Explaining Adjusting Entries: Examples, Accounting Assumptions & Principles Necessitating Their Use
The overall purpose of utilizing adjusting entries is to accomplish financial statements that present fairly the true financial conditions of
an enterprise and the results of its operations, in accordance with generally accepted accounting principles. Although entries to correct erroneous postings are also referred to as adjusting entries, the latter generally refers to accounting entries used as tools to bring the book balances in accordance with the “matching principles” and “proper disclosure.”
The following sections feature adjusting entry examples presented according to their classifications as asset, liability, income, and capital accounts. The explanations further discuss the significance of the accounting procedures that give rise to said valuation entries.
Asset Accounts
Cash
Ordinarily, businesses do not retain large amounts of cash on hand; the asset is mostly maintained as cash in bank. Hence, adjusting entries that affect cash transactions arise after bank statement reconciling items have been established. This is after cash balance per books and cash in bank reconciliation have been made. However, bear in mind that not all reconciling items require passing of accounting entries, since transit time for checks to clear and bank cut-off hours are factors to consider.
In order to illustrate the instances when accounting entries are necessary, the following are examples of reconciling items:
- Installment payments electronically deposited by various customers in company’s bank accounts - $960
The accounts receivable bookkeeper has to pass an entry for this reconciling item, since customers opted to deposit the installment payments directly to the company’s bank account via the electronic payment system.
- Check for $850, issued on September 30 to electric utility company to pay for the office electrical consumption for the month. This will be reflected in the bank statement for October, since the bank will receive the check only when the utility company’s bank will present the check for clearing against the company’s checking account.
No adjusting entry is required inasmuch as the transaction will be automatically taken up in the bank’s transactions for the succeeding month.
- Bank charges for cost of 10 checkbooks ordered by the company - $200
An adjusting entry will be taken up to reduce the cash in bank balance per book, since the charges likewise reduced the actual cash in bank balance.
Adjusting Entry examples to reconcile the cash in bank per books vs. actual cash in bank balance:
Dr. Cash in Bank ——— $960
Cr. Installment Sales Receivable ——— $960
Dr. Bank Charges ——— $200
Cr. Cash in Bank ——— $200
Accounts Receivable
The most common adjusting entries involving the accounts receivable account are the entries made to reclassify defaulted accounts and to write off bad debts after they have been deemed as no longer collectible or sold to a collecting agent.
The following “givens” will be used to illustrate the examples of adjusting entries for this account.
- Six installment sales totaling accounts $2,850 are already past their due dates, while the aging of accounts receivable reveals that a total of $5,350 installment sales have been past due for more than 180 days. In addition, total interests accrued by these accounts have reached $1,875. On the other hand, bad debts totaling $4,600 have been sold to the company’s collecting agent at a discounted price of $4,200.
Adjusting entries to bring the company’s installment sales receivable account to its near-accurate and proper value:
1. To reclassify accounts already past due:
Dr. Past Due Installment Sales Receivables ——— $2,850
Cr. Installment Sales Receivables ——— $2, 850
2. To take up doubtful and uncollectible accounts:
Dr. Bad Debts Expense ———- $5,350
Cr. Allowance for Doubtful Accounts ——— $5,350
3. To reverse the accrued income on doubtful and uncollectible account:
Dr. Interest Income from Installment Sales ——— $1,875
Cr. Accrued Interest Receivable – Installment Sales ——— $1,875
4. To write off bad debts sold to collecting agents:
Dr. Allowance for Doubtful Accounts ——— $4, 600
Cr. Accounts Receivable ——— $4,600
5. To record the sale of bad debts at a discounted price:
Dr. Cash ——— $4,200
Cr. Revenue from Installment Sales ——— $4,200
Note: No loss was recognized at the time the bad debts were sold, because the original amount was already zeroed-out and was previously recognized as a loss or expense when the allowance for doubtful account was set up.
The adjusting entry examples and explanations for Merchandise Inventory, Prepaid Expenses, and Fixed Assets can be gleaned in a separate article entitled Examples of Post-Adjusted and Post-Closing Trial Balance.
Liability Accounts
Accounts Payable and Notes Payable
The proceeds received from these liabilities are often received net of the interest payment due to the loan, usually for a period of one year. Upon recording of the liability, the interest has been recorded as a prepaid expense; hence the adjusting entry to recognize the expense portion will be similar to the examples presented in the related article mentioned in the previous section.
Accrued Interest and Other Expenses Payable
Adjusting entries are necessary at year-end for material amounts of interests and other operating expenses, to which the company is billed at month-end. Ordinarily, year-end refers to December 31, and bills received on this date will be paid on January of the new accounting cycle.
If the bookkeeper waits for the actual payment of the bill, operating expenses for the current year will be understated and the accounting entries for the payment will be reflected as transactions of the new accounting cycle.
Adjusting entry examples and explanations for these expenses are illustrated in the article entitled Matching Principle: Explanations & Examples.
Income Accounts
Adjusting Entries for Revenue Recognition
These are entries passed in order to bring the values of the income account to their near-actual values since the recognition of some income is deferred until the conditions transpire or period elapses.
Different methods of revenue recognition will give rise to the adjusting entries necessary to record the portion earned during the accounting period. The examples and explanations for these accounting entries are discussed in details in the related article entitled Revenue Recognition Principle vs. Matching Principle.
Capital Accounts
As a general rule, the Owner’s Capital account or the Common Stocks Issued and Outstanding account should not be used when making adjusting entries.
Adjustments to owner’s capital accounts that are related to the income or loss presented in the previous years will have to make use of a revaluation reserve account – Capital Adjustment Account. That way, readers of the financial statement are properly guided that part of the company’s increase or decrease in net worth for the current year is attributed to an adjustment of the previous year’s income or loss.
The Capital Adjustment Account will still be closed and zeroed-out against the Profit and Loss Summary for the year in the general ledger book; it will be presented separately in the Owner’s or Stockholders’ Equity portion of the Balance Sheet.
For corporations, the Capital Adjustment Account will be closed against the Retained Earnings account and also presented separately in the Stockholder’s Equity as an item that increased or reduced the Retained Earnings account.
Transactions that give rise to adjusting entries against Capital or Retained Earnings account may stem from an IRS assessment or an SEC directive to restate or revalue the company’s income or asset. The pending implementation of IFRS accounting rules is expected to create valuation changes that will affect previous years’ income or loss.
Example:
A company who uses the LIFO depreciation allowed under US GAAP rules can no longer use this depreciation method if the IFRS reporting rules will prevail. The latter does not allow the LIFO method; hence the Accumulated Depreciation accounts will be revalued in order to maintain proportion and consistent methods of valuation. An adjusting entry will make use of the revaluation reserve account, i.e.:
Adjusting Entries vs. Owner’s Capital or Stockholders’ Equity
To revalue the depreciated portion of the Furniture, Fixtures, and Equipment account:
Dr. Accumulated Depreciation - FFE — xyz
Cr. Capital Adjustment Account — xyz
To close the Capital Adjustment Account for the year:
Dr. Capital Adjustment Account — xyz
Cr. Profit and Loss Summary or Retained Earning (for corporations)
Presentation of Capital Adjustment Account in the Owner’s Equity of the Balance sheet
Owner’s Capital, Beginning — xyz
Less: Drawings, Owner — xyz
Add: Capital Adjustment Account — xyz
Add or Less: Net Income or Net Loss for the year — xyz
Owner’s Capital, End — xyz
Presentation of Capital Adjustment Account in the Retained Earnings in the Stockholders’ Equity of the Balance sheet
Retained Earnings, Beg. — xyz
Add: Capital Adjustment Account — xyz
Add or Less: Net Income or Net Loss for the year — xyz
Retained Earnings, End. — xyz
Reference Materials and Image Credits Section
Reference Materials
- Jacksonville State University College of Commerce and Businss: Adjusting Journal Entries
Image Credits:
