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Chapter2: Review of the Accounting Process

Adjusting Entries

Step 6 in the processing cycle is to record in the general journal and post to the ledger accounts the effect of internal events on the accounting equation. These transactions do not involve an exchange transaction with another entity and, therefore, are not initiated by a source document. They are recorded at the end of any period when financial statements are prepared. These transactions are commonly referred to as adjusting entries internal transactions recorded at the end of any period when financial statements are prepared..

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STEP 6 Record adjusting entries and post to the ledger accounts.


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   Even when all transactions and events are analyzed, corrected, journalized, and posted to appropriate ledger accounts, some account balances will require updating. Adjusting entries are required to implement the accrual accounting model. More specifically, these entries are required to satisfy the realization principle and the matching principle. Adjusting entries help ensure that all revenues earned in a period are recognized in that period, regardless of when the cash is received. Also, they enable a company to recognize all expenses incurred during a period, regardless of when cash payment is made. As a result, a period's income statement provides a more complete measure of a company's operating performance and a better measure for predicting future operating cash flows. The balance sheet also provides a more complete assessment of assets and liabilities as sources of future cash receipts and disbursements. You might think of adjusting entries as a method of bringing the company's financial information up to date before preparing the financial statements.

   
   FINANCIAL
   Reporting Case

Q1, p. 51

   Adjusting entries are necessary for three situations:

1.

 

Prepayments, sometimes referred to as deferrals.

2.

 

Accruals.

3.

 

Estimates.

   
   FINANCIAL
   Reporting Case

Q2, p. 51

Prepayments

Prepayments Prepayments are transactions in which the cash flow precedes expense or revenue recognition. occur when the cash flow precedes either expense or revenue recognition. For example, a company may buy supplies in one period but use them in a later period. The cash outflow creates an asset (supplies) which then must be expensed in a future period as the asset is used up. Similarly, a company may receive cash from a customer in one period but provide the customer with a good or service in a future period. For instance, magazine publishers usually receive cash in advance for magazine subscriptions. The cash inflow creates a liability (unearned revenue) that is recognized as revenue in a future period when it is earned.

PREPAID EXPENSES.   Prepaid expenses Prepaid expenses represent assets recorded when a cash disbursement creates benefits beyond the current reporting period. are the costs of assets acquired in one period and expensed in a future period. Whenever cash is paid, and it is not to (1) satisfy a liability or (2) pay a dividend or return capital to owners, it must be determined whether or not the payment creates future benefits or whether the payment benefits only the current period. The purchase of machinery, equipment, or supplies or the payment of rent in advance are examples of payments that create future benefits and should be recorded as assets. The benefits provided by these assets expire in future periods and their cost is expensed in future periods as related revenues are recognized.

   To illustrate this concept, assume that a company paid a radio station $2,000 in July for advertising. If that $2,000 were for advertising provided by the radio station during the month of July, the entire $2,000 would be expensed in the same period as the cash disbursement. If, however, the $2,000 was a payment for advertising to be provided in a future period, say the month of August, then the cash disbursement creates an asset called prepaid advertising. An adjusting entry is required at the end of August to increase advertising expense (decrease shareholders' equity) and to decrease the asset prepaid advertising by $2,000. Assuming that the cash disbursement records a debit to an asset, as in this example, the adjusting entry for a prepaid expense is, therefore, a debit to an expense and a credit to an asset.

   The unadjusted trial balance can provide a starting point for determining which adjusting entries are required for a period, particularly for prepayments. Review the July 31, 2011, unadjusted trial balance for the Dress Right Clothing Corporation in Illustration 2–6 on page 64 and try to anticipate the required adjusting entries for prepaid expenses.

   

The adjusting entry required for a prepaid expense is a debit to an expense and a credit to an asset.

   The first asset that requires adjustment is supplies, $2,000 of which were purchased during July. This transaction created an asset as the supplies will be used in future periods. The company could either track the supplies used or simply count the supplies at the end of the period and determine the dollar amount of supplies remaining. Assume that Dress Right determines that at the end of July, $1,200 of supplies remain. The following adjusting journal entry is required.

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To record the cost of supplies used during the month of July.

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   After this entry is recorded and posted to the ledger accounts, the supplies (asset) account is reduced to a $1,200 debit balance, and the supplies expense account will have an $800 debit balance.

   The next prepaid expense requiring adjustment is rent. Recall that at the beginning of July, the company paid $24,000 to its landlord representing one year's rent in advance. As it is reasonable to assume that the rent services provided each period are equal, the monthly rent is $2,000. At the end of July 2011, one month's prepaid rent has expired and must be recognized as expense.

   

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To record the cost of expired rent for the month of July.

   After this entry is recorded and posted to the ledger accounts, the prepaid rent account will have a debit balance of $22,000, representing 11 remaining months at $2,000 per month, and the rent expense account will have a $2,000 debit balance.

   The final prepayment involves the asset represented by furniture and fixtures that was purchased for $12,000. This asset has a long life but nevertheless will expire over time. For the previous two adjusting entries, it was fairly straightforward to determine the amount of the asset that expired during the period.

   However, it is difficult, if not impossible, to determine how much of the benefits from using the furniture and fixtures expired during any particular period. Recall from Chapter 1 that one approach to implementing the matching principle is to “recognize an expense by a systematic and rational allocation to specific time periods.”

   

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   Assume that the furniture and fixtures have a useful life of five years (60 months) and will be worthless at the end of that period, and that we choose to allocate the cost equally over the period of use. The amount of monthly expense, called depreciation expense, is $200 ($12,000 ÷ 60 months = $200), and the following adjusting entry is recorded.

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To record depreciation of furniture and fixtures for the month of July.

   The entry reduces an asset, furniture and fixtures, by $200. However, the asset account is not reduced directly. Instead, the credit is to an account called accumulated depreciation. This is a contra account to furniture and fixtures. The normal balance in a contra asset account will be a credit, that is, “contra,” or opposite, to the normal debit balance in an asset account. The purpose of the contra account is to keep the original cost of the asset intact while reducing it indirectly. In the balance sheet, furniture and fixtures is reported net of accumulated depreciation. This topic is covered in depth in Chapter 11.

   After this entry is recorded and posted to the ledger accounts, the accumulated depreciation account will have a credit balance of $200 and the depreciation expense account will have a $200 debit balance. If a required adjusting entry for a prepaid expense is not recorded, net income, assets, and shareholders' equity (retained earnings) will be overstated.

UNEARNED REVENUES.   Unearned revenues Unearned revenues represent liabilities recorded when cash is received from customers in advance of providing a good or service. are created when a company receives cash from a customer in one period for goods or services that are to be provided in a future period. The cash receipt, an external transaction, is recorded as a debit to cash and a credit to a liability. This liability reflects the company's obligation to provide goods or services in the future.

   To illustrate an unearned revenue transaction, assume that during the month of June a magazine publisher received $24 in cash for a 24-month subscription to a monthly magazine. The subscription begins in July. On receipt of the cash, the publisher records a liability, unearned subscription revenue, of $24. Subsequently, revenue of $1 is earned as each monthly magazine is published and mailed to the customer. An adjusting entry is required each month to increase shareholders' equity (revenue) to recognize the $1 in revenue earned and to decrease the liability. Assuming that the cash receipt entry included a credit to a liability, the adjusting entry for unearned revenues, therefore, is a debit to a liability, in this case unearned subscription revenue, and a credit to revenue.

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   Once again, the unadjusted trial balance provides information concerning unearned revenues. For Dress Right Clothing Corporation, the only unearned revenue in the trial balance is unearned rent revenue. Recall that the company subleased a portion of its building to a jewelry store for $500 per month. On July 16, the jewelry store paid Dress Right $1,000 in advance for the first two months' rent. The transaction was recorded as a debit to cash and a credit to unearned rent revenue.

   

The adjusting entry required when unearned revenues are earned is a debit to a liability and a credit to revenue.

   At the end of July, how much of the $1,000 has been earned? Approximately one-half of one month's rent has been earned, or $250, requiring the following adjusting journal entry.

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To record previously unearned rent revenue earned during July.

   After this entry is recorded and posted to the ledger accounts, the unearned rent revenue account is reduced to a credit balance of $750 for the remaining one and one-half months' rent, and the rent revenue account will have a $250 credit balance. If this entry is not recorded, net income and shareholders' equity (retained earnings) will be understated, and liabilities will be overstated.

   

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ALTERNATIVE APPROACH TO RECORD PREPAYMENTS.   The same end result can be achieved for prepayments by recording the external transaction directly into an expense or revenue account. In fact, many companies prefer this approach. For simplicity, bookkeeping instructions may require all cash payments for expenses to be debited to the appropriate expense account and all cash receipts for revenues to be credited to the appropriate revenue account. The adjusting entry then records the unexpired prepaid expense (asset) or unearned revenue (liability) as of the end of the period.

   For example, on July 1, 2011, Dress Right paid $24,000 in cash for one year's rent on its building. The entry included a debit to prepaid rent. The company could have debited rent expense instead.

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   The adjusting entry then records the amount of prepaid rent as of the end of July, $22,000, and reduces rent expense to $2,000, the cost of rent for the month of July.

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   The net effect of handling the transactions in this manner is the same as the previous treatment. Either way, the prepaid rent account will have a debit balance at the end of July of $22,000, and the rent expense account will have a debit balance of $2,000. What's important is that an adjusting entry is recorded to ensure the appropriate amounts are reflected in both the expense and asset before financial statements are prepared.

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   Similarly, the July 16 cash receipt from the jewelry store representing an advance for two months' rent could have been recorded by Dress Right as a credit to rent revenue instead of unearned rent revenue (a liability).

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   If Dress Right records the entire $1,000 as rent revenue in this way, it would then use the adjusting entry to record the amount of unearned revenue as of the end of July, $750, and reduce rent revenue to $250, the amount of revenue earned during the month of July.

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Accruals

Accruals Accruals involve transactions where the cash outflow or inflow takes place in a period subsequent to expense or revenue recognition. occur when the cash flow comes after either expense or revenue recognition. For example, a company often uses the services of another entity in one period and pays for them in a subsequent period. An expense must be recognized in the period incurred and an accrued liability recorded. Also, goods and services often are provided to customers on credit. In such instances, a revenue is recognized in the period earned and an asset, a receivable, is recorded.

   Many accruals involve external transactions that automatically are recorded from a source document. For example, a sales invoice for a credit sale provides all the information necessary to record the debit to accounts receivable and the credit to sales revenue. However, there are some accruals that involve internal transactions and thus require adjusting entries. Because accruals involve recognition of expense or revenue before cash flow, the unadjusted trial balance will not be as helpful in identifying required adjusting entries as with prepayments.

ACCRUED LIABILITIES.   For accrued liabilities Accrued liabilities represent liabilities recorded when an expense has been incurred prior to cash payment., we are concerned with expenses incurred but not yet paid. Dress Right Clothing Corporation requires two adjusting entries for accrued liabilities at July 31, 2011.

   The first entry is for employee salaries for the second half of July. Recall that on July 20 the company paid employees $5,000 for salaries for the first half of the month. Salaries for the second half of July will probably be paid in early August. Nevertheless, the company incurred an expense in July for services provided to it by its employees. Also, there exists an obligation at the end of July to pay the salaries earned by employees. An adjusting entry is required to increase salaries expense (decrease shareholders' equity) and to increase liabilities for the salaries payable. The adjusting entry for an accrued liability always includes a debit to an expense, and a credit to a liability. Assuming that salaries for the second half of July are $5,500, the following adjusting entry is recorded.

   

The adjusting entry required to record an accrued liability is a debit to an expense and a credit to a liability.

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To record accrued salaries at the end of July.

   After this entry is recorded and posted to the general ledger, the salaries expense account will have a debit balance of $10,500 ($5,000 + 5,500), and the salaries payable account will have a credit balance of $5,500.

   

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   The unadjusted trial balance does provide information about the second required accrued liability entry. In the trial balance we can see a balance in the notes payable account of $40,000. The company borrowed this amount on July 1, 2011, evidenced by two notes, each requiring the payment of 10% interest. Whenever the trial balance reveals interest-bearing debt, and interest is not paid on the last day of the period, an adjusting entry is required for the amount of interest that has built up (accrued) since the last payment date or the last date interest was accrued. In this case, we calculate interest as follows:

   

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   Interest rates always are stated as the annual rate. Therefore, the above calculation uses this annual rate multiplied by the principal amount multiplied by the amount of time outstanding, in this case one month or one-twelfth of a year.

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To accrue interest expense for July on notes payable.


   After this entry is recorded and posted to the ledger accounts, the interest expense account will have a debit balance of $333, and the interest payable account will have a credit balance of $333. Failure to record a required adjusting entry for an accrued liability will cause net income and shareholders' equity (retained earnings) to be overstated, and liabilities to be understated.4

ACCRUED RECEIVABLES.   Accrued receivables Accrued receivables involve situations when the revenue is earned in a period prior to the cash receipt. involve the recognition of revenue earned before cash is received. An example of an internal accrued revenue event is the recognition of interest earned on a loan to another entity. For example, assume that Dress Right loaned another corporation $30,000 at the beginning of August, evidenced by a note receivable. Terms of the note call for the payment of principal, $30,000, and interest at 8% in three months. An external transaction records the cash disbursement—a debit to note receivable and a credit to cash of $30,000.

   What adjusting entry would be required at the end of August? Dress Right needs to record the interest revenue earned but not yet received and the corresponding receivable. Interest receivable increases and interest revenue (shareholders' equity) also increases. The adjusting entry for accrued receivables always includes a debit to an asset, a receivable, and a credit to revenue. In this case, at the end of August Dress Right recognizes $200 in interest revenue <a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_im0202.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a> and makes the following adjusting entry. If this entry is not recorded, net income, assets, and shareholders' equity (retained earnings) will be understated.

   

The adjusting entry required to record an accrued revenue is a debit to an asset, a receivable, and a credit to revenue.

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   There are no accrued revenue adjusting entries required for Dress Right at the end of July.

   

To accrue interest revenue earned in August on note receivable.

   The required adjusting entries for prepayments and accruals are recapped with the aid of T-accounts in Graphic 2–4. In each case an expense or revenue is recognized in a period that differs from the period in which cash was paid or received. These adjusting entries are necessary to properly measure operating performance and financial position on an accrual basis.

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GRAPHIC 2–4
Adjusting Entries
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Estimates

A third classification of adjusting entries is estimates Accountants often must make estimates in order to comply with the accrual accounting model.. Accountants often must make estimates of future events to comply with the accrual accounting model. For example, the calculation of depreciation expense requires an estimate of expected useful life of the asset being depreciated as well as its expected residual value. We discussed the adjusting entries for depreciation expense in the context of its being a prepayment, but it also could be thought of as an estimate.

   One situation involving an estimate that does not fit neatly into either the prepayment or accrual classification is bad debt expenseTo record bad debt expense for July..This expense is neither a prepayment nor an accrual because it does not involve the payment of cash either before or after an expense is incurred. In Chapter 1 we looked briefly at the allowance method of accounting for bad debts. For this method we need an estimate of the amount of accounts receivable that ultimately will prove to be uncollectible. This estimate is needed to properly match the bad debt expense with the revenue it helps generate, as well as to reflect the collectible portion of the receivable in the balance sheet. Here's an example.

   The July 31, 2011, unadjusted trial balance for Dress Right shows a balance in accounts receivable of $2,000. Assume that the company's management felt that, of this amount, only $1,500 ultimately would be collected. An adjusting entry is required to decrease accounts receivable and increase bad debt expense (decrease shareholders' equity) by $500. The adjusting entry is:

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To record bad debt expense for July.

   Notice that we don't reduce the accounts receivable account directly. Instead we credit a contra account, called allowance for uncollectible accounts, to reduce it indirectly. After this entry is recorded and posted to the ledger accounts, bad debt expense will have a debit balance of $500 and the allowance for uncollectible accounts account will have a credit balance of $500.5

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   The contra account is used to keep intact in the accounts receivable account the total amount of receivables that are still outstanding. The allowance account will always have a credit balance equal to estimated bad debts on existing accounts receivable. Only when a specific customer's account is actually written off as uncollectible would accounts receivable be reduced. At this point, the $500 is just an estimate. In the balance sheet, accounts receivable is shown net of the allowance account, in this case $1,500. The focus of this adjustment approach is to value accounts receivable, net of the allowance, at an amount that reflects the company's best estimate of what it thinks will actually be collected from customers.

   We explore accounts receivable and bad debts in more depth in Chapter 7.

   Illustration 2–7 recaps the July 31, 2011, adjusting entries for Dress Right Clothing Corporation as they would appear in a general journal. The journal entries are numbered [1] to [7] corresponding to the number used in the worksheet illustrated in Appendix 2A.   <a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/820130/blue_dot.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (9.0K)</a>LO5

ILLUSTRATION 2–7
The General Journal—Adjusting Entries
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   After the adjusting entries are posted to the general ledger accounts, the next step— step 7—in the processing cycle is to prepare an adjusted trial balance trial balance after adjusting entries have been recorded.. The term adjusted refers to the fact that adjusting entries have now been posted to the accounts. Recall that the column titled Post Ref. (Posting Reference) is the number assigned to the general ledger account that is being debited or credited. Illustration 2–8 shows the July 31, 2011, adjusted trial balance for Dress Right Clothing Corporation.

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ILLUSTRATION 2–8
Adjusted Trial Balance

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STEP 7
Prepare an adjusted trial balance.

CONCEPT REVIEW EXERCISE

The Wyndham Wholesale Company needs to prepare financial statements at the end of August 2011 for presentation to its bank. An unadjusted trial balance as of August 31, 2011, was presented in a previous concept review exercise on page 66.

   The following information also is available:

   

ADJUSTING ENTRIES


a. 

The company anticipates that of the $25,000 in accounts receivable from customers, $2,500 will not be collected.

b. 

The note payable requires the entire $30,000 in principal plus interest at 10% to be paid on July 31, 2012. The date of the loan is August 1, 2011.

c. 

Depreciation on the equipment for the month of August is $500.

d. 

The note receivable is dated August 16, 2011. The note requires the entire $20,000 in principal plus interest at 12% to be repaid in four months (the loan was outstanding for one-half month during August).

e. 

The prepaid rent of $6,000 represents rent for the months of August and September.

Required:

1. 

Prepare any necessary adjusting entries at August 31, 2011.

2. 

Prepare an adjusted trial balance as of August 31, 2011.

3. 

What is the total net effect on income (overstated or understated) if the adjusting entries are not made?

1.

 

Prepare any necessary adjusting entries at August 31, 2011.

   

SOLUTION


  a. 

An adjusting entry is required to adjust allowance for uncollectible accounts to $2,500. Because there is no balance in the allowance account before adjustment, the adjusting entry must record a bad debt expense of $2,500.

p. 75

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  b. 

An adjusting entry is required to accrue the interest expense on the note payable for the month of August. Accrued interest is calculated as follows:

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  c. 

Depreciation expense on the equipment must be recorded.

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  d. 

An adjusting entry is required for the one-half month of accrued interest revenue earned on the note receivable. Accrued interest is calculated as follows:

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  e. 

An adjusting entry is required to recognize the amount of prepaid rent that expired during August.

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2.

 

Prepare an adjusted trial balance as of August 31, 2011.

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p. 76

3.

 

What is the effect on income (overstated or understated), if the adjusting entries are not made?

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We now turn our attention to the preparation of financial statements.




4Dress Right Clothing is a corporation. Corporations are income-tax-paying entities. Income taxes—federal, state, and local—are assessed on an annual basis and payments are made throughout the year. An additional adjusting entry would be required for Dress Right to accrue the amount of estimated income taxes payable that are applicable to the month of July. Accounting for income taxes is introduced in Chapter 4 and covered in depth in Chapter 16.

5If the allowance for uncollectible accounts had a credit balance before the adjusting entry, say $150, the adjusting entry would have required only a $350 debit to bad debt expense and credit to the allowance account.

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