Objective 4.1: Explain why adjustments are needed.

Why Adjustments Are Needed

• Accounting systems records daily transactions. Sometimes cash does not come in or paid immediately.

• Cash may not be paid or received in period related to revenues or expenses.

• For adjusting journal entries, there is no cash involved.

• Adjustments are made at the end of the accounting period.

• Adjusting entries always have one balance sheet account and one income statement account.

• The purpose of adjustments at the end of the period is to state the following at appropriate amounts:

  • Assets are reported at amounts representing the economic benefits that remain at the end of the accounting period.

  • Liabilities are reported as amounts owed at the end of the accounting period.

  • Revenues are recorded after service or sale is provided (revenue recognition principle).

  • Expenses are recorded in the same period that we needed the expense to earn revenue (expense recognition/”matching” principle).

• There are two categories for adjustments:

  • Deferrals

  • Accruals

Deferral Adjustments

• Defer means to postpone until later.

• Deferral adjustments arise because a cash transaction happened first.

• There are two things to considered regarding deferral adjustments:

  • Deferral adjustments are used to DECREASE balance sheet accounts and INCREASE corresponding income statement accounts.

  • Each deferral adjustment involves:

    • One asset and one expenses account OR

    • One liability and one revenue account.

• Regarding expenses:

  • Assets such as supplies or prepaid rent are reported on the balance sheet.

  • Once these assets are used, they move over to the income statement as “supplies expense” or “rent expense”.

• Regarding revenues:

  • A liability, specifically “deferred revenue”, is reported on the balance sheet.

  • Once a service or sale is provided, the deferred revenue is moved onto the income statement as “sales revenue” or “service revenue”.

Accrual Adjustments

• Accrual adjustments are needed when a company has earned revenue or incurred an expense in the current period but has not recorded it because cash will be paid later.

• There are two things to consider regarding accrual adjustments:

  • These adjustments are used to record revenues or expenses when they occur prior to receiving or paying cash, and to adjust corresponding balance sheet accounts.

  • Each accrual adjustment involves:

    • One asset and one revenue account OR

    • One liability and one expense account.

• Cash is never in an accrual adjustment because cash is paid or received AFTER.

• Regarding revenues:

  • Assets on the balance sheet will be followed by the word “receivable” (ex: rent receivable, interest receivable), meaning the right to collect later.

  • Once collected, the asset moves to the income statement as rent or interest revenue.

• Regarding expenses:

  • Liabilities are reported on the balance sheet and will be followed by the word “payable” (wages payable, interest payable), meaning they will have to pay later.

  • Once the liability is paid, it moves to the income statement as an expense (wages expense, interest expense).

Deferral vs Accrual Accounting

• For deferral adjustments, assets are paired with expenses and liabilities are paired with revenues.

• For accrual adjustments, assets are paired with revenues and liabilities are paired with expenses.

Objective 4.2: Prepare adjustments needed at the end of the period.

Adjustment Analysis, Recording, and Summarizing

• Adjustments are not made daily because it is more efficient for them to be made at the end of the accounting period.

• The first step is to find the current unadjusted balances.

• Next, the desired adjustments should be identified.

• Make the adjustments and create the adjusted trial balance to ensure debits still equal credits.

• If debits do equal credits and there are no further adjustments, the final financial statement can be made.

Depreciation

• Depreciation is the process of allocating the cost of buildings, vehicles, and equipment (tangible assets) to the accounting periods in which they are used.

• The expense recognition principle says that when equipment is used to generate revenue, part of the cost is becomes an expense.

• With depreciation, an account on the income statement called Depreciation Expense records the cost of equipment at the time.

• On the balance sheet, we use the contra account Accumulated Depreciation to record the reduced value of the equipment.

• The journal entry:

  • Debit Depreciation Expense

  • Credit Accumulated Depreciation

• A contra account is an account that is an offset to, or reduction of, another account.

  • It can never be alone, it must be attached to another account.

  • Its purpose is to bring down the value of the account its “stuck” to.

  • The contra account’s normal balance is the opposite of the account its stuck to.

Amortization

• Amortization is the corollary to depreciation and relates to intangible assets.

• An amortization expense is an expense on the income statement.

• Accumulated amortization:

  • Found on the balance sheet.

  • Attaches itself to advertisements, patents, software etc.

  • It brings the value down for the assets.

  • It has a normal credit balance.

Objective 4.3: Prepare an adjusted trial balance.

Adjusted Trial Balance

• The adjusted trial balance ensures that debits still equal credits.

• Adjusted t-accounts balances are transferred into debit and credit columns.

• Accumulated Depreciation and Accumulated Amortization belong with assets.

• The trial balance lists accounts in the order they will appear in the balance sheet, statement of retained earnings, and income statement.

Objective 4.4: Prepare financial statements.

Financial Statements

• Account balances from the adjusted trial balances are in the Statement of Retained Earnings.

• The total of Retained Earnings and Dividends from the adjusted trial balance equal beginning Retained Earnings on the Statement of Retained Earnings.

• Retained Earnings should be from the Statement of Retained Earnings and not the adjusted trial balance.

Objective 4.5: Explain the closing process.

Closing Accounts

• The closing process is done at the end of the year.

• Accounting records are prepped to be tracked in the following year.

• Accounts that are tracked for a limited period of time and closed at the end of the year are called temporary accounts, which consists of revenues, expenses, and dividends.

• Net income or loss and dividends are moved into the Retained Earnings account (subcategory of stockholders’ equity).

• Accounts that are not closed and carry into the next year are called permanent accounts, which consists of assets, liabilities, and stockholders’ equity.

• Retained earnings for the end of the year becomes the beginning balance for the next year.

• 2 journal entries for closing accounts are needed:

  • Entry 1.) Debit revenue accounts, credit expense accounts, then debit or credit the difference to Retained Earnings.

• Entry 2.) Debit Retained Earnings and credit Dividends

Post Closing Trial Balance

• Post closing entries are the last step in the accounting process and will ensure all income statement accounts and the dividend account have a zero balance.

• The post closing trial balance is the last step to check:

  • If debits are still equal to credits.

  • If all temporary accounts are closed.

• The post closing trial balance will only have the balances of permanent accounts, temporary accounts should be zero. It should look like:

Objective 4.6: Explain how adjustments affect financial results.

Adjusted Financial Results

• Adjustments show that revenues (earned) and expenses (incurred) are reported properly.

• If there were no adjustments, a company’s performance would have an inaccurate portrayal.