In order for revenues to be recorded in the period in which services are per- formed and for expenses to be recognized in the period in which they are in- curred, companies make adjusting entries. In short, adjustments ensure that companies, like SAP (DEU), Cathay Pacific Airways (HKG), and Nokia (FIN), follow the revenue recognition and expense recognition principles.
The use of adjusting entries makes it possible to report on the statement of financial position the appropriate assets, liabilities, and equity at the statement date. Adjusting entries also make it possible to report on the income statement the proper revenues and expenses for the period. However, the trial balance—the first pulling together of the transaction data—may not contain up-to-date and complete data. This occurs for the following reasons.
1. Some events are not journalized daily because it is not expedient. Examples are the consumption of supplies and the earning of salaries and wages by employees.
2. Some costs are not journalized during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transac- tions. Examples of such costs are building and equipment depreciation and rent and insurance.
3. Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period.
Adjusting entries are required every time a company, such as Sony (JPN), prepares financial statements. At that time, Sony must analyze each account in the trial balance to determine whether it is complete and up-to-date for financial statement purposes. The analysis requires a thorough understanding of Sony’s operations and the interrelationship of accounts. Because of this involved pro- cess, usually a skilled accountant prepares the adjusting entries. In gathering the adjustment data, Sony may need to make inventory counts of supplies and re- pair parts. Further, it may prepare supporting schedules of insurance policies, rental agreements, and other contractual commitments. Companies often pre- pare adjustments after the statement of financial position date. However, they date the entries as of the statement of financial position date.
Types of Adjusting Entries
Adjusting entries are classified as either deferrals or accruals. Each of these classes has two subcategories, as Illustration 3-20 shows.
We review specific examples and explanations of each type of adjustment in sub- sequent sections. We base each example on the October 31 trial balance of Pioneer Advertising Agency Inc. (Illustration 3-19). We assume that Pioneer uses an account- ing period of one month. Thus, Pioneer will make monthly adjusting entries, dated October 31.
Deferrals:
1. Prepaid expenses: Expenses paid in cash before they are used or consumed.
2. Unearned revenues: Cash received before services are performed.
Accruals:
1. Accrued revenues: Revenues for services performed but not yet received in cash or recorded.
2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.
ILLUSTRATION 3-20 Categories of Adjusting Entries
5 LEARNING OBJECTIVE Explain the reasons for preparing adjusting entries.
Underlying Concepts Preparation of fi nancial statements for subperiods such as quarters or months improves the timeliness of the information but raises verifi ability concerns due to estimates in preparing adjusting entries.
Adjusting Entries for Deferrals
To defer means to postpone or delay. Deferrals are expenses or revenues that are recog- nized at a date later than the point when cash was originally exchanged. The two types of deferrals are prepaid expenses and unearned revenues.
If a company does not make an adjustment for these deferrals, the asset and lia- bility are overstated, and the related expense and revenue are understated. For ex- ample, in Pioneer Advertising’s trial balance (Illustration 3-19), the balance in the asset Supplies shows only supplies purchased. This balance is overstated; the related expense account, Supplies Expense, is understated because the cost of supplies used has not been recognized. Thus the adjusting entry for deferrals will decrease a statement of financial position account and increase an income statement account. Illustration 3-21 shows the effects of adjusting entries for deferrals.
Prepaid Expenses. Assets paid for and recorded before a company uses them are called prepaid expenses. When expenses are prepaid, a company debits an asset account to show the service or benefit it will receive in the future. Examples of common prepay- ments are insurance, supplies, advertising, and rent. In addition, companies make pre- payments when they purchase buildings and equipment.
Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use and consumption (e.g., supplies). The expiration of these costs does not require daily entries, an unnecessary and impractical task. Accordingly, a company like Louis Vuitton (LVMH Group) (FRA) usually postpones the recognition of such cost expirations until it prepares financial statements. At each statement date, Louis Vuitton makes adjusting entries to record the expenses that apply to the current accounting period and to show the remaining amounts in the asset accounts.
As shown above, prior to adjustment, assets are overstated and expenses are under- stated. Thus, an adjusting entry for prepaid expenses results in a debit to an expense account and a credit to an asset account.
ILLUSTRATION 3-21 Adjusting Entries for Deferrals
Prepaid Expenses
Unearned Revenues Asset
Credit Adjusting Entry (–) Unadjusted
Balance
ADJUSTING ENTRIES
Expense
Debit Adjusting Entry (+)
Liability Revenue
Credit Adjusting Entry (+) Debit
Adjusting Entry (–)
Unadjusted Balance
The Accounting Cycle 81 Supplies. A business enterprise may use several different types of supplies. For example,
a public accounting firm will use office supplies such as stationery, envelopes, and ac- counting paper. An advertising firm will stock advertising supplies such as graph paper, video film, and poster paper. Supplies are generally debited to an asset account when they are acquired. Recognition of supplies used is generally deferred until the adjustment process. At that time, a physical inventory (count) of supplies is taken. The difference between the balance in the Supplies (asset) account and the cost of supplies on hand represents the supplies used (expense) for the period.
For example, Pioneer Advertising purchased advertising supplies costing 25,000 on October 5. Pioneer therefore debited the asset Supplies. This account shows a bal- ance of 25,000 in the October 31 trial balance (see Illustration 3-19). An inventory count at the close of business on October 31 reveals that 10,000 of supplies are still on hand. Thus, the cost of supplies used is 15,000 ( 25,000 2 10,000). The analysis and adjustment for Supplies is summarized in Illustration 3-22.
After adjustment, the asset account Supplies now shows a balance of 10,000, which equals the cost of supplies on hand at the statement date. In addition, Supplies Expense shows a balance of 15,000, which equals the cost of supplies used in October. Without an adjusting entry, October expenses are understated and net income overstated by 15,000. Moreover, both assets and equity are overstated by 15,000 on the October 31 statement of financial position.
Insurance. Most companies maintain fire and theft insurance on merchandise and equip- ment, personal liability insurance for accidents suffered by customers, and automobile insurance on company cars and trucks. The extent of protection against loss determines the cost of the insurance (the amount of the premium to be paid). The insurance policy specifies the term and coverage. The minimum term usually covers one year, but three- to five-year terms are available and may offer lower annual premiums. A company usu- ally debits insurance premiums to the asset account Prepaid Insurance when paid. At the financial statement date, it then debits Insurance Expense and credits Prepaid Insur- ance for the cost that expired during the period.
For example, on October 4, Pioneer Advertising paid 6,000 for a one-year fire insur- ance policy, beginning October 1. Pioneer debited the cost of the premium to Prepaid
Supplies used;
record supplies expense Supplies purchased;
record asset
Oct. 31 Oct. 5
Supplies
Insurance Policy Nov
500 Dec 500 Jan
500 Feb
500 March
500 April 500
May 500 June
500 July 500 Aug
500 Sept 500 1 YEAR 6,000 Oct
500
FIRE INSURANCE 1 year insurance policy
6,000
Insurance expired;
record insurance expense.
Insurance purchased;
record asset Oct. 1
Oct. 31
Insurance ILLUSTRATION 3-22 Adjustment for Supplies
A = L + E
215,000 215,000
Cash Flows no effect Debit–Credit
Analysis
Journal Entry
Posting Basic Analysis
Equation Analysis
Oct. 5 25,000 Oct. 31 Bal. 10,000
Oct. 31 Adj. 15,000 Supplies
Oct. 31 Adj. 15,000 Oct. 31 Bal. 15,000
Supplies Expense Debits increase expenses: debit Supplies Expense 15,000.
Credits decrease assets: credit Supplies 15,000.
Oct. 31 Supplies Expense Supplies
(To record supplies used)
15,000
15,000 The expense Supplies Expense is increased 15,000, and the asset Supplies is decreased 15,000.
Assets Supplies – 15,000
=
=
Liabilities + Equity Supplies Expense
– 15,000 (1)
Insurance at that time. This account still shows a balance of 6,000 in the October 31 trial balance. An analysis of the policy reveals that 500 ( 6,000 4 12) of insurance expires each month. The analysis and adjustment for insurance is summarized in Illustration 3-23.
The asset Prepaid Insurance shows a balance of 5,500, which represents the unex- pired cost for the remaining 11 months of coverage. At the same time, the balance in Insurance Expense equals the insurance cost that expired in October. Without an ad- justing entry, October expenses are understated by 500 and net income overstated by
500. Moreover, both assets and equity also are overstated by 500 on the October 31 statement of financial position.
Depreciation. Companies, like Caterpillar (USA) or Siemens (DEU), typically own vari- ous productive facilities, such as buildings, equipment, and motor vehicles. These assets provide a service for a number of years. The term of service is commonly referred to as the useful life of the asset. Because Siemens, for example, expects an asset such as a building to provide service for many years, Siemens records the building as an asset, rather than an expense, in the year the building is acquired. Siemens records such assets at cost, as required by the historical cost principle.
To follow the expense recognition principle, Siemens should report a portion of the cost of a long-lived asset as an expense during each period of the asset’s useful life.
Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner.
Need for depreciation adjustment. Under IFRS, the acquisition of productive facilities is viewed as a long-term prepayment for services. The need for making periodic adjust- ing entries for depreciation is therefore the same as we described for other prepaid expenses. That is, a company recognizes the expired cost (expense) during the period and reports the unexpired cost (asset) at the end of the period. The primary causes of depreciation of a productive facility are actual use, deterioration due to the elements, and obsolescence. For example, at the time Siemens acquires an asset, the effects of these factors cannot be known with certainty. Therefore, Siemens must estimate them. Thus, depreciation is an estimate rather than a factual measurement of the expired cost.
Debit–Credit Analysis
Journal Entry Basic Analysis
Equation Analysis
Debits increase expenses: debit Insurance Expense 500.
Credits decrease assets: credit Prepaid Insurance 500.
Oct. 31 Insurance Expense Prepaid Insurance
(To record insurance expired)
500 500
The expense Insurance Expense is increased 500, and the asset Prepaid Insurance is decreased 500.
Assets Prepaid Insurance
2 500
(2) =
=
Liabilities +
Insurance Expense 2 500 Equation
Analysis
Posting
Prepaid Insurance Insurance Expense
Oct. 4 6,000 Oct. 31 Bal. 5,500
Oct. 31 Adj. 500 Oct. 31 Adj. 500 Oct. 31 Bal. 500
Equity
A = L + E
2500 2500
Cash Flows no effect
ILLUSTRATION 3-23 Adjustment for Insurance
The Accounting Cycle 83 To estimate depreciation expense, Siemens often divides the cost of the asset by
its useful life. For example, if Siemens purchases equipment for 10,000 and expects its useful life to be 10 years, Siemens records annual depreciation of 1,000.
In the case of Pioneer Advertising, it estimates depreciation on its office equipment to be 4,800 a year (cost 50,000 less residual value 2,000 divided by useful life of 10 years), or 400 per month. The analysis and adjustment for depreciation is summa- rized in Illustration 3-24.
The balance in the Accumulated Depreciation—Equipment account will increase 400 each month. Therefore, after journalizing and posting the adjusting entry at November 30, the balance will be 800.
Statement presentation. Accumulated Depreciation—Equipment is a contra asset ac- count. A contra asset account offsets an asset account on the statement of financial position. This means that the Accumulated Depreciation—Equipment account offsets the Equipment account on the statement of financial position. Its normal balance is a credit. Pioneer Advertising uses this account instead of crediting Equipment in order to disclose both the original cost of the equipment and the total expired cost to date. In the statement of financial position, Pioneer deducts Accumulated Depreciation—
Equipment from the related asset account as follows.
Depreciation recognized;
record depreciation expense Equipment purchased;
record asset Oct. 1
Oct. 31
Depreciation
Equipment Nov 400
Dec 400
Jan 400 Feb
400 March 400 April
400 May 400 June
400 July 400
Aug 400
Sept 400 Oct
400
Depreciation = 4,800/
year Debit–Credit
Analysis
Journal Entry
Posting Basic Analysis
Oct. 31 Adj. 400 Oct. 31 Bal. 400 Accumulated Depreciation—Equipment
Oct. 31 Adj. 400 Oct. 31 Bal. 400
Depreciation Expense Oct. 1 50,000
Oct. 31 Bal. 50,000 Equipment
Debits increase expenses: debit Depreciation Expense 400.
Credits increase contra assets: credit Accumulated Depreciation—Equipment 400.
Oct. 31 Depreciation Expense Accumulated Depreciation—
Equipment (To record monthly depreciation)
400 400 The expense Depreciation Expense is increased 400, and the contra asset Accumulated Depreciation—Equipment is increased 400.
Assets Accumulated Depreciation—Equipment
2 400
=
=
Liabilities +
Depreciation Expense 2 400 Equation
Analysis
Equity
ILLUSTRATION 3-24 Adjustment for Depreciation
A = L + E
2400 2400
Cash Flows no effect
ILLUSTRATION 3-25 Statement of Financial Position Presentation of Accumulated Depreciation
Equipment 50,000
Less: Accumulated depreciation—equipment 400 49,600
The book value (or carrying value) of any depreciable asset is the difference between its cost and its related accumulated depreciation. In Illustration 3-25, the book
value of the equipment at the statement of financial position date is 49,600. Note that the asset’s book value generally differs from its fair value. The reason: Depreciation is an allocation concept, not a valuation concept. That is, depreciation allocates an asset’s cost to the periods in which it is used. Depreciation does not attempt to report the actual change in the value of the asset.
Depreciation expense identifies that portion of the asset’s cost that expired during the period (in this case, October). Without this adjusting entry, total assets, total equity, and net income are overstated, and depreciation expense is understated.
A company records depreciation expense for each piece of equipment, such as trucks or machinery, and for all buildings. A company also establishes related accu- mulated depreciation accounts for the above, such as Accumulated Depreciation—
Trucks, Accumulated Depreciation—Machinery, and Accumulated Depreciation—
Buildings.
Unearned Revenues. When companies receive cash before services are performed, they record a liability by increasing (crediting) a liability account called unearned revenues. In other words, a company now has a performance obligation (liability) to provide service to one of its customers. Items like rent, magazine subscriptions, and customer deposits for future service may result in unearned revenues. Airlines, such as Ryanair (IRL), China Southern Airlines (CHN), and Southwest (USA), treat re- ceipts from the sale of tickets as unearned revenue until they provide the flight ser- vice. Tuition received prior to the start of a semester is another example of unearned revenue.
Unearned revenues are the opposite of prepaid expenses. Indeed, unearned rev- enue on the books of one company is likely to be a prepayment on the books of the company that made the advance payment. For example, if we assume identical ac- counting periods, a landlord will have unearned rent revenue when a tenant has prepaid rent.
When a company, such as Ryanair, receives payment for services to be performed in a future accounting period, it credits an unearned revenue (a liability) account to recognize the liability that exists. Ryanair subsequently recognizes revenue when it performs the service. However, making daily recurring entries to record this revenue is impractical. Therefore, Ryanair delays recognition of revenue until the adjustment process. Then, Ryanair makes an adjusting entry to record the revenue for services performed during the period and to show the liability that remains at the end of the accounting period. In the typical case, liabilities are overstated and revenues are un- derstated prior to adjustment. Thus, the adjusting entry for unearned revenues re- sults in a debit (decrease) to a liability account and a credit (increase) to a revenue account.
For example, Pioneer Advertising received 12,000 on October 2 from R. Knox for advertising services expected to be completed by December 31. Pioneer credited the payment to Unearned Service Revenue. This liability account shows a balance of 12,000 in the October 31 trial balance. Based on an evaluation of the service Pioneer performed for Knox during October, the company determines that it should recognize 4,000 of revenue in October. The liability (Unearned Service Revenue) is therefore decreased and equity (Service Revenue) is increased, as shown in Illustration 3-26.
The liability Unearned Service Revenue now shows a balance of 8,000. This amount represents the remaining advertising services expected to be performed in the future. At the same time, Service Revenue shows total revenue recognized in October of 104,000. Without this adjustment, revenues and net income are understated by 4,000 in the income statement. Moreover, liabilities are overstated and equity is understated by 4,000 on the October 31 statement of financial position.
12,000
Thank you in advance for
your work I will finish by Dec. 31
Some service has been performed; some revenue
is recorded Cash is received in advance;
liability is recorded Oct. 2
Oct. 31
Unearned Revenues
The Accounting Cycle 85
Adjusting Entries for Accruals
The second category of adjusting entries is accruals. Companies make adjusting entries for accruals to record revenues for services performed and expenses incurred in the current accounting period. Without an accrual adjustment, the revenue account (and the related asset account) or the expense account (and the related liability account) are understated. Thus, the adjusting entry for accruals will increase both a statement of financial position and an income statement account. Illustration 3-27 shows adjusting entries for accruals.
Debit–Credit Analysis
Journal Entry
Posting Basic Analysis
Oct. 31 Adj. 4,000 Oct. 2 12,000
Oct. 31 Bal. 8,000
Oct. 31 100,000 31 Adj. 4,000 Oct. 31 Bal. 104,000
Unearned Service Revenue Service Revenue
Debits decrease liabilities: debit Unearned Service Revenue 4,000.
Credits increase revenues: credit Service Revenue 4,000.
Oct. 31 Unearned Service Revenue Service Revenue
(To record revenue for services performed)
4,000 4,000 The liability Unearned Service Revenue is decreased 4,000, and the revenue Service Revenue is increased 4,000.
Assets
Unearned Service Revenue
= Liabilities + Equation
Analysis
2 4,000
Service Revenue 1 4,000
Equity
ILLUSTRATION 3-26 Adjustment for Unearned Service Revenue
A = L + E
24,000
14,000 Cash Flows
no effect
Accrued Revenues
Accrued Expenses
Asset Revenue
Debit Adjusting Entry (+)
Expense Liability
Credit Adjusting Entry (+) Debit
Adjusting Entry (+)
Credit Adjusting Entry (+)
ADJUSTING ENTRIES
ILLUSTRATION 3-27 Adjusting Entries for Accruals
Accrued Revenues. Revenues for services performed but not yet recorded at the statement date are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in the case of interest revenue. These are unrecorded because the earning of interest does not involve daily transactions. Companies do not record interest revenue on a daily basis because it is often impractical to do so. Accrued revenues also may result from ser- vices that have been performed but not yet billed nor collected, as in the case of commis- sions and fees. These may be unrecorded because only a portion of the total service has been performed and the clients will not be billed until the service has been completed.
An adjusting entry records the receivable that exists at the statement of financial position date and the revenue for the services performed during the period. Prior to adjustment, both assets and revenues are understated. Accordingly, an adjusting entry for accrued revenues results in a debit (increase) to an asset account and a credit (increase) to a revenue account.
In October, Pioneer Advertising performed services worth 2,000 that were not billed to clients on or before October 31. Because these services are not billed, they are not recorded. The accrual of unrecorded service revenue increases an asset account, Accounts Receivable. It also increases equity by increasing a revenue account, Service Revenue, as shown in Illustration 3-28.
My fee is 2,000
Revenue and receivable are recorded for unbilled services Accrued Revenues
Debit–Credit Analysis
Journal Entry
Posting Basic Analysis
Accounts Receivable
Debits increase assets: debit Accounts Receivable 2,000.
Credits increase revenues: credit Service Revenue 2,000.
Oct. 31 Accounts Receivable Service Revenue
(To record revenue for services performed) 2,000
2,000 The asset Accounts Receivable is increased 2,000, and the revenue Service Revenue is increased 2,000.
Assets =
=
Liabilities + Accounts
Receivable 1 2,000
Service Revenue 1 2,000 Equation
Analysis
Oct. 31 100,000 31 4,000 31 Adj. 2,000 Oct. 31 Bal. 106,000 Oct 31 72,000
31 Adj. 2,000 Oct. 31 Bal. 74,000
Service Revenue Equity
ILLUSTRATION 3-28 Accrual Adjustment for Receivable and Revenue Accounts
A = L + E
12,000
12,000 Cash Flows
no effect
The asset Accounts Receivable shows that clients owe 74,000 at the statement of financial position date. The balance of 106,000 in Service Revenue represents the total revenue for services performed during the month ( 100,000 1 4,000 1 2,000). With- out an adjusting entry, assets and equity on the statement of financial position, and revenues and net income on the income statement, are understated.
Accrued Expenses. Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses, such as interest, rent, taxes, and salaries. Accrued expenses result from the same causes as accrued revenues. In fact, an accrued expense on the books of one company is an accrued revenue to another company. For example, the 2,000 accrual of service revenue by Pioneer Advertising is an accrued expense to the client that received the service.