Adjusting Entries

Before financial statements are prepared, additional journal entries, called adjusting entries, are made to ensure that the company's financial records adhere to the revenue recognition and matching principles. Adjusting entries are necessary because a single transaction may affect revenues or expenses in more than one accounting period and also because all transactions have not necessarily been documented during the period.
Each adjusting entry usually affects one income statement account (a revenue or expense account) and one balance sheet account (an asset or liability account). For example, suppose a company has a $1,000 debit balance in its supplies account at the end of a month, but a count of supplies on hand finds only $300 of them remaining. Since supplies worth $700 have been used up, the supplies account requires a $700 adjustment so assets are not overstated, and the supplies expense account requires a $700 adjustment so expenses are not understated.
Adjustments fall into one of five categories: accrued revenues, accrued expenses, unearned revenues, prepaid expenses, and depreciation.

Accrued Revenues

An adjusting entry to accrue revenues is necessary when revenues have been earned but not yet recorded. Examples of unrecorded revenues may involve interest revenue and completed services or delivered goods that, for any number of reasons, have not been billed to customers. Suppose a customer owes 6% interest on a three-year, $10,000 note receivable but has not yet made any payments. At the end of each accounting period, the company recognizes the interest revenue that has accrued on this long-term receivable.
Unless otherwise specified, interest is calculated with the following formula: principal x annual interest rate x time period in years.



Most textbooks use a 360-day year for interest calculations, which is done here. In practice, however, most lenders make more precise calculations by using a 365-day year.
Since the company accrues $50 in interest revenue during the month, an adjusting entry is made to increase (debit) an asset account (interest receivable) by $50 and to increase (credit) a revenue account (interest revenue) by $50.

If a plumber does $90 worth of work for a customer on the last day of April but doesn't send a bill until May 4, the revenue should be recognized in April's accounting records. Therefore, the plumber makes an adjusting entry to increase (debit) accounts receivable for $90 and to increase (credit) service revenue for $90.

Accounting records that do not include adjusting entries for accrued revenues understate total assets, total revenues, and net income.

Accrued Expenses

An adjusting entry to accrue expenses is necessary when there are unrecorded expenses and liabilities that apply to a given accounting period. These expenses may include wages for work performed in the current accounting period but not paid until the following accounting period and also the accumulation of interest on notes payable and other debts.
Suppose a company owes its employees $2,000 in unpaid wages at the end of an accounting period. The company makes an adjusting entry to accrue the expense by increasing (debiting) wages expense for $2,000 and by increasing (crediting) wages payable for $2,000.

If a long-term note payable of $10,000 carries an annual interest rate of 12%, then $1,200 in interest expense accrues each year. At the close of each month, therefore, the company makes an adjusting entry to increase (debit) interest expense for $100 and to increase (credit) interest payable for $100.

Accounting records that do not include adjusting entries for accrued expenses understate total liabilities and total expenses and overstate net income.

Unearned Revenues

Unearned revenues are payments for future services to be performed or goods to be delivered. Advance customer payments for newspaper subscriptions or extended warranties are unearned revenues at the time of sale. At the end of each accounting period, adjusting entries must be made to recognize the portion of unearned revenues that have been earned during the period.
Suppose a customer pays $1,800 for an insurance policy to protect her delivery vehicles for six months. Initially, the insurance company records this transaction by increasing an asset account (cash) with a debit and by increasing a liability account (unearned revenue) with a credit. After one month, the insurance company makes an adjusting entry to decrease (debit) unearned revenue and to increase (credit) revenue by an amount equal to one sixth of the initial payment.

Accounting records that do not include adjusting entries to show the earning of previously unearned revenues overstate total liabilities and understate total revenues and net income.

Prepaid Expenses

Prepaid expenses are assets that become expenses as they expire or get used up. For example, office supplies are considered an asset until they are used in the course of doing business, at which time they become an expense. At the end of each accounting period, adjusting entries are necessary to recognize the portion of prepaid expenses that have become actual expenses through use or the passage of time.
Consider the previous example from the point of view of the customer who pays $1,800 for six months of insurance coverage. Initially, she records the transaction by increasing one asset account (prepaid insurance) with a debit and by decreasing another asset account (cash) with a credit. After one month, she makes an adjusting entry to increase (debit) insurance expense for $300 and to decrease (credit) prepaid insurance for $300.

Prepaid expenses in one company's accounting records are often—but not always—unearned revenues in another company's accounting records. Office supplies provide an example of a prepaid expense that does not appear on another company's books as unearned revenue.
Accounting records that do not include adjusting entries to show the expiration or consumption of prepaid expenses overstate assets and net income and understate expenses.

Depreciation

Depreciation is the process of allocating the depreciable cost of a long-lived asset, except for land which is never depreciated, to expense over the asset's estimated service life. Depreciable cost includes all costs necessary to acquire an asset and make it ready for use minus the asset's expected salvage value, which is the asset's worth at the end of its service life, usually the amount of time the asset is expected to be used in the business. For example, if a truck costs $30,000, has an expected salvage value of $6,000, and has an estimated service life of sixty months, then $24,000 is allocated to expense at a rate of $400 each month ($24,000 ÷ 60 = $400). This method of calculating depreciation expense, called straight-line depreciation, is the simplest and most widely used method for financial reporting purposes.
Some accountants treat depreciation as a special type of prepaid expense because the adjusting entries have the same effect on the accounts. Accounting records that do not include adjusting entries for depreciation expense overstate assets and net income and understate expenses. Nevertheless, most accountants consider depreciation to be a distinct type of adjustment because of the special account structure used to report depreciation expense on the balance sheet.
Since the original cost of a long-lived asset should always be readily identifiable, a different type of balance-sheet account, called a contra-asset account, is used to record depreciation expense. Increases and normal balances appear on the credit side of a contraasset account. The net book value of long-lived assets is found by subtracting the contra-asset account's credit balance from the corresponding asset account's debit balance. Do not confuse book value with market value. Book value is the portion of the asset's cost that has not been written off to expense. Market value is the price some-one would pay for the asset. These two values are usually different.
Suppose an accountant calculates that a $125,000 piece of equipment depreciates by $1,000 each month. After one month, he makes an adjusting entry to increase (debit) an expense account (depreciation expense–equipment) by $1,000 and to increase (credit) a contra-asset account (accumulated depreciation–equipment) by $1,000.

On a balance sheet, the accumulated depreciation account's balance is subtracted from the equipment account's balance to show the equipment's net book value.

ACME Manufacturing Partial Balance Sheet December 31, 20X7 Property, Plant, and Equipment     Equipment 125,000     Less: Accumulated Depreciation (1,000) 124,000

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By Muhammad Atif Saeed on 23:25. Filed under Accounting . Follow any responses to the RSS 2.0. Leave a response