11

Session threeSession three

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OutlineOutline Adjusting EntriesAdjusting Entries 4 types of Adjusting Entries4 types of Adjusting Entries

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IntroductionIntroduction The purpose of adjusting entries The purpose of adjusting entries is to assign to each accounting is to assign to each accounting period appropriate amounts of period appropriate amounts of revenue & expenserevenue & expense

Are needed at the end of each Are needed at the end of each accounting period to make accounting period to make certain that appropriate amounts certain that appropriate amounts of revenue & expense are of revenue & expense are reported in the company’s income reported in the company’s income statementstatement

44

Adjusting entries assign Adjusting entries assign revenue to the period in which revenue to the period in which they are earned, and expenses they are earned, and expenses to the periods in which related to the periods in which related goods or service are used.goods or service are used.

55

deferrals and accrualsdeferrals and accruals1/2 1/2

deferraldeferral is the postponement of recognition is the postponement of recognition of “an expense already paid but of “an expense already paid but not yet incurred” ornot yet incurred” or

““a revenue already collected but a revenue already collected but not yet earned”not yet earned”

decrease in a balance sheet decrease in a balance sheet account and increase in an income account and increase in an income statement accountstatement account

66

deferrals and accrualsdeferrals and accruals2/2 2/2

accrualsaccruals is the recognition of “an expense is the recognition of “an expense already incurred but unpaid” oralready incurred but unpaid” or

““revenue earned but uncollected”revenue earned but uncollected” increase in both balance sheet and increase in both balance sheet and income statement accountincome statement account

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4 Types of Adjusting 4 Types of Adjusting EntriesEntries1.1.Converting Assets to ExpensesConverting Assets to Expenses

2.2.Converting Liabilities to RevenueConverting Liabilities to Revenue

3.3.Accruing Unpaid RevenueAccruing Unpaid Revenue

4.4.Accruing Uncollected RevenueAccruing Uncollected Revenue

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I. Converting Assets to I. Converting Assets to ExpenseExpense An adjusting entry is made to An adjusting entry is made to allocate a portion of the asset’s allocate a portion of the asset’s cost from the balance sheet to the cost from the balance sheet to the income statement as an expense.income statement as an expense.

This adjusting entry reflects the This adjusting entry reflects the fact that part of the asset has fact that part of the asset has been used up or become an expense been used up or become an expense – during the current accounting – during the current accounting periodperiod

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Adjusting entry is recorded by Adjusting entry is recorded by debiting the appropriate debiting the appropriate expense account and crediting expense account and crediting the related asset account.the related asset account.

Example: Prepaid expenses & Example: Prepaid expenses & entries to record depreciation entries to record depreciation expense.expense.

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SuppliesSupplies April 1, $400 worth of supplies were April 1, $400 worth of supplies were purchased.purchased.

Apr Apr 11 SuppliesSupplies 400400

CashCash 400400

Apr Apr 3030 Supplies ExpenseSupplies Expense 150150

SuppliesSupplies 150150

On April 29 the inventory count shows On April 29 the inventory count shows that $ 250 of supplies are still on hand.that $ 250 of supplies are still on hand.

1111

Prepaid ExpensePrepaid Expense Payments in advance are often made Payments in advance are often made for such items are insurance, rent for such items are insurance, rent and office suppliesand office supplies

Prepaid expenses are assets; they Prepaid expenses are assets; they become expenses only as the goods become expenses only as the goods or services are used up.or services are used up.

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Prepaid TaxesPrepaid Taxes Assume that on April 1 a business made Assume that on April 1 a business made the quarterly property tax payment of the quarterly property tax payment of $600.$600.

Apr Apr 11

Prepaid Property Prepaid Property TaxTax 600600

CashCash 600600

Apr Apr 3030

Property Tax Property Tax ExpenseExpense 200200

Prepaid Property Prepaid Property taxtax 200200

Since the payment covers 3 months, the Since the payment covers 3 months, the tax expense will be $200 per monthtax expense will be $200 per month

1313

Prepaid RentPrepaid Rent Assume that on April 1 a business paid Assume that on April 1 a business paid $1,800 to cover rent for the next three $1,800 to cover rent for the next three monthsmonths

Apr Apr 11 Prepaid RentPrepaid Rent 1,801,80

00

CashCash 1,801,8000

Apr Apr 3030 Rent ExpenseRent Expense 600600

Prepaid RentPrepaid Rent 600600

Since there is a 3 months prepaid involved, Since there is a 3 months prepaid involved, the rent expense for each month is $600the rent expense for each month is $600

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Prepaid InterestPrepaid Interest Assume that the business found it necessary Assume that the business found it necessary to take out a loan of $5,000 for the local to take out a loan of $5,000 for the local bank on April 1. The period of the loan was bank on April 1. The period of the loan was 2 months, with interest of 12% a year.2 months, with interest of 12% a year.

Apr Apr 11 CashCash 4,904,90

00Prepaid InterestPrepaid Interest 100100

Short-term Short-term InvestmentInvestment

5,005,0000Apr Apr

3030 Interest ExpenseInterest Expense 5050Prepaid InterestPrepaid Interest 5050

$5,000 x 12% per year X 2/12 year = $100, then $100/2 months = $50$5,000 x 12% per year X 2/12 year = $100, then $100/2 months = $50

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Insurance PoliciesInsurance Policies Insurance policies also a prepaid Insurance policies also a prepaid expense, this policies provides a expense, this policies provides a service, insurance protection, service, insurance protection, over a specific period of time.over a specific period of time.

As time passes, the insurance As time passes, the insurance policy expires. That is, it is policy expires. That is, it is used up in business operations used up in business operations (expense)(expense)

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Insurance PoliciesInsurance Policies April 1, a business paid a $ 1,200 April 1, a business paid a $ 1,200 premium for 1 year insurance in advance.premium for 1 year insurance in advance.

Apr Apr 11 Prepaid InsurancePrepaid Insurance 1,201,20

00

CashCash 1,201,2000

Apr Apr 3030 Insurance ExpenseInsurance Expense 100100

Prepaid Prepaid InsuranceInsurance 100100

At the end of April, 1/12 of the 1,200 or At the end of April, 1/12 of the 1,200 or 100, has expired (been used up)100, has expired (been used up)

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Depreciation /1Depreciation /1 Means the systematic allocation of Means the systematic allocation of the cost of a depreciable asset to the cost of a depreciable asset to expense over the asset’s useful expense over the asset’s useful life.life.

Depreciable assets (equipment, Depreciable assets (equipment, machineries, building) are physical machineries, building) are physical objects that retain their size and objects that retain their size and shape but that eventually wear out shape but that eventually wear out or become obsolete.or become obsolete.

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Depreciation /2Depreciation /2 Depreciation expense occurs Depreciation expense occurs continuously over the life of the continuously over the life of the asset, in effect, depreciation asset, in effect, depreciation expense is paid in advance when the expense is paid in advance when the asset is originally purchased.asset is originally purchased.

Therefore, adjusting entries are Therefore, adjusting entries are needed to transfer an appropriate needed to transfer an appropriate amounts at the asset’s cost to amounts at the asset’s cost to depreciation expensedepreciation expense

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Assume that machinery costing $15,000 was Assume that machinery costing $15,000 was purchased on February 1, of the current purchased on February 1, of the current year and was effected to last 10 years. year and was effected to last 10 years. With the straight-line method of With the straight-line method of accounting (equal changes each period), accounting (equal changes each period), the depreciation would be $1,500 a year, the depreciation would be $1,500 a year, or $125 per monthor $125 per month

Feb Feb 2727

Depreciation Depreciation Expense:MachineryExpense:Machinery 125125

Accumulated Accumulated Depreciation:MachineryDepreciation:Machinery 125125

MachineryMachinery 15,0015,0000

Less: Accumulated Less: Accumulated Depreciation:MachinerDepreciation:Machineryy

125125 14,8714,8755

2020

II. Converting Liabilities II. Converting Liabilities to Revenueto Revenue Amounts collected in advance Amounts collected in advance don’t represents revenue, don’t represents revenue, because these amounts have not because these amounts have not yet been earned.yet been earned.

Amounts collected from customers Amounts collected from customers in advance are recorded by in advance are recorded by debiting the cash account and debiting the cash account and crediting an unearned revenue crediting an unearned revenue account (deferred revenue)account (deferred revenue)

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The balance of an unearned revenue The balance of an unearned revenue account is considered to be a account is considered to be a liability; it appears in the liability; it appears in the liability section of the balance liability section of the balance sheet, not in the income statement.sheet, not in the income statement.

Adjusting entry consists of a debit Adjusting entry consists of a debit to a liability account (unearned to a liability account (unearned revenue) and a credit to a revenue revenue) and a credit to a revenue account. account.

2222

Unearned RentUnearned Rent Assume that a landlord received $1,800 Assume that a landlord received $1,800 rent in advance ($600 per month) on rent in advance ($600 per month) on April 1.April 1.

Apr Apr 11 CashCash 1,801,80

00

Unearned RentUnearned Rent 1,801,8000

Apr Apr 3030 Unearned RentUnearned Rent 600600

Rent IncomeRent Income 600600 Note: unearned Rent Revenue (unearned rent) is a Note: unearned Rent Revenue (unearned rent) is a liability account an “advance” – it’s not revenue.liability account an “advance” – it’s not revenue.

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Unearned CommissionUnearned Commission Assume that $300 was received and Assume that $300 was received and recorded on April 1 for Sales Commission recorded on April 1 for Sales Commission for 3 months.for 3 months.

Apr Apr 11 CashCash 300300

Unearned CommissionUnearned Commission 300300

Apr Apr 3030 Unearned CommissionUnearned Commission 100100

Earned Commission Earned Commission IncomeIncome 100100

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III. Accruing Unpaid III. Accruing Unpaid ExpenseExpense Recognized expenses that will be Recognized expenses that will be paid in future transactions, paid in future transactions, therefore, no cost has yet been therefore, no cost has yet been recorded in the accounting recorded in the accounting records.records.

At the end of the accounting At the end of the accounting period, an adjusting entry period, an adjusting entry should be made to record any should be made to record any expenses that have accrued but expenses that have accrued but that have not yet been recorded. that have not yet been recorded.

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The adjusting entry consists of The adjusting entry consists of a debit to an expense account a debit to an expense account and credit to a liability and credit to a liability accountaccount

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Accrued SalariesAccrued Salaries Assume that April 30 falls on Tuesday, then, Assume that April 30 falls on Tuesday, then, 2 days of that week will apply to April and 3 2 days of that week will apply to April and 3 days to May. The payroll is $500 per day, days to May. The payroll is $500 per day, $2500 per week. The company pays it’s $2500 per week. The company pays it’s employees every Friday.employees every Friday.

Apr Apr 3030 Salaries ExpenseSalaries Expense 1,001,00

00

Salaries PayableSalaries Payable 1,001,0000May 3May 3 Salaries ExpenseSalaries Expense 1,501,50

00

Salaries PayableSalaries Payable 1,001,0000

CashCash 2,502,5000

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Interest Payable (Accrual of Interest Interest Payable (Accrual of Interest Expense)Expense) Assume that on Nov. 30, 2002, a company barrowed Assume that on Nov. 30, 2002, a company barrowed $4000 from bank by issuing an interest-bearing $4000 from bank by issuing an interest-bearing notes payable. The loan is to be repaid in 3 notes payable. The loan is to be repaid in 3 months (on Feb. 28, 2003), along with interest months (on Feb. 28, 2003), along with interest computed at an annual rate of 9%.computed at an annual rate of 9%.

Nov Nov 3030 CashCash 4,004,00

00

Notes PayableNotes Payable 4,004,0000Dec 31Dec 31 Interest ExpenseInterest Expense 3030

Interest Interest PayablePayable 3030

2828

Feb 28Feb 28 Notes PayableNotes Payable 4,004,0000

Interest PayableInterest Payable 6060Interest ExpenseInterest Expense 3030

CashCash 4,094,0900

To record the repayment of the loan, To record the repayment of the loan, including $90 in interest chargesincluding $90 in interest charges

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IV. Accruing Uncollected IV. Accruing Uncollected RevenueRevenue The term accrued revenue often is The term accrued revenue often is used to describe revenue that has used to describe revenue that has been earned during the period but been earned during the period but that has been recorded prior to that has been recorded prior to the closing date.the closing date.

This adjusting entry consists of This adjusting entry consists of a debit to an account receivable a debit to an account receivable and a credit to the appropriate and a credit to the appropriate revenue account.revenue account.

3030

Accounts ReceivableAccounts Receivable Assume that in April, a service oriented business Assume that in April, a service oriented business entered into an agreement to perform routine entered into an agreement to perform routine maintenance. For a flat fee of $1500 per month maintenance. For a flat fee of $1500 per month payable on the fifteenth (15) of each month.payable on the fifteenth (15) of each month.

Apr Apr 3030

Accounts Accounts ReceivableReceivable 750750

Repair Service Repair Service RevenueRevenue 750750

The business began rendering services on The business began rendering services on April 15 but the first monthly payment April 15 but the first monthly payment will not be received until May 15.will not be received until May 15.

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May May 1515 CashCash 15001500

Accounts Accounts ReceivableReceivable 750750

Repair Service Repair Service RevenueRevenue 750750

The collection of the first monthly fee The collection of the first monthly fee will occur in the next accounting period.will occur in the next accounting period.

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Interest ReceivableInterest Receivable A business holds a note receivable from a A business holds a note receivable from a customer for 10,000. The note, due in 3 customer for 10,000. The note, due in 3 months, bears interest at 12% and was months, bears interest at 12% and was issued on March 1.issued on March 1.

10,000 * 12% per year * ¼ years = $30010,000 * 12% per year * ¼ years = $300

Apr Apr 3030

Interest Interest ReceivableReceivable 100100

Interest IncomeInterest Income 100100

By the end of April, interest for 2 months By the end of April, interest for 2 months has been earned.has been earned.

3333

May May 3030 CashCash 10,30010,300

Notes Notes ReceivableReceivable

10,0010,0000

Interest Interest ReceivableReceivable 200200

Interest Interest IncomeIncome 100100

When the note is settled by the customer When the note is settled by the customer in May, the customer would pay the in May, the customer would pay the principal plus the interest.principal plus the interest.

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1.1. Allocating assets to expense to Allocating assets to expense to reflect expenses incurred during the reflect expenses incurred during the accounting periodaccounting period

2.2. Allocating revenues received in Allocating revenues received in advance to revenue to reflect revenues advance to revenue to reflect revenues earned during the accounting periodearned during the accounting period

3.3. Accruing expenses to reflect expenses Accruing expenses to reflect expenses incurred during the accounting period incurred during the accounting period that are unpaid and unrecordedthat are unpaid and unrecorded

4.4. Accruing revenues to reflect revenues Accruing revenues to reflect revenues earned during the accounting period earned during the accounting period that are uncollected and unrecordedthat are uncollected and unrecorded