Chapter Two: Adjusting Entries 400

Adjusting entries are required to implement the

*accrual accounting model*

Adjusting entries are necessary for three situations:

1) *Prepayments*, sometimes referred to as *deferrals*. 2) *Accruals* 3) *Estimates*

Radio Station Example

A company paid a radio station $2,000 in July for advertising. If that $2,000 were for advertising provided by the radio station during the month of July, the entire $2,000 would be expensed in the same period as the cash disbursement. If, however, the $2,000 was a payment for advertising to be provided in a future period, say the month of August, then the cash disbursement creates an asset called prepaid advertising. An adjusting entry is required at the end of August to increase advertising expense (decrease shareholders' equity) and to decrease the asset prepaid advertising by $2,000. Assuming that the cash disbursement records a debit to an asset, as in this example, the adjusting entry for a prepaid expense is, therefore, a debit to an expense and a credit to an asset.

The Adjusting Entry for Accrued Receivables always includes

A debit to an asset, a receivable, and a credit to revenue. In this case, at the end of August Dress Right recognizes $200 in interest revenue ($30,000 × 8% × 1/12) and makes the following adjusting entry. If this entry is not recorded, net income, assets, and shareholders' equity (retained earnings) will be understated.

The unadjusted trial balance can provide

A starting point for determining which adjusting entries are required for a period, particularly for prepayments. Review the July 31, 2016, unadjusted trial balance for the Dress Right Clothing Corporation which tries to anticipate the required adjusting entries for prepaid expenses.

Accrued Liabilities we are

Concerned with expenses incurred but not yet paid.

Estimates

Accountants often must make estimates in order to comply with the accrual accounting model.

A third classification of adjusting entries is estimates

Accountants often must make estimates of future events to comply with the accrual accounting model. *For example*, the calculation of depreciation expense requires an estimate of expected useful life of the asset being depreciated as well as its expected residual value. We discussed the adjusting entries for depreciation expense in the context of its being a prepayment, but it also could be thought of as an estimate

Accounting for Bad Debit

Accounting for bad debts requires a company to estimate the amount of accounts receivable that ultimately will prove to be uncollectible and to reduce accounts receivable by that estimated amount. This is neither a prepayment nor an accrual because it does not involve the payment of cash either before or after income is reduced

After the Entry of Deferred Rent Revenue

After this entry is recorded and posted to the ledger accounts, the deferred rent revenue account is reduced to a credit balance of $750 for the remaining one and one-half months' rent, and the rent revenue account will have a $250 credit balance. If this entry is not recorded, net income and shareholders' equity (retained earnings) will be understated, and liabilities will be overstated.

accruals involve external transactions

Automatically are recorded from a source document. *For example*, a sales invoice for a credit sale provides all the information necessary to record the debit to accounts receivable and the credit to sales revenue. However, there are some accruals that involve internal transactions and thus require adjusting entries. Because accruals involve recognition of expense or revenue before cash flow, the unadjusted trial balance will not be as helpful in identifying required adjusting entries as with prepayments.

Required Updating

Even when all transactions and events are analyzed, corrected, journalized, and posted to appropriate ledger accounts, some account balances will require updating.

Example of Alternative Approach to Record Prepayments

For example, on July 1, 2016, Dress Right paid $24,000 in cash for one year's rent on its building. The entry included a debit to prepaid rent. The company could have debited rent expense instead.

*Magazine Subscription*

For instance, magazine publishers usually receive cash in advance for magazine subscriptions. The cash inflow creates a liability (deferred revenue) that is recognized as revenue in a future period when the goods or services are transferred to customers.

Accruals

Involve transactions where the cash outflow or inflow takes place in a period subsequent to expense or revenue recognition.

Accrued Receivables

Involves situations when the revenue is recognized in a period prior to the cash receipt.

One adjusting-entry situation

Involving an estimate that does not fit neatly into either the prepayment or accrual classification is bad debts.

These adjusting entries are

Necessary to properly measure operating performance and financial position on an accrual basis

*Example*: For Dress Right Clothing Corporation, the only deferred revenue in the trial balance is deferred rent revenue. Recall that the company subleased a portion of its building to a jewelry store for $500 per month.

On July 16, the jewelry store paid Dress Right $1,000 in advance for the first two months' rent. The transaction was recorded as a debit to cash and a credit to deferred rent revenue. At the end of July, how much of the $1,000 must be recognized? Approximately one-half of one month's rent service has been provided, or $250, requiring the following adjusting journal entry.

Prepaid Expenses

Prepaid expense represent assets recorded when a cash disbursement creates benefits beyond the current reporting period.

Prepayments

Prepayments are transaction in which the cash flow precedes expense or revenue recognition.

Step Six

Record adjusting entries and post to the ledger accounts.

Deferred Revenues

Represent Liabilities record when cash is received from customers in advance of providing a good or service.

Accrued Liabilities

Represent liabilities recorded when an expense has been incurred prior to cash payment.

The Adjusting Entry

Required for a prepaid expense is a debit to an expense and a credit to an asset.

The first asset that requires adjustment is supplies

The $2,000 of which were purchased during July. This transaction created an asset as the supplies will be used in future periods. The company could either track the supplies used or simply count the supplies at the end of the period and determine the dollar amount of supplies remaining. Assume that Dress Right determines that at the end of July, $1,200 of supplies remain. The following adjusting journal entry is required.

The purchase of buildings, equipment, or supplies or the payment of rent in advance are examples of payments that create future benefits and should be recorded as assets.

The benefits provided by these assets expire in future periods and their cost is expensed in future periods as related revenues are recognized.

Example Employee Salaries

The first entry is for employee salaries for the second half of July. Recall that on July 20 the company paid employees $5,000 for salaries for the first half of the month. Salaries for the second half of July will probably be paid in early August. Nevertheless, the company incurred an expense in July for services provided to it by its employees. Also, there exists an obligation at the end of July to pay the salaries earned by employees. An adjusting entry is required to increase salaries expense (decrease shareholders' equity) and to increase liabilities for the salaries payable. The adjusting entry for an accrued liability always includes a debit to an expense, and a credit to a liability. Assuming that salaries for the second half of July are $5,500, the following adjusting entry is recorded.

After the adjusting entries are posted to the general ledger accounts

The next step—Step 7—in the processing cycle is to prepare an adjusted trial balance. The term adjusted refers to the fact that adjusting entries have now been posted to the accounts. Recall that the column titled Post Ref. (Posting Reference) is the number assigned to the general ledger account that is being debited or credited.

Accrued receivables involve

The recognition of revenue for goods or services transferred to customers before cash is received. An example of an internal accrued revenue event is the recognition of interest earned on a loan to another entity. *For example*, assume that Dress Right loaned another corporation $30,000 at the beginning of August, evidenced by a note receivable. Terms of the note call for the payment of principal, $30,000, and interest at 8% in three months. An external transaction records the cash disbursement—a debit to note receivable and a credit to cash of $30,000.

Alternative Approach to Record Prepayments

The same end result can be achieved for prepayments by recording the external transaction directly into an expense or revenue account. In fact, many companies prefer this approach. For simplicity, bookkeeping instructions may require all cash payments for expenses to be debited to the appropriate expense account and all cash receipts for revenues to be credited to the appropriate revenue account. The adjusting entry then records the unexpired prepaid expense (asset) or deferred revenue (liability) as of the end of the period.

More specifically

These entries help ensure that all revenues are recognized in the period goods or services are transferred to customers, regardless of when the cash is received. Also, they enable a company to recognize all expenses incurred during a period, regardless of when cash payment is made. As a result, a period's income statement provides a more complete measure of a company's operating performance and a better measure for predicting future operating cash flows. The balance sheet also provides a more complete assessment of assets and liabilities as sources of future cash receipts and disbursements. You might think of adjusting entries as a method of bringing the company's financial information up to date before preparing the financial statements.

Step Six in the processing cycle is:

To record in the general journal and post to the ledger accounts the effect of internal events on the accounting equation. These transactions do not involve an exchange transaction with another entity and, therefore, are not initiated by a source document. They are recorded at the *end of any period* when financial statements are prepared. These transactions are commonly referred to as *adjusting entries*.

Deferred revenues are created

When a company receives cash from a customer in one period for goods or services that are to be provided in a future period. The cash receipt, an external transaction, is recorded as a debit to cash and a credit to a liability. This liability reflects the company's obligation to provide goods or services in the future.

Accruals Occurs

When the cash flow comes after either expense or revenue recognition. *For example*, a company often uses the services of another entity in one period and pays for them in a subsequent period. An expense must be recognized in the period incurred and an accrued liability recorded. Also, goods and services often are provided to customers on credit. In such instances, a revenue is recognized in the period goods or services are transferred to customers and an asset, a receivable, is recorded

Prepayments Occurs

When the cash flow precedes either expense or revenue recognition. *For example*, a company may buy supplies in one period but use them in a later period. The cash outflow creates an asset (supplies) which then must be expensed in a future period as the asset is used up. Similarly, a company may receive cash from a customer in one period but provide the customer with a good or service in a future period.

Prepaid Expenses are

the costs of assets acquired in one period and expensed in a future period. Whenever cash is paid, and it is not to (1) satisfy a liability or (2) pay a dividend or return capital to owners, it must be determined whether or not the payment creates future benefits or whether the payment benefits only the current period.

After this entry is recorded and posted to the ledger accounts

the supplies (asset) account is reduced to a $1,200 debit balance, and the supplies expense account will have an $800 debit balance.