Adjusting Entries • Adjusting Entries bring certain account balances up to date at the end of the accounting period. • Adjusting Entries are made after preparing the trial balance at the end of the accounting period. • Adjusted Trial balance is made after posting adjusting entries to the ledger. 12/31/2010 UPDATE
The Need for Adjusting Entries The purpose of adjusting entries is to assign to each period the appropriate amounts of revenue and expenses End-of-the-period procedure
Reason for Adjustments It can be inefficient and costly to account for certain types of transactions on a daily basis.
Reason for Adjustments • An example of the inefficiency of recording certain transactions follows: • Each time an employee removes a pen from the supplies closet, a journal entry debiting Supplies Expense and crediting Supplies for $1.25 (estimated cost of pen) should be recorded. However, it would be very costly and inefficient to try to keep up with each little transaction like this. So instead, we wait until the end of the accounting period and determine the total amount of supplies used. Then we make one adjusting entry to account for all the supplies used during the period.
Adjusting Entries Adjusting Entries are necessary when accrual basisaccounting is used. Adjusting entries allow businesses to adhere to the Matching Principle.
Accrual Basis Accounting Under accrual basis accounting, revenues are recognized when earned (regardless of whether cash has been received) and expenses are recognized when incurred (regardless of cash payment).
The Matching Principle The Matching Principle states that expenses should be “matched” together with the income they produced in the same time period.
Characteristics of Adjustments Adjusting entries will always have the following characteristics: • Adjusting entries are internal transactions. • Adjusting entries are non-cash transactions—the Cash account will not be used in an adjusting entry. • Adjusting entries will always involve at least one income statement account and one balance sheet account.
Types of Adjusting Entries • Recorded Costs or Prepaid Expenses are expenses paid in cash and recorded as assets prior to being used. For examples Insurance policies, shop supplies and depreciation. • Unearned revenue(or deferred revenue) is revenue received in cash and recorded as liabilities prior to being earned. • Unrecorded or Accrued expenses (also called accrued liabilities) are expenses already incurred but not yet paid or recorded. • Unrecorded Accrued revenue(also called accrued asset) is revenue already earned but not yet paid or recorded.
How to Analyze an Adjusting Entry When analyzing an adjusting entry, look for the item that has not been recorded but should have been. This information is often not explicit and must be inferred from the data given. For expenses, look for the amount used. For revenue, look for the amount earned.
Analyzing an Adjusting Entry:Recorded Costs or Prepaid Expenses You have the following data about an adjustment: Prepaid $18,000 for 12 months of insurance on Feb1 of the current year. Make the appropriate adjustment as of the month ending on December 31.
Analyzing an Adjusting Entry:An Example Original Entry: On Feb1 the following entry would be recorded when the insurance was prepaid: Prepaid Insurance 18,000 Cash 18,000 Prepaid Insurance is an asset account – it is an amount owned by the company that has economic value.
Analyzing an Adjusting Entry:An Example Each month, a portion of the prepaid insurance expires. At the end of the month, the Prepaid Insurance and Insurance Expense accounts must be updated for the insurance that has expired (been used).
Analyzing an Adjusting Entry:An Example • Let’s divide the analysis of this transaction into two parts: • What accounts are involved? When something is “used up” it indicates an expense account. In this case, we need to debit Insurance Expense for the expired insurance. Furthermore, the asset, Prepaid Insurance, has decreased so we will credit this asset. • What is the amount of the adjustment? • See the next slide for the calculation of the amount of expired insurance.
Record the Adjustment Adjusting entries are always recorded on the last day of the fiscal period. For our example, the period closes on Dec 31. The adjustment is journalized as follows:
Recorded Costs or Prepaid Expenses • Shop Supplies • Depreciation
Analyzing an Adjusting Entry:Unearned Revenue Let’s try another example. You have the following data about an adjustment: Monthly rent is $2,000. The company received rent of 3 months in advance on Dec 1.
Analyzing an Adjusting Entry:Another Example Original Entry: On Dec1, Cash would be debited and a liability account called Unearned Painting Revenue would be credited. The liability account is credited because you owe the customer. You owe the customer painting services.) Cash 6,000 Unearned Rev6,000
Analyzing an Adjusting Entry:Another Example As each month passes by, you are earning a portion of the unearned revenue. At the end of the period, the Unearned Rent Revenueand RentRevenue Earnedaccounts must be updated for the revenue that has now been earned.
Completing the Adjustment We have performed step 1 of the analysis: the accounts involved are Unearned Rent Revenue (a liability) and Rent Revenue (a revenue). So far, the adjusting entry looks as follows: Note that as we perform the services owed, the liability decreases (this is accomplished by debiting Unearned Rent Revenue) and the revenue earned increases (this is accomplished by crediting Rent Revenue).
Unrecorded Expenses • Accrual of Salaries Expense • Accrual of Interest Expense