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Adjusting Entries

At the end of each accounting period, adjusting entries must be made to ensure that all balance sheet and income statement items are stated at the correct amount.

Transactions generally are recorded in a journal as they happen, that is, in chronological order, and then posted to the ledger accounts. The entries are based on the best information available at the time. Although the majority of accounts are up-to-date at the end of an accounting period, and their balances can be included in the financial statements, some accounts require adjustment to reflect current circumstances. In general, these accounts are not updated throughout the period because it is impractical or inconvenient to make entries on a daily or weekly basis. So at the end of each accounting period, in order to report all asset, liability, and owners’ equity amounts properly, and to recognize all revenues and expenses for the period on an accrual basis, accountants are required to make any necessary adjustments prior to preparing the financial statements. The entries that reflect these adjustments are called, as you would expect, adjusting entries.

One difficulty with adjusting entries is that the need for an adjustment is not signaled by a specific event such as the receipt of a bill or the receipt of cash from a customer. Rather, adjusting entries are recorded on the basis of an analysis of the circumstances at the close of each accounting period. This analysis process involves just two steps:

1. Determine whether the amounts recorded for all assets and liabilities are correct. If not, debit or credit the appropriate asset or liability. In short, fix the balance sheet. 2. Determine what revenue or expense adjustments are required because of the changes in recorded amounts of assets and liabilities indicated in (1). Debit or credit the appropriate revenue or expense. In short, fix the income statement.

As we discuss adjusting entries, remember that the basic purpose of adjustments is to bring account balances current in order to report all asset, liability, and owners’ equity amounts properly and to recognize all revenues and expenses for the period on an accrual basis. This is done so that the income statement and the balance sheet will reflect the proper operating results and financial position at the end of the accounting period.

Adjustments result from one of two sequences of events: (1) new information requires an adjustment to a transaction that has already been recorded, or (2) no transaction has been recorded even though a business event has occurred. Examples of these two occurrences are given below.

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An Event Already Recorded Suppose a company purchases a one-year insurance policy by paying $1,200 on October 1, Year 1. On October 1, a journal entry would have been made recording the outflow of cash and the purchase of insurance as follows:

Oct. 1 Prepaid Insurance 1,200 Cash 1,200

On December 31, an adjustment would have to be made to the prepaid insurance account to reflect the fact that part of that asset has been used up. No notice is received from the insurance company as a reminder that the policy is 3⁄12 expired; the company must remember to make this adjustment. Thus, an adjustment is required to reduce the prepaid insurance account to reflect the fact that only nine months of Prepaid Insurance remain. See the timeline below:

$1,200 = (12 months × $100 per month)October 1 September 30| - - - - - - - - - - - - - - - - - - - - - - - - -||- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - | December 31 3 months used up 9 months still an asset

The adjusting journal entry to bring the original amounts to their updated balances at year-end is:

Dec. 31 Insurance Expense 300 Prepaid Insurance 300

When the adjusting entry is entered in the journal and posted, the proper amount of Insurance Expense ($300) will be shown as an expense on the income statement, and the proper amount of Prepaid Insurance ($900) will be carried forward to the next period as an asset on the balance sheet, as illustrated in the following three T accounts.

Prepaid Insurance Cash Insurance Expense

1,200 | | 1,200 | | 300 | 300 |

900 | | 300 |

to balance sheet to income statement

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Two other examples of situations in which it is necessary to make adjustments to previously made journal entries are as follows: • Cash received in advance, initially recorded as the liability Unearned Revenue, and then slowly earned over time • Supplies, initially recorded as an asset, that are then slowly used over time

In each case, the adjusting entry is constructed by first determining what entry is needed to make the recorded balance sheet item correct as of the end of the period. The other half of the adjusting journal entry is then used to make sure revenues and expenses are correctly recorded.

An Event Not Yet Recorded Just as expenses can be recorded by the using up of assets (as was the case with the insurance example), expenses can be recorded as liabilities are created. Consider the following example: A chemical spill in November Year 1 at one of a company’s factories will require extensive cleanup costing $23,000. The cleanup will take place in Year 2. Nothing has been recorded regarding this spill.

To represent its current financial position and earnings, the company must record the impact of this event in the accounts even though cash transactions have not yet occurred. The chemical cleanup costs will not be paid until Year 2. However, under accrual-basis accounting, these costs are expenses of Year 1 and should be recognized in the current year’s income statement, with the corresponding liability shown on the balance sheet as of the end of the year. To the balance sheet, Chemical Cleanup Liability must be credited (increased) for $23,000. The debit half of this adjusting entry is to Chemical Cleanup Expense, resulting in the proper inclusion of this expense in the Year 1 income statement. The adjusting journal entry is as follows:

Dec. 31 Chemical Cleanup Expense 23,000 Chemical Cleanup Liability 23,000

FYIMost companies don’t have to be reminded to search out unrecorded assets and revenues and recognize them. On the other hand, unrecorded liabilities and expenses are things companies would rather forget. Auditors must take care to ensure that all unrecorded liabilities and expenses are properly reported.

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Two other examples of situations in which it is necessary to make adjustments to record previously unrecorded items are as follows: •Interestearned,butnotyetcollectedincash.Theinterestisearnedgradually,creating the asset Interest Receivable, which would go unrecorded at year-end unless an adjusting entry were made. •Wagesearnedbyemployeesnearyear-endbutnotpaidwithCashuntilthefollowingyear. A liability, Wages Payable, exists at year-end and must be recorded through an adjusting entry.

As before, the adjusting entry is constructed by first determining what entry is needed to recognize the unrecorded item so it can be included in the balance sheet. The other half of the adjusting journal entry is then used to make sure revenues and expenses are correctly recorded for the period.

Accrual accounting is the process that accountants use in adjusting raw transaction data into refined measures of a firm’s economic performance. In practice, the adjusting entries are the tools used to implement the concepts of accrual accounting. As such, the adjusting entries are probably the most important among all the journal entries. The adjusting entries also require the most judgment.