1. 3 The Adjusting Process Financial and Managerial Accounting 13e
C H A P T E R
The Adjusting Process
Financial and Managerial Accounting
13e
Warren
Reeve
Duchac
human/iStock/360/Getty Images

2. LO1: Describe the nature of the adjusting process.
Learning Objectives
LO1: Describe the nature of the adjusting process.
LO2: Journalize entries for accounts requiring adjustment.
LO3: Summarize the adjustment process.
LO4: Prepare an adjusted trial balance.
LO5: Describe and illustrate the use of vertical analysis in evaluating a company’s performance and financial condition.
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3. Nature of the Adjusting Process (slide 1 of 2)
The accounting period concept requires that revenues and expenses be reported in the proper period.
Under the accrual basis of accounting, revenues are reported on the income statement in the period in which they are earned.
For example, revenue is reported when the services are provided to customers.
Cash may or may not be received from customers during this period.
The accounting concept supporting this reporting of revenues is called the revenue recognition concept.
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4. Nature of the Adjusting Process (slide 2 of 2)
Under accrual accounting, revenues are recognized when services have been performed or products have been delivered to customers. Revenue is measured as assets received, such as cash or accounts receivable, in exchange for a service or product. This process of recording revenues is called revenue recognition.
The accounting concept supporting reporting revenues and related expenses in the same period is called the matching concept.
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.
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5. The Adjusting Process (slide 1 of 2)
Under the accrual basis, some of the accounts need updating at the end of the accounting period for the following reasons:
Some expenses are not recorded daily.
For example, the daily use of supplies would require many entries with small amounts.
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.
Some revenues and expenses may be unrecorded.
For example, a company may have provided services to customers that it has no billed or recorded at the end of the accounting period.
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6. The Adjusting Process (slide 2 of 2)
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.
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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7. Accounts Requiring Adjustment
Indicate with a Yes or No whether or not each of the following accounts normally requires an adjusting entry:
Cash
Prepaid Rent
Wages Expense
Land
Accounts Receivable
Unearned Rent No
Yes
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8. Types of Accounts Requiring Adjustment
The following basic types of accounts require adjusting entries:
Prepaid expenses
Unearned revenues
Accrued revenues
Accrued expenses
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9. Prepaid Expenses
Prepaid expenses are the advance payment of future expenses and are recorded as assets when cash is paid.
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10. Prepaid Expenses (slide 1 of 2)
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11. Prepaid Expenses (slide 2 of 2)
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12. Unearned Revenues
Unearned revenues are the advance receipt of future revenues and are recorded as liabilities when cash is received.
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13. Unearned Revenues (slide 1 of 2)
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14. Unearned Revenues (slide 2 of 2)
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15. Accrued Revenues
Accrued revenues are unrecorded revenues that have been earned and for which cash has yet to be received.
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16. Accrued Revenues (slide 1 of 2)
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17. Accrued Revenues (slide 2 of 2)
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18. Accrued Expenses
Accrued expenses are unrecorded expenses that have been incurred and for which cash has yet to be paid.
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19. Accrued Expenses (slide 1 of 2)
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20. Accrued Expenses (slide 2 of 2)
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21. Wages owed but not yet paid. Supplies on hand.
Type of Adjustment
Classify the following items as (1) prepaid expense, (2) unearned revenue, (3) accrued expense, or (4) accrued revenue:
Wages owed but not yet paid.
Supplies on hand.
Fees received but not yet earned.
Fees earned but not yet received.
Accrued expense
Prepaid expense
Unearned revenue
Accrued revenue
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22. Unadjusted Trial Balance for NetSolutions
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23. Expanded Chart of Accounts for NetSolutions
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24. Prepaid Expenses: Supplies (slide 1 of 2)
The December 31, 2015, unadjusted trial balance of NetSolutions indicates a balance in the supplies account of $2,000. Some of these supplies were used during December, and some are still on hand (not used). Assuming that on December 31 the amount of supplies on hand is $760, the amount to be transferred from the asset account to the expense account is computed as follows:
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25. Prepaid Expenses: Supplies (slide 2 of 2)
Assets = Liabilities Stockholders’ Equity (Expense)
Accounting Equation Impact
increase
decrease
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26. Prepaid Expenses: Prepaid Insurance
The December 31, 2015, unadjusted trial balance of NetSolutions indicates a balance in the prepaid insurance account of $2,400. The debit balance of $2,400 represents the December 1 prepayment of insurance for 12 months. At the end of December, the insurance expense account is increased (debited), and the prepaid insurance account is decreased (credited) by $200, the insurance for one month.
Assets = Liabilities Stockholders’ Equity (Expense)
Accounting Equation Impact
increase
decrease
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27. Impact of Omitting the Adjusting Entries for Prepaid Expenses
If the preceding adjustments for supplies ($1,240) and insurance ($200) are not recorded, the financial statements prepared as of December 31 will be misstated.
Arrow (1) indicates the effect of the understated expenses on assets.
Arrow (2) indicates the effect of the overstated net income on stockholders’ equity.
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28. Adjustment for Prepaid Expense
The prepaid insurance account had a beginning balance of $6,400 and was debited for $3,600 of premiums paid during the year. Journalize the adjusting entry required at the end of the year, assuming the amount of unexpired insurance related to future periods is $3,250.
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29. Unearned Revenues Accounting Equation Impact
The December 31 unadjusted trial balance of NetSolutions indicates a balance in the unearned rent account of $360. This balance represents the receipt of three months’ rent on December 1 for December, January, and February. At the end of December, one month’s rent has been earned.
Assets = Liabilities Stockholders’ Equity (Revenue)
Accounting Equation Impact
decrease
increase
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30. Impact of Omitting the Adjusting Entry for Unearned Revenues
If the preceding adjustment of unearned rent and rent revenue is not recorded, the financial statements prepared on December 31 will be misstated.
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31. Adjustment for Unearned Revenue
The balance in the unearned fees account, before adjustment at the end of the year, is $44,900. Journalize the adjusting entry required if the amount of unearned fees at the end of the year is $22,300.
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32. Accrued Revenues Accounting Equation Impact
Assume that NetSolutions signed an agreement with Danker Co. on December 15 to provide services at a rate of $20 per hour. As of December 31, NetSolutions had provided 25 hours of services. The revenue will be billed on January 15.
Assets = Liabilities Stockholders’ Equity (Revenue)
Accounting Equation Impact
increase
increase
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33. Impact of Omitting the Adjusting Entry for Accrued Revenues
If the adjustment for the accrued revenue ($500) is not recorded, the financial statements prepared on December 31 will be misstated.
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34. Adjustment for Accrued Revenues
At the end of the current year, $13,680 of fees have been earned but have not been billed to clients. Journalize the adjusting entry to record the accrued fees.
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35. Accrued Expenses (slide 1 of 2)
NetSolutions pays it employees biweekly. During December, NetSolutions paid wages of $950 on December 13 and $1,200 on December 27. As of December 31, NetSolutions owes $250 of wages to employees for Monday and Tuesday, December 30 and 31.
Accounting Equation Impact
Assets = Liabilities Stockholders’ Equity (Expense)
increase
increase
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36. Accrued Expenses (slide 2 of 2)
NetSolutions paid wages of $1,275 on January 10. This payment includes the $250 of accrued wages recorded on December 31.
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37. Accrued Wages
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38. Impact of Omitting the Adjusting Entry for Accrued Expenses
If the adjustment for wages ($250) is not recorded, the financial statements prepared on December 31 will be misstated.
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39. Adjustment for Accrued Expense
Sanregret Realty Co. pays weekly salaries of $12,500 on Friday for a five-day week ending on that day. Journalize the necessary adjusting entry at the end of the accounting period, assuming that the period ends on Thursday.
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40. Depreciation Expense (slide 1 of 5)
Fixed assets, or plant assets, are physical resources that are owned and used by a business and are permanent or have a long life.
As time passes, a fixed asset loses its ability to provide useful services. This decrease in usefulness is called depreciation.
All fixed assets, except land, lose their usefulness and, thus, are said to depreciate.
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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41. Depreciation Expense (slide 2 of 5)
The fixed asset account is not decreased (credited) when making the related adjusting entry. 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).
Accumulated depreciation accounts are called contra accounts, or contra asset accounts.
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42. Depreciation Expense (slide 3 of 5)
The normal titles for fixed asset accounts and their related contra asset accounts are as follows:
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43. Depreciation Expense (slide 4 of 5)
NetSolutions estimates the depreciation on its office equipment to be $50 for the month of December.
Accounting Equation Impact
Assets = Liabilities Stockholders’ Equity (Expense)
increase
increase
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44. Depreciation Expense (slide 5 of 5)
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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45. Impact of Omitting the Adjusting Entry for Depreciation
If the adjustment for depreciation ($50) is not recorded, the financial statements prepared on December 31 will be misstated.
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46. Adjustment for Depreciation
The estimated amount of depreciation on equipment for the current year is $4,250. Journalize the adjusting entry to record the depreciation.
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47. Summary of Adjustments (slide 1 of 3)
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48. Summary of Adjustments (slide 2 of 3)
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49. Summary of Adjustments (slide 3 of 3)
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50. Adjusting Entries—NetSolutions
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51. Ledger with Adjusting Entries—NetSolutions (slide 1 of 5)
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52. Ledger with Adjusting Entries—NetSolutions (slide 2 of 5)
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53. Ledger with Adjusting Entries—NetSolutions (slide 3 of 5)
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54. Ledger with Adjusting Entries—NetSolutions (slide 4 of 5)
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55. Ledger with Adjusting Entries—NetSolutions (slide 5 of 5)
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56. Effect of Omitting Adjustments
For the year ending December 31, 2016, Mann Medical Co. mistakenly omitted adjusting entries for (1) $8,600 of unearned revenue that was earned, (2) earned revenue of $12,500 that was not billed, and (3) accrued wages of $2,900. Indicate the combined effect of the errors on (a) revenues, (b) expenses, and (c) net income for the year ended December 31, 2016.
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57. Adjusted Trial Balance
The purpose of the adjusted trial balance is to verify the equality of the total debit and credit balances before the financial statements are prepared.
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58. Adjusted Trial Balance
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59. Effect of Errors on Adjusted Trial Balance
For each of the following errors, considered individually, indicate whether the error would cause the adjusted trial balance totals to be unequal. If the error would cause the adjusted trial balance totals to be unequal, indicate whether the debit or credit total is higher and by how much.
The adjustment for accrued fees of $5,340 was journalized as a debit to Accounts Payable for $5,340 and a credit to Fees Earned of $5,340.
The adjustment for depreciation of $3,260 was journalized as a debit to Depreciation Expense for $3,620 and a credit to Accumulated Depreciation for $3,260.
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60. Financial Analysis and Interpretation: Vertical Analysis (slide 1 of 3)
Comparing each item in a financial statement with a total amount from the same statement is referred to as vertical analysis.
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.
In vertical analysis of an income statement, each item is stated as a percent of revenues or fees earned.
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61. Financial Analysis and Interpretation: Vertical Analysis (slide 2 of 3)
$12,500
= .067 or 6.7%
$187,500
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62. Financial Analysis and Interpretation: Vertical Analysis (slide 3 of 3)
$36,250
= or 26.3%
$137,764
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63. Vertical Analysis (slide 1 of 2)
Two income statements for Fortson Company follow:
Prepare a vertical analysis of Fortson Company’s income statements.
Does the vertical analysis indicate a favorable or an unfavorable trend?
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64. Vertical Analysis (slide 2 of 2)
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