Adjusting Accounts For

Financial Statements
Chapter 3

Wild and Shaw

Financial and Managerial Accounting
9th Edition

Copyright ©2022 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
 Learning Objective C1

Explain the importance of

periodic reporting and the role
of accrual accounting.

© McGraw-Hill Education 3-2

 The Accounting Period
Exhibit
3.1

The time period assumption presumes that an organization’s activities can

be divided into specific time periods such as a month or year. A fiscal year
consists of any 12 consecutive months. A calendar year consists of 12
consecutive months ending on December 31.
© McGraw-Hill Education 3-3
Learning Objective C1: Explain the importance of periodic reporting and the role of accrual accounting.
Accrual Basis versus Cash Basis
Accrual Basis Cash Basis
Revenues are recorded Revenues are recorded
when products or when cash is received, and
services are delivered, expenses are recorded
and records expenses when cash is paid.
when incurred.

© McGraw-Hill Education 3-4

Learning Objective C1: Explain the importance of periodic reporting and the role of accrual accounting.
Accrual Basis versus Cash Basis
Accrual Basis Example (1 of 2)
Exhibit
3.2

On the accrual basis, $100 of insurance expense

is recognized in 2021, $1,200 in 2022, and
$1,100 in 2023.
The expense is matched with the periods
benefited by the insurance coverage.
© McGraw-Hill Education 3-5
Learning Objective C1: Explain the importance of periodic reporting and the role of accrual accounting.
Accrual Basis versus Cash Basis
Cash Basis Example (2 of 2)
Exhibit
3.3

On December 1, 2021, FastForward paid $2,400 cash for a

24-month business insurance policy.

Using the cash basis, the entire $2,400 would be recognized

as insurance expense in 2021. No insurance expense from
this policy would be recognized for the 2022 or 2023 periods
covered by the policy.
© McGraw-Hill Education 3-6
Learning Objective C1: Explain the importance of periodic reporting and the role of accrual accounting.
 Recognizing Revenues
The revenue recognition principle
requires that revenue be recorded
when the goods or services are
provided to customers and at an
amount expected to be received
from customers.

© McGraw-Hill Education 3-7

Learning Objective C1: Explain the importance of periodic reporting and the role of accrual accounting.
 Recognizing Expenses
The expense recognition (or matching)
principle requires that expenses be recorded
in the same accounting period as the
revenues that are recognized as a result of
those expenses. This matching of expenses
with the revenue benefits is a major part of
the adjusting process.

© McGraw-Hill Education 3-8

Learning Objective C1: Explain the importance of periodic reporting and the role of accrual accounting.
 Framework for Adjustments
There are four types of adjustments for transactions
that extend over more than one period.

Adjustments are made using a 3-step process:

Step 1: Determine what the current account balance equals.
Step 2: Determine what the current account balance should
equal.
Step 3: Record an adjusting entry to get from step 1 to step 2.

© McGraw-Hill Education 3-9

Learning Objective C1: Explain the importance of periodic reporting and the role of accrual accounting.
 Learning Objective P1

Prepare adjusting entries for

deferral of expenses.

© McGraw-Hill Education 3-10

 Prepaid (Deferred) Expenses
Prepaid expenses are assets paid for in advance of
receiving their benefits.
Examples: Prepaid Insurance, Prepaid Rent, Supplies

Exhibit
3.5

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 3-11
 Adjusting for Prepaid Insurance
Step 1
Step 1: Determine current balance:
• FastForward paid $2,400 to cover insurance for 24 months
that began on December 1, 2021.
• FastForward recorded the expenditure as Prepaid Insurance
on December 1.

PREPAID INSURANCE
24-month policy
Beginning 12/01
$2,400

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 3-12
 Adjusting for Prepaid Insurance
Step 2
Step 2: Balance in prepaid insurance should equal $2,300.
On 12/31, $100 for one month’s worth of insurance has expired.

PREPAID INSURANCE INSURANCE EXPENSE

$2,400 $100
$100
$2,400/24 months = $100

Insurance Expense is debited $100 to recognize the amount of insurance

coverage for December and Prepaid Insurance is credited for $100 to reduce
it’s balance to $2,300.

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 3-13
 Adjusting for Prepaid Insurance
Step 3
(Balance Sheet) (Income Statement)
PREPAID INSURANCE INSURANCE EXPENSE
$2,400 adj. $100
$100 adj.
Bal. $2,300
The Income Statement will
The Balance Sheet will show show $100 (1 month) of
$2,300 (23 months) of insurance expired!
Prepaid Insurance remaining!
© McGraw-Hill Education 3-14
Learning Objective P1: Prepare adjusting entries for deferral of expenses.
 Adjusting Entry –
Prepaid Insurance
The general journal adjustment on Dec. 31 and
general ledger account balances are as follows:

Prepaid Insurance 128 Insurance Expense 637

Dec. 1 2,400 Dec. 31 100 Dec. 31 100
Bal. 2,300

Dec. 31 Insurance Expense 100

Prepaid Insurance 100
To record first month's expired insurance
Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 3-15
 Adjusting for Supplies
Steps 1 and 2
Step 1: FastForward purchased $9,720 of supplies in
December. Some of these supplies were used during
December.
Step 2: A physical count performed on 12/31 shows that
unused supplies equal $8,670.

SUPPLIES
Purchases during December $9,720

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 3-16
 Adjusting for Supplies Step 3
Step 3: Adjusting entry reduces Supplies by $1,050 or the difference
between the beginning balance and the physical count on 12/31.
(Balance Sheet) (Income Statement)
SUPPLIES SUPPLIES EXPENSE
$9,720 adj. $1,050
$1,050 adj.
Bal. $8,670
The Income Statement will
The Balance Sheet will show show $1,050 (1 month) of
$8,670 of supplies remaining! Supplies expired!

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 3-17
 Adjusting Entry – Supplies
We’ve seen the adjustment in the T-accounts but
we need to record the adjustment on Dec. 31
in the General Journal
Supplies 126 Supplies Expense 652

Dec. 9,720 Dec. 31 1,050 Dec. 31 1,050

Bal. 8,670

Dec. 31 Supplies Expense 1,050

Supplies 1,050
To record supplies used
Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 3-18
 Depreciation
Instead of expensing the cost of a plant asset
(equipment, building, cars, etc.) in the year it
is purchased we allocate, or spread out, the
cost over their expected useful lives. This is
called depreciation.
The formula for straight-line depreciation is:

Straight-Line Asset Cost - Salvage Value

Depreciation =
Useful Life

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 3-19
 Adjusting for Depreciation – Step 1
• FastForward purchased equipment on Dec. 1 for
$26,000.
• It has an estimated useful life of five years.
• The equipment is expected to be worth about
$8,000 at the end of five years.
• They purchased the equipment on Dec. 1 but it is
now Dec. 31.
Because FastForward expects the equipment to be worth $8,000
when the five years are over, only $18,000 of the cost will be
spread over the next 5 years (60 months).
Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 3-20
 Straight-Line Depreciation
Step 1: FastForward purchased equipment
on December 1 for $26,000.
FORMULA:
Calculate Net Cost (amount to depreciate).
Original Salvage Net Cost
Cost Value =
$26,000 $8,000 = $18,000

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 3-21
 Adjusting for Depreciation – Step 2
• Equipment has a useful life of 5 years. The equipment
is expected to be worth $8,000 at the end of five
years. FastForward is using straight-line depreciation.
$18,000 ($26,000 – $8,000) of the cost needs to be
spread over the next 60 months.
One month = $18,000 / 60 = $300.

© McGraw-Hill Education 3-22

Learning Objective P1: Prepare adjusting entries for deferral of expenses.
 Adjusting for Depreciation – Step 3
Depreciation adjustment reflected in our
T-accounts looks like this:
Equipment Depreciation Expense
12/1 26,000 12/31 300

Accumulated Depreciation
12/31 300

• Record adjusting entry for $300 for one month.

• The depreciation amount of $300 is credited to the
Accumulated Depreciation account instead of the
asset account.
Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 3-23
 Adjusting Entry – Depreciation
Equipment Depreciation Expense
12/1 26,000 12/31 300

Accumulated Depreciation-Equipment
12/31 300

Dec. 31 Depreciation Expense 300

Accumulated Depreciation - Equipment 300
To record monthly equipment depreciation

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 3-24
 Depreciation – Balance Sheet
Exhibit
3.7

On February 28, 2022, after three months of

depreciation have been taken, the Equipment is shown
at its $25,100 book value, or net of accumulated
depreciation.

Learning Objective P1: Prepare adjusting entries for deferral of expenses. © McGraw-Hill Education 3-25
 Learning Objective P2

Prepare adjusting entries for

deferral of revenues.

© McGraw-Hill Education 3-26

 Deferral of Revenue
Unearned revenue is cash received in
advance of providing products or services.

Exhibit
3.8

Learning Objective P2: Prepare adjusting entries for deferral of revenues. © McGraw-Hill Education 3-27
 Adjusting for Unearned Revenues
Steps 1 and 2
Step 1: FastForward’s client paid a 60-day fee in advance
covering the period from 12/27 – 2/24 and recorded:
Dec. 26 Cash 3,000
Unearned Consulting Revenue 3,000
Received advance payment for services
Step 2: FastForward earns payment as time passes.
At 12/31, 5 days’ service is earned, 5/60 × $3,000 =
$250.
Step 3: Adjusting entry reduces liability, Unearned
Consulting Revenue, by $250 for 5 days’ of revenue.
Consulting Revenue of $250 is earned.
Learning Objective P2: Prepare adjusting entries for deferral of revenues. © McGraw-Hill Education 3-28
 Adjusting for Unearned Revenue
Step 3
(Balance Sheet) (Income Statement)
UNEARNED CONSULTING
CONSULTING REVENUE
REVENUE
$3,000 12/26 $4,200 12/5
12/31 $250 1,600 12/12
250 12/31
$2,750 12/31 Bal.
$6,050 12/31 Bal.
The Balance Sheet will show The Income Statement will
$2,750 of Unearned Consulting show $6,050 total Consulting
Revenue unearned. Revenue earned.
Learning Objective P2: Prepare adjusting entries for deferral of revenues. © McGraw-Hill Education 3-29
 Adjusting Entry – Unearned Revenue
Adjusting entry recorded on Dec. 31 transfers $250
from unearned to earned consulting revenue.

Dec. 31 Unearned Consulting Revenue 250

Consulting Revenue 250
To record earned revenue received in advance

Learning Objective P2: Prepare adjusting entries for deferral of revenues. © McGraw-Hill Education 3-30
 Learning Objective P3

Prepare adjusting entries for

accrued expenses.

© McGraw-Hill Education 3-31

 Accrued Expense
Accrued expenses are costs incurred in a
period that are
both unpaid and unrecorded.

Exhibit
3.9

Learning Objective P3: Prepare adjusting entries for accrued expenses. © McGraw-Hill Education 3-32
 Adjusting for Accrued Salaries
Steps 1, 2, and 3
Step 1: FastForward pays its employee $70 per day, or
$350 for a five-day work week. Salaries are paid every
two weeks on a Friday.
Step 2: 12/31 is a Wednesday, so three day’s salaries are
owed at year end which equals $70 × 3 = $210.
Step 3: Adjusting entry increases a liability, Salaries
Payable, and increases Salaries Expense for $210 with
the following journal entry:

Dec. 31 Salaries Expense 210

Salaries Payable 210
To record three days' accrued salaries
Learning Objective P3: Prepare adjusting entries for accrued expenses. © McGraw-Hill Education 3-33
 Adjusting for Accrued Salaries –
Financial Statements
(Balance Sheet) (Income Statement)
SALARIES PAYABLE SALARIES EXPENSE

$210 $700
12/31 adj. 12/12
12/26 700
$210 12/31 Bal. 12/31 adj. 210
12/31 Bal. $1,610

The Income Statement will

The Balance Sheet will show
show $1,610 total Salaries
$210 of Salaries Payable owed.
Expense.

Learning Objective P3: Prepare adjusting entries for accrued expenses. © McGraw-Hill Education 3-34
 Future Cash Payment of Accrued Expenses
Accrued expenses at the end of one period result in a
cash payment in a future period.
On 12/31, FastForward recorded accrued salaries of
$210.
On 1/9 of the next year, the following entry will reduce
the accrued liability, salaries payable, and record the
expense for 7 days of work in January.
Jan 9 Salaries Payable (3 x $70) 210
Salaries Expense (7 x $70) 490
Cash 700
To record earned revenue received in advance
© McGraw-Hill Education 3-35
Learning Objective P3: Prepare adjusting entries for accrued expenses.
 Learning Objective P4

Prepare adjusting entries for

accrued revenues.

© McGraw-Hill Education 3-36

 Accrued Revenue
Accrued revenues are revenues earned in a period that
are both unrecorded and not yet received in cash or
other assets.

Exhibit
3.11

Learning Objective P4: Prepare adjusting entries for accrued revenues. © McGraw-Hill Education 3-37
 Adjusting for Accrued Services Revenue
Steps 1, 2, and 3
Step 1: On 12/12, FastForward’s customer agreed to pay
$2,700 on 1/10 of the next year for future services over
the next 30 days.
Step 2: On 12/31, 20 days worth of services have been
provided and earned which totals $1,800 ($2,700 ×
20/30 days).
Step 3: Adjusting entry increases an asset, Accounts
Receivable, and increases the Consulting Revenue
account for $1,800 with the following journal entry:
Dec. 31 Accounts Receivable 1,800
Consulting Revenue 1,800
To record 20 days' accrued revenue.
Learning Objective P4: Prepare adjusting entries for accrued revenues. © McGraw-Hill Education 3-38
 Adjusting for Accrued Services Revenue
– Financial Statements
(Balance Sheet) (Income Statement)
ACCOUNTS RECEIVABLE CONSULTING REVENUE

adj. $1,800 $6,050

1,800 adj.
Bal. $1,800 $7,850 Bal.

The Income Statement will

The Balance Sheet will show
show $7,850 total
$1,800 of Accounts Receivable.
Consulting Revenue

Learning Objective P4: Prepare adjusting entries for accrued revenues. © McGraw-Hill Education 3-39
 Future Cash Receipt of Accrued Revenues
Accrued revenue at the end of one period results in a cash
receipt in a future period.
On 12/31, FastForward recorded accrued revenue earned of
$1,800.
On 1/10 of the next year, the following entry will reduce the
accounts receivable, record revenue earned for 10 days and
receipt of $2,700 cash.

Jan. 10 Cash 2,700

Accounts Receivable (20 days) 1,800
Consulting Revenue (10 days) 900
To record earned revenue received in advance
Learning Objective P4: Prepare adjusting entries for accrued revenues. © McGraw-Hill Education 3-40
 Links to Financial Statements
Exhibit
3.12

© McGraw-Hill Education 3-41

Learning Objective P4: Prepare adjusting entries for accrued revenues.
 Learning Objective P5

Prepare financial statements

from an adjusted trial balance.

© McGraw-Hill Education 3-42

 Adjusted Trial Balance
Exhibit
3.13

An Unadjusted Trial
Balance is a list of
accounts and balances
prepared before
adjustments are recorded.
An Adjusted Trial
Balance is a list of
accounts and balances
prepared after adjusting
entries have been
recorded and posted to the
ledger.

© McGraw-Hill Education 3-43

Learning Objective P5: Prepare financial statements from an adjusted trial balance.
 Steps for Preparing Financial
Statements from an Adjusted Trial
Balance
Step 1— Prepare income statement using revenue and expense
accounts from adjusted trial balance.
Step 2—Prepare statement of retained earnings using retained
earnings and dividends from trial balance; and pull net
income from step 1.
Step 3—Prepare balance sheet using asset and liability accounts
along with common stock from trial balance; and pull
updated retained earnings balance from step 2.
Step 4—Prepare statement of cash flows from changes in cash
flows for the period (illustrated later in the book).
© McGraw-Hill Education 3-44
Learning Objective P5: Prepare financial statements from an adjusted trial balance.
 Preparing Financial Statements from an Adjusted Trial Balance

Exhibit
3.14

© McGraw-Hill Education 3-45

Learning Objective P5: Prepare financial statements from an adjusted trial balance.
 Learning Objective P6

Prepare closing entries and a

post-closing trial balance.

© McGraw-Hill Education 3-46

 Closing Process
1. Resets revenue,
expense, and
Identify accounts
dividends account
for closing.
balances to zero at
the end of the period.
Record and post
2. Updates Retained closing entries.
Earnings account to
match that reported
in the balance sheet
Prepare post-closing
and statement of
trial balance.
retained earnings.
© McGraw-Hill Education 3-47
Learning Objective P6: Prepare closing entries and a post-closing trial balance.
 Temporary and
Permanent Accounts

The closing process applies only to

temporary accounts.
© McGraw-Hill Education 3-48
Learning Objective P6: Prepare closing entries and a post-closing trial balance.
 Recording Closing Entries
1. Close Credit Balances in Revenue Accounts to
Income Summary.
2. Close Debit Balances in Expense accounts to
Income Summary.
3. Close Income Summary account to Retained
Earnings.
4. Close Dividends to Retained Earnings.

© McGraw-Hill Education 3-49

Learning Objective P6: Prepare closing entries and a post-closing trial balance.
 Recording Closing Entries Example
Exhibit
3.15

© McGraw-Hill Education 3-50

Learning Objective P6: Prepare closing entries and a post-closing trial balance.
 Post-Closing Trial Balance
▪ List of permanent accounts and their
balances after posting closing entries.
▪ Total debits and credits must be equal.
▪ All temporary accounts have a zero
balance.

© McGraw-Hill Education 3-51

Learning Objective P6: Prepare closing entries and a post-closing trial balance.
 Post-Closing Trial Balance Example
Exhibit
3.18

© McGraw-Hill Education 3-52

Learning Objective P6: Prepare closing entries and a post-closing trial balance.
 Accounting Cycle
Exhibit
3.19

Learning Objective P6: Prepare closing entries and a post-closing trial balance. © McGraw-Hill Education 3-53
 Learning Objective C2

Explain and prepare a

classified balance sheet.

© McGraw-Hill Education 3-54

 Classified Balance Sheet
Exhibit
3.20

Current items are expected to come due (collected and

owed) within the longer of one year or the company’s
normal operating cycle.
Most operating cycles are less than one year, so most
companies use a one-year period in deciding what assets
and liabilities are current.
© McGraw-Hill Education 3-55
Learning Objective C2: Explain and prepare a classified balance sheet.
 Classified Balance Sheet Example
Exhibit
3.21

© McGraw-Hill Education 3-56

Learning Objective C2: Explain and prepare a classified balance sheet.
 Current Assets
Current assets are expected to be sold,
collected, or used within one year or the
company’s operating cycle, whichever is
longer.
Examples: cash, short-term investments,
accounts receivable, short-term notes
receivable, merchandise inventory, and
prepaid expenses.
© McGraw-Hill Education 3-57
Learning Objective C2: Explain and prepare a classified balance sheet.
 Long-Term Investments

Long-term investments are expected to be held for

more than one year or the operating cycle.
Examples: notes receivable and investments in stocks
and bonds expected to be held for more than the
longer of one year or the operating cycle.

© McGraw-Hill Education 3-58

Learning Objective C2: Explain and prepare a classified balance sheet.
 Plant Assets

Plant assets are tangible long-lived assets used to

produce or sell products and services.
Examples: equipment, machinery, buildings, and
land that are used to sell products and services.
Also called property, plant, and equipment (PP&E)
or fixed assets.

© McGraw-Hill Education 3-59

Learning Objective C2: Explain and prepare a classified balance sheet.
 Intangible Assets

Intangible assets are long-term assets used to

produce or sell products and services and that
lack physical form.
Examples: patents, trademarks, copyrights,
franchises, and goodwill.

© McGraw-Hill Education 3-60

Learning Objective C2: Explain and prepare a classified balance sheet.
 Current Liabilities

Current liabilities are liabilities due within the longer of

one year or the company’s operating cycle.
Examples: accounts payable, wages payable, taxes
payable, interest payable, and unearned revenues.

© McGraw-Hill Education 3-61

Learning Objective C2: Explain and prepare a classified balance sheet.
 Long-Term Liabilities

Long-term liabilities are liabilities not due within the

longer of one year or the company’s operating cycle.
Examples: notes payable, mortgages payable, bonds
payable, and lease obligations.

© McGraw-Hill Education 3-62

Learning Objective C2: Explain and prepare a classified balance sheet.
 Equity

Equity is the owner’s claim on the assets.

For a corporation, reported in retained earnings
and common stock accounts.
Equity is not separated into current and noncurrent
categories.

© McGraw-Hill Education 3-63

Learning Objective C2: Explain and prepare a classified balance sheet.
 Learning Objective A1

Compute and analyze profit

margin and current ratio.

© McGraw-Hill Education 3-64

 Profit Margin
The profit margin ratio measures the company’s net
income to net sales.
Exhibit
Profit Net income 3.22
=
Margin Net sales

Visa and Mastercard’s Profit Margin

Exhibit
3.23

© McGraw-Hill Education 3-65

Learning Objective A1: Compute and analyze profit margin and current ratio.
 Current Ratio
Helps assess the company’s ability to pay its
debts in the near future

Exhibit
Current assets
Current ratio = 3.24
Current liabilities

Exhibit
3.25

© McGraw-Hill Education 3-67

Learning Objective A1: Compute and analyze profit margin and current ratio.
 Learning Objective P8

Appendix 3B
Prepare a work sheet and
explain its usefulness.

© McGraw-Hill Education 4-67

 Benefits of a Work Sheet
Helps in
preparing Reduces risk of
financial errors.
statements. Not a
required
report. Shows effects
Links accounts
and adjustments of proposed
to financial “what-if”
statements. transactions.

A work sheet is a document that is used internally by companies to help with

adjusting and closing accounts and with preparing financial statements.
© McGraw-Hill Education 3-74
Learning Objective P8: Prepare a work sheet and explain its usefulness.
 Use of a Work Sheet
Five steps:
Step 1: Enter Unadjusted Trial Balance
Step 2: Enter Adjustments
Step 3: Prepare Adjusted Trial Balance
Step 4: Sort Adjusted Trial Balance Amounts
to Financial Statements
Step 5: Total Statement Columns, Compute
Income or Loss, and Balance Columns

© McGraw-Hill Education 3-75

Learning Objective P8: Prepare a work sheet and explain its usefulness.
 Work Sheet Example
Exhibit
3B.1

© McGraw-Hill Education 3-76

Learning Objective P8: Prepare a work sheet and explain its usefulness.