
• Accrued revenue and accrued expenses
• Amortization
• Prepare an Adjusted Trial Balance

Pre-Test
Instructions: You're going to test your accounting knowledge before you begin the Module content.
With the following questions answer true or false.

1. The smallest accounting period normally used in business is one month.

2. Adjusting entries are used only to correct errors in the accounting records.
3. Advance payments received from clients are recorded as soon as they are received.
4. The cash Basis of accounting means that business accepts cash payments only from its clients.
5. Goods sold or services performed are never recorded until they are paid for.
6. The matching principle requires that we attempt to record the cost in the same period as the
related revenue.
7. The Realization (revenue recognition) principle requires that revenue be recorded (recognized)
when it is earned. This may be in a different period than the cash is received.
8. If a customer buys something in June, but does not pay for it until July, the seller will record the
sale in July.
 9. Some accounting entries are based on estimates.
10. The purpose of adjusting records periodically is to make sure the company appears profitable at
all times.

Answers:

1. True
2. False
3. True
4. False
5. False
6. True
7. True
8. False
9. True
10. False

Adjusting Entries
Throughout a company’s life, ongoing and frequent decisions are made regarding its operation. Very
often, financial statements form the basis of many of these decisions.

To be useful in the decision making process:

• Statements must be produced regularly and frequently

• Consistent recording and reporting methods must be used

But, why are adjusting entries needed?

Why are Adjusting Entries Needed?

To understand the need for adjustments, we need to first consider how the passage of time affects
accounting records.

Period is an accounting term that describes a span of time with a beginning and end. The span is usually,
but not always a month, quarter or year.

For example:

1. Monies paid today may be an advance payment for expenses that will be incurred in a later
period. (Period: An accounting term that describes a span of time with a beginning and end. The
span is usually, but not always a month, quarter or year.)
2. Cash received today may be a deposit for services to be performed at some time in the future.
3. Revenue earned today may not be received in cash until a later period.
4. Expenses incurred today may not be paid until a later period.
5. An asset purchased today will help earn revenue over the next several periods.
Adjusting Entries Cycle
1. Economic Event: Analyze Transactions
2. Record: Enter in General Journal & prepare Adjusting Entries
3. Summarize: Post to General Ledger & post Adjusting Entries
4. Prepare Financial Reports: Prepare Trail Balance, Adjusted Trail Balance, & Financial Statements.

The Time-Period Assumption

Ensures that accounting information is reported at regular intervals.

Period: Monthly, Quarterly, Annually

Interacts with the revenue- and expense-recognition criteria, and the matching objective.

Requires that income be measured accurately each period.

The Time-Period Assumption

Assumes that the total economic life of a business can be divided into smaller artificial time periods for
which financial statements can be prepared.

Imagine yourself in this situation:

Z-Tekko Cellphones is looking for investment capital to expand its operations.
• To encourage investors to purchase shares, how often should Z-Tekko prepare financial
statements?
• Should Z-Tekko prepare financial statements?
• Every 5 Years?

Investors will be unlikely to buy shares. They will not recive information frequently enough to make wise
investment decisions.

• Once a Year?

Investors are more likely to invest because they will receive more timely information, and can review
year-to-year trends. However, if Z-Tekko produced statements yearly and monthly, the investors could
also manage their investments from month to month.

• Once a month?

Investors are more likely to invest because they will receive more timely information. However, if Z-
Tekko produced statements yearly and monthly, the investors could also manag their investments from
month to month.

Generally Accepted Accounting Principle (GAAP)

However, smaller artificial time periods can create a problem. Earlier, you noticed that a transaction
occurring in one period may affect the results of one or more later periods. The challenge for
accountants is to fairly allocate the financial impact of such transactions among all of the periods
affected. Therefore, accountants generally use Accrual-Basis accounting to do so.
Cash-Basis Accounting
The Cash-Basis of accounting records the impact of a transaction only when cash has actually been
exchanged.

Expenses are not matched with revenues, and revenue and expenses may be understated or overstated
in any given period. For this reason, the financial statements can often be misleading.

The Cash-Basis suits only some self-employment situations and very small businesses, such as those with
no receivables or payables.

Accrual-Basis Accounting
The Generally Accepted Accounting Principles you are learning in this subject relate to the Accrual-Basis
of accounting.

The Accrual-Basis involves adjusting the accounts to reflect the impact of all transactions related to a
given period, whether or not the transaction actually occurred in that period.

The Accrual-Basis ensures that revenues and expenses are stated accurately for each period, and that
there is consistency in their reporting in financial statements.

Accrual-Basis Accounting (con't)

• Also called accrual accounting
• Based on the time period assumption and recognition criteria for revenues and expenses.
• Consequently, accrual accounting is required by GAAP for both ASPE and IFRS

Accrual-Basis Accounting vs. Cash-Basis Accounting

What is the difference?
Accrual accounting records the effect of each business transaction as it occurs.
Cash-basis accounting records transactions only when cash receipts and cash payments occur.

Accrual Basis:
• Records revenues when they are earned
• Records expenses when they are incurred

Cash Basis:
• Records cash receipts as revenue
• Records cash payments as expense

Example 1:

James Purchases $4 000 of supplies on account.

 Accrual Entry Cash Entry
Supplies 4 000 No entry
Accounts Payable 4 000 because no
cash was
Purchased supplies on credit. paid/

Example 2:

James completed a job on credit for $15, 000.

Accrual Entry Cash Entry

Accounts Receivable 15 000 No entry
Service Revenue 15 000 because no
Earned revenue on account cash was paid.

Recognition Criteria for Revenues

Revenue recognition states that revenue should be recognized when it is earned

Revenue is earned when:

a. Goods delivered or services completed.
b. Contractual agreements have been met.

Record revenue equal to the cash value of the goods or service transferred to the customer.

Realization (Revenue Recognition) Principle

Revenue should be recorded (recognized) in the accounting records in the period in which it is earned,
not when the cash is received.

Costs should be recorded (recognized) in the accounting records in the period they are incurred, not
when the cash is paid.

Example:

Test your Understanding:

In January you sell $100,000 worth of product to a single customer who agrees to pay for the
product in February. You also received a January utility invoice in the amount of $6,000 that is
not due until February 4.

What will you record?

Answer:

Recognition Criteria for Expenses

Matching Objective:

Matches expenses incurred with revenues earned during the accounting period.

Definition of Expenses:
Cost of assets and services consumed when earning revenue.

To match expenses against revenues means to subtract the related expenses from the revenue to
compute net income (or net loss).

Matching Principle

Whenever possible the costs incurred to generate revenue should be matched and recorded in the same
period as the related revenue.

For example:
Answer:

Introduction to Adjusting Entries

Allocating the financial impact over more than one accounting period is usually achieved through
Adjusting Entries. They ensure that all of the general ledger accounts reflect the financial impact of all
transactions within that particular period, even though the evidence of some transactions, (i.e., invoice,
cheque) has not yet been prepared or received.

Adjusting Entries affect at least one balance sheet account, and at least one income statement account.
Adjustments may be classified as:

• Prepayments
• Accruals
• Estimates

What are Prepayments?

Prepayments can be prepaid expenses, or unearned revenue. Prepaid expenses are considered current
assets. Unearned revenue is considered a current liability.

In the examples that follow, cash was paid in advance of the expense or revenue being recognized.
Prepaid Expenses: Costs which are paid for before the expense has been incurred.
Unearned Revenue: Money received for goods or services before they have been provided.

Prepaid Expenses
The following transactions illustrate how we would record prepaid expenses, and make adjustments
when the prepaid expenses get used up.

Example 1:

On March 1, Sally paid $750 rent for her clinic for the month of March.

The journal entry to record the payment looks like this:

Account Name Debits Credits

Prepaid Rent Expense 750
Cash 750

Prepaying the rent will allow Sally to occupy her clinic for the coming month. However, over the month,
the rent will expire (be used up).

On March 1, Sally paid $750 rent for her clinic for the month of March.

For her accounting records to be accurate, Sally will have to record the expense of the rent “used” at the
end of the month.

The adjusting entry at the end of March will look like this:

Account Name Debits Credits

Rent Expense 750
Prepaid Rent Expense 750

Example 2:

On March 5, Sally spent $2,000 to purchase enough supplies for her veterinary clinic to last for three
months.

The journal entry to record the purchase looks like this:

Account Name Debits Credits

Supplies 2 000
Cash 2 000

She expects to use some of the supplies in March, some in April and the rest in May.

On March 5, Sally spent $2,000 to purchase enough supplies for her veterinary clinic to last for three
months.
For her accounting records to be accurate, Sally will have to record another entry eachmonth to account
for the expense of the supplies used during that month. Assume Sally uses $600 worth of supplies
during March.

The adjusting entry at the end of March will look like this:

Account Name Debits Credits

Supply Expense 600
Supplies 600

Sally will record additional adjusting entries for supplies in April and May.

Example 3:

On March 10, Sally purchased $900 of insurance to insure her clinic against fire and theft for the next
year.

The journal entry to record the purchase looks like this:

Account Name Debits Credits

Prepaid Insurance Expense 900
Cash 900

Each Month, she will use up some of that insurance, until it is time to renew the policy.

On March 10, Sally purchased $900 of insurance to insure her clinic against fire and theft for the next
year.

At the end of each month, she will need to record the expense of the insurance that has been used in
that month.

The adjusting entry at the end of March will look like this:

Account Name Debits Credits

Insurance Expense 75
Prepaid Insurance Expense 75
(900 /12=75)

Each month during the year, Sally will record another adjusting entry for insurance expense.

Prepaid Expenses
Imagine yourself in this situation:

Louie's Landscaping has a year end of December 31. He produces financial statements at the year end
only. The company started the year with a balance of $500 in the supplies account. During the year they
purchased $3,000 worth of supplies. The count of supplies on hand at year-end indicated a value of
$400. Here is what the adjusting entry would look like.
 Account Name Debits Credits
Supply Expense 3 100
Supplies 3 100

Unearned Revenue
Prepayments can also be related to Unearned Revenue:

In the example below, Cash was received as a deposit in advance of the revenue being earned.

Example: In January, Louie found a new customer for his summer landscaping service. The customer
paid Louie a deposit of $150 in January, to guarantee lawn care service starting in April and lasting until
September. Louie will record the receipt of the deposit as a liability because he still owes the customer
the work.

In January, the journal entry to record the receipt of the deposit looked like this:
Account Name Debits Credits
Cash 150
Unearned Revenue 150

From April to September, as Louie performs the lawn care service each month, he will decrease his
liability and "earn" some of the $150 he received in January.

Assume that Louie earns $25 (150/ 6 months).

The adjusting entry at the end of April looks like this:

Account Name Debits Credits

Unearned Revenue 25
Revenue 25

Louie will record a similar adjusting entry each month during the summer.

Unearned revenue is actually the opposite of a prepaid expense. A prepaid expense in one organization
can be unearned revenue in another.

For example, Sally recorded her March rent as a prepaid expense. Her landlord would record the same
rent as unearned revenue.

Unearned Revenue
Imagine yourself in this situation:
Z-Tekko Cellphones rents out part of one of its buildings for $7,000 per month. The tenant has
paid the rent for December in advance. Prepare an adjusting entry for the December rent.

Answer:
 Account Name Debits Credits
Unearned Revenue 7 000
Rent Revenue 7 000

What are Accruals?

Accruals are transactions that are recorded before cash transfers from one party to another. Here are
two examples:

Estimating and recognizing an expense (such as property taxes) on the income statement in the period
to which it applies, even though you have not received a bill or invoice yet.

Recognizing revenue on the income statement in the period to which it applies, even though you have
not received the actual cash yet.

Accrued Expenses
In the examples that follow, expenses are recognized in advance of the cash being paid.

Example 1:

On October 1, Sally borrowed $4,000 for one year, with interest at 5%, to purchase equipment for her
veterinary clinic.

The loan interest that accrues each period during the term of the loan must be recorded.

The adjusting entry at the end of October looks like this:

Account Name Debits Credits

Interest Expense 16.67
Interest Payable 16.67

(4,000 x 0.05/ 12= 16.67)

Example 2:

George's Electronics hired a new employee on July 30 at a salary of $400 per week. She will
receive her first paycheque on August 9.

Since she worked two days in July, though, her salary for July must be recorded in the July
financial statements as an accrued expense.

The adjusting entry at the end of July looks like this:

Account Name Debits Credits

Salary Expense 160
Salary Payable 160
(400 / 5 x 2 days= 160)

Accrued Expenses
Imagine yourself in this situation:

George's Electronics has 10 employees who earn $1,000 for each day worked. They are paid each Friday
for the current week. December 31 falls on a Thursday. Prepare an adjusting entry for the end of
December.

Answer:

Account Name Debits Credits

Salary Expense 4 000
Salary Payable 4 000

Accrued Revenue
In the examples below, revenue is earned in advance of the cash being received.
1. In May, Mary Smith met with a client four time to provide legal advice. The client was billed $800
on May 31, and will probably pay the bill in early June.
2. On July 23, George’s Electronics sold $3 000 of iPhones on account to a business client. The client
will not pay for them until the bill is receives in August.

Example 1:

Since the revenue was actually earned in May, though, it must be recorded in the May financial
statements.

The adjusting entry at the end of May looks like this:

Account Name Debits Credits

Accounts Receivable 800
Revenue 800

Example 2:

Meanwhile, the revenue from the sale must be recorded in the July financial statements.

The adjusting entry at the end of July looks like this:

Account name Debits Credits

Accounts Receivable 3 000
Revenue 3 000
Accrued Revenue
Imagine yourself in this situation:
On September 15, Louis fertilized the lawns of three clients. On September 30, he prepared and should
be mailed invoices with the total of $300. Prepare an adjusting entry for the end of September.

Answer:

Account Name Debits Credits

Accounts Receivable 300
Revenue 300

What are Estimates?

Since accountants can't predict the future, they must sometimes estimate the impact of future events
on a current accounting period.

In the example that follows, a fixed (capital) asset is purchased. It is expected to have a useful life of ten
years. Can you see how this is similar to a long-term prepayment?

Since the purchase will have a long-term impact on the accounting records, it will require an adjusting
entry in every accounting period of the asset's lifetime.

Amortization
According to the matching principle, the expense of the asset should be matched with the revenue it
helps to generate. Since the asset's expected useful life is ten years, matching will occur during the
current period and several future periods.

To achieve this match, the cost of the asset will be amortized over the asset's lifetime. The Amortization
Expense account recognizes the portion of the cost that expires (is used up) each period.

We must also record the accumulation of the amortization expense over time. We do this using a contra
account. By offsetting the accumulated amortization against the original asset cost, it is easy to
determine the book value of the asset.

Amortized: Expensing a portion of cost of the asset in each of the accounting periods of the asset’s
expected useful life.

Contra: An account used for entries that must be offset against related accounts. Its normal balance (DR
or CR) will be the opposite of related account.

Book Value: The cost of the asset that has not yet been allocated.

Amortization
Example:
In November, Z-Tekko purchased a piece of equipment for $12,000 used in the manufacture of
cellphones.

The entry to record the capital purchase looks like this:

Account Name Debits Credits

Manufacturing Equipment 12 000
Cash 12 000

In November, Z-Tekko purchased a piece of equipment for $12,000 used in the manufacture of
cellphones.

The expected useful life of the equipment is ten years. The amount of amortization expense each
monthly period is

(12,000/ 10/ 12=100)

The adjusting entry at the end of November looks like this:

Account Name Debits Credits

Amortization Expense-Mfg. 100
Equipment
Accumulated Amortization-Mfg. 100
Equip.

Louie's transactions have been analyzed, journalized, and posted. The next step is to prepare financial
statements. We will need a trial balance.

Amortization
Imagine yourself in this situation:

On June 1, George's Electronics purchased a fixed (capital) asset at a cost of $27,000. The asset is
expected to have a useful life of 2 years and a residual value of $3,000. This results in a monthly
amortization charge of $1,000. Prepare an adjusting entry for the end of June.

Account Name Debits Credits

Amortization Expense 1 000
Accumulated Amortization 1 000

Case Study #1
Scenario: Louie's Landscaping opened for business on October 1, 2013. Its year end is December 31.

Instructions: Please prepare the necessary entries from the information given.
Question 1
Work was completed on December 30, 2013, and an invoice was issued to the client for $500.

Question 2
The company purchased $400 of supplies on October 1. Supplies on hand at year end were $250.

Question 3
The company rented facilities for 12 months at $1,000 per month. The first 3 months were paid
in advance.

Question 4
Insurance costing $2,400 for 12 months was paid in advance.

Question 5
Equipment was purchased with a 3 year useful life. The annual amortization is calculated to be $12,000.

Question 6
The loan payable of $5,000 obtained on October 1 plus interest, is due on October 1, 2014. Interest on
the loan payable is calculated at 10% per annum.

Question 7
Wages are $500 per week and paid on Friday of the current week. December 31 falls on a Tuesday.

Answers
Account Name Debits Credits
Accounts Receivable 500
Revenue 500
Supply Expense 150
Supplies 150
Rent Expense 3,000
Prepaid Rent 3,000
Insurance Expense 600
Prepaid Insurance 600
Amortization Expense 3,000
Accumulated Amortization 3,000
Interest Expense 125
Interest Payable 125
Salary Expense 200
Salary Payable 200

Journalizing and Posting Adjusting Entries

Adjusting entries are usually journalized together, at the end of the general journal for that period. They
are then posted to the general ledger, according to the procedures you learned in Module 2.
 GENERAL
JOURNAL
Date Account Titles Ref. Debit Credit
and Explanations
Adjustments

From the updated general ledger, an Adjusted Trial Balance is then prepared. Financial statements are
then prepared from the Adjusted Trial Balance.

Adjusting Trial Balance

Scenario: Louie's Landscaping opened for business on October 1, 2013. Its year end is December 31.

Instructions

• In the left column of the table is the unadjusted trial balance for Louie's Landscaping as of
December 31, 2013.
• Reading from the list of adjusting entries in the file "Case Study#1" under the resource tab on
the top right corner, enter the account balances as they should now appear in the Adjusted Trial
Balance.

Company ABC Trail Balance December 31, 2013

Unadjusted Adjusted
DR CR DR CR
Cash 5 000
Accounts 14 000
Receivable
Supplies 400
Prepaid Rent 4 000
Prepaid Insurance 2 400
Equipment 38 000
Accumulated 0
Amortization
Accounts Payable 1 500
Loan Payable 5 000
Interest Payable 0
Salary Payable 0
Unearned 3 500
Revenue
Owner Equity 45 300
Revenue 12 000
Interest Expense 0
Salary Expense 3 000
Rent Expense 0
Insurance 0
Expense
Amortization 0
Expense
 Unadjusted Adjusted
Supply Expense 0
Advertising 500
Expense

The Adjusted Trail Balance Answers

Unadjusted Adjusted
DR CR DR CR
Cash 5 000 5 000
Accounts 14 000 14 500
Receivable
Supplies 400 250
Prepaid Rent 4 000 1 000
Prepaid Insurance 2 400 1 800
Equipment 38 000 38 000
Accumulated 0 3 000
Amortization
Accounts Payable 1 500 1 500
Loan Payable 5 000 5 000
Interest Payable 0 125
Salary Payable 0 200
Unearned 3 500 3 500
Revenue
Owner Equity 45 300 45 300
Revenue 12 000 12 500
Interest Expense 0 125
Salary Expense 3 000 3 200
Rent Expense 0 3 000
Insurance 0 600
Expense
Amortization 0 3 000
Expense
Supply Expense 0 150
Advertising 500 500
Expense
TOTAL 67 300 67 300 71 125 71 125

Post-Test
Answer true or false to the following questions.

1. Adjusting entries are prepared at the beginning of each period.

2. The Revenue Recognition requires that revenue be recognized (recorded) when it is earned. This
may be in a different period than the cash received.
3. The matching principle requires that we attempt to (as close as possible) record the cost in the
same period as their related revenue is:
 4. The cash basis of accounting requires adherence to both the revenue recognition and matching
principle.
5. Each Adjusting entry effects a balance sheet and income statement:
6. The prepayment of insurance would be recorded with a debit to prepaid insurance expense and
would appear as an asset on the balance sheet:
7. Fixed or capital assets such as automobiles or buildings are normally fully expensed when they
are purchased.
8. Cash received as a deposit for services to be provided in the future is credited to unearned
revenue which appears on the income statement:
9. Supplies are immaterial and therefore always expensed when purchased:
10. The month end occurs on Wednesday. Employees can total salaries of $1,000 per day. The total
weekly salary of $5,00 will be paid at the end of the week (Friday). A salary expense of $3,000
for the three days (Monday, Tuesday and Wednesday) should be accrued as this amount was
earned by employees during the month even though it will not be paid out until the following
month:

Answers:

1. False
2. True
3. True
4. False
5. True
6. True
7. False
8. False
9. False
10. True

Case Study # 2
Instructions: Record the 8 transactions.

July 31 – Amortization expense for furniture is $100 per month.

July 31 – Amortization expense for the computer is $200 per month.
July 31 – One month of prepaid rent was used $2,000.
July 31 – Record the accrued interest payable of $117 (20,000*0.07/12) on the bank loan.
July 31 – Record the accrued interest payable of $92 (11,000*0.10/12) on the note for office furniture.
July 31 – A count of the office supplies revealed that $250 of supplies were used.
July 31 – One month of prepaid insurance was used $200.
July 31 – Overtime salary earned by the office assistant during the month but unpaid $150.

General Journal
 Date Account Titles and Ref. Debit Credit
Explanations
July 31 Amortization Expense 100
Furniture
July 31 Accumulated Amortization 100
Furniture
July 31 Amortization Computer 200
Expense
July 31 Accumulated Amortization 200
Computer
July 31 Rent Expense 2 000

July 31 Prepaid Rent Expense 2 000

July 31 Bank Loan Interest Expense 117

July 31 Bank Loan Interest Payable 117

July 31 Note Payable Interest 92

Expense
July 31 Note Payable Interest 92
Payable
July 31 Office Supply Expense 250

July 31 Office Supplies 250

July 31 Insurance Expense 200

July 31 Prepaid Insurance Expense 200

July 31 Salary Expense 150

July 31 Salary Payable 150

You have completed Adjustments

Remember to check the timeline before you proceed to the next module to ensure you have completed
any assignments as required. Check with your instructor if you have any questions.