Skip to main content
Business LibreTexts

3.3: Adjusting Entries

  • Page ID
    20081
    • girl-160172__340.png
    • Contributed by Henry Dauderis and David Annand
    • Athabasca University
    • Sourced from Lyryx Learning

    learning Objective

    Explain the use of and prepare the adjusting entries required for prepaid expenses, depreciation, unearned revenues, accrued revenues, and accrued expenses.

    At the end of an accounting period, before financial statements can be prepared, the accounts must be reviewed for potential adjustments. This review is done by using the unadjusted trial balance. The unadjusted trial balance is a trial balance where the accounts have not yet been adjusted. The trial balance of Big Dog Carworks Corp. at January 31 was prepared in Chapter 2 and appears in Figure 3.4.1 below. It is an unadjusted trial balance because the accounts have not yet been updated for adjustments. We will use this trial balance to illustrate how adjustments are identified and recorded.

    Big Dog Carworks Corp.

    Unadjusted Trial Balance

    At January 31, 2015

    Acct. Account Debit Credit
    101 Cash $3,700
    110 Accounts receivable 2,000
    161 Prepaid insurance 2,400
    183 Equipment 3,000
    184 Truck 8,000
    201 Bank loan $6,000
    210 Accounts payable 700
    247 Unearned revenue 400
    320 Share capital 10,000
    330 Dividends 200
    450 Repair revenue 10,000
    654 Rent expense 1,600
    656 Salaries expense 3,500
    668 Supplies expense 2,000
    670 Truck operation expense 700
    $27,100 $27,100

    Figure \(\PageIndex{1}\): Unadjusted Trial Balance of Big Dog Carworks Corp. at January 31, 2015

    Adjustments are recorded with adjusting entries. The purpose of adjusting entries is to ensure both the balance sheet and the income statement faithfully represent the account balances for the accounting period. Adjusting entries help satisfy the matching principle. There are five types of adjusting entries as shown in Figure 3.4.2, each of which will be discussed in the following sections.

    imga-1.png

    Figure \(\PageIndex{2}\): Five Types of Adjusting Entries

    Adjusting Prepaid Asset Accounts

    An asset or liability account requiring adjustment at the end of an accounting period is referred to as a mixed account because it includes both a balance sheet portion and an income statement portion. The income statement portion must be removed from the account by an adjusting entry.

    Refer to Figure 3.4.1 which shows an unadjusted balance in prepaid insurance of $2,400. Recall from Chapter 2 that Big Dog paid for a 12-month insurance policy that went into effect on January 1 (transaction 5).

    imgb-1.png

    Figure \(\PageIndex{3}\)

    At January 31, one month or $200 of the policy has expired (been used up) calculated as $2,400/12 months = $200.

    The adjusting entry on January 31 to transfer $200 out of prepaid insurance and into insurance expense is:

    General Journal
    Date Account/Explanation F Debit Credit
    Jan 31 Insurance Expense 200
    Prepaid Insurance 200
    To adjust for the use of one month of Prepaid Insurance.

    As shown below, the balance remaining in the Prepaid Insurance account is $2,200 after the adjusting entry is posted. The $2,200 balance represents the unexpired asset that will benefit future periods, namely, the 11 months from February to December, 2015. The $200 transferred out of prepaid insurance is posted as a debit to the Insurance Expense account to show how much insurance has been used during January.


    imgc-1.png

    Figure \(\PageIndex{4}\)

    If the adjustment was not recorded, assets on the balance sheet would be overstated by $200 and expenses would be understated by the same amount on the income statement.

    Adjusting Unearned Liability Accounts

    On January 15, Big Dog received a $400 cash payment in advance of services being performed.

    imgd-1.png

    Figure \(\PageIndex{5}\)

    This advance payment was originally recorded as unearned, since the cash was received before repair services were performed. At January 31, $300 of the $400 unearned amount has been earned. Therefore, $300 must be transferred from unearned repair revenue into repair revenue. The adjusting entry at January 31 is:

    General Journal
    Date Account/Explanation F Debit Credit
    Jan 31 Unearned Repair Revenue 300
    Repair Revenue 300
    To adjust for repair revenue earned.

    After posting the adjustment, the $100 remaining balance in unearned repair revenue ($400 – $300) represents the amount at the end of January that will be earned in the future.


    imge-1.png

    Figure \(\PageIndex{6}\)

    If the adjustment was not recorded, unearned repair revenue would be overstated (too high) by $300 causing liabilities on the balance sheet to be overstated. Additionally, revenue would be understated (too low) by $300 on the income statement if the adjustment was not recorded.

    Adjusting Plant and Equipment Accounts

    Plant and equipment assets, also known as long-lived assets, are expected to help generate revenues over the current and future accounting periods because they are used to produce goods, supply services, or used for administrative purposes. The truck and equipment purchased by Big Dog Carworks Corp. in January are examples of plant and equipment assets that provide economic benefits for more than one accounting period. Because plant and equipment assets are useful for more than one accounting period, their cost must be spread over the time they are used. This is done to satisfy the matching principle. For example, the $100,000 cost of a machine expected to be used over five years is not expensed entirely in the year of purchase because this would cause expenses to be overstated in Year 1 and understated in Years 2, 3, 4, and 5. Therefore, the $100,000 cost must be spread over the asset's five-year life.

    The process of allocating the cost of a plant and equipment asset over the period of time it is expected to be used is called depreciation. The amount of depreciation is calculated using the actual cost and an estimate of the asset's useful life and residual value. The useful life of a plant and equipment asset is an estimate of how long it will actually be used by the business regardless of how long the asset is expected to last. For example, a car might have a manufacturer's suggested life of 10 years but a business may have a policy of keeping cars for only 2 years. The useful life for depreciation purposes would therefore be 2 years and not 10 years. The residual value is an estimate of what the plant and equipment asset will be sold for when it is no longer used by a business. Residual value can be zero. There are different formulas for calculating depreciation. We will use the straight-line method of depreciation:

    \[\frac{Cost−Estimated \ Residual \ Value}{Estimated \ Useful \ Life}\]

    The cost less estimated residual value is the total depreciable cost of the asset. The straight-line method allocates the depreciable cost equally over the asset's estimated useful life. When recording depreciation expense, our initial instinct is to debit depreciation expense and credit the Plant and Equipment asset account in the same way prepaids were adjusted with a debit to an expense and a credit to the Prepaid asset account. However, crediting the Plant and Equipment asset account is incorrect. Instead, a contra account called accumulated depreciation must be credited. A contra account is an account that is related to another account and typically has an opposite normal balance that is subtracted from the balance of its related account on the financial statements. Accumulated depreciation records the amount of the asset's cost that has been expensed since it was put into use. Accumulated depreciation has a normal credit balance that is subtracted from a Plant and Equipment asset account on the balance sheet.

    Initially, the concept of crediting Accumulated Depreciation may be confusing because of how we learned to adjust prepaids (debit an expense and credit the prepaid). Remember that prepaids actually get used up and disappear over time. The Plant and Equipment asset account is not credited because, unlike a prepaid, a truck or building does not get used up and disappear. The goal in recording depreciation is to match the cost of the asset to the revenues it helped generate. For example, a $50,000 truck that is expected to be used by a business for 4 years will have its cost spread over 4 years. After 4 years, the asset will likely be sold (journal entries related to the sale of plant and equipment assets are discussed in Chapter 8).

    The adjusting journal entry to record depreciation is:

    General Journal
    Date Account/Explanation F Debit Credit
    Depreciation Expense XX
    Accumulated Depreciation XX
    To adjust for depreciation.

    Subtracting the accumulated depreciation account balance from the Plant and Equipment asset account balance equals the carrying amount or net book value of the plant and equipment asset that is reported on the balance sheet.

    Let's work through two examples to demonstrate depreciation adjustments. Big Dog Carworks Corp.'s January 31, 2015 unadjusted trial balance showed the following two plant and equipment assets:

    Big Dog Carworks Corp.

    Unadjusted Trial Balance

    At January 31, 2015

    Acct. Account Debit Credit
    183 Equipment 3,000
    184 Truck 8,000

    The equipment was purchased for $3,000.

    imgf.png

    Figure \(\PageIndex{7}\)

    The equipment was recorded as a plant and equipment asset because it has an estimated useful life greater than 1 year. Assume its actual useful life is 10 years (120 months) and the equipment is estimated to be worth $0 at the end of its useful life (residual value of $0).

    \[\frac{Cost−Estimated \ Residual \ Value}{Estimated \ Useful \ Life} \ =\ \frac{$3,000−$0}{120 months} \ =\ \frac{$25}{month}\]

    Note that depreciation is always rounded to the nearest whole dollar. This is because depreciation is based on estimates — an estimated residual value and an estimated useful life; it is not exact. The following adjusting journal entry is made on January 31:

    General Journal
    Date Account/Explanation F Debit Credit
    Jan 31 Depreciation Expense, Equipment 25
    Accumulated Depreciation, Equipment 25
    To adjust for one month of depreciation on the equipment.

    When the adjusting entry is posted, the accounts appear as follows:

    imgg.png

    Figure \(\PageIndex{8}\)

    For financial statement reporting, the asset and contra asset accounts are combined. The net book value of the equipment on the balance sheet is shown as $2,975 ($3,000 – $25).

    BDCC also shows a truck for $8,000 on the January 31, 2015 unadjusted trial balance.


    imgh.png

    Figure \(\PageIndex{9}\)

    Assume the truck has an estimated useful life of 80 months and a zero estimated residual value. At January 31, one month of the truck cost has expired since it was put into operation in January. Using the straight-line method, depreciation is calculated as:

    \[\frac{Cost−Estimated \ Residual \ Value}{Estimated \ Useful \ Life} \ = \frac{$8,000−$0}{80 months}\ = \frac{$100}{month}\]

    The adjusting entry recorded on January 31 is:

    General Journal
    Date Account/Explanation F Debit Credit
    Jan 31 Depreciation Expense, Truck 100
    Accumulated Depreciation, Truck 100
    To adjust for one month of depreciation on the truck.

    When the adjusting entry is posted, the accounts appear as follows:


    imgi.png

    Figure \(\PageIndex{10}\)

    For financial statement reporting, the asset and contra asset accounts are combined. The net book value of the truck on the balance sheet is shown as $7,900 ($8,000 – $100).

    If depreciation adjustments are not recorded, assets on the balance sheet would be overstated. Additionally, expenses would be understated on the income statement causing net income to be overstated. If net income is overstated, retained earnings on the balance sheet would also be overstated.

    It is important to note that land is a long-lived asset. However, it is not depreciated because it does not get used up over time. Therefore, land is often referred to as a non-depreciable asset.

    Adjusting for Accrued Revenues

    Accrued revenues are revenues that have been earned but not yet collected or recorded. For example, a bank has numerous notes receivable. Interest is earned on the notes receivable as time passes. At the end of an accounting period, there would be notes receivable where the interest has been earned but not collected or recorded. The adjusting entry for accrued revenues is:

    General Journal
    Date Account/Explanation F Debit Credit
    Receivable XXX
    Revenue XXX
    To adjust for accrued revenue.

    For Big Dog Carworks Corp., assume that on January 31, $400 of repair work was completed for a client but it had not yet been collected or recorded. BDCC must record the following adjusting entry:

    General Journal
    Date Account/Explanation F Debit Credit
    Jan 31 Accounts Receivable 400
    Repair Revenue 400
    To adjust for accrued revenue.

    imgj.png

    Figure \(\PageIndex{11}\)

    If the adjustment was not recorded, assets on the balance sheet would be understated by $400 and revenues would be understated by the same amount on the income statement.

    Adjusting for Accrued Expenses

    Accrued expenses are expenses that have been incurred but not yet paid or recorded. For example, a utility bill received at the end of the accounting period is likely not payable for 2–3 weeks. Utilities for the period have been used but have not yet been paid or recorded. The adjusting entry for accrued expenses is:

    General Journal
    Date Account/Explanation F Debit Credit
    Expense XXX
    Payable XXX
    To adjust for accrued expense.

    Accruing Interest Expense

    For Big Dog Carworks Corp., the January 31, 2015 unadjusted trial balance shows a $6,000 bank loan balance. Assume it is a 4%, 60-day bank loan\(^1\). It was dated January 3 which means that on January 31, 28 days of interest have accrued (January 31 less January 3 = 28 days) as shown in Figure 3.6.

    imgk.png

    Figure \(\PageIndex{12}\)

    \(^1\): The maturity date is March 4, 2015 calculated as: January 31 less January 3 = 28 days + 28 days in February = 56 days + 4 days = March 4.

    The formula for calculating interest when the term is expressed in days is:

    \[Interest \ = \ Principal×Interest \ Rate×\frac{Elapsed \ time \ in \ days}{365}\]

    The interest expense accrued at January 31 is calculated as:

    \[Interest \ = \ $6,000×0.04×28365 \ = \ $18\] (rounded to nearest whole dollar)

    Interest is normally expressed as an annual rate. Therefore, the 28 days must be divided by the 365 days in a year. Normally all interest calculations in this textbook are rounded to two decimal places. However, for simplicity of demonstrations in this chapter, we will round to the nearest whole dollar.

    BDCC's adjusting entry on January 31 is:

    General Journal
    Date Account/Explanation F Debit Credit
    Jan 31 Interest Expense 18
    Interest Payable 18
    To adjust for accrued interest; $6,000 X 4% X 28/365 = $18.41 (rounded to $18 for illustrative purposes in this chapter).

    This adjusting entry enables BDCC to include the interest expense on the January income statement even though the payment has not yet been made. The entry creates a payable that will be reported as a liability on the balance sheet at January 31.

    When the adjusting entry is posted, the accounts appear as:

    imgl.png

    Figure \(\PageIndex{13}\)

    On February 28, interest will again be accrued and recorded as:

    General Journal
    Date Account/Explanation F Debit Credit
    Feb 28 Interest Expense

    Interest Expense

    18
    Interest Payable

    Interest Payable

    18
    To adjust for accrued interest; $6,000 X 4% X 28/365 = $18.41 (rounded to $18 for illustrative purposes in this chapter).

    On March 4 when the bank loan matures, Big Dog will pay the interest and principal and record the following entry:

    General Journal
    Date Account/Explanation F Debit Credit
    Mar 4 Interest Expense 3
    Interest Payable 36
    Bank Loan 6,000
    Cash 6039
    To record payment of the bank loan and interest; interest expense for March is \[$6,000 X 4% X 4/365 \ =\ $2.63\] (rounded to $3 for illustrative purposes in this chapter).

    The $36 debit to interest payable will cause the Interest Payable account to go to zero since the liability no longer exists once the cash is paid. Notice that the total interest expense recorded on the bank loan was $39−$18 expensed in January, $18 expensed in February, and $3 expensed in March. The interest expense was matched to the life of the bank loan.

    Accruing Income Tax Expense

    Another adjustment that is required for Big Dog Carworks Corp. involves the recording of corporate income taxes. In most jurisdictions, a corporation is taxed as an entity separate from its shareholders. For simplicity, assume BDCC's income tax due for January 2015 is $500. The adjusting entry is at January 31:

    General Journal
    Date Account/Explanation F Debit Credit
    Jan 31 Income Tax Expense 500
    Income Tax Payable 500
    To adjust for January accrued income tax.

    When the adjusting entry is posted, the accounts appear as follows:

    imgm.png

    Figure \(\PageIndex{14}\)

    The above adjusting entry enables the company to match the income tax expense accrued in January to the income earned during the same month.

    The five types of adjustments discussed in the previous paragraphs are summarized in Figure 3.4.15.


    imgn.png

    Figure \(\PageIndex{15}\): Summary of the Five Types of Adjusting Entries