Understanding Accounting
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Unit 1 · Chapter 2 · Course objective 1.2

Adjusting the records at period end

An accurate trial balance can still need adjustments before a company prepares its financial statements.

About 15 minutes to read

Course objective

  • 1.2 Sort a period-end economic event into its adjustment type, compute the adjustment, and state how omitting the entry affects net income, assets, liabilities, and equity.

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  1. 0:00 You are listening to Chapter 2 of the ACC 300 course reading, Adjusting the records at period end.
  2. 0:06 This chapter supports course objective 1.2: analyze period-end information, prepare adjusting entries, and explain their effects on the financial statements.
  3. 0:17 By the end, you should be able to classify the four timing patterns and compare a required ending balance with the ledger.
  4. 0:26 You should also be able to record an adjustment and trace an omitted adjustment into the statements. This recording is a draft audio review preview.
  5. 0:36 The written chapter remains the version to trust while this recording is under review.
  6. 0:42 Beacon Design has been in business for 1 year. On December 31, its trial balance reports total debits of 186,400 dollars and total credits of 186,400 dollars.
  7. 0:55 Every recorded entry has support, uses the correct accounts, and appears in the total. The trial balance accurately summarizes the transactions posted so far, but some balances are out of date.
  8. 1:11 Beacon completed service on December 30 that it has not billed. Employees also worked in December for wages that Beacon will pay on January 5.
  9. 1:23 An insurance policy has partly expired, a client advance has been partly earned, and Beacon has used its equipment for the year. These events must be reflected before Beacon prepares its financial statements.
  10. 1:40 Reporting periods and the events that cross them. A business operates continuously, but financial statements cover stated periods. One activity may span several months, pay periods, or calendar years.
  11. 1:56 Accountants must divide that activity among the periods it affects. The reporting date creates a question: how much of an activity belongs in the current period? The original cash entry or invoice may not answer it.
  12. 2:13 The accountant may also need contracts, completion reports, timesheets, schedules, or physical counts. Adjusting entries use that evidence to bring the accounts up to date.
  13. 2:27 Cash-basis accounting. Under cash-basis accounting, an entity records revenue when it receives cash or cash equivalents. It records expense when it pays cash or cash equivalents.
  14. 2:41 The bank statement provides evidence for cash receipts and payments, which makes many cash-basis entries easy to verify. A company also avoids many accruals and estimates.
  15. 2:54 Cash-basis and accrual-basis income can be the same for a period.
  16. 2:59 That result is possible when the company has no receivables, prepaid assets, equipment, unpaid obligations, or advance payments at either end of the period.
  17. 3:10 Cash-basis records answer a useful question: how much cash came in and went out? But cash movement and business performance do not always occur in the same period.
  18. 3:23 The limits of the cash basis. Beacon completed 4,800 dollars of design service on December 30. It will send the invoice on January 3 and expects payment by January 20.
  19. 3:35 Beacon's employees completed 2,700 dollars of work in December that Beacon will pay as part of the January 5 payroll.
  20. 3:43 Under the cash method, neither the 4,800 dollars of service nor the 2,700 dollars of wages appears on the December financial statements.
  21. 3:53 December revenue is 4,800 dollars too low, and December expense is 2,700 dollars too low. The net effect is a 2,100 dollars understatement of December income.
  22. 4:05 January then reports revenue and expense from work completed in the prior year. The difference for a full year is not always the 2,100 dollars year-end amount.
  23. 4:16 The 4,800 dollars of revenue and 2,700 dollars of expense do not disappear under the cash basis; they move into January.
  24. 4:25 If Beacon starts and ends the year with similar timing differences, amounts carried into the current year can offset amounts carried out of it.
  25. 4:36 To see the comparison after startup, suppose Beacon is now ending its second year. The net effect of unbilled work and unpaid wages was 900 dollars at the start of the year and 2,100 dollars at the end.
  26. 4:50 Cash-basis income would be understated by the 1,200 dollars increase, not by the full 2,100 dollars ending difference.
  27. 4:59 A full-year comparison therefore depends on the change in the accrual position, not only the year-end amount. That difference often grows with the business.
  28. 5:10 A growing company may end the year with more unbilled work, unpaid wages, and other timing differences than it had at the beginning.
  29. 5:20 Cash-basis accounting reports some of that growth in the next period instead of the period in which it occurred. Cash-basis income can also change when managers change the timing of receipts and payments.
  30. 5:34 Collecting from customers before year-end and delaying payments until January raises cash-basis income without changing the work performed in December.
  31. 5:45 Delaying collections and paying expenses before year-end has the opposite effect.
  32. 5:50 Accrual accounting reduces the effect of those cash-timing choices by reporting performance and resource use in the periods in which they occur. Check your understanding.
  33. 6:02 Beacon completes work in December and collects the cash in January. Under accrual accounting, which month reports the revenue? Answer. December, because that is when Beacon completed the work.
  34. 6:16 Accrual-basis accounting and adjusting entries. The work and the cash still appear, but in different periods.
  35. 6:24 That difference matters when the financial statements are meant to report December performance and the obligations that exist on December 31.
  36. 6:35 Accrual-basis accounting reports revenue when an entity earns it and reports expense when it consumes a resource or incurs an obligation. The related cash receipt or payment may occur in the same period or another one.
  37. 6:52 US GAAP recognition and measurement generally use accrual accounting. The statement of cash flows separately reports cash receipts and payments.
  38. 7:03 Throughout this course, earned is shorthand for meeting the applicable US GAAP revenue-recognition requirements. For revenue from contracts with customers, Chapter 8 explains when a performance obligation is satisfied.
  39. 7:19 An adjusting entry updates account balances for information available at the reporting date, before the statements are prepared. This course organizes period-end entries by the purpose they serve:
  40. 7:34 Purpose, Timing; The question it answers, Which period does this amount belong to?; An example, December wages paid in January; Covered in, This chapter.
  41. 7:48 Purpose, Estimation; The question it answers, What amount should be recorded when measurement is uncertain?; An example, Depreciation based on an estimated useful life and salvage value; Covered in, This chapter.
  42. 8:06 Purpose, Correction; The question it answers, Do the records accurately reflect an event that already happened?; An example, A bank service charge Beacon did not record; Covered in, Unit 4, bank reconciliations.
  43. 8:24 Purpose, Presentation; The question it answers, Is the amount in the correct place on the statements?; An example, Debt due within 1 year, classified as current; Covered in, Unit 3, the balance sheet.
  44. 8:41 Purpose, Measurement; The question it answers, Does the recorded amount comply with the required measurement guidance?; An example, Inventory that must be written down; Covered in, Units 5 and 6, write-downs and impairment.
  45. 9:01 Each timing entry in this chapter uses one income-statement account and one balance-sheet account. Estimates, corrections, presentation entries, and measurement entries may use a different structure.
  46. 9:16 Check your understanding. Employees earn December wages that Beacon will pay in January. What type of year-end entry is this? Answer. It is a timing entry.
  47. 9:29 The entry records December expense and the liability that exists at year-end. The rule, the four timing adjustments in this chapter. The adjusting entry does not include Cash.
  48. 9:43 The company recorded the cash transaction earlier or will record it later. For the four timing patterns in this section, an entry that changes Cash is not an adjusting entry.
  49. 9:56 It may instead record a cash transaction or correct an earlier omission.
  50. 10:02 Compare the required ending balance with the ledger balance. Each timing adjustment in this section updates a balance-sheet account. Use three steps to determine the entry.
  51. 10:15 Determine the account's required ending balance on December 31. Use evidence about the business, such as completion reports, timesheets, contracts, or physical counts. Read what the account shows in the ledger.
  52. 10:31 Record the difference. For the timing adjustments here, that amount also enters revenue or expense. Beacon's Prepaid Insurance account shows how the three steps work:
  53. 10:44 Step, 1. Determine the required ending balance; Evidence, The policy has 3 months left at 1,000 dollars per month.; Result, 3,000 dollars debit. Step, 2.
  54. 11:00 Read the ledger balance; Evidence, Beacon recorded the 12,000 dollars premium and no later reduction.; Result, 12,000 dollars debit. Step, 3.
  55. 11:15 Record the difference; Evidence, Prepaid Insurance must decrease by 9,000 dollars.; Result, 9,000 dollars credit.
  56. 11:26 The entry debits Insurance Expense for 9,000 dollars and credits Prepaid Insurance for 9,000 dollars.
  57. 11:34 The same calculation can start with the amount used: 1,000 dollars per month for 9 months equals 9,000 dollars of expense.
  58. 11:43 Checking the 3,000 dollars ending asset against the policy confirms that the entry did not leave an unsupported balance. Suppose Beacon accidentally recorded the 12,000 dollars policy as 12,500 dollars.
  59. 11:58 Recording 9,000 dollars of expense would leave a 3,500 dollars asset, but the policy supports only 3,000 dollars of remaining coverage.
  60. 12:08 The 500 dollars difference is a recording error that Beacon must investigate and correct separately, not additional insurance expense.
  61. 12:19 Companies use account reconciliations, schedules, physical counts, and cutoff procedures to determine each account's required ending balance.
  62. 12:29 These procedures matter because an equal trial balance does not identify a missing adjustment or an unsupported balance. Check your understanding.
  63. 12:40 The policy supports 3,000 dollars of Prepaid Insurance, but the ledger shows 3,500 dollars after the normal expense entry. Should Beacon record the extra 500 dollars as Insurance Expense? Answer. No.
  64. 12:55 The unsupported 500 dollars signals a recording error that Beacon must investigate and correct separately.
  65. 13:03 The four timing patterns: accruals and deferrals. Timing adjustments fall into four patterns.
  66. 13:11 A deferral is a cash-first pattern: the company initially records an asset or liability and recognizes the related expense or revenue in a later period.
  67. 13:23 An accrual is an activity-first pattern: the company records revenue or expense before the related cash moves. Use two questions to identify the pattern: Did cash move before or after the economic activity?
  68. 13:39 Did the company provide goods or services, or did it receive or use resources or services?
  69. 13:46 The timing-pattern table uses the company's role and the order of cash and activity.
  70. 13:53 When a company provides goods or services after receiving cash, it reduces a contract liability, such as unearned revenue, as it performs.
  71. 14:05 When it provides goods or services before receiving cash, it records accrued revenue and either a receivable or contract asset, as required by the contract terms.
  72. 14:18 When a company receives or uses resources after paying cash, it reduces a prepaid asset as it uses the resource. When it receives or uses resources before paying cash, it records an accrued expense and a payable.
  73. 14:35 The category identifies the balance-sheet account to review. It also identifies the income-statement effect: performance for a customer can create revenue, and resource use or employee service can create expense.
  74. 14:51 Depreciation is a separate period-end adjustment. Cash timing does not identify its amount. Beacon allocates equipment cost using supported estimates instead. Check your understanding.
  75. 15:05 Cash moved first, and Beacon still owes the customer service. Which timing pattern applies? Answer. Unearned or deferred revenue. The company reports the remaining service obligation as a liability.
  76. 15:20 The two event-first patterns record activity missing from the ledger. The account itself may already contain other activity.
  77. 15:30 Accounts Receivable, for example, may include many invoiced sales before Beacon adds one uninvoiced job.
  78. 15:38 Beacon's 4,800 dollars of uninvoiced services is accrued revenue, and its 2,700 dollars of unpaid wages is an accrued expense. The two cash-first patterns are deferrals. They adjust an amount already in the ledger.
  79. 15:54 The cash transaction records a prepaid asset or a contract liability, such as Unearned Revenue. As Beacon uses the prepaid resource or performs for the customer, the remaining asset or liability decreases.
  80. 16:09 Accrued revenue and accrued expenses. Return to Beacon's year end. Beacon performed 4,800 dollars of design service on December 30 and has not invoiced it.
  81. 16:21 Event, Design service; Activity date, December 30: Beacon completes 4,800 dollars of work.; Reporting date, December 31: record revenue and a receivable.; Billing, collection, or payment, Invoice January 3; collect January 20..
  82. 16:45 Event, Employee service; Activity date, Employees complete 2,700 dollars of work in December.; Reporting date, December 31: record expense and a payable.; Billing, collection, or payment, Pay January 5..
  83. 17:07 The activity date determines the reporting period. The later invoice, collection, and payment settle the resulting receivable or payable. The account to examine is Accounts Receivable.
  84. 17:21 It should include a 4,800 dollars claim on December 31 because Beacon has done the work and its right to payment is unconditional under the contract. Sending the invoice is an administrative step.
  85. 17:36 The ledger shows nothing for this job, so the adjusting entry records the 4,800 dollars difference:
  86. 17:44 The December 31 adjusting entry debits Accounts Receivable, an asset, for 4,800 dollars and credits Service Revenue for 4,800 dollars.
  87. 17:58 The credit puts the 4,800 dollars of revenue in December, when the work was done, and where the cash method left it out. When the customer pays on January 20, Beacon debits Cash and credits Accounts Receivable.
  88. 18:14 Collection settles the existing claim; it does not create revenue a second time.
  89. 18:20 The January 20 collection entry debits Cash, an asset, for 4,800 dollars and credits Accounts Receivable, an asset, for 4,800 dollars.
  90. 18:33 Beacon's December wages require a separate accrued-expense adjustment. The account to review is Wages Payable. It should show 2,700 dollars on December 31, the amount that employees earned and Beacon owes.
  91. 18:50 It shows nothing for this work because payroll does not run until January 5. The adjusting entry records the 2,700 dollars difference:
  92. 19:00 The December 31 adjusting entry debits Wages Expense for 2,700 dollars and credits Wages Payable, a liability, for 2,700 dollars.
  93. 19:13 When Beacon pays the payroll on January 5, it debits Wages Payable and credits Cash. The payment settles the liability recorded on December 31.
  94. 19:26 The January 5 payment entry debits Wages Payable, a liability, for 2,700 dollars and credits Cash, an asset, for 2,700 dollars.
  95. 19:39 Prepaid expenses and unearned (deferred) revenue. In both accrual examples, the ledger contained no amount for the year-end event, so the adjustment was the full amount.
  96. 19:53 The deferral patterns start with a recorded balance and update it for the portion used or performed. Beacon paid 12,000 dollars on April 1 for a 12-month insurance policy running from April 1 through March 31.
  97. 20:10 Beacon recorded the payment as an asset, Prepaid Insurance, because on April 1 the entire 12 months of coverage was still ahead of it. The account to examine is Prepaid Insurance.
  98. 20:25 Its required ending balance includes only the coverage Beacon has not used by December 31:
  99. 20:32 Policy: 12,000 dollars for 12 months, at 1,000 dollars per month, Apr 1 to Dec 31, coverage used; Months, 9; Amount, 9,000 dollars.
  100. 20:49 Policy: 12,000 dollars for 12 months, at 1,000 dollars per month, Jan 1 to Mar 31, coverage still ahead; Months, 3; Amount, 3,000 dollars.
  101. 21:08 Policy: 12,000 dollars for 12 months, at 1,000 dollars per month, Total paid on April 1; Months, 12; Amount, 12,000 dollars.
  102. 21:24 The required ending balance of Prepaid Insurance is 3,000 dollars. It shows 12,000 dollars because nothing has come out of the account since April. The entry records the 9,000 dollars difference:
  103. 21:41 The December 31 adjusting entry debits Insurance Expense for 9,000 dollars and credits Prepaid Insurance, an asset, for 9,000 dollars.
  104. 21:53 The 9,000 dollars is insurance expense. Prepaid Insurance now shows 3,000 dollars. The amount is an asset because Beacon still holds a right to that coverage at December 31.
  105. 22:06 The client advance begins with a liability rather than an asset. On November 1, a client paid Beacon 6,000 dollars in advance for 6 months of design support running from November 1 through April 30.
  106. 22:22 Beacon recorded Unearned Revenue, a contract liability, because it owed the client 6 months of work. The account to examine is Unearned Revenue.
  107. 22:33 Its required ending balance includes only the support Beacon still owes at December 31:
  108. 22:40 Contract: 6,000 dollars for 6 months, at 1,000 dollars per month, Nov 1 to Dec 31, support performed; Months, 2; Amount, 2,000 dollars.
  109. 22:56 Contract: 6,000 dollars for 6 months, at 1,000 dollars per month, Jan 1 to Apr 30, support still owed; Months, 4; Amount, 4,000 dollars.
  110. 23:11 Contract: 6,000 dollars for 6 months, at 1,000 dollars per month, Total received on November 1; Months, 6; Amount, 6,000 dollars.
  111. 23:26 The required ending balance of Unearned Revenue is 4,000 dollars. It shows 6,000 dollars. The entry records the 2,000 dollars difference:
  112. 23:40 The December 31 adjusting entry debits Unearned Revenue, a liability, for 2,000 dollars and credits Service Revenue for 2,000 dollars.
  113. 23:52 The 2,000 dollars is service revenue, earned by performing 2 months of the contract. Neither entry changes Cash because the cash transactions were recorded earlier.
  114. 24:04 Each adjustment reduces an asset or liability to the amount that remains on December 31.
  115. 24:11 If Beacon had adjusted insurance monthly through November, Prepaid Insurance would show 4,000 dollars (12,000 dollars less 8 months at 1,000 dollars per month) before the December entry.
  116. 24:25 The supported ending balance would still be 3,000 dollars, so the December adjustment would be 1,000 dollars:
  117. 24:33 Suppose Beacon has adjusted insurance through November. The December 31 entry debits Insurance Expense for 1,000 dollars and credits Prepaid Insurance, an asset, for 1,000 dollars.
  118. 24:49 Prepaid Insurance ends at 3,000 dollars whether Beacon adjusts once at year-end or once each month. Insurance Expense for the year also totals 9,000 dollars.
  119. 25:02 The frequency of the adjustments changes the amount left for the final entry, not the final annual balances.
  120. 25:10 The accountant must therefore read the ledger rather than assume that the full annual adjustment is still needed.
  121. 25:19 Estimates use evidence about an uncertain amount. Some period-end amounts cannot be known exactly.
  122. 25:26 The company applies the required measurement method to available evidence and documents the estimates used in that method. Beacon's approved timesheets provide the 2,700 dollars wage accrual. Depreciation is different.
  123. 25:40 The equipment invoice provides its cost, but no invoice states exactly how long Beacon will use the equipment or how much Beacon will recover when it stops using it.
  124. 25:52 Beacon estimates the useful life and salvage value from the equipment's expected use, condition, maintenance, technological change, and available market information.
  125. 26:03 An estimate is not a guess chosen to reach a desired income amount. It is a measurement based on the best evidence available at the reporting date. Different reasonable assumptions can produce different amounts.
  126. 26:17 Beacon must document its method and assumptions and revise the estimate when new evidence changes what it reasonably expects. Check your understanding.
  127. 26:27 Why is the 2,700 dollars wage accrual different from estimated depreciation? Answer. Approved timesheets determine the wage amount. Depreciation also requires supported assumptions about useful life and salvage value.
  128. 26:42 Depreciation uses the asset's cost, its expected salvage value, and its expected useful life. The invoice supports the cost. The salvage value and useful life require judgment based on the available evidence.
  129. 26:56 The calculation below uses those inputs to compute depreciation and present the asset. Unit 6 addresses later changes in the estimates.
  130. 27:05 Depreciation. Beacon bought equipment on January 2 for 18,000 dollars. It expects to use the equipment for 5 years and recover 3,000 dollars at the end.
  131. 27:18 The depreciable amount is 15,000 dollars (18,000 dollars - 3,000 dollars). Beacon uses straight-line depreciation, one method permitted under US GAAP.
  132. 27:30 It assigns 3,000 dollars to each full year (15,000 dollars divided by 5 years). The credit uses Accumulated Depreciation, a contra account, rather than reducing Equipment.
  133. 27:45 A contra account has the opposite normal balance from its related account and reduces that account for presentation.
  134. 27:54 The December 31 depreciation entry debits Depreciation Expense for 3,000 dollars. It credits Accumulated Depreciation for 3,000 dollars. Accumulated Depreciation is a contra-asset account.
  135. 28:11 Under these assumptions, Accumulated Depreciation has a required credit balance of 3,000 dollars after year 1, 6,000 dollars after year 2, and 9,000 dollars after year 3.
  136. 28:25 A depreciation schedule provides an independent total to compare with the ledger. The credit goes to Accumulated Depreciation, not Equipment. Equipment stays at its 18,000 dollars cost.
  137. 28:40 Under the stated assumptions, Accumulated Depreciation increases by 3,000 dollars for each full year of use. The balance sheet reports both accounts and the difference between them:
  138. 28:55 Balance sheet at December 31, Equipment; Amount, 18,000 dollars. Balance sheet at December 31, Less: accumulated depreciation; Amount, negative 3,000 dollars.
  139. 29:14 Balance sheet at December 31, Carrying amount; Amount, 15,000 dollars.
  140. 29:22 The carrying amount is the amount at which the asset is reported once accumulated depreciation has been deducted. It is not what the equipment would sell for, and it is not what Beacon would pay to replace it.
  141. 29:37 It is the part of the cost Beacon has not yet assigned to an expense. Why not reduce Equipment directly? The two balances answer different questions. Equipment reports the asset's cost.
  142. 29:51 Accumulated Depreciation reports how much of that cost Beacon has allocated to expense.
  143. 29:57 A 15,000 dollars carrying amount by itself could describe a 16,000 dollars asset that has received little depreciation or an 80,000 dollars asset that has received much more.
  144. 30:09 Reporting cost and accumulated depreciation separately preserves information that the net amount alone would hide.
  145. 30:18 Unit 4 uses the same presentation idea when an allowance for credit losses is deducted from gross receivables. The schedule can also reveal a missed entry.
  146. 30:29 Suppose Beacon records 3,000 dollars in years 1 and 2 but misses year 3. A normal 3,000 dollars year 4 entry produces this ledger balance:
  147. 30:39 The Accumulated Depreciation T-account at the end of year 4 has four expected credits of 3,000 dollars each. The company recorded the year 1, year 2, and normal year 4 entries, but omitted the year 3 entry.
  148. 30:57 The ledger therefore has a 9,000-dollar credit balance instead of the required 12,000-dollar credit balance.
  149. 31:06 The depreciation schedule requires a 12,000 dollars credit balance at the end of year. The 9,000 dollars ledger balance is 3,000 dollars too low because the year 3 credit is. missing.
  150. 31:20 Beacon should not record the full 6,000 dollars ledger-to-schedule difference as year 4 Depreciation Expense. Half belongs to the missed year 3 entry.
  151. 31:31 Beacon must identify the cause and apply the guidance for correcting a prior-period error. The balance comparison finds the discrepancy; it does not determine the correction. Check your understanding.
  152. 31:47 Beacon missed last year's depreciation. Why should it not automatically record the entire ledger-to-schedule difference as this year's Depreciation Expense? Answer. Part of the difference belongs to the prior year.
  153. 32:03 Recording the full amount this year could misstate current-year income. If Beacon omits this entry, annual net income and assets are each overstated by 3,000 dollars.
  154. 32:16 Where accounting judgment enters. Some entries follow directly from fixed evidence. If Beacon's completion report shows 4,800 dollars of service completed on December 30, that revenue belongs in December.
  155. 32:31 Judgment remains in three places. Completeness. An omitted adjustment can leave the trial balance equal. Account reconciliations, cutoff work, and review procedures help identify activity that has not been recorded.
  156. 32:47 Measurement. An estimate requires a method, relevant evidence, and supported assumptions. The evidence may support one amount or a range of reasonable amounts, depending on the estimate. Period and scope.
  157. 33:02 Contract terms, completion evidence, and the applicable accounting guidance determine whether an event belongs in December.
  158. 33:11 When the facts require judgment, the accountant documents the evidence and the reason for the conclusion.
  159. 33:19 The effect of an omitted adjustment on the statements. Because each of these entries touches one income-statement account and one balance-sheet account, omitting one misstates both statements.
  160. 33:34 If Beacon omits the 4,800 dollars revenue accrual, December's net income is understated by 4,800 dollars.
  161. 33:43 Assets are understated by the same 4,800 dollars, and so is equity, since net income closes into retained earnings.
  162. 33:52 If Beacon omits the 2,700 dollars wage accrual, net income is overstated by 2,700 dollars, and liabilities are understated by the same amount. Omitting both:
  163. 34:05 Omission, The 4,800 dollars revenue accrual; Net income, understated 4,800 dollars; Assets, understated 4,800 dollars; Liabilities, no effect; Equity, understated 4,800 dollars.
  164. 34:28 Omission, The 2,700 dollars wage accrual; Net income, overstated 2,700 dollars; Assets, no effect; Liabilities, understated 2,700 dollars; Equity, overstated 2,700 dollars.
  165. 34:51 Omission, Both; Net income, understated 2,100 dollars; Assets, understated 4,800 dollars; Liabilities, understated 2,700 dollars; Equity, understated 2,100 dollars.
  166. 35:12 The income statement is off by 2,100 dollars, which is far less than either error on its own, while both balance-sheet lines are wrong by considerably more.
  167. 35:24 A reviewer scanning net income for a large variance sees nothing. Review an adjustment before using it. A colleague or software tool may prepare an adjusting entry.
  168. 35:36 The reviewer remains responsible for the evidence, checks, and final decision. Before accepting the entry, the reviewer should answer these questions: Which entity and reporting date does the entry cover?
  169. 35:51 Which documents and accounting guidance support it? Does an independent calculation produce the same amount? Do the date, accounts, and debit and credit sides match the underlying event?
  170. 36:04 Is any required fact missing or inconsistent with another source? Suppose a proposed entry debits Wages Expense and credits Cash for 2,700 dollars on December 31.
  171. 36:16 The entry balances, and the timesheets support the expense amount. The January 5 pay date shows that cash did not leave Beacon in December, so the credit is wrong.
  172. 36:28 The reviewer changes the credit to Wages Payable and records the timesheets and pay date as support. If the timesheets are missing or conflict with the payroll record, the reviewer cannot support the 2,700 dollars.
  173. 36:44 The entry needs more evidence before it can be accepted. For each adjustment, determine the supported ending balance, compare it with the ledger, and record the current-period difference.
  174. 36:57 Then trace both sides of the missing entry to the financial statements. A trial balance can remain equal even when the ledger omits the entry.
  175. 37:08 Return to the written chapter for the optional lessons and on-page practice. For each adjustment, determine the required ending balance, compare it with the ledger, and record the current-period difference.
  176. 37:22 Then trace both sides of an omitted entry to the financial statements.
In this chapter
  1. Reporting periods and the events that cross them
  2. Why cash timing is not enough
  3. Accrual-basis accounting and adjusting entries
  4. Why account balances need adjustment
  5. Determine the adjustment from required and recorded balances
  6. The four timing patterns: accruals and deferrals
  7. Accrued revenue and accrued expenses
  8. Prepaid expenses and unearned (deferred) revenue
  9. Estimates and depreciation
  10. Where accounting judgment enters
  11. The effect of an omitted adjustment on the statements
  12. Review an adjustment before using it
  13. Chapter wrap-up
  14. Identify the adjustment
  15. Adjust unearned revenue
  16. Trace an omission
Review and resources
  1. Class materials
  2. Other common mistakes
  3. Optional lessons
  4. Primary sources
  5. Optional reading

Beacon Design has been in business for 1 year. On December 31, its trial balance reports total debits of $186,400 and total credits of $186,400. Every recorded entry has support, uses the correct accounts, and appears in the total.

The trial balance accurately summarizes the transactions posted so far, but some balances are out of date. Beacon completed service on December 30 that it has not billed. Employees also worked in December for wages that Beacon will pay on January 5. An insurance policy has partly expired, a client advance has been partly earned, and Beacon has used its equipment for the year. These events must be reflected before Beacon prepares its financial statements.

Reporting periods and the events that cross them

A business operates continuously, but financial statements cover stated periods. One activity may span several months, pay periods, or calendar years. Accountants must divide that activity among the periods it affects.

The reporting date creates a question: how much of an activity belongs in the current period? The original cash entry or invoice may not answer it. The accountant may also need contracts, completion reports, timesheets, schedules, or physical counts. Adjusting entries use that evidence to bring the accounts up to date.

Why cash timing is not enough

Under cash-basis accounting, an entity records revenue when it receives cash and records expense when it pays cash. Those records show when cash moved, but cash movement and business activity do not always occur in the same period.

Beacon completed $4,800 of design service on December 30. It will send the invoice on January 3 and expects payment by January 20. Beacon's employees completed $2,700 of work in December that Beacon will pay as part of the January 5 payroll.

Under the cash basis, neither the $4,800 of service nor the $2,700 of wages appears on the December financial statements. December revenue is $4,800 too low, and December expense is $2,700 too low. The net effect is a $2,100 understatement of December income. January then reports revenue and expense from work completed in the prior year.

Accrual-basis accounting and adjusting entries

December financial statements must include the service Beacon completed and the wages it incurred in December, even though the related cash moves in January.

Accrual-basis accounting reports revenue when an entity earns it and reports expense when it consumes a resource or incurs an obligation. The related cash receipt or payment may occur in the same period or another one. Financial statements prepared under US GAAP use accrual-basis accounting. The statement of cash flows separately reports cash receipts and payments.

Throughout this course, earned is shorthand for meeting the applicable US GAAP revenue-recognition requirements. For revenue from contracts with customers, Chapter 8 explains when a performance obligation is satisfied.

An adjusting entry updates account balances for information available at the reporting date, before the statements are prepared. It records the difference between what the accounts currently show and what they must report at period end.

Why account balances need adjustment

An adjusting entry records period-end information that the ledger does not yet report correctly. Common reasons an adjusting entry is required include:

  • Activity has occurred but has not been recorded. Accrued revenue and accrued expense record activity that belongs in the current period.
  • A previously recorded balance is out of date. Prepaid expense and unearned revenue update an existing asset or liability for the portion used or earned.
  • A period-end amount requires allocation or estimation. Depreciation and other estimates use a measurement method and current evidence.

An adjustment may reflect more than one of these reasons. A correction, by contrast, fixes an error in an earlier entry; it is not a separate type of adjusting entry.

Determine the adjustment from required and recorded balances

Use three steps to determine an adjusting entry.

  1. Determine the account's required ending balance at the reporting date. Use evidence such as completion reports, timesheets, contracts, schedules, or physical counts.

  2. Find the recorded balance in the ledger.

  3. Prepare and record the adjusting entry. Use the difference to determine the amount and direction of the account change. After the entry is posted, the account should report the required balance.

For Beacon's unpaid wages, the timesheets support a required $2,700 credit balance in . Beacon's ledger shows no balance for those wages. Beacon therefore credits Wages Payable for $2,700 and debits for $2,700.

The rest of this chapter applies the same method. The categories that follow help identify the accounts and evidence to examine; they do not replace the comparison of required and recorded balances.

The four timing patterns: accruals and deferrals

Timing adjustments fall into four patterns. A deferral is a cash-first pattern: the company initially records an asset or liability and recognizes the related expense or revenue in a later period. An accrual is an activity-first pattern: the company records revenue or expense before the related cash moves. Use two questions to identify the pattern: Did cash move before or after the economic activity? Did the company provide goods or services, or did it receive or use resources or services?

Cash timing
Cash first: deferralActivity first: accrual
Provides goods or servicesUnearned (deferred) revenue
Reduce the liability as the company performs.		Accrued revenue
Record revenue and the related asset.
Receives or uses resources or servicesPrepaid expense
Reduce the asset as the company uses it.		Accrued expense
Record an expense and a payable.

Both activity-first patterns are accruals. They record activity missing from the ledger. An account may contain other activity. , for example, may include invoiced sales before Beacon adds one uninvoiced job. Beacon's $4,800 of uninvoiced services is accrued revenue, and its $2,700 of unpaid wages is an accrued expense.

Both cash-first patterns are deferrals. They adjust an amount already in the ledger. The cash transaction records a prepaid asset or a liability, such as . As Beacon uses the prepaid resource or performs for the customer, the remaining asset or liability decreases.

Each timing pattern connects one or more income-statement accounts with one or more balance-sheet accounts. For example, a payroll accrual may debit more than one expense account and credit more than one payroll liability. Other adjustments may use a different account structure.

Quick checkCash moved first, and Beacon still owes the customer service. Which timing pattern applies?

Answer: Unearned or deferred revenue. The company reports the remaining service obligation as a liability.

Common mistake
  • Mistaken idea: A deferral means recording nothing until later

    Correction: Deferring revenue or expense does not postpone recording cash. Record a prepaid asset when paying for future benefits, or a liability when receiving an advance for future work. Later use or performance produces the expense or revenue.

    Read the full explanation

Accrued revenue and accrued expenses

Return to Beacon's year end. Beacon performed $4,800 of design service on December 30 and has not invoiced it.

Event Activity date Reporting date Billing, collection, or payment
Design service December 30: Beacon completes $4,800 of work. December 31: record revenue and a receivable. Invoice January 3; collect January 20.
Employee service Employees complete $2,700 of work in December. December 31: record expense and a payable. Pay January 5.

The activity date determines the reporting period. The later invoice, collection, and payment settle the resulting receivable or payable.

The required ending balance in includes a $4,800 claim because Beacon has done the work and its right to payment is unconditional under the contract. Sending the invoice is an administrative step. The recorded balance includes nothing for this job, so the adjustment records the $4,800 difference:

December 31
Account
Debit
Credit
Account type
Accounts Receivable
$4,800
asset
Service Revenue
$4,800
revenue

The credit puts the $4,800 of revenue in December, when the work was done, and where the cash method left it out.

When the customer pays on January 20, Beacon debits and credits . Collection settles the existing claim; it does not create revenue a second time.

January 20
Account
Debit
Credit
Account type
Cash
$4,800
asset
Accounts Receivable
$4,800
asset

Beacon's December wages require a separate accrued-expense adjustment. The required ending balance in is $2,700, the amount that employees earned and Beacon owes. The recorded balance includes nothing for this work because payroll does not run until January 5. The adjustment records the $2,700 difference:

December 31
Account
Debit
Credit
Account type
Wages Expense
$2,700
expense
Wages Payable
$2,700
liability

When Beacon pays the payroll on January 5, it debits and credits . The payment settles the liability recorded on December 31.

January 5
Account
Debit
Credit
Account type
Wages Payable
$2,700
liability
Cash
$2,700
asset

Prepaid expenses and unearned (deferred) revenue

In both accrual examples, the ledger contained no amount for the year-end event, so the adjustment was the full amount. The deferral patterns start with a recorded balance and update it for the portion used or performed.

Beacon's account shows how the three steps apply to a deferral.

On April 1, Beacon paid $12,000 for 12 months of insurance coverage running through March 31 of the following year. Beacon debited , and each month of coverage costs $1,000.

Use the three-step method before recording the entry:

1Required ending balance
Given: 3 months of coverage remain at $1,000 per month.
3 months × $1,000 = $3,000 debit.
2Recorded balance
Given: The ledger contains the $12,000 premium and no reduction.
$12,000 debit.
3Adjustment
Calculate: Reduce the recorded balance to the required balance.
$12,000 − $3,000 = $9,000 credit.

The T-account shows how the adjustment produces the required ending balance:

This comparison is why the accountant determines the required balance from independent evidence before relying on the ledger balance.

The entry debits for $9,000 and credits for $9,000. The remaining $3,000 is an asset because Beacon still has 3 months of coverage.

Suppose Beacon accidentally recorded the $12,000 policy as $12,500. Recording $9,000 of expense would leave a $3,500 asset, but the policy supports only $3,000 of remaining coverage. The $500 difference is a recording error that Beacon must investigate and correct separately. It is not additional insurance expense.

Companies use account reconciliations, schedules, physical counts, and cutoff procedures to determine required balances. An equal trial balance does not identify a missing adjustment or an unsupported balance.

Quick checkThe policy supports $3,000 of Prepaid Insurance, but the ledger shows $3,500 after the normal expense entry. Should Beacon record the extra $500 as Insurance Expense?

Answer: No. The unsupported $500 signals a recording error that Beacon must investigate and correct separately.

The client advance begins with a liability rather than an asset. On November 1, a client paid Beacon $6,000 in advance for 6 months of design support running from November 1 through April 30. Beacon recorded , a liability, because it owed the client 6 months of work.

At December 31, Beacon has performed 2 of the 6 months and still owes 4 months of support. The required ending balance in is therefore a $4,000 credit (4 months × $1,000). The recorded balance is the original $6,000 credit. The adjustment is the $2,000 difference.

The adjusting entry records the $2,000 decrease in the liability and the $2,000 of revenue for the support Beacon has provided:

December 31
Account
Debit
Credit
Account type
Unearned Service Revenue
$2,000
liability
Service Revenue
$2,000
revenue

The $2,000 is service revenue, earned by performing 2 months of the contract.

Neither the insurance adjustment nor the client-advance adjustment changes because Beacon recorded both cash transactions earlier. Each adjustment reduces an asset or liability to the amount that remains on December 31.

If Beacon had adjusted insurance monthly through November, would show $4,000 ($12,000 less 8 months at $1,000 per month) before the December entry. The required ending balance would still be $3,000, so the December adjustment would be $1,000:

December 31
Account
Debit
Credit
Account type
Insurance Expense
$1,000
expense
Prepaid Insurance
$1,000
asset

ends at $3,000 whether Beacon adjusts once at year-end or once each month. for the year also totals $9,000. The frequency of the adjustments changes the amount left for the final entry, not the final annual balances. The accountant must therefore read the ledger rather than assume that the full annual adjustment is still needed.

Estimates and depreciation

Depreciation is not one of the four timing patterns. Cash timing does not determine its amount. Instead, the company allocates cost using a measurement method and supported estimates. Some inputs cannot be known exactly, so the company documents the evidence used to estimate them.

Beacon's approved timesheets provide the $2,700 wage accrual. Depreciation is different. The equipment invoice provides its cost. No invoice states how long Beacon will use the equipment or how much it will recover when use ends. Beacon estimates the useful life and salvage value from the equipment's expected use, condition, maintenance, technological change, and available market information.

An estimate is not a guess chosen to reach a desired income amount. It is a measurement based on the best evidence available at the reporting date. Different reasonable assumptions can produce different amounts. Beacon must document its method and assumptions and revise the estimate when new evidence changes what it reasonably expects.

Quick checkWhy is the $2,700 wage accrual different from estimated depreciation?

Answer: Approved timesheets determine the wage amount. Depreciation also requires supported assumptions about useful life and salvage value.

Beacon bought equipment on January 2 for $18,000. It expects to use the equipment for 5 years and recover $3,000 at the end. The depreciable amount is $15,000 ($18,000 - $3,000). Beacon uses straight-line depreciation, one method permitted under US GAAP. It assigns $3,000 to each full year ($15,000 ÷ 5 years). Unit 6 addresses later changes in these estimates.

The credit uses , a contra account, rather than reducing . A contra account has the opposite normal balance from its related account and reduces that account for presentation.

December 31
Account
Debit
Credit
Account type
Depreciation Expense
$3,000
expense
Accumulated Depreciation
$3,000
contra-asset

Under these assumptions, has a required credit balance of $3,000 after year 1, $6,000 after year 2, and $9,000 after year 3. A depreciation schedule provides an independent total to compare with the ledger.

The balance sheet reports both accounts and the difference between them:

Balance sheet at December 31 Amount
Equipment $18,000
Less: accumulated depreciation (3,000)
Carrying amount $15,000

The carrying amount is the amount at which the asset is reported once accumulated depreciation has been deducted. It is not what the equipment would sell for, and it is not what Beacon would pay to replace it. It is the part of the cost Beacon has not yet assigned to an expense.

Why not reduce directly? The two balances answer different questions. reports the asset's cost. reports how much of that cost Beacon has allocated to expense. A $15,000 carrying amount by itself could describe a $16,000 asset that has received little depreciation or an $80,000 asset that has received much more. Reporting cost and accumulated depreciation separately preserves information that the net amount alone would hide. Unit 4 uses the same presentation idea when an allowance for credit losses is deducted from gross receivables.

Common mistake
  • Mistaken idea: Depreciation measures an asset's market-value decline

    Correction: Depreciation allocates an asset's depreciable cost to the periods that use it. It does not estimate the price a buyer would pay for the asset today.

    Read the full explanation

The schedule can also reveal a missed entry. Suppose Beacon records $3,000 in years 1 and 2 but misses year 3. After Beacon records the normal $3,000 year 4 entry, the ledger contains:

The depreciation schedule requires a $12,000 credit balance at the end of year 4. The $9,000 ledger balance is $3,000 too low because the year 3 credit is missing.

Beacon should not record the $3,000 ledger-to-schedule difference as year 4 Depreciation Expense. The difference comes from the missed year 3 entry. Beacon must identify the cause and apply the guidance for correcting a prior-period error. The balance comparison finds the discrepancy; it does not determine the correction.

Quick checkBeacon missed last year's depreciation. Why should it not automatically record the entire ledger-to-schedule difference as this year's Depreciation Expense?

Answer: Part of the difference belongs to the prior year. Recording the full amount this year could misstate current-year income.

If Beacon omits the year 4 depreciation entry, annual net income, assets, and equity are each overstated by $3,000. Liabilities are not affected.

Where accounting judgment enters

The amount of judgment depends on the adjustment. Beacon's completion report directly supports the amount and completion date of the $4,800 service. Other adjustments require the accountant to evaluate whether the records are complete, measure an uncertain amount, or determine whether and when an event should be recorded.

Completeness. Beacon's missing wage accrual leaves the trial balance equal. Account reconciliations, cutoff work, and review procedures help identify activity that has not been recorded.

Measurement. An estimate requires a method, relevant evidence, and supported assumptions. The evidence may support one amount or a range of reasonable amounts, depending on the estimate. Beacon's useful-life and salvage-value estimates affect its depreciation calculation.

Recognition and period. Contract terms, completion evidence, and the applicable accounting guidance determine whether and when an event should be recorded. Beacon's completion report supports recording the $4,800 service in December. When the facts require judgment, the accountant documents the evidence and the reason for the conclusion.

The effect of an omitted adjustment on the statements

Because the timing adjustments in these examples connect income-statement and balance-sheet accounts, omitting one misstates both statements.

If Beacon omits the $4,800 revenue accrual, December's net income is understated by $4,800. Assets are understated by the same $4,800, and so is equity, since net income closes into retained earnings. If Beacon omits the $2,700 wage accrual, net income is overstated by $2,700, and liabilities are understated by the same amount.

The examples have the following effects:

Omission Net income Assets Liabilities Equity
The $4,800 revenue accrual understated $4,800 understated $4,800 no effect understated $4,800
The $2,700 wage accrual overstated $2,700 no effect understated $2,700 overstated $2,700
The $9,000 insurance adjustment overstated $9,000 overstated $9,000 no effect overstated $9,000
The $2,000 unearned-revenue adjustment understated $2,000 no effect overstated $2,000 understated $2,000
Both accruals understated $2,100 understated $4,800 understated $2,700 understated $2,100

The income statement is off by $2,100, which is far less than either error on its own, while both balance-sheet lines are wrong by considerably more. A reviewer scanning net income for a large variance sees nothing.

Review an adjustment before using it

A colleague or software tool may prepare an adjusting entry. The reviewer remains responsible for the evidence, checks, and final decision. Before accepting the entry, the reviewer should answer these questions:

  • Which entity and reporting date does the entry cover?
  • Which documents and accounting guidance support it?
  • Does an independent calculation produce the same amount?
  • Do the date, accounts, and debit and credit sides match the underlying event?
  • Is any required fact missing or inconsistent with another source?

Suppose a proposed entry debits and credits for $2,700 on December 31. The entry balances, and the timesheets support the expense amount. The January 5 pay date shows that cash did not leave Beacon in December, so the credit is wrong. The reviewer changes the credit to and records the timesheets and pay date as support.

If the timesheets are missing or conflict with the payroll record, the reviewer cannot support the $2,700. The entry needs more evidence before it can be accepted.

Beacon's original trial balance had equal debit and credit totals, but several balances were incomplete or out of date. The five period-end adjustments add missing activity, update recorded balances, and allocate equipment cost to the period. Each entry preserves equality between total debits and total credits while producing balances that reflect the reporting-date information.

Chapter wrap-up

Use these optional activities to apply the chapter to new facts. Your work is not submitted.

Identify the adjustment

Use the order of the cash and the economic event. Then identify the asset, liability, or contra-asset that needs to be updated.

Classify period-end adjustments

Classify each fact by the adjustment it requires.

  1. Work is complete, but the customer has not been billed or paid. The contract gives the company an unconditional right to payment.

  2. Employees have worked, but the company will pay them next month.

  3. The company paid for 12 months of insurance, and 3 months remain.

  4. A customer paid for 20 hours of work, and 6 hours remain.

  5. Equipment was used during the period, and the company must allocate part of its cost using supported estimates.

  6. The company completed a second uninvoiced job and has an unconditional right to payment.

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Adjust unearned revenue

Harborline Studio

Harborline received $7,200 for 6 monthly design reports and credited Unearned Revenue. By December 31, it has delivered 2 reports. Record the adjustment.

1

Prepare the journal entry

Choose each account and side. Then enter the amount.

AccountSideAmount

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2

Post to the ledger

For each account, choose the posting side and compute the ending balance.

Ledger account 1

Opening balance: shown after the journal entry

Ledger account 2

Opening balance: shown after the journal entry

Complete the journal entry first.

3

Update the trial balance

Before this transaction, each column totaled $shown after posting. Enter the new totals.

Complete the ledger postings first.

Paper version

Prepare the journal entry on paper before opening the answer.

Show the journal entry and checks
AccountDebitCredit
Unearned Revenue $2,400
Service Revenue $2,400
Ledger check
  • Unearned Revenue: post $2,400 to the debit side; ending balance $4,800 credit.
  • Service Revenue: post $2,400 to the credit side; ending balance $44,400 credit.

Updated trial-balance totals: $77,400 debit and $77,400 credit.

Trace an omitted adjustment

Trace an omitted adjustment

Harborline omits a $1,800 adjustment for insurance coverage used during December. Classify each reported amount.

  1. Net income

  2. Assets

  3. Liabilities

  4. Equity

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Key concepts in this chapter

Use a concept page when you want a definition, a fuller explanation, or related practice.

Use now

These pages explain ideas used in this chapter.

  • Carrying amount — The amount at which an asset or liability is recognized in the statement of financial position after applicable accumulated allocations, allowances, or other measurement adjustments at…
  • Accounting estimate — A reported or input amount determined using current information, assumptions, and judgment when the relevant economic characteristic cannot be measured with complete precision at the…
  • Accrual-basis accounting — An accounting basis that recognizes the effects of transactions and other events in the periods in which the relevant economic activity occurs, even when the related cash receipt or…
  • Accrued expense — An expense recognized for resources or services used in the current period before the related cash payment, with a corresponding liability for the unsettled amount.
  • Accrued revenue — Revenue recognized for performance occurring in the current period before the related cash is collected and, in a basic fact pattern, before the customer is billed, with a corresponding…
  • Accumulated depreciation — A credit normal contra asset that accumulates depreciation recognized on a related depreciable asset through the reporting date and is deducted from the related gross carrying amount in…
  • Adjusting entry — A journal entry recorded as part of period end reporting to bring account balances up to date for economic activity, estimates, or classifications not fully reflected in the unadjusted…
  • Cash basis accounting — A basis of accounting that records revenue when cash is received and expense when cash is paid, without regard to the period in which the underlying performance or benefit occurred.
  • Contra account — An account linked to a related account or class that ordinarily carries the opposite normal balance and is used to present or analyze an offset without erasing the related gross amount…
  • Deferral — A timing pattern in which cash is paid or received before the related resource consumption or performance is recognized, so an asset or liability carries the unrecognized portion into a…
  • Depreciation — The systematic allocation of a tangible long lived asset's depreciable amount over its estimated useful life. The allocated cost may be reported as expense immediately or included in…
  • Prepaid expense — An asset arising when an entity pays before receiving or consuming the related future economic benefit, with the asset reduced and expense recognized as that benefit is consumed under…
  • Unearned revenue — A liability arising in a basic cash first arrangement when an entity receives consideration before satisfying the related performance or refund obligation, with the liability reduced and…

Review

Open these pages if you need to refresh earlier work.

  • Recording error — A mistake made while recording or posting a transaction, which either leaves total debits equal to total credits or does not, and which a trial balance can therefore hide or expose.
In class

Class materials

Materials from meeting 2 on Thu 9/3: View the class slides, or download the PDF, 153 KB.

Common mistakes

Use these pages to check mistakes that can produce a plausible but incorrect answer.

  • Mistaken idea: The cash date decides the reporting period

    Correction: A reporting period divides continuing activity into dated intervals. Under accrual accounting, the cash date alone does not decide when revenue or expense belongs in the statements. If employees work in December and are paid in January, the December service can create a December expense and year-end liability. The January payment then settles the liability. If a customer pays before the company performs, the cash receipt can create a liability rather than current revenue. The applicable transaction guidance determines the accounting. The time-period assumption creates the need for cutoff; it does not replace recognition rules.

Optional lessons

These lessons are not assigned. Complete as many as you find useful, including none. Choose one when its description matches where you need help or where you want more detail.

Primary sources

These are official sources cited by the reading or its lessons. Their status differs: the FASB Codification is authoritative US GAAP, while the FASB Conceptual Framework is not. Open the source page to check its role.

Optional reading

These readings are optional. Use them when you want another explanation of the same subject. For authoritative US GAAP, use the relevant FASB Codification guidance.

Unit 1: Financial reporting, its institutions, and the accounting cycle