Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 3 Accrual Accounting Concepts 105

Balance Sheet

Assets  Liabilities Stockholders’ Equity

Accts. Prepaid Office Notes Accts. Unearned Capital Retained

Cash Rec. Insur.Supp.Equip.LandPay.Pay.RevenueStockEarnings

8 ,930 1,900 8 ,400 240 8 ,500 12,000 16, 800 140 1, 800 11,000 10,230

1,200 1,200

7,730 1,900 8 ,400 240 8 ,500 12,000 16, 800 140 1, 800 11,000 9,030

Statement of Cash Flows

l. Financing 1,200

Statement of

Cash Flows

Income

Statement

Income Statement

Balances

l. Paid dividends

Balances

THE ADJUSTMENT PROCESS

Accrual concepts of accounting require the accounting records to be updated prior to

preparing financial statements. This updating process, called the adjustment process,

is necessary to properly match revenues and expenses. This is an application of the

matching concept.

Adjustments are necessary because, at any point in time, some accounts (elements)

of the accounting equation will not be up to date. For example, as time passes, prepaid

insurance will expire and supplies will be used in operations. However, it is not effi-

cient to record the daily expiration of prepaid insurance or the daily usage of supplies.

Rather, the accounting records are normally updated just prior to preparing the fi-

nancial statements.

You may wonder why we were able to prepare the September and October finan-

cial statements for Family Health Care in Chapter 2 without recording any adjust-

ments. The answer is that in September and October, Family Health Care only entered

into cash transactions. When all of a party’s transactions are cash transactions, no ad-

justments are necessary. However, Family Health Care had accrual transactions in

November. Thus, we must now address the adjustment process.

Deferrals and Accruals

The financial statements are affected by two types of adjustments—deferrals and

accruals. Whether a deferral or an accrual, each adjustment will affect a balance sheet

account and an income statement account.

Deferralsare created by recording a transaction in a way that delays or defers the

recognition of an expense or a revenue. Common examples of deferrals are described

below.

• Prepaid expensesor deferred expenses are items that initially have been recorded
  as assets but are expected to become expenses over time or through the normal
  operations of the business. For Family Health Care, prepaid insurance is
  an example of a deferral that will normally require adjustment. Other exam-
  ples include supplies, prepaid advertising, and prepaid interest. McDonald’s

Describe and illustrate the
end-of-the-period adjust-
ment process.

3