Adjusting entries

 To demonstrate the need for an accounting adjusting entry let's assume that a company borrowed money from its bank on December 1, 2020 and that the company's accounting period ends on December 31. The bank loan specifies that the first interest payment on the loan will be due on March 1, 2021. This means that the company's accounting records as of December 31 do not contain any payment to the bank for the interest the company incurred from December 1 through December 31. (Of course the loan is costing the company interest expense every day, but the actual payment for the interest will not occur until March 1.)

For the company's December income statement to accurately report the company's profitability, it must include all of the company's December expenses—not just the expenses that were paid. Similarly, for the company'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's interest expense is included on December's income statement and the interest due as of December 31 is included on the December 31 balance sheet. The adjusting entry will debit Interest Expense and credit Interest Payable for the amount of interest from December 1 to December 31.

Another situation requiring an adjusting journal entry arises when an amount has already been recorded in the company's accounting records, but the amount is for more than the current accounting period. To illustrate let's assume that on December 1, 2020 the company paid its insurance agent $2,400 for insurance protection during the period of December 1, 2020 through May 31, 2021. 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 of the insurance coverage and cost have been used up or expired. Hence the income statement for December 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 cost of five months of the insurance coverage that has not yet been used up. (The cost not used up is referred to as the asset Prepaid Insurance. The cost that is used up is referred to as the expired cost Insurance Expense.) This means that the balance sheet dated December 31 should report five months of insurance cost or $2,000 ($400 per month times 5 months) in the asset account Prepaid Insurance. Since it is unlikely that the $2,400 transaction on December 1 was recorded this way, an adjusting entry will be needed at December 31, 2020 to get the income statement and balance sheet to report this accurately.

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

Adjusting Entries - Asset Accounts

Adjusting entries assure that both the balance sheet and the income statement are up-to-date on the 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 following preliminary balance sheet, which reports the account balances prior to any adjusting entries:

Let's begin with the asset accounts:

Cash $1,800

The Cash account has a preliminary balance of $1,800—the amount in the general ledger. Before issuing the balance sheet, one must ask, "Is $1,800 the true amount of cash? Does it agree to the amount computed on the bank reconciliation?" The accountant found that $1,800 was indeed the true balance. (If the preliminary balance in Cash does not agree to the bank reconciliation, entries are usually needed. For example, if the bank statement included a service charge and a check printing charge—and they were not yet entered into the company's accounting records—those amounts must be entered into the Cash account. See the major topic Bank 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 often referred to as the amount of open or unpaid sales invoices and is often found in the accounts receivable subsidiary ledger.) When those open invoices are sorted according to the date of the sale, the company can tell how old the receivables are. Such a report is referred to as an aging of accounts receivable. Let's assume the review indicates that the preliminary balance in Accounts Receivable 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 amounts the company has an absolute right to receive—not just the amounts that have been billed on a sales invoice. Similarly, the income statement should report all revenues that have been earned—not 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 billed until January 10. Because this $3,000 was earned in December, it must be entered and reported on the financial statements for December. An adjusting entry dated December 31 is prepared in order 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 account and one will be an income statement account. In a smaller font size we will indicate the type of account next to the account title 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:

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

Notice that the ending balance in the asset Accounts Receivable is now $7,600—the correct amount that the company has a right to receive. The income statement account balance has been increased by the $3,000 adjustment amount, because this $3,000 was also earned in the accounting period but had not yet been entered into the Service Revenues account. The balance in Service Revenues will increase during the year as the account is credited whenever a sales invoice 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 customer pays some of the amount owed to the company. Therefore the balance in Accounts Receivable might be approximately the amount of one month's sales, if the company allows customers to pay their invoices in 30 days.

At the end of the accounting year, the ending balances in the balance sheet accounts (assets and liabilities) will carry forward to the next accounting year. The ending balances in the income statement accounts (revenues and expenses) are closed after the year's financial statements are prepared 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 balance sheet, experienced accountants realize that it is likely that some of the accounts receivable might not 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 be collected, 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 the debit balance in Accounts Receivable and the credit balance in Allowance for Doubtful Accounts is referred to as the net realizable value.)

Let's assume that a review of the accounts receivables indicates that approximately $600 of the receivables will not be collectible. This means that the balance in Allowance for Doubtful Accounts 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 Accounts and the income statement account Bad Debts Expense.

The adjusting journal entry for Allowance for Doubtful Accounts is:

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

Supplies $1,100

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

The adjusting entry for Supplies in general journal format is:

Notice that the ending balance in the asset Supplies is now $725—the correct amount of supplies that the company actually has on hand. The income statement account Supplies Expense has been increased by the $375 adjusting entry. It is assumed that the decrease in the supplies on hand 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 Expense will start the next accounting year with a zero balance. The balance in the asset Supplies at the end 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. The correct balance needs to be determined. The correct amount is the amount that has been paid by the company for insurance coverage that will expire after the balance sheet date. If a review of the 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. All other amounts should be charged to Insurance Expense.

The adjusting journal entry for Prepaid Insurance is:

Note that the ending balance in the asset Prepaid Insurance is now $600—the correct amount of insurance that has been paid in advance. The income statement account Insurance Expense has been increased by the $900 adjusting entry. It is assumed that the decrease in the amount prepaid was the amount being used or expiring during the current accounting period. The balance in Insurance Expense starts with a zero balance each year and increases during the year as the account is debited. The balance at the end of the accounting year in the asset Prepaid Insurance will 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 recorded in the account Equipment. The $25,000 balance in Equipment is accurate, so no entry is needed in this account. As an asset account, the debit balance of $25,000 will carry over to the next accounting year.

Accumulated Depreciation - Equipment $7,500

Accumulated Depreciation - Equipment is a contra asset account and its preliminary balance of $7,500 is the amount of depreciation actually entered into the account since the Equipment was acquired. The correct balance should be the cumulative amount of depreciation from the time that the equipment was acquired through the date of the balance sheet. A review indicates that as of December 31 the accumulated amount of depreciation should be $9,000. Therefore the account 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 that is pertinent to this adjusting entry and which will be debited for $1,500 is Depreciation Expense - Equipment.

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

The ending balance in the contra asset account Accumulated Depreciation - Equipment at the end of 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 and this account will begin the next accounting year with a balance of $0.

Quiz: Take the quiz after the class.

1. Every adjusting entry affects?

(a) Income statement account only
(b) Balance sheet account only
(c) Both A & B
(d) None

2. If a business pays for only 11 months rent during a financial year, what accounting term is given to the outstanding one month's rent?

(a) Repayment
(b) Prepayment
(c) Underpayment
(d) Payable

3. The record of such transactions in the book of prime entry is called?

(a) Adjustments
(b) Trial balance
(c) Ledger
(d) Income Statement

4. Adjusting Entries?

(a) Assign revenue to the period in which they are earned
(b) Help to properly measure the period’s Net Profit / Loss
(c) Bring asset and liability account to correct balances
(d) All of about statements are true regarding Adjusting Entries

5. A balance of unearned rent at the end of period represents?

(a) An asset
(b) An expenses
(c) A liability
(d) Revenue

6. Which one of the following is an example of unearned income?

(a) Cash paid to supplier
(b) Advanced received from bank
(c) Advanced received from a customer for a purchase order place by him
(d) Cash discount received from customer

7. The portion of cost expires during a year is?

(a) Cost
(b) Expense
(c) Expenditure
(d) None

8. Which of the following is not an adjusting entry?

(a) Debit unearned revenue; credit revenue
(b) Debit insurance expense; credit pre-paid insurance
(c) Debit cash; credit unearned revenue
(d) Debit wages expense; credit wages payable

9. A liability account that reports amounts received in advance of providing goods and services?

(a) Unearned Revenue
(b) Earned liabilities
(c) Earned Revenue
(d) Revenue

10. Which of the following entries records the utility bill incurred but not paid from the water company?

(a) Debit Utilities Expense; credit Utilities Payable
(b) Debit Accounts Payable; credit Utilities Payable
(c) Debit Accounts Payable; credit Cash
(d) Debit Utilities Payable; credit Accounts Receivable