The Accounting Cycle: Adjustments

INTRODUCTION TO THE ADJUSTING PROCESS

• Accrual-Based Accounting: This accounting method requires that revenues are recorded in the period they are earned and expenses are recorded in the period they are incurred, regardless of when cash is exchanged.

• The Matching Challenge: A significant challenge arises when cash receipts and payments do not align with the recording of respective revenues and expenses. Adjustments bridge this gap.

• The Adjusting Process: A series of steps performed to ensure all accounts are reported accurately at the end of the accounting period.

• Timing of Adjustments: While steps 1 to 3 of the accounting cycle are performed repeatedly during the period, adjusting entries are made specifically at the end of the accounting period before financial statements are prepared.

• Accounting Period: The specific length of time covered by the financial statements.

• Fiscal Year: A consecutive 12-month period chosen by a company for its financial reporting cycle.

THE FIVE CATEGORIES OF ADJUSTING ENTRIES

Adjusting entries are not used to correct errors; they are planned updates to account for the passage of time or the completion of obligations. They generally fall into these categories:

1. Accrued Revenue: Revenue earned but not yet received or recorded.

2. Accrued Expenses: Expenses incurred but not yet paid or recorded.

3. Unearned Revenue: Liability created when cash is received before the service/product is provided.

4. Prepaid Expenses: Assets created when cash is paid before the service/product is used.

5. Depreciation: The process of allocating the cost of long-term assets over their useful lives.

ACCRUED REVENUE (LO 5-2)

• Definition: Revenue that accumulates over time (such as interest) or revenue for completed services that have not yet been billed or recorded.

• Accounting Rule: An accrued revenue adjustment will always involve a debit to a receivable asset account and a credit to a revenue account.

• Specific Examples:

  • Interest on a loan.

  • Completed services not yet billed to the client.

  • Contracts for work performed over a long duration.

• Scenario Example: A service contract for 30 days starting September 21, worth $6,000$.

  • By September 30, 10 days have passed ($1/3$ of the contract).

  • Revenue earned: $\frac{10}{30} \times 6,000 = 2,000$.

  • Journal Entry (Sep 30):

    • Debit: Accounts Receivable $2,000$

    • Credit: Service Revenue $2,000$

  • Recording Collection (Oct 20):

    • Debit: Cash $6,000$

    • Credit: Accounts Receivable $2,000$ (to clear existing receivable)

    • Credit: Service Revenue $4,000$ (for the 20 days worked in October)

ACCRUED EXPENSES (LO 5-3)

• Definition: Expenses incurred (used) during the period but not yet paid or recorded. These can be based on actual invoices received after the period closes or on estimates.

• Accounting Rule: An accrued expense adjustment will always involve a debit to an expense account and a credit to a liability account.

• Common Examples: Salaries, interest, utilities, accounting fees, and property taxes.

• Salaries Expense Adjustment:

  • Necessary if work is performed in one period but paid in the next.

  • Calculation Scenario: An employee earns $2,000$ every two weeks ($10$ working days). Daily rate = $2,000 / 10 = 200$. If the employee works 5 days in April but is paid in May, the business accrues $5 \times 200 = 1,000$ at the end of April.

  • Journal Entry (Apr 29):

    • Debit: Salaries Expense $1,000$

    • Credit: Salaries Payable $1,000$

  • Payment Entry (May 6):

    • Debit: Salaries Expense $1,000$ (for time in May)

    • Debit: Salaries Payable $1,000$ (to clear the April liability)

    • Credit: Cash $2,000$

• Interest Expense Adjustment:

  • Interest is the cost of borrowing money that grows with time. It requires three pieces of data: Principal, Interest Rate, and Term.

  • Computation Formula: $\text{Interest} = \text{Principal} \times \text{Rate} \times \text{Time}$

  • Example: $10,000$ loan at $5\%$ borrowed July 1, maturing October 1. Financial statements prepared Sept 30.

  • Accrued Interest = $10,000 \times 0.05 \times \frac{3}{12} = 125$.

  • Journal Entry (Sep 30):

    • Debit: Interest Expense $125$

    • Credit: Interest Payable $125$

  • Payment of Loan (Oct 1):

    • Debit: Bank Loan $10,000$

    • Debit: Interest Payable $125$

    • Credit: Cash $10,125$

UNEARNED REVENUE (LO 5-4)

• Definition: A liability account recording obligations to customers who have paid in advance. Examples include rent, magazine subscriptions, gift cards, and deposits.

• Accounting Rule: When the service is eventually provided, the adjustment involves a debit to the liability (Unearned Revenue) and a credit to a revenue account.

• Scenario Example (Raina Property):

  • March 1: Collects $6,600$ for 3 months rent ($2,200$/month).

  • Initial Entry: Debit Cash $6,600$, Credit Unearned Revenue $6,600$.

  • Adjustment (March 31): Debit Unearned Revenue $2,200$, Credit Service Revenue $2,200$.

  • Result: Remaining liability is $4,400$ for the remaining two months.

PREPAID EXPENSES (LO 5-5)

• Definition: An asset account representing payments made for services or products to be used in the future.

• Accounting Rule: Adjustments are made as the asset is used up. The entry involves a debit to an expense account and a credit to the asset (Prepaid Expense) account.

• Scenario Example (Tenant's Point of View):

  • March 1: Tenant pays $6,600$ for 3 months rent in advance.

  • Initial Entry: Debit Prepaid Rent $6,600$, Credit Cash $6,600$.

  • Adjustment (March 31): Debit Rent Expense $2,200$, Credit Prepaid Rent $2,200$.

  • Result: Remaining asset balance is $4,400$.

DEPRECIATION AND CONTRA ASSETS (LO 5-6)

• Purpose: Depreciation is the process of allocating the cost of long-term Property, Plant, and Equipment (PPE) over its useful life to match expenses with revenue. It is an allocation process, not a valuation process.

• Useful Life: The length of time the asset is expected to be usable for generating revenue.

• Land: Note that land does not depreciate because it has an unlimited useful life.

• Net Book Value (NBV): The accounting value of an asset. Formula: $\text{Net Book Value} = \text{Original Cost} - \text{Accumulated Depreciation}$.

• Contra Account: An account like Accumulated Depreciation that is linked to a specific asset account. It records decreases in the asset's value to keep the original cost entry intact.

  • Assets increase with debits; Contra Assets (Accumulated Depreciation) increase with credits.

• Straight-Line Depreciation Method: Allocates cost evenly over the asset's life.

  • Formula: $\text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}}$

  • Residual (Salvage) Value: The estimated value of the asset at the end of its useful life.

• Numerical Example:

  • Asset Cost: $10,000$, Useful Life: 5 years, Residual Value: $1,000$.

  • Calculation: $\frac{10,000 - 1,000}{5} = 1,800 \text{ per year}$.

  • Journal Entry (Dec 31): Debit Depreciation Expense $1,800$, Credit Accumulated Depreciation—Machine $1,800$.

• Partial Year Depreciation: If a machine is purchased Sept 1 and year-end is Dec 31, record 4 months.

  • Calculation: $1,800 \times \frac{4}{12} = 600$.

SUMMARY OF ADJUSTMENT IMPACTS

If an adjusting entry is omitted, the financial statements will be inaccurate as follows:

• Accrued Revenue: Expenses are unaffected; Revenue understated; Net Income understated; Assets understated; Equity understated.

• Accrued Expenses: Revenue unaffected; Expenses understated; Net Income overstated; Liabilities understated; Equity overstated.

• Unearned Revenue: Expenses unaffected; Revenue understated; Net Income understated; Liabilities overstated; Equity understated.

• Prepaid Expenses: Revenue unaffected; Expenses understated; Net Income overstated; Assets overstated; Equity overstated.

• Depreciation: Revenue unaffected; Expenses understated; Net Income overstated; Assets (via contra-asset) overstated; Equity overstated.

PREPARING AN ADJUSTED TRIAL BALANCE (LO 5-7)

• The Accounting Cycle Sequence:

  1. Regular transactions recorded and posted.

  2. Step 4: Prepare Unadjusted Trial Balance.

  3. Step 5: Journalize and post Adjusting Entries.

  4. Step 6: Prepare Adjusted Trial Balance (proves total debits = total credits after adjustments).

• Worksheet Construction: A worksheet lists the Unadjusted Trial Balance, the Adjustments (DR and CR), and the final Adjusted Trial Balance balances. This is an optional step used to ensure balancing before ledger posting.

ETHICS AND INTERNAL CONTROLS (LO 5-8)

• Unethical Behavior: Management might manipulate adjustments to improve financial appearance. Examples include:

  • Ignoring depreciation or accrued expenses to understate total expenses.

  • Overestimating accrued revenue or understating remaining unearned revenue to inflate income.

  • Unjustifiably changing the estimated useful life of an asset.

• Internal Controls:

  • Comparing present adjusting entries to historical data to identify missing entries.

  • Management review of all debt contracts and long-term liabilities at year-end to ensure interest accruals are correct.

QUESTIONS AND DISCUSSION

• Q: Which of the following does not require an adjusting entry: Unearned revenue, Owner’s withdrawals, Depreciation, or Accrued expenses?

• A: Owner's withdrawals.

• Q: FastNet signed a one-year contract for $1,200$ for services from March 1, 2022, to February 28, 2023. How much revenue is recognized for the fiscal year ending Dec 31, 2022?

• A: $1,000$ (10 months out of 12).

• Q: A company borrowed $5,000$ on July 1, 2022, at $7\%$ interest. How much interest is accrued at Dec 31, 2022?

• A: $175$ ($5,000 \times 0.07 \times \frac{6}{12}$).

• Q: Unearned revenue has an unadjusted credit balance of $4,000$ and a debit adjustment of $1,600$. What is the adjusted balance?

• A: Credit $2,400$.

• Q: Prepaid rent has an unadjusted debit balance of $6,000$ and a credit adjustment of $2,400$. What is the adjusted balance?

• A: Debit $3,600$.

• Q: A machine purchased for $25,000$ with a $5,000$ residual value and 5-year life results in what annual depreciation?

• A: $4,000$ (calculated as $\frac{25,000 - 5,000}{5}$).

CHAPTER EXERCISE AND SOLUTION

Unadjusted Balances (March 31, 2022):

• Cash: $4,000$ (DR)

• Prepaid Rent: $3,200$ (DR)

• PPE: $8,000$ (DR)

• Unearned Revenue: $1,000$ (CR)

• Notes Payable: $2,000$ (CR)

• Owner, Capital: $8,100$ (CR)

• Owner, Withdrawals: $1,500$ (DR)

• Service Revenue: $6,000$ (CR)

• Total Unadjusted: $17,100$

Adjustments Required:

1. Rent used: $800$ (Debit Rent Expense, Credit Prepaid Rent).

2. Depreciation: $120$ (Debit Depreciation Expense, Credit Accumulated Depreciation).

3. Unearned revenue earned: $400$ (Debit Unearned Revenue, Credit Service Revenue).

Adjusted Trial Balance Totals:

• Debit Total: $17,220$

• Credit Total: $17,220$

• Notable Adjusted Balances: Prepaid Rent $2,400$; Service Revenue $6,400$; Unearned Revenue $600$.