Adjusting Entries

Measuring Business Income

• Accounting period assumption
• Cash accounting versus accrual accounting
• Matching principle
• Materiality concept
 Adjusting Entries
• Journal entries that update the general ledger
accounts to state revenues, expenses, assets,
and liabilities more accurately
• Involve
– One balance sheet account
– One income statement account
– Never cash
 Adjusting Process
• Identify the accounts requiring adjustment
• Determine unadjusted balances
• Determine correct (adjusted) balances for
each account
• Prepare adjusting entry to bring accounts in
agreement with adjusted balances
 Deferrals
• A cash payment or receipt occurred in current
period
• Must defer a portion of expense or revenue
until a future period
 Deferrals
• Two situations
– Pay a cost of benefit in advance and allocate cost
as expenses to periods that receive benefit
 Deferrals
• Two situations
– Pay a cost of benefit in advance and allocate cost
as expenses to periods that receive benefit
– Receive a cash revenue in advance and allocate
amounts as revenues to periods in which revenues
earned
 Prepaid Insurance
• Dec. 1, paid $600 for 12 month insurance
premium recording as asset, Prepaid
Insurance
• At Dec. 31
– Prepaid Insurance balance $600
– Insurance Expense balance $0
 Prepaid Insurance
• As of Dec. 31, one month’s insurance has
expired and become expense
• Correct Dec. 31 balance
– Prepaid Insurance $550
– Insurance Expense $50
 Prepaid Insurance
• Adjusting entry
– Debit Insurance Expense $50
• Increases Insurance Expense to correct balance $50
– Credit Prepaid Insurance $50
• Decreases Prepaid Insurance to correct balance $550
 Depreciation Expense
• Similar to prepaid insurance but for long-term
asset
• Decrease in asset not recorded in asset
account
• Recorded as increase in contra asset -
Accumulated Depreciation
 Depreciation Expense

Before After
Balance Sheet
Trucks $26,000 $26,000
Accum Deprec 400 800

Income Statement

Depreciation expense $0 $400

 Unearned Revenues
• Dec. 1, received $600 for 6 month rent
recording as liability, Unearned Rent
• At Dec. 31
– Unearned Rent balance $600
– Rent Revenue balance $0
 Unearned Revenues
• As of Dec. 31, one month’s rent has been
earned and become revenue
• Correct Dec. 31 balance
– Unearned Revenue $500
– Rent Revenue $100
 Unearned Revenues
• Adjusting entry
– Debit Unearned Rent $100
• Decreases Unearned Rent to correct balance $500
– Credit Rent Revenue $100
• Increases Rent Revenue to correct balance $100
 Accruals
• Recognize revenues and expenses that have
accumulated (accrued) during the accounting
period but have not been recorded
 Accrued Revenues
• Dec.11, received 30-day, 15% note from
customer.
• At Dec. 31
– Interest Revenue balance $0
– Interest Receivable balance $0
 Accrued Revenues
• As of Dec. 31, 20 days interest has been
earned and become revenue
• $1,200 x 0.15 x 20/360 = $10
• Correct Dec. 31 balance
– Interest Revenue $10
– Interest Receivable $10
 Accrued Revenues
• Adjusting entry
– Debit Interest Receivable $10
• Increases Interest Receivable to correct balance $10
– Credit Interest Revenue $10
• Increases Interest Revenue to correct balance $10
 Accrued Expenses
• Employees paid Friday for 5-day work week at
$1,000 per week
• At Dec. 31, a Tuesday
– Wages Expense balance $50,000 - represents past
weeks wages
– Wages Payable balance $0
 Accrued Expenses
• As of Dec. 31, 2 days wages have been
incurred and become expense
• Correct Dec. 31 balance
– Wages Expense $50,200
– Wages Payable $200
 Accrued Expenses
• Adjusting entry
– Debit Wages Expense $200
• Increases Wages Expense to correct balance $50,200
– Credit Wages Payable $200
• Increases Wages Payable to correct balance $200
Summarize Adjustments
 Analyzing Information
• Use questions to compare companies
 Income Statement
• Which company has the higher revenues?
• Which company has the higher percentage
change in revenues?
• Which company has the lower percentage of
expenses to revenues?
 Balance Sheet
• Which company has the higher assets?
• What is the percentage change in assets for
each company?
• Is the percent of total liabilities to total
liabilities plus owners’ equity increasing or
decreasing? Which company is more risky?
 Integrative Analysis
• Are companies operating efficiently by using
least amount of assets to generate a given
level of revenues?
– Calculate total asset turnover
• Are companies operating efficiently by using
least amount of assets to generate a given net
income?
– Calculate return on assets