Adjustment of Financial

Statement
 Matching Principle

• Requires that expenses be recorded in the

same period in which the revenues they
helped produce are recorded
 Accrual Basis Accounting

• Adheres to the time period assumption and

revenue recognition and matching principles
• Revenue is recorded when earned,
rather than when cash is received
• Expense recorded when incurred,
rather than when cash is paid
• Accrual accounting records events when the
economic event occurs
 Adjusting Entries

• Adjusting entries are made to adjust or

update accounts at the end of the accounting
period
• Adjusting entries can be categorized as
– Prepayments
– Accruals
 Types of Adjusting Entries

– Prepayments
• Prepaid expenses
• Unearned revenues
– Accruals
• Accrued revenues
• Accrued expenses
 Prepayments

• Cash has been spent but the item acquired has

not been used or consumed (prepaid expenses)
• Cash has been collected but the revenue has
not been earned (unearned revenues)
 Supplies

On January 5 the company paid $2,500 for

advertising supplies.
Advertising Advertising Supplies
Cash Supplies Expense
Jan. 5 2,500 Jan. 5 2,500

GENERAL JOURNAL Debit Credit

Jan. 5 Advertising Supplies 2,500
Cash 2,500
Purchased advertising supplies
 Supplies

An inventory on January 31 reveals that $1,000 of supplies

remain on hand; therefore, $1,500 of supplies had been used.
($2,500 - $1,000) =$ 1,500
Advertising Advertising
Cash Supplies Supplies Expense
Jan. 5 2,500 Jan. 5 2,500 Jan. 31 1,500 Jan. 31 1,500
Bal. 1,000

GENERAL JOURNAL Debit Credit

Jan. 31 Advertising Supplies Expense 1,500
Advertising Supplies 1,500
To record advertising supplies consumed
 Prepaid Expenses

On February 4 the company paid $600 for a 1-year insurance

policy; coverage began February 1.
Prepaid Insurance
Cash Insurance Expense
Feb. 4 600 Feb. 4 600

GENERAL JOURNAL Debit Credit

Feb. 4 Prepaid Insurance 600
Cash 600
Purchased one-year policy effective February 1
 Prepaid Expenses

On February 28, $50 ($600/12 months) of the insurance

had been used or had expired.
Prepaid Insurance
Cash Insurance Expense
Feb. 4 600 Feb. 4 600 Feb. 28 50 Feb. 28 50

GENERAL JOURNAL Debit Credit

Feb. 28 Insurance Expense 50
Prepaid Insurance 50
Record insurance expense for the month
 Amortization

• How do you apply

the matching
principle to the cost
of a long-lived
asset?
 Depreciation

• Allocate the cost of an asset to expense over

its useful life
• Depreciation is an allocation concept, not a
valuation concept

Note: This is not an attempt to reflect the actual

change in value of an asset.
 Depreciation Example

• Assume a piece of equipment was purchased

on March 2 for $5,000. Its salvage value is
$200 and its useful life is 10 years
• Straight-line amortization calculation is:
Cost - Salvage value = $5,000 - $200 = $480/yr
Useful Life 10 OR
$40/mo
 Depreciation Example
Accumulated Dep-
Office Equipment Depreciation
Office Equipment Expense
Mar. 2 5,000 Mar. 31 40 Mar. 31 40

GENERAL JOURNAL Debit Credit

Mar. 31 Depreciation Expense 40
Accumulated depreciation– 40
Office Equipment
To record monthly depreciation
Accumulated depreciation is a contra asset account – an offset
(deduction) against the asset account.
 Balance Sheet Presentation

Office equipment $5,000

Less: Accumulated depreciation 40

Net book value 4,960

Net book value

 Unearned Revenues

Received on August 2 $1,200 for advertising services

expected to be completed by December 31.
Unearned Service Service
Cash Revenue Revenue
Aug. 2 1,200 Aug. 2 1,200

GENERAL JOURNAL Debit Credit

Aug. 2 Cash 1,200
Unearned Service Revenue 1,200
Collected money for work to be performed by
December 31
 Unearned Revenues

During August, $400 of the revenue was earned.

Unearned Service Service

Cash Revenue Revenue
Aug. 2 1,200 Aug. 31 400 Aug. 2 1,200 Aug. 31 400
Bal. 800

GENERAL JOURNAL Debit Credit

Aug. 31 Unearned Service Revenue 400
Service Revenue 400
To record revenue earned
 Accruals

• Revenue has been earned, but not

collected (accrued revenues)
• Expenses were incurred, but not yet paid
(accrued expenses)

Note: Entry has not yet been recorded!

 Accrued Revenues

• Revenues earned but not yet received in

cash or recorded at the end of period
 Accrued Revenues

Earned $200 for advertising services to clients in

October, but they were not billed until after October 31.

Accounts Service
Receivable Revenue
Oct. 31 200 Oct. 31 200

GENERAL JOURNAL Debit Credit

Oct . 31 Accounts Receivable 200
Service Revenue 200
 Accrued Expenses

• Expenses incurred but not yet paid or

recorded at the end of period
 Accrued Interest Expense

Interest expense is the cost a company

incurs to use money. Information needed to
calculate interest expense:
• Face value of note
• Interest rate (always expressed in annual rate)
• The length of time note is outstanding
 Accrued Interest Expense

Formula for Calculating Interest

Face Value Annual Time

of Note Interest in Terms of Interest
Rate One Year

$ 5,000 X 12% X 1/12 = $50

 Accrued Interest Expense

Interest Expense Interest Payable

Oct. 31 50 Oct. 31 50

GENERAL JOURNAL Debit Credit

Oct. 31 Interest Expense 50
Interest Payable 50
Accrue interest expense for the month
 Accrued Salaries Expense

• Assume that the employees receive total

salaries of $2,000 for a five-day (Monday to
Friday) work week, or $400 a day.
• Salaries were last paid on October 26 and the
next payment of salaries will be November 9.
As shown on the calendar on the following
slide there are three unpaid work days remain
as of October 31.
Accrued Salaries Expense
(Salaries paid after the service has been performed)
 Accrued Salaries Expense

Salaries Expense Salaries Payable

Oct. 31 1,200 Oct. 31 1,200

GENERAL JOURNAL Debit Credit

Oct. 31 Salaries Expense 1,200
Salaries Payable 1,200
Accrue salary expense for the month
 Adjusted Trial Balance

• Adjusted trial balance proves the equity of

total debit balances and total credit balances
after the adjusting entries have been made
• Financial statements can be easily prepared
from the adjusted trial balance
 Closing the Books

• Closing entries
– Transfer the temporary account balances to
update the retained earnings account
– Reduce the balances in the temporary
accounts to zero to prepare for the next
period’s postings
 Illustration 4-17

Temporary Permanent

All revenue accounts All asset accounts

All expense accounts All liability accounts

Shareholders’ equity
Dividends account
accounts
Individual Expenses Individual Revenues

2 Income Summary 1

3 Retained Earnings
is a permanent
Retained Earnings account; the others
shown here
are temporary

4
Dividends
Required Steps in the Accounting Cycle

• Analyse business transactions

• Journalize the transactions
• Post to general ledger accounts
• Prepare a trial balance
• Journalize and post adjusting entries
(prepayments and accruals)
Required Steps in the Accounting Cycle

• Prepare an adjusted trial balance

• Prepare financial statements
• Journalize and post closing entries
• Prepare a post-closing trial balance