Unit 11 – Adjusting the Books
Introducing Adjustments
• Not enough – (Debits = Credits)
• They must also be accurate.
• Many transactions begin in one accounting period, but
continue to have an effect for several more accounting
periods.
• Adjustments: are accounting changes recorded to ensure
that all account balances are correct.
– Purpose: to ensure that the financial statements are accurate.
– Ex: Employees who work overtime or earn bonuses (not
recorded by end of fiscal period)
• Expenses will be too low (Salaries Expense does not include overtime)
• Liabilities will be incorrect (debt owing to workers – Salaries Payable
will not be shown on the balance sheet)
Prepaid Expenses
• Are expense payments made in advance.
– Assets (rent, insurance, and supplies)
– Items of value owned until they are used up or no longer
have value.
• Example (Supplies)
– Assets as long as they are owned and unused.
– Once used – no value – asset to an expense.
• “Adjusting entries” are recorded when financial
statements are prepared to ensure their accuracy.
(even though these changes occur on a regular basis)
• Conversion of prepaid assets to expenses.
Ex: Prepaid Rent
• Requirement of office rent of $1700 to be paid in
advance for 3 months. (Apr – June)
– Rent expense not debited
– Account called Prepaid Rent is debited
– At the end of April
• Prepaid rent (asset valued at $3400)
• (1/3 of asset has been used)
• This adjusting entry has two effects:
– It records Rent Expense of $1700 for April
– It decreases Prepaid Rent by $1700
If not made: Expenses (too low), Net income (too high), Assets (too high)
Ex: Prepaid Rent
Adjusting Entry
Apr.
30 Rent Expense
170000
Prepaid Rent
170000
To record rent expense for April
T-Accounts
Prepaid Rent
Apr.1
Balance
5 100 Apr.30
3 400
Balance Sheet
$3400
Rent Expense
1 700
Apr.30
1 700
Income Statement
$1700
Ex: Supplies (prepaid expense)
• Each working day, small amounts of supplies
are used up. (only adjusted before financial
statements are prepared)
• April 30th – count of all supplies remaining
– $600 worth of unused supplies. (original $700)
Total supplies purchased
Less: Supplies left
Supplies used
$700
600
$100
Ex: Supplies
Adjusting Entry
Apr.
30 Supplies Expense
100.00
Supplies
100.00
To adjust the supplies account
and to record the supplies
expense for the month
T-Accounts
Supplies
Apr.1
Balance
700 Apr.30
600
Balance Sheet
$600
Supplies Expense
100
Apr.30
100
Income Statement
$100
Ex: Prepaid Insurance
• April 1st – Insurance policy $720 for one year
– Covers fire, theft, and accidental damage to all office
furniture and equipment
• At the end of April, one month’s insurance has
been used and must be recorded as an expense.
• The cost of one month’s insurance is (1/12) of
$720, or $60.
Ex: Prepaid Insurance
Adjusting Entry
Apr.
30 Insurance Expense
60.00
Prepaid Insurance
60.00
To record one month’s insurance
expense.
T-Accounts
Prepaid Insurance
Apr.1
Balance
720 Apr.30
660
Balance Sheet
$660
Insurance Expense
60
Apr.30
60
Income Statement
$60
Introducing Depreciation
• Expense: money spent on things used to produce
revenue for a business
• Equipment used up in operating the business, its cost
becomes an expense of the business.
– Ex: Equipment purchased for $12 000
• Estimated shelf life ~ 5 years
• After that time, it will be worthless. ($ spent will have been used
up)
• Loses value each year (not instantly worthless)
• A portion of the cost of the equipment is assigned as an expense
to each year’s operation. (consistent with the matching principle)
• Cost of using fixed assets during an accounting period to produce
revenue for that period…therefore shown as an expense on the
income statement for that period.
Depreciation
• Is the allocation of the cost of a fixed asset to the
fiscal periods in which it is used.
– “Amortization”
• Ex: Initial cost of $12 000 spread over 5 years
– Depreciation figure of $2400 per year.
– Assumes that the equipment is worthless after 5 years
and has no scrap value or trade-in value.
• The Depreciation of using up of fixed assets is an
expense of operating a business and is recorded
on the income statement.
Ex: Equipment (Depreciation)
Adjusting Entry
Dec.
31 Depreciation Expense - Equipment
2400.00
Accumulated Depreciation – Equip.
2400.00
To record depreciation for the year.
T-Accounts
Equipment
Jan. 1 12 000
Balance Sheet
$12 000
Accumulated DepreciationEquipment
Dec. 31 2400
Balance Sheet
$2 400
Depreciation ExpenseEquipment
Dec. 31 2400
Income Statement
$2 400
Ex: Equipment (Depreciation)
Management Consultant Services
Partial Balance Sheet
December 31, 20Fixed Assets
Equipment
Less: Accumulated Depreciation
$ 12 000
2 400
9 600
More Depreciation
• Method of spreading the cost of a fixed asset
over the life of that asset.
• Converting cost into an expense
• Separate accounts for each group of fixed
assets (Buildings, Equipment, Delivery Trucks)
– Depreciation Expense account
– Accumulated Depreciation account
• Assets cannot depreciate past 100%.
Why Accumulated Depreciation
account?
Allows us to monitor two types of info:
1) Original cost of the equipment
2) Total amount of depreciation recorded over
the years.
(instead of simply reducing the value of the
equipment account on the balance sheet)
Valuation or Contra Accounts
• Offsets the value of another account.
– Ex: Accumulated Depreciation
• Used to arrive at the value of an asset
• Has a credit balance (opposite to the normal
debit balances found in most asset accounts)
• Book value:
(Cost of an asset) – (Accumulated Depreciation)
Book value continued…
• Book value – value according to the books of
the company.
• Actual value – amount received if the asset is
sold
• …Depreciation is NOT valuation.
Straight – Line Method
(Calculating Depreciation)
• Allocates the same amount of depreciation to each fiscal period.
• Original cost – Salvage value = Total writeoff over the period the item is used.
Declining-Balance Method (Fixed Percentage)
(Calculating Depreciation)
• Allocates a greater amount of depreciation to the
first years of an asset’s life.
– More realistic
• An automobiles depreciation is greatest in its first year.
• Each year a fixed percent is charged.
Journal Entries – Declining-Balance Method
The adjusting entry used for the declining-balance method of depreciation must
show a different amount each year.
Year
1
Depreciation Expense – Equip.
2400.00
Accumulated Depreciation – Equip.
2400.00
To record the first year’s depreciation
Year
2
Depreciation Expense – Equip.
Accumulated Depreciation – Equip.
To record the second year’s
depreciation.
1920.00
1920.00
Depreciation & Income Taxes
• Income taxes in Canada
– Declining-Balance Method is used.
– “Capital Cost Allowance”
• Maximum rates of depreciation are set by the
government.
–
–
–
–
For each class (buildings, machinery, trucks, etc.)
Rates vary from (4% - 100%)
4% (Class 1) – bridges and airplane runways
100% (Classes 12, 23, 25) – tools and dental
instruments that cost less than $200.
Depreciation & Income Taxes
More Depreciation & Taxes
• Land is NOT depreciable. (unlimited life)
– Business cannot claim capital cost allowance on land.
• For income tax purposes, a business does not have to
use depreciation expense (capital cost allowance) in a
particular year.
– Carry over to a year when the company is actually making
a profit…help reduce income taxes.
• As a result…the amount of depreciation used in a
particular year is often determined by the estimated
profits or losses and the estimated income tax.
Two sets of books
• Legal to have separate records of the same
business results.
– One for themselves
• Use straight-line method (feels its best)
– One for the government
• Use declining-balance method
The Principle of Materiality
• Requires that information that could affect the
decisions of the users of financial statements be
included when the financial statements are
prepared.
• Example: If a balance sheet includes an account
receivable that the accountant knows the
customer will never be able to pay, that
information is material…in other words…it is
important info that must be disclosed to the
users or readers of the balance sheet.
The Principle of Conservatism
• Requires that, where there are acceptable
alternative accounting treatments for an item,
accountants choose the one that will result in
lower net income and net assets.
• “Applying a conservative philosophy to the
accounting process”