Adjusting Entries

CSS Accountancy & Auditing

World Times Academy, Lahore

Accounting Cycle & Adjusting Entries Entries Accounting Cycle Accounting cycle is the financial process starting starting with recording business transactions and leading up to the preparation of financial financial statements. This statements. This process demonstrates the purpose of financial accounting to create useful financial information in the form of general-purpose general-purpose financial statements. In other words, the sole purpose of recording transactions and keeping track of expenses and revenues is turn this data into meaning financial information by presenting it in the form of a balance sheet, income statement, statement of owner's equity, and statement of cash flows. The accounting cycle is a set of steps that are repeated in the same order every period. The culmination of these steps is the preparation of financial statements. Some companies prepare financial statements on a q uarterly basis whereas other companies prepare them annually. This means that quarterly companies complete one entire accounting cycle every three months while annual companies only complete one accounting cycle per year.

Accounting Cycle Steps This cycle starts with a business busi ness event. Bookkeepers analyze the transaction and record it in the general journal with a journal entry. The debits and credits credits from the journal are then posted to the general ledger ledger where an unadjusted trial balance can be prepared. After accountants and management analyze analyze the balances on the unadjusted trial balance, they can then make end of period adjustments like depreciation expense and expense accruals. These adjusted journal entries are posted to the trial balance turning it into an adjusted trial balance. Now that all the end of the year adjustments are made and the adjusted trial balance matches the subsidiary accounts, financial statements can be prepared. After financial statements are published and released to the public, the company can close its books for the period. Closing entries are made and posted to the post closing trial balance. At the start of the next accounting period, period, occasionally reversing journal entries are made to cancel cancel out the accrual entries made in the previous period. After the reversing entries are posted, the accounting cycle starts all over again with the occurrence of a new business transaction. Here is a simplified summary of the steps in a traditional accounting cycle. Some textbooks list more steps than this, but I like to simplify them and combine as many steps as possible. 1. 2. 3. 4. 5. 6. 7. 8. 9.

-- Identify business events, analyze these transactions, and record them as journal entries -- Post journal entries to applicable T-accounts or ledger accounts -- Prepare an unadjusted an unadjusted trial balance from the general ledger -- Analyze the trial balance and make end of period adjusting entries -- Post adjusting journal entries and prepare the adjusted trial balance -- Use the adjusted trial balance to prepare financial statements -- Close all temporary income statement accounts with closing entries -- Prepare the post-closing the post-closing trial balance for the next accounting period -- Prepare reversing Prepare reversing entries to cancel temporary adjusting entries if applicable

Flow Chart After this cycle is complete, it starts over at the beginning. Here is an accounting cycle flow chart. 1|Page Dated: October 30, 2015

By: Prof. Asif Masood Ahmad 0321 9842495


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As you can see, the cycle keeps revolving every period. Note that some steps are repeated more than once during a period. Obviously, business transactions occur and numerous journal entries are recording during one period. Only one set of financial statements is prepared however.

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Throughout this section, we'll be looking at the business events and transactions that happen to Paul's Guitar Shop, Inc. over the course of its first year in business. Let's take a look at how Paul starts his accounting cycle below.

Introduction to Adjusting Entries Adjusting journal entries are made to update the accounts and bring them to their correct balances. The preparation of adjusting entries is an application of the accrual concept of accounting and the matching principle. The accrual concept states that income is recognized when earned regardless of when collected and expense is recognized when incurred regardless of when paid. The matching principle aims to align expenses with revenues. Expenses should be recognized in the period when the revenues generated by such expenses are recognized.

Purpose of Adjusting Entries The main purpose of adjusting entries is to update the accounts to conform the accrual concept. At the end of the accounting period, some income and expenses may have not been recorded, taken up or updated; hence, th ere is a need to update the accounts. If adjusting entries are not prepared, some income, expense, asset, and liability accounts may not reflect their true values when reported in the financial statements. For this reason, adjusting entries are necessary.

Composition of an Adjusting Entry Adjusting entries affect at least one nominal account and one real account. A nominal account is an account whose balance is measured from period to period. Nominal accounts include all accounts in the Income Statement, plus owner's withdrawal. They are also called temporary accounts or income statement accounts. Examples of nominal accounts are: Service Revenue, Salaries Expense, Rent Expense, Utilities Expense, Mr . Gray Drawing etc.

2|Page Dated: October 30, 2015




A real account has a balance that is measured cumulatively, rather than from period to period. Real accounts include all accounts in the balance sheet. They are also called permanent accounts or balance sheet accounts . Examples of real accounts are: Cash, Accounts Receivable, Rent Receivable, Accounts Payable,

and Owner’s Capital

etc.

All adjusting entries include at least a nominal account and a real account.

Types of Adjusting Entries Generally, there are 4 types of adjusting entries. Adjusting entries are prepared for the following: 1. Accrued Income – income earned but not yet received 2. Accrued Expense – expenses incurred but not yet paid 3. Deferred Income – income received but not yet earned 4. Prepaid Expense – expenses paid but not yet incurred Also, adjusting entries are made for: 5. Depreciation 6. Doubtful Accounts or Bad Debts, and other allowances

Adjusting Entry for Accrued Revenue Accrued income (or accrued revenue) refers to income already earned but has not yet been collected. At the end of every period, accountants should make sure that they are properly included as income. When a company has performed services or sold goods to a customer, it should be recognized as income even if the amount is still to be collected at a future date. If no journal entry was ever made for the above, then an adjusting entry is necessary.

Pro-Forma Entry The adjusting entry to record accrued revenue is: Mmm dd Receivable account* Income account**

x,xxx.xx x,xxx.xx

*Appropriate receivable account such as Accounts Receivable, Rent Receivable, Interest Receivable, etc. **Income account such as Service Revenue, Rent Income, Interest Income, etc.

Here's an Example In our previous set of transactions, assume this additional information: On December 31, 2014, Gray Electronic Repair Services rendered $300 worth of services to a client. However, the amount has not yet been collected. It was agreed that the customer will pay the amount on January 15, 2015. The transaction was never recorded in the books of the company.





In this case, we should make an adjusting entry to recognize the income since it has already been earned. The adjusting entry would be: Dec

31 Accounts Receivable Service Revenue

300.00 300.00

Here are some more illustrations.

More Examples: Adjusting Entries for Accrued Income Example 1: Company ABC leases its building space to a tenant. The tenant agreed to pay monthly rental fees of $2,000 covering a period from the 1st to the 30th or 31st of every month. On December 31, 2014, ABC Company did not receive the rental fee for December yet and no record was made in the journal.

Under the accrual basis, the rent income above should already be recognized because it has already been earned even if it has not yet been collected. The adjusting journal entry would be: Dec

31 Rent Receivable Rent Income

2,000.00 2,000.00

Example 2: ABC Company lent $9,000 at 10% interest on December 1, 2014. The amount will be collected after 1 year. At the end of December, no entry was entered in the journal to take up the interest income.

Interest is earned through the passage of time. In the case above, the $9,000 principal plus a $900 interest will be collected by the company after 1 year. The $900 interest pertains to 1 year. However, 1 month has already passed. The company is already entitled to 1/12 of the interest, as prorated. Therefore the adjusting entry would be to recognize $75 (i.e. $900 x 1/12) as interest income: Dec

31 Interest Receivable Interest Income

75.00 75.00

The basic concept you need to remember is recognition of income. When is income recognized? Under the accrual concept of accounting, income is recognized when earned regardless of when collected. If the company has already earned the right to it and no entry has been made in the jou rnal, then an adjusting entry to record the income and a receivable is necessary.

Adjusting Entry for Accrued Expenses Accrued expenses refer to expenses that are already incurred but have not yet been paid. At the end of period, accountants should make sure that they are properly recorded in the books of the company. Here's the rule. If a company incurred, used, or consumed all or part of an expense, that expense or part of it should be properly recognized even if it has not yet been paid. If such has not been recognized, then an adjusting entry is necessary.

Pro-Forma Entry The pro-forma adjusting entry to record an accrued expense is: mmm dd Expense account*

x,xxx.xx





Liability account**

x,xxx.xx

*Appropriate expense account (such as Utilities Expense, Rent Expense, Interest Expense, etc.) **Appropriate liability account (Utilities Payable, Rent Payable, Interest Payable, Accounts Payable, etc.)

For Example For the month of December 2014, Gray Electronic Repair Services used a total of $ 1,800 worth of electricity and water. The company received the bills on January 10, 2015. When should the expense be recorded, December 2014 or January 2015? Answer – in December 2014. According to the accrual concept of accounting, expenses are recognized when incurred regardless of when paid. The amount above pertains to utilities used in December . Therefore, if no entry was made for it in December then an adjusting entry is necessary. Dec

31 Utilities Expense Utilities Payable

1,800.00 1,800.00

In the adjusting entry above, Utilities Expense is debited to recognize the expense and Utilities Payable to record a liability since the amount is yet to be paid. Here are some more examples.

More Examples: Adjusting Entries for Accrued Expense Example 1: VIRON Company entered into a rental agreement to use the premises of DON's building. The agreement states that VIRON will pay monthly rentals of $1,500. The lease started on December 1, 2014. On December 31, the rent for the month has not yet been paid and no record for rent expense was made.

In this case, VIRON Company already incurred (consumed/used) the expense. Even if it has not yet been paid, it should be recorded as an expense. The necessary adjusting entry would be: Dec

31 Rent Expense Rent Payable

1,500.00 1,500.00

Example 2: VIRON Company borrowed $6,000 at 12% interest on August 1, 2014. The amount will be paid after 1 year. At the end of December, the end of the accounting period, no entry was entered in the journal to take up the interest.

Let's analyze the above transaction. VIRON will be paying $6,000 principal plus $720 interest after a year. The $720 interest covers 1 year. At the end of December, a part of that is already incurred, i.e. $720 x 5/12 or $300. That pertains to interest for 5 months, from August 1 to December 31. The adjusting entry would be: Dec

31 Interest Expense Interest Payable

300.00 300.00

Expenses are recognized when incurred regardless of when paid. What you need to remember here is this: when it has been consumed or used and no entry was made to record the expense, then there i s a need for an adjusting entry.

Adjusting Entry for Unearned Revenue 5|Page Dated: October 30, 2015




Unearned revenue (also known as deferred revenue/income) represents revenue already collected but not yet earned. Hence, they are also called "advances from customers". It is to be noted that under the accrual concept, income is recognized when earned regardless of when collected. And so, unearned revenue should not be included as income yet; rather, it is recorded as a liability. This liability represents an obligation of the company to render services or deliver goods in the future. It will be recognized as income only when the goods or services have been delivered or rendered. At the end of the period, unearned revenues must be checked and adjusted if necessary. The adjusting entry for unearned revenue depends upon the journal entry made when it was initially recorded. There are two ways of recording unearned revenue: (1) the liability method, and (2) the income method.

Liability Method of Recording Unearned Revenue Under the liability method, a liability account is recorded when the amount is collected. The common accounts used are: Unearned Revenue, Deferred Income, Advances from Customers, etc. For this illustration, let us use Unearned Revenue. Suppose on January 10, 2015, ABC Company made $30,000 advanced collections from its customers. If the liability method is used, the entry would be: Jan

10 Cash Unearned Revenue

30,000.00 30,000.00

Take note that the amount has not yet been earned, thus it is proper to record it as a liability. Now, what if at the end of the month, 20% of the unearned revenue has been rendered? This will require an adjusting entry. The adjusting entry will include: (1) recognition of $6,000 income, i.e. 20% of $30,000, and (2) decrease in liability (unearned revenue) since some of it has already been rendered. The adjusting entry would be: Jan

31 Unearned Revenue Service Income

6,000.00 6,000.00

We are simply separating the earned part from the unearned portion. Of the $30,000 unearned revenue, $6,000 is recognized as income. In the entry above, we removed $6,000 from the $30,000 liability. The balance of unearned revenue is now at $24,000.

Income Method of Recording Unearned Revenue 6|Page Dated: October 30, 2015




Under the income method, the accountant records the entire collection under an incomeaccount. Using the same transaction above, the initial entry for the collection would be: Jan

10 Cash Service Income

30,000.00 30,000.00

If at the end of the year the company earned 20% o f the entire $30,000, then the adjusting entry would be: Jan

31 Service Income Unearned Income

24,000.00 24,000.00

By debiting Service Income for $24,000, we are decreasing the income initially recorded. The balance of Service Income is now $6,000 ($30,000 - 24,000), which is actually the 20% portion already earned. By crediting Unearned Income, we are recording a liability for $24,000. Notice that the resulting balances of the accounts under the two methods are the same (Cash: $30,000; Service Income: $6,000; and Unearned Income: $24,000).

Another Example On December 1, 2014, DRG Company collected from TRM Corp. a total of $60,000 as rental fee for three months starting December 1. Under the liability method, the initial entry would be: Dec

1 Cash Unearned Rent Income

60,000.00 60,000.00

On December 31, 2014, the end of the accounting period, 1/3 of the rent received has already been earned (prorated over 3 months).

We should then record the income through this adjusting entry: Dec

31 Unearned Rent Income Rent Income

20,000.00 20,000.00

In effect, we are transferring $20,000, one-third o f $60,000, from the Unearned Rent Income (a liability) to Rent Income (an income account) since that portion has already been earned. If the company made use of the income method, the initial entry would be:



CSS Accountancy & Auditing Dec

1 Cash Rent Income

World Times Academy, Lahore 60,000.00 60,000.00

In this case, we must decrease Rent Income by $40,000 because that part has not yet been earned. The income account shall have a balance of $20,000. The amount removed from income shall be transferred to liability (Unearned Rent Income). The adjusting entry would be: Dec

31 Rent Income Unearned Rent Income

40,000.00 40,000.00

Conclusion If you have noticed, what we are actually doing here is making sure that the earned part is included in income and the unearned part into liability. The adjusting entry will alw ays depend upon the method used when the initial entry was made. If you are having a hard time understanding this topic, I suggest you go over and study the lesson again. Sometimes, it really takes a while to get the concept. Preparing adjusting entries is one of the most challenging (but important) topics for beginners.

Adjusting Entries for Prepaid Expense Prepaid expenses (a.k.a. prepayments) represent payments made for expenses which have not yet been incurred. In other words, these are "advanced payments" by a company for supplies, rent, utilities and others that are still to be consumed. Expenses are recognized when they are incurred regardless of when paid. Expenses are considered incurred when they are used, consumed, utilized or has expired. Because prepayments they are not yet incurred, they are not recorded as expenses. Rather, they are classified as current assets. Prepaid expenses may need to be adjusted at the end of the accounting period. The adjusting entry for prepaid expense depends upon the journal entry made when it was initially recorded. There are two ways of recording prepayments: (1) the asset method, and (2) the expense method.

Asset Method Under the asset method, a prepaid expense account (an asset) is recorded when the amount is paid. Prepaid expense accounts include: Office Supplies, Prepaid Rent, Prepaid Insurance, and others. In one of our previous illustrations (if you have been following our comprehensive illustration for Gray Electronic Repair Services), we made this entry to record the purchase of service supplies: Dec

7 Service Supplies Cash

1,500.00 1,500.00

Take note that the amount has not yet been incurred, thus it is proper to record it as an asset.





Suppose at the end of the month, 60% o f the supplies have been used. Thus, out of the $1,500, $900 worth of supplies have been used and $600 remain unused. The $900 must then be recognized as expense since it has already been used.

In preparing the adjusting entry, our goal is to transfer the used part from the asset initially recorded into expense us to arrive at the proper balances shown in the illustration above.

– for

The adjusting entry will include: (1) recognition of expense and (2) decrease in the asset initially recorded (since some of it has already been used). The adjusting entry would be: Dec

31 Service Supplies Expense Service Supplies

900.00 900.00

The "Service Supplies Expense" is an expense account while "Service Supplies" is an asset. After making the entry, the balance of the unused Service Supplies is now at $600 ($1, 500 debit and $900 credit). Service Supplies Expense now has a balance of $900. Now, we've achieved our goal.

Expense Method Under the expense method, the accountant initially records the entire payment as expense. If the expense method was used, the entry would have been: Dec

7 Service Supplies Expense Cash

1,500.00 1,500.00

Take note that the entire amount was initially expensed. If 60% was used, then the adjusting entry at the end of the month would be: Dec

31 Service Supplies Service Supplies Expense

600.00 600.00

This time, Service Supplies is debited for $600 (the unused portion). And then, Service Supplies Expense is credited thus decreasing its balance. Service Supplies Expense is now at $900 ($1,500 debit and $600 credit). Notice that the resulting balances of the accounts under the two methods are the same (Cash paid: $1,500; Service Supplies Expense: $900; and Service Supplies: $600).

Another Example GVG Company acquired a six-month insurance coverage for its properties on September 1, 2014 for a total of $6,000.





Under the asset method, the initial entry would be: Sep

1 Prepaid Insurance Cash

6,000.00 6,000.00

On December 31, 2014, the end of the accounting period, part of the prepaid insurance already has expired (hence, expense is incurred). The expired part is the insurance from September to December. Thus, we should make the following adjusting entry: Dec

31 Insurance Expense Prepaid Insurance

4,000.00 4,000.00

Of the total six-month insurance amounting to $6,000 ($1, 000 per month), the insurance for 4 months has already expired. In the entry above, we are actually transferring $4,000 from the asset to the expense account (i.e., from Prepaid Insurance to Insurance Expense).

If the company made use of the expense method, the initial entry would be: Sep

1 Insurance Expense Cash

6,000.00 6,000.00

In this case, we must decrease Insurance Expense by $2,000 because that part has not yet been incurred (not used/not expired). Insurance Expense shall then have a balance of $4,00 0. The amount removed from the expense shall be transferred to Prepaid Insurance. The adjusting entry would be: Dec

31 Prepaid Insurance Insurance Expense

2,000.00 2,000.00

Conclusion What we are actually doing here is making sure that the incurred (used/expired) portion is included in expense and the unused part into asset. The adjusting entry will always depend upon the method used when the initial entry was made. If you are having a hard time understanding this topic, I suggest you go over and study the lesson again. Sometimes, it really takes a while to get the concept. Preparing adjusting entries is one of the challenging (but important) topics for beginners.

Adjusting Entry for Depreciation Expense When a fixed asset is acquired by a company, it is recorded at cost (generally, cost is equal to the purchase price of the asset). This cost is recognized as an asset and not expense. 10 | P a g e Dated: October 30, 2015




The cost is to be allocated as expense to the periods in which the asset is used. This is done by recording depreciation expense. There are two types of depreciation – physical and functional depreciation. Physical depreciation results from wear and tear due to frequent use and/or exposure to elements like rain, sun and wind. Functional or economic depreciation happens when an asset becomes inadequate for its purpose or becomes obsolete. In this case, the asset decreases in value even without any physical deterioration.

Understanding the Concept of Depreciation There are several methods in depreciating fixed assets. The most common and simplest is the straight-line depreciation method . Under the straight line method, the cost of the fixed asset is distributed evenly over the life of the asset. For example, ABC Company acquired a delivery van for $40,000 at the beginning o f 2012. Assume that the van can be used for 5 years. The entire amount of $40,000 shall be distributed over five years, hence depreciation expense of $8,000 each year.

Straight-line depreciation expense is computed using this formula: Depreciable Cost – Residual Value Estimated Useful Life Depreciable Cost: Historical or un-depreciated cost of the fixed asset Residual Value or Scrap Value : Estimated value of the fixed asset at the end of its useful life Useful Life: Amount of time the fixed asset can be used (in months or years)

In the above example, there is no residual value. Depreciation expense is computed as: = $40,000 – $0 5 years = $8,000 / year

With Residual Value

11 | P a g e Dated: October 30, 2015




What if the delivery van has an estimated residual value of $10,000? The depreciation expense then wou ld be computed as: = $40,000 – $10,000 5 years = $30,000 5 years = $6,000 / year

How to Record Depreciation Expense Depreciation is recorded by debiting Depreciation Expense and crediting Accumulated Depreciation. This is recorded at the end of the period (usually, at the end of every month, quarter, or year). The entry to record the $6,000 depreciation every year would be: Dec

31 Depreciation Expense Accumulated Depreciation

6,000.00 6,000.00

Depreciation Expense: An expense account; hence, it is presented in the income statement. It is measured from period to period. In the illustration above, the depreciation expense is $6,000 for 2012, $6,000 for 2013, $6,000 for 2014, etc. Accumulated Depreciation: A balance sheet account that represents the accumulated balance of depreciation. It is continually measured; hence the accumulated depreciation balance is $6,000 at the end of 2012, $12,000 in 2013, $18,000 in 2014, $24,000 in 2015, and $30,000 in 2016.

Accumulated depreciation is a contra-asset account. It is presented in the balance sheet as a deduction to the related fixed asset. Here's a table illustrating the computation of the carrying value of the delivery van. 2012 Delivery Van - Historical Cost $40,000 Less: Accumulated Depreciation 6,000 Delivery Van - Carrying Value $34,000

2013 $40,000 12,000 $28,000

2014 $40,000 18,000 $22,000

2015 $40,000 24,000 $16,000

2016 $40,000 30,000 $10,000

Notice that at the end of the useful life of the asset, the carrying value is equal to the residual value.

Depreciation for Acquisitions Made Within the Period 12 | P a g e Dated: October 30, 2015




The delivery van in the example above has been acquired at the beginning of 2012, i.e. January. Therefore, it is easy to calculate for the annual straight-line depreciation. But what if the delivery van was acquired on April 1, 2012? In this case we cannot apply the entire annual depreciation in the year 2012 because the van has been used only for 9 months (April to December). We need to prorate. For 2012, the depreciation expense would be: $6,000 x 9/12 = $4,500. Years 2013 to 2016 will have $6,000 annual depreciation expense. In 2017, the van will be used for 3 months only (January to March) since it has a useful life of 5 years (i.e. April 1, 2012 to March 31, 2017). The depreciation expense for 2017 would be: $6,000 x 3/12 = $1,500, and thus completing the accumulated depreciation of $30,000. 2012 (April to December) 2013 (entire year) 2014 (entire year) 2015 (entire year) 2016 (entire year) 2017 (January to March) Total for 5 years

$ 4,500 6,000 6,000 6,000 6,000 1,500 $ 30,000

Adjusting Entry for Bad Debts Expense Companies provide services or sell goods for cash or on credit . Allowing credit tends to encourage more sales. However, businesses that allow credit are faced with the risk that their receivables may not be collected. Accounts receivable should be presented in the balance sheet at net realizable value, i.e. the most probable amount that the company will be able to collect. Net realizable value for accounts receivable is computed like this: Accounts Receivable - Gross Amount Less: Allowance for Bad Debts Accounts Receivable - Net Realizable Value

$ 100,000 3,000 $ 97,000

Allowance for Bad Debts (also often called Allowance for Doubtful Accounts) represents the estimated portion of the Accounts Receivable that the company will not be able to collect.

Take note that this amount is an estimate. There are several methods in estimating doubtful accounts.The estimates are often based on the company's past experiences. To recognize doubtful accounts or bad debts, an adjusting entry must be made at the end of the period. The adjusting entry for bad debts looks like this: Dec

31 Bad Debts Expense Allowance for Bad Debts

xxx.xx xxx.xx





Bad Debts Expense a.k.a. Doubtful Accounts Expense : An expense account; hence, it is presented in the i ncome statement. It represents the estimated uncollectible amount for credit sales/revenues made during the period. Allowance for Bad Debts a.k.a. Allowance for Doubtful Accounts: A balance sheet account that represents the total estimated amount that the company will not be able to collect from its total Accounts Receivable.

What is the difference between Bad Debts Expense and Allowance for Bad Debts ? Bad Debts Expense is an income statement account while the latter is a balance sheet account. Bad Debts Expense represents the uncollectible amount for credit sales made during the period . Allowance for Bad Debts, on the other hand, is the uncollectible portion of the entire Accounts Receivable . You can also use Doubtful Accounts Expense and Allowance for Doubtful Accounts in lieu of Bad Debts Expense and Allowance for Bad Debts. However, it is a good practice to use a uniform pair. Some say that Bad Debts have a higher degree of uncollectibility that Doubtful Accounts. In actual practice, however, the distinction is not really significant.

Here's an Example Gray Electronic Repair Services estimates that $100.00 of its credit revenue for the period will not be collected. The entry at the end of the period would be: Dec

31 Bad Debts Expense

100.00

Allowance for Bad Debts

100.00

Again, you may use Doubtful Accounts. Just be sure to use a logical (and uniform) pair every time. For example: Dec

31 Doubtful Accounts Expense

100.00

Allowance for Doubtful Accounts

100.00

If the company's Accounts Receivable amounts to $3,400 and its Allowance for Bad Debts is $100, then the Accounts Receivable shall be presented in the balance sheet at $3,300 – the net realizable value. Accounts Receivable (Gross Amount) Less: Allowance for Bad Debts Accounts Receivable - Net Realizable Value

$ 3,400 100 $ 3,300

Example This example is a continuation of the accounting cycle problem we have been working on. In the previous step we prepared an unadjusted trial balance. Here we will pass adjusting entries. Relevant information for the preparation of adjusting entries of Company A Office supplies having original cost $4,320 were unused till the end of the period. Office supplies having original cost of $22,800 are shown on unadjusted trial balance. Prepaid rent of $36,000 was paid for the months January, February and March. The equipment costing $80,000 has useful life of 5 years and its estimated salvage value is $14,000. Depreciation is provided using the straight line depreciation method. The interest rate on $20,000 note payable is 9%. Accrue the interest for one month. $3,000 worth of service has been provided to the customer who paid advance amount of $4,0 00. The adjusting entries of Company A are: 14 | P a g e Dated: October 30, 2015


CSS Accountancy & Auditing Date Jan 31


Account

Debit 18,480

Supplies Expense Office Supplies

Credit 18,480

Supplies Expense = $22,800 − $4,320 = $18,480 Jan 31

Rent Expense Prepaid Rent

12,000 12,000

Rent Expense = $36,000 ÷ 3 = $12,000 Jan 31

Depreciation Expense Accumulated Depreciation

1,100 1,100

Depreciation Expense = ($80,000 − $14,000) ÷ (5 × 12) = $1, 100 Jan 31

Interest Expense Interest Payable

150 150

Interest Expense = $20,000 × (9% ÷ 12) = $150 Jan 31

Unearned Revenue Service Revenue

3,000 3,000

Adjusted Trial Balance An adjusted trial balance is prepared after adjusting entries are made and posted to the ledger. This is the second trial balance prepared in the accounting cycle. Its purpose is to test the equality between debits and credits after adjusting entries are entered into the books of the company. To illustrate how it works, here is a sample unadjusted trial balance: Gray Electronic Repair Services Unadjusted Trial Balance December 31, 2014

Account Title Cash Accounts Receivable Service Supplies Furniture and Fixtures Service Equipment Accounts Payable Loans Payable Mr. Gray, Capital Mr. Gray, Drawing Service Revenue Rent Expense Salaries Expense Taxes and Licenses Totals

Debit $ 7,480.00 3,400.00 1,500.00 3,000.00 16,000.00

Credit

$

9,000.00 12,000.00 13,200.00

7,000.00 9,550.00 1,500.00 3,500.00 370.00 $ 43,750.00 $ 43,750.00

At the end of the period, the following adjusting entries were made: 15 | P a g e Dated: October 30, 2015




Dec 31 Accounts Receivable Service Revenue

300.00 300.00

31 Utilities Expense Utilities Payable

1,800.00 1,800.00

31 Service Supplies Expense Service Supplies

900.00

31 Depreciation Expense Accumulated Depreciation

720.00

900.00

720.00

After posting the above entries, the values of some of the items in the unadjusted trial balance will change. Take the first adjusting entry. Accounts Receivable is debited hence is increased by $300. Service Revenue is credited for $300. The balance of Accounts Receivable is increased to $3,700, i.e. $3, 400 unadjusted balance plus $300 adjustment. Service Revenue will now be $9,850 from the unadjusted balance of $9, 550. Next entry. Utilities Expense and Utilities Payable did not have any balance in the unadjusted trial balance. After posting the above entries, they will now appear in the adjusted trial balance. Third. Service Supplies Expense is debited for $900. Service Supplies is credited for $900. The Service Supplies account had a debit balance of $1,500. After incorporating the $900 c redit adjustment, the balance will now be $600 (debit). And fourth. There were no Depreciation Expense and Accumulated Depreciation in the unadjusted trial balance. Because of the adjusting entry, they will now have a balance of $720 in the adjusted trial balance.

Adjusted Trial Balance Example After incorporating the adjustments above, the adjusted trial balance would look like this. Just like in the unadjusted trial balance, total debits and total credits should be equal.

Gray Electronic Repair Services Adjusted Trial Balance December 31, 2014 Account Title Cash Accounts Receivable Service Supplies Furniture and Fixtures Service Equipment Accumulated Depreciation Accounts Payable Utilities Payable Loans Payable Mr. Gray, Capital Mr. Gray, Drawing Service Revenue

Debit $ 7,480.00 3,700.00 600.00 3,000.00 16,000.00

Credit

$

720.00 9,000.00 1,800.00 12,000.00 13,200.00

7,000.00 9,850.00




Rent Expense Salaries Expense Taxes and Licenses Utilities Expense Service Supplies Expense Depreciation Expense Totals


1,500.00 3,500.00 370.00 1,800.00 900.00 720.00 $ 46,570.00 $ 46,570.00

MCQs Practice for the Adjusting Entries 1. Accruals occur when cash flows: A) Occur before expense recognition. B) Occur after revenue or expense recognition. C) Are uncertain. D) May be substituted for goods or services. Answ er: B

2. An example of a contra account is: A) Depreciation expense. B) Accounts receivable. C) Sales revenue. D) Accumulated depreciation. Answ er: D

3. The purpose of closing entries is to transfer: A) Accounts receivable to retained earnings when an account is fully paid. B) Balances in temporary accounts to a permanent account. C) Inventory to cost of goods sold when merchandise is sold. D) Assets and liabilities when operations are discontinued. Answ er: B

4. Which of the following would not be used as an adjusting entry? A) Prepaid Rent Rent expense B) Cash Unearned revenue C) Interest expense Interest payable D) Bad debt expense Allowance for doubtful accounts Answ er: B

5. The adjusting entry required when amounts previously recorded as unearned revenues are earned includes: A) A debit to a liability. B) A debit to an asset. C) A credit to a liability. D) A credit to an asset. Answ er: A





6. Bland Foods purchased a two-year fire and extended coverage insurance policy on August 1, 2003, and charged the $4,200 premium to Insurance expense. At its December 31, 2003, year-end, Bland Foods would record which of the following adjusting entries? A) Insurance expense Prepaid insurance B) Prepaid insurance Insurance expense C) Insurance expense Prepaid insurance Insurance payable D) Prepaid insurance Insurance expense

875 875 875 875 875 3,325 4,200 3,325 3,325

Answ er: D

Rationale: Entry on 8/1:

Insurance expense 4,200 Cash Unused at 12/31: $4,200 x 19/24 = $3,325

7.

4,200

The employees of Neat Clothes work Monday through Friday. Every other Friday the company issues payroll checks totaling $32,000. The current pay per iod ends on Friday, July 3. Neat Clothes is now preparing quarterly financial statements for the three months ended June 30. What is the adjusting entry to record accrued salaries at the end of June? A) Salaries expense 22,400 Prepaid salaries 9,600 Salaries payable 32,000 B) Salaries expense 6,400 Salaries payable 6,400 C) Prepaid salaries 9,600 Salaries payable 9,600 D) Salaries expense 22,400 Salaries payable 22,400 Answ er: D

Rationale: Amount accrued: $32,000 x 7/10 = $22,400

8. On September 1, 2003, Time Magazine sold 600 one-year subscriptions for $81 each. The total amount received was credited to Unearned subscriptions revenue. What would be the required adjusting entry at December 31, 2003? A) Unearned subscriptions revenue 48,600 Subscriptions revenue 16,200 Prepaid subscriptions 32,400 B) Unearned subscriptions revenue 16,200 Subscriptions revenue 16,200 C) Unearned subscriptions revenue 16,200 Subscriptions payable 16,200 D) Unearned subscriptions revenue 32,400 Subscriptions revenue 32,400 Answ er: B





Rationale: Entry on 9/1: Cash 48,600 Unearned subscriptions revenue

48,600

Amount earned: $48,600 x 4/12 = $16,200 9. On December 31, 2002, Typical Fashions had balances in its Accounts receivable and Allowance for uncollectible accounts of $48,400 and $940, respectively. During 2003, Typical Fashions wrote off $820 in Accounts receivable and determined that there should be an Allowance for uncollectible accounts of $1,140 at December 31, 2003. Bad debt expense for 2003 would be: A) $ 320. B) $1,140. C) $ 820. D) $1,020. Answ er: D

Rationale: Write-Offs

Allowance for Uncollectible 940 12/31/02 ? record BD 1,140 12/31/03

Bad debt expense = $1,140 + 820 - 940 = $1,020

10. Fink Insurance collected premiums of $18,000,000 from its customers during the current year. The adjusted balance in the Unearned premiums account increased from $6 million to $8 million dollars during the year. What was Fink's revenues from earned insurance premiums for the current year? A) $10,000,000. B) $16,000,000. C) $18,000,000. D) $20,000,000. Answ er: B

Rationale: Cash collections Deduct increase in unearned premiums Premiums earned

$18,000,000 2,000,000 $16,000,000



Adjusting Entries

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