Lesson 3:  Adjusting the Accounts

Up to this point, you have learned the first steps in the Accounting cycle. These are:

  1. Analyze each transaction;

  2. Journalize each transaction;

  3. Post each transaction to the ledger;

  4. At the end of the accounting period, prepare a trial balance.

Learning Objectives

The transactions covered in chapters 1 and 2 are primarily ones that arise from some external source, such as selling services on account, or purchasing an asset. Quite often, one can visualize an exchange taking place in such transactions.

The transactions discussed in Chapter 3 are called adjustments. Adjustments must be made to reflect such items as:

  1. Revenues that have been earned this period, but not as yet recorded. Example: a service has been performed in March, but the customer has not been billed. Under accrual accounting rules, that revenue must be reflected in the income statement for March.

  2. Expenses that have been incurred, but not yet recorded. For example, an insurance policy purchased at the beginning of the year may have partially expired, due solely to the passage of time. That expiration of the policy should be considered an expense. An adjusting entry would be made to convert a portion of the Prepaid Insurance to Insurance Expense.

  3. Various plant and equipment items used in the business wear out as they are being used. The cost of such assets can be "written off" (converted to an expense) on a periodic basis. This write-off is called depreciation. An entry would be made to debit Depreciation Expense. The credit would be made to a contra-asset account called Accumulated Depreciation.

Your major objective in Chapter 3 is to understand the types of adjustments typically made to the accounts, and why those adjustments need to be made. As implied in examples 1-3 above, the "why" of adjustments has to do with allocating revenues and expenses to the appropriate period.

Accrual Accounting

Accounting can be done in a couple of different ways.  We are studying accrual accounting, not cash-basis accounting.  A simple definition of accrual accounting is:  "record all revenues in the period we earn them; record all expenses in the period we incur them."  For revenues, the basic approach is to determine when the revenue was earned. If the revenue was earned (i.e. services were performed) this period, then the revenue should be reflected in this period. Never mind that the collection of the customer's receivable won't happen for two months; we are concerned with completing the earning process in measuring revenue. We focus on the earning process, not the receipt of cash.

Expenses work in a similar way.  If our advertisement is to run in the newspaper this month, we want the Advertising Expense to reflect the cost of the advertisement -- even if we are going to pay for the advertisement next month.  We look for the incurrence of the expense, rather than the timing of the cash payment.

Facts about Adjustments

Here are some true statements about Adjusting Entries:

  1. Every adjustment affects one income statement account and one balance sheet accountThe income statement account will be a revenue or an expense.

  2. Adjustments are only done at the end of an accounting period.  We will assume that the entire accounting cycle takes place in one month's time.  Therefore, the adjustments would be recorded at the end of each month.

  3. You will not see the cash account used in any adjustment. If an increase or decrease in cash happens, it is handled as a regular transaction, not an adjustment.

  4. The accountant must use good judgment in deciding if an adjustment is necessary; many adjustments could be overlooked because there is no external notification that an adjustment is necessary. Example: your company will not be billed for the wear and tear on your equipment and vehicles. You must determine a useful life for such items and allocate the asset cost to each year that the asset is likely to benefit the company.

  5. Accrual accounting and cash-basis accounting are different forms of accounting. When individuals prepare their taxes, they normally do so on a cash basis. Accrual accounting requires that adjustments be made to properly reflect periodic revenues and expenses.

  6. There are two principles of accounting that are satisfied by the adjusting process. First, we want to make sure we record all revenues that were earned this period. This is called the revenue recognition principle. The revenue recognition principle says that "we must record all revenues in the period they were earned, regardless of whether the cash has been received." So if we performed services for a customer on account, or even if the customer hasn't been sent a bill, we record the revenue. If we earn revenue from a bank account, that too would be recorded.

    Second, we want to match all expenses that we incurred this period to the revenues earned this period. This is called the matching principle. Some expenses such as rent expense involve paying cash for the expense. However, using up supplies is also an expense, one in which an asset other than cash is being consumed. Similarly, using up insurance and equipment are considered expenses in the adjusting process.

    You will recall that revenues and expenses come together on the income statement, so these two principles are the foundation for computing net income according to accrual accounting rules.

Adjustment Examples

Here are a few adjustments that you should know how to do.  I suggest that you focus on the revenue or expense applicable to each adjustment.

1.  The Supplies adjustment records the cost of supplies used up during the month.  The supplies used up are debited to the Supplies Expense account.   The offsetting credit reduces the Supplies account to the proper balance (the amount of supplies actually left on the shelf).  Example: Johnson Company purchased $1,050 of supplies on January 1. At the end of January, they counted the supplies and found that $700 of supplies were left. This would imply that $350 of the supplies were used up. On the last day of the month, an adjustment would be made to record the amount of supplies used up:

General Journal

Date

Accounts

Ref

Debit

Credit

Jan 31

Supplies Expense

 

350

 

....Supplies

    

350

 

Supplies used in January = $350.

     

2.  The Insurance adjustment is quite similar.  Suppose that a $2400 insurance policy was purchased on January 1, and that it is a one-year policy.    This would mean that one month's worth of the policy ($200 worth) expires each month.  At the end of January, we would record this adjustment.  

General Journal

Date

Accounts

Ref

Debit

Credit

Jan 31

Insurance Expense

  

200

  

 

....Prepaid Insurance

      

200

 

Insurance expired in  January = $200.

        

3.  Depreciation is the cost of equipment or buildings that have been used up during the month. Suppose the company purchased a $36,000 truck on January 1, that is estimated to last for 36 months.  The company will record depreciation on a monthly basis, at the rate of $1,000 per month.  The depreciation adjustment for January will look like this.   

General Journal

Date

Accounts

Ref

Debit

Credit

Jan 31

Depreciation Expense

  

1000

  

 

....Accumulated Depreciation--Equipment

      

1000

 

 Depreciation on Equipment = $1,000.

        

Depreciation Expense is an expense account, just like Supplies Expense or Insurance Expense.  These expenses will be reported on the Income Statement.  Accumulated Depreciation--Equipment is considered a contra-asset (contra means "against"). At the end of January, after the depreciation adjustment, the Equipment account will appear on the balance sheet like this:   

Cash

 

$2,000

Accounts Receivable

 

8,000

Equipment

$36,000

 

Less Accumulated Depreciation

1,000

35,000

Total Assets

 

$45,000

Notice that the Accumulated Depreciation is subtracted from the asset cost of $36,000.    The $35,000 amount is called the "book value" of the asset, and will decline by $1,000 each month as the Accumulated Depreciation continues to increase. After 36 months, the Equipment will still have a $36,000 balance, but the Accumulated Depreciation will also be $36,000, and the book value will be at zero. After that, further depreciation may not be taken on this asset.

Note that the Equipment account and the Accumulated Depreciation Equipment account are two separate accounts. And, while it is true that we subtract accumulated depreciation from the Equipment account on the balance sheet, a trial balance would show the status of the two accounts separately. In the example shown above, the Equipment account has a balance of $36,000 and the Accumulated Depreciation--Equipment account has a balance of $1,000. So, we only compute the book value on the balance sheet.

4.  We must adjust for Unearned Revenue that has been earned.    Unearned Revenue is an account used when customers make an advance payment to us for future services.  For example, if a client comes to us in January, and pays us $5,000 for consulting services we will provide next month, we cannot count the $5,000 as revenue.    Revenue can only be recorded when we earn it.  How would the receipt of $5,000 in cash be recorded?  Here's how: 

General Journal

Date

Accounts

Ref

Debit

Credit

Jan 15

Cash

  

5000

  

 

....Unearned Revenue

      

5000

 

 Received customer deposit for future services.

        

This receipt of cash is a normal recurring transaction for many types of business. At the end of the month, let us assume that one-half of the Unearned Revenue has now been earned. In other words, during the remainder of January, we have provided $2500 of the services we are obligated to provide. The following adjustment would convert $2500 of the obligation to revenue.

General Journal

Date

Accounts

Ref

Debit

Credit

Jan 31

Unearned Revenue

  

2500

  

 

....Service Revenue

    

2500

 

 Customer deposits of $2500 have now been earned

        

Note: Unearned Revenue is considered a liability, so it goes on the balance sheet. Do not be tempted to put Unearned Revenue on the Income Statement, even though the word "revenue" is in its title.

5.  Salaries earned by employees but not paid to them.  At the end of a month, we must determine if employees have worked any hours that they have not been paid for.  This could happen, for example, if employees are paid every Friday and January 31 happens to be a Wednesday.  There would be three days of salaries (Monday, Tuesday, and Wednesday) for which the employees won't get paid until Friday.  We must include the January salaries as expenses for January, so that they appear on January's income statement.  Suppose we pay our employees $500 per day and we owe them for Monday, Tuesday and Wednesday, with Wednesday being January 31.

The adjustment will appear as follows:  

General Journal

Date

Accounts

Ref

Debit

Credit

Jan 31

Salaries Expense

  

1500

  

 

....Salaries Payable

      

1500

 

 Salaries owed to employees at Jan. 31 = $1500.

        

Let's go one step further and ask this question: what entry would be made on Friday, February 2? Our payroll will be 5 times $500 or $2500. We also have to clear the liability established on Wednesday January 31. The entry would look like this:

General Journal

Date

Accounts

Ref

Debit

Credit

Feb 2

Salaries Expense

  

1,000

  

 

Salaries Payable

   

1,500

 

 

.... Cash

   

2,500

 

 Salaries owed to employees at Jan. 31 = $1500.

        

Note that this technique specifically assigns the salaries expense to the proper month.

6.  Interest earned on a Note Receivable.  Suppose we received a $1,000 Note Receivable on January 1 that earns interest at the rate of 6% per year.  As of January 31, there will be interest owed to us (Interest Receivable).    When we earn interest, it is considered a revenue.  The amount of interest can be computed using the formula:  Interest = Principal * Rate * Time.   (The * means multiply.)  The time must be in years.  If the note was outstanding for one month, we would consider the time to be one-twelfth of a year.   The interest amount would therefore be $1,000 * .06 * 1/12 = $5.00.  The adjustment would be: 

General Journal

Date

Accounts

Ref

Debit

Credit

Jan 31

Interest Receivable

  

5

  

 

....Interest Revenue

      

5

 

 Interest earned on note receivable = $5.

        

The Note Receivable illustrated might arise if we loaned a client $1,000 and they gave us the note to signify their indebtedness. Our reward for loaning out cash is the interest revenue we earn over time.

Your textbook discusses notes from the opposite point of view. For example, we might borrow $1,000 from the bank and incur interest expense. An adjustment would be made at the end of the accounting period involving a debit to Interest Expense, and a credit to Interest Payable.

Remember that every adjustment is 1) recorded in the journal and 2) posted to the ledger, just like the regular transactions. These entries will occur on the last day of the accounting period. After the adjustments are posted, the accountant verifies that the ledger is still in balance by preparing an Adjusted Trial Balance.

The Accounting Cycle, as we have now explored it consists of the following steps:

  1. Analyze each transaction;

  2. Journalize each transaction;

  3. Post each transaction to the ledger;

  4. At the end of the accounting period, prepare a trial balance;

  5. Journalize the Adjusting Entries;

  6. Post each Adjusting Entry to the ledger;

  7. Prepare an Adjusted Trial Balance.

  8. At this point, you could prepare the financial statements--Income Statement, Owner's Equity Statement, and Balance Sheet.

Chapter 3 presents a challenge to most accounting students. Although an accountant would say that adjusting entries are completely logical, you may find it easier just to memorize the Chapter 3 entries. It is helpful to remember that we need to adjust the accounts in order to adhere to accrual accounting principles--particularly the revenue recognition principle and the matching principle.