Adjusting Entries Principles of Accounting Help Lesson #4 By Laurie L. Swanson This presentation is under development.

Adjusting Entries Adjusting Entries bring certain account balances up to date at the end of the accounting period. 12/31/2010 UPDATE

Adjustments Adjusting entries are required when changes in certain accounts have not been recorded in the accounting records. Adjustments are necessary for items that have either been deferred or accrued.

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 are necessary when accrual basis accounting 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—no new source document exists for the adjustment. Adjusting entries are non-cash transactions—the Cash account will never be used in an adjusting entry. Adjusting entries will always involve at least one income statement account and one balance sheet account.

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: An Example You have the following data about an adjustment: Prepaid $15,000 for 12 months of insurance on Sept 1 of the current year. Make the appropriate adjustment as of the end of the fiscal period.

Analyzing an Adjusting Entry: An Example Original Entry: On Sept 1 the following entry would be recorded when the insurance was prepaid: Prepaid Insurance 15,000 Cash 15,000 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 fiscal period, 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.

Analyzing an Adjusting Entry: An Example $15,000 for 12 months= $1,250/month (15,000/12) ------- Policy purchased on Sept 1. Months that have expired between purchase and fiscal year-end = 4 (Sept, Oct, Nov, Dec) Amount of adjustment = $5,000 ($1,250/month X 4 months)

Record the Adjustment Adjusting entries are always recorded on the last day of the fiscal period. For our example, the fiscal period closes on Dec 31. The adjustment is journalized as follows: DATE ACCOUNT POST REF DEBIT CREDIT Dec 31 Insurance Expense 5000 00 Prepaid Insurance

Analyzing an Adjusting Entry: Another Example Let’s try another example. You have the following data about an adjustment: You received $12,000 advance cash on November 1 for a painting job you are to complete over the next three months.

Analyzing an Adjusting Entry: Another Example Original Entry: On November 1, 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 12,000 Unearned Painting Rev 12,000

Analyzing an Adjusting Entry: Another Example Each month as you perform painting services, you are earning a portion of the unearned revenue. At the end of the fiscal period, the Unearned Painting Revenue and Painting Revenue accounts 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 Painting Revenue (a liability) and Painting Revenue (a revenue). So far, the adjusting entry looks as follows: DATE ACCOUNT POST REF DEBIT CREDIT Dec 31 Unearned Painting Revenue Painting Revenue Note that as we perform the services owed, the liability decreases (this is accomplished by debiting Unearned Painting Revenue) and the revenue earned increases (this is accomplished by crediting Painting Revenue).

Step 2: What amount is Used in the Adjustment? $12,000 for 3 months= $4,000/month (12,000/3) ------- Cash advance received on November 1. Two months of work have been completed by the fiscal year-end (Nov and Dec) Amount of adjustment = $8,000 ($4,000/month X 2 months)

Complete the Adjusting Entry Now fill in the amount of the adjustment: DATE ACCOUNT POST REF DEBIT CREDIT Dec 31 Unearned Painting Revenue 8,000 00 Painting Revenue

Next Step You are now closer to completing the accounting cycle. You can continue to practice adjusting entries by choosing the Adjusting Entries Practice presentation. The next step in the accounting cycle is to prepare an Adjusted Trial Balance.