Principles of Accounting
HelpLesson #4
Adjusting Entries
By Laurie L. Swanson
This presentation is under development.
Adjusting Entries
Adjusting Entries
bring certain account
balances up to date
at the end of the
accounting period.
12/31/2010
UPDATE
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.
Reason for Adjustments
It can be inefficient and costly to
account for certain types of
transactions on a daily basis.
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.
Adjusting Entries
Adjusting Entries are necessary when
accrual basis accounting is used.
Adjusting entries allow businesses to
adhere to the Matching Principle.
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).
The Matching Principle
The Matching
Principle states that
expenses should be
“matched” together
with the income
they produced in
the same time
period.
Characteristics of Adjustments
Adjusting entries will always have the
following characteristics:
•Adjusting entries are internal transactions—no
new source document exists for the adjustment.
•Adjusting entries are non-cash transactions—the
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.
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.
Analyzing an Adjusting Entry:
An 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.
Analyzing an Adjusting Entry:
An Example
Original Entry: On Sept 1 the following entry
would be recorded when the insurance was
prepaid:
Prepaid Insurance
15,000
Cash
15,000
Prepaid Insurance is an asset account – it is an
amount owned by the company that has
economic value.
Analyzing an Adjusting Entry:
An 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).
Analyzing an Adjusting Entry:
An Example
Let’s divide the analysis of this transaction into two parts:
1.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.
2.What is the amount of the adjustment?
See the next slide for the calculation of the amount of
expired insurance.
Analyzing an Adjusting Entry:
An 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)
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:
DATE
Dec
ACCOUNT
31
Insurance Expense
Prepaid Insurance
POST
REF
DEBIT
CREDIT
5000 00
5000
00
Analyzing an Adjusting Entry:
Another Example
Let’s 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.
Analyzing an Adjusting Entry:
Another 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
Analyzing an Adjusting Entry:
Another 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.
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:
DATE
Dec
ACCOUNT
31
POST
REF
DEBIT
CREDIT
Unearned Painting Revenue
Painting Revenue
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).
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)
Complete the Adjusting Entry
Now fill in the amount of the adjustment:
DATE
Dec
ACCOUNT
31
Unearned Painting Revenue
Painting Revenue
POST
REF
DEBIT
CREDIT
8,000 00
8,000
00
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.