ADJUSTING ENTRIES

To make sure that financial statements are in line with the matching principle and
the accrual basis of accounting, adjusting entries are made. These are entries made at
the end of the reporting period, usually on December 31, to show the accruals,
deferrals, depreciation and bad debts of a business.
 Accruals: Transactions where cash is NOT YET paid or received but there is an
expense that has incurred or there is an income that was earned. Adjusting
entries are made to show incurred expenses or earned income. For example, a
business makes a loan on September and the interest is paid at maturity date on
May next year. On December 31, under the matching principle the business has
incurred an interest expense even though it is only paid on May next year.

 Deferrals: Transactions where cash is already paid or received. Adjusting entries

are made to show the unearned and earned portions of a deferred revenue and
the used and unused portions of a prepaid asset. For example, a business paid
for an insurance policy lasting for 9 months in September. On December 31,
adjusting entries are made to show how much of the insurance policy has
expired or has been used this year and how much of it is unused or can be used
in the following year.

 Depreciation: The systemic and rational allocation of an asset’s value during its
useful life. As time goes on, the value of a PPE decreases due to wear and tear
and continued used. Once this happens, the PPE will not qualify as an asset
anymore since it can’t provide economic benefits to the business. Instead of
expensing it when the day comes that the PPE stop working, we depreciate it as
an expense, little by little, until the day comes that the PPE become obsolete.

 Bad debts: What happens when a customer can’t pay back the debts that they
owe to the business? You recognize a bad debts expense. This is what happens
when an accounts receivable can’t provide economic benefits to the business
anymore since the debtor has no ability to pay it.
Adjusting entries for accruals
To compute the adjusting entries for accruals we need to find the interest.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑥 𝑅𝑎𝑡𝑒 𝑥 𝑇𝑖𝑚𝑒
Principal is the face value of the note. Rate is interest rate of the note while time is the
expired portion of the note. In other words, the number of months between December
31 and when the note was made divided by 12 which represents 1 year. If the note
mature in less than a year or longer than 1 year then don’t use 12 months.

There are two types of adjusting entries for accruals

 Accrued expenses: A business recognizes an expense to be paid in the future.
This means that you debit interest expense and credit interest payable.
 Accrued income: A business recognizes an income to be received in the future.
This means that you debit interest receivable and credit interest income.

Example: A business issued a 12%, 100,000 peso note payable for 1 year on October
1. Compute for accrued interest expenses.
Solution:
3 𝑚𝑜.
𝐼 = 100,000 𝑥 12% 𝑥 = 3,000
12 𝑚𝑜.
Since this is an accrued expense where a business recognizes an expense to be paid in
the future, we debit interest expense and credit interest payable.

A trick for computing the months passed:

Another way of computing months from Dec. 31 is by assigning numbers of each
month. January would be 1, February would be 2, March would be 3 and etc. Subtract
the number from 13 to get the months from Dec 31. If the date is on the 30 th or the 31st,
use the number for the next month. In the problem above, the reason why Oct. 1 is 3
months is because 13 – 10 = 3
𝑡 = 13 − 𝑚 = 13 − 10 = 3 𝑚𝑜𝑛𝑡ℎ𝑠

Example: A business received a 12% note receivable for 100,000 good for one year on
April 1. Compute accrued interest income.
Solution:
 9 𝑚𝑜.
𝐼 = 100,000 𝑥 12% 𝑥 = 9,000
12 𝑚𝑜.
𝑡 = 13 − 4 = 9 𝑚𝑜.
Since this is accrued income, where a business recognizes an income to be received in
the future, we debit interest receivable and credit interest income.
𝑛𝑜. 𝑜𝑓 𝑚𝑜𝑛𝑡ℎ𝑠
𝐴𝐽𝐸 = 𝑃 𝑥
𝑡𝑜𝑡𝑎𝑙 𝑚𝑜𝑛𝑡ℎ𝑠

Example: A business rents out a building for 50,000 monthly. As of Dec. 31, the tenant
has not paid for the month of December.
This problem is an accrued income because it recognizes an income to be received in
the future and no cash has been paid out or received yet. However, unlike the previous
two problem, there is no interest rate. In situations like this, we use the formula above
where the principal is multiplied by the number of months divided by the total number of
months. The principal of the problem is 50,000. The number of months is 1 since only
December was not yet paid and the total number of months is also 1 since this rent is
monthly and not yearly.
1 𝑚𝑜.
𝐴𝐽𝐸 = 50,000 𝑥 = 50,000
1 𝑚𝑜.
Since this is accrued income, where a business recognizes an income to be received in
the future, we debit rent receivable and credit rent income.

Adjusting entries for deferrals: Transactions where cash is already paid or received.
Unlike in accruals where cash is not yet paid or received. There are two types of
deferrals. These are
 Deferred expenses: Adjusting entries that show the used and unused portions
of a prepaid asset. For example, a business paid for an insurance policy lasting
for 9 months in September 1. On December 31, adjusting entries are made to
show how much of the insurance policy has expired or has been used this year
and how much of it is unused or can be used in the following year. The two
methods in approaching deferred expenses are asset method and expense
method. Both of which are normal debit accounts. The business uses the asset
method if prepaid expense is debited in the original journal entry. The business
uses the expense method if an expense account is debited in the original journal
entry.
  Deferred income: Adjusting entries that show the unearned and earned portions
of cash received from customers. For example, a business received cash for rent
for 9 months in September 1. On December 31, adjusting entries are made to
show how much of the rent has been earned (rent due for this year) or unearned
(rent due for next year). Remember that can only be earned if the time for it has
passed. The two methods in approaching deferred income are liability method
and income method. Both of which are normal credit accounts. The business
uses the liability method if a liability account is credited in the original journal
entry. The business uses the income method if an income account is credited in
the original journal entry.

Example: A business prepays a 120,000, 1 year insurance in Oct. 1 with a debit to

prepaid insurance. Make a deferral adjusting entry on Dec. 31.
Since the business debited to an asset account in the original entry. The business using
the asset method. Before we proceed, you need to take note of the following.
 Our goal in deferred expenses is to record both the asset and the expense
account. If the asset account is debited in the OJE, we record the expense
account in the AJE. This is called the asset method. If the expense account is
debited in the OJE, we record the asset account in the AJE. This is called the
expense method.
 Prepaid expenses represent the unused portion to be used next year. In other
words, prepaid expenses is the number of months from Jan 1 up until it expires.
 Expenses represent the used portion that was used this year. In other words,
expenses is the number of months from when the cash was paid up until Dec.
31.
Since the asset account (unused) was already recorded in the OJE, we will record the
expense account (used) in the AJE, which is the number of months from when the cash
was paid (October 1) up until Dec. 31.
3 𝑚𝑜.
𝐴𝐽𝐸 = 120,000 𝑥 = 30,000
12 𝑚𝑜.
To make the adjusting entry, we will record the expense account and reduce the asset
account. Since expenses are a normal debit account then it is debited. The asset
account is credited to reduce its balance and to transfer its value to expenses. Under
the asset method, here is the adjusting journal entry.
Insurance expense 30,000
Prepaid insurance 30,000
Example: A business prepays a 120,000, 1 year insurance in Oct. 1 with a debit to
insurance expense. Make a deferral adjusting entry on Dec. 31.
Since the business debited to an expense account (used) in the original entry. The
business is the using expense method.
Since the expense account (used) was already recorded in the OJE, we will record the
asset account (unused) in the AJE, which is the number of months from Jan 1 up until
the rent expires.
9 𝑚𝑜.
𝐴𝐽𝐸 = 120,000 𝑥 = 90,000
12 𝑚𝑜.
To make the adjusting entry, we will record the asset account and reduce the expense
account. Since assets are a normal debit account then it is debited. The expense
account is credited to reduce its balance and to transfer its value to assets. Under the
expense method, here is the adjusting journal entry.
Prepaid insurance 90,000
Insurance expense 90,000

Deferred income:
Example: A business that rents buildings receives a 120,000 prepayment from a
customer good for one year on April 1 with a credit to unearned rent. Make a deferral
adjusting entry on Dec. 31.
Since the business credited to a liability account in the original entry. The business is
using the liability method. Before we proceed, you need to take note of the following.
 Our goal in deferred income is to record both the liability and the income account.
If the liability account is recorded in the OJE, we record the income account in
the AJE. This is called the liability method. If the income account is recorded in
the OJE, we record the liability account in the AJE. This is called the liability
method.
 Unearned income represents the unearned portion to be earned next year. In
other words, unearned income is the number of months from Jan 1 up until the
prepayment expires.
 Income represent the earned portion that was earned this year. In other words,
income is the number of months from when the cash was paid up until Dec. 31.
Since the liability account (unearned) was already recorded in the OJE, we will record
the income account (earned) in the AJE, which is the number of months from when the
prepayment was received (April 1) up until Dec. 31.
 9 𝑚𝑜.
𝐴𝐽𝐸 = 120,000 𝑥 = 90,000
12 𝑚𝑜.
To make the adjusting entry, we will record the income account and reduce the liability
account. Since income is a normal credit account then it is credited. The liability account
is debited to reduce its balance and to transfer its value to income. Under the liability
method, here is the adjusting journal entry.
Unearned rent 90,000
Rent income 90,000

Example: A business that rents buildings receives a 120,000 prepayment from a

customer good for one year on April 1 with a credit to rent income. Make a deferral
adjusting entry on Dec. 31.
Since the business credited to an income account in the original entry. The business is
using the income method.
Since the income account (earned) was already recorded in the OJE, we will record the
liability account (unearned) in the AJE, which is the number of months from January 1
up until the prepayment expires in April 1 next year.
3 𝑚𝑜.
𝐴𝐽𝐸 = 120,000 𝑥 = 30,000
12 𝑚𝑜.
To make the adjusting entry, we will record the liability account and reduce the income
account. Since liability is a normal credit account then it is credited. The income account
is debited to reduce its balance and to transfer its value to liabilities. Under the income
method, here is the adjusting journal entry.
Rent income 30,000
Unearned rent 30,000
Here is a table to organize all learnings from deferrals
Method used Account in OJE Recorded in Reduced in Time duration
AJE AJE used
Asset method Asset (debit) Expense Asset (credit) Payment to
(debit) Dec. 31
Expense method Expense (debit) Asset (debit) Expense Jan. 1 to
(credit) maturity
Liability method Liability (credit) Income Liability (debit) Payment to
(credit) Dec. 31
Income method Income (credit) Liability Income (debit) Jan. 1 to
(credit) maturity
Adjusting entries for depreciation:
To make adjusting entries for depreciation, debit depreciation expense and credit
accumulated depreciation (contra asset that reduces the balance of PPE). All entries
here are using the straight line method. If you want to learn more depreciation methods,
check out my notes in depreciation methods. The formula for depreciation expense are
as follows.
𝑛𝑜. 𝑜𝑓 𝑚𝑜𝑛𝑡ℎ𝑠 𝑝𝑎𝑠𝑠𝑒𝑑
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝐶𝑜𝑠𝑡 ÷ 𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 𝑥
12
Example: A business buys a machine for 420,000 on November 31 with a useful life of 8
years. Compute for depreciation expense.
Solution:
1 𝑚𝑜.
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 420,000 ÷ 8 𝑥 = 4,375
12 𝑚𝑜.
Journal entry:
Depreciation expense 4,375
Accumulated depreciation 4,375

Adjusting entries for bad debts expense:

To make adjusting entries for bad debts expense, debit bad debts expense and
credit allowance for doubtful accounts (contra asset that reduces the balance of
accounts receivable).
Example 45,000 of accounts receivable were estimated to be of doubtful collection.
Journal entry:
Bad debts expense 45,000
Allowance for doubtful accounts 45,000