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Adjusting Entries: Bringing Accuracy to Financial Statement Figures

written by: madel57•edited by: Linda Richter•updated: 11/2/2010

"Adjusting entries? You still have to work on those before presenting the financial statements, Miss Lopez? Are those really so difficult that you cannot assign those to your assistant?" says, Mr. Fox, the owner. Let's look at categories of adjusting entries to see how Miss Lopez will fare.

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    What's Going On? Jowen's First Business Day of 2009

    computerdeletekey0461 Mr. Fox, the owner of Jowen Trading, is wondering why his accountant, Miss Lopez, scheduled the first business day of the new year, 2009, on a Wednesday. "It is nice to have the first meeting of the year on a Monday, not a Wednesday," he says. "Sir, I have not yet finalized the financial statements because of the ongoing physical count," Miss Lopez explains. "They will be ready on Monday, but they must be reviewed first before presenting them on Wednesday." Miss Lopez explains why there is a need to include the adjusting and reversing entries in the book of accounts before preparing the financial statements. She understands why her boss is in a hurry. He will meet with some business associates the following week who might be interested in joining him in his flourishing business.

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    The Need for Adjusting Entries

    The only way to know how successfully a business has operated is to close its doors, sell all its assets, pay the liabilities, and return any excess cash to the owners. This process of going out of business is called liquidation. This, however, is not a practical way of measuring business performance.

    Accounting information is valued when it is communicated early enough to be used for economic decision-making. To provide timely information, accountants have divided the economic life of a business into artificial time periods. This assumption is referred to as the periodicity concept.

    Periodicity concept is a concept that allows accounting periods to be divided generally into a month, a quarter, or a year; but the most basic accounting period is one year.

    Businesses need periodic reports to assess their financial conditions and performances, and they need to report accurate information for appropriate decision making. It is considered accurate if reports are prepared in accordance with generally accepted accounting principles. One of these principles is the matching principle where revenues earned for a certain period should match corresponding expenses for the said period. To do this, entities should recognize adjusting entries. In the next section, we will know why adjusting entries are needed to make accurate reports.

    There are only a few accounts that need to be adjusted at the end of the accounting year, but it is important that these accounts are brought up to their accurate amounts to avoid either understating or overstating certain accounts. Financial statements users must understand that understatement or overstatement leads to the inaccurate reporting of financial results.

    In all categories of adjusting entries, the following are considered:

    1. Accounting period - In this case, it is January 1 to December 31, 2009
    2. Transaction date
    3. Transaction amount

    For other categories of adjusting entries, however, other variables are included to properly compute the amount to be adjusted, like the estimated life of equipment and the salvage value for the computation of depreciation.comp1 

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    What are the Categories of Adjusting Entries, Examples, and their Effects on the Financial Statement Figures?

    Let us start with Deferrals:

    Sometimes the business allocates assets to expenses; that is, paying expenses in advance to take discounts. It also pays certain expenses in advance so that cash or resources will not be diverted to other obligations. At the end of the period, the estimated amount that has expired during the period or that has benefited during the period is transferred from the asset account to an expense account. Examples of these kind of deferrals are the prepaid expenses and depreciation of property and equipment.

    In the illustrations, Jowen Trading's business transactions are utilized. December 31 is the ending period. Individual accounts are also worked on to illustrate how to prepare the adjusting entries. An individual account has two sides - left and right side. Normal balances of the accounts are also considered. Assets and expenses are normally placed on the left side of the account while liabilities and income are placed on the right side of the account.

    Prepaid Rent

    Say, for example, Jowen Trading, which started its Denver branch on January 1, 2009, paid $12,000 on November 1, 2009, representing the advance 12-month payment for rent. An asset account for $12,000 with the account title “Prepaid Rent" on November 1, 2009, is created. The individual account called "Prepaid Rent" with the amount of $12,000 is placed at its left side. At the ending period, December 31, 2009, it is proper to segregate the expired portion (expense portion) from the asset account, therefore, to take into effect the deduction of $2,000 (November 1 to December 31); $2,000 should be placed at the right side of the account, "Prepaid Rent".

    Please continue on Page 2 for more on Categories of Adjusting Entries

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    The preparation of financial statements is guided by generally accepted accounting principles. One of these principles is the matching principle, in which appropriate expenses are matched against the revenue earned during the period. To realize this, various categories of adjusting entries must be inserted before the closing of the books to bring financial figures into their accurate amounts.
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    Categories of Adjusting Entries: Prepaid Rent, continued

    Take a look at the computations:

    To determine how much will be removed from the prepaid rent account, let us compute how much rent is spent each month:

    One year prepaid rent $12,000 divided by 12 months = $1,000/month

    At the end of December 31, 2009, the expired portion of the $12,000 is $1,000 multiplied by 2 months (November 1 to December 31) or $2,000.

    Therefore, at the end of the period, December 31, 2009, Prepaid Rent has a remaining balance of $10,000.

    The effect of the deduction will create another account while prepaid rent will be reduced by $2,000:

    Prepaid Rent - $10,000

    Rent Expense - $2,000

    Unused Offices

    It is practical for Jowen to buy office supplies in bulk. On September 1, 2009, the business bought $5,000 worth of office supplies. On that date, an asset account of Unused Supplies of $5,000 was created. On December 31, 2009, after the physical count, only $2,000 in unused supplies is counted; therefore, supplies worth $3,000 have been used. To deduct $3,000 from $5,000, $3,000 is placed at the right side of the asset account “Unused Offices." Unused supplies will have a new balance of $2,000. Since $3,000 is an expense, we will create another account named "Used Supplies" and we will place $3,000 on its left side.

    To summarize the above adjustment, two accounts are adjusted or created:

    Unused Supplies $2,000 and Used Supplies $3,000

    Depreciation of Property and Equipment

    A Property and Equipment account is created in the accounting books when the company acquires buildings, computers, service vehicles, and office furniture. These assets help generate income to the business, therefore, aside from wearing out, a portion of these assets should be charged to expenses because of the usage. They are subject, then, to depreciation.

    Aside from the factors to be considered in making adjusting entries mentioned earlier, the accountant needs information on the number of years the company will use the asset and the salvage value, if any.

    Say, for example, Jowen purchased office furniture worth $100,000 on September 1, 2009, which has an estimated life of 5 years and can be sold for $20,000 (salvage value) after its estimated life.

    To compute the monthly depreciation and the depreciation expense for Jowen:

    Cost of furniture minus salvage value divided by the number of estimated years of life divided by 12 months multiplied by 4 months (September 1 to December 12, 2009)

    $100,000 - $20,000 divided by 5 years divided by 12 months multiplied by 4 months equals $5,333.33

    The total depreciation expense from September 1 to December 31, 2009 is $5,333.33. Two accounts are created from this adjustment: depreciation expense of $5,333.33 which is included in the operating expenses and $5,333.33 accumulated depreciation for office furniture which is deducted from the Office Furniture account (an asset account).

    Revenues Received in Advance of Revenues

    There are times when a company receives cash for services or goods even before services are rendered or goods are delivered. In this case, the entity has the obligation to perform the service or to deliver the goods because the advanced payment received is already an obligation on the part of the entity.

    Jowen, aside from selling goods, is also engaged in advertising. For example, the entity received $24,000 on October 1, 2009, representing a 12-month advertising contract from Abella Woodcraft, Incorporated. Jowen recognizes $24,000 as a liability on the date it is received; therefore an Unearned Advertising Income account is created on October 1, 2009. Let us remember that contrary to the asset account, which is placed at the left side, Unearned Advertising Income, a liability account, is placed at the right side of the account “Unearned Advertising Income." At the end of 2009, only three months' income is earned from the $24,000 or a total of $6,000.

    To adjust $24,000, it is necessary to deduct $6,000 (representing the earned portion) from $24,000 to reflect the true amount of obligation remained on December 31, 2009. To deduct the $6,000 from $24,000, $6,000 is placed at the left side of the account “Unearned Advertising Income" so at the end of the period, Unearned Advertising Income has an outstanding balance of $18,000 and $6,000 representing advertising income is added to the advertising income previously recorded.

    Please cotninue on page 3 for more on Categories of Adjusting Entries

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    The omission of various categories of adjusting entries will result in the overstatement or understatement of the accounts affected. This would result in users being misled as to the real picture of the business. Review the examples given in this helpful article.
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    Categories of Adjusting Entries: Unearned Advertising Income, continued

    To summarize, Unearned Advertising Income (a Liability Account) has an outstanding balance of $18,000 while $6,000 is added to the Earned Advertising Income (Revenue Account).

    The second category of adjustments is the Accruals.

    An entity often incurs expenses before paying for them. Cash payments are usually made at regular intervals of time such as weekly, monthly, quarterly, or annually. If the accounting period ends on a date that does not coincide with the scheduled cash payment date, an adjusting entry is needed to reflect the expense incurred since the last payment. This adjustment helps the entity avoid the impractical preparation of hourly or daily journal entries just to accrue expenses. Salaries and interest are examples of expenses that are incurred before payment is made.

    Accrued Salaries

    Jowen pays its store personnel on a weekly basis on Saturdays because it is considered contractual.

    Adjustments for accrued salaries usually happened as these personnel are paid.

    If the last weekly payment is on the 27th of November, the daily payroll for November 29, 30, and 31 (Monday, Tuesday and Wednesday) will not be paid until the next payroll date, December 3, 2009; and since the accountant will prepare the report for the month of November, the 3-day wage expense which is not paid will be considered as salaries payable on December 3, 2009.

    An Accrued Salaries or Salaries Payable account will then be created at the end of November totaling $3,000 if the daily payroll is $1,000. Two accounts will be created: Salaries Expense and Accrued Salaries (liability account) with both having the same amount of $3,000.

    Accrued Interest

    It cannot be avoided that clients give notes as settlement of their accounts. If Jowen allows this practice and if a certain client settles his account with a 10%, 60-day note amounting to $4,000 on December 1, 2009, then at the end of the period, December 31, 2009, an interest of $33.33 ($4,000 multiplied by 10% multiplied by 1/12 (from December 1 to December 31) should be recognized although collection will not be made. This $33.33 will be added to the Interest Receivable (an asset account) and an Interest Income account will be created.

    Bad Debts Expense

    One of the principles in accounting is conservatism. Conservatism expects the least returns. One of its application is on Accounts Receivable. In a $100,000 receivables, for example, 10 percent is expected to be uncollectible. Therefore, $10,000--or $100,000 multiplied by 10%--is treated as bad debts expense charged to Operations, and an account called Estimated Uncollectibles amountng to $10,000 is deducted from the gross, $100,000. Net realizable value of receivables, therefore, is $90,000.

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    Conclusion: Significance of Adjusting Entries on Financial Reporting

    Accountants make adjusting entries in order to reflect economic activities that have occurred but have not yet been recorded. How? Adjusting entries assign revenues to the period they are earned and expenses to the period they are incurred. These entries are needed to properly state the profit for the period, to bring related asset and liability accounts to correct balances in the financial statements.

    In short, various categories of adjusting entries are needed to ensure that the revenue and expense recognition principles are followed resulting in financial statements reporting the effects of all transactions at the end of the period.

    Adjusting entries involve changing account balances at the end of the period from what is the current balance of the account to what is the correct balance for proper financial reporting. Without adjusting entries, financial statements may not fairly show the solvency of the entity in the balance sheet and the profitability of the income statement.

    From the general journal where adjusting entries are made, adjusting entries are posted in the ledgers of the individual accounts that are affected. They are posted at the left and right sides of the involved accounts. After the postings of individual ledgers, the accountant may be able to produced a so-called Adjusted Trial Balance from which the Income Statement and Balance Sheet are prepared.

    Book and Image Credits:

    Basic Accounting Volume 1 by Balada and Balada, 2010 computerdeletekey0461 comp1