LO 4 2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries ACCT& 201

Insurance is typically purchased by prepaying for an annual or semi-annual policy. Or, rent on a building may be paid ahead of its intended use (e.g., most landlords require monthly rent to be paid at the beginning of each month). Another example of prepaid expense relates to supplies that are purchased and stored in advance of actually needing them.

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Interest expense arises from notes payable and other loanagreements. The company has accumulated interest during the periodbut has not recorded or paid the amount. This creates a liabilitythat the company must pay at a future date. You cover more detailsabout computing interest in Current Liabilities, so for now amounts are given. Accrued expenses are expenses incurred in aperiod but have yet to be recorded, and no money has been paid.Some examples include interest, tax, and salary expenses.

Introduction to the Closing Entries

To learn more, check out CFI’s free Accounting Fundamentals Course. The accounting cycle incorporates all the accounts, journal entries, T accounts, debits, and credits, adjusting entries over a full cycle. Companies are required to close their books at the end of eachfiscal year so that they can prepare their annual financialstatements and tax returns. However, most companies prepare monthlyfinancial statements and close their books annually, so they have aclear picture of company performance during the year, and giveusers timely information to make decisions. Our discussion here begins with journalizing and posting theclosing entries (Figure5.2).

Accrued Expenses

A company may choose its yearly reporting period to be based on a calendar or fiscal year. If a company uses a calendar year, it is reporting financial data from January 1 to December 31 of a specific year. This may be useful for businesses needing to coincide with a traditional yearly tax schedule. It can also be easier to track for some businesses without formal reconciliation practices, and for small businesses.

In the last section, we took NeatNiks right up to the unadjusted trial balance at the end of the month of October. Deferrals are prepaid expense and revenueaccounts that have delayed recognition until they have how to use xero accounting software been used orearned. This recognition may not occur until the end of a period orfuture periods. When deferred expenses and revenues have yet to berecognized, their information is stored on the balance sheet.

Again, both approaches produce the same financial statement results. Another type of adjusting journal entry pertains to the accrual of unrecorded expenses and revenues. Accruals are expenses and revenues that gradually accumulate throughout an accounting period. Accrued expenses relate to such things as salaries, interest, rent, utilities, and so forth. Accrued revenues might relate to such events as client services that are based on hours worked. The remaining $6,000 amount would be transferred to expense over the next two years by preparing similar adjusting entries at the end of 20X2 and 20X3.

When the company keeps yearly information,the year could be based on a fiscal or calendar year. Some nonpublic companies may choose to use cash basis accountingrather than accrual basis accounting to report financialinformation. Recall from Introduction to Financial Statements that cash basisaccounting is a method of accounting in which transactions are notrecorded in the financial statements until there is an exchange ofcash.

The first entry requires revenue accounts close to the IncomeSummary account. The first entrycloses revenue accounts to the Income Summary account. The secondentry closes expense accounts to the Income Summary account.

All of the accounts he used during the period will be shown on the general ledger, not only those accounts impacted by the $200 sale. Start at the top with the checking account balance or whatever is the first account on the trial balance. If it’s petty cash, then you should have a petty cash count at the end of the period that matches what is shown on the trial balance (which is the ledger balance).

This position will need to retrace the steps a suspect may have taken to cover up fraudulent financial activities. Understanding how a company operates can help identify fraudulent activities that veer from the company’s position. Some of the best forensic accountants have put away major criminals such as Al Capone, Bernie Madoff, Ken Lay, and Ivan Boesky. In thiscircumstance, earnings management was considered illegal, costingthe company millions of dollars in fines. Recall that prepaid rent related to rent that was paid in advance.

Accounts Receivable increases (debit) for $1,500 because thecustomer has not yet paid for services completed. Service Revenueincreases (credit) for $1,500 because service revenue was earnedbut had been previously unrecorded. For example, let’s say a company pays $2,000 for equipment thatis supposed to last four years.

1. The allocated cost up tothat point is recorded in Accumulated Depreciation, a contra assetaccount.
2. Recall that cash basis accounting is a method of accounting in which transactions are not recorded in the financial statements until there is an exchange of cash.
3. This means that thecurrent balance of these accounts is zero, because they were closedon December 31, 2018, to complete the annual accounting period.
4. The preceding discussion of adjustments has been presented in great detail because it is imperative to grasp the underlying income measurement principles.
5. They arealso transparent with their internal trial balances in several keygovernment offices.

The company may also enter into alease agreement that requires several months, or years, of rent inadvance. Each month that passes, the company needs to record rentused for the month. Depreciation may also require an adjustment at the end of theperiod. Recall that depreciation isthe systematic method to record the allocation of cost over a givenperiod of certain assets.

They may even be asked to testify to their findings in a court of law. There are several other accounting methods or concepts thataccountants will sometimes apply. The first is modifiedaccrual accounting, which is commonly used in governmentalaccounting and merges accrual https://www.bookkeeping-reviews.com/ basis and cash basis accounting. Thesecond is tax basis accounting that is used inestablishing the tax effects of transactions in determining the taxliability of an organization. There are several other accounting methods or concepts that accountants will sometimes apply.

The eighth step in the accounting cycle is preparing closingentries, which includes journalizing and posting the entries to theledger. Long-lived assets like buildings and equipment will provide productive benefits to a number of periods. However, one simple approach is called the straight-line method, where an equal amount of asset cost is assigned to each year of service life. The accrual method is considered to better match revenues and expenses and standardizes reporting information for comparability purposes.

In addition to annual reporting, companies often need or choose to report financial statement information in interim periods. Each entry has one income statement account and onebalance sheet account, and cash does not appear in either of theadjusting entries. Each entry has one income statement account and one balance sheet account, and cash does not appear in either of the adjusting entries. If dividends were not declared, closing entries would cease atthis point. If dividends are declared, to get a zero balance in theDividends account, the entry will show a credit to Dividends and adebit to Retained Earnings.

As you will learn in Corporation Accounting, there are three components to thedeclaration and payment of dividends. The first part is the date ofdeclaration, which creates the obligation or liability to pay thedividend. The second part is the date of record that determines whoreceives the dividends, and the third part is the date of payment,which is the date that payments are made. Printing Plus has $100 ofdividends with a debit balance on the adjusted trial balance. Theclosing entry will credit Dividends and debit RetainedEarnings.

One fundamental concept to consider related to the accounting cycle—and to accrual accounting in particular—is the idea of the accounting period. Besides deferrals, other types of adjusting entries includeaccruals. At the end of the year after analyzing the unearned feesaccount, 40% of the unearned fees have been earned. Insurance policies can require advanced payment of fees forseveral months at a time, six months, for example.

These entry examples show the uses of adjusting entries in accounting. Adjusting journal entries record changes in asset or liability accounts, such as revenue or expenses, to adjust the ledger at the end of the accrual period. Thus, adjusting journal entries are crucial records in the accounting process and allow companies to more accurately evaluate their position at the end of the period.

The company wants to depreciate theasset over those four years equally. This means the asset will lose$500 in value each year ($2,000/four years). In the first year, thecompany would record the following adjusting entry to showdepreciation of the equipment. Supplies increases (debit) for $400, and Cash decreases (credit)for $400. When the company recognizes the supplies usage, thefollowing adjusting entry occurs. Accounts Receivable increases (debit) for $1,500 because the customer has not yet paid for services completed.

The initial accounting entry below needs to be adjusted by the second entry, which records a debit of $3000 in unearned revenue as a liability account. Notice that revenues, expenses, dividends, and income summaryall have zero balances. The post-closing T-accounts will be transferred to thepost-closing trial balance, which is step 9 in the accountingcycle. To further clarify this concept, balances are closed to assureall revenues and expenses are recorded in the proper period andthen start over the following period.

We can break down steps five and six of the accounting cycle into a bit more detail. Analyzing and Recording Transactions was the first of threeconsecutive chapters covering the steps in the accounting cycle(Figure4.2). In this case, Unearned Fee Revenue increases (credit) and Cashincreases (debit) for $48,000. There are a few other guidelines that support the need foradjusting entries.

We also discuss the purpose of adjustingentries and the accounting concepts supporting their need. The salary theemployee earned during the month might not be paid until thefollowing month. For example, the employee is paid for the priormonth’s work on the first of the next month. The financialstatements must remain up to date, so an adjusting entry is neededduring the month to show salaries previously unrecorded and unpaidat the end of the month.

Interest expense arises from notes payable and other loan agreements. The company has accumulated interest during the period but has not recorded or paid the amount. This creates a liability that the company must pay at a future date. You cover more details about computing interest in Current Liabilities, so for now amounts are given.