BUS103: Introduction to Financial Accounting

Adjusting entries are journal entries made at the end of an accounting period that allocate income and expenses to their proper period.

Learning Objectives

• Identify when and why adjusting entries are made
• List the types of adjusting entries

Key Points

• The matching principle of accrual accounting demands that revenues and associated costs are recognized in the same accounting period.
• The types of adjusting entries are prepayments, accrual, estimates, and inventory.
• Depreciation is an example of an estimated adjusting entry.
• In a periodic inventory system, an adjusting entry is used to determine the cost of goods sold expense. However, an adjusting entry is not necessary for a company using perpetual inventory.
• Adjusting entries for expenses such as interest, taxes, rent, and salaries are the most common accrual entries.
  

Terms

• accrue
  (intransitive, accounting) To be incurred as a result of the passage of time.The monthly financial statements show all the actual but only some of the accrued expenses.
• revenue
  Income that a company receives from its normal business activities, usually from the sale of goods and services to customers.
  

Examples

Consider our yoga studio example. Some of our previously recognized transactions need to be adjusted in later periods:

July

a. Recognize insurance expense Prepaid Insurance -100, Insurance Expense 100; Assets(-)=Equity(-)

b. Depreciation @ $20/month Accumulated Depreciation 20, Depreciation Expense 20; Assets(-)=Equity(-)

August

a. Recognize insurance expense Prepaid Insurance -100, Insurance Expense 100; Assets(-)=Equity(-)

b. Depreciation @ $20/month Accumulated Depreciation 20, Depreciation Expense 20; Assets(-)=Equity(-)

c. Pay wages from July Cash -300, Wage Payable -300; Assets(-), Liabilities(-)

d. Pay utilities from July Cash -200, Utility Payable -200; Assets(-), Liabilities(-) The journal entries to record these transactions would be as follows:

July

a. Expiration of insurance Insurance expense 200 Prepaid insurance 200

b. Depreciation on studio equipment (500 for 25 months = 20/month)Depreciation expense 20 Accumulated Depreciation 20

August

a. Expiration of insurance Insurance expense 200 Prepaid insurance 200

b. Depreciation on studio equipment (500 for 25 months = 20/month)Depreciation expense 20 Accumulated Depreciation 20

c. Pay wage from July Wage payable 300 Cash 300

d. Pay utility bill from July Utility payable 200 Cash 200

What are Adjusting Entries

For accounting purposes, adjusting entries are journal entries made at the end of an accounting period. Adjusting entries allocate income and/or expenses to the period in which they actually occurred . The revenue recognition principle states that income and expenses must match. This is why adjusting entries need to be made under an accrual based accounting system. Based on this, revenues and associated costs are recognized in the same accounting period. However, the actual cash may be received or paid at a different time.

The General Ledger

The General Ledger contains all entries from both the General Journal and the Special Journals.

The Types of Adjusting Entries

There are several different types of adjusting entries. Each one accounts for a different situation.

• Prepayments - adjusting entries for prepayments are necessary to account for cash that has been paid prior to delivery of goods or completion of services. When this cash is paid, it is first recorded in a prepaid expense asset account; the account is to be expensed either with the passage of time (e.g. rent, insurance) or through use and consumption (e.g. supplies). The adjusting entry would credit the asset (e.g. supplies) account and debit a related expense account (e.g. supplies expense)
• Accruals - accrued revenues are revenues that have been recognized (that is, services have been performed or goods have been delivered), but their cash payment have not yet been recorded or received. When the revenue is recognized, it is recorded as a receivable. Accrued expenses have not yet been paid for, so they are recorded in a payable account. Expenses for interest, taxes, rent, and salaries are commonly accrued for reporting purposes.
• Estimates - An adjusting entry for an estimate occurs when the exact amount of an expense cannot easily be determined. For example, the depreciation of fixed assets is an expense that has to be estimated. The entry for bad debt expense can also be classified as an estimate.
• Inventory - in a periodic inventory system, an adjusting entry is used to determine the cost of goods sold expense. This entry is not necessary for a company using perpetual inventory.

Consider our yoga studio example. Some of our previously recognized transactions need to be adjusted in later periods:

July

a. Recognize insurance expense

Prepaid Insurance -100, Insurance Expense 100; Assets(-)=Equity(-)

b. Depreciation @ $20/month

Accumulated Depreciation 20, Depreciation Expense 20; Assets(-)=Equity(-)

August

a. Recognize insurance expense

Prepaid Insurance -100, Insurance Expense 100; Assets(-)=Equity(-)

b. Depreciation @ $20/month

Accumulated Depreciation 20, Depreciation Expense 20; Assets(-)=Equity(-)

c. Pay wages from July

Cash -300, Wage Payable -300; Assets(-), Liabilities(-)

d. Pay utilities from July

Cash -200, Utility Payable -200; Assets(-), Liabilities(-)

The journal entries to record these transactions would be as follows:

July

a. Expiration of insurance

Insurance expense.....................................200

-----Prepaid insurance..........................................200

b. Depreciation on studio equipment (500 for 25 months = 20/month)

Depreciation expense.................................20

-----Accumulated Depreciation.................................20

August

a. Expiration of insurance

Insurance expense.................................200

-----Prepaid insurance .................................200

b. Depreciation on studio equipment (500 for 25 months = 20/month)

Depreciation expense.................................20

-----Accumulated Depreciation........................20

c. Pay wage from July

Wage payable.................................300

-----Cash................................................300

d. Pay utility bill from July

Utility payable.................................200

-----Cash.................................................200