Accounting – Chapter 4: Adjustments, Financial Statements and the Quality of Earnings
Accounting cycle: the process used by entities to analyze and record transactions, adjust the
records at the end of the period, prepare financial statements and prepare the records for the next
Purpose and Types of Adjustments
Revenues are recorded when earned (revenue principle)
Expenses are recorded when they are incurred to generate revenue during the same period
Assets are reported at amounts that represent the probable future benefits remaining at the end of
Liabilities are reported at amounts that represent the probable future sacrifices of assets or
services owed at the end of the period.
Adjusting entries: are entries necessary at the end of the accounting period to identify and
record all revenues and expenses of that period.
Types of Adjustments
There are 4 types of adjustments divided into two categories:
Deferred revenues – previously recorded liabilities that were created when cash was received in
advance and that must be adjusted for the amount of revenue actually earned during the period.
Accrued revenues – revenues that were earned but not recorded because cash was received after
the services were performed or goods were delivered.
Deferred expenses – previously recorded assets, such as prepaid rent, supplies and equipment
that were created when cash was paid in advance and that must be adjusted for the amount of
expense actually incurred during the period through use of the asset.
Accrued expenses – expenses that were incurred but were not recorded because cash was paid
after the goods or services were used.
Each of these types of adjustments involves two entries:
1. One for the cash receipt of payment
2. One for recording the revenue or expense in the proper period
Cash is never adjusted! Cash was recorded when received prior to the end of the period, or will
be recorded when collected in a future period.
There are 3 steps in analyzing adjustments at the end of the period:
1. Identify the type of adjustment – If cash was received or paid, then deferred revenue and
deferred expense accounts exist at the end of the period, but are overstates. If cash has not
been received or aid, then revenues and expenses that have been accrued but have not
been recorded are understated. 2. Determine the amount – of revenue that has been earned or expense that has been
incurred during the period.
3. Record the adjusting journal entry – and post it to the appropriate accounts.
Trial balance: a list of all accounts with their balances, to provide a check on the equality of the
debits and credits.
Before adjusting the accounting records, managers first review the unadjusted trial balance.
Property, plant and equipment represent deferred expenses that will be use