Adjusting Entries

In the accounting process, there may be economic events that do not immediately trigger the
recording of the transaction. These are addressed via adjusting entries, which serve to match
expenses to revenues in the accounting period in which they occur. There are two general
classes of adjustments:

Accruals - revenues or expenses that have accrued but have not yet been recorded.

o An example of an accrual is interest revenue that has been earned in one period
even though the actual cash payment will not be received until early in the next
period. An adjusting entry is made to recognize the revenue in the period in which it
was earned.

Deferrals - revenues or expenses that have been recorded but need to be deferred to a
later date.

o An example of a deferral is an insurance premium that was paid at the end of one
accounting period for insurance coverage in the next period. A deferred entry is
made to show the insurance expense in the period in which the insurance coverage
is in effect.

How to Make Adjusting Entries

Like regular transactions, adjusting entries are recorded as journal entries. The following
illustrates adjustments for accrued and deferred items.

Accrued Items

As an example of an accrued item, consider the accrual of interest revenue. The journal entry
would be similar to the following:

Adjusting Entry for Interest Accrual

Date Accounts Debit Credit

mm/dd Interest Receivable xxxx.xx

Interest Revenue xxxx.xx

The date of the above entry would be at the end of the period in which the interest was earned.
The adjusting entry is needed because the interest was accrued during that period but is not
payable until sometime in the next period. The adjusting entry is posted to the general ledger in
the same manner as other journal entries.

In the next period when the cash is actually received, one makes the following journal entry:

Journal Entry for Interest Received

Date Accounts Debit Credit

mm/dd Cash xxxx.xx

Interest Receivable xxxx.xx

Deferred Items
For deferrals, a journal entry already has been made in asset or liability accounts and an
adjusting entry is needed to move the balances to expense or revenue accounts in the next
accounting period. Consider the case in which the firm prepays insurance premiums in one
period for insurance coverage in the next period. The journal entry made at the time of payment
would be similar to the following:

Journal Entry for Prepaid Insurance

Date Accounts Debit Credit

mm/dd Prepaid Insurance xxxx.xx

Cash xxxx.xx

In the next period when the insurance coverage is in effect, one makes the following adjusting
entry:

Adjusting Entry for Prepaid Insurance

Date Accounts Debit Credit

mm/dd Insurance Expense xxxx.xx

Prepaid Insurance xxxx.xx

For a single deferred item, there may be several adjusting entries over subsequent accounting
periods as the expense or revenue for the item is recognized over time.

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.

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.)

Adjusting Entries Asset Accounts

Adjusting entries assure that both the balance sheet and the income statement are up-to-date on
the accrual basis of accounting. A reasonable way to begin the process is by reviewing the
amount or balance shown in each of the balance sheet accounts. We will use the following
preliminary balance sheet, which reports the account balances prior to any adjusting entries:

Parcel Delivery Service

Preliminary Balance Sheetbefore adjusting entries
 December 31, 2010

Assets Liabilities

$ $
Cash Notes Payable
1,800 5,000
Accounts Receivable 4,600 Accounts Payable 2,500
Supplies 1,100 Wages Payable 1,200
1,30
Prepaid Insurance 1,500 Unearned Revenues
0
Equipment 25,000 Total Liabilities 10,000
Accumulated (7,500)
Depreciation
Owner's Equity
Mary Smith, Capital
16,500

$26,50 Total Liabilities & Owner's $26,50

Total Assets
0 Equity 0
Let's begin with the asset accounts:

Cash $1,800

The Cash account has a preliminary balance of $1,800the amount in the general ledger.
Before issuing the balance sheet, one must ask, "Is $1,800 the true amount of cash? Does it
agree to the amount computed on the bank reconciliation?" The accountant found that $1,800
was indeed the true balance. (If the preliminary balance in Cash does not agree to the bank
reconciliation, entries are usually needed. For example, if the bank statement included a service
charge and a check printing chargeand they were not yet entered into the company's
accounting recordsthose amounts must be entered into the Cash account. See the major topic
Bank Reconciliation for a thorough discussion and illustration of the likely journal entries.)

Accounts Receivable $4,600

To determine if the balance in this account is accurate the accountant might review the detailed
listing of customers who have not paid their invoices for goods or services. (This is often referred
to as the amount of open or unpaid sales invoices and is often found in the accounts receivable
subsidiary ledger.) When those open invoices are sorted according to the date of the sale, the
company can tell how old the receivables are. Such a report is referred to as an aging of
accounts receivable. Let's assume the review indicates that the preliminary balance in
Accounts Receivable of $4,600 is accurate as far as the amounts that have been billed and not
yet paid.

However, under the accrual basis of accounting, the balance sheet must report all the amounts
the company has an absolute right to receivenot just the amounts that have been billed on a
sales invoice. Similarly, the income statement should report all revenues that have been earned
not just the revenues that have been billed. After further review, it is learned that $3,000 of
work has been performed (and therefore has been earned) as of December 31 but won't be billed
until January 10. Because this $3,000 was earned in December, it must be entered and reported
on the financial statements for December. An adjusting entry dated December 31 is prepared in
order to get this information onto the December financial statements.

To assist you in understanding adjusting journal entries, double entry, and debits and credits,
each example of an adjusting entry will be illustrated with a T-account.

Here is the process we will follow:

1. Draw two T-accounts. (Every journal entry involves at least two accounts. One account to
be debited and one account to be credited.)
 2. Indicate the account titles on each of the T-accounts. (Remember that almost always one
of the accounts is a balance sheet account and one will be an income statement
account. In a smaller font size we will indicate the type of account next to the account
title and we will also indicate some tips about debits and credits within the T-accounts.)
3. Enter the preliminary balance in each of the T-accounts.
4. Determine what the ending balance ought to be for the balance sheet account.
5. Make an adjustment so that the ending amount in the balance sheet account is correct.
6. Enter the same adjustment amount into the related income statement account.
7. Write the adjusting journal entry.

Let's follow that process here:

Accounts Receivable (balance sheet account)

Debit Credit
Increases an asset Decreases an asset
Preliminary Balance 4,600
ADJUSTING ENTRY 3,000
Correct Balance 7,600

Service Revenues (income statement

account)

Debit Credit
Decreases Revenues Increases Revenues
60,234 Preliminary Balance
3,000 ADJUSTING ENTRY
63,234 Correct Balance
The adjusting entry for Accounts Receivable in general journal format is:

Date Account Name Debit Credit

Dec. 31, 2010 Accounts Receivable 3,000

Service Revenues 3,000

Notice that the ending balance in the asset Accounts Receivable is now $7,600the correct
amount that the company has a right to receive. The income statement account balance has
been increased by the $3,000 adjustment amount, because this $3,000 was also earned in the
accounting period but had not yet been entered into the Service Revenues account. The balance
in Service Revenues will increase during the year as the account is credited whenever a sales
invoice is prepared. The balance in Accounts Receivable also increases if the sale was on credit
(as opposed to a cash sale). However, Accounts Receivable will decrease whenever a customer
pays some of the amount owed to the company. Therefore the balance in Accounts Receivable
might be approximately the amount of one month's sales, if the company allows customers to
pay their invoices in 30 days.

At the end of the accounting year, the ending balances in the balance sheet accounts (assets
and liabilities) will carry forward to the next accounting year. The ending balances in the income
statement accounts (revenues and expenses) are closed after the year's financial statements are
prepared and these accounts will start the next accounting period with zero balances.

Allowance for Doubtful Accounts $0

(It's common not to list accounts with $0 balances on balance sheets.)

Although the Allowance for Doubtful Accounts does not appear on the preliminary balance sheet,
experienced accountants realize that it is likely that some of the accounts receivable might not
be collected. (This could occur because some customers will have unforeseen hardships, some
customers might be dishonest, etc.) If some of the $4,600 owed to the company will not be
collected, the company's balance sheet should report less than $4,600 of accounts receivable.
However, rather than reducing the balance in Accounts Receivable by means of a credit amount,
the credit amount will be reported in Allowance for Doubtful Accounts. (The combination of the
debit balance in Accounts Receivable and the credit balance in Allowance for Doubtful Accounts
is referred to as the net realizable value.)

Let's assume that a review of the accounts receivables indicates that approximately $600 of the
receivables will not be collectible. This means that the balance in Allowance for Doubtful
Accounts should be reported as a $600 credit balance instead of the preliminary balance of $0.
The two accounts involved will be the balance sheet account Allowance for Doubtful Accounts
and the income statement account Bad Debts Expense.

Allowance for Doubtful Accounts (balance

sheet account)

Debit Credit
Decreases a contra asset Increases a contra asset
0 Preliminary Balance
600 ADJUSTING ENTRY
600 Correct Balance

Bad Debts Expense (income statement

account)

Debit Credit
Increases an expense Decreases an expense
Preliminary Balance 0
ADJUSTING ENTRY 600
Correct Balance 600

The adjusting journal entry for Allowance for Doubtful Accounts is:

Date Account Name Debit Credit

Dec. 31, 2010 Bad Debts Expense 600

Allowance for Doubtful
600
Accounts
It is possible for one or both of the accounts to have preliminary balances. However, the balances
are likely to be different from one another. Because Allowance for Doubtful Accounts is a balance
sheet account, its ending balance will carry forward to the next accounting year. Because Bad
Debts Expense is an income statement account, its balance will not carry forward to the next
year. Bad Debts Expense will start the next accounting year with a zero balance.

Supplies $1,100

The Supplies account has a preliminary balance of $1,100. However, a count of the supplies
actually on hand indicates that the true amount of supplies is $725. This means that the
preliminary balance is too high by $375 ($1,100 minus $725). A credit of $375 will need to be
entered into the asset account in order to reduce the balance from $1,100 to $725. The related
income statement account is Supplies Expense.

Supplies (balance sheet account)

Debit Credit
Increases an asset Decreases an asset
Preliminary Balance 1,100
375 ADJUSTING ENTRY
Correct Balance 725
 Supplies Expense (income statement
account)

Debit Credit
Increases an expense Decreases an expense
Preliminary Balance 1,600
ADJUSTING ENTRY 375
Correct Balance 1,975

The adjusting entry for Supplies in general journal format is:

Date Account Name Debit Credit

Dec. 31, 2010 Supplies Expense 375

Supplies 375
Notice that the ending balance in the asset Supplies is now $725the correct amount of supplies
that the company actually has on hand. The income statement account Supplies Expense has
been increased by the $375 adjusting entry. It is assumed that the decrease in the supplies on
hand means that the supplies have been used during the current accounting period. The balance
in Supplies Expense will increase during the year as the account is debited. Supplies Expense will
start the next accounting year with a zero balance. The balance in the asset Supplies at the end
of the accounting year will carry over to the next accounting year.

Prepaid Insurance $1,500

The $1,500 balance in the asset account Prepaid Insurance is the preliminary balance. The
correct balance needs to be determined. The correct amount is the amount that has been paid
by the company for insurance coverage that will expire after the balance sheet date. If a review
of the payments for insurance shows that $600 of the insurance payments is for insurance that
will expire after the balance sheet date, then the balance in Prepaid Insurance should be $600.
All other amounts should be charged to Insurance Expense.

Prepaid Insurance (balance sheet account)

Debit Credit
Increases an asset Decreases an asset
Preliminary Balance 1,500
900 ADJUSTING ENTRY
Correct Balance 600

Insurance Expense (income statement

account)

Debit Credit
Increase an expense Decreases an expense
Preliminary Balance 1,000
ADJUSTING ENTRY 900
Correct Balance 1,900

The adjusting journal entry for Prepaid Insurance is:

Date Account Name Debit Credit

Dec. 31, 2010 Insurance Expense 900

Prepaid
900
Insurance

Note that the ending balance in the asset Prepaid Insurance is now $600the correct amount of
insurance that has been paid in advance. The income statement account Insurance Expense has
been increased by the $900 adjusting entry. It is assumed that the decrease in the amount
prepaid was the amount being used or expiring during the current accounting period. The
balance in Insurance Expense starts with a zero balance each year and increases during the year
as the account is debited. The balance at the end of the accounting year in the asset Prepaid
Insurance will carry over to the next accounting year.

Equipment $25,000

Equipment is a long-term asset that will not last indefinitely. The cost of equipment is recorded in
the account Equipment. The $25,000 balance in Equipment is accurate, so no entry is needed in
this account. As an asset account, the debit balance of $25,000 will carry over to the next
accounting year.

Accumulated Depreciation - Equipment $7,500

Accumulated Depreciation - Equipment is a contra asset account and its preliminary balance
of $7,500 is the amount of depreciation actually entered into the account since the Equipment
was acquired. The correct balance should be the cumulative amount of depreciation from the
time that the equipment was acquired through the date of the balance sheet. A review indicates
that as of December 31 the accumulated amount of depreciation should be $9,000. Therefore
the account Accumulated Depreciation - Equipment will need to have an ending balance of
$9,000. This will require an additional $1,500 credit to this account. The income statement
account that is pertinent to this adjusting entry and which will be debited for $1,500 is
Depreciation Expense - Equipment.

Accumulated Depreciation - Equipment (balance

sheet acct)

Debit Credit
Decreases a contra asset Increases a contra asset
7,500 Preliminary Balance
1,500 ADJUSTING ENTRY
9,000 Correct Balance

Depreciation Expense - Equipment (income

statement acct)

Debit Credit
Increases an expense Decreases an expense
Preliminary Balance 0
ADJUSTING ENTRY 1,500
Correct Balance 1,500
The adjusting entry for Accumulated Depreciation in general journal format is:

Date Account Name Debit Credit

Dec. 31, 2010 Depreciation Expense - Equipment 1,500

Accumulated Depreciation -
1,500
Equipment

The ending balance in the contra asset account Accumulated Depreciation - Equipment at the
end of the accounting year will carry forward to the next accounting year. The ending balance in
Depreciation Expense - Equipment will be closed at the end of the current accounting period and
this account will begin the next accounting year with a balance of $0.

Adjusting Entries Liability Accounts

Notes Payable $5,000

Notes Payable is a liability account that reports the amount of principal owed as of the balance
sheet date. (Any interest incurred but not yet paid as of the balance sheet date is reported in a
separate liability account Interest Payable.) The accountant has verified that the amount of
principal actually owed is the same as the amount appearing on the preliminary balance sheet.
Therefore, no entry is needed for this account.

Interest Payable $0 (It's common not to list accounts with $0 balances on balance sheets.)

Interest Payable is a liability account that reports the amount of interest the company owes as of
the balance sheet date. Accountants realize that if a company has a balance in Notes Payable,
the company should be reporting some amount in Interest Expense and in Interest Payable.
The reason is that each day that the company owes money it is incurring interest expense and
an obligation to pay the interest. Unless the interest is paid up to date, the company will always
owe some interest to the lender.

Let's assume that the company borrowed the $5,000 on December 1 and agrees to make the
first interest payment on March 1. If the loan specifies an annual interest rate of 6%, the loan will
cost the company interest of $300 per year or $25 per month. On March 1 the company will be
required to pay $75 of interest. On the December income statement the company must report
one month of interest expense of $25. On the December 31 balance sheet the company must
report that it owes $25 as of December 31 for interest.

Interest Payable (balance sheet account)

Debit Credit
Decreases a liability Increases a liability
0 Preliminary Balance
25 ADJUSTING ENTRY
25 Correct Balance

Interest Expense (income statement

account)

Debit Credit
Increases an expense Decreases an expense
Preliminary Balance 0
ADJUSTING ENTRY 25
Correct Balance 25
The adjusting journal entry for Interest Payable is:

Date Account Name Debit Credit

Dec. 31, 2010 Interest Expense 25

Interest Payable 25
It is unusual that the amount shown for each of these accounts is the same. In the future months
the amounts will be different. Interest Expense will be closed automatically at the end of each
accounting year and will start the next accounting year with a $0 balance.

Accounts Payable $2,500 (It is common not to list accounts with $0 balances on balance
sheets.)

Accounts Payable is a liability account that reports the amounts owed to suppliers or vendors as
of the balance sheet date. Amounts are routinely entered into this account after a company has
received and verified all of the following: (1) an invoice from the supplier, (2) goods or services
have been received, and (3) compared the amounts to the company's purchase order. A review
of the details confirms that this account's balance of $2,500 is accurate as far as invoices
received from vendors.

However, under the accrual basis of accounting the balance sheet must report all the amounts
owed by the companynot just the amounts that have been entered into the accounting system
from vendor invoices. Similarly, the income statement must report all expenses that have been
incurrednot merely the expenses that have been entered from a vendor's invoice. To illustrate
this, assume that a company had $1,000 of plumbing repairs done in late December, but the
company has not yet received an invoice from the plumber. The company will have to make an
adjusting entry to record the expense and the liability on the December financial statements. The
adjusting entry will involve the following accounts:

Accounts Payable (balance sheet account)

Debit Credit
Decreases a liability Increases a liability
2,500 Preliminary Balance
1,000 ADJUSTING ENTRY
3,500 Correct Balance

Repairs & Maintenance Expense (income

statement acct)

Debit Credit
Increases an expense Decreases an expense
Preliminary Balance 7,870
ADJUSTING ENTRY 1,000
Correct Balance 8,870

The adjusting entry for Accounts Payable in general journal format is:

Date Account Name Debit Credit

Dec. 31, 2010 Repairs & Maintenance Expense 1,000

Accounts Payable 1,000
The balance in the liability account Accounts Payable at the end of the year will carry forward to
the next accounting year. The balance in Repairs & Maintenance Expense at the end of the
accounting year will be closed and the next accounting year will begin with $0.
Wages Payable $1,200

Wages Payable is a liability account that reports the amounts owed to employees as of the
balance sheet date. Amounts are routinely entered into this account when the company's payroll
records are processed. A review of the details confirms that this account's balance of $1,200 is
accurate as far as the payrolls that have been processed.

However, under the accrual basis of accounting the balance sheet must report all of the payroll
amounts owed by the companynot just the amounts that have been processed. Similarly, the
income statement must report all of the payroll expenses that have been incurrednot merely
the expenses from the routine payroll processing. For example, assume that December 30 is a
Sunday and the first day of the payroll period. The wages earned by the employees on December
30-31 will be included in the payroll processing for the week of December 30 through January 5.
However, the December income statement and the December 31 balance sheet need to include
the wages for December 30-31, but not the wages for January 1-5. If the wages for December 30-
31 amount to $300, the following adjusting entry is required as of December 31:

Wages Payable (balance sheet account)

Debit Credit
Decreases a liability Increases a liability
1,200 Preliminary Balance
300 ADJUSTING ENTRY
1,500 Correct Balance

Wages Expense (income statement

account)

Debit Credit
Increases an expense Decreases an expense
Preliminary Balance 13,120
ADJUSTING ENTRY 300
Correct Balance 13,420

The adjusting journal entry for Wages Payable is:

Date Account Name Debit Credit

Dec. 31, 2010 Wages Expense 300

Wages Payable 300

The $1,500 balance in Wages Payable is the true amount not yet paid to employees for their
work through December 31. The $13,420 of Wages Expense is the total of the wages used by the
company through December 31. The Wages Payable amount will be carried forward to the next
accounting year. The Wages Expense amount will be zeroed out so that the next accounting year
begins with a $0 balance.

Unearned Revenues $1,300

Unearned Revenues is a liability account that reports the amounts received by a company but
have not yet been earned by the company. For example, if a company required a customer with a
poor credit rating to pay $1,300 before beginning any work, the company increases its asset
Cash by $1,300 and it should increase its liability Unearned Revenues by $1,300.

As the company does the work, it will reduce the Unearned Revenues account balance and
increase its Service Revenues account balance by the amount earned (work performed). A review
of the balance in Unearned Revenues reveals that the company did indeed receive $1,300 from a
customer earlier in December. However, during the month the company provided the customer
with $800 of services. Therefore, at December 31 the amount of services due to the customer is
$500.

Let's visualize this situation with the following T-accounts:

Unearned Revenues (balance sheet account)

Debit Credit
Decreases a liability Increases a liability
1,300 Preliminary Balance
ADJUSTING ENTRY 800
500 Correct Balance

Service Revenues (income statement

account)

Debit Credit
Decreases revenues Increases revenues
63,234 Preliminary Balance
800 ADJUSTING ENTRY
64,034 Correct Balance

The adjusting entry for Unearned Revenues in general journal format is:

Date Account Name Debit Credit

Dec. 31, 2010 Unearned Revenues 800

Service Revenues 800
Since Unearned Revenues is a balance sheet account, its balance at the end of the accounting
year will carry over to the next accounting year. On the other hand Service Revenues is an
income statement account and its balance will be closed when the current year is over. Revenues
and expenses always start the next accounting year with $0.