Archive for October, 2008

The Need for Adjusting Entries

For purposes of measuring income and preparing financial statements, the life of a business is divided into a series of accounting periods. This practice enables decision makers to compare the financial statements of successive periods and to identity significant trends.

But measuring net income for a relatively short accounting period—-such us a month or even a year—poses a problem because, as mentioned above, some business activities affect the revenue and expenses of multiple accounting periods. Therefore, adjusting entries are needed at the end of each accounting period to make certain that appropriate amounts of revenue and expense are reported in the company’s income statement.

For example, magazine publishers often sell two- or three-year subscriptions to their publications. At the end of each accounting period, these publishers make adjusting entries recognizing the portion of their advance receipts that have been earned during the current period. Most companies also purchase insurance policies that benefit more than one period. Therefore, an adjusting entry is needed to make certain that an appropriate portion of each policy’s total cost is reported in the income statement as insurance expense for the period. In short, adjusting entries are needed whenever transactions affect the revenue or expenses of more than one accounting period. These entries assign revenues to the period in which they are earned, and expenses to the periods in which related goods or services are used.

Adjusting entries are accounting journal entries that convert a company’s accounting records to the accrual basis of accounting. An adjusting journal entry is typically made just prior to issuing a company’s financial statements.

To demonstrate the need for an accounting adjusting entry let’s assume that a company borrowed money from its bank on December 1, 2005 and that the company’s accounting period ends on December 31. The bank loan specifies that the first interest payment on the loan will be due on March 1, 2006. This means that the company’s accounting records as of December 31 do not contain any payment to the bank for the interest the company incurred from December 1 through December 31. (Of course the loan is costing the company interest expense every day, but the actual payment for the interest will not occur until March 1.) For the company’s December income statement to accurately report the company’s profitability, it must include all of the company’s December expenses—not just the expenses that were paid. Similarly, for the company’s balance sheet on December 31 to be accurate, it must report a liability for the interest owed as of the balance sheet date. An adjusting entry is needed so that December’s interest expense is included on December’s income statement and the interest due as of December 31 is included on the December 31 balance sheet. The adjusting entry will debit Interest Expense and credit Interest Payable for the amount of interest from December 1 to December 31.

Another situation requiring an adjusting journal entry arises when an amount has already been recorded in the company’s accounting records, but the amount is for more than the current accounting period. To illustrate let’s assume that on December 1, 2005 the company paid its insurance agent $2,400 for insurance protection during the period of December 1, 2005 through May 31, 2006. The $2,400 transaction was recorded in the accounting records on December 1, but the amount represents six months of coverage and expense. By December 31, one month of the insurance coverage and cost have been used up or expired. Hence the income statement for December should report just one month of insurance cost of $400 ($2,400 divided by 6 months) in the account Insurance Expense. The balance sheet dated December 31 should report the cost of five months of the insurance coverage that has not yet been used up. (The cost not used up is referred to as the asset Prepaid Insurance. The cost that is used up is referred to as the expired cost Insurance Expense.) This means that the balance sheet dated December 31 should report five months of insurance cost or $2,000 ($400 per month times 5 months) in the asset account Prepaid Insurance. Since it is unlikely that the $2,400 transaction on December 1 was recorded this way, an adjusting entry will be needed at December 31, 2005 to get the income statement and balance sheet to report this accurately.

For now we want to highlight some important points. There are two scenarios where adjusting journal entries are needed before the financial statements are issued:

  • Nothing has been entered in the accounting records for certain expenses or revenues, but those expenses and/or revenues did occur and must be included in the current period’s income statement and balance sheet.

  • Something has already been entered in the accounting records, but the amount needs to be divided up between two or more accounting periods.

Adjusting entries almost always involve a

  • balance sheet account (Interest Payable, Prepaid Insurance, Accounts Receivable, etc.) and an

  • income statement account (Interest Expense, Insurance Expense, Service Revenues, etc.)

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Accruing Wages Payable

If you have employees, chances are you owe them a certain amount of wages at the end of an accounting period. If so, an adjusting entry is required in your general journal.

As an example, on December 31, 2004 you owe your employees one week of salary that will be paid on January 7, 2005. The gross wages for that week are $1,512.00. Make the following general journal entry:

Debit Credit

Wages expense 1,512

Accrued wages 1,512

To accrue wages owed but unpaid on 12/31/2004

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Adjusting Entries

The number of adjustments needed at the end of each accounting period depends entirely upon the nature of the company’s business activities. However, most adjusting entries fall into one of four general categories:


Certain end-of-period adjustments must be made when you close your books. Adjusting entries are made at the end of an accounting period to account for items that don’t get recorded in your daily transactions. In a traditional accounting system, adjusting entries are made in a general journal.

Some adjusting entries are straightforward. Others require judgment and some accounting knowledge. You will have to decide if you are going to tackle some or all adjusting entries, or if you want to pay your accountant to do them. If your accountant prepares adjusting entries, he or she should give you a copy of these entries so that you can enter them in your general ledger.

The following are situations requiring adjusting journal entries. Some, but not all, should apply to your business:

  • Accrue wages earned by employees but not yet paid to them.

  • Accrue employer share of FICA taxes due.

  • Accrue property taxes.

  • Record interest expenses paid on a mortgage or loan and update the loan balance.

  • Record prepaid insurance.

  • Adjust your books for inventory on hand at period end.

  • Accrue interest income earned but not yet received.

  • Record depreciation expense.

  • Adjust for bad debts.

  • Accrue dividends payable if a corporation.

  • Accrue income taxes payable if a corporation.

  • Account for the sale of fixed assets.

  • Set up accounts receivable balance if your day-to-day books are maintained on a cash basis.

  • Set up accounts payable balance if your day-to-day books are maintained on a cash basis.

After all adjusting entries are made, do the following to complete your books for the accounting period:

  1. Foot the general journal.

  2. Post the general journal totals to the general ledger.

  3. Foot the general ledger accounts to arrive at the final, adjusted balance for each account.

  4. Prepare an adjusted trial balance using the general ledger balances.

  5. Prepare financial statements using the adjusted trial balance.

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Prepaid Insurance

Typically, insurance premiums are paid when coverage begins. So if you paid for an insurance policy during the accounting period, you probably bought coverage for several months or a year in advance. At the end of the accounting period, a prepaid expense account called prepaid insurance should be set up as an asset, reflecting insurance coverage for the future that you have already paid for. This can be done by making an adjusting entry in your general journal.

You paid an annual insurance premium of $1,200 on September 1, 2004, and charged the $1,200 to insurance expense in your cash disbursements journal. As of December 31, 2004, you have used up just four months ($400) of this coverage, and have eight months of coverage coming to you. This eight months of prepaid coverage ($800) represents an asset to you. Make the following general journal entry:

Debit Credit

Prepaid insurance 800

Insurance expense 800

To set up eight months of prepaid insurance on 12/31/2004

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Prepaid Insurance

Typically, insurance premiums are paid when coverage begins. So if you paid for an insurance policy during the accounting period, you probably bought coverage for several months or a year in advance. At the end of the accounting period, a prepaid expense account called prepaid insurance should be set up as an asset, reflecting insurance coverage for the future that you have already paid for. This can be done by making an adjusting entry in your general journal.

You paid an annual insurance premium of $1,200 on September 1, 2004, and charged the $1,200 to insurance expense in your cash disbursements journal. As of December 31, 2004, you have used up just four months ($400) of this coverage, and have eight months of coverage coming to you. This eight months of prepaid coverage ($800) represents an asset to you. Make the following general journal entry:

Debit Credit

Prepaid insurance 800

Insurance expense 800

To set up eight months of prepaid insurance on 12/31/2004

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Adjusting Entry for Inventory

Do you maintain an inventory of merchandise for sale to your customers? If so, you need to physically count the items that are in your inventory at the end of the accounting period. Your general ledger inventory account should show the total cost of your inventory items on hand at period end. Adjusting entries are required in your general journal so that your ending inventory is reflected on your books.

On December 31, 2004, you physically count the inventory items you have on hand. Using your costs and the quantities of items on hand, you determine that the total cost of your inventory at December 31 is $18,500. Looking back at your general ledger, you see that you started the year with a December 31, 2003, inventory cost of $15,200. Make the following general journal entries to update inventory:

Debit Credit

Purchases 15,200

Inventory 15,200

To clear out beginning (1/1/2004) inventory

Debit Credit

Inventory 18,500

Purchases 18,500

To book ending inventory at 12/31/2004

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Accruing Interest Income Receivable

If you are earning interest income that will be payable sometime after the end of the accounting period, you need to make an adjusting entry in your general journal. The entry is needed to reflect the amount of unpaid interest income you have earned as of the end of the accounting period.

As an example, say that your company has a one-year, $10,000 certificate of deposit that you purchased on May 1, 2004. It pays simple interest, at 6 percent, at the end of its term on April 30, 2005. As of December 31, 2004, you have earned $400, which is eight months of interest (10,000 x 6% x 8/12). You should make the following adjusting entry:

Debit Credit

Interest receivable 400

Interest income 400

To record eight months’ accrued interest on 12/31/2004

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Recording Depreciation Expense

At the end of an accounting period, you must make an adjusting entry in your general journal to record depreciation expenses for the period. The Internal Revenue Service has very specific rules regarding the amount of an asset that you can depreciate each year. You don’t have to compute depreciation for your books the same way you compute it for tax purposes, but to make your life simpler, you should. You should consult your accountant about how to compute depreciation.

More than likely, your accountant will make this adjusting entry for you, or your accountant may be able to provide you with a schedule showing the amount of depreciation for each asset for each year.

Your business has equipment and a building. Using a depreciation schedule provided by your accountant, you determine that current period depreciation is $3,400 on the equipment, and $2,550 on the building. You need to make the following adjusting entry to record depreciation expense and update your accumulated depreciation accounts:

Debit Credit

Depreciation expense 5,950

Accum. depr. equip. 3,400

Accum. depr. bldg. 2,550

To record depreciation for the period ended 12/31/04

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Adjusting for Bad Debts

Do you extend credit to your customers? If so, do you have any accounts receivable at year end that you know are uncollectible? If you do, the end of the year is a good time to make an adjusting entry in your general journal to write off any worthless accounts.

You extend credit to your regular customers, and normally do not experience any trouble collecting from them. Since you rarely have trouble collecting from your customers, you have not set up a reserve for bad debts. However, as you review your accounts receivable at year end, you notice that a particular customer, now insolvent, still owes you $750. You are certain that you will never be paid. Write off this account by making the following adjusting entry:

Debit Credit

Bad debt expense 750

Accounts receivable 750

To record bad debts for the year ended 12/31/2004

Be sure to write off this account in your accounts receivable ledger, so that it agrees with your general ledger.

If you extend credit to numerous customers, and your experience is that a certain amount of your sales on account will be uncollectible, you should probably set up a reserve for bad debts. That way, your books and financial statements will more accurately reflect your true financial picture. At the end of every year, you should evaluate your accounts receivable and adjust your allowance for bad debts accordingly. Your accountant may be able to help you do this.

You extend credit to your customers, and experience tells you that a small amount of your sales on account will never be collected. On December 31, 2004, you evaluate your accounts receivable. You estimate that $1,000 of your receivables will not be collectible. On December 31, 2003, you estimated that $800 of your receivables at that time were uncollectible and your reserve for bad debts account in the general ledger currently reflects that $800 balance. You need to make the following adjusting entry to record this $200 increase in estimated bad debts:

Debit Credit

Bad debt expense 200

Allowance for bad debts 200

To adjust allowance for uncollectible accounts at 12/31/2004

For what to do if you’ve written off a bad debt, but the customer later pays some or all of what he owes, see bad debt recoveries.

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Closing Entries

After financial statements are prepared, you are ready to get your books ready for the next accounting period by clearing out the income and expense accounts in the general ledger and transferring the net income (or loss) to your owner’s equity account. This is done by preparing closing entries in the general journal.

Note the distinction between adjusting entries and closing entries. Adjusting entries are required to update certain accounts in your general ledger at the end of an accounting period. They must be done before you can prepare your financial statements and income tax return. Closing entries are needed to clear out your revenue and expense accounts as you start the beginning of a new accounting period.

Preparing your closing entries is a very simple, mechanical process. Follow these steps:

  1. Close the revenue accounts. Prepare one journal entry that debits all the revenue accounts. (These accounts will have a credit balance in the general ledger prior to the closing entry.) Credit an account called “income summary” for the total.

  2. Close the expense accounts. Prepare one journal entry that credits all the expense accounts. (These accounts will have a debit balance in the general ledger prior to the closing entry.) Debit the income summary account for the total.

  3. Transfer the income summary balance to a capital account. Prepare a journal entry that clears out the income summary account. This entry effectively transfers the net income (or loss) of the business to the owner’s equity account.

  4. Close the drawing account. If your business is a sole proprietorship or partnership, close the drawing accounts (if any) by preparing a journal entry that credits the drawing account and debits the owner’s equity account.

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