The Adjusting Process, Part II

Adjusting Entries Rules

• Adjusting entries are journal entries that change, update, and adjust specific accounts.
• Needed because certain accounts are not updated or correct at a specific point in time (fiscal year or interim period).
• Ensures that financial statements (balance sheet and income statement) contain all monetary values applicable to that accounting period.
• Must be prepared every time financial statements are prepared
• Impacts all financial statements: income statement, balance sheet, statement of owner's equity, and statement of cash flow.
• Applies accrual accounting rules to transactions spanning multiple accounting periods.

Key Rules

• Adjusting entries never affect the cash account.
• Every adjusting entry includes an income statement account (revenues or expenses) and a balance sheet account (assets or liabilities), but never cash.

Preparing Adjusting Entries - Three-Step Process

1. Determine the current balance in the accounts (unadjusted trial balance).
2. Determine what the current balance should be in the account.
3. If there's a difference between the current and the
   Corrected balance, prepare an adjusting entry.

Types of Adjusting Entries

Two main types:

1. Deferrals (Postponements)
2. Accruals

Deferrals

• Involve allocating costs (expenses) or revenues between two or more accounting periods.
  • Deferral of expenses: Postponement of expense recognition already paid for and recorded which means cash is paid in advance of using the asset or incurring the expense.
  • Deferral of revenue: Postponement of revenue recognition received in advance (unearned).

Deferral of Expenses

• Expense cannot be recorded until it's incurred.
• When assets are purchased, expense recognition is deferred until the asset is used up, expired, or consumed.
• The cost of doing business cannot be recognized as an expense until it has been used to help generate revenue.

Deferral of Revenues

• Cash is collected in advance before performing a service.
• Revenue cannot be recorded until it's earned, creating unearned revenue (a liability).
• Unearned revenue means there is an obligation to provide a service.

Accruals

• Recognition of unrecorded expenses or revenues.
  • Accrual of expenses: Recognition of an expense that has arisen but hasn't been recorded.
  • Accrual of revenues: Recognition of revenue that has been earned but not yet recorded.
• Adjustments needed because resources have been used up or revenue has been earned but not yet recorded.

Adjustments Diagram

• Adjustments are needed for all types of businesses.

Deferrals

• Cash is paid or received before expense or revenue recognition.
  • Paying cash before incurring an expense results in prepaid or deferred expenses.
  • Receiving cash before revenue is recognized results in unearned revenue.
• Expenses are deferred until incurred to match revenues.
• Cash has already been paid or collected, so the cash account is never used in deferral adjustments.

Accruals

• Cash is paid or received after the expense or revenue is earned/recognized.
  • Accrued expenses are incurred daily, and books need to be updated.
  • Accrued revenues are earned daily and need to be recorded.
• Cash is never used in accrual adjustments.

Summary of Adjustments

• Deferrals: Cash already paid or collected.
  • Cash collected: Defer revenue until earned (unearned revenue).
  • Cash paid: Defer expense until asset expires.
• Accruals: Nothing on the books, update and adjust.
  • Expenses: Pay cash after recognition.
  • Revenues: Collect cash after recognition.

Deferral of Prepaid Expenses

• Expenses often benefit more than one accounting period.
• Prepaids are debited to an asset account (unused portion).
• The amount of the asset consumed is transferred to an expense account.
• Assets are recorded first, then expenses are recognized as the asset is used to earn revenue (matching rule).
• Examples: supplies, rent, leases, insurance.
• The prepaid amount is debited to an asset account, then allocated to an expense account as it expires.

Example

Treadle Website Design paid two months' rent in advance for $3,200$ on July 1.

• Debit prepaid rent account (asset) for $3,200$.
• By July 31, half of the prepaid rent has expired.
• Adjusting entry: Debit rent expense $1,600$, credit prepaid rent $1,600$.
• Ending balance: Prepaid rent is $1,600$, reflecting August's rent.

Journal Entry

• Debit Rent Expense
• Credit Prepaid Rent

Long-Term Assets - Deferrals/Prepaid Expenses

• Purchased or paid for in advance (deferrals).
• Benefit more than one accounting period.
• Cost is allocated over time and called depreciation.

Plant Assets

• Expected to provide benefits to multiple accounting periods.
• Examples are computers, equipment, buildings, machines, furniture.
• All plant assets except land depreciate.
• Expenses are reported gradually over the asset's useful life.

Contra Account - Accumulated Depreciation

• A special account is needed since the original historical cost is kept for assets that depreciate.
• A contra account is called accumulated depreciation and has a credit normal balance (opposite of an asset).
• Tracks the monetary value of all depreciation expense recorded for that asset.
• Reported on the financial statement directly underneath its linked account by way of subtraction.
• Any amount expensed is the expired portion; any amount left in the asset account is the unexpired portion.

Example

• Website design company paid $1,500$ for a computer on July 1.
• By July 31, the computer has depreciated $50$.
• Adjustment: Debit depreciation expense $50$, credit accumulated depreciation $50$.

Journal Entry

• Debit Depreciation Expense
• Credit Accumulated Depreciation

Balance Sheet Presentation

• Computer shows at $1,500$ (original historical cost).
• Accumulated Depreciation is subtracted
• The book or carrying value is $1450$, representing the computer's current value.

Deferral of Revenue Entries

• Cash is received in advance of performing the service, creating unearned revenue (a liability).
• The company owes the customer a service.

Explanation

• First recorded, they are usually credited to a liability account (unadjusted balance).
• The earned percentage of the liability is transferred from the liability account to the revenue account.

Example

• Website company receives $1,400$ in advance for website design.
• By July 31, $800$ has been earned.
• Adjusting entry: Debit unearned revenue $800$, credit design revenue $800$.
• The remaining balance is $600$, and earned revenue is $800$.

Journal Entry

• Debit Unearned Revenue
• Credit Design Revenue

Accruals

• Accrued expenses: Costs that have been incurred but are unpaid or unrecorded.
• Accrued expenses must be recorded on the income statement in the period they have been incurred.
• Adjusting entries involve increases to expense accounts and liability accounts.
• Examples: wages, interest, taxes.

Explanation

• First recorded, they are going to be credited to a liability account and expense account.
• The adjusting entries are always going to increase to show that expense have been incurred but not recorded yet.
• With accruals it's an increase for all accounts involved

Example

Website design company pays employees every two weeks. The last pay period ended on July 26. The secretary worked from July 29-31 but won't be paid until the regular payday in August.

• $2,400 / 10 working days = $240 per day.
• $240/day * 3 days = $720.
• Adjusting the balances of three days to show for an employee working, and incurring revenue for those three days
• Adjusting entry: Debit wage/salary expense $720$, credit wage/salaries payable $720$.

Journal entry

• Dr Wages or Salary Expense
• Cr Wages or Salary Payable

Accrual of Revenues

• Revenues that have been earned daily but not yet been updated to the general ledger.
• Happens when Revenue has been earned but cash has not yet been received

Explanation

• Means cash or any other asset have yet to exchange and be received by the company to mark in the debit column
• Will increases both for the assets account(balance sheet )and for the revenue account(income statement).

Example

• Landscaping company agrees to weekly lawn maintenance for Marsh Company starting July 1.
• The fee for the month is $600$ and will be billed at the end of the month.
• Adjusting entry: Debit accounts receivable $600$, credit landscaping revenue $600$.

Journal Entry

• Dr Accounts Receivable
• Cr Landscaping Revenue