CHAPTER 7

ADJUSTING ENTRY

 The Accounting Cycle (steps 5 and 6):

 Prepare and post adjusting entries
 Prepare adjusted trial balance

Transactions:
 External transactions occur between two different entities and are easy to record
because there are always source documents evidencing the transaction
 Internal transactions occur within a single entity and are more difficult to record
because source documents my not always be present

Accounting Principles
 Matching Principle
o Forms the basis of accrual accounting
o States that revenue earned and the costs incurred to produce that revenue
must be recorded in the same period
 Revenue Recognition Principle
o States that revenue must be recognized (recorded) in the period in which it is
earned
 Expense Recognition Principle (same as the matching principle)
o States that expenses must be recorded in the period in which the related
revenue was recognized

Accrual Basis Accounting:

 Accrual vs. Cash Basis Accounting
 Deferred Expenses (prepaid expenses)
 Deferred Revenues (unearned revenues)
 Accrued Expenses (accrued liabilities)
 Accrued Revenues (accrued assets)
 Unbilled vs. unearned revenues

Journalizing adjusting entries

 Always have at least one income statement account (revenue or expense) and one
balance sheet account (asset or liability)
 Never recorded for cash, dividends, capital stock or retained earnings

Effects on the financial statements will be if adjusting entries are omitted

Effect of Omitting Adjusting Entry

Type of Adjusting What Adjusting On Account On Financial
Entry Entry Does Balance Statement
Increase expense Understates Overstates net
Deferred Expenses expense income
Decrease asset Overstates asset Overstates total
assets
Increase revenue Understate revenue Understate net
Deferred Revenues income
Decrease liability Overstate liability Overstate total
liabilities
 Increase expense Understate Overstate net
Accrued Expenses expense income
Increase liability Understate liability Understate total
liabilities
Increase revenue Understate revenue Understate net
Accrues Revenues income
Increase asset Understate asset Understate total
assets
o Understate the amount that is reported on the financial statement is less than
it should be.
o Overstate
- The reported amount is incorrect, and
- The reported amount is more than the true or correct amount.

Depreciation
 All long-lived assets are depreciated except for land
 Depreciation accounts for the decline in usefulness of a long-lived asset over its
useful life
 Systematically records a portion of the cost of a long-lived asset as an expense to
match against the revenue in the accounting period
 Depreciation expense is frequently calculated using the straight-line method
 Adjusting entry for depreciation is always

Depreciation expense xxx

Accumulated depreciation xxx

 The asset account is NOT credited for the decline in value; instead the credit is
recorded in a contra-asset account, accumulated depreciation
 Contra-asset means an account on the asset side of the accounting equation or
balance sheet which has a normal credit balance
 Net Book Value is the balance in the asset account less the balance in the related
accumulated depreciation account

Adjusted Trial Balance:

 Starts with trial balance before adjustments
 Adds or deducts adjusting entries as appropriate
 Forms the basis for preparing financial statements

ADJUSTING ENTRIES

 Adjusting entries are required to record internal transactions and to bring assets and
liability accounts to their proper balances and record expenses or revenues in the
proper accounting period.
 Therefore adjusting entries always affect one income statement account (revenue
or expense) and one balance sheet account (asset or liability).
 Adjusting entries are prepared either when:
o The current unadjusted balance in the account is known and the amount of the
activity to be adjusted is known
o The current unadjusted balance in the account is known and the required
balance after adjustment is known.
 There are two basic types of adjusting entries: Deferrals and Accruals
o Deferral is paying or receiving cash in advance without incurring the expenses
 or earning the revenue.
o Accrual is incurring the expenses and earning the revenue without paying or
receiving cash.

Example #1
J Company has a $1,000 unadjusted balance in the Office Supplies account on
December 31.
Required: What is the proper adjusting entry if Johnson could determine
a. The amount of supplies remaining unused?
b. The amount of supplies actually used?

Solution#1
a. If J Company simply counted the remaining supplies on December 31 and
determined that they had a cost of $450, the Office Supplies account would look like
this:
Office Supplies
Unadjusted Balance 1,000
ADJUSTMENT -> ? Supplies Used
Required Ending Balance 450

The adjustment would be: $1,000 – 450 = $550, the amount used.

Dec. 31 Supplies expense 550

Office Supplies 550

b. If J Company had required employees to fill out a form noting the supplies used
each time they were taken from the supply cabinet, the supplies used would add up
as $550. The Office Supplies account would look like this:

Office Supplies
Unadjusted Balance 1,000
ADJUSTMENT -> 550 Supplies Used
Required Ending Balance ?

The adjustment would be the amount used, $550

Dec. 31 Supplies expense 550

Office Supplies 550

Notice several things about the adjusting entry:

 The entry was the same in both situations.
 The entry was made for the amount of activity or change in the account during the
period.
 The entry included one balance sheet account, Office Supplies and one income
statement account, Supplies Expense.
 The ending balance in the account WAS NOT part of the adjusting journal entry.
Rather, the adjusting entry was recorded to create the proper ending balance in the
account.
 DEFERRED REVENUE AND EXPENSES

 Deferrals occur when cash changes hands prior to when the revenue is earned or
expense is incurred. Recording the revenue or expense is postponed or deferred
until a subsequent economic event has occurred which causes revenue to be earned
or expense to be incurred.
 Deferred Revenues (also referred to as unearned revenue) are initially recorded as a
liability and adjusted at the end of the period for the portion that has been earned.
This occurs when payment is received in advance of performing the service.

Any Date Cash (Cash received in advance)

Unearned
Revenue

Dec. 31 Unearned Revenue (Amount earned as of year-end)

Fees Earned

 Deferred Expenses (also referred to as prepaid expenses) are initially recorded as

assets and adjusted at the end of the period for the portion that has been used up
or expired.

Any Date Prepaid Insurance (Cost of insurance policy)

Cash

Dec. 31 Insurance Expense (Portion of policy that has expired)

Prepaid Insurance

ACCRUED REVENUE AND EXPENSE

 Accruals occur when revenue is earned or expense is incurred prior to the cash
changing hands. Deferred revenues and deferred expenses have not been
recorded prior to preparing and recording the adjusting entry.
 Accrued Revenues – are revenues that have been earned, but have not been
recorded. Payment has not been received.

Dec. 31 Accounts Receivable (amount earned as of year-end)

Fees Earned

 Accrued Expenses – are expenses that have been incurred and a debt or liability is
owed to a third party; however neither the expenses nor liability have been
recorded.

Dec. 31 Interest Expense (amount earned as of year-end)

Interest Payable
Example #2
The following information is available as of year-end.
a) Unexpired insurance at December 31 $1,500
b) Supplies on hand at December 31 $400
c) Depreciation of building for the year $1,750
d) Depreciation of equipment for the year $5,800
e) Revenue unearned at December 31 $2,000
f) Accrued salaries and wages at December 31 $2,300
g) Fees earned but unbilled on December 31 $4,850

F Company
Trial Balance
December 31
Cash 8,700
Accounts Receivable 20,600
Prepaid Insurance 4,400
Supplies 1,950
Land 45,000
Building 134,500
Accumulated Depreciation-Bldg. 86,700
Equipment 80,100
Accumulated Depreciation-Equip. 61,300
Accounts Payable 7,500
Unearned Revenue 6,000
Capital Stock 15,300
Retained Earnings 54,000
Dividends 8,000
Fees Earned 199,400
Salaries and Wages Expense 70,200
Utilities Expense 23,200
Advertising Expense 18,000
Repairs Expense 11,500
Miscellaneous Expense 4,050
Totals 430,200 430,200

Required: Journalize the adjusting entries and label them as accruals or deferrals,
adding accounts as needed.

Solution #2

a. Deferred Expense
Insurance Expense 2,900
Prepaid Insurance 2,900

b. Deferred Expense
Supplies expense 1,550
Supplies 1,550

c. Deferred Expense
Depreciation Expense-Bldg. 1,750
Accum. Depr.-Equip 1,750
 d. Deferred Expense
Depreciation Expense-Equip 5,800
Accum. Depr.-Equipment 5,800

e. Deferred Revenue
Unearned Revenue 4,000
Fees Earned 4,000

f. Accrued Expense
Wages Expense 2,300
Wages Payable 2,300

g. Accrued Revenue
Accounts Receivable 4,850
Fees Earned 4,850

Example #3

Refer to the data in Example #2.

Required: Determine the adjusted balances of the accounts and prepare an adjusted
trial balance.

Solution #3

F Company
Adjusted Trial Balance
December 31, 20--
Cash 8,700
Accounts Receivable 25,450
Prepaid Insurance 1,500
Supplies 450
Land 45,000
Building 134,500
Accumulated Depreciation-Bldg. 88,450
Equipment 80,100
Accumulated Depreciation-Equip. 67,100
Accounts Payable 7,500
Salaries and Wages Payable 2,300
Unearned Revenue 2,000
Capital Stock 15,300
Retained Earnings 54,000
Dividends 8,000
Fees Earned 208,250
Salaries and Wages Expense 72,500
Utilities Expense 23,200
Advertising Expense 18,000
Repairs Expense 11,500
Depreciation Expense-Equipment 5,800
Depreciation Expense-Bldg. 1,750
Miscellaneous Expense 4,050
 Insurance Expense 2,900
Supplies Expense 1,550
Totals 444,900 444,900

ADJUSTING ENTRIES AND ERRORS

 Failure to journalize and post adjusting entries at the end of the period will cause
multiple financial statement items to be misstated.
 At least one balance sheet account and one income statement account for each
entry not made or incorrectly made.

Example #4

A Company failed to record accrued wages of $5,000 at the end of the period.

Required: a. Determine the adjusting entry that should have been made.
b. Determine which accounts and financial statements would have been
affected by the error.
c. Determine whether the accounts and financial statements would have
been understated or overstated and the amount of the misstatement.

Solution #4

The adjusting entry should have been:

Wages Expense 5,000
Wages Payable 5,000

This entry should have increased wages expense with a debit and increased wages
payable with a credit. Failing to record this entry caused the following errors:

a. Wages Expense will be understated by $5,000, so

b. Total Expenses will be understated by $5,000, so
c. Net Income will be overstated by $5,000, and when closed to RE,
d. Retained Earnings will be overstated by $5,000.
e. Wages Payable will be understated by $5,000, so
f. Total Liabilities will be understated by $5,000

Example #5
At the end of October, the first month of operations, the following selected data were
taken from the financial statements of C Company:

Net Income for October $102,500

Total Assets at October 31 228,750
Total Liabilities at October 31 60,500
Total Stockholders’ Equity at October 31 168,250

The following adjusting entries were omitted at the end of the month:

a. Supplies used during October $800

b. Depreciation of equipment for October $3,000
c. Unbilled fees earned at October 31 $1,200
 d. Accrued wages at October 31 $500

Required: a. Journalize the entries to record the omitted adjustments.

b. Determine the correct amounts for Net Income, Total Assets, Total
Liabilities and Total Stockholders’ Equity as of October 31.

Solution #5

a. Supplies Expense 800

Supplies 800
b. Depreciation Exp.-Equip. 3,000
Accum. Depr.-Equip 3,000
c. Accounts Receivable 1,200
Fees Earned 1,200
d. Wages Expense 500
Wages Payable 500

Net Income Assets Liabilities Equity

Reported Balance 102,500 228,750 60,500
Corrections:
Adjustment (a) -800 -800 --- -800
Adjustment (b) -3,000 -3,000 --- -3,000
Adjustment (c) +1,200 +1,200 --- +1,200
Adjustment (d) -500 --- +500 -500
Corrected Balance 99,400 226,150 61,000 165,150

TRIAL BALANCE

 A Trial Balance is a summary of all account balances in the general ledger. Each
account and its balance (debit or credit) is listed on the trial balance. Total of all
debit account balances must equal the total of all credit debit balances.
 A trial balance is useful in determining whether the general ledger is in balance
(total debits equal total credits). It will not identify errors in the general ledger or in
preparing the trial balance for which debits equal credits or if an entry is not posted
to the general ledger at all.
 Trial balances are typically prepared three times during the accounting cycle:
o Unadjusted which is prepared prior to adjusting entries
o Adjusted which is prepared after adjusting entries and is the basis for
preparing financial statements
o Post-closing which is prepared after closing entries.
 IS
Type of Adjusting Pro- DR or
Account Title or
Entry Forma CR
SFP
1. ACRRUED EXPENSE EXPENSE Utilities Expense Debit IS
LIABILITY Utilities Payable Credit SFP

2. PREPAID EXPENSE ASSET METHOD

--- > ASSET EXPENSE Insurance Expense Debit IS
ASSET Prepaid Insurance Credit SFP

EXPENSE METHOD
ASSET Prepaid Insurance Debit SFP
EXPENSE Insurance Expense Credit IS

3. DEPRECIATION EXPENSE Depreciation Expense Debit IS

CONTRA Accumulated Depreciation Credit SFP
ASSET – Equip.

4. ACCRUED INCOME ASSET Interest Receivable Debit SFP

INCOME Interest Income Credit IS

5. UNEARNED INCOME LIABILITY METHOD

--- > LIABILITY LIABILITY Unearned Rent Income Debit SFP

INCOME METHOD
INCOME Rent Income Debit IS
LIABILITY Unearned Rent Income Credit SFP

6. BAD DEBTS ALLOWANCE METHOD

EXPENSE Bad Debts Expense Debit IS
CONTRA Allowance for Bad Debts Credit SFP
ASSET

or:
EXPENSE Doubtful Accounts Expense Debit IS
CONTRA Allowance for Doubtful Credit SFP
ASSET Accounts

DIRECT WRITE-OFF
METHOD
EXPENSE Bad Debts / Doubtful Debit IS
Accounts Expense
ASSET Accounts Receivable Credit SFP