Recap of Last Class

• Balancing Accounts
• Trial Balance
 Learning objectives
• Adjusting Entries

• Depreciation

• Accruals - accumulate over time

• Deferrals - put off to a later time / postpone

• Adjusting entries are journal entries made at
the end of accounting period to allocate
revenue & expenses to the period in which
they are actually applicable.

• Adjusting entries are required because normal

journal entries are based on actual
transactions (cash / bank), and the date on
which these transactions occur may not be the
date required to fulfill the matching principle
of accrual accounting.
 Purpose of Adjusting Entries
• The main purpose of adjusting entries is to update
the accounts to conform with the accrual concept.
At the end of the accounting period, some income
and expenses may have not been recorded, taken
up or updated; hence, there 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.
 Types of Adjusting Entries
Generally, there are 4 types of adjusting entries.

• Accrued Income (Income Receivable) – income earned but not yet received

• Accrued Expense – (Expenses Payable) expenses incurred but not yet paid

• Deferred Income (Unearned Income) – income received but not yet earned

• Deferred Expenses (Prepaid Expense) – expenses paid but not yet incurred

Also, adjusting entries are made for:

• Depreciation

• Doubtful Accounts or Bad Debts, and other allowances

Accrued Income / Income Receivable
Accrued income (or income receivable) refers to
income already earned but has not yet been
collected.
Accrued Income / Income Receivable (Continued)

Our warehouse is larger than we need and so

we rent part of it to another business for
£1,800 per annum.
Accrued Income / Income Receivable (Continued)

The rent receivable account will appear as:

Accrued expenses / Expenses Payable
Accrued expenses refer to expenses that are
already incurred but have not yet been paid.
Rent of £4,000 per year as payable at the end of
every three months. The rent was paid on
time in March, but this is not always the case.
 Accrued expenses / Expenses Payable
(Continued)
The rent for the last quarter was paid on 5
January, which is after year end, so the books
will appear as:
 Accrued expenses (Continued)
The true rent figure for the year must be shown
in the profit and loss account
 Accrued expenses (Continued)
The accrued rent expense must be shown on
the rent account
 Unearned Income
• Unearned income, also called deferred income
or revenue, refers to income already collected
but not yet earned. These are to be properly
classified as liabilities, not income. There are
two methods in recording deferrals:
the income method and the liability method. 
 Liability Method of Recording Unearned / Accrued
Income
• Under the liability method, a liability account
is recorded when the amount is collected.
• Suppose on January 10, 2016, ABC Company
made $30,000 advanced collections from its
customers.  If the liability method is used, the
entry would be:
Jan 10 Cash 30,000.00  
    Unearned Revenue   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 Income / Revenue 6,000.00  

    Income   6,000.00
 Income Method of Recording Unearned Revenue
Under the income method, the accountant records the entire
collection under an income account. Using the same transaction
above, the initial entry for the collection would be:
Jan 10 Cash 30,000.00  
    Income   30,000.00

If at the end of the year the company earned 20% of the entire $30,00, then
the adjusting entry would be:

Jan 31 Income 24,000.00  

    Unearned Income   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).
Prepaid expenses (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. Hence, they are included in the
company's assets.
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 since they are readily available for use.
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.
Dec 7 Service Supplies 1,500.00  
    Cash   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% of 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 – for us to arrive at the proper balances
shown in the illustration above.

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 900.00  

    Service Supplies   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, we initially records the entire payment as
expense. If the expense method was used, the entry would have been:
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 7 Service Supplies Expense 1,500.00  
    Cash   1,500.00

Dec 31 Service Supplies 600.00  

    Service Supplies Expense   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).
Questions
 Next Class
- Depreciation

- Doubtful / Bad Debts

- Closing & Reversing Entries

- Opening & Closing Trial Balance