Principles of Accounting

Help Lesson #4

Adjusting Entries
By Laurie L. Swanson

This presentation is under development.

 Adjusting Entries

Adjusting Entries
bring certain 12/31/2010

account balances UPDATE

up to date at the
end of the
accounting
period.
 Adjustments
Adjusting entries are required
when changes in certain accounts
have not been recorded in the
accounting records.
Adjustments
are necessary
for items that
have either
been deferred
or accrued.
Reason for Adjustments
It can be inefficient and
costly to account for certain
types of transactions on a
daily basis.
 Reason
An example of thefor Adjustments
inefficiency of recording
certain transactions follows:

Each time an employee removes a pen from

the supplies closet, a journal entry debiting
Supplies Expense and crediting Supplies for
$1.25 (estimated cost of pen) should be
recorded. However, it would be very costly
and inefficient to try to keep up with each little
transaction like this. So instead, we wait until
the end of the accounting period and
determine the total amount of supplies used.
Then we make one adjusting entry to account
for all the supplies used during the period.
 Adjusting Entries

Adjusting Entries are necessary

when accrual basis accounting is
used.

Adjusting entries allow businesses

to adhere to the Matching Principle.
 Accrual Basis Accounting

Under accrual basis accounting,

revenues are recognized when
earned (regardless of whether cash
has been received) and expenses
are recognized when incurred
(regardless of cash payment).
The Matching Principle
The Matching
Principle states
that expenses
should be
“matched”
together with
the income they
produced in the
same time
period.
 Characteristics of
Adjustments
Adjusting entries will always have the
following characteristics:
• Adjusting entries are internal
transactions—no new source document
exists for the adjustment.
• Adjusting entries are non-cash
transactions—the Cash account will never
be used in an adjusting entry.
• Adjusting entries will always involve at
least one income statement account and
one balance sheet account.
 How to Analyze an Adjusting
Entry
When analyzing an adjusting
entry, look for the item that has
not been recorded but should have
been. This information is often
not explicit and must be inferred
from the data given.
For expenses, look for the amount
used. For revenue, look for the
amount earned.
 Analyzing an Adjusting
Entry:
An Example
You have the following data about an
adjustment:
Prepaid $15,000 for 12 months of
insurance on Sept 1 of the current
year. Make the appropriate
adjustment as of the end of the fiscal
period.
 Analyzing an Adjusting
Entry:
An Example
Original Entry: On Sept 1 the following
entry would be recorded when the
insurance was prepaid:
Prepaid Insurance 15,000
Cash 15,000

Prepaid Insurance is an asset account – it

is an amount owned by the company
that has economic value.
 Analyzing an Adjusting
Entry:
An Example
Each month, a portion of the prepaid
insurance expires. At the end of the
fiscal period, the Prepaid Insurance and
Insurance Expense accounts must be
updated for the insurance that has
expired (been used).
 Analyzing an Adjusting
Entry:
An Example
Let’s divide the analysis of this transaction into
two parts:
1. What accounts are involved?
When something is “used up” it indicates an
expense account. In this case, we need to
debit Insurance Expense for the expired
insurance. Furthermore, the asset, Prepaid
Insurance, has decreased so we will credit this
asset.
2. What is the amount of the adjustment?
See the next slide for the calculation of the
amount of expired insurance.
 Analyzing an Adjusting
Entry:
An Example
$15,000 for 12 months=
$1,250/month (15,000/12)
-------
Policy purchased on Sept 1.
Months that
have expired between purchase
and fiscal year-end = 4 (Sept, Oct,
Nov, Dec)
Amount of adjustment = $5,000
($1,250/month X 4 months)
 Record the Adjustment
Adjusting entries are always
recorded on the last day of the
fiscal period. For our example, the
fiscal period closes on Dec 31. The
adjustment is journalized as
follows:
POST
DATE ACCOUNT DEBIT CREDIT
REF

0
Dec 31 Insurance Expense 5000
0
Prepaid Insurance 5000 00
 Analyzing an Adjusting
Entry:
Another Example
Let’s try another example. You have the
following data about an adjustment:
You received $12,000 advance cash
on November 1 for a painting job you
are to complete over the next three
months.
 Analyzing an Adjusting
Entry:
Another
Original Entry: Example
On November 1, Cash
would be debited and a liability account
called Unearned Painting Revenue would
be credited. The liability account is credited
because you owe the customer. You owe
the customer painting services.)
Cash 12,000
Unearned Painting Rev 12,000
 Analyzing an Adjusting
Entry:
Another Example
Each month as you perform painting
services, you are earning a portion of the
unearned revenue. At the end of the fiscal
period, the Unearned Painting Revenue and
Painting Revenue accounts must be
updated for the revenue that has now been
earned.
 Completing the Adjustment
We have performed step 1 of the analysis:
the accounts involved are Unearned
Painting Revenue (a liability) and
Painting Revenue (a revenue). So far, the
adjusting entry looks as follows:
POST
DATE ACCOUNT DEBIT CREDIT
REF

Unearned Painting
Dec 31
Revenue
Painting Revenue

Note that as we perform the services

owed, the liability decreases (this is
accomplished by debiting Unearned
Painting Revenue) and the revenue
earned increases (this is accomplished by
Step 2: What amount is
Used in the Adjustment?
$12,000 for 3 months=
$4,000/month (12,000/3)
-------
Cash advance received on
November 1. Two months of
work have been completed by the
fiscal year-end (Nov and Dec)
Amount of adjustment = $8,000
($4,000/month X 2 months)
 Complete the Adjusting
Entry
Now fill in the amount of the
adjustment:

POST
DATE ACCOUNT DEBIT CREDIT
REF

Unearned Painting 0
Dec 31 8,000
Revenue 0
Painting Revenue 8,000 00
 Next Step
You are now closer to completing the
accounting cycle. You can continue to
practice adjusting entries by choosing
the Adjusting Entries Practice
presentation.

The next step in the accounting cycle is

to prepare an Adjusted Trial Balance.