Adjusting Entries, Part I This presentation accompanies the Accounting Course Manual (© Craig Pence, 2004). It is correlated with Module 3 of the Course Manual. This presentation is concerned with adjustments for deferred revenue and expense items. Adjustments for accrued revenues and expenses are addressed in the “Adjusting Entries, Part II” presentation that can be accessed from Module 3 of the Course Manual.

Adjusting Entries for Deferrals “Adjusting entries” are made to adjust incorrect account balances, and correct them. The adjusting entries are made at the end of the accounting period, before the financial statements are prepared. They are necessary because many events that did change the account balances were not recorded during the period. And for good reason. For example, the Supplies account was not reduced every time a paper clip or rubber band was used. Likewise, several other account changes were not recorded when they occurred, simply because it was not convenient, or even feasible, to do so. Now, at the end of the period, we must play “catch-up” and make these entries. If we do not, the account balances, and the financial statements, will not be correct. The adjusting entries might just as well be called “catch-up entries!”

Which Accounts Need Adjustment? No errors were made in recording the transactions during the period, yet the highlighted accounts are incorrect! Those highlighted in green represent deferrals and will require one type of adjusting entry; those in yellow are accruals that will require another.

Deferred Expenses Adjusting entries for “deferrals” are one type of adjustment. Under accrual basis accounting rules, payments for things such as supplies or equipment are recorded as assets since they represent resources that will benefit the business in future periods. However, these assets are eventually used up, and the benefit expires. When this happens, the asset becomes a business expense.

Deferred Expenses, Continued When something is “deferred” it is “put off” until later. By recording supplies and equipment purchases as assets, we are “deferring” the recording of an expense until later, when the asset is used up, expires, or wears out. Another name for “deferred expense” is “prepaid expense,” and “Prepaid Insurance” is another of the deferred expense asset accounts. Insurance coverage benefits the business, and the payment of insurance premiums is recorded by debiting this asset account. Over time, however, as the benefit expires, the asset account must be reduced and an expense must be recorded.

Supplies and Prepaid Insurance Here is our trial balance again. Since it was not feasible to record the use of each paper clip during the period, nor each day’s expired insurance coverage, the balances for Supplies and Prepaid Insurance in our trial balance are incorrect. They must be reduced to account for the supplies that were used up and for the expiration of insurance coverage during the period. Therefore, we must adjust these deferred expense asset accounts in order to correct them.

The Supplies Adjusting Entry The Supplies account balance indicates that $350 of supplies are presently on hand. If we take an inventory of the existing supplies and determine that the cost of the supplies we still have is only $200, then we know that $150 of supplies have been used up and have become an expense of the period. The adjusting entry that is required is:

Prepaid Insurance Adjusting Entry The balance in Prepaid Insurance is also incorrect. If we know that the original $1,000 premium was paid on December 1 for 10 months of coverage, then $100 of the coverage (one tenth) has expired and become an expense that has been incurred during the month of December. The adjusting entry to record the expiration of the coverage is:

Adjusting the Equipment Account Equipment must also be adjusted. If it has been used during the period, “wear and tear” has occurred. In fact, after many years of use, the equipment will be completely worn out and of no benefit at all. The period-by-period reduction in the amount of benefit the equipment can provide to the business is referred to as “depreciation;” and just as we have done with the other deferred expense asset accounts (Supplies and Prepaid Insurance) we must reduce the Equipment account and record Deprecation Expense. However, the cost concept requires that we maintain the original $5,000 cost of the equipment in the Equipment account, so we will not be able to reduce the Equipment account directly. We must do so indirectly!

Accumulated Depreciation Note that we did not violate the cost concept in our previous adjusting entries. The adjusted balances in Supplies ($200) and Prepaid Insurance ($900) do represent the costs of the remaining supplies and the unexpired insurance coverage. However, the cost of the equipment, no matter how worn it might become, will always be $5,000. Therefore, this balance must remain in the Equipment account, and we will be forced to reduce the account indirectly -- by recording a credit to a separate, but associated, account called Accumulated Depreciation. In effect, we will have two accounts in the general ledger for our equipment!

Adjusting for Depreciation Expense Another problem associated with depreciation concerns the determination of the expense amount. Unlike an insurance policy, the useful life of the equipment can only be estimated. If it is estimated that the equipment will last 50 months before it is completely worn out, then the estimated monthly depreciation expense amount is $100 ($5,000 ÷ 50). If the equipment was purchased on December 1, the adjusting entry to record one month’s depreciation is:

Adjusting for Depreciation Expense Accumulated Depreciation is referred to as a contra- account. Its balance will be subtracted from the $5,000 Equipment account balance on the Balance Sheet, and the remainder (the undepreciated portion of the asset’s cost, called its book value) is then listed among the assets.

The Unearned Revenue Account “Unearned revenues” are deferred revenue items. Similar to deferred expenses, unearned revenues arise when cash is received from customers for services that are to be performed at a later time. The revenue cannot be recorded until it has been earned, so it is “deferred” and a liability is recorded instead. This liability account is called Unearned Revenue.

Adjusting Unearned Revenue Our trial balance lists an account balance of $1,000 in the Unearned Revenue account. Suppose we determine that this came from an advance payment received from a customer on December 1. We must now determine how much of the work has been done. Suppose we find that one fourth of the job has been done. This means that $250 of the revenue has been earned ($1,000 x ¼), and our adjusting entry is:

Effects of the Adjusting Entries The adjustments for deferrals have affected most of the accounts on the trial balance. The highlighted accounts are those that have changed.

Conclusion We have just seen that most of the account balances have been affected by adjusting entries for deferred revenue and expense items. It is important that we make them! Had the adjustments not been made, several errors would have occurred in the financial statements. The table below summarizes them.