Notes: Adjusting Entries, Closing, and KLO Example

Learning objectives

• Explain how profit is measured and reported under the accrual and cash bases of accounting
• Identify the four major circumstances in which adjusting journal entries are necessary
• Record and post adjusting journal entries and prepare an adjusted trial balance and financial statements
• Describe the purpose of the closing process and prepare closing entries

Accrual vs Cash bases of accounting

• The main difference between the accrual and cash bases of accounting is the timing of when revenues and expenses are recorded.
• Cash basis:
  • records revenues when cash is received
  • records expenses when cash is paid
• Accrual basis:
  • records revenues when they are earned
  • records expenses when they are incurred
• Recall from 22108, the revenue and expense recognition principle

Four major adjusting journal entry circumstances

• There are 4 main scenarios where adjusting entries are required:
  1) When cash is received before revenue is earned (unearned revenue)
  2) When cash is received after revenue is earned (accrued revenue)
  3) When cash is paid before expenses are incurred (prepaid expenses)
  4) When cash is paid after expense is incurred (accrued expenses)
• Adjusting journal entries are made in the general journal to record revenues and expenses that have been earned or incurred but not yet recorded.

Scenario 1: Unearned revenue

• End of month Netflix example: they earned 1/12 or $10 of revenue from an annual $120 subscription received on 1 July (12 months).
• Entries:
  • 1 July: DR Cash 120 CR Unearned revenue 120
    (To record cash received for future streaming services)
  • 31 July: DR Unearned revenue 10 CR Revenue 10
    (To record revenue earned during July)

Scenario 2: Accrued revenue

• Legal firm provides services to appeal a parking fine for $500, work completed on 23 May; billed on 10 June; paid on 21 June; books closed 31 May.
• Adjusting entry at period end (31 May):
  • 31 May: DR Accounts Receivable 500 CR Revenue 500
    (To record revenue earned during May)
• Entry when cash is received (21 June):
  • 21 June: DR Cash 500 CR Accounts Receivable 500
    (To record receipt of cash for client services)

Scenario 3: Prepaid expenses

• General example: end of month, one month of insurance has been consumed, cost $200 ([$2400 ÷ 12] × 1 month).
• Example details: a 12-month public liability insurance policy for $2400 purchased on 1 July.
• Entries:
  • 1 July: DR Prepaid expense 2400 CR Cash 2400
    (To record purchase of public liability insurance)
  • 31 July: DR Insurance expense 200 CR Prepaid expense 200
    (To record insurance expense incurred in July)
• Note: For a $2400/12 per month policy, monthly expense = rac{2400}{12} = 200 op

Scenario 3 (KLO): Prepaid expense

• Beginning of the month, KLO purchased an annual professional indemnity insurance for $3600.
• Entry at the start:
  • 1 July: DR Prepaid Expense 3600 CR Cash 3600
    (To record purchase of professional indemnity insurance)
• Monthly adjustment (in current month):
  • 31 July: DR Insurance expense 300 CR Prepaid expense 300
    (To record insurance expense incurred in current month; monthly amount = rac{3600}{12} = 300)

Scenario 4: Accrued expenses

• Example: Barangaroo Construction uses $5000 of electricity in July; bill received on 31 July; payment due 28 August; books closed 31 July.
• Entries:
  • 31 Jul: DR Electricity expense 5000 CR Electricity Payable 5000
    (To record electricity incurred in July)
  • 28 Aug: DR Electricity Payable 5000 CR Cash 5000
    (To record payment of electricity bill)

Adjusting entries - Summary

• Revenue Unearned (When cash is received before revenue is earned)
  • Entry before period end: DR Cash CR Liability
  • Adjusting entry at period end: DR Liability CR Revenue
  • Entry after period end: DR Revenue CR Receivable
• Revenue Accrued (When cash is received after revenue is earned)
  • Entry before period end: - DR Receivable CR Revenue
  • Adjusting entry at period end: DR Cash CR Receivable
• Expense Prepaid (When cash is paid before expenses are incurred)
  • Entry before period end: DR (Prepaid) Asset CR Cash
  • Adjusting entry at period end: DR Expense CR (Prepaid) Asset
• Expense Accrued (When cash is paid after expense is incurred)
  • Entry before period end: - DR Expense CR Payable
  • Adjusting entry at period end: DR Payable CR Cash

3.3 Record and post adjusting journal entries and prepare an adjusted trial balance and financial statements – comprehensive example

Kids Learn Online (KLO) overview

• Transactions on the last day of the current month:
  1) KLO developed a quizlet app for a customer who paid $4000 at the beginning of the month.
  2) KLO developed the first half (50%) of an app; the other half will be developed mid-next month. The customer has agreed to pay $3000 for the whole app.
  3) At the beginning of the month, KLO purchased an annual professional indemnity insurance for $3600.
  4) KLO’s daily payroll is $1000 a day (5-day work week). It pays employees on Saturday for the previous Monday to Friday. The last day of the current month is a Friday.
• Tasks: record and post adjusting entries, and prepare an adjusted trial balance and financial statements.

(1) App revenue and unearned revenue

• Entry to record revenue earned from the upfront payment:
  • DR Unearned revenue 4000 CR Revenue 4000
    (To record revenue earned from the upfront payment)
• After this entry, comparative notes show the following: Unearned revenue remaining = 0; Revenue total so far = 5500 (based on the slide totals).
• Resulting balances (as shown): Revenue total becomes 5500; Unearned revenue is $0 at period end.

(2) Revenue recognition for the 50% app phase

• To recognize revenue for the completed portion (50%) of the app under a $3000 total contract:
  • DR Accounts Receivable 1500 CR Revenue 1500
    (To record revenue earned for 50% of the app)
• Running totals: Revenue increases by 1500 (cumulative revenue = 5500 + 1500 = 7000 in the worked example).

(3) Prepaid expense – insurance (KLO)

• Beginning of month: DR Prepaid Expense 3600 CR Cash 3600
  (To record purchase of professional indemnity insurance)
• Current month adjustment (assuming 1 month of coverage):
  • DR Insurance expense 300 CR Prepaid expense 300
    (To record insurance expense incurred in current month; monthly amount = rac{3600}{12} = 300)

(4) Daily payroll (KLO)

• Payroll for the current month (5 days at $1000/day): total = 5000
• Entry to accrue salaries incurred during the month:
  • DR Salary Expense 5000 CR Salary Payable 5000
    (To record salaries incurred during current month)

Adjusted Trial Balance (KLO)

• The adjusted trial balance (current month) shows these balances (debits and credits must balance):
  • Debits: Cash 23600, Equipment 3500, Accounts Receivable 5500, Prepaid Expense 3300, Salary Expense 5000, Electricity Expense 300, Insurance expense 300, Dividends 100
  • Credits: Revenue 11000, Accounts Payable 3500, Salary Payable 5000, Share Capital 20000, Unearned Revenue 0
• Totals on both sides: 39500 matches on both sides

Income Statement (KLO)

• Revenue: 11000
• Expenses:
  • Electricity expense: 300
  • Insurance expense: 300
  • Salary expense: 5000
• Total expenses: 5600
• Profit: Profit = Revenue - Expenses = 11000 - 5600 = 5400

Statement of Changes in Equity (SOCIE)

• Beginning retained earnings: 0
• Add: Profit 5400
• Less: Dividends 100
• Ending retained earnings: 5300

Balance Sheet (KLO)

• Assets:
  • Cash: 20000 (or the ending cash shown in the table; adjust per month)
  • Equipment: 3500
  • Accounts Receivable: 7000
  • Prepaid Expense: 3300
  • Total assets: 33800
• Liabilities:
  • Accounts Payable: 3500
  • Salary Payable: 5000
  • Unearned Revenue: 0
  • Total liabilities: 8500
• Equity:
  • Share Capital: 20000
  • Retained Earnings: 5300
  • Total equity: 25300
• Total liabilities and equity: 33800
• Note: Assets = Liabilities + Equity

3.4 Describe the purpose of the closing process and prepare closing entries

• The closing process transfers the balances of revenue, expense, and dividends to Retained Earnings, preparing accounts for the next period.
• Closing entries used in the KLO example:
  • Close Revenue to Retained Earnings:
  • DR Revenue 11000 CR Retained Earnings 11000
    (To close the revenue account)
  • Close Expenses to Retained Earnings:
  • DR Retained Earnings 5600 CR Electricity Expense 300 CR Insurance Expense 300 CR Salary Expense 5000
    (To close the expense accounts)
  • Close Dividends to Retained Earnings:
  • DR Retained Earnings 100 CR Dividends 100
    (To close the dividends account)
• Retained Earnings balance after closing: 5300 ext{ CR} (as shown in SOCIE and balance sheet)

3.5 In Summary – next steps

• Read Chapter 3 and attempt the interactive exercises in the textbook
• Attend your workshop and tutorial
• Get ready for Week 4 by working through Topic 4: Accounting for different business structures
• Key takeaways:
  • The main difference between accrual and cash bases is the timing of when revenues and expenses are recorded.
  • There are 4 main adjusting entries: (1) Unearned revenue; (2) Accrued revenue; (3) Prepaid expense; (4) Accrued expense
  • The closing process transfers all revenue, expense, and dividend balances to Retained Earnings.