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.