Visual Tutorial

Adjusting Entries

Introduction to Adjusting Entries

Adjusting entries are logical and necessary for a company to have meaningful income statements and balance sheets.

Adjusting entries are part of the accrual method of accounting (as opposed to the cash method).

Note

If a company wants to measure its profitability during a short time period, it should use the accrual method of accounting instead of the cash method.

Accrual accounting requires the use of adjusting entries.

Under the accrual method, the income statement will report:

  • All revenues that were earned during the period (regardless of when cash is received)
  • Expenses that pertain to the revenues or to the period (regardless of when cash is paid)
Note

Under the accrual method, the income statement will report the amounts for:

  1. Revenues earned
  2. Expenses that pertain to the revenues
  3. Expenses that pertain to the accounting period
  4. The resulting net income

Under the accrual method, the balance sheet will report:

  • The receivables that were earned (but haven’t been collected)
  • The liabilities/obligations that occurred (but haven’t been paid)
Note

Under the accrual method of accounting, the balance sheet will report all of the assets it has a right to receive, all of the liabilities it has incurred, and the resulting owner’s (stockholders’) equity.

Adjusting entries are necessary in order to report the proper amounts of assets, liabilities, revenues, expenses, gains, losses, and the resulting net income and owner’s (stockholders’) equity under the accrual method of accounting.

Note

Adjusting entries are necessary to report all transactions that have occurred, not just those where the paperwork was processed.

Next, we’ll look at three examples of the need for adjusting entries.

Example #1.

A company had an emergency repair on the last day of the accounting period but the company does not receive a bill from the contractor by the time the financial statements are prepared. If this transaction is omitted, the income statement will not be reporting the true amount of expenses it incurred, and the resulting net income will be wrong.

Without an adjusting entry, the balance sheet will also omit a liability and will be reporting the incorrect amount of owner’s equity.

Example #2.

A company paid its six-month property insurance premium of $12,000 in December. The six-month coverage begins on December 9 and ends on June 8. Some of the cost should be reported as a December expense, but most of the cost is a prepayment of the expense to be reported between January 1 and June 8. If the company prepares monthly financial statements, then each month some of the cost needs to be reported as Insurance Expense. The portion of the cost that remains unexpired should be reported in the current asset account Prepaid Insurance.

If an adjusting entry is not recorded each month:

  • Monthly income statements will report the wrong amount of expenses and net income.
  • Balance sheets will report the wrong amount of prepaid insurance, current assets, total assets, and owner’s equity.

Example #3.

A company purchases an asset to be used in the business. The asset will be used for five years and will then be scrapped. The asset’s cost of $60,000 is recorded on one day in December, but it needs to be expensed over the asset’s life of 60 months.

If an adjusting entry is not made each month:

  • Monthly income statements will report the wrong amount of expenses and net income.
  • Monthly balance sheets will report the wrong amount of assets and owner’s equity.

The three adjusting entries we just discussed correspond to the following classifications used by accountants.

Three types of adjusting entries

  1. Accruals (revenues are earned or expenses are incurred before the paperwork is processed)
  2. Deferrals (cash is received before revenues are earned; cash is paid before costs are expensed)
  3. Others (depreciation, allowance for doubtful accounts, amortization)

As our three examples indicated, adjusting entries are necessary in order for both the income statement and the balance sheet to report the proper amounts.

Note

Adjusting entries are needed in order for both the…

  1. Income statement to report the true amount of
    • Revenues
    • Expenses
    • Net income
  2. Balance sheet to report the proper amount of
    • Assets
    • Liabilities
    • Owner’s equity (or stockholders’ equity)

In addition to needing a debit and credit, every adjusting entry will also involve

  1. A balance sheet account (asset or liability), and
  2. An income statement account (revenue or expense)

Let’s visualize the requirements of adjusting entries by using T-accounts. Every adjusting entry will require:

    A balance sheet account:          AND    An income statement account:

One of these accounts will need a debit entry (an entry on the left side) and one of these accounts will need a credit entry (an entry on the right side).

Preparing an Adjusting Entry to Accrue an Expense

Let’s return to our first example where an emergency repair occurred near the end of an accounting period. Since the paperwork was not available, an adjusting entry was needed in order to report both the expense and the liability. Let’s assume that the amount is estimated at $9,000.

The following T-accounts demonstrate how to prepare the necessary adjusting entry for the emergency repair estimated to be $9,000:

A balance sheet account: AND An income statement account:

If you need help with debits and credits, see AccountingCoach.com’s free Explanation of Debits and Credits.

The adjusting entry will be entered in the general journal as follows:

This adjusting entry may be referred to as an accrual, an accrual-type adjusting entry, an accrued expense, or an accrued liability.

Note

An accrual adjusting entry is needed when an expense and/or liability have occurred but the paperwork/transaction has not been recorded as of the time that the income statement and balance sheet are prepared.

In addition to accruing for expenses and liabilities, a company must accrue for revenues and the receivables that have been earned but not recorded as of the time that the financial statements are prepared. Accrued revenues will be discussed next.

Preparing an Adjusting Entry to Accrue Revenues

Accruals can also involve revenues and the assets/receivables that have been earned (but have not been recorded as of the time that the income statement and balance sheet are prepared). Without an adjusting entry, these revenues will be omitted from the income statement and the related assets/receivables will be omitted from the balance sheet.

Note

When revenues have been earned, but have not been entered into the accounting records, an accrual-type adjusting entry is necessary for the financial statements to report the revenues and the assets/receivables.

To illustrate the adjusting entry for accruing revenues, let’s assume that a company earns interest on its investment in a government bond. However, the interest is received only twice per year on June 1 and December 1. Since the company is earning some of the interest every day of the year, on December 31 it will have a right to receive one month’s interest. If the semiannual (six-month) interest is $6,000, the December 31 adjusting entry will be 1/6 of $6,000. Here are the T-accounts to help us prepare the necessary adjusting entry:

The adjusting entry to be entered into the general journal for the interest earned is:

Here’s a recap on the accruing of expenses and revenues (and the related liabilities and assets):

Accrual adjusting entries are needed under the accrual method of accounting because

  1. Expenses and/or revenues occurred, but they were not recorded, and
  2. The liabilities or assets had not yet been recorded.

For an accrued expense (which needs to be reported on the income statement) there also needs to be an accrued liability (which needs to be reported on the balance sheet).

Usually the following expenses will need to be accrued: wages, electricity, natural gas, property taxes, repairs, and interest expense. These expenses occurred prior to processing the payroll, or receiving the bill for the items used.

For an accrued revenue (which needs to be reported on the income statement) there also needs to be an accrued asset/receivable (which needs to be reported on the balance sheet).

Usually the following revenues will need to be accrued: interest earned, rent earned, sales, and service revenues where the revenues were earned but the paperwork has not been processed.

Review your adjusting entries by asking:

  1. Do the ending balances of the asset and liability accounts make sense?
  2. Can another person easily review the calculations/documentation?
  3. Will another person agree with the account balances after the adjusting entries?

Preparing an Adjusting Entry for a Deferred Expense

Adjusting entries are needed when cash has been paid prior to an expense occurring. The amount of the prepaid expense is reported as an asset on the company’s balance sheet. The prepaid amount is known as a deferral, a deferred expense, or as a prepaid expense.

Note

Deferred expenses

Cash has been paid prior to the expense occurring.
Can be thought of as a prepaid expense.
Will involve an asset account.

To illustrate deferred expenses, let’s assume that a company pays $12,000 on December 1 for the property insurance premium covering a six-month period of December 1 through May 31. The entire $12,000 is paid on one day but the cost needs to be expensed over approximately 182 days. Let’s begin by assuming that the $12,000 payment was recorded with a debit to the asset Prepaid Insurance and a credit to the asset Cash. An adjusting entry will be required prior to issuing any financial statements after December 1.

The adjusting entry for the insurance premium expiring during December will be $2,000 (1 month out of the 6-month cost of $12,000). The amount prepaid as of December 31 is $10,000 (5 months out of the 6-month cost of $12,000). If we assume that the first income statement and balance sheet will be as of December 31, the following adjusting entry will be required:

Note that the asset account Prepaid Insurance has a balance of $10,000—the amount that remains prepaid or unexpired at December 31. Insurance Expense is $2,000—the amount that expired in December.

The adjusting entry to be entered into the general journal for the insurance if the $12,000 was initially recorded in the asset account Prepaid Insurance:

If the $12,000 payment for the six-month property insurance premium was debited to Insurance Expense (instead of Prepaid Insurance) when it was paid on December 1, the adjusting entry on December 31 will be different. The adjusting entry for the property insurance premium will be $10,000 (5 months out of the 6-month cost of $12,000) that needs to be deferred to the balance sheet. The amount of the expense is $2,000 (1 month out of the 6-month cost).

Note that the asset account Prepaid Insurance has a balance of $10,000—the amount that remains prepaid or unexpired at December 31. Insurance Expense is $2,000—the amount that expired in December.

The adjusting entry to be entered into the general journal for the insurance if the $12,000 was initially recorded in Insurance Expense:

The important result of adjusting entries is to report the correct amounts on the income statement and balance sheet. Note that the two adjusting entries we presented for the insurance had to be different in order for the amounts to be correct.

Note

Regardless of how the $12,000 was initially recorded…

  1. The ending balance in the asset account Prepaid Insurance must be $10,000 at December 31 (5 months x $2,000 per month), which is the amount that is prepaid/unexpired at December 31.
  2. The Insurance Expense for the one month of December must be $2,000 (1 month x $2,000), which is the amount that has expired during December.

Other examples of prepaid expenses might be prepaid trade association dues, prepaid rent, prepaid advertising, and prepaid legal fees. Prepaid expenses are the amounts which were paid in advance of being expensed. The prepaid amounts are reported as assets on the balance sheet and are often reported in the current assets section. As the amounts are used up or expire, the asset account balance is reduced by a credit entry and the related debit amount will be entered in an income statement expense account.

Preparing an Adjusting Entry for Deferred Revenues

Adjusting entries are also required for deferred revenues. Deferred revenues occur when cash is received in advance of it being earned. Deferred revenues are reported as liabilities on the balance sheet and may be referred to as a deferral, prepayment, prepaid revenues, unearned revenues, and/or customer deposits.

Note

Deferred revenues

Cash has been received prior to being earned.
Can be thought of as a prepayment of future revenues.
Will involve a liability account.

To illustrate deferred revenues, let’s assume that the insurance company receives $12,000 on December 1 for the property insurance premiums covering the six months of December 1 through May 31. The entire $12,000 is received on one day, but the revenues will be earned over the following 182 days. If the $12,000 receipt was recorded by the insurance company with a debit to Cash and a credit to Unearned/Deferred Revenues, an adjusting entry will be needed prior to issuing any financial statement after December 1.

The insurance company’s adjusting entry for the insurance premiums earned during December will be $2,000 (1 month out of the 6-month amount of $12,000). The amount that should remain unearned/deferred is $10,000 (5 months out of the 6-month amount). If the insurance company issues its first income statement and balance sheet as of December 31, the following adjusting entry will be needed:

Note that the liability account Unearned Revenues has a balance of $10,000 (the amount that remains unearned at December 31). Ins Premium Revenues is $2,000 (the amount that was earned in December).

The December 31 adjusting entry to be entered into the general journal for the insurance premiums earned if the $12,000 received on Dec. 1 was initially recorded as a liability:

If the insurance company had credited Insurance Premium Revenues (instead of crediting Unearned Revenues) for the entire $12,000 receipt on December 1, the adjusting entry on December 31 will be different. In this case the adjusting entry will need to be $10,000—the amount to be deferred (5 months out of the 6-month amount of $12,000). In other words, $10,000 should be reported as a liability and only $2,000 (1 month out of the 6-month amount) should be reported as earned. 

A balance sheet account:      AND    An income statement account:

Note that the liability account Unearned Revenues has a balance of $10,000—the amount that remains unearned at December 31. Ins Premium Revenues is $2,000—the amount that was earned in December.

The adjusting entry to be entered into the general journal by the insurance company if the $12,000 was initially recorded in the revenues account:

The important result of adjusting entries is that the amounts reported on the income statement and balance sheet are the correct amounts.

The two adjusting entries had different amounts because of the accounts used to record the initial $12,000. However, regardless of where the initial amount was recorded, the insurance company’s December 31 balance sheet must report a liability of $10,000, and its December income statement must report revenues of $2,000.

Note

The insurance company’s financial statements must report the following:

  1. The ending balance in the liability account Unearned Revenues must be a credit of $10,000 (5 months x $2,000 per month), which is the amount that is unearned/deferred as of December 31.
  2. The Insurance Premium Revenues for the one month of December must be $2,000 (1 month x $2,000).

Preparing an Adjusting Entry for a Depreciation

Adjusting entries are necessary for recording the depreciation of certain long-term assets used in a business. These assets are referred to as plant assets or fixed assets and include buildings, equipment, furniture, fixtures, vehicles, etc. (Land is not depreciated.)

Depreciation is the expensing of the cost of a plant asset over its useful life. The cost of the plant assets and their accumulated depreciation are reported in the long-term asset section of the balance sheet under the heading property, plant, and equipment.

Note

Depreciation

Expensing the cost of a long-term asset (that is used in the business) to the periods in which the asset is used. This is done in order to comply with the matching principle.

The depreciation recorded on an income statement is usually different from the amount reported on the U.S. income tax return for the same period. We are illustrating only the depreciation for the income statement.

Assume that a company acquires a new delivery vehicle at a cost of $60,000. The vehicle is expected to have a useful life of 5 years (or 60 months) and will have no salvage value at the end of 60 months. Further, the company issues monthly financial statements. Under the straight-line method of depreciation, the amount of depreciation will be $1,000 per month:

In the case of depreciation, the asset account such as Vehicles is not reduced. Rather, another balance sheet account Accumulated Depreciation: Vehicles will be used for recording the credit amount. This account is described as a contra account because its credit balance is contrary to the balance expected in an asset account. Here are the T-accounts and the adjusting entry for recording the monthly depreciation of $1,000:

    A balance sheet account:          AND    An income statement account:

The monthly adjusting entry to be entered into the general journal for the depreciation is:

Since the account Accumulated Depreciation: Vehicles is a balance sheet account, its balance will not be closed at the end of an accounting year. The credit balance in that account will continue to grow until it reaches a credit balance of $60,000. At that point the monthly adjusting entry for depreciation will stop. On the other hand, the account Depreciation Expense is an income statement account, and its balance will be closed at the end of each accounting year.

Note

Accumulated Depreciation is an asset account with a credit balance. This account is not closed at the end of an accounting year. Its credit balance will grow until it reaches the total amount that needs to be depreciated (cost minus expected salvage amount).

Depreciation Expense is an income statement account. At the end of each accounting year, the balance is closed.

The End

There are more resources to assist you under our topic Adjusting Entries

Restart

Turn on study mode to focus

Study Mode:
OFFON
Mark the Tutorial as Complete