adjusting entries_4 parts

8/7/2019 Adjusting Entries_4 Parts

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Part 1 Introduction to Adjusting Entries

Adjusting entries are accounting journal entries that convert a company's accounting records tothe accrual basis of accounting. An adjusting journal entry is typically made just prior toissuing a company's financial statements.

To demonstrate the need for an accounting adjusting entry let's assume that a company borrowedmoney from its bank on December 1, 2010 and that the company's accounting period ends onDecember 31. The bank loan specifies that the first interest payment on the loan will be due onMarch 1, 2011. This means that the company's accounting records as of December 31 do notcontain any payment to the bank for the interest the company incurred from December 1through December 31. (Of course the loan is costing the company interest expense every day, butthe actual payment for the interest will not occur until March 1.) For the company's Decemberincome statement to accurately report the company's profitability, it must include all of thecompany's December expensesnot just the expenses that were paid. Similarly, for thecompany's balance sheet on December 31 to be accurate, it must report a liability for the

interest owed as of the balance sheet date. An adjusting entry is needed so that December'sinterest expense is included on December's income statement and the interest due as ofDecember 31 is included on the December 31 balance sheet. The adjusting entry will debitInterest Expense and credit Interest Payable for the amount of interest from December 1 toDecember 31.

Another situation requiring an adjusting journal entry arises when an amount has already beenrecorded in the company's accounting records, but the amount is for more than the currentaccounting period. To illustrate let's assume that on December 1, 2010 the company paid itsinsurance agent $2,400 for insurance protection during the period of December 1, 2010 throughMay 31, 2011. The $2,400 transaction was recorded in the accounting records on December 1,

but the amount represents six months of coverage and expense. By December 31, one month ofthe insurance coverage and cost have been used up or expired. Hence the income statement forDecember should report just one month of insurance cost of $400 ($2,400 divided by 6 months)in the account Insurance Expense. The balance sheet dated December 31 should report the costof five months of the insurance coverage that has not yet been used up. (The cost not used up isreferred to as the asset Prepaid Insurance. The cost that is used up is referred to as the expiredcost Insurance Expense.) This means that the balance sheet dated December 31 should reportfive months of insurance cost or $2,000 ($400 per month times 5 months) in the asset accountPrepaid Insurance. Since it is unlikely that the $2,400 transaction on December 1 was recordedthis way, an adjusting entry will be needed at December 31, 2010 to get the income statementand balance sheet to report this accurately.

The two examples of adjusting entries have focused on expenses, but adjusting entries alsoinvolve revenues. This will be discussed later when we prepare adjusting journal entries.

For now we want to highlight some important points.

There are two scenarios where adjusting journal entries are needed before the financialstatements are issued:
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Nothing has been entered in the accounting records for certain expenses or revenues, butthose expenses and/or revenues did occur and must be included in the current period'sincome statement and balance sheet.

Something has already been entered in the accounting records, but the amount needs tobe divided up between two or more accounting periods.

Adjusting entries almost always involve a balance sheet account (Interest Payable, Prepaid Insurance, Accounts Receivable, etc.)

and an income statement account (Interest Expense, Insurance Expense, Service Revenues, etc.)

Part 2 Adjusting Entries - Asset Accounts

Adjusting entries assure that both the balance sheet and the income statement are up-to-date onthe accrual basis of accounting. A reasonable way to begin the process is by reviewing the

amount or balance shown in each of the balance sheet accounts. We will use the followingpreliminary balance sheet, which reports the account balances prior to any adjusting entries:

Parcel Delivery Service

Preliminary Balance Sheetbefore adjusting entries

December 31, 2010

Assets Liabilities

Cash $ 1,800 Notes Payable $ 5,000

Accounts Receivable 4,600 Accounts Payable 2,500

Supplies 1,100 Wages Payable 1,200

Prepaid Insurance 1,500 Unearned Revenues 1,300

Equipment 25,000 Total Liabilities 10,000

Accumulated Depreciation (7,500)

Owner's Equity

Mary Smith, Capital 16,500

Total Assets$26,500 Total Liabilities & Owner's

Equity

$26,500

Let's begin with the asset accounts:

Cash $1,800

The Cash account has a preliminary balance of $1,800the amount in thegeneral ledger.Before issuing the balance sheet, one must ask, "Is $1,800 the true amount of cash? Does it agreeto the amount computed on the bank reconciliation?" The accountant found that $1,800 wasindeed the true balance. (If the preliminary balance in Cash does not agree to the bankreconciliation, entries are usually needed. For example, if the bank statement included a servicecharge and a check printing chargeand they were not yet entered into the company's
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accounting recordsthose amounts must be entered into the Cash account. See the major topicBank Reconciliation for a thorough discussion and illustration of the likely journal entries.)

Accounts Receivable $4,600

To determine if the balance in this account is accurate the accountant might review the detailed

listing of customers who have not paid their invoices for goods or services. (This is oftenreferred to as the amount of open or unpaid sales invoices and is often found in the accountsreceivable subsidiary ledger.) When those open invoices are sorted according to the date of thesale, the company can tell how old the receivables are. Such a report is referred to as an aging ofaccounts receivable. Let's assume the review indicates that the preliminary balance in AccountsReceivable of $4,600 is accurate as far as the amounts that have been billed and not yet paid.

However, under the accrual basis of accounting, the balance sheet must report all the amountsthe company has an absolute right to receivenot just the amounts that have been billed on asales invoice. Similarly, the income statement should report all revenues that have been earnednot just the revenues that have been billed. After further review, it is learned that $3,000 of

work has been performed (and therefore has been earned) as of December 31 but won't be billeduntil January 10. Because this $3,000 was earned in December, it must be entered and reportedon the financial statements for December. An adjusting entry dated December 31 is prepared inorder to get this information onto the December financial statements.

To assist you in understanding adjusting journal entries, double entry, and debits and credits,each example of an adjusting entry will be illustrated with a T-account.

Here is the process we will follow:1. Draw two T-accounts. (Every journal entry involves at least two accounts. One account

to be debited and one account to be credited.)2. Indicate the account titles on each of the T-accounts. (Remember that almost always one

of the accounts is a balance sheet accountand one will be an income statementaccount. In a smaller font size we will indicate the type of account next to the accounttitle and we will also indicate some tips about debits and credits within the T-accounts.)

3. Enter the preliminary balance in each of the T-accounts.4. Determine what the ending balance ought to be for the balance sheet account.5. Make an adjustment so that the ending amount in the balance sheet account is correct.6. Enter the same adjustment amount into the related income statement account.7. Write the adjusting journal entry.

Let's follow that process here:

Accounts Receivable (balance sheet account)

Debit

Increases an asset

Credit

Decreases an asset

Preliminary Balance 4,600ADJUSTING ENTRY 3,000

Correct Balance 7,600
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Service Revenues(income statement account)

Debit

Decreases Revenues

Credit

Increases Revenues

60,234 Preliminary Balance

3,000 ADJUSTING ENTRY63,234 Correct Balance

The adjusting entry for Accounts Receivable in general journal format is:

Date Account Name Debit Credit

Dec. 31, 2010 Accounts Receivable 3,000

Service Revenues 3,000

Notice that the ending balance in the asset Accounts Receivable is now $7,600the correctamount that the company has a right to receive. The income statement account balance has beenincreased by the $3,000 adjustment amount, because this $3,000 was also earned in theaccounting period but had not yet been entered into the Service Revenues account. The balancein Service Revenues will increase during the year as the account is credited whenever a salesinvoice is prepared. The balance in Accounts Receivable also increases if the sale was on credit(as opposed to a cash sale). However, Accounts Receivable will decrease whenever a customerpays some of the amount owed to the company. Therefore the balance in Accounts Receivablemight be approximately the amount of one month's sales, if the company allows customers topay their invoices in 30 days.

At the end of the accounting year, the ending balances in the balance sheet accounts (assets andliabilities) will carry forward to the next accounting year. The ending balances in the incomestatement accounts (revenues and expenses) are closed after the year's financial statements areprepared and these accounts will start the next accounting period with zero balances.

Allowance for Doubtful Accounts $0

(It's common not to list accounts with $0 balances on balance sheets.)Although the Allowance for Doubtful Accounts does not appear on the preliminary balancesheet, experienced accountants realize that it is likely that some of the accounts receivable mightnot be collected. (This could occur because some customers will have unforeseen hardships,some customers might be dishonest, etc.) If some of the $4,600 owed to the company will not becollected, the company's balance sheet should report less than $4,600 of accounts receivable.However, rather than reducing the balance in Accounts Receivable by means of a credit amount,the credit amount will be reported in Allowance for Doubtful Accounts. (The combination of thedebit balance in Accounts Receivable and the credit balance in Allowance for Doubtful Accountsis referred to as the net realizable value.)
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Let's assume that a review of the accounts receivables indicates that approximately $600 of thereceivables will not be collectible. This means that the balance in Allowance for DoubtfulAccounts should be reported as a $600 credit balance instead of the preliminary balance of $0.The two accounts involved will be the balance sheet account Allowance for Doubtful Accountsand the income statement account Bad Debts Expense.

Allowance for Doubtful Accounts(balance sheet account)

Debit

Decreases a contra asset

Credit

Increases a contra asset

0 Preliminary Balance600 ADJUSTING ENTRY

600 Correct Balance

Bad Debts Expense(income statement account)

DebitIncreases an expense

CreditDecreases an expense

Preliminary Balance 0ADJUSTING ENTRY 600

Correct Balance 600

The adjusting journal entry for Allowance for Doubtful Accounts is:


Dec. 31, 2010 Bad Debts Expense 600Allowance for Doubtful Accounts 600

It is possible for one or both of the accounts to have preliminary balances. However, the balancesare likely to be different from one another. Because Allowance for Doubtful Accounts is abalance sheet account, its ending balance will carry forward to the next accounting year. BecauseBad Debts Expense is an income statement account, its balance will not carry forward to the nextyear. Bad Debts Expense will start the next accounting year with a zero balance.

Supplies $1,100The Supplies account has a preliminary balance of $1,100. However, a count of the suppliesactually on hand indicates that the true amount of supplies is $725. This means that thepreliminary balance is too high by $375 ($1,100 minus $725). A credit of $375 will need to beentered into the asset account in order to reduce the balance from $1,100 to $725. The relatedincome statement account is Supplies Expense.

Supplies(balance sheet account)
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Debit

Increases an asset

Credit

Decreases an asset

Preliminary Balance 1,100375 ADJUSTING ENTRY

Correct Balance 725

Supplies Expense(income statement account)

Debit

Increases an expense

Credit

Decreases an expense

Preliminary Balance 1,600ADJUSTING ENTRY 375


The adjusting entry for Supplies in general journal format is:


Dec. 31, 2010 Supplies Expense 375

Supplies 375

Notice that the ending balance in the asset Supplies is now $725the correct amount of suppliesthat the company actually has on hand. The income statement account Supplies Expense hasbeen increased by the $375 adjusting entry. It is assumed that the decrease in the supplies onhand means that the supplies have been used during the current accounting period. The balance

in Supplies Expense will increase during the year as the account is debited. Supplies Expensewill start the next accounting year with a zero balance. The balance in the asset Supplies at theend of the accounting year will carry over to the next accounting year.

Prepaid Insurance $1,500

The $1,500 balance in the asset account Prepaid Insurance is the preliminary balance. Thecorrect balance needs to be determined. The correct amount is the amount that has been paid bythe company for insurance coverage that will expire after the balance sheet date. If a review ofthe payments for insurance shows that $600 of the insurance payments is for insurance that will

expire after the balance sheet date, then the balance in Prepaid Insurance should be $600. Allother amounts should be charged to Insurance Expense.

Prepaid Insurance(balance sheet account)

Debit

Increases an asset

Credit

Decreases an asset

Preliminary Balance 1,500900 ADJUSTING ENTRY
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Correct Balance 600

Insurance Expense(income statement account)

Debit

Increase an expense

Credit




The adjusting journal entry for Prepaid Insurance is:


Dec. 31, 2010 Insurance Expense 900

Prepaid Insurance 900

Note that the ending balance in the asset Prepaid Insurance is now $600the correct amount ofinsurance that has been paid in advance. The income statement account Insurance Expense hasbeen increased by the $900 adjusting entry. It is assumed that the decrease in the amount prepaidwas the amount being used or expiring during the current accounting period. The balance inInsurance Expense starts with a zero balance each year and increases during the year as theaccount is debited. The balance at the end of the accounting year in the asset Prepaid Insurancewill carry over to the next accounting year.

Equipment $25,000

Equipment is a long-term asset that will not last indefinitely. The cost of equipment is recordedin the account Equipment. The $25,000 balance in Equipment is accurate, so no entry is neededin this account. As an asset account, the debit balance of $25,000 will carry over to the nextaccounting year.

Accumulated Depreciation - Equipment $7,500

Accumulated Depreciation - Equipment is a contra asset account and its preliminary balance of

$7,500 is the amount ofdepreciation actually entered into the account since the Equipment wasacquired. The correct balance should be the cumulative amount of depreciation from the timethat the equipment was acquired through the date of the balance sheet. A review indicates that asof December 31 the accumulated amount of depreciation should be $9,000. Therefore theaccount Accumulated Depreciation - Equipment will need to have an ending balance of $9,000.This will require an additional $1,500 credit to this account. The income statement account thatis pertinent to this adjusting entry and which will be debited for $1,500 is Depreciation Expense -Equipment.
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Accumulated Depreciation - Equipment(balance sheet acct)

Debit

Decreases a contra asset

Credit

Increases a contra asset

7,500 Preliminary Balance

1,500 ADJUSTING ENTRY9,000 Correct Balance

Depreciation Expense - Equipment(income statement acct)

Debit


Credit


Preliminary Balance 0ADJUSTING ENTRY 1,500


The adjusting entry for Accumulated Depreciation in general journal format is:


Dec. 31, 2010 Depreciation Expense - Equipment 1,500

Accumulated Depreciation - Equipment 1,500

The ending balance in the contra asset account Accumulated Depreciation - Equipment at the endof the accounting year will carry forward to the next accounting year. The ending balance in

Depreciation Expense - Equipment will be closed at the end of the current accounting period andthis account will begin the next accounting year with a balance of $0.

Part 3 Adjusting Entries - Liability Accounts

Notes Payable $5,000

Notes Payable is a liability account that reports the amount of principal owed as of the balancesheet date. (Any interest incurred but not yet paid as of the balance sheet date is reported in aseparate liability account Interest Payable.) The accountant has verified that the amount of

principal actually owed is the same as the amount appearing on the preliminary balance sheet.Therefore, no entry is needed for this account.

Interest Payable $0 (It's common not to list accounts with $0 balances on balance sheets.)Interest Payable is a liability account that reports the amount of interest the company owes as ofthe balance sheet date. Accountants realize that if a company has a balance in Notes Payable, thecompany should be reporting some amount in Interest Expense and in Interest Payable. Thereason is that each day that the company owes money it is incurring interest expense and an
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obligation to pay the interest. Unless the interest is paid up to date, the company will always owesome interest to the lender.

Let's assume that the company borrowed the $5,000 on December 1 and agrees to make the firstinterest payment on March 1. If the loan specifies an annual interest rate of 6%, the loan will cost

the company interest of $300 per year or $25 per month. On March 1 the company will berequired to pay $75 of interest. On the December income statement the company must report onemonth of interest expense of $25. On the December 31 balance sheet the company must reportthat it owes $25 as of December 31 for interest.

Interest Payable(balance sheet account)

Debit

Decreases a liability

Credit

Increases a liability

0 Preliminary Balance25 ADJUSTING ENTRY

25 Correct Balance

Interest Expense(income statement account)

Debit


Credit


Preliminary Balance 0ADJUSTING ENTRY 25

Correct Balance 25

The adjusting journal entry for Interest Payable is:


Dec. 31, 2010 Interest Expense 25

Interest Payable 25

It is unusual that the amount shown for each of these accounts is the same. In the future months

the amounts will be different. Interest Expense will be closed automatically at the end of eachaccounting year and will start the next accounting year with a $0 balance.Accounts Payable $2,500 (It is common not to list accounts with $0 balances on balance sheets.)Accounts Payable is a liability account that reports the amounts owed to suppliers orvendorsasof the balance sheet date. Amounts are routinely entered into this account after a company hasreceived and verified all of the following: (1) an invoice from the supplier, (2) goods or serviceshave been received, and (3) compared the amounts to the company's purchase order. A review
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of the details confirms that this account's balance of $2,500 is accurate as far as invoices receivedfrom vendors.

However, under the accrual basis of accounting the balance sheet must report all the amountsowed by the companynot just the amounts that have been entered into the accounting system

from vendor invoices. Similarly, the income statement must report all expenses that have beenincurrednot merely the expenses that have been entered from a vendor's invoice. To illustratethis, assume that a company had $1,000 of plumbing repairs done in late December, but thecompany has not yet received an invoice from the plumber. The company will have to make anadjusting entry to record the expense and the liability on the December financial statements. Theadjusting entry will involve the following accounts:

Accounts Payable(balance sheet account)

Debit


Credit


2,500 Preliminary Balance1,000 ADJUSTING ENTRY

3,500 Correct Balance

Repairs & Maintenance Expense(income statement acct)

DebitIncreases an expense

CreditDecreases an expense

Preliminary Balance 7,870ADJUSTING ENTRY 1,000


The adjusting entry for Accounts Payable in general journal format is:


Dec. 31, 2010 Repairs & Maintenance Expense 1,000Accounts Payable 1,000

The balance in the liability account Accounts Payable at the end of the year will carry forward tothe next accounting year. The balance in Repairs & Maintenance Expense at the end of theaccounting year will be closed and the next accounting year will begin with $0.

Wages Payable $1,200
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Wages Payable is a liability account that reports the amounts owed to employees as of thebalance sheet date. Amounts are routinely entered into this account when the company's payrollrecords are processed. A review of the details confirms that this account's balance of $1,200 isaccurate as far as the payrolls that have been processed.

However, under the accrual basis of accounting the balance sheet must report all of the payrollamounts owed by the companynot just the amounts that have been processed. Similarly, theincome statement must report all of the payroll expenses that have been incurrednot merely theexpenses from the routine payroll processing. For example, assume that December 30 is aSunday and the first day of the payroll period. The wages earned by the employees on December30-31 will be included in the payroll processing for the week of December 30 through January 5.However, the December income statement and the December 31 balance sheet need to includethe wages for December 30-31, but not the wages for January 1-5. If the wages for December 30-31 amount to $300, the following adjusting entry is required as of December 31:

Wages Payable(balance sheet account)

Debit


Credit


1,200 Preliminary Balance300 ADJUSTING ENTRY


Wages Expense(income statement account)

Debit


Credit




The adjusting journal entry for Wages Payable is:


Dec. 31, 2010 Wages Expense 300

Wages Payable 300
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The $1,500 balance in Wages Payable is the true amount not yet paid to employees for theirwork through December 31. The $13,420 of Wages Expense is the total of the wages used by thecompany through December 31. The Wages Payable amount will be carried forward to the nextaccounting year. The Wages Expense amount will be zeroed out so that the next accounting yearbegins with a $0 balance.

Unearned Revenues $1,300

Unearned Revenues is a liability account that reports the amounts received by a company buthave not yet been earned by the company. For example, if a company required a customer with apoor credit rating to pay $1,300 before beginning any work, the company increases its asset Cashby $1,300 and it should increase its liability Unearned Revenues by $1,300.

As the company does the work, it will reduce the Unearned Revenues account balance andincrease its Service Revenues account balance by the amount earned (work performed). A reviewof the balance in Unearned Revenues reveals that the company did indeed receive $1,300 from acustomer earlier in December. However, during the month the company provided the customer

with $800 of services. Therefore, at December 31 the amount of services due to the customer is$500.

Let's visualize this situation with the following T-accounts:

Unearned Revenues(balance sheet account)

Debit


Credit


1,300 Preliminary BalanceADJUSTING ENTRY 800

500 Correct Balance

Service Revenues(income statement account)

Debit

Decreases revenues

Credit

Increases revenues

63,234 Preliminary Balance800 ADJUSTING ENTRY


The adjusting entry for Unearned Revenues in general journal format is:


Dec. 31, 2010 Unearned Revenues 800
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Service Revenues 800

Since Unearned Revenues is a balance sheet account, its balance at the end of the accountingyear will carry over to the next accounting year. On the other hand Service Revenues is anincome statement account and its balance will be closed when the current year is over. Revenues

and expenses always start the next accounting year with $0.

Part 4 Accruals & Deferrals, Avoiding Adjusting Entries

Adjusting entries are often sorted into two groups:accrualsanddeferrals.

Accruals

Accruals (or accrual-type adjusting entries) involve both expenses and revenues and areassociated with the first scenario mentioned in the introduction to this topic:

Nothing has been entered in the accounting records for certain expensesand/or revenues, but those expenses and/or revenues did occur and must beincluded in the current period's income statement and balance sheet.

Accrual of Expenses

An accountant might say, "We need to accrue the interest expense on the bank loan." Thatstatement is made because nothing had been recorded in the accounts for interest expense, butthe company did indeed incur interest expense during the accounting period. Further, thecompany has a liability or obligation for the unpaid interest up to the end of the accountingperiod. What the accountant is saying is that an accrual-type adjusting journal entry needs to berecorded.

The accountant might also say, "We need to accrue for the wages earned by the employees on

Sunday, December 30, and Monday, December 31." This means that an accrual-type adjustingentry is needed because the company incurred wages expenses on December 30-31 but nothingwill be entered routinely into the accounting records by the end of the accounting period onDecember 31.

A third example is the accrual of utilities expense. Utilities provide the service (gas, electric,telephone) and then bill for the service they provided based on some type of metering. As a resultthe company will incur the utility expense before it receives a bill and before the accountingperiod ends. Hence, an accrual-type adjusting journal entry must be made in order to properlyreport the correct amount of utilities expenses on the current period's income statement and thecorrect amount of liabilities on the balance sheet.

Accrual of Revenues

Accountants also use the term "accrual" or state that they must "accrue" when discussingrevenues that fit the first scenario. For example, an accountant might say, "We need to accrue forthe interest the company has earned on its certificate of deposit." In that situation the companyprobably did not receive any interest nor did the company record any amounts in its accounts,but the company did indeed earn interest revenue during the accounting period. Further the
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company has the right to the interest earned and will need to list that as an asset on its balancesheet.

Similarly, the accountant might say, "We need to prepare an accrual-type adjusting entry for therevenues we earned by providing services on December 31, even though they will not be billed

until January."

Deferrals

Deferrals or deferral-type adjusting entries can pertain to both expenses and revenues and refer tothe second scenario mentioned in the introduction to this topic:

Something has already been entered in the accounting records, but theamount needs to be divided up between two or more accounting periods.

Deferral of Expenses

An accountant might say, "We need to defer some of the insurance expense." That statement ismade because the company may have paid on December 1 the entire bill for the insurancecoverage for the six-month period of December 1 through May 31. However, as of December 31

only one month of the insurance is used up. Hence the cost of the remaining five months isdeferred to the balance sheet accountPrepaid Insurance until it is moved to InsuranceExpense during the months of January through May. If the company prepares monthly financialstatements, a deferral-type adjusting entry may be needed each month in order to move one-sixthof the six-month cost from the asset account Prepaid Insurance to the income statement accountInsurance Expense.

The accountant might also say, "We need to defer some of the cost of supplies." This deferral isnecessary because some of the supplies purchased were not used or consumed during theaccounting period. An adjusting entry will be necessary to defer to the balance sheet the cost ofthe supplies not used, and to have only the cost of supplies actually usedbeing reported on the

income statement. The costs of the supplies not yet used are reported in the balance sheetaccount Supplies and the cost of the supplies used during the accounting period are reported inthe income statement account Supplies Expense.

Deferral of Revenues

Deferrals also involve revenues. For example if a company receives $600 on December 1 inexchange for providing a monthly service from December 1 through May 31, the accountantshould "defer" $500 of the amount to a liability accountUnearned Revenues and allow $100 tobe recorded as December service revenues. The $500 in Unearned Revenues will be deferreduntil January through May when it will be moved with a deferral-type adjusting entry fromUnearned Revenues toService Revenues at a rate of $100 per month.

Avoiding Adjusting EntriesIf you want to minimize the number of adjusting journal entries, you could arrange for eachperiod's expenses to be paid in the period in which they occur. For example, you could ask yourbank to charge your company's checking account at the end of each month with the currentmonth's interest on your company's loan from the bank. Under this arrangement December'sinterest expense will be paid in December, January's interest expense will be paid in January, etc.You simply record the interest payment and avoid the need for an adjusting entry. Similarly,
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your insurance company might automatically charge your company's checking account eachmonth for the insurance expense that applies to just that one month.

adjusting entries_4 parts

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