DEMONSTRATION PROBLEM
Adjusting Entry for Prepaid Insurance
An example of an expense that is typically paid in advance is insurance. Insurance
policies are paid at the beginning of a policy period. This outlay of cash is recorded in
Prepaid Insurance—an asset account. The portion of the insurance coverage that has
expired by the end of the accounting period must be transferred to an expense
account.
Graphically, this can be illustrated as follows:
New Data
Asset: Prepaid
Insurance
Expense: Insurance
Expense
Amount of Insurance
Coverage Expired
For example, on December 1, Atherton Plumbing purchased a 6-month insurance
policy for $600. As of December 31, one month (or $100) of that coverage had
expired.
Original
Entry:
Prepaid Insurance………
Cash………….…
600
Adjusting
Entry:
Insurance Expense……...
Prepaid Insurance
100
600
100
The T-accounts follow.
Prepaid Insurance
12/1
600
Adj. 100
Bal.
Insurance Expense
Adj. 100
500
The T-accounts show that the $500 (or 5 months) of insurance coverage that has not
expired is carried as the balance in the prepaid insurance account.
Adjusting Entry for Supplies
Another asset that must be adjusted at the end of the accounting period is the supplies
account. All supplies are recorded in the supplies account as they are purchased. By
the end of the accounting period, some of the supplies will have been used. The
supplies used must be taken out of the supplies account and transferred to an expense
account.
Graphically, this can be illustrated as follows:
New Data
Asset: Supplies
Expense: Supplies
Expense
Amount of Supplies
that Have Been Used
For example, on December 5, Atherton Plumbing purchased $250 in supplies. As of
December 31, only $50 worth of those supplies were left.
Original
Entry:
Supplies………….….
Cash…………
250
250
Adjusting
Supplies Expense……
200
Entry:
Supplies……..
(NOTE: $200 represents the supplies used)
200
The T-accounts follow.
Supplies
12/5
250
Bal.
50
Supplies Expense
Adj. 200
Adj. 200
The T-accounts show that the balance of the supplies account is $50—the amount of
supplies left.
To illustrate why businesses typically count the amount of supplies left at the end of
the month and use that information to determine the cost of supplies used, ask your
students the following question:
What is the easiest way to determine how many miles you have driven your
car this month? Answer: record the beginning and ending odometer readings.
This is easier than writing down the miles driven each time the car is used.
Adjusting Entry for Unearned Revenue
If payment for goods or services is received before the goods are delivered or the
service is performed, it cannot be recognized as revenue. Revenue can be recorded
only after it is earned. Therefore, when payment is received in advance, it is recorded
in an unearned revenue account. This is a liability account. By receiving payment, the
company has obligated itself to deliver the goods or provide the services for which it
was paid. This obligation is expressed in the accounting records as a liability. If a
portion (or all) of the revenue has been earned by the end of the accounting period,
some (or all) of the unearned revenue is transferred to a revenue account.
Graphically, this can be illustrated as follows:
New Data
Liability: Unearned
Revenue: Fees
Earned
Revenue
Amount of Revenue
(or
other revenue
that Has Been Earned
earned
account
as
appropriate)
For example, on November 2, Huber Rental Properties received 3 months' rent,
totaling $2,400, in advance for one of its commercial properties. As of December 31,
2 months' worth of this rent had been earned.
Original
Entry:
Cash…………………….
Unearned Rent….
2,400
Adjusting
Entry:
Unearned Rent………….
Rent Income…….
1,600
2,400
1,600
The T-accounts follow.
Unearned Rent
Adj. 1,600
Rent Income
11/2 2,400
Bal.
Adj. 1,600
800
The T-accounts show that the balance of the unearned rent is equal to the one month's
rent that has not been earned—$800.
You will probably need to stress that “unearned” rent is a liability on the balance
sheet; “earned” rent is revenue on the income statement.
Adjusting Entry for Accrued Expenses
Any expenses that a business has incurred must be recorded before preparing financial
statements, in order to get a true measure of profitability. The act of recording
expenses that have not been paid is called accruing expenses.
One common example is wages paid to employees. Many organizations pay their
employees on Friday. Wages expense is generally recorded only when wages are paid.
Therefore, if the accounting period ends on a day other than payday, the employees
will have earned wages that have not been recorded as an expense. These wages must
be accrued.
Graphically, this can be illustrated as follows:
New Data
Expense: Wages Expense
Amount of Wages
that Employees Have
Earned
Liability: Wages Payable
For example, assume that December 31 is a Wednesday. On that date, Huber Rental
Properties owes $500 in wages to employees. These wages will be paid on Friday, the
usual payday.
Original
Entry:
None
Adjusting
Entry:
Wages Expense………….
Wages Payable…..
500
500
The T-accounts follow.
Wages Expense
Adj. 500
Wages Payable
Adj. 500
Adjusting Entry for Accrued Revenues
Any revenue that a business has earned must be recorded before preparing financial
statements in order to get a true measure of profitability. The act of recording
revenues that have not been received is called accruing revenues.
One example of accrued revenue is interest. Assume that a company charges its
customers interest whenever they ask for more than 30 days to pay for a credit
purchase. The interest is paid at the same time as the receivable. At the end of an
accounting period, that company may have earned interest that it has not received,
since the customer has not paid the account. That interest must be recorded in a
revenue account (to show it has been earned) and a receivable account (to show it will
be received in the future).
Graphically, this can be illustrated:
New Data
Revenue: Interest Income
Amount of Interest
that Has Been Earned
Asset: Interest Receivable
For example, Atherton Plumbing granted a customer additional time to pay an
invoice; however, the customer must pay interest at a rate of 10% annually. At the end
of the accounting period, the interest that has accumulated totals $80.
Original
Entry:
None
Adjusting
Entry:
Interest Receivable…………..
Interest Income………
80
80
The T-accounts follow.
Interest Receivable
Adj.
80
Interest Income
Adj. 80
Other examples of accrued revenues would be commissions earned by a travel agent
but not billed or fees earned by an attorney but not billed. You could also illustrate
the concept of accrued revenue by asking your students to estimate any wages they
have earned that have not been paid as of today.
Adjusting Entry for Depreciation
Read the following scenario to your class:
Assume that your car needs four new tires. One set of tires you are considering
costs $200. The manufacturer estimates that these tires will last 20,000 miles.
Since you drive about 10,000 miles per year, that equates to 2 years.
Another set of tires costs $300. These tires should last 40,000 miles or 4 years.
Assuming that you plan to keep your car at least another 4 years, which set of
tires is the best deal? Why?
The $200 set of tires will cost the driver $100 per year. The $300 set will cost
only $75 per year. Therefore, the $300 set is a better value in the long run.
It is common to break the cost of a long-term asset into a cost per year or a cost per
month when evaluating whether or not to purchase the asset. Allocating the cost of an
asset (such as the tires) to the years it is used makes it easier to determine the yearly
expense of owning the asset. The cost of owning the $300 set of tires is $75 per year.
The accrual basis of accounting requires business owners to allocate the cost of longterm assets to the years they are used. This process is called depreciation.
Consider the following example. A florist purchases a delivery van for $12,000. The
van will last 3 years. What is the florist's cost per year for this van? (Answer:
$4,000.)
When the florist purchases the van, he will record it in an asset account. Does that van
remain an asset forever? No, after 3 years, the van's usefulness will be gone.
Therefore, the van's cost must be transferred from the asset account to an expense
account over the 3 years it is used. In other words, the van must be depreciated over
the 3 years it is used.
The florist's accountant is required to record depreciation on the delivery van for the
following two reasons:
1. Whenever an asset is used up in running a business, it must be recorded as an
expense. Similar to supplies or prepaid insurance, the florist's van will not last
forever. Its usefulness will eventually expire. Therefore, a portion of the van will
be recorded as an expense in each year the van is used.
2. The matching principle dictates that all costs incurred in running a business must
be matched against the revenues they generate. The van will allow the florist to
sell flowers and make deliveries for 3 years. Therefore, a portion of the cost of the
van must be matched against the revenue earned in each of those 3 years.
Graphically, this can be illustrated as follows:
New Data
Asset: Delivery
Van
Portion of the Van's
Usefulness that Has
Expired
Expense: Depreciation
Expense
The journal entries to record the purchase of the van and the first year's depreciation
are as follows:
Original
Entry:
Delivery Van…………………………
Cash………………………….
12,000
Adjusting
Entry:
Depreciation Expense—Delivery Van
Accumulated Depreciation
—Delivery Van…………..
4,000
12,000
4,000
Note that the account credited by the adjusting entry is Accumulated Depreciation—
Delivery Van. This is a contra-asset account—an account that works "against" another
asset account to reduce it. The accumulated depreciation—delivery van account
works against the delivery van account.
The T-accounts follow.
Delivery Van
Bal.
Depreciation Expense—Delivery Van
12,000
Adj. 4,000
12,000
Bal. 4,000
Accumulated Depreciation—
Delivery Van
Adj. 4,000
The asset and contra-asset accounts are
reported on the balance sheet as follows:
Bal. 4,000
Delivery van
Less: Accum. deprec.
Net book value of van
$12,000
4,000
$ 8,000
Why use a contra-account to record the adjusting entry for depreciation? Why not just
reduce the delivery van account directly?
1. Both the original cost and the amount of depreciation recorded on a fixed asset
should be reported on the balance sheet. Therefore, the amounts are kept in
separate accounts.
2. Any depreciation recorded on a fixed asset is just an estimate of the asset's
usefulness that has expired. This estimate is maintained in a separate account.
As you cover the adjusting entries for depreciation, you will probably need to
emphasize the following points:
1.
2.
3.
4.
A fixed asset must be owned and used by the business.
Depreciation expense is a noncash expense.
Depreciation is not related to the value of the asset.
The normal balance of the accumulated depreciation account is a credit.