Adjusting Entries

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Adjusting Entries
Principles of Accounting
Help Lesson 4
By Laurie L. Swanson This presentation is under
development.
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Adjusting Entries
Adjusting Entries bring certain account balances
up to date at the end of the accounting period.
12/31/2010 UPDATE
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Adjustments
Adjusting entries are required when changes in
certain accounts have not been recorded in the
accounting records.
Adjustments are necessary for items that have
either been deferred or accrued.
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Reason for Adjustments
It can be inefficient and costly to account for
certain types of transactions on a daily basis.
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Reason for Adjustments
An example of the inefficiency of recording
certain transactions follows Each time an
employee removes a pen from the supplies closet,
a journal entry debiting Supplies Expense and
crediting Supplies for 1.25 (estimated cost of
pen) should be recorded. However, it would be
very costly and inefficient to try to keep up
with each little transaction like this. So
instead, we wait until the end of the accounting
period and determine the total amount of supplies
used. Then we make one adjusting entry to
account for all the supplies used during the
period.
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Adjusting Entries
Adjusting Entries are necessary when accrual
basis accounting is used. Adjusting entries
allow businesses to adhere to the Matching
Principle.
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Accrual Basis Accounting
Under accrual basis accounting, revenues are
recognized when earned (regardless of whether
cash has been received) and expenses are
recognized when incurred (regardless of cash
payment).
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The Matching Principle

• The Matching Principle states that expenses
  should be matched together with the income they
  produced in the same time period.

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Characteristics of Adjustments
Adjusting entries will always have the following
characteristics

• Adjusting entries are internal transactionsno
  new source document exists for the adjustment.
• Adjusting entries are non-cash transactionsthe
  Cash account will never be used in an adjusting
  entry.
• Adjusting entries will always involve at least
  one income statement account and one balance
  sheet account.

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How to Analyze an Adjusting Entry
When analyzing an adjusting entry, look for the
item that has not been recorded but should have
been. This information is often not explicit and
must be inferred from the data given.
For expenses, look for the amount used. For
revenue, look for the amount earned.
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Analyzing an Adjusting EntryAn Example
You have the following data about an adjustment
Prepaid 15,000 for 12 months of insurance on
Sept 1 of the current year. Make the appropriate
adjustment as of the end of the fiscal period.
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Analyzing an Adjusting EntryAn Example
Original Entry On Sept 1 the following entry
would be recorded when the insurance was
prepaid Prepaid Insurance 15,000 Cash 15,0
00 Prepaid Insurance is an asset account it is
an amount owned by the company that has economic
value.
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Analyzing an Adjusting EntryAn Example
Each month, a portion of the prepaid insurance
expires. At the end of the fiscal period, the
Prepaid Insurance and Insurance Expense accounts
must be updated for the insurance that has
expired (been used).
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Analyzing an Adjusting EntryAn Example

• Lets divide the analysis of this transaction
  into two parts
• What accounts are involved?
• When something is used up it indicates an
  expense account. In this case, we need to debit
  Insurance Expense for the expired insurance.
  Furthermore, the asset, Prepaid Insurance, has
  decreased so we will credit this asset.
• What is the amount of the adjustment?
• See the next slide for the calculation of the
  amount of expired insurance.

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Analyzing an Adjusting EntryAn Example
15,000 for 12 months 1,250/month
(15,000/12) ------- Policy purchased on Sept 1.
Months that have expired between purchase and
fiscal year-end 4 (Sept, Oct, Nov, Dec) Amount
of adjustment 5,000 (1,250/month X 4 months)
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Record the Adjustment
Adjusting entries are always recorded on the last
day of the fiscal period. For our example, the
fiscal period closes on Dec 31. The adjustment
is journalized as follows
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Analyzing an Adjusting EntryAnother Example
Lets try another example. You have the
following data about an adjustment
You received 12,000 advance cash on November 1
for a painting job you are to complete over the
next three months.
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Analyzing an Adjusting EntryAnother Example
Original Entry On November 1, Cash would be
debited and a liability account called Unearned
Painting Revenue would be credited. The liability
account is credited because you owe the customer.
You owe the customer painting services.)
Cash 12,000 Unearned Painting Rev 12,000
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Analyzing an Adjusting EntryAnother Example
Each month as you perform painting services, you
are earning a portion of the unearned revenue.
At the end of the fiscal period, the Unearned
Painting Revenue and Painting Revenue accounts
must be updated for the revenue that has now been
earned.
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Completing the Adjustment
We have performed step 1 of the analysis the
accounts involved are Unearned Painting Revenue
(a liability) and Painting Revenue (a revenue).
So far, the adjusting entry looks as follows
Note that as we perform the services owed, the
liability decreases (this is accomplished by
debiting Unearned Painting Revenue) and the
revenue earned increases (this is accomplished by
crediting Painting Revenue).
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Step 2 What amount is Used in the Adjustment?
12,000 for 3 months 4,000/month
(12,000/3) ------- Cash advance received on
November 1. Two months of work have been
completed by the fiscal year-end (Nov and
Dec) Amount of adjustment 8,000 (4,000/month
X 2 months)
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Complete the Adjusting Entry
Now fill in the amount of the adjustment
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Next Step
You are now closer to completing the accounting
cycle. You can continue to practice adjusting
entries by choosing the Adjusting Entries
Practice presentation.
The next step in the accounting cycle is to
prepare an Adjusted Trial Balance.