The Basics of Adjusting Entries

The Basics of Adjusting EntriesExplain the reasons for adjusting entries and identify the major types of adjusting entries.In order for revenues to be recorded in the period in which services are performed and for expenses to be recognized in the period in which they are incurred, companies make adjusting entries. Adjusting entries ensure that the revenue recognition and expense recognition principles are followed.Adjusting entries are necessary because the trial balance?the first pulling together of the transaction data?may not contain up-to-date and complete data. This is true for several reasons:1.Some events are not recorded daily because it is not efficient to do so. Examples are the use of supplies and the earning of wages by employees.2.Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions. Examples are charges related to the use of buildings and equipment, rent, and insurance.3.Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period.Adjusting entries are required every time a company prepares financial statements. The company analyzes each account in the trial balance to determine whether it is complete and up to date for financial statement purposes. Every adjusting entry will include one income statement account and one balance sheet account.International NoteInternal controls are a system of checks and balances designed to detect and prevent fraud and errors. The Sarbanes-Oxley Act requires U.S. companies to enhance their systems of internal control. However, many foreign companies do not have to meet strict internal control requirements. Some U.S. companies believe that this gives foreign firms an unfair advantage because developing and maintaining internal controls can be very expensive.Types of Adjusting EntriesAdjusting entries are classified as either deferrals or accruals. As Illustration 3-2 shows, each of these classes has two subcategories.t0001Illustration 3-2Categories of adjusting entriesSubsequent sections give examples of each type of adjustment. Each example is based on the October 31 trial balance of Pioneer Advertising Agency from Chapter 2, reproduced in Illustration 3-3.t0002Illustration 3-3Trial balanceWe assume that Pioneer Advertising uses an accounting period of one month. Thus, monthly adjusting entries are made. The entries are dated October 31.Adjusting Entries for Deferrals4.Prepare adjusting entries for deferrals.To defer means to postpone or delay. Deferrals are expenses or revenues that are recognized at a date later than the point when cash was originally exchanged. The two types of deferrals are prepaid expenses and unearned revenues.PREPAID EXPENSESWhen companies record payments of expenses that will benefit more than one accounting period, they record an asset called prepaid expenses or prepayments. When expenses are prepaid, an asset account is increased (debited) to show the service or benefit that the company will receive in the future. Examples of common prepayments are insurance, supplies, advertising, and rent. In addition, companies make prepayments when they purchase buildings and equipment.Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use (e.g., supplies). The expiration of these costs does not require daily entries, which would be impractical and unnecessary. Accordingly, companies postpone the recognition of such cost expirations until they prepare financial statements. At each statement date, they make adjusting entries to record the expenses applicable to the current accounting period and to show the remaining amounts in the asset accounts.Prior to adjustment, assets are overstated and expenses are understated. Therefore, as shown in Illustration 3-4, an adjusting entry for prepaid expenses results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account.w0007Illustration 3-4Adjusting entries for prepaid expensesLet?s look in more detail at some specific types of prepaid expenses, beginning with supplies.SUPPLIESThe purchase of supplies, such as paper and envelopes, results in an increase (a debit) to an asset account. During the accounting period, the company uses supplies. Rather than record supplies expense as the supplies are used, companies recognize supplies expense at the end of the accounting period. At the end of the accounting period, the company counts the remaining supplies. As shown in Illustration 3-5, the difference between the unadjusted balance in the Supplies (asset) account and the actual cost of supplies on hand represents the supplies used (an expense) for that period.w0008w0009Illustration 3-5Adjustment for suppliesRecall from Chapter 2 that Pioneer Advertising Agency purchased supplies costing $2,500 on October 5. Pioneer recorded the purchase by increasing (debiting) the asset Supplies. This account shows a balance of $2,500 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still on hand. Thus, the cost of supplies used is . This use of supplies decreases an asset, Supplies. It also decreases owner?s equity by increasing an expense account, Supplies Expense. This is shown in Illustration 3-5.After adjustment, the asset account Supplies shows a balance of $1,000, which is equal to the cost of supplies on hand at the statement date. In addition, Supplies Expense shows a balance of $1,500, which equals the cost of supplies used in October. If Pioneer does not make the adjusting entry, October expenses are understated and net income is overstated by $1,500. Moreover, both assets and owner?s equity will be overstated by $1,500 on the October 31 balance sheet.INSURANCECompanies purchase insurance to protect themselves from losses due to fire, theft, and unforeseen events. Insurance must be paid in advance, often for more than one year. The cost of insurance (premiums) paid in advance is recorded as an increase (debit) in the asset account Prepaid Insurance. At the financial statement date, companies increase (debit) Insurance Expense and decrease (credit) Prepaid Insurance for the cost of insurance that has expired during the period.w0010On October 4, Pioneer Advertising paid $600 for a one-year fire insurance policy. Coverage began on October 1. Pioneer recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in the October 31 trial balance. Insurance of expires each month. The expiration of prepaid insurance decreases an asset, Prepaid Insurance. It also decreases owner?s equity by increasing an expense account, Insurance Expense.As shown in Illustration 3-6, the asset Prepaid Insurance shows a balance of $550, which represents the unexpired cost for the remaining 11 months of coverage. At the same time, the balance in Insurance Expense equals the insurance cost that expired in October. If Pioneer does not make this adjustment, October expenses are understated by $50 and net income is overstated by $50. Moreover, both assets and owner?s equity will be overstated by $50 on the October 31 balance sheet.w0011Illustration 3-6Adjustment for insuranceDEPRECIATIONA company typically owns a variety of assets that have long lives, such as buildings, equipment, and motor vehicles. The period of service is referred to as the useful life of the asset. Because a building is expected to provide service for many years, it is recorded as an asset, rather than an expense, on the date it is acquired. As explained in Chapter 1, companies record such assets at cost, as required by the historical cost principle. To follow the expense recognition principle, companies allocate a portion of this cost as an expense during each period of the asset?s useful life. Depreciation is the process of allocating the cost of an asset to expense over its useful life.w0012Need for Adjustment.The acquisition of long-lived assets is essentially a long-term prepayment for the use of an asset. An adjusting entry for depreciation is needed to recognize the cost that has been used (an expense) during the period and to report the unused cost (an asset) at the end of the period. One very important point to understand: Depreciation is an allocation concept, not a valuation concept. That is, depreciation allocates an asset?s cost to the periods in which it is used. Depreciation does not attempt to report the actual change in the value of the asset.For Pioneer Advertising, assume that depreciation on the equipment is $480 a year, or $40 per month. As shown in Illustration 3-7, rather than decrease (credit) the asset account directly, Pioneer instead credits Accumulated Depreciation?Equipment. Accumulated Depreciation is called a contra asset account. Such an account is offset against an asset account on the balance sheet. Thus, the Accumulated Depreciation?Equipment account offsets the asset Equipment. This account keeps track of the total amount of depreciation expense taken over the life of the asset. To keep the accounting equation in balance, Pioneer decreases owner?s equity by increasing an expense account, Depreciation Expense.w0013Illustration 3-7Adjustment for depreciationThe balance in the Accumulated Depreciation?Equipment account will increase $40 each month, and the balance in Equipment remains $5,000.Helpful HintAll contra accounts have increases, decreases, and normal balances opposite to the account to which they relate.Statement Presentation.As indicated, Accumulated Depreciation?Equipment is a contra asset account. It is offset against Equipment on the balance sheet. The normal balance of a contra asset account is a credit. A theoretical alternative to using a contra asset account would be to decrease (credit) the asset account by the amount of depreciation each period. But using the contra account is preferable for a simple reason: It discloses both the original cost of the equipment and the total cost that has been expensed to date. Thus, in the balance sheet, Pioneer deducts Accumulated Depreciation?Equipment from the related asset account, as shown in Illustration 3-8.t0024Illustration 3-8Balance sheet presentation of accumulated depreciationBook value is the difference between the cost of any depreciable asset and its related accumulated depreciation. In Illustration 3-8, the book value of the equipment at the balance sheet date is $4,960. The book value and the fair value of the asset are generally two different values. As noted earlier, the purpose of depreciation is not valuation but a means of cost allocation.Depreciation expense identifies the portion of an asset?s cost that expired during the period (in this case, in October). The accounting equation shows that without this adjusting entry, total assets, total owner?s equity, and net income are overstated by $40 and depreciation expense is understated by $40.Illustration 3-9 summarizes the accounting for prepaid expenses.t0003Illustration 3-9Accounting for prepaid expensesAlternative TerminologyBook value is also referred to as carrying value.UNEARNED REVENUESWhen companies receive cash before services are performed, they record a liability by increasing (crediting) a liability account called unearned revenues. In other words, a company now has a performance obligation (liability) to transfer a service to one of its customers. Items like rent, magazine subscriptions, and customer deposits for future service may result in unearned revenues. Airlines such as United, American, and Delta, for instance, treat receipts from the sale of tickets as unearned revenue until the flight service is provided.w0014Unearned revenues are the opposite of prepaid expenses. Indeed, unearned revenue on the books of one company is likely to be a prepaid expense on the books of the company that has made the advance payment. For example, if identical accounting periods are assumed, a landlord will have unearned rent revenue when a tenant has prepaid rent.When a company receives payment for services to be performed in a future accounting period, it increases (credits) an unearned revenue (a liability) account to recognize the liability that exists. The company subsequently recognizes revenues when it performs the service. During the accounting period, it is not practical to make daily entries as the company performs services. Instead, the company delays recognition of revenue until the adjustment process. Then, the company makes an adjusting entry to record the revenue for services performed during the period and to show the liability that remains at the end of the accounting period. Typically, prior to adjustment, liabilities are overstated and revenues are understated. Therefore, as shown in Illustration 3-10, the adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.w0015Illustration 3-10Adjusting entries for unearned revenuesPioneer Advertising received $1,200 on October 2 from R. Knox for advertising services expected to be completed by December 31. Pioneer credited the payment to Unearned Service Revenue. This liability account shows a balance of $1,200 in the October 31 trial balance. From an evaluation of the service Pioneer performed for Knox during October, the company determines that it should recognize $400 of revenue in October. The liability (Unearned Service Revenue) is therefore decreased, and owner?s equity (Service Revenue) is increased.As shown in Illustration 3-11, the liability Unearned Service Revenue now shows a balance of $800. That amount represents the remaining advertising services expected to be performed in the future. At the same time, Service Revenue shows total revenue recognized in October of $10,400. Without this adjustment, revenues and net income are understated by $400 in the income statement. Moreover, liabilities will be overstated and owner?s equity will be understated by $400 on the October 31 balance sheet.w0016Illustration 3-11Service revenue accounts after adjustmentIllustration 3-12 summarizes the accounting for unearned revenues.t0004Illustration 3-12Accounting for unearned revenuesACCOUNTING ACROSS THE ORGANIZATIONTurning Gift Cards into Revenuep0017Those of you who are marketing majors (and even most of you who are not) know that gift cards are among the hottest marketing tools in merchandising today. Customers purchase gift cards and give them to someone for later use. In a recent year, gift-card sales topped $95 billion.Although these programs are popular with marketing executives, they create accounting questions. Should revenue be recorded at the time the gift card is sold, or when it is exercised? How should expired gift cards be accounted for? In a recent balance sheet, Best Buy reported unearned revenue related to gift cards of $479 million.Source: Robert Berner, ?Gift Cards: No Gift to Investors,? BusinessWeek (March 14, 2005), p. 86.Suppose that Robert Jones purchases a $100 gift card at Best Buy on December 24, 2013, and gives it to his wife, Mary Jones, on December 25, 2013. On January 3, 2015, Mary uses the card to purchase $100 worth of CDs. When do you think Best Buy should recognize revenue and why?> DO IT!Adjusting Entries for DeferralsThe ledger of Hammond Company, on March 31, 2015, includes these selected accounts before adjusting entries are prepared.5.Prepare adjusting entries for accruals.The second category of adjusting entries is accruals. Prior to an accrual adjustment, the revenue account (and the related asset account) or the expense account (and the related liability account) are understated. Thus, the adjusting entry for accruals will increase both a balance sheet and an income statement account.ACCRUED REVENUESRevenues for services performed but not yet recorded at the statement date are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in the case of interest revenue. These are unrecorded because the earning of interest does not involve daily transactions. Companies do not record interest revenue on a daily basis because it is often impractical to do so. Accrued revenues also may result from services that have been performed but not yet billed nor collected, as in the case of commissions and fees. These may be unrecorded because only a portion of the total service has been performed and the clients will not be billed until the service has been completed.An adjusting entry records the receivable that exists at the balance sheet date and the revenue for the services performed during the period. Prior to adjustment, both assets and revenues are understated. As shown in Illustration 3-13, an adjusting entry for accrued revenues results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account.w0018Illustration 3-13Adjusting entries for accrued revenuesIn October, Pioneer Advertising performed services worth $200 that were not billed to clients on or before October 31. Because these services are not billed, they are not recorded. The accrual of unrecorded service revenue increases an asset account, Accounts Receivable. It also increases owner?s equity by increasing a revenue account, Service Revenue, as shown in Illustration 3-14.w0019w0020Illustration 3-14Adjustment for accrued revenueThe asset Accounts Receivable shows that clients owe Pioneer $200 at the balance sheet date. The balance of $10,600 in Service Revenue represents the total revenue for services performed by Pioneer during the month . Without the adjusting entry, assets and owner?s equity on the balance sheet and revenues and net income on the income statement are understated.On November 10, Pioneer receives cash of $200 for the services performed in October and makes the following entry.Equation analyses summarize the effects of transactions on the three elements of the accounting equation, as well as the effect on cash flows.The company records the collection of the receivables by a debit (increase) to Cash and a credit (decrease) to Accounts Receivable.Illustration 3-15 summarizes the accounting for accrued revenues.t0006Illustration 3-15Accounting for accrued revenuesACCRUED EXPENSESExpenses incurred but not yet paid or recorded at the statement date are called accrued expenses. Interest, taxes, and salaries are common examples of accrued expenses.Companies make adjustments for accrued expenses to record the obligations that exist at the balance sheet date and to recognize the expenses that apply to the current accounting period. Prior to adjustment, both liabilities and expenses are understated. Therefore, as Illustration 3-16 shows, an adjusting entry for accrued expenses results in an increase (a debit) to an expense account and an increase (a credit) to a liability account.w0021Illustration 3-16Adjusting entries for accrued expensesLet?s look in more detail at some specific types of accrued expenses, beginning with accrued interest.Ethics NoteA report released by Fannie Mae?s board of directors stated that improper adjusting entries at the mortgage-finance company resulted in delayed recognition of expenses caused by interest rate changes. The motivation for such accounting apparently was the desire to hit earnings estimates.ACCRUED INTERESTPioneer Advertising signed a three-month note payable in the amount of $5,000 on October 1. The note requires Pioneer to pay interest at an annual rate of 12%.The amount of the interest recorded is determined by three factors: (1) the face value of the note; (2) the interest rate, which is always expressed as an annual rate; and (3) the length of time the note is outstanding. For Pioneer, the total interest due on the $5,000 note at its maturity date three months in the future is , or $50 for one month. Illustration 3-17 shows the formula for computing interest and its application to Pioneer for the month of October.t0007Illustration 3-17Formula for computing interestAs Illustration 3-18 shows, the accrual of interest at October 31 increases a liability account, Interest Payable. It also decreases owner?s equity by increasing an expense account, Interest Expense.w0022Illustration 3-18Adjustment for accrued interestInterest Expense shows the interest charges for the month of October. Interest Payable shows the amount of interest the company owes at the statement date. Pioneer will not pay the interest until the note comes due at the end of three months. Companies use the Interest Payable account, instead of crediting Notes Payable, to disclose the two different types of obligations?interest and principal?in the accounts and statements. Without this adjusting entry, liabilities and interest expense are understated, and net income and owner?s equity are overstated.Helpful HintIn computing interest, we express the time period as a fraction of a year.INTERNATIONAL INSIGHTCashing In on Accrual Accountingp0023The Chinese government, like most governments, uses cash accounting. A recent report, however, noted that it decided to use accrual accounting versus cash accounting for about $38 billion of expenditures in a recent budget projection. The Chinese government decided to expense the amount in the year in which it was originally allocated rather than when the payments would be made. Why did the Chinese government do this? It enabled the government to keep its projected budget deficit below a 3% threshold. While the Chinese government was able to keep its projected shortfall below 3%, it did suffer some criticism for its inconsistent accounting. Critics charge that this inconsistent treatment reduces the transparency of China?s accounting information. That is, it is not easy for outsiders to accurately evaluate what is really going on.Source: Andrew Batson, ?China Altered Budget Accounting to Reduce Deficit Figure,? Wall Street Journal Online (March 15, 2010).Accrual accounting is often considered superior to cash accounting. Why, then, were some people critical of China?s use of accrual accounting in this instance?ACCRUED SALARIES AND WAGESCompanies pay for some types of expenses, such as employee salaries and wages, after the services have been performed. Pioneer paid salaries and wages on October 26 for its employees? first two weeks of work. The next payment of salaries will not occur until November 9. As Illustration 3-19 shows, three working days remain in October (October 29-31).w0024Illustration 3-19Calendar showing Pioneer?s pay periodsAt October 31, the salaries and wages for these three days represent an accrued expense and a related liability to Pioneer. The employees receive total salaries and wages of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries and wages at October 31 are . This accrual increases a liability, Salaries and Wages Payable. It also decreases owner?s equity by increasing an expense account, Salaries and Wages Expense, as shown in Illustration 3-20.w0025Illustration 3-20Adjustment for accrued salaries and wagesAfter this adjustment, the balance in Salaries and Wages Expense of is the actual salary and wages expense for October. The balance in Salaries and Wages Payable of $1,200 is the amount of the liability for salaries and wages Pioneer owes as of October 31. Without the $1,200 adjustment for salaries and wages, Pioneer?s expenses are understated $1,200 and its liabilities are understated $1,200.Pioneer Advertising pays salaries and wages every two weeks. Consequently, the next payday is November 9, when the company will again pay total salaries and wages of $4,000. The payment consists of $1,200 of salaries and wages payable at October 31 plus $2,800 of salaries and wages expense for November . Therefore, Pioneer makes the following entry on November 9.This entry eliminates the liability for Salaries and Wages Payable that Pioneer recorded in the October 31 adjusting entry, and it records the proper amount of Salaries and Wages Expense for the period between November 1 and November 9.Illustration 3-21 summarizes the accounting for accrued expenses.t0009Illustration 3-21Accounting for accrued expensesPEOPLE, PLANET, AND PROFIT INSIGHTGot Junk?p0026Do you have an old computer or two that you no longer use? How about an old TV that needs replacing? Many people do. Approximately 163,000 computers and televisions become obsolete each day. Yet, in a recent year, only 11% of computers were recycled. It is estimated that 75% of all computers ever sold are sitting in storage somewhere, waiting to be disposed of. Each of these old TVs and computers is loaded with lead, cadmium, mercury, and other toxic chemicals. If you have one of these electronic gadgets, you have a responsibility, and a probable cost, for disposing of it. Companies have the same problem, but their discarded materials may include lead paint, asbestos, and other toxic chemicals.What accounting issue might this cause for companies?> DO IT!Adjusting Entries for AccrualsMicro Computer Services began operations on August 1, 2015. At the end of August 2014, management prepares monthly financial statements. The following information relates to August.1.At August 31, the company owed its employees $800 in salaries and wages that will be paid on September 1.2.On August 1, the company borrowed $30,000 from a local bank on a 15-year mortgage. The annual interest rate is 10%.3.Revenue for services performed but unrecorded for August totaled $1,100.Prepare the adjusting entries needed at August 31, 2015.Action Plan?Make adjusting entries at the end of the period to recognize revenues for services performed and for expenses incurred.?Don?t forget to make adjusting entries for accruals. Adjusting entries for accruals will increase both a balance sheet and an income statement account.SolutionRelated exercise material: BE3-2, BE3-7, E3-5, E3-6, E3-7, E3-8, E3-9, and DO IT! 3-3.Summary of Basic RelationshipsIllustration 3-22 summarizes the four basic types of adjusting entries. Take some time to study and analyze the adjusting entries. Be sure to note that each adjusting entry affects one balance sheet account and one income statement account.t0010Illustration 3-22Summary of adjusting entriesIllustrations 3-23 and 3-24 show the journalizing and posting of adjusting entries for Pioneer Advertising Agency on October 31. The ledger identifies all adjustments by the reference J2 because they have been recorded of the general journal. The company may insert a center caption ?Adjusting Entries? between the last transaction entry and the first adjusting entry in the journal. When you review the general ledger in Illustration 3-24, note that the entries highlighted in color are the adjustments.t0011Illustration 3-23General journal showing adjusting entriest0012Illustration 3-24General ledger after adjustmentHelpful Hint1.Adjusting entries should not involve debits or credits to Cash.2.Evaluate whether the adjustment makes sense. For example, an adjustment to recognize supplies used should increase Supplies Expense.3.Double-check all computations.4.Each adjusting entry affects one balance sheet account and one income statement account.Copyright ? 2013 John Wiley & Sons, Inc. 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