Adjusting Journal Entries Additional Practice Problems

Adjusting Entry Practice: Deferrals vs. Accruals

• The practice focuses on identifying whether an adjusting entry is a deferral or an accrual, including error analysis.

Deferrals

• A deferral adjustment is a postponement of an adjustment.
• Categories:
  • Prepaid Expenses:
    • An asset is recorded, and the expense is deferred until the asset is used or expires.
    • Once the asset helps earn revenue, the matching rule is applied, and the expense is recorded.
    • Adjust the asset to record the usage and incurred expense.
  • Unearned Revenues:
    • Cash is collected in advance of performing a service.
    • Revenue cannot be recorded until it's earned (accrual accounting).
    • Defer recognizing the revenue until it has been earned.

Accruals

• Accrual of Revenue and Accrual of Expense.
• Accruals happen daily and need to be adjusted and updated on the books.

Identifying Adjustments

1. Revenue not yet earned but collected in advance:
   • Unearned revenue (deferral of revenue adjustment).
   • Adjusting entry decreases the liability and recognizes the revenue.
   • Deferral adjustments always decrease the balance sheet account.
2. Office supplies on hand that will be used in the next period:
   • Prepaid expense.
   • Assets provide a future benefit; once used, they expire and become expenses.
   • Expense recorded when the asset is used to generate revenue (matching rule).
   • Office supplies are resources, but if not used in the current period, the expense is prepaid.
   • A deferral expense adjusting entry decreases the asset for the amount used or expired.
3. Interest revenue collected, not yet earned:
   • Deferral or unearned revenue.
4. Rent not yet collected, but already earned:
   • Accrued revenue.
   • Adjust and accrue the revenue on the books, to be collected in a future period.
   • Accrual accounting recognizes revenue regardless of cash collections.
   • The adjusting entry adds revenue to the books and recognizes an accounts receivable.
5. An expense incurred not yet paid or recorded:
   • Accrued expense.
   • Recognize the expense regardless of cash; payment at a later date (obligation).
6. A revenue earned not yet collected or recorded:
   • Accrued revenues.
   • Recognize because the revenue has been earned, so prepare an adjusting entry.
7. Expense not yet incurred paid in advance:
   • Prepaid expense.
8. Interest expense incurred not yet paid:
   • Accrued expenses.

Summary of Deferrals vs. Accruals

• Prepaid expenses and unearned revenue are examples of deferrals.
  • Postpone the expense or the revenue until incurred and earned.
  • Adjusting entries decrease the balance sheet account (asset for prepaid expenses, liability for unearned revenue).
• Accruals: Adjust and add to the books.
  • Adjusting entries increase the balance sheet account (receivable for accrued revenue, payable for accrued expense).
  • If something is used up, there is an amount owed.
  • If something is earned, there is an amount to be received.

Error Analysis

• Identify the type of adjustment.
• Determine if assets or liabilities are over or understated pre-adjustment.
• Determine if revenues or expenses are over or understated pre-adjustment.
• Determine the impact on net income and owner's capital.

Example A: Service revenue earned but unbilled totals $600

• Type of adjustment: Accrued revenue.
• Prior to adjustment:
  • Assets: Understated (accruals add to the books)
  • Revenues: Understated. Need to adjust and put revenue on our books.
  • Net Income: Understated (less revenue recorded than should be).
  • Owner's Capital: Understated (net income travels to the owner's capital account).

Example B: Store supplies of $300 are on hand, ledger shows $1,900 balance

• Type of adjustment: Prepaid expense (deferral of expense entry).
• Prior to adjustment:
  • Assets: Overstated (1,900 in account but only 300 on hand).
  • Expenses: Understated (need to adjust and add expenses to the books).
  • Net Income: Overstated (expenses are too low).
  • Owner's Capital: Overstated (net income is overstated).

Example C: Utility expenses of $275 have been accrued

• Type of adjustment: Accrual of expense.
• Prior to adjustment:
  • Liabilities: Understated (have used utilities but haven't paid yet)
  • Expenses: Understated (need to adjust and add this to the books).
  • Net Income: Overstated (expenses are understated which overstates income).
  • Owner's Capital: Overstated (net income is overstated).

Example D: Service revenue of $490 collected in advance has been earned

• Type of adjustment: Deferral or unearned revenue adjustment.
• Prior to adjustment:
  • Liabilities: Overstated (deferrals decrease the balance sheet account; unearned revenue is a liability).
  • Revenues: Understated (need to adjust and add revenue as it's been earned).
  • Net Income: Understated (less revenue shows than it should).
  • Owner's Capital: Understated (net income is inderstated).

General Rules

• Prior to adjustment, the revenue or expense account will always be understated because we need to adjust and add it to our books.
• Whatever is wrong with net income will also be wrong with the owner's capital because income or loss is transferred to the owner's capital.
• On accrual adjusting entries, the asset and liability will always be understated because accruals add to the balance sheet account.
• Since deferrals are postponements, the balance sheet account will always be overstated, because deferrals decrease that balance sheet account. We prepaid the expense, we've prepaid the service.
• Each accrual of revenue, accrual of expense, deferral of expense, and deferral of revenue adjustment all act the same way.