Chapter Three: Adjusting the AccountsAccountants divide the economic life of a business into artificial time periods. This convenient assumption is referred to as the time period assumption.Interim periods  monthly and quarterly time periodsFiscal year  an accounting time period that is one year in lengthCalendar year  January 1st – December 31st Accrual-basis accounting: accounting basis in which companies record transactions that change a company’s financial statements in the periods in which the events occur.Cash-basis accounting: accounting basis in which companies record revenue when they receive cash and an expense when they pay cash.• Not in accordance with GAAPRevenue recognition principle: the principle that companies recognize revenue in the accounting period in which it is earned.Expense recognition principle (matching principle): the principle that companies match efforts (expenses) with accomplishments (revenues).Adjusting entries ensure that the revenue recognition and expense recognition principles are followed. A company must make adjusting entries every time it prepares financial statements. It analyzes each account in the trial balance to determine whether it is complete and up-to-date.• Deferrals1. Prepaid Expenses. Expenses paid in cash and recorded as assets before they are used or consumed.2. Unearned Revenues. Cash received and recorded as liabilities before revenue is earned.• Accruals 1. Accrued Revenues. Revenues earned but not yet received in cash or recorded.2. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded.Adjusting Entries for Deferrals• Deferrals: either prepaid expenses (expenses paid in cash that benefit more than one accounting period and that are recorded as assets) or unearned revenue (cash received and recorded as liabilities before revenue is earned). o Prepaid expenses  An adjusting entry for prepaid expense increases (debits) an expense account and decreases (credits) an asset account.  Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner. (estimate rather than factual) The difference between the cost of any depreciable asset and its related accumulated depreciation is its book value.o Unearned revenue  An adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.ACCOUNTING FOR PREPAID EXPENSESExamples: insurance, supplies, advertising, rent, depreciationReason for adjustment: prepaid expenses recorded in asset accounts have been used.Accounts before adjustment: assets overstated. Expenses understated.Adjusting entry: Dr. Expenses. Cr. AssetsACCOUNTING FOR UNEARNED REVENUEExamples: rent, magazines, subscriptions, customer deposits for future servicesReason for adjustment: unearned revenues recorded in liability accounts have been earned.Accounts before adjustment: liabilities overstates. Revenues understated.Adjusting entry: Dr. Liabilities. Cr. Revenues.Adjusting Entries for Accruals• Accruals: adjusting entries for either accrued revenues (revenues earned but not yet received in cash or recorded) or accrued expenses (expenses incurred but not yet paid in cash or recorded).o Accrued revenues An adjusting entry for accrued revenues increases (debits) an asset account and increases (credits) a revenue account.o Accrued expenses An adjusting entry for accrued expenses increases (debits) an expense account and increases (credits) a liability account. Interest = face value of note x annual interest rate x time (terms of one yr.)ACCOUNTING FOR ACCRUED REVENUESExamples: interest, rent, services performed but not collectedReason for adjustment: revenues have been earned but not yet received in cash or recorded.Accounts before adjustment: assets understated. Revenues understated.Adjusting entry: Dr. Assets. Cr. RevenuesACCOUNTING FOR ACCRUED EXPENSESExamples: interest, rate, salariesReason for adjustment: expenses have been incurred but not yet paid in cash or recorded.Accounts before adjustment: expenses understated. Liabilities understated.Adjusting entry: Dr. Expenses. Cr. LiabilitiesThe company has journalized and posted all adjusting entries. Next it prepares another trial balance form the ledger accounts. This is called an adjusted trial balance. Its purpose is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments. The accounts in the adjusted trial balance contain all data that the company needs to prepare financial statements. Chapter Four: Completing the Accounting CycleA worksheet is a multiple-column form used in the adjustment process and in preparing financial statements. The use of a worksheet is optional.• Steps1. Prepare a trial balance on the worksheeta. Enter titles, and debit/credit columns2. Enter the adjustments in the adjustments columnsa. Keying (debit/credit amounts)3. Enter adjusted balances in the adjusted trial balance columnsa. For each account, the amount in the adjusted trial balance columns is the balance that will appear in the ledger after journalizing and posting the adjusting entries.4. Extend adjusted trial balance amounts to appropriate financial statement columns5. Total the statement columns, compute the net income (or net loss), and complete the worksheeta. The debit amount balances the income statement columns; the credit amount balances the balance sheet columns.Preparing Financial Statements from a Worksheet• Once the worksheet is completed, the company has all the info. needed to prepare a financial statement. However, the completed worksheet is not a substitute for formal financial statements. A worksheet is essentially a working tool of the accountant. Preparing Adjusting Entries from a Worksheet• A worksheet is not a journal, and it cannot be used as a basis for posting to ledger accounts. The adjusting entries are prepared from the adjustments columns of the worksheet. The journalizing andposting of adjusting entries follows the preparation of financial statements when a worksheet is used. Closing the Books• At the end of the accounting period, the company makes the accounts ready for the next period. This is called closing the books. In closing the books, companies make separate entries to close revenues and expenses to income summary, income summary to retained earnings, and dividends to retained