Adjusting Entries

Adjusting Entries

A. Time Period Assumption--the economic life of a business is divided into
artificial time periods (a month, a quarter, a year, etc.) so that the
business can assess its financial condition and results of operations
1. Cash-basis Accounting--under cash-basis accounting transactions are
recorded in the period in which cash is received or paid (cash-basis
accounting is not accepted for generally accepted accounting
principles)
2. Accrual-basis Accounting--under accrual-basis accounting transactions
are recorded in the period in which the events occur (accrual-basis
accounting is required for generally accepted accounting principles)
a. Revenue Recognition Principle--under the revenue realization
principle (realization principle) revenue is recognized in the
accounting period in which it is earned
b. Matching Principle--under the matching principle expense is
recognized in the accounting period in which it is incurred

B. Adjusting Entries--adjusting entries are entries made at the end of the
accounting period to ensure that revenues and expenses are recognized in
the correct accounting period
1. Accruals--accruals are adjusting entries that are necessary to record
revenues earned and expenses incurred in the current period that have
not been recognized through daily entries
a. Expenses
1) Accounting--when an accrual for an expense is made, an expense
account is always debited and a liability account is always
credited
2) Illustrations
a) A business has a payroll cost of $5,000 for the 5-day work
week ending January 2 of year 2; the payroll was paid on
January 2 of year 2
Year 1:
December 31:
Salary Expense 3,000
(3/5 x 5,000)
Salaries Payable 3,000

Year 2:
January 2:
Salaries Payable 3,000
Salary Expense 2,000
(2/5 x 5,000)
Cash 5,000

b) A business issued a $1,500, 1-year, 8% note on November 1
of year 1; the note was paid on November 1 of year 2
Year 1:
November 1:
Cash 1,500
Notes Payable 1,500

December 31:
Interest Expense 20
(8% x 1,500 x 2/12)
Interest Payable 20

Year 2:
November 1:
Interest Payable 20
Interest Expense 100
(10/12 x 120)
Notes Payable 1,500
Cash 1,620
(1,500 + 120)

b. Revenues
1) Accounting--when an accrual for a revenue is made a revenue
account is always credited and a receivable account is always
is debited
2) Illustrations
a) A business bills $200 per hour for legal services rendered;
as of December 31 of year 1, 10 hours of legal services
have been performed on a client’s case, but not billed;
during year 2, 5 hours of legal services were performed in
completing the case; the client paid for the legal services
on January 20 of year 2
Year 1:
December 31:
Accounts Receivable 2,000
(10 x 200)
Legal Fees 2,000

Year 2:
January 20:
Cash 3,000
(15 x 200)
Accounts Receivable 2,000
Legal Fees 1,000
(5 x 200)

b) A business received a $1,500, 1-year, 8% note on November 1
of year 1; the note was collected on November 1 of year 2

Year 1:
November 1:
Notes Receivable 1,500
Cash 1,500

December 31:
Interest Receivable 20
(8% x 1,500 x 2/12)
Interest Income 20

Year 2:
November 1:
Cash 1,620
(1,500 + 120)
Interest Receivable 20
Interest Income 100
(10/12 x 120)
Notes Receivable 1,500

2. Deferrals--deferrals are adjusting entries that are necessary to record
the portion of revenue type items that have been collected in advance
that are earned and unearned and the portion of expense type items that
have been paid in advance that are expired and unexpired in the correct
accounting period
a. Expenses
1) Accounting--the necessary adjusting entry will depend upon the
way prepayment of the expense item was originally recorded
a) Asset Account--if the prepayment of the expense item was
originally recorded in as asset account, the amount of the
prepayment that has been used is transferred to an expense
account
I) Depreciation--for buildings, equipment, and similar
assets, the decrease in the asset account is recorded
in a contra account, called accumulated depreciation,
so that valuable information about the original cost
and age of the asset will not be lost
b) Expense Account--if the prepayment of the expense item was
originally recorded in an expense account, the amount of
the prepayment that has not been used is transferred to an
asset account
2) Illustrations
a) On January 1 of year 1 a business purchased supplies in the
amount of $6,000; the supplies were recorded in an asset
account when purchased; on December 31 of year supplies in
the amount of $700 were unused

January 1:
Supplies 6,000
Cash 6,000

December 31:
Supplies Expense 5,300
(6,000 – 700)
Supplies 5,300

b) On January 1 of year 1 a business purchased supplies in the
amount of $6,000; the supplies were recorded in an expense
account when purchased; on December 31 of year supplies in
the amount of $700 were unused
January 1:
Supplies Expense 6,000
Cash 6,000

December 31:
Supplies 700
Supplies Expense 700

c) On April 1 of year 1 a business purchased a 2-year
insurance policy in the amount of $7,200; the insurance
policy was recorded in an asset account when purchased
April 1:
Prepaid Insurance 7,200
Cash 7,200

December 31:
Insurance Expense 2,700
(9 x 7,200 / 24)
Prepaid Insurance 2,700

d) On April 1 of year 1 a business purchased a 2-year
insurance policy in the amount of $7,200; the insurance
policy was recorded in an expense account when purchased
April 1:
Insurance Expense 7,200
Cash 7,200

December 31:
Prepaid Insurance 4,500
(15 x 7,200 / 24)
Insurance Expense 4,500


e) On January 1 of year 1 a business purchased equipment in
the amount of $25,000; the equipment has an estimated
useful life of 5 years
January 1:
Equipment 25,000
Cash 25,000

December 31:
Depreciation Expense 5,000
(25,000 / 5)
Accumulated Depreciation 5,000

b. Revenues
1) Accounting-the necessary adjusting entry will depend upon the
way the collection of the revenue item was originally recorded
a) Liability Account--if the collection of the revenue item
was originally recorded in a liability account, the amount
of the collection that has been earned is transferred to a
revenue account
b) Revenue Account--if the collection of the revenue item
was originally recorded in a revenue account, the amount of
the collection that has not been earned is transferred to a
liability account
2) Illustrations
a) On April 1 of year 1 a business sold a 2-year insurance
policy in the amount of $7,200; the insurance policy was
recorded in a liability account when sold
April 1:
Cash 7,200
Unearned Premiums 7,200

December 31:
Unearned Premiums 2,700
(9 x 7,200 / 24)
Premiums Income 2,700

b) On April 1 of year 1 a business sold a 2-year insurance
policy in the amount of $7,200; the insurance policy was
recorded in a revenue account when sold
April 1:
Cash 7,200
Premiums Income 7,200

December 31:
Premiums Income 4,500
(15 x 7,200 / 24)
Unearned Premiums 4,500
c) On August 1 of year 1 a business sold 3-year subscriptions
to its monthly magazine in the amount of $14,400; the
subscriptions were recorded in a liability account when
sold
August 1:
Cash 14,400
Unearned Subscriptions 14,400

December 31:
Unearned Subscriptions 2,000
(5 x 14,400 / 36)
Subscriptions Income 2,000

d) On August 1 of year 1 a business sold 3-year subscriptions
to its monthly magazine in the amount of $14,400; the
subscriptions were recorded in a revenue account when sold
August 1:
Cash 14,400
Subscriptions Income 14,400

December 31:
Subscriptions Income 12,400
(31 x 14,400 / 36)
Unearned Subscriptions 12,400