ADJUSTING THE ACCOUNTS
The journal entries we will discuss in this chapter are
called adjusting entries. Adjusting entries
are entries required at the end of the accounting period to
bring the accounts to their proper balances before financial
statements are prepared.
THE
NEED FOR ADJUSTING ENTRIES
The income statement of business reports all revenues
earned and all expenses incurred to generate those revenues
during a given period. If the income statement does not
report all revenues and expenses, it is incomplete,
inaccurate, and possibly, misleading,. Similarly, a balance
sheet that does not report all of the entity's assets,
liabilities, and owner's equities at a specific point n time
may be misleading.
Since those interested in the activities of a business
need timely information, financial statements must be
prepared periodically. To prepare such statements, the
accountant arbitrarily divides an entity's accounting
periods. An accounting period may be one month, one quarter,
or one year. An accounting period of one year is called
accounting year, or fiscal year. A fiscal year is any 12
consecutive moths, and it may or may not coincide with the
calendar year, ending December 31.
Periodic reporting necessitates the preparation of
adjusting entries. Adjusting entries are journal entries made
at the end of an accounting period to bring about a proper
matching of revenues and expenses. Adjusting entries reflect
economic activity that has been taken place but has not yet
been properly recorded. Why has this activity not been
recorded by the end of the period? The reason is that either
(1) it is more convenient or economical to wait until the end
of the period to record the activity or (2) no source
documents concerning that activity have yet come to the
accountant's attention.
Adjusting entries bring the accounts to their proper
balances before financial statements are prepared. Adjusting
entries convert the amounts that should be in the accounts
for proper financial reporting. Accountants make this
conversion by analyzing the accounts, determining which one
needs adjustments. For example, assume a three-year insurance
policy costing P1, 800 was purchased at the beginning of the
year and debited to Prepaid Insurance. At year-end, it is
obvious that P600 of the cost should be removed front the
assets and recorded as an expense. Failure to do so misstates
assets and net income on the financial statements.
Events such as the using up of insurance coverage that has
been prepaid is known as continuous event. Most adjusting
entries are the result of continuous events. The need for
adjusting entries is based on the matching
principle. The matching principle requires that
expenses incurred in producing revenues be deducted from the
revenues they generated during the accounting period. This
matching of expenses and revenues is necessary for the income
statement to present an accurate picture of the profitability
of a business.
Benefits from many assets such as prepaid expenses (for
example, prepaid insurance and prepaid rent) are being
received continuously by a company. Thus the expense relating
to these items could also be recognized continuously as time
elapses. An entry could be made frequently, even daily, to
record the expense incurred. Typically, the entry is not made
until financial statements are to be prepared. Therefore, if
monthly financial statements are prepared, monthly adjusting
entries are required. By custom, and in some instances by
law, businesses report to their owners at least once a year.
Remember, however, that the entry transferring an amount form
an asset account to an expense account should transfer only
the cost of the portion of the asset that has expired.
CASH
VERSUS ACCRUAL BASIS ACCOUNTING
Some relatively small business firms and professionals,
such as physicians, lawyers, and accountants, may account for
their revenues and expenses on a cash basis. The cash
basis of accounting recognizes revenues when
cash is received and recognizes expenses when cash is paid.
For example, under the cash basis, services rendered to
clients in 1994 for which cash was collected in 1995 would be
treated as 1995 revenues. Similarly, under the cash basis,
expenses incurred in 1994 for which cash was disbursed in
1995 would be treated as 1995 expenses. Because of these
improper assignments of revenues and expenses, the cash basis
of accounting is generally considered unacceptable. Companies
using cash basis may not have to prepare adjusting entries.
The cash basis is acceptable only under those circumstances
in which the results approximate those obtained under the
accrual basis of accounting.
Throughout the text we use the accrual basis of
accounting. The accrual basis of accounting
recognizes revenues when sales are made or services
performed, regardless of when cash is received. Expenses are
recognized as incurred, whether or not cash had been paid.
For instance, when services are performed for a customer on
account, the revenue is recorded at the time even though cash
has not been received. Later, when the cash is received, no
revenue is recorded because it has already been recorded.
Under the accrual basis, adjusting entries are use to bring
the accounts up-to-date for economic activity that has taken
place but has not yet been recorded. Accurate financial
statements can then be prepared.
An example of economic activity that would require an
adjusting entry is the purchase and gradual use of office
supplies. When office supplies are purchased, they are
recorded in an asset account, Office Supplies. Even though
office supplies are used during the accounting period, the
accountant usually waits until the end of the accounting
period to record their consumption. The cost and nuisance of
making an entry every time a small amount of office supplies
is used outweighs the benefits of having precisely accurate
account balance during the period. Instead, an adjusting
entry is made at the end of the period to bring the accounts
to their proper balances before financial statements are
prepared.
CLASSES
AND TYPES OF ADJUSTING ENTRIES
Adjusting entries can be grouped into two broad classes;
deferred (meaning to postpone of delay) items and accrued
(meaning to grow or accumulate) items. Deferred
items consist of adjusing entries involving
data previously recorded in accounts. These entries involve
the transfer of data already recorded in asset and liability
accounts to expense and revenue accounts. Deferrals are also
defined as the postponement of the recognition of revenue
that is already collected or an expense that is already paid.
Accrued items consist of
adjusting entries relating to activity on which no data have
been previously recorded in the accounts. These entries
involve the initial, or first, recording of assets and
liabilities and the related revenues and expenses. Accruals
also mean the accumulation of revenues and expenses that have
not yet been recorded.
Deferred items include prepaid expenses and unearned
revenues. Accrued items include accrued expenses and accrued
revenues.
PREPAID
EXPENSES
Prepaid expenses are commodities
and services that have been purchased for consumption but are
not consumed at the end of the period. It includes supplies
and advance payment of expenses such as rent, insurance, and
property taxes. The potion of the asset that has been used
during the period will become and expense, the remainder will
become an expense in the future. It is because of this
deferral of benefits that prepaid expenses are sometimes
called deferred charges.
The two methods of accounting for prepaid expenses are the
asset method and the
expense method. When prepaid expenses are
recorded initially as an asset, the asset account is debited
at the date of purchase. When prepaid expenses are recorded
initially as an expense, the expense account is debited at
the date of purchase.
The prepaid expense is analyzed at the end of the period
to determine the expired portion and the unexpired portion.
The appropriate adjusting entries are made. In summary form,
the methods of recording prepaid expenses are as follows:
To illustrate, assume that the company had
purchased supplies of P2, 500 for cash. An inventory of
supplies at the end of the period amounts to P1, 150. The
entry to record (a) the purchase of supplies and (b) the
adjusting entry at the end of the period will be:
The effects of these entries are illustrated
in the following T-accounts:
Another type of prepaid expense is prepaid
insurance. To illustrate, assume that on May 1, the company
paid P1, 500 for a one year fire insurance premium. The
company closes its books on December 31.
Computations:
P1, 500 insurance for one year/12 months = P125 insurance for one month.
P125 X 8 months (May – December) = P1, 000 expired insurance.
P1, 500 – 1, 000 = P500 unexpired insurance.
The effect of these entries may be reflected in the
following T-accounts:
Regardless of which method is employed to any
particular case, the amount that is reported as expense in
the income statement, and the amount that is recorded as an
asset in the balance sheet will be the same. To avoid
confusion and waste of time, the method adopted for each
particular type of prepaid expense should be consistently
followed from year to year.
Unearned Revenue
Revenue received in advance that represents a
liability is called unearned revenue.
The portion of the liability that is discharged during the
period through delivery of goods or services has been earned:
the remainder will be earned in the future. It is because of
this deferment that unearned revenue are frequently called deferred
credits. For example, magazine publishers
ordinarily received advance payment for subscriptions
extending to periods ranging from a few months to a number of
years. At the end of the accounting period, the portion of
receipts applicable to future periods has not been earned and
should appear in the balance sheet as a liability. The
liability account may be called Unearned Revenue, Revenue
Received in Advance, Advances by Customers, or some similar
titles. The earned potion appears in the income statement.
As in the case of prepaid expenses, there are
two methods of recording unearned revenue; the liability
method and the revenue method.
Under the liability method, a liability account is credited
when revenue is received in advance. In the revenue method, a
revenue account is credited when revenue is received. At the
end of the accounting period, the amount earned and unearned
is computed to determine the proper adjusting entry.
To illustrate, assume that the company
received P9, 000 cash from a tenant as advance payment of
rent for six months beginning September 1. The books are
closed on December 31.
Computations:
P9, 000 rent for six months/6 = P1, 500 rent for one month
P1, 500 x 4 months (September to December) = P6, 000 earned rent
P9, 00o0 – 6, 000 = P3, 000 unearned rent
The effect of these entries may be reflected
in the following T-accounts:
As was explained in connection with prepaid
expenses, the results obtained are the same under both
methods. The method adopted for each particular kind of
unearned revenue should constantly be followed from year to
year.
Depreciation of Plant Assets
Just as prepaid insurance and prepaid rent
indicate gradual using up of a previously recorded asset, so
does depreciation. However, the overall period of time
involved in using up a depreciable asset such as buildings,
for example, is much longer and less definite than for
prepaid expenses. A prepaid expense generally involves a
fairly small amount of money; depreciable asset usually
involves larger sums of money.
A depreciable asset
is a man-made asset such as a building, machine, vehicle, or
piece of equipment that provides service to a business. Since
these assets are gradually used up over time, depreciation
expense is recorded on them. Depreciation expense
is the amount of asset cost assigned as an expense to a
particular time period. The process of recording depreciation
expense is called depreciation accounting.
Three factors involved in the
computation of depreciation expense:
1. Asset cost – is the amount a
company paid to purchase the depreciable asset.
2. Estimated residual value – is the amount that the
asset can probably be sold for at the end of its
estimated useful life. The other terms used for residual
value are salvage value, scrap value, and trade-in value.
3. Estimated useful life – is the estimated number
of time periods that a company can made use of the
assets. Useful life is not estimate, not an exact
measurement that must be made in advance.
The equation for determining the amount of
depreciation expense for each time period is:
Asset Cost - Estimated Residual Value = Depreciation Expense for each time period
Estimated Useful Life
Accountants use different methods for recording
depreciation. The method illustrated here is known as the straight-line
method. Straight-line depreciation assigns the
same amount of depreciation expense to each accounting period
over the life of the asset. To illustrated the use of the
formula, assume that on the Jan. 1, the company purchased
equipment at a cost of P7, 200. The estimated salvage value
of this equipment was P600, and estimated useful life is 10
years. The annual depreciation on the equipment is:
P7, 200 – P600 = P600 annual depreciation
10 years
The amount of depreciation for one month would be 1/12 of
the annual amount. Thus, depreciation expense for January is
P55. The difference between an asset's cost and its salvage
value is sometimes referred to as an asset's depreciable
amount. The depreciable amount must be
allocated as an expense to the various periods in the asset's
useful life to satisfy the matching principle.
The depreciation on the equipment for January is recorded
as follows:
Jan 31 Depreciation Expense – Equipment 55
Accumulated Depreciation – Equipment 55
Depreciation expense is reported in the income statement.
Accumulated depreciation
The accumulated depreciation account
is reported in the balance sheet as a deduction from the
related asset. The accumulated depreciation account is contra
account that shows the total of all depreciation recorded on
the asset up through the valance sheet date. A contra asset
is a deduction from the asset to which it relates in the
balance sheet. The purpose of contra asset account is to
reduce the original cost of the asset down on its
undepreciated cost of book value. The debit balance in the
asset account (original cost) minus the credit balance in the
accumulated depreciation account equals the undepreciated
cost or the book value of the asset. Book value is the cost
net yet allocated to an expense.
Depreciation Expense for each time period Depreciation is
credited to an accumulated depreciation account instead of
directly to the asset because recorded amounts are correct.
To provide more complete balance sheet information to users
of the financial statements, both original acquisition cost
and accumulated depreciation are shown. For example, on
January 31, 19A balance sheet, the accumulated depreciation
is shown as a deduction of the asset equipment:
Equipment P7, 200
Less: Accumulated Depreciation 55
P7, 145
The accumulated depreciation account balance increases
each period by the amount of depreciation expense recorded
until it finally reached the amount equal to the original
cost of the asset less estimated salvage value.
Accrued
Expenses(Liabilities)
Some expenses accrue from day to day but are ordinarily
recorded only when they are paid. The amounts of such items
accrued but unpaid at the end of the fiscal period are both
an expense and a liability, hence, the accrual may be
referred to as an accrued liability, an accrued
payable, or an accrued expense.
The most common example of accrued expense is
the accrued salaries. For companies paying their employees
every end of the week instead of the end of the month, they
usually have accrued salaries since the end of the week
normally do not coincide with the end of the month. For
example, assume that the company pays a total of P1, 200
every Saturday. The T-account representing payment of
salaries during the month of January would be like this.
If January 28 is a Saturday, then the last day of the
month (Jan. 31) falls on a Tuesday, as shown in the following
diagram:
If financial statements are to be made on
January 31, the balance of the salaries expense account will
be understated because salaries recorded is only up to Jan.
28. The entry required to up-date the salaries expense
account will be:
Jan 31 Salaries Expense 400
Salaries Payable 400
The debit in the adjusting entry brings the month's
salaries expense up to its correct P5, 200 amount for income
statement purposes. The credit to salaries payable records
the P400 salary liability to employees. The salaries payable
is shown as a liability in the balance sheet.
Accrued
Assets (Revenues)
Accrues assets are assets that exist at the end of the
accounting period that have not yet been recorded. These
assets represent rights to receive future payments that are
not legally due at the balance sheet date. To present an
accurate picture of the affairs of the business on the
balance sheet, these rights must be recognized at the end of
the accounting period by preparing an adjusting entry to
correct the account balances. An example of this type of
adjustment would be revenues earned that have not been billed
or collected. To indicate the dual nature of these
adjustments, in addition to the asset recorded, the related
revenue must also be recorded. Because the revenue must also
be recorded, this adjustment may also be called accrued
revenue.
Services may be performed for customers in one accounting
period while the billing for those services takes place in
different accounting period.
Assume that the company performed P 2, 500 of services on
account for a client in the last few days of January. Because
it takes time to do the paper work, the client will be billed
for the services in February. The necessary adjusting journal
entry at January 31 is:
Jan 31 Accounts Receivable 2, 500
Service Revenue 2, 500
The service revenue appears in the income statement, and
the asset, accounts receivable appears on the balance sheet.
