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More Adjusting Entries
More Adjusting Entries
When you are looking at an unadjusted trial balance, there is a high degree of
likelihood that exact list of accounts and balances does not properly reflect the true
financial position of the company as of the last day of the accounting period. When
you see one of the following accounts, you should be highly suspicious that an
adjusting entry is required.
Deferred Expenses
Deferred Revenues
Accrued Expenses
Accrued Revenues
Valuation Accounts
Income Taxes - for a corporation
As you know, a basic difference between revenues and expenses is who is paying
and who is receiving. The difference between deferrals and accruals is when does
the critical event take place and when does the money change hands. Deferrals,
money changes hands before the event takes place, resulting in prepaid expenses and
unearned revenues. Accruals, the event takes place before the money changes hands.
I have set up the basic examples of each below - your textbook goes into much
greater detail.
Deferred Expenses/Prepaid Expenses (both phrases describe the same situation)
Assume that our business rents a building for $100 a month and we pay the rent the
first day of the month. Question. What should our income statement report for rent
expense for the year? Answer. $1200. So, what entry should we make each month
to accomplish this?
Rent Expense
$100
Cash
$100
What if the building owners came to us and said they would reduce the rent to $1000
a year if we paid for 2 years rent on January 1 and we did. What entry would this
require? Cash had definitely decreased by $2000 - what other account has changed.
On January 1, to be conceptually correct, we have exchanged one asset, cash, for
another asset, the right to use the building for the next two years. So we increase one
asset, let's call it "Prepaid Rent" and decreased another asset "Cash"
Prepaid Rent
Cash
$2000
$2000
This entry is exactly right on 1/1. But when 12/31 comes around and we are ready to
prepare our financial statements - does this paint a correct picture of our company?
Did cash go down by $2000? Yes. Do we have prepaid rent of $2000 at the END of
the year? NO. We have the right to use the building (prepaid rent) for one more
year. And by the way, should we report any rent expense for the year? Yes, $1000.
This example highlights the need for adjusting entries. The transaction is recorded
exactly right when it occurred, but then, as a result of something (in this case- the
passage of time) things change and we need to "update" the accounts to reflect the
proper balance for financial statement presentation, i.e., adjusting entries.
In this case we want to decrease prepaid rent (asset) by $1000 and increase rent
expense (decrease capital) by $1000.
Rent Expense
Prepaid Rent
$1000
$1000
Prepaid Rent
+2000
-1000
+1000
Rent Expense
+1000
+1000
Is this right, on 12/31 did cash go down $2000 for the year? Yes. Do we have prepaid
rent of $1000? Yes. Do we have rent expense of $1000? Yes. Perfect. This is only
one example for prepaid expenses, but the concept applies to anything that a
company prepays.
Deferred Expenses/Deferred Revenues (again both refer to the same)
Hey, what if you were the person who OWNED the building as opposed to the guy
renting above. What entries would you make? You would definitely have more
assets (cash) on 1/1 but what else do you have? Any other assets change? NO. Did
you earn the revenue yet? NO. So, if capital doesn't change (revenue) and no other
asset changes, the only thing left is liabilities. Does this seem reasonable? YES.
Why? Because now you, as the owner of the building, you have an obligation (debt,
owe, whatever) to this person to use the building for the next 2 years or you owe him
back the $2000. So what entry do you make on 1/1?
Cash
Unearned Rent
2,000
2,000
Perfect on 1/1. You have an increase in cash and an increase in obligations which is
exactly what your entry shows. BUT on 12/31, do you still owe the use of the
building for 2 more years? NO only one more year now, AND you have earned the
revenue for the use of the building for the past years. So you need an adjustment to
show the decrease in the liability and to increase revenues.
Unearned Rent
Rent Revenue
1,000
1,000
Accrued Expenses
Totally different example, lets say you hire someone on 1/1 Monday to clean your
house everyday for $10 AND they end up cleaning your house everyday for the
entire year. What amount should the account "house cleaning expense" have in it as
of 12/31 when you prepare financial statements? Let's see, 10 buck a day, 365 days
in the year, $3,650. Man, that's great. Ok. Let's see how this plays out. Let's say we
pay this person every Sunday, so on Sunday, 1/ 7, the person has worked 7 days, we
pay them $70, and we record the following transaction:
House cleaning expense
Cash
$70
$70
Perfect, we have incurred the expense, we have paid the expense, and we have
recorded the expense. Absolutely perfect. And we will do the exact same thing
every Sunday for the rest of the year. So let's zoom ahead. Today is Sunday, 12/29
(don't get out a calendar to see if this matches, lets just assume it does). What entry
do you make? Same one.
House cleaning expense
Cash
$70
$70
Now it is Dec 31, time to prepare financial statements. What balance should house
cleaning expense show? $3,650. How much does is show? $3,630. Why? Because
the person cleaned on Monday (December 30) and Tuesday (December 31) and
haven't got paid yet and therefore no entry was made. But shouldn't it have been
recorded? Yes. Again, we have incurred the expense, we haven't paid it, but we still
need to record it. How do we get the expense to go from 3630 to 3650? Increase it
by $20. And, because we haven't paid in, on 12/31 we have an obligation (liability)
to pay this $20 which also needs to be recorded.
House cleaning expense
$20
House Cleaning Payable
$20
Now the expense will show $3,650, cash has gone down by $3630 and liabilities
have gone up by $20. Perfect. [This is a little off the subject, but what entry do you
make on next Sunday?
House cleaning exp
House cleaning pay
50
20
Cash
70
Accrued Revenue
What if you were the cleaner?
Every Sunday.
Cash
House cleaning Revenue
70
On 12/31
House Cleaning Receivable
House Cleaning Revenue
20
70
20
Now your revenue would show $3,650 - exactly what it should show.
Valuation Account - Contra Asset Account - Depreciation
Assume a company buys a candle for $100 on January 1. The candle will burn
exactly one year - it goes out at exactly 11:59 on December 31. What entry would
you make to record its purchase?
Candle
Cash
$100
$100
This is exactly right on January 1. The company has a piece of property that it owns
that will provide probable future economic benefit - i.e. an asset which is property
described as candle. It has increased, and to increase an asset, debit candle. The
company paid cash, an asset, which decreased. To decrease an asset, credit cash.
PERFECT. Everything is recorded as it should be on Jan 1. Time goes by and now
it's December 31, time to prepare the financial statements. Do we still have an asset
(probable future economic benefit) in the form of a candle? No, it's gone, its been all
used up. When we use something up to operate the business, that is an expense. So,
we need to make an entry to recognize the expense and decrease the asset.
Candle Expense $100
Candle
$100
So where are we? We report $100 increase in candle expense for the year and $100
decrease in cash. The candle account has cancelled itself out - dr 100 cr 100 =
balance of $0.
January 1, buy a new candle for $100. We could make the same entries as above, but
sooner or later we would just
Candle Expense $100
Cash
$100
$1000
$1000
Ok, perfect. Now time goes by and its Dec 31? Does the company still have an
asset (candle light for 10 years) that it had on Jan 1? No. A portion of the candle has
been used up (expense) which obviously means the asset has decreased. What entry
do we make? Doesn't it make sense that we would have to debit Candle Expense to
recognize the candle used up and then credit Candle to show the decrease in the
asset?
Candle Expense
Candle
Now the question is "for what amount"? The company paid $1000 for a 10 year
asset which 1 year (or 10%) has been used up. When faced with allocation problems
in accounting, we usually take what's referred to as a "systematic and rational"
approach which means we basically uses common sense unless some other factor
enters in that requires us to be a little more creative. In this case, if they paid $1000
for a 10 year asset, that means essentially that ($1000/10) $100 worth of the asset is
used up each year - so we adjust by that amount, $100. So, for years 11 - 20, what
effect does this have on the financial statements? Same as before, the income
statement each year will report $100 candle expense (whether you buy 1 year or 10
year candles). Doesn't this make sense - you are using up the same asset each year
so you should have the same results. As far as the balance sheet goes, the purchase
of the candle just exchanged one asset, cash, for another asset, candle - which has a
net effect of zero. Then each year, the asset candle decreases by $100 and owners
equity has a corresponding decrease ($100) to reflect the impact the expense has on
owners equity.
Ok, think about that stuff for awhile.
Now think about this, let's talk about a car instead of a candle. When I tell you that a
company has $100 car expense on the income statement, what comes to your mind?
I'm thinking tune ups, gas, and some type of an expense I have associated with the
car. And another thing, when I decrease the record (account) I have been keeping for
the car, what comes to your mind? I'm thinking you got rid of a car.
Let's remove the possibility of confusion. When we are making an adjusting entry to
reflect the using up of a plant asset (car, building, equipment, etc), let's preface the
account with the word depreciation so I can understand the difference between cost
allocation and new expenditures. And, since the car (or at least 1/10th of it) has not
actually disappeared, let's make sure that we identify that we are recording a
decrease in the asset because we think we are using it up as opposed to it actually
being gone. This approach would give us the following adjusting entry.
Deprecation Expense - Car
Accumulated Deprecation - Car
$100
$100
depreciation, inventory, etc. So keeping studying the chapters and really try to
understand the examples that are given.