Adjusting Entries – Liability Accounts

Notes Payable $5,000

Notes Payable is a liability account that reports the amount of principal owed as of the balance sheet date. (Any interest incurred but not yet paid as of the balance sheet date is reported in a separate liability account Interest Payable.) The accountant has verified that the amount of principal actually owed is the same as the amount appearing on the preliminary balance sheet. Therefore, no entry is needed for this account.

Interest Payable $0

(It’s common not to list accounts with $0 balances on balance sheets.)

Interest Payable is a liability account that reports the amount of interest the company owes as of the balance sheet date. Accountants realize that if a company has a balance in Notes Payable, the company should be reporting some amount in Interest Expense and in Interest Payable. The reason is that each day that the company owes money it is incurring interest expense and an obligation to pay the interest. Unless the interest is paid up to date, the company will always owe some interest to the lender.

Let’s assume that the company borrowed the $5,000 on December 1 and agrees to make the first interest payment on March 1. If the loan specifies an annual interest rate of 6%, the loan will cost the company interest of $300 per year or $25 per month. On March 1 the company will be required to pay $75 of interest. On the December income statement the company must report one month of interest expense of $25. On the December 31 balance sheet the company must report that it owes $25 as of December 31 for interest.

The adjusting journal entry for Interest Payable is:

It is unusual that the amount shown for each of these accounts is the same. In the future months the amounts will be different. Interest Expense will be closed automatically at the end of each accounting year and will start the next accounting year with a $0 balance.

Accounts Payable $2,500

Accounts Payable is a liability account that reports the amounts owed to suppliers or vendors as of the balance sheet date. Amounts are routinely entered into this account after a company has received and verified all of the following: (1) an invoice from the supplier, (2) goods or services have been received, and (3) compared the amounts to the company’s purchase order. A review of the details confirms that this account’s balance of $2,500 is accurate as far as invoices received from vendors.

However, under the accrual basis of accounting the balance sheet must report all the amounts owed by the company—not just the amounts that have been entered into the accounting system from vendor invoices. Similarly, the income statement must report all expenses that have been incurred—not merely the expenses that have been entered from a vendor’s invoice. To illustrate this, assume that a company had $1,000 of plumbing repairs done in late December, but the company has not yet received an invoice from the plumber. The company will have to make an adjusting entry to record the expense and the liability on the December financial statements. The adjusting entry will involve the following accounts:

The adjusting entry for Accounts Payable in general journal format is:

The balance in the liability account Accounts Payable at the end of the year will carry forward to the next accounting year. The balance in Repairs & Maintenance Expense at the end of the accounting year will be closed and the next accounting year will begin with $0.

Wages Payable $1,200

Wages Payable is a liability account that reports the amounts owed to employees as of the balance sheet date. Amounts are routinely entered into this account when the company’s payroll records are processed. A review of the details confirms that this account’s balance of $1,200 is accurate as far as the payrolls that have been processed.

However, under the accrual basis of accounting the balance sheet must report all of the payroll amounts owed by the company—not just the amounts that have been processed. Similarly, the income statement must report all of the payroll expenses that have been incurred—not merely the expenses from the routine payroll processing. For example, assume that December 30 is a Sunday and the first day of the payroll period. The wages earned by the employees on December 30-31 will be included in the payroll processing for the week of December 30 through January 5. However, the December income statement and the December 31 balance sheet need to include the wages for December 30-31, but not the wages for January 1-5. If the wages for December 30-31 amount to $300, the following adjusting entry is required as of December 31:

The adjusting journal entry for Wages Payable is:

The $1,500 balance in Wages Payable is the true amount not yet paid to employees for their work through December 31. The $13,420 of Wages Expense is the total of the wages used by the company through December 31. The Wages Payable amount will be carried forward to the next accounting year. The Wages Expense amount will be zeroed out so that the next accounting year begins with a $0 balance.

Unearned Revenues $1,300

Unearned Revenues is a liability account that reports the amounts received by a company but have not yet been earned by the company. For example, if a company required a customer with a poor credit rating to pay $1,300 before beginning any work, the company increases its asset Cash by $1,300 and it should increase its liability Unearned Revenues by $1,300.

As the company does the work, it will reduce the Unearned Revenues account balance and increase its Service Revenues account balance by the amount earned (work performed). A review of the balance in Unearned Revenues reveals that the company did indeed receive $1,300 from a customer earlier in December. However, during the month the company provided the customer with $800 of services. Therefore, at December 31 the amount of services due to the customer is $500.

Let’s visualize this situation with the following T-accounts:

The adjusting entry for Unearned Revenues in general journal format is:

Since Unearned Revenues is a balance sheet account, its balance at the end of the accounting year will carry over to the next accounting year. On the other hand Service Revenues is an income statement account and its balance will be closed when the current year is over. Revenues and expenses always start the next accounting year with $0.