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Adjusting Entries
Accounting Terms Review
A new accounting principle, the matching principle, will be introduced in this lesson. Here's a review of other accounting principles you have learned:
Business entity- the business functions as a legal and financial entity seperate from its owners or any other business.
Going concern- the business will continue to operate for the foreseeable future.
Time period- assumes that all the transactions reported did in fact occur within the time period as listed.
Cost Principle- accounting for purchases must be at their cost price.
Disclosure principle- any and all information that affects the full understanding of a company's financial statements must be included with the financial statements.
Matching Principle
Before financial statements are prepared (either monthly, quarterly, or yearly financial statements), the accountant will make sure that all expenses which occurred in the accounting period are "matched" with the revenues earned during the same period. This comparison is the "Matching Principle". The matching principle matches the expenses and revenues of the same period which provides a reliable measure of profit, because it shows the expenses required to produce the revenue.
Producing Revenue
Business owners and managers want to determine whether the expenses are actually producing more revenue. That is why expenses and revenues are matched in the same period. Adjusting entries are the journal entries that must be made to allow the "matching" to take place.
Adjustments
The accountant will analyze the accounts in the trial balance to identify specific accounts that must be adjusted to bring them up-to-date. Journal entries made to update general ledger accounts at the end of a fiscal period are called adjustments or adjusting entries.
Reasons for Adjustments
There are many reasons for adjustments:
- Some expenses extend over more than one period.
- Some revenues may not have been recorded yet.
- Some assets may have lost value.
Let's look at these types of adjusting entries individually.
Extended Expenses
Some expenses extend over more than one period.
Let's say you opened business on November 1st and you purchased a 1-year insurance policy for $1,200.00 on Nov 1st.
- If this policy were for the year – how much would be allocated to each month?
- $1,200.00 / 12 months = $100 per month
Insurance Entry
So when you purchased this insurance you made the following entry:
- Prepaid Insurance (Asset) $1,200.00
- Cash (Asset) $1,200.00
You purchased one asset (Prepaid Insurance) with another asset (Cash). Prepaid Insurance is an asset because you own it and if you were to cancel it, they would have to return to you the unused portion.
- At the end of December, how much insurance do you have remaining?
- $1,000.00 because two months have been used up – or expensed, because time has passed.
Adjustment Entry
On December 31, your books still show $1,200 in Prepaid Insurance and that is incorrect. It should be $1,000 because two months have been used up, or expired, or expensed. So we need to bring our books up to date with the following adjusting entry:
- Insurance Expense $200.00
- Prepaid Insurance $200.00
Insurance expense will be debited because the account is increased and Prepaid Insurance will be credited because the account is decreased for the amount of the adjustment.
After this entry, your Prepaid Insurance will show a debit balance of $1,000.00 – which is now correct. The Insurance Expense will show a debit balance of $200.00 – which is correct, the $200 expense for insurance belongs to November and December, and are now correctly reflected in the right period.
Revenues Not Recorded
Some revenues may not have been recorded yet.
Usually when a sale is made or a service is provided, the revenue is recorded immediately. However, sometimes the customer may say to "bill them", they are going to pay later. These transactions require an adjusting journal entry if the company has not yet recorded the transaction. The company needs to show that they will receive move later (Accounts Receivable) from a Sale (Revenue). This will be a very familiar transaction:
Made a sale for $900.00 and the customer says to Bill them:
- Accounts Receivable (Asset) $900.00
- Sales (Revenue) $900.00
Accounts receivable will be debited because the account is increased and Sales is credited because it is also increased.
Lost Value
Some assets may have lost value.
One adjusting entry involves long-term assets, such as: building, vehicles, and equipment. When you purchase one of these assets, you record the asset at the purchase price. In 4-5 years, is that vehicle or equipment still worth the same amount? No, it's not. Why isn't it? Because of Depreciation. Depreciation is the wear and tear of an asset over its estimated useful life.
Recording Asset Depreciation
Because an asset will lose value, the business needs to be able to state the actual or book value of the asset. We do this by recording the asset's depreciation. Each period, the amount the asset has depreciated (lost value) is calculated and is recorded as an adjusting entry.
Equipment Depreciation
If I tell you the depreciation for the Equipment is $500, the adjusting journal entry is:
- Depreciation Expense-Equipment $500.00
- Accumulated Depreciation-Equipment $500.00
Depreciation expense- Equipment will be debited because the account is increased and Accumulated Depreciation- Equipment is credited because it is also increased.
Accumulated Depreciation
Accumulated Depreciation is a "Contra Asset". Contra means to "go against".
- If an asset has a normal debit balance – what do you think a "Contra Asset's" normal balance would be?
- Credit
The accumulated depreciation goes right after the asset and reduces the "book value" of the asset.
Example:
- Equipment $6,000
- Less: Accumulated Depreciation $ 500
- Book Value of Equipment $5,500
$6,000 - $500 = $5,500
Calculating Depreciation
Let's look at how to calculate the amount of depreciation for each period. To calculate depreciation you need to know:
- The cost of the asset
- How many years the asset is expected to last
- Salvage Value – what you think you can sell the asset for at the end of it's useful life
Straight-line Depreciation
Different methods can be used to calculate depreciation; we will use the simplest method - straight-line depreciation. Under the straight-line depreciation method, equal amounts of depreciation expense is charged each fiscal period over the asset's useful life. Here's the formula:
Cost of Equipment - Salvage Value ÷ Estimated Years of Usefulness
The Internal Revenue Service has guidelines as to methods of depreciation and estimated life of various assets.
Equipment Purchase Example
Equipment purchased for $6,000 has a salvage value of $1,200 at the end of its 5 year estimated useful life. That means that its cost was $6,000, it will last for about 5 years, and the owner should expect to receive $1,200 when sold or traded in at the end of the 5 year period.
Cost of Equipment - Salvage Value ÷ Estimated Years of Usefulness
$6,000 - $1,200 ÷ 5 years =
$4,800 ÷ 5 years =
$960 depreciation per year
The adjusting entry for this would be:
- Depreciation Expense-Equipment $960
- Accumulated Depreciation-Equipment $960
Depreciation expense- Equipment will be debited because the account is increased and Accumulated Depreciation- Equipment is credited because it is also increased.
Adjustments Key Points
Let's summarize the key points of adjustments before learning how they should be journalized:
- As assets are used up, some portions are allocated to expense accounts.
- A prepaid item is something that was paid in advance and is considered an asset.
- Depreciation is the process of spreading the original cost of the asset over its expected useful life.
- Three factors are considered in calculating the annual amount of depreciation expense: original cost, estimated salvage value, and estimated useful life.
- Accumulated depreciation is a contra-asset account.
- Each period, the amount in the Accumulated Depreciation account grows larger, while the cost of the equipment remains the same.
- Adjustments update certain accounts so that they will be up-to-their latest balance before financial statements are prepared.
- Adjustments are the result of internal transaction.
- Each adjusting entry usually affects one income statement account (revenue and expense) and one balance sheet account (assets, liabilities, or equity).
Adjustment Terms Review
Accumulated Depreciation- the total amount of depreciation expense that has been recorded since the purchase of an asset.
Adjustments- changes journalized to update ledger accounts at the end of a fiscal period.
Contra Account- an account that reduces a related account and has the opposite normal balance of its related account.
Depreciation- the portion of an asset's cost transferred to an expense account in each fiscal period during the asset's useful life.
Fixed Assets- long-term assets that cannot easily be converted to cash, also called property, plant, and equipment.
Matching Principle- revenue from business activities and expenses associated with earning that revenue are recorded in the same accounting period.
Prepaid- An asset that is paid for prior to using. As this asset is consumed or used or "expensed", an adjusting entry will transfer the amount "expensed" from the Prepaid Asset account to the Expense account.
Salvage- property's value at the end of its useful life.
Straight-line Depreciation- charging an equal amount of depreciation expense for an asset each fiscal period.