The Adjusting Process And Related Entries

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Business Activity IllustrationIn the previous chapter, tentative financial statements were prepared directly from a trial balance. However, a caution was issued about adjustments that may be needed to prepare a truly correct and up-to-date set of financial statements. This occurs because of multi-period items (revenue and expense items that relate to more than one accounting period) and accrued items (revenue and expense items that have been earned or incurred in a given period, but not yet entered into the accounting records). In other words, the ongoing business activity brings about changes in account balances that have not been captured by a journal entry. Time brings about change, and an adjusting process is needed to cause the accounts to appropriately reflect those changes. These adjustments typically occur at the end of each accounting period, and are akin to temporarily cutting off the flow through the business pipeline to take a measurement of what is in the pipeline. This is consistent with the revenue and expense recognition rules.

Critical thinking skills are essential in extending the fundamental principles to almost any situation. These instances pertain to the particular context. It is important to aim for a conceptual comprehension of these instances. The subsequent conversation elucidates common modifications. A solid grasp of accounting measurement principles, combined with a thorough understanding of a specific company’s operations, is necessary. What is needed is a thorough understanding of a specific company’s operations, along with a solid grasp of accounting measurement principles. It is simply impossible to document every possible adjustment that a business might have to undertake.

Multi-Period Items versus Accrued Items

 

Prepaid Expenses

It is common to pay in advance for services and goods. Insurance is typically purchased by prepaying for a semi-annual or annual policy. Most landlords require monthly rent to be paid at the beginning of each month. Alternatively, rent may be paid in advance for a building that is intended to be used in the future. Another example of prepaid expenses relates to supplies that are actually stored and purchased in advance. These prepaid expenses represent future economic benefits that are acquired in exchange for cash payments. As such, they give rise to an initial expenditure and are considered an asset. Adjustments are needed to transfer the cost of the asset’s consumption to the appropriate expense account and reduce the asset’s account. As time passes, the asset is diminished.

As a general representation of this process, let’s assume that on June 1, an asset of $300 rises initially due to a transaction. This transaction involves the transfer of expenses and the removal of $100 per month from the balance sheet. Furthermore, it is assumed that this transaction gives rise to an increase in income and a decrease in assets, resulting in lower income and equity.

Prepaid expense illustration

Here are the T-accounts that display the effect on the balance sheet account for Prepaid Mowing. Please pay attention to the journal entries for this example and analyze them.

Prepaid Mowing Journal Entries

Illustration of Prepaid Insurance

The adjustment and the transaction on January 1 would require the following entries, as of December 31. $3,000, which is one-third of $9,000, would have lapsed by December 31, 20X1, signifying one out of three years of insurance coverage. On January 1, 20X1, a $9,000 insurance policy for a duration of three years was bought, with upfront cash payment made to secure future protection. Typically, insurance policies are bought ahead of time.

Prepaid insurance journal entry

In 20X1, the income statement would show an insurance expense of $3,000, while the balance sheet at the end of 20X1 would indicate prepaid insurance of $6,000 ($9,000 debit minus $3,000 credit) as a result of the above entry and adjusting entry. This remaining amount of $6,000 would be transferred to the expense account over the next two years, specifically in 20X2 and 20X3, by preparing similar adjusting entries at the end of each year.

Illustration of Prepaid Rent

On March 31, 20X1, half of the rental duration has passed, and financial statements need to be prepared. On March 1, 20X1, a two-month lease was signed and rent was paid in advance for $3,000. The subsequent journal entries would be necessary to document the transaction on March 1 and make adjustments to rent expense and prepaid rent on March 31.

Prepaid rent journal entry

 

How Often are Adjustments Needed?

The adjustment for rent occurred at the end of March, but the adjustment for insurance was applied at the end of December for the purpose of illustrating the difference. The assumption in the first illustration was that only the adjustments which were needed at that time were prepared, and it was not stated what was not included in the financial statements being prepared only at the end of the year. It was explicitly stated in the second illustration that the financial statements were to be prepared at the end of March.

Accurate determination of the appropriate quantity needs to be established through meticulous examination and deliberate contemplation. Each circumstance possesses a certain level of uniqueness, and the suitable expense quantity should be allocated to the specific period under scrutiny, while the remaining amount is to be carried forward to a balance sheet account for subsequent time period(s). Whenever adjustments are made, financial statements ought to be prepared, and there exists a moral to this tale.

Illustration of Supplies

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The amount of $200 in supplies on hand is deducted from the supplies account, leaving an amount of $700 to be used subsequently. The remaining balance of supplies on hand is reported as an asset, while the amount used for supplies results in an expense on the income statement. The expense for supplies should be debited and recorded as Supplies Expense. The initial purchase of supplies is recorded by debiting Supplies and crediting Cash.

Supplies Journal Entry

One might need to find it necessary to “retrace steps” in the calculation of used supplies, assuming that $700 had been left over and only $200 were purchased since December, with the remaining supplies physically counted at the end of one period in the storage room.

If the ending balance at December 31, 20X2, is $300 and an extra $1,000 of supplies is acquired during 20X2, these records would be necessary, with the subsequent year posing a slightly greater difficulty.

Supplies Journal Entries continued

During the period, $900 was utilized, resulting in a remaining balance of $300 for supplies. At the start of the year, the account had a balance of $200, and an additional $1,000 in purchases were made, giving a total available amount of $1,200 for the period. However, it is important to note that $900 of this amount must be allocated as an expense, leaving a clear amount of $1,000.

Supplies Illustration

 

Depreciation

The equipment and buildings, such as assets, that have been lived in for a long time will provide productive benefits in periods of numbers. A portion of their cost is allocated to each period, which is called depreciation. A subsequent chapter will cover depreciation in great detail. However, a simple approach called the straight-line method, where the cost of the asset is assigned an equal amount each year of its service life, will be covered in detail in a subsequent chapter.

An example of a way to directly credit the account asset, rather than crediting Depreciation Accumulated, and debit Expense Depreciation involves making an annual entry. This expense would be reported on the income statement for each year of the year’s January 1 ($50,000 = 3/150,000 $150,000) = $50,000 per year if a truck with a 3-year life was purchased.

Depreciation journal entry

The balance sheet reports accumulated depreciation as a contra asset, which is an account that is subtracted from a related account, resulting in a credit. In other words, depreciation expense and accumulated depreciation show how the expense of depreciation is allocated over time.

Big Rig Income Statements and Balance Sheets

The asset can then be eliminated from the accounts, assuming it is fully utilized and retired. By the end of the asset’s lifespan, its expense has been completely depreciated and its net book value has been reduced to zero. As of December 31, 20X2, the net book value of the truck is $50,000, which is comprised of a cost of $150,000 minus accumulated depreciation of $100,000. The difference between the asset’s cost and accumulated depreciation is referred to as the book value (or “net book value”) of the asset. However, it is also decreased annually due to the increasing accumulated depreciation. As indicated on each year’s balance sheet, the asset is consistently reported at its original cost of $150,000.

Unearned Revenues

It is important to remember that revenue cannot be recognized in the income statement until the earnings process is complete. Revenue unearned is reported as a liability, reflecting the company’s obligation to deliver products in the future. Initially, advance payments received are recorded as a debit to Cash and a credit to revenue unearned. For example, a magazine publisher may sell a multi-year subscription and collect full payment at the beginning of the subscription period. Businesses often collect money in advance for providing services or goods.

Illustrative examples of the accounting treatment for unearned revenues are provided below: Below are examples that illustrate how unearned revenues are accounted for: Additionally, it is crucial to note that the reported revenue only represents the value of goods and services that have been delivered. This amount represents the entity’s responsibility for future performance. The balance sheet at the conclusion of an accounting period would include the remaining unearned revenue for goods and services that have not yet been delivered. As goods and services are provided (such as the delivery of magazines), the Unearned Revenue account is decreased (debited) and the Revenue account is increased (credited).

Unearned Revenue journal entry

Accruals

The hours worked on by the client services may generate revenues. Expenses such as utilities, rent, interest, and salaries are also related to the accrued expenses. Revenues and expenses gradually accumulate throughout the accounting period as accruals. Another type of journal entry pertains to the accrual of unrecorded revenues.

Accrued Salaries

Few businesses, if any, typically have daily payroll. Suppose a business has employees who collectively earn $1,000 on the last payday that occurred on December 26, 20X8, as shown in the calendar. As of the end of the accounting period, which pertains to December 31, 20X9, the company owes its employees for the three days worked in the following week, but they will not be paid until January.

Accrued salary journal entry

 

Salary Calendar

Before moving on to the next topic, let’s consider the entry that will be needed on the next payday in 20X9. Suppose the total payroll on that date in 20X9 amounts to $7,000, with an additional $3,000 relating to the prior year (20X8) and seven extra days of work.

The journal entry for the actual payday must indicate that the $10,000 is partially allocated for expenses and partially utilized to settle a previously established liability.

Accrued salary journal entry continued

Accrued Interest

The most significant components of interest charges encompass loans. Consequently, the borrowing amount, commonly referred to as “principal,” the interest rate, also known as the “rate,” and the duration of the borrowing period, referred to as “time,” are contingent upon the extent of interest. The total amount of interest on a loan can be calculated by multiplying the principal by the rate and then multiplying that result by the time.

The loan on different dates accounting for the loan on December 31, 20X2 would be as follows (assuming a December year end and an appropriate year-end adjusting entry for the accrued interest). It is assumed that a loan of 18 months was taken out on July 1, 20X1 and was due on December 31, 20X2. This is essential for allocating the correct interest cost to each accounting period. However, even if the interest is not payable until the end of the loan, it is still logical and suitable to accrue the interest as time elapses. For example, if $100,000 is borrowed at an annual interest rate of 6% for 18 months, the total interest will amount to $9,000 ($100,000 X 6% X 1.5 years).

Accrued Interest journal entry

Accrued Rent

The rent that was prepaid in advance, which is the opposite of the discussed rent, is Accrued rent. Recall that the rent prepaid is related to the rent that was paid in advance. Although the asset has already been utilized, the rent accrued has not been paid yet.

For example, assume that the office space is leased by Cabul X1 company. The agreement stipulates that the rent will be paid within 10 days after the end of each month, adjusting the appropriate entry for December.

Accrued Rent Journal Entry

When the rental payment is made on January 10, 20X2, this record would be required:

Accrued Rent Journal Entry continued

Accrued Revenue

Many businesses provide services to clients with the understanding that the hours worked on various projects for these clients may be tracked by the accounting firm, and billed periodically for other units of service (or hours). Even though the physical billing of the client may not occur until the following month, the service earned during a particular month will likely be accumulated and billed with the periodic billing occurring in the following month.

Accrued Revenue Journal Entry

 

Recap of Adjusting

The measurement of periods into the process of flowing business is a complex task that divides the accounting process into specific time intervals, such as the end and beginning of a year, quarter, or month. This process rarely stops and starts, and can grow very complex at other times. The preceding illustrations provide fairly straightforward examples of these processes. The element of judgment in accounting is crucial for developing an understanding and appreciation for the correct measurement of expenses and revenues. Perhaps the most important element in accounting is grasping the underlying principles of income measurement, as it has been extensively discussed in great detail preceding the adjustments.

Adjusted Trial Balance

Keep in mind that the next chapter provides a detailed look at the balance trial after it has been adjusted. This chapter demonstrates the equality of credits and debits in the adjusted balance trial, which shows that the financial statements can be directly prepared from the correct adjusting entries.

Alternate Procedure

In either method, the balances of the Insurance Expense and Prepaid Insurance accounts are the same as of December 31. The amount used during the period is reduced to match the expense through a credit that offsets it. The adjusting entry at the end of the period establishes the Prepaid Expense account by debiting it for the amount related to future periods. In the “income statement approach,” the Expense account is debited at the time of purchase. In the “balance sheet approach,” the expenditure was initially recorded in a prepaid account on the balance sheet. For Prepaid Insurance, a “balance sheet approach” is shown on the left. There are multiple ways to account for the mechanics of prepaid expenses and unearned revenues.

Balance sheet approach versus the income statement approach

Both approaches produce the same financial results statement. The amount of earned revenue does not increase, yet the unearned revenue is reduced by adjusting entries made at the end of the subsequent period. The income statement approach, where the initial receipt is entirely recorded as revenue, is the correct approach. The balance sheet approach for unearned revenue is presented below on the left. Accounting for unearned revenue can also follow either the income statement or balance sheet approach.

Balance sheet approach versus the income statement approach

If the entire unearned revenue or prepaid item is fully earned or consumed by the end of the accounting period, the income statement approach recognizes the advantage. There would be no need for an adjusting entry because the revenue or expense was recorded fully at the original transaction date.

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Did you learn?
Why are adjusting entries needed?
Understand and be able to prepare adjusting entries for multiperiod costs and revenues and accrued revenues and expenses.
Know when adjustments are needed.
Define the term “accrual.”
Distinguish between a trial balance and an adjusted trial balance.
Be able to deal with the alternative treatment of prepaid expenses and unearned revenues.
Why might the alternative treatment of adjustments “simplify” the accounting process?

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