Accounting Principles: A Business Perspective, 8e: Adjustments For Financial Reporting

Accounting Principles:
A Business Perspective, 8e
Chapter 3:
Adjustments for
Financial Reporting
Copyright 2005 Hermanson Edwards Maher
Chapter 3
Cash versus Accrual Basis

Accounting
z Cash basis accounting:
Revenues and expenses are not recorded until cash
is received or paid out.
Adjusting entries may not be necessary.
z Accrual basis accounting:

seeks to record changes in assets and liabilities and
the related changes in revenues and expenses in
the period in which they occur.
Adjusting entries are necessary for many items.
Accounting Principles: A Business Perspective 8e
Chapter 3
Adjusting Entries
z Adjusting entries are triggered by the arrival of
the end of the accounting period rather than by
the giving, receiving, or creating of a source
document.
z Their purpose is to bring the accounts to their
proper balances before financial statements
are prepared.

Chapter 3
The Need for Adjusting Entries

z The need for adjusting entries arises because:
Economic activity occurs continuously, not solely in
the transactions that the accountant records.
Information in financial statements would be
incomplete without the added adjusting entries.

Chapter 3
Time of Preparation of Adjusting

Entries
z Adjusting entries must be recorded whenever
financial statements are to be prepared.
z Adjusting entries may be recorded more
frequently, but must be recorded annually in
keeping with requirements (or tradition) of
annual reporting.

Chapter 3
Classes and Types of Adjusting

Entries
Deferred items
z Consist of entries that relate to data previously
recorded in the accounts.
z Asset/Expense adjustments:
Prepaid insurance
Prepaid rent
Supplies on hand
Depreciation
Chapter 3
Classes and Types of Adjusting

Entries Continued
z Unearned revenues
Customers make advance cash payments for
services to be rendered.
Cash receipt gives rise to a liability.
Accrued items
z consist of those entries relating to activity on
which nothing has been previously recorded in
the accounts.
Chapter 3
Adjustments for Deferred Items

z Asset/expense adjustmentsprepaid
expenses and depreciation
Service potential is recognized and recorded in
asset accounts.
As service potential expires, part of the cost of the
asset is removed from the asset account and
charged to expense.

Chapter 3

Continued
Depreciation is recorded on long-term assets such

as:
z Buildings
z Machinery
z Equipment
A debit is made to depreciation expense. The

expiration of the asset is recorded in a contra
account, Accumulated Depreciation, rather than
credited directly to the asset account.
Chapter 3

Continued
Accumulated depreciation is reported in the balance

sheet as a deduction from the related asset
account.
z Liability/revenue adjustmentsunearned
revenues
Liability is canceled by the rendering of services,
which results in a debit to a liability account and a
credit to a revenue account.

Chapter 3
Adjustments for Accrued Items

z Asset/revenue adjustmentsaccrued assets
Arise when revenues are earned in the current
period, but the cash is collected the next period.
An adjustment must be made debiting an asset and
crediting a revenue.

Chapter 3
Adjustments for Accrued Items

Continued
z Liability/expense adjustmentsaccrued
liabilities
Arise when expenses are incurred in the current
period, but cash is paid in the next period.
If employee services have been incurred in
generating revenues but have not yet been paid,
both an expense and a liability must be recorded.

Chapter 3
Effects of Failing to Prepare

Adjusting Entries
z Failure to prepare proper adjusting entries
causes net income and the balance sheet to be
in error.

Chapter 3
Depreciation
The three factors involved in the computation of
depreciation are:
1. Asset cost.
2. Estimated useful lifethe estimated number of periods
that a company can make use of an asset.
3. Estimated salvage or scrap valuethe amount for
which an asset can probably be sold at the end of its
estimated useful life.

Chapter 3
Depreciation (continued)
The straight-line depreciation formula is as
follows:
Annual
Asset cost Estimated salvage value
depreciation =
Estimated number of years of useful life

Chapter 3
Depreciation (continued)
The journal entry to record depreciation is as
follows:
Depreciation Expense
Accumulated Depreciation
To record depreciation expense.

XX
XX
Chapter 3
Cash Basis and Accrual Basis of

Accounting Compared
Cash Basis
Accrual Basis
Revenues are
recognized
As cash is
received
Expenses are
recognized
As cash is paid
As earned (goods
are delivered or
services are
performed)
As incurred to
produce
revenues

Chapter 3
Deferred Items Adjusting Entries

Asset/Expense
Adjustments
Asset
Decrease
(Credit)
Liability/Revenue
Adjustment
Liability
Decrease
(Debit)
Previously
recorded date
Previously
recorded date
Expense Increase
(Debit)
Revenue Increase
(Credit)
Data previously recorded in an asset account are transferred to an

expense account, or data previously recorded in a liability account are
transferred to a revenue account.
Chapter 3
Deferred Items Adjusting Entries

Asset/Expense
Adjustments
Asset
Increase
(Debit)
New
Data
Expense Increase
(Credit)
Liability/Revenue
Adjustment
Liability
Increase
(Credit)
New
Data
Revenue Increase
(Debit)
Data not previously recorded are entered into an asset account and a
revenue account or a liability account and an expense account.
Chapter 3
Effects of Failure to Recognize

Adjustments
Failure to
Recognize
Effect on
Net Income
Effect on Balance
Sheet Items
1. Consumption of the
benefits of an asset (prepaid
expense)
Overstates
net income
Overstates assets
Overstates retained
earnings
2.Earning of previously
unearned revenues
Understates
net income
Overstates liabilities
Understates retained
earnings
3. Accrual of assets
Understates
net income
Understates assets
Understates retained
earnings
4. Accrual of liabilities
Overstates
net income
Understates liabilities
Overstates retained
earnings

Chapter 3
Trend Percentages
z Calculated by dividing all amounts for an item
such as net income or sales by the amount for
that item in the base year.

Trend Percentages for Wal-Mart Stores, Inc.

For Net Income (1991-2001)
Chapter 3
Dollar Amount of Net Income

(millions)
Percentage of 1991
Net Income
1991
1,291
100
1992
1,609
125
1993
1,995
155
1994
2,333
181
1995
2,681
208
1996
2,740
212
1997
3,056
237
1998
3,526
273
1999
4,430
343
2000
5,377
416
2001
6,395
488


Accounting Principles: A Business Perspective, 8e: Adjustments For Financial Reporting

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Accounting Principles: A Business Perspective, 8e: Adjustments For Financial Reporting

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Accounting Principles:

Copyright 2005 Hermanson Edwards Maher

Cash versus Accrual Basis

z Accrual basis accounting:

Accounting Principles: A Business Perspective 8e

The Need for Adjusting Entries

Accounting Principles: A Business Perspective 8e

Time of Preparation of Adjusting

Accounting Principles: A Business Perspective 8e

Classes and Types of Adjusting

Classes and Types of Adjusting

Adjustments for Deferred Items

Accounting Principles: A Business Perspective 8e

Adjustments for Deferred Items

Depreciation is recorded on long-term assets such

A debit is made to depreciation expense. The

Adjustments for Deferred Items

Accumulated depreciation is reported in the balance

Accounting Principles: A Business Perspective 8e

Adjustments for Accrued Items

Accounting Principles: A Business Perspective 8e

Adjustments for Accrued Items

Accounting Principles: A Business Perspective 8e

Effects of Failing to Prepare

Accounting Principles: A Business Perspective 8e

Accounting Principles: A Business Perspective 8e

Accounting Principles: A Business Perspective 8e

Accounting Principles: A Business Perspective 8e

Cash Basis and Accrual Basis of

Accounting Principles: A Business Perspective 8e

Deferred Items Adjusting Entries

Data previously recorded in an asset account are transferred to an

Deferred Items Adjusting Entries

Effects of Failure to Recognize

Accounting Principles: A Business Perspective 8e

Accounting Principles: A Business Perspective 8e

Trend Percentages for Wal-Mart Stores, Inc.

Dollar Amount of Net Income

Accounting Principles: A Business Perspective 8e

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