You are on page 1of 18

4

CHAPTER

Adjusting
The Accounts

ITMFLP 67
MODULE
OVERVIEW

FINANCIAL
ACCOUNTING

t t t
Accounting As Analysis Overview
An Information of Financial of Merges and
System Statement I Consolidation
Chapter 1 Chapter 11 Chapter 13

t t
Analysis
The Recording of Financial
Process Statement II
Chapter 2 Chapter 12

t
Accounting For
Trading
Operations
Chapter 3

t t t
Accounting Accounting For
Adjusting
Concepts Fixed Assets And
The Accounts
Chapter 5 Depreciation
Chapter 4
Chapter 6

t
Bank
Reconciliation
Statements
Chapter 7

t
Bad Debts
Chapter 8

t
Accounting For
Inventories
Chapter 9

t
Bonds Payables
And Leases
Chapter 10

68 ITMFLP
4
CHAPTER

Adjusting
The Accounts

Contents Page

Learning Objectives 70

4.1 Selecting An Accounting Time Period 71

4.2 Recognizing Revenues and Expenses 71

4.3 Need For Adjusting Entries 72

4.4 Types For Adjusting Entries 73

4.4.1 Prepaid Expenses 73

4.4.2 Prepaid Revenue 75

4.4.3 Accrued Expenses 77

4.4.4 Accrued Revenue 80

4.5 The Adjusted Trail Balance 82

4.6 The Accounting Cycle 83

Self-Assessed Questions 84

ITMFLP 69
Chapter Overview

ADJUSTING
THE ACCOUNTS

Needs For
Adjusting Entries

Type of
Adjusting Entries

Prepaid Prepaid Accrued Accrued


Expenses Revenues Expenses Revenues

The Adjusted
Trail Balance

Learning Objectives

After studying this chapter, you should be able to:

1. Explain the periodicity assumption.

2. Differentiate between the revenue recognition principle and the matching


principle.

3. Explain the need for adjusting entries.

4. Identify the types of adjusting entries.

5. State the required steps in the accounting cycle.

6. Explain the accrual basis of accounting.

70 ITMFLP
4
CHAPTER

Adjusting
The Accounts

4.1 Selecting An Accounting Time Period

Accountants make the assumption that the economic life of a business can be
divided into artificial time periods. This assumption is referred to as the
periodicity or time period assumption. Many business transactions affect more
than one of these arbitrary time periods. Therefore, it is necessary to determine
the relevance of each business transaction to specific accounting periods. Doing
so may involve subjective judgments and estimates. Generally, the shorter the
time period (e.g., a month or a quarter of a year), the more difficult it becomes
to determine the proper adjustments to be made.

Both small and large companies find it necessary to prepare financial statements
on a periodic basis to assess their financial condition and results of operations.
Accounting time periods are generally a month, a quarter, or a year. Monthly
and quarterly time periods are often referred to as interim periods. Most large
companies are required to prepare both interim ( quarterly) and annual financial
statements. Accounting time periods that are one year in length are referred to
as financial years. Financial years usually begin with the first day of a month
and end on the last day of a month, 12 months later. The accounting period
most frequently used coincides with the calendar year ( January 1 to December
31 ). However, there are many exceptions, such as those businesses or companies
choosing the tax year as their accounting periods.

4.2 Recognising Revenues And Expenses

Determining the amount of revenues and expenses to be reported in a given


accounting period can be difficult. Therefore, accountants have developed two
principles as part of generally accepted accounting principles (GAAP) that help
in this determination. One of these principles is the revenue recognition
principle. This principle dictates that revenue be recognised in the accounting
period in which it is earned. Revenue is considered to be earned in a service
enterprise at the time the service is performed. For example, assume that a dry
cleaning business cleans clothing on July 31 but customers do not claim and pay
for their clothes until the first week of August. Under the revenue recognition
principle, revenue is earned in July when the service is performed and not
in August when the cash is received. At July 31, the dry cleaner would report
“ an asset” i.e. an accrued revenue on its balance sheet and revenue in its
profit and loss account for the service performed.

In recognising expenses , accountants follow the approach of “let the expenses


follow the revenues.” Thus, expense recognition is tied to revenue recognition.
In the preceding example, this means that the salary expense incurred in
performing the cleaning service on July 31 should be reported in the profit

ITMFLP 71
and loss account for the same period as that in which the service revenue is
recognised. The critical issue in expense recognition is when the expense makes
its contribution to revenue.

This may or may not be the same period in which the expense is paid. If the
salary incurred on July 31 is not paid until August, the dry cleaner would report
salaries payable on its July 31 balance sheet.

The practice of expense recognition is referred to as the matching principle


because it dictates that efforts (expenses) be matched with accomplishments
(revenues). Once the assumption is made that the economic life of a business
can be divided into artificial time periods, it follows that the revenue recognition
and matching principles can be applied.

4.3 Need For Adjusting Entries

In order for revenues to be recorded in the period in which they are earned,
and for expenses to be recognised in the period in which they are incurred,
adjusting entries are made at the end of the accounting period. In short,
adjustments are needed to ensure that the revenue recognition and matching
principles are followed.

The use of adjusting entries makes it possible to report on the sheet the
appropriate assets, liabilities, and owner’s equity (capital) at the statement date
and to report on the profit and loss account the proper net profit (or loss) for
the period. A trial balance may not contain up-to-date and complete financial
statement data for the following reasons:

1. Some events, such as the earning of wages by employees, is not journalised


daily because it is inexpedient to do so.
2. The expiration of some costs, such as building and equipment deterioration
and rent and insurance, is not journalised during the accounting period
because these costs expire with the passage of time rather than as a result
of recurring daily transactions.
3. Some items, such as the cost of utility service, may be unrecorded because
the bill for the service has not been received.

Adjusting entries are required every time financial statements are prepared. An
essential starting point is an analysis of 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 the company’s operations
and the interrelationship of accounts. The preparation of adjusting entries is
often an involved process that requires the services of a skilled professional. In
accumulating the adjustment data, the company may need to make stock counts
of supplies and repair parts. Also it may be desirable to prepare supporting

72 ITMFLP
4
CHAPTER

Adjusting
The Accounts

schedules of insurance policies, rental agreements, and other contractual


commitments. Adjustments are often prepared after the balance sheet date.
However, the entries are dated as of the balance sheet date.

4.4 Types Of Adjusting Entries

Adjusting entries can be classified as either prepayments or accruals. Each of


these classes has two subcategories as shown below:

4.4.1 Prepaid Expenses

Sometimes a business makes a payment during the current period which applies
partly to the present period and partly to a future period. Only that part of the
payment which relates to the current period should be charged against revenue
for the period. If the full payment was charged it would mean part of the next
period’s expenses were being matched against this period’s revenue. To overcome
this situation, an adjusting entry for the prepaid amount is made.

Exhibit Worked Example


4.1

A business pays a 12-month motor vehicle insurance premium of RM 240 on


1 May. This would be recorded as a debit of RM 240 to the expense account,
Motor Vehicle Insurance Expense and a credit to the asset account, Cash. At
30th June, two months later the ledger has to be closed to determine profit.

Thus it is necessary to recognise two months or one-sixth of the RM 240 (RM40)


as an expense and the remaining five-sixths (RM 200) as prepaid for the next
period. The adjusting journal entry required on 30 June in the general journal
would be:

General Journal

Date Particulars Debit Credit


June 30 Prepaid Insurance 200
Motor Vehicle Insurance Expense 200
(Ten months’ insurance prepaid)

ITMFLP 73
After this entry has been posted, the ledger account would be as follows:

Motor Vehicle Insurance Expenses

1996 RM 1996 RM
May 1 Cash 240 June 30 Prepaid Insurance 200

Prepaid Insurance

1996 RM 1996 RM
June 30 Motor Vehicle
Expenses Insurance 200

The effect of the adjusting entry has been to reduce the balance in the expense
account to RM40 ( 2 months’ insurance), which is the actual amount of expense
incurred in the period ended 30 June 1996, and to raise an asset account,
Prepaid Insurance, of RM 200 representing the cost of the insurance attributable
to the next accounting period.

Prepayments represent that part of the expense for which value has not been
received and, because it is value owing to the business, it is classified as an asset.
The prepayment will provide value within the next 12 months and is therefore
a current asset.
The amount in the expense account would be closed to the Profit and Loss
Account. The closing journal entry would be:

General Journal

Date Particulars Debit Credit


June 30 Profit and Loss 40
Motor Vehicle Insurance Expense 200
(Closing entry for insurance expense)

After this entry has been posted, the ledger account would appear as follows:

Motor Vehicle Insurance Expenses

1996 RM 1996 RM
May 1 Cash 240 June 30 Prepaid Insurance 200
Profit and Loss 40

240 240

The Prepaid Insurance account is a temporary account raised for adjusting


entry purposes only. On the first day of the next accounting period, the account
must be closed and the amount transferred back to the expense account, i.e.
the accountant must reverse the adjusting entry made. The journal entries
made to reverse adjustments are known as reversing entries.

74 ITMFLP
4
CHAPTER

Adjusting
The Accounts

As time passes in the next period, more and more of the insurance premium
will be used, thus ceasing to be an asset. In recognition of this, the full
prepayment is immediately transferred back to the expense account. The
necessary reversing journal entry would be:

General Journal

Date Particulars Debit Credit


July1 Motor Vehicle Insurance Expense 200
Prepaid Insurance 200
(Reversing entry for prepayment)

After this entry is posted, the ledger accounts would appear as follows:

Motor Vehicle Insurance Expense

1996 RM 1996 RM
May 1 Cash 240 June 30 Prepaid Insurance 200
Profit and Loss 40

240 240

July 1 Prepaid Insurance 200


s

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○


Prepaid Insurance t

1996 RM 1996 RM
June 30 Motor Vehicle July 1 Motor Vehicle
Insurance Expense 200 Insurance Expense 200

4.4.2 Prepaid Revenue (Revenue Received In Advance)

An adjusting entry is required here because the revenue received for the period
is greater than that earned, i.e. the service has been paid for but will not be
completed until the next accounting period. The revenue will not be realised
until the next accounting period and; if for some reason the goods are not
supplied or the services performed, the amount received in advance would
have to be refunded. The prepaid revenue is in the nature of a current liability.

ITMFLP 75
Exhibit Worked Example
4.2

Highway Magazines received a 12 months’ subscription from a customer on


1 March 1996 of RM 84. This would be recorded by debiting the asset account,
Bank, and crediting the revenue account, Subscription Revenue. On 30 June
1996, when the profit for the period is to be determined, only 4 months of
subscription period have passed, i.e. only one-third of the year’s subscription
received has been earned. The remaining two-thirds, or RM 56, is applicable to
the next accounting period. The adjustment to ensure only RM 28 of revenue
is counted as earned and that liability for the remaining RM 56 is recognised
is as follows:

General Journal

Date Particulars Debit Credit


June 30 Subscription Revenue 56
Prepaid Revenue 56
(Revenue received in advance)

The ledger account at the end of the period after profit determination would
appear as follows:

Subscription Revenue

1996 RM 1996 RM
June 30 Prepaid Revenue 56 March 1 Bank 84
Profit and Loss 28

84 84

Prepaid Revenue

1996 RM 1996 RM
June 30 Prepaid Insurance 56

To prepare the ledger for the next accounting period, it is once again necessary
to reverse the adjusting entry made. In the new period, the revenue for the last
8 months’ subscription will be earned, and therefore the RM 56 must be
transferred back to the revenue account, Subscription Revenue. The liability
account, Prepaid Revenue, is closed as the liability will be extinguished by the
passage of time in the new period. The reversing journal entry would be:

76 ITMFLP
4
CHAPTER

Adjusting
The Accounts

General Journal

Date Particulars Debit Credit


July1 Prepaid Revenue 56
Subscription Revenue 56
(Reversing entry for prepaid revenue)

The ledger accounts would appear as follows:

Subscription Revenue

1996 RM 1996 RM
June 30 Prepaid Revenue 56 March 1 Bank 84
Profit and Loss 28

84 84

July 1 Prepaid Revenue 56


s
○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○


t Prepaid Revenue

1996 RM 1996 RM
July 1 Subscription Revenue 56 June 30 Prepaid Insurance 56

4.4.3 Accrued Expenses

This adjustment is necessary whenever the amount paid for the period is less
than the expense incurred for the period. The most common adjustment of
this type occurs with wages. Quite often balance sheet date is a few days before
the next scheduled pay day and so a few days’ wages will be owing - the work
has been performed and the benefit obtained, but there is no expense recorded
in the ledger to cover the wages owing for those days.

ITMFLP 77
Exhibit
4.3 Worked Example

The wages bill for Halim Trading is RM 350 a week (5 working days). On
balance sheet date, 30 June 1996, a total of RM 17,850 had been paid for the
year and wages for 3 working days of RM 210 were owing.

The adjusting entry must recognise the liability to employees for work done but
not yet paid for, and also increase the expense account to the full amount
incurred for the period. The adjusting journal entry to record this is as follows:

General Journal

Date Particulars Debit Credit


June 30 Wages Expense 210
Accrued Expenses 210
(Three days’ wages owing)

The ledger accounts after posting the adjustment will appear as follows:

Wages Expense

1995-96 RM 1996 RM
July-June Bank 17,850
June 30 Accrued Expenses 210

Accrued Expenses

1996 RM 1996 RM
June 30 Wages Expenses 210

The closing journal entry would be:

General Journal

Date Particulars Debit Credit


June 30 Profit and Loss 18,060
Wages Expense 18,060
(Closing entry for wages)

After posting this entry, the accounts would appear as follows:

78 ITMFLP
4
CHAPTER

Adjusting
The Accounts

Wages Expense

1995-96 RM 1996 RM
July-June Bank 17,850 June 30 Profit and Loss 18,060
Accrued Expenses 210

18,060 18,060

Accrued Expenses

1996 RM 1996 RM
June 30 Wages Expense 210

On the first day of the next accounting period, it will be necessary to reverse
the adjustment made to avoid double counting of the wages when paid. On pay
day RM 350 will be paid, but of this RM 210 has already been counted as an
expense, and only RM 140 is applicable to the accounting period in which pay
day falls. Therefore, the following reversing entry is required:

General Journal

Date Particulars Debit Credit


June 30 Accrued Expenses 210
Wages Expense 210
(Reversing entry for accrued wages)

After this entry is posted on the first day of the new accounting period, and
after the first pay day of the new period has passed, the ledger accounts would
appear as:
Wages Expense

1995-96 RM 1996 RM
July-June Bank 17,850 June 30 Profit and Loss 18,060
June 30 Accrued Expenses 210

18,060 18,060

July 2 Bank 350 July 1 Accrued Expenses 210


s

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○


t Accrued Expenses

1996 RM 1996 RM
July 1 Wages Expenses 210 June 30 Wages Expense 210

The reversing entry has canceled out the liability and also ensured that the
Wages Expense account only shows RM 140 as expenses incurred for the new
period.

ITMFLP 79
4.4.4 Accrued Revenue

Here we are concerned with the situation where revenue has been earned but
not yet received. Any such revenue related to the major activity of the business
would normally already have been recorded in the Debtors’ account at the time
the sale was made or service provided.

However, with non-operating income this would not be the case, and an
adjustment to recognise the asset, accrued revenue, and to add the revenue
earned to that already received, would be necessary.

Exhibit
Worked Example
4.4

A firm purchased RM 10,000 of 10 per cent Bank Negara Bonds on 1 November


1995 on which interest is paid biannually on 31 March and 30 September. By
30 June 1996, the firm will have received interest for 6 months (RM 250) but
have earned interest for 9 months (RM 750). Therefore, there is 3 months’
interest earned (RM 250) for the period, but not yet received. The adjusting
journal entry to adjust the ledger accounts is as follows:

General Journal

Date Particulars Debit Credit


June 30 Accrued Revenue 250
Interest Revenue 250
(Three month’ interest accrued)

The ledger accounts after this entry is posted would be as follows:

Interest revenue

1995-96 RM 1996 RM
March 30 Bank 500
June 30 Accrued Revenue 250

Accrued Revenue

1996 RM 1996 RM
June 30 Interest Revenue 250

80 ITMFLP
4
CHAPTER

Adjusting
The Accounts

The Interest Revenue account now has in it the 9 months interest applicable to
the period ended 30 June 1996, i.e. RM 750, and this would be transferred to
the Profit and Loss Account as part of the closing procedure. The Accrued
Revenue account represents the asset for the amount owing to the business,
and will appear in the balance sheet as a current asset.

As with accrued expenses, a reversing entry is necessary at the beginning of the


next period to avoid double counting. Of the next amount of interest received,
RM 500 on 30 September, only RM 250 is applicable to the period in which it
is received. The reversing entry ensures that this correct apportionment of
revenue is achieved between the two periods. The entry would be:

General Journal

Date Particulars Debit Credit


July1 Interest Revenue 250
Accrued Revenue 250
(Reversing entry for accrued revenue)

After the interest is received on 30 September, the ledger account would appear
as follows:

Interest Revenue

1996 RM 1996 RM
June 30 Profit and Loss 750 March 30 Bank 500
June 30 Accrued Revenue 250

750 750

July 1 Accrued Revenue 250 Sept. 30 Bank 500


s

○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○


Prepaid Insurance t

1996 RM 1996 RM
June 30 Interest Revenue 250 July 1 Interest Revenue 250

If the reversal had not been done, the entire RM 500 received on 30 September
1996, would be counted as revenue for the year July 1996 to June 1997, whereas
RM 250 has already been counted for the year ended 30 June 1996. The reversal
thus avoids double counting of the RM 250.

ITMFLP 81
Summary of Basic Relationships

Pertinent data on each of the four basic types of adjusting entries are summarized
in the following illustration. From an analysis of the adjusting entries shown in
the summary, it can be seen that each adjusting entry affects one balance sheet
account and one profit and loss account.

Type of Account Accounts Adjusting


Adjustment Relationship Before Adjustment Entry

1. Prepaid Expenses Asset and Assets Understated Dr. Assets


Expenses Expenses Overstated Cr. Expenses

2. Prepaid Revenue Liabilitiesand Liabilities Understated Dr. Revenue


Revenue Revenues Overstated Cr.Liabilities

3. Accrued Revenues Assets and Assets Understated Dr. Assets


Revenues Revenues Understated Cr. Revenues

4. Accrued Expenses Expenses and Expenses Understated Dr. Expenses


Liabilities Liabilities Understated Cr.Liabilities

4.5 The Adjusted Trial Balance

After all adjusting entries have been journalised and posted, another trial balance
is prepared from the ledger accounts. This trial balance is called an adjusted
trial balance. An adjusted trial balance shows the balances of all accounts,
including those that have been adjusted, at the end of the accounting period.
The purpose of an adjusted trial balance is to show the effects of all financial
events that have occurred during the accounting period. The procedures for
preparing an adjusted trial balance are identical to those described in the
previous chapter for preparing a trial balance.

An adjusted trial balance proves the equality of the total debit balances and the
total credit balances in the ledger after all adjustments have been made. The
proof provided by an adjusted trial balance, like the proof contained in a trial
balance, extends only to the mathematical accuracy of the ledger. Because the
accounts contain all data that are needed for financial statements, the adjusted
trial balance provides the primary basis for the preparation of financial
statements.

82 ITMFLP
4
CHAPTER

Adjusting
The Accounts

4.6 The Accounting Cycle

The accounting cycle begins with the analysis of business transactions through
source documents and ends with the preparation of closing entries. The cycle
represents the flow of information from the beginning of the recording process
to the preparation of financial reports. Study Exhibit 4.5. The steps in the cycle
are performed in sequence and are repeated in each period.

Exhibit
4.5

THE ACCOUNTING CYCLE

SOURCE DOCUMENTS




JOURNAL





LEDGER




TRAIL BALANCE





ADJUSTING ENTRIES




ADJUSTED TRAIL BALANCE







FINANCIAL STATEMENTS




CLOSING ENTRIES

ITMFLP 83
The required steps in the accounting cycle can be summarised as follows:

1. Analyse business transactions through source documents.


2. Journalise the transactions into the journal (s).
3. Post to ledger accounts.
4. Prepare a trial balance.
5. Journalise and post adjusting entries.
6. Prepare an adjusted trial balance.
7. Prepare financial statements.
8. Journalise and post closing entries.

What you have learned in this chapter is the accrual basis of accounting. Accrual
basis accounting means that events that change a business’s financial statements
are recorded in the periods in which the events occur, rather than in the
periods in which the business receives or pays cash.
Under cash basis accounting, revenue is recorded only when the cash is received,
and an expense is recorded only when cash is paid. As a result, the cash basis
of accounting often leads misleading financial statements. For example, it fails
to record revenue which has been earned but for which the cash has not been
received, and therefore the revenue recognition principle is violated. As such,
the cash basis of accounting is not in accordance with generally accepted
accounting principles.

1. What are the revenue recognition and matching principles?


2. What are the four types of adjusting entries?
3. How do adjusting entries for prepaid expenses differ from those for
prepaid revenues?
4. How do adjusting entries for accrued expenses differ from those for
accrued revenues?
5. What is a closing journal entry? When is it used? What is its purpose?
6. What are the required steps in the accounting cycle?
7. What are the differences between the cash and accrual bases of
accounting?.

84 ITMFLP