mastering adjusting entries

Mastering Adjusting Entries


American Institute of Professional Bookkeepers

© American Institute of Professional Bookkeepers, 2010


Cash v. Accrual Basis

Accrual basis

Revenues recognized when earned

Expenses recognized when incurred

Cash basis

Revenues recognized when cash is received

Expenses recognized when cash is paid


Cash v. Accrual BasisIn 2008, PubCo offers 2-year subscriptions to New Magazine, for $20 (8 quarterly issues @ $2.50) and collects $20,000.

Cost: $6 a year per subscriber, which is paid at the time of publication.

PubCo takes out a 2-year loan for $10,000 at 10% simple interest rate. Both interest and principal are payable at the end of 2 years.



Revenue

PublishingExpense

InterestExpense

$20,000 $10,000$10,000

6,000 6,000 6,000 6,000

2,000 1,000 1,000

$ - 0 -

- 0 -($8,000) $3,000$14,000 $3,000

Total profit for 2 years is the same under both methods: $6,000But, the timing of those profits may be different.

Profit

Cash basis Accrual basis20X8 20X9 20X8 20X9



Accrual basis



Cash basis



Earnings = cash received – expenses paid.

(When revenues are earned or expenses incurred is irrelevant.)

Earnings = revenues earned – expenses incurred

(When cash is received or expenses paid is irrelevant.)

Earnings = cash received – expenses paid.

(When revenues are earned or expenses incurred is irrelevant.)



Cash basis



NOT GAAP Earnings = revenues earned – expenses incurred

(When cash is received or expenses paid is irrelevant.)

Accrual basis




Cash v. Accrual BasisYou are a caterer. The transactions you are about to see occur in March.

What should you report as March revenues and expenses under: cash basis accounting? accrual basis accounting?


Prepay $2,400 rent for 4 months (includes the current month).

Receive $300 cash for catering services.

Cater a luncheon and submit an invoice for $1,200 that will be settled next month.

Receive a $200 utility bill that you will pay next month.

Receive $1,000 from a customer for a function catered last month.

Receive a $500 deposit on a wedding you will cater later in the year.

Cash AccrualCash v. Accrual Basis

$2,400 $ 600

$ 300 $ 300

$ 0 $1,200

$ 0 $ 200

$1,000$ 0

$ 500$ 0


Adjusting EntriesHere are the principles of adjusting entries: Recognition of revenues and expenses is

unrelated to receipt or payment of cash. Cash may be received before or after the

service is performed (or goods are sold). Cash may be paid before or after the expense

is incurred. Adjusting entries are used when cash is

received or paid at a different time from when the service is performed (or goods are sold) or the expense is incurred.


Adjusting EntriesIn 2008, PubCo offers 2-year subscriptions to New Magazine, for $20 (8 quarterly issues @ $2.50) and collects $20,000.

20,000 or20,000

CashRevenue

CashUnearned Revenue

20,00020,000

But neither entry records the amount of revenue earned in 20X8 on the accrual basis: $10,000.

How can this be corrected?


Adjusting Entries

Adjusting entries apply the accrual method to transactions when cash flows and earnings (revenues less expenses) are not simultaneous.

Cash flows BEFOREBEFORE the revenue is earned or expense is incurred

Cash flows AFTERAFTER the revenue is earned or expense is incurred




Adjusting Entries

Expenses paid, but not yet incurred

Cash received, but not yet earned

Expenses incurred, but not yet paid

Revenues earned, but cash not yet received



Adjusting Entries


ComCo lends ZyCo $10,000 on July 1 and will be repaid the $10,000 principal + $1,200 interest on June 30 of the following year.


Adjusting Entries



ComCo earns revenue each month the loan is not repaid. As of Dec. 31, it has earned 6 months’ interest. To compute: $1,200/12 months = $100 a month × 6 months = $600 earned revenue



Adjusting Entries



ComCo records an adjusting entry to show that it earned $600 revenue:

Interest ReceivableInterest Revenue

600600



Adjusting Entries


Thus, the adjusting entry to accrue revenue is:

In addition to interest, other common accrued revenues include commissions, royalties and rent.

____ Receivable ____ Revenue



Adjusting Entries


Thus, the adjusting entry to accrue revenue is:____ Receivable

____ Revenue

This adjusting entry increases assets

. . . and increases revenues/net income.



Adjusting Entries


Thus, the adjusting entry to accrue revenue is:____ Receivable

____ Revenue



Adjusting Entries


Thus, the adjusting entry to accrue revenue is:

Because this entry increases assets, if it is omitted, assets will be UNDERSTATEDUNDERSTATED.

____ Receivable ____ Revenue

Because the entry increases income, if it is omitted, net income will be UNDERSTATEDUNDERSTATED.



Adjusting Entries


Expenses paid but not yet incurred

Cash received but not yet earned



Cash flows AFTER AFTER the revenue is earned or expense is incurred


Adjusting Entries


KTC pays its office staff $5,000 every 2 weeks. The final payday for the year ended Oct. 31, 20X1, is Friday, Oct. 24. What adjustment is needed on Oct. 31 (the company’s year end)?



Adjusting Entries



24 25

26 27 28 29 30 31



Adjusting Entries



24 25

26 27 28 29 30 31For these days, labor costs were incurred . . .



Adjusting Entries



2424 2525

2626 2727 2828 2929 3030 3131but not paid by year end



Adjusting Entries



KTC must record an adjusting entry to recognize 1 week’s wage expense.

Wages ExpenseWages Payable

2,5002,500



Adjusting Entries

Thus, the adjusting entry to accrue expenses is

In addition to wages, other common accrued expenses include rent, commissions, royalties, utilities, and interest.


____ Expense____ Payable



Adjusting Entries





This adjusting entry increases expenses (and therefore reduces net income)

. . . and increases liabilities.


Adjusting Entries






Adjusting Entries




____ Payable

Because this entry reduces net income, if it is omitted, net income will be OVERSTATEDOVERSTATED.Because this entry increases liabilities, if it is omitted, liabilities will be UNDERSTATEDUNDERSTATED.

____ Expense




Adjusting Entries






Cash flows BEFORE BEFORE the revenue is earned or expense is incurred


Adjusting Entries

On March 1, StorageCo rents out a unit and receives $900 for the first 3 months’ rent. The company has a year end of April 30.



Adjusting Entries

Unearned RentCash

Rent RevenueCash

900900

900900

The $900 payment received in advance can be recorded in two ways:





Adjusting Entries

3/1 4/30 5/31

Unearned RentCash

Rent RevenueCash

900900

900900



The $900 payment received in advance can be recorded in two ways:



Adjusting Entries

Rent Revenue

300600

9003/1600 600

On March 1, StorageCo rents out a unit and receives $900 for the first 3 months’ rent.


Unearned Rent



Adjusting Entries

Rent Revenue

300600

9003/1600 600

Unearned RentRent Revenue

600600



Unearned Rent



Adjusting Entries

Rent Revenue

300600

9003/1300 300



Unearned Rent



Adjusting Entries

Rent Revenue

300600

9003/1300 300

Rent RevenueUnearned Rent

300300



Unearned Rent


Adjusting Entries


Unearned ___ Rev.___ Revenue

How the AJE is made depends on how receipt of the $900 payment was recorded. It could be:

___ RevenueUnearned ___ Rev.

This is the AJE if the cash was recorded as unearned revenue

This is the AJE if the cash was recorded as revenue



Adjusting Entries





This AJE reduces liabilities . . .


. . . and increases net income

This AJE reduces net income . . .

. . . and increases liabilities


Adjusting Entries







Adjusting Entries

Cash received, but not yet earned This AJE reduces

liabilities—without it, liabilities will be OVERSTATEDOVERSTATED


How the AJE is made depends on how receipt of the $900 payment was recorded. It could be:Unearned ___ Rev.

___ Revenue

This entry increases net income—without it, net income will be UNDERSTATEDUNDERSTATED


Adjusting Entries

Cash received, but not yet earned This AJE increases

liabilities; without it, liabilities will be UNDERSTATEDUNDERSTATED



This entry reduces net income—without it, net income will be OVERSTATEDOVERSTATED



Revenues earned, but cash not received


Adjusting Entries




Expenses incurred, but not paid


Adjusting Entries



On Sept. 1, NewCo, a calendar year company, purchases a 1-year insurance policy for $600.


Adjusting Entries

Expenses paid, but not yet incurred Prepaid Ins.

CashInsurance Exp.

Cash600600

600600

The $600 paid on Sept. 1 can be recorded in two ways:




Adjusting Entries


9/1 12/31 8/31

The $600 paid on Sept. 1 can be recorded in two ways:Prepaid Ins.

Cash 600600 Insurance Exp.

Cash 600600




Adjusting Entries


Prepaid Insurance

Insurance Expense

400200

6009/1200 200



200 400


Adjusting Entries


Prepaid Insurance

Insurance Expense

6009/1200 200



Insurance ExpensePrepaid Insurance

200200


Adjusting Entries


Prepaid Insurance

Insurance Expense

400200

6009/1400 400



200 400Insurance ExpenseMastering Adjusting Entries

Adjusting Entries


Prepaid Insurance

Insurance Expense

6009/1400 400

400400



Prepaid Insurance


Adjusting Entries

____ ExpensePrepaid Exp.

Prepaid Exp.____Expense

This is the AJE if the payment was recordedin a asset account

This is the AJE if the payment was recorded in an expense account



How the AJE is made depends on how the $600 payment was recorded. It could be:


Adjusting Entries


This AJE reduces net income . . .

. . . and reduces assets

This AJE increases assets . . .

. . . and increases net income


Prepaid Exp.____ExpenseExpenses

paid, but not yet incurred



Adjusting Entries


Prepaid Exp.____ExpenseExpenses

paid, but not yet incurred




Adjusting Entries

This AJE increases expenses—without it, net income will be OVERSTATED

It also reduces assets—without it, assets will be OVERSTATEDOVERSTATED






Adjusting Entries

This entry increases assets—without it, assets will be UNDERSTATED


It also reduces expenses —without it, net income will be UNDERSTATED



Prepaid Exp.____Expense


ExpenseLiability

AssetRevenue

ExpenseAsset

AssetExpense

LiabilityRevenue

RevenueLiability

Basic Adjustments--Summary

Expenses are understated and net income is overstated.

Expenses are understated and net income is overstated.

Liabilities are understated.

Expenses are overstated and net income is understated.

Revenues and net income are understated.Assets are understated.

Assets are overstated.

Assets are understated.

Liabilities are understated.

Liabilities are overstated. Revenues and net income are understated.

Revenues and net income are overstated.

AJEType of

Adj. Financial Statement Effect if AJE not Made

AccruedExpense

AccruedRevenuePrepaidExpense

DeferredRevenue


Adjusting EntriesIn addition to the AJEs needed for routine accruals and deferrals, there are other end-of-period adjusting entries, including: depreciation expense bad debt expense


Depreciation ExpenseThe AJE to recognize depreciation for the period is:

Depreciation ExpenseAccumulated Depreciation

xxxxxx

This entry increases expenses. It also reduces assets because the year-end balance in Accumulated Depreciation is subtracted from the related asset account to arrive at that asset’s net book value.

Straight-line depreciation expense is calculated as follows:

Annual depreciation expense


Depreciation Expense

Cost - Residual valueEstimated useful life

(in years)

=

25,000



Cost Residualvalue

Estimateduseful life

= Annual depreciation expense

6

$4,000Each year, Patco will make the following adjusting entry:

Depreciation ExpenseAccumulated Depreciation

4,0004,000

1,000

PatCo purchases for its business equipment that costs $25,000. PatCo estimates that the equipment will have a useful life of 6 years and, at the end of its life will have a residual value of $1,000.



Each year, the balance in Accumulated Depreciation increases as follows:

At the end of Year 3, PatCo will report on its balance sheet:

EquipmentAccumulatedDepreciation

25,000 4,000 Yr 14,000 Yr 24,000 Yr 3

12,000

25,00012,00013,000

Equipment - At CostLess: Accumulated DepreciationEquipment (net)


Bad Debt ExpenseThe matching principle requires an attempt to match costs with the revenues that the costs helped produce.One application of the matching principle is bad debt.The matching principle requires companies to estimate bad debt (a cost), then match the bad debt to its related noncash sales (revenue).


Bad Debt ExpenseThe entry to record bad debt expense is:

Bad Debt ExpenseAllowance For Doubtful Accounts

xxxxxx

This entry reduces income and reduces assets (the credit to Allowance For Doubtful Accounts is subtracted from Accounts Receivable).

35,000 4,20030,800

Accounts ReceivableLess: Allowance For Doubtful AcctsNet Realizable Value

The difference between the ending balances in Accounts Receivable and Allowance For Doubtful Accounts is the net realizable value.


Estimating Bad Debt ExpenseBad debt for book purposes can be estimated in either of two ways:1. as a percentage of credit sales; or2. as the percentage of accounts receivable that

the company estimates it will not be able to collect.

= 4,000


Estimating Bad Debt Expense

Driscoll Co. estimates that each year 2% of its credit sales will be uncollectible. Credit sales for 20X8 are $200,000.

1. As a percentage of credit sales. A firm estimates the percentage of credit sales percentage of credit sales it will not collect and each year takes that amount as bad debt expense.

Bad Debt ExpenseAllowance For Doubtful Accounts

4,0004,000

200,000

2%

×The adjusting entry to record bad debt expense for 20X8 is:



Note that when using the percentage of credit sales method, the balance in Allowance For Doubtful Accounts is irrelevant to the AJE.

1. As a percentage of credit sales. A firm estimates the percentage of credit sales percentage of credit sales it will not collect and each year takes that amount as bad debt expense.


Estimating Bad Debt Expense2. As a percentage of A/R estimated to be uncollectible. At year-end, the balance in Allowance account is adjusted to reflect the percentage of accounts receivable estimated to be uncollectible.

Potage’s A/R has a year-end balance of $20,000. It estimates that 3% of this amount will be uncollectible. The Allowance For Doubtful Accounts currently has a $400 credit balance.

20,0003%

= 600

400

×

So, the Allowance account must be adjusted to end with a $600 credit balance.

Allowance For Doubtful Accounts

600

currentbalance



Potage’s A/R has a year-end balance of $20,000. It estimates that 3% of this amount will be uncollectible. The Allowance For Doubtful Accounts currently has a $400 credit balance.

400


600200 adjustment

Bad Debt Exp.Allowance

200200

2. As a percentage of A/R estimated to be uncollectible. At year-end, the balance in Allowance account is adjusted to reflect the percentage of accounts receivable estimated to be uncollectible.



x,xxx


x,xxxx,xxx

(based on calculation)

2. As a percentage of A/R estimated to be uncollectible. At year-end, the balance in Allowance account is adjusted to reflect the percentage of accounts receivable estimated to be uncollectible.



2,5005,500

3,0005,500 5,500

Bad DebtExpense


StoreCo’s Accounts Receivable currently has a balance of $50,000. Its Allowance account has a $3,000 debit balance. StoreCo estimates that 5% of accounts receivable will be uncollectible.

Allowance For Doubtful AccountsBad Debt Expense 5,500

5,500

($50,000 × 5%)



2,500

3,000


StoreCo’s Accounts Receivable currently has a balance of $50,000. Its Allowance account has a $3,000 debit balance. StoreCo estimates that 5% of accounts receivable will be uncollectible.


Estimating Bad Debt ExpenseOnce a customer’s account is deemed uncollectible, it is taken off the books:

Allowance For Doubtful AccountsAccounts Receivable

xxxxxx

This entry has no effect on total assets because it reduces Accounts Receivable and its offsetting Allowance account by the same amount.


Tips on Adjusting Journal EntriesEvery AJE must include at least: one income statement account (revenue or

expense) and one balance sheet account (asset or liability)

Never cash!


The Chart of AccountsCompanies generally number GL accounts. Each category of accounts is given a series of numbers. For example:Assets 100 – 199Liabilities 200 – 299Owners Equity 300 – 399Revenue 400 – 499Expense 500 - 599


Normal BalancesAll accounts have a normal balance − e.g., for A/R a debit balance is normal.The normal balance is the side (debit or credit) on which an increase is recorded.

For example, to increase Cash, you debit it, so Cash normally has a debit balance. To increase Revenue, you credit it, so Revenue normally has a credit balance.


Normal BalancesAssets Liabilities

Owners’Equity

increases increases increases

Revenues Expensesincreases increases

normalbalance

normalbalance

normalbalance

normalbalance

normalbalance


AccountCashAccounts ReceivableInventoryPrepaid RentAccumulated DepreciationAccounts PayableUnearned RevenueEquipmentCost of Goods SoldRent ExpenseSales RevenueOwner, CapitalAllowance For Doubtful AccountsLandBuilding

Normal Balances: ExerciseAccount

typeNormal bal.Debit Credit

Asset DRAsset DRAsset DRAsset DRAsset CR

Liability CRLiability CRAsset DR

Expense DRExpense DRRevenue CR

O/E CRAsset CRAsset DRAsset DR


The first step in the trial balance is the unadjusted trial balance.

The Worksheet

Trial balanceAccounts Dr Cr

Under Accounts, list each account title. Under Trial balance, enter that account’s balance in the appropriate column.


Under Adjustments enter any end-of-period adjustment to the account—an accrual, deferral or other adjustment.

Trial balanceAccounts Dr Cr Dr Cr

Adjustments

The Worksheet


Under Adjusted trial Balance, enter the adjusted account balance (i.e., including any accrual, deferral or other adjustment).

Trial balanceAccounts Dr Cr Dr Cr Dr Cr

Adjustments Adjusted TB


Cash 3,000Accounts Receivable 2,200Supplies 2,000Prepaid Insurance 2,400Land 18,000Office Equipment 1,800Accounts Payable 1,900Unearned Rent 300Bert Weems, Capital 24,000Bert Weems, Drawing 3,000Fees Earned 15,300Wages Expense 4,275Rent Expense 2,600Supplies Expense 800 Uti l i t ies Expense 985 Insurance Expense 440

Account Title Debit Credit Debit Credit Debit Credit

Adjusted Trial balance Adjustments trial balance

FunkytimeWorksheet

For the year ended July 31, 2009

The first step it is the unadjusted trial balance

Example: Supplies Expense must be adjusted to show that only $400 worth of supplies are on hand at year end.

1,600

1,600

minus

plus

400

2,400

41,500 41,500


Cash 3,000Accounts Receivable 2,200Supplies 2,000 1,600 400Prepaid Insurance 2,400Land 18,000Office Equipment 1,800Accounts Payable 1,900Unearned Rent 300Bret Weems, Capital 24,000Bret Weems, Drawing 3,000Fees Earned 15,300Wages Expense 4,275Rent Expense 2,600Supplies Expense 800 1,600 2,400Uti l i t ies Expense 985 Insurance Expense 440



FunkytimeWorksheet


41,500 41,500

Example: The 12- month insurance policy was purchased on June 1.

400

400

minus

plus

2,000

840


Cash 3,000Accounts Receivable 2,200Supplies 2,000 1,600 400Prepaid Insurance 2,400 400 2,000Land 18,000Office Equipment 1,800Accounts Payable 1,900Unearned Rent 300Bret Weems, Capital 24,000Bret Weems, Drawing 3,000Fees Earned 15,300Wages Expense 4,275Rent Expense 2,600Supplies Expense 800 1,600 2,400Uti l i t ies Expense 985 Insurance Expense 440 400 840



FunkytimeWorksheet


When all the adjustments are entered in the Adjustments columns, the new balances are entered in the Adjusted trial balance columns


Cash 3,000 3,000Accounts Receivable 2,200 2,200Supplies 2,000 1,600 400Prepaid Insurance 2,400 400 2,000Land 18,000 18,000Office Equipment 1,800 1,800Accounts Payable 1,900 1,900Unearned Rent 300 120 180Bret Weems, Capital 24,000 24,000Bret Weems, Drawing 3,000 3,000Fees Earned 15,300 15,300Wages Expense 4,275 375 4,650Rent Expense 2,600 2,600Supplies Expense 800 1,600 2,400Uti l i t ies Expense 985 985Insurance Expense 440 400 840 Wages Payable 375 375Rent Revenue 120 120Depreciat ion Exp. 100 100Accumulated Depr. 100 100



FunkytimeWorksheet


41,500 41,500 2,595 2,595 41,975 41,975


FunkytimeWorksheet



Cash 3,000Accounts Receivable 2,200Supplies 400Prepaid Insurance 2,000Land 18,000Office Equipment 1,800Accounts Payable 1,900Unearned Rent 180Bret Weems, Capital 24,000Bret Weems, Drawing 3,000Fees Earned 15,300Wages Expense 4,650Rent Expense 2,600Supplies Expense 2,400Uti l i t ies Expense 985Insurance Expense 840 Wages Payable 375Rent Revenue 120Depreciat ion Exp. 100Accumulated Depr. 100


Adjusted Income Balance trial balance statement sheet

FunkytimeWorksheet


41,975 41,975

The revenue and expense balances are extended from the Adjusted tr ial balance columns to the Income statement columns, and . . .





FunkytimeWorksheet


41,975 41,975

The asset, l iabil i ty and owner’s equity balances are extended from the Adjusted tr ial balance to the Balance sheet columns.





FunkytimeWorksheet


41,975 41,975

3,0002,200

4002,000

18,0001,800

1,900180

24,0003,000

15,3004,6502,600

2,400 985840

375120

100100

11,575 15,420 30,400 26,555


Fees Earned 15,300Wages Expense 4,650Rent Expense 2,600Supplies Expense 2,400Uti l i t ies Expense 985Insurance Expense 840 Wages Payable 375Rent Revenue 120Depreciat ion Exp. 100Accumulated Depr. 100

15,3004,6502,600

2,400 985840

375120

100100



FunkytimeWorksheet


41,975 41,975 11,575 15,420 30,400 26,5553,845 3,845

15,42015,420 30,400 30,400

As a check, net income is added to the Income statement Debit column and Balance sheet Credit column.

The difference between the Income statement Debit and Credit columns is net income.

mastering adjusting entries

Education

expenses incurredwhen

payment of cash

cash basis accounting

accrual basisyou

accrual basisin

accrual basis accounting

incurredcash basisrevenues

recognition of revenues