ADJUSTING JOURNAL ENTRIES

LESSON OBJECTIVES
After studying the remaining steps of the Accounting Cycle, you should be able to: Differentiate Cash Basis from Accrual Basis of Accounting Apply the principle of proper matching of cost and expenses against revenue and the different adjusting entries Prepare worksheet and financial statements of a Merchandising Business Perform, at the end of the accounting period, the last six steps to complete the accounting cycle.

Accounting Cycle
1. Gather Documents 2. Analyze and Record

3. Post to the Ledger

4. Prepare the Trial Balance 5. Prepare Adjusting Entries and Worksheet 6. Prepare the Financial Statements 7. Prepare Closing Entries 8. Prepare Post-closing TB 9. Prepare Reversing Entries (optional)

ACCOUNTING PERIOD
Time Period Principle (12-month period) Calendar vs Fiscal Accounting Period

INACCURATE GENERAL LEDGER BALANCES

At the end of an accounting period, ledger balances may not reflect accurate amounts because: Income earned and Expenses Incurred are not yet recorded Recorded in the books are Income not yet earned or Expenses not yet expired Some assets should be expired or used up or should be revalued to its net realizable amount.

ADJUSTING ENTRIES
Needed to reflect the proper amounts of revenues realized and expenses incurred during a period. Usually, the following items are adjusted:
Accruals (Income and Expense) Deferrals (Prepayments and Unearned Income) Depreciation Bad Debts or Doubtful Accounts Merchandise Inventory Ending

REMEMBER
An adjusting entry will NEVER involve a debit or credit to Cash; and Each adjusting entry will affect at least one balance sheet account and one income statement account

TWO QUESTIONS

1.What is the TYPE of Adjustment? 2.What is the PERIOD of Adjustment?

ACCRUED REVENUES (INCOME) and EXPENSES

Accrual vs. Cash Basis of Accounting Revenue Recognition Principle - Accrual of Income arises when services have been rendered but no amount of payment have been collected. Matching Principle (Expense Recognition Principle) - Accrual of Expense arises when expenses are already incurred during the period but are not yet paid.

ACCRUED REVENUES (INCOME)

Example:
Your lawn maintenance company agrees to provide 30 hours of work at $60 per hour for Company A. As of Dec 31, you have worked 20 hours on this contract. The 20 hours worth of revenues earned in December, must be recorded in December, even though you havent billed your customer yet.

ACCRUED REVENUES (INCOME)

GENERAL JOURNAL
DATE DESCRIPTION
REF

DEBIT

CREDIT

Dec 31 Accounts Receivable Service Revenue To record accrued revenues

1,200 1,200

Accounts Receivable
12/31 1,200

Service Revenue
1,200 12/31

ACCRUED EXPENSES
Example: Office employees are paid every two weeks. On December 31, five days salaries of an office employee for PhP300 per day have accrued. The five days salaries amounting to PhP1,500 (300 * 5) has to be accrued at December 31.

ACCRUED EXPENSES
GENERAL JOURNAL
DATE DESCRIPTION
REF

DEBIT

CREDIT

Dec 31 Salaries Expense Accrued Salaries Expense To record accrued salaries.

1,500 1,500

Salaries Expense
12/31 1,500

Accrued Sal. Payable

1,500 12/31

DEFERRALS: PREPAYMENTS
Represents advance payment for service or expense still to be incurred or used up in the future. Recorded as ASSET PREPAID EXPENSES. Represents a right to receive service for cash already paid. Two methods of Recording:
Asset Method Asset Initial Recognition Day 1 Expense Method Expense Initial Recognition Day 1

PREPAID EXPENSES (cont.)

Example: Jervin Drugstore issued a check on Nov. 1, 2008 for PhP9,000 as payment of store rent for six (6) months. Adjusting Entries as of December 31, 2008 using both methods.

PREPAID EXPENSES (cont.)

To illustrate:
2008 NOV 1,500.00 DEC 1,500.00 JAN 1,500.00 FEB 1,500.00 2009 MAR 1,500.00 APR 1,500.00 TOTAL 9,000.00

EXPIRED

UNEXPIRED

ASSET METHOD (Day 1)

GENERAL JOURNAL
DATE DESCRIPTION
REF

DEBIT

CREDIT

Nov 1 Prepaid Rent Cash

To record advance payment of rent.

9,000 9,000

Prepaid Rent
11/1 9,000

ASSET METHOD (AJE)

GENERAL JOURNAL
DATE DESCRIPTION
REF

DEBIT

CREDIT

Dec 31 Rent Expense Prepaid Rent

To adjust for two months expired rent.

3,000 3,000

Prepaid Rent
11/1 9,000 6,000 3,000 12/31 12/31

Rent Expense
3,000

EXPENSE METHOD (Day 1)

GENERAL JOURNAL
DATE DESCRIPTION
REF

DEBIT

CREDIT

Nov 1 Rent Expense Cash

To record advance payment of rent.

9,000 9,000

Rent Expense
11/1 9,000

EXPENSE METHOD (AJE)

GENERAL JOURNAL
DATE DESCRIPTION
REF

DEBIT

CREDIT

Dec 31 Prepaid Rent Rent Expense

To adjust for 4 months unexpired rent.

6,000 6,000

Rent Expense
11/1 9,000 3,000 6,000 12/31 12/31

Prepaid Rent
6,000

UNEARNED REVENUES (INCOME)

Represents a liability of the business since cash was already collected for service that has not been rendered yet. At the end of the year, determine the earned portion which should be properly separated and recognized as income. Two methods of Recording:
Liability Method Liability Initial Recognition (Day 1) Income Method Income Initial Recognition (Day 1)

UNEARNED REVENUES (INCOME) cont.

Example: On October 1, 2008, Michael Jay Clinic received PhP6,000, as advance payment of 4 month- rent from Anna Tess. Adjusting entry as of December 31, 2008 using both methods.

UNEARNED REVENUES (INCOME) cont.

To illustrate:
2008 OCT 1,500.00 NOV 1,500.00 DEC 1,500.00 2009 JAN 1,500.00 TOTAL 6,000.00

EARNED

UNEARNED

LIABILITY METHOD (Day 1)

GENERAL JOURNAL
DATE DESCRIPTION
REF

DEBIT

CREDIT

Oct

1 Cash Unearned Rent Income

To record advance collection of rent for four months.

6,000 6,000

Unearned Rent Income 6,000 10/1

LIABILITY METHOD (AJE)

GENERAL JOURNAL
DATE DESCRIPTION
REF

DEBIT

CREDIT

Dec 31 Unearned Rent Income Rent Income

To adjust for 3 months rent earned.

4,500 4,500

Unearned Rent Income 12/31 4,500 6,000 10/1

Rent Income
4,500 12/31

1,500

INCOME METHOD (Day 1)

GENERAL JOURNAL
DATE DESCRIPTION
REF

DEBIT

CREDIT

Oct

1 Cash Rent Income

To record advance collection of rent for four months.

6,000 6,000

Rent Income 6,000

10/1

INCOME METHOD (AJE)

GENERAL JOURNAL
DATE DESCRIPTION
REF

DEBIT

CREDIT

Dec 31 Rent Income Unearned Rent Income

To adjust for 1 month unearned rent.

1,500 1,500

Rent Income 12/31 1,500 6,000 10/1

Unearned Rent Income

1,500 12/31

4,500

DEPRECIATION
Property, Plant and Equipment (PPE) are longlived tangible assets such as land, building, furniture, machinery and equipment used in the operation of the business. All plant assets, but LAND, decline in usefulness as they age, becomes obsolete or inadequate. Cost of PPE (Balance Sheet) is spread or allocated throughout the useful life of such PPE. This process is called Depreciation. Depreciation Expense (Income Statement)

DEPRECIATION (cont.)
3 factors in determining depreciation:
Cost acquisition price including incidental expenses necessary to acquire the asset and make it ready for use. Scrap/ Disposal/ Salvage Value realizable or recoverable value of the asset at the end of its useful life. Or, the amount to be received when you sell the asset at the end of its useful life. Useful Life productive life of the asset which may be expressed in number of years, or number of machine hours or number of units produced.

Formula:
Straight-Line Depreciation Expense (per period)

Asset Cost Scrap Value

Useful Life

DEPRECIATION (cont.)
Proforma Entry in recording depreciation expense:
Dr Cr Depreciation Expense PPE Accumulated Depreciation PPE xxx xxx

Accumulated Depreciation is a contra asset account (normal balance is CR). This is a cumulative figure. Carrying/ Net Book Value is the difference between Cost and Accumulated Depreciation. Represents the unexpired cost of the asset.

DEPRECIATION (cont.)
Assets Cash . . . Computer Equipment Less: Accumulated Depreciation Total Assets Your Company Balance Sheet May 31, 20XX $XXXX

36,000 (1,000)

35,000 $XXXX

Book Value

DEPRECIATION (cont.)
Assets Cash . . . Computer Equipment Less: Accumulated Depreciation Total Assets Your Company Balance Sheet June 30, 20XX $XXXX

36,000 (2,000)

34,000 $XXXX

Book Value

DEPRECIATION (example)
On May 1, 2008, Gentess Laundry Shop issued a check for the purchase of a washing machine worth PhP16,000. It also paid PhP3,000 for the installation of this item in the shop. The shop expects to benefit from this asset for a period of three (3 years) and afterwards sell this for PhP1,000. Compute and make a journal entry of the depreciation expense for the month of May. Total Depreciation Expense in 2008? Net Book Value/ Carrying Value as of December 31, 2008.

DEPRECIATION (example)
GENERAL JOURNAL
DATE DESCRIPTION
REF

Including installation cost.

DEBIT CREDIT

May 1 Laundry Equipment Cash Purchased washing machine.

19,000 19,000

Laundry Equipment
5/1 19,000

DEPRECIATION (example)
Cost = PhP19,0000 Scrap Value = PhP1,000 Useful Life = 3 years
6,000 (per year) Straight-Line Depreciation Expense (per period) = = 19,000 1,000 3 Asset Cost Scrap Value Useful Life

DEPRECIATION (example)
Cost = PhP19,0000 Scrap Value = PhP1,000 Useful Life = 36 months
P500 (per month) Straight-Line Depreciation Expense (per period) = = 19,000 1,000 36 Asset Cost Scrap Value Useful Life

DEPRECIATION (example)
Depreciation in 2008:
PhP500 x 8 months = PhP4,000
Depreciation per month

PhP6,000 x 8/12 = PhP4,000

Depreciation per year

DEPRECIATION (example)
May 31
Depreciation Expense Laundry Equipment
Accumulated Depreciation Laundry Equipment

500
500

To record depreciation for the month.

Note: Record the adjustment every month-end (May December). Total Depreciation Expense for the Year.

DEPRECIATION (example)
Laundry Equipment
5/1 19,000
12/31 19,000
Accumulated Depreciation Laundry Equipment

500 500 500 500 500 500 500 500 4,000

5/31 6/31 7/31 8/31 9/31 10/31 11/31 12/31 12/31

DEPRECIATION (example)
Balance Sheet: Laundry Equipment Accumulated Depreciation - Laundry Equipment Book Value Income Statement: Depreciation Expense

19,000
(4,000) 15,000 4,000

DEPRECIATION (example)
How much depreciation would be recognized in 2009? How much is the Accumulated Depreciation balance as of 2009? How much is the Net Book Value as of 2009?

DEPRECIATION (example)
Depreciation Expense in 2009:
PhP6,000 (yearly depreciation).

Accumulated depreciation as of 12/31/2009:

PhP4,000 (2008) plus PhP6,000 (2009) = PhP10,000.

Net Book Value as of 12/31/2009:

PhP19,000 (cost) minus PhP10,000 (AD) = PhP6,333.

DEPRECIATION (Disclosure)
Property, Plant and Equipment (PPE) usually is a one line item in the Balance Sheet, net of Accumulated Depreciation amount, in total. A Note to Financial Statements is used to disclose the details of PPE.

BAD DEBTS (DOUBTFUL ACCOUNTS)

In spite of great caution in the granting of credits to customers, the business may suffer some loss from its inability to collect the receivables. This is known as bad debts. An expense is recognized for the estimated uncollectible accounts.

BAD DEBTS
Two methods to record:
Direct Write-Off recognizes bad debts only when it is certain that the company will not be able to collect the account anymore. Entry: Dr Bad Debts Expense xxx Cr Accounts Receivable xxx
Allowance Method provides for bad debts at the time the sales is recorded. The uncollectible account is determined by estimation based on the companys past experience or experience of other companies within the same business industry. Entry: Dr Bad Debts Expense xxx Cr Allowance for Bad Debts xxx

BAD DEBTS
Balance Sheet Presentation:
Accounts Receivable Less Allowance for Bad Debts Net Amortized Cost xxx (xxx) xxx

Income Statement Presentation:

Operating Expenses Bad Debts xxx

BAD DEBTS
At the end of the current period, the accounts receivable account has a debit balance of PhP80,000. Analysis of the accounts in the customers ledger indicates that 10% will be uncollectible.
Entry: Dr Bad Debts Expense 8,000 Cr Allowance for Bad Debts 8,000

BAD DEBTS
At the end of the current period, the accounts receivable account has a debit balance of PhP80,000.
Analysis of the accounts in the customers ledger indicates that 10% will be uncollectible. Assume that Allowance for Bad Debts has a PhP2,000 credit balance. Entry: Dr Bad Debts Expense 6,000 Cr Allowance for Bad Debts 6,000

BAD DEBTS
At the end of the current period, the accounts receivable account has a debit balance of PhP80,000.
Analysis of the accounts in the customers ledger indicates that 10% will be uncollectible. Assume that Allowance for Bad Debts has a PhP3,000 debit balance. Entry: Dr Bad Debts Expense 11,000 Cr Allowance for Bad Debts 11,000

BAD DEBTS
Ageing Analysis another method of estimating bad debts. Receivables are provided with allowance for uncollectible accounts based on their age (days past due).
Please see excel file.

Merchandise Inventory, End

At yearend, a physical count is made to determine the unsold merchandise which represent an asset. This is an adjustment (periodic inventory system) to account for merchandise inventory ending Merchandise Inv, End xxx Income Summary xxx Considered as a deduction from COS.

SUMMARY
Account Balance Before Adjustment Types of Adjustment Accrued Expenses Accrued Revenues Prepaid Expenses: Asset Method Expense Method Unearned Revenues: Asset - O Asset - U Expense - U Expense - O Expense Prepaid Expense (A) Prepaid Expense (A) Expense Adjusting Entry Account Debited Expense Receivable (A) Account Credited Payable (L) Revenues

Balance Sheet Accounts

Liabilities - U Asset - U

Income Statement Accounts

Expense - U Income - U

Liability Method
Income Method Depreciation Bad Debts

Liability - O
Liability - U Assets - O Assets - O

Income - U
Income - O Expense - U Expense - U

Unearned Rev (L)

Revenues Expense Expense

Revenues
Unearned Rev (L) Contra Asset Contra Asset

Preparation of Adjusted Trial Balance and Financial Statements

After preparing and posting the adjusting entries to the ledger, the adjusted trial balance is prepared. The financial statements can then be prepared from the figures shown in its adjusted trial balance. A 10-column worksheet is used to facilitate efficiency in preparing financial statements.

S 3-10
Account Title Cash Supplies Equipment Accum. depr. - Equip. Accounts payable Interest payable Note payable Suzanne Byrd, capital Service revenue Rent expense Supplies expense Depreciation expense Interest expense Totals

Scissors Hair Stylists Worksheet December 31, 2008

Trial Balance Dr. 400 700 17,000 Cr. Adjustments Dr. Cr. a. 500 1,000 200 3,000 6,000 12,000 4,000 a. 500
b. 1,000 b. 1,000

Adjusted Trial Balance Dr. 400 200

17,000

Cr.

c. 100

2,000 200 100 3,000 6,000

12,000

100 22,200

22,200

c. 100 1,600

1,600

4,000 500 1,000 100

23,300 23,300

Scissors Hair Stylists Worksheet December 31, 2008 Adjusted Trial Balance Account Title Dr. Cr. Cash 400 Supplies 200 Equipment 17,000 Accum. depr. - Equip. 2,000 Accounts payable 200 Interest payable 100 Note payable 3,000 Suzanne Byrd, capital 6,000 Service revenue 12,000 Rent expense 4,000 Supplies expense 500 Depreciation expense 1,000 Interest expense 200 Totals 23,300 23,300

Net Income $6,300

Scissors Hair Stylists Worksheet December 31, 2008 Adjusted Trial Balance Account Title Dr. Cr. Cash 400 Supplies 200 Equipment 17,000 Accum. depr. - Equip. 2,000 Accounts payable 200 Interest payable 100 Note payable 3,000 Suzanne Byrd, capital 6,000 Service revenue 12,000 Rent expense 4,000 Supplies expense 500 Depreciation expense 1,000 Interest expense 200 Totals 23,300 23,300

Balance Sheet Accounts

Income Statement Accounts

Scissors Hair Stylists

Scissors Hair Stylists Income Statement Worksheet For the Year Ended December 31, 2008 December 31, 2005 Service revenue $12,000 Adjusted Trial Balance Expenses: Account Title Dr. Cr. Rent expense $ 4,000 400 Cash 200 Supplies Supplies expense 500 Equipment 17,000 Depreciation expense 1,000 Accum. depr. - Equip. 2,000 Interest expense 200 Accounts payable 200 Interest payable 100 Total Expenses 5,700 Note payable 3,000 Net Income $ 6,300 Suzanne Byrd, capital 6,000 Service revenue 12,000 Rent expense 4,000 Supplies expense 500 Income Statement Depreciation expense 1,000 Accounts Interest expense 200 Totals 23,300 23,300

Scissors Hair Stylists Worksheet Scissors Hair Stylists December 31, 2008 Statement of Owner's Equity Adjusted Trial Balance the Year Ended December 31, 2008 For Account Title Dr. Cr. S. Byrd, Capital, Jan. 1, $ 6,000 Cash 2008 400 Supplies 200 Add: Net Income 6,300 Equipment 17,000 S. Byrd, Capital, Dec. 31, Accum. depr. - Equip. $12,300 2,000 2008 Accounts payable 200 Interest payable 100 Note payable 3,000 Suzanne Byrd, capital 6,000 Service revenue 12,000 Rent expense 4,000 Supplies expense 500 1,000 Depreciation expense 200 Interest expense 23,300 23,300 Totals

Scissors Hair Stylists Worksheet December 31, 2005 Adjusted Trial Balance Account Title Dr. Cr. 400 Scissors Hair Stylists Cash 200 Balance Sheet Supplies 17,000 December 31, 2008 Equipment 2,000 Accum. depr. - Equip. Assets Liabilities Sheet Balance Accounts payable 200400 Cash $ Accounts payable Accounts Interest payable 100 Supplies 200 Interest payable Note payable 3,000 Suzanne Byrd, capital 6,000 Equipment $17,000 Note payable Service revenue 12,000 Less: Total Liabilities 4,000 Rent expense Accumulated 2,000 15,000 Depreciation 500 Supplies expense Depreciation expense 1,000 Owner's Equity 200 Interest expense S. Byrd, Capital 23,300 23,300 Totals
Total Assets $15,600

200 100

3,000 3,300

12,300 $ 15,600

Closing the Accounts

Refers to the end-period step that prepares the accounts for recording the transactions of the next period. Consists of journalizing and posting the closing entries. Sets the balances of the revenue and expense accounts (nominal accounts) back to zero. Owners withdrawal account is also considered nominal account, hence also closed.

Closing the Accounts

The asset, liability and owners capital (permanent or real accounts) are not closed at the end of the period because their balances are not sued to measure income. Balances are carried over to become the beginning balances of the next period.

Reversing Entries
Posted after the books have been closed and the post-closing trial balance has proved the equality of the debits and credits in the ledger. Recorded at the beginning of next accounting period. For convenience and consistency in handling accrued and deferred items.

Reversing Entries
The reversing entries are made for the following adjusting entries.
Accrual of Expenses Accrual of Revenues Unearned Income, if the Income Method is used Prepaid Expenses, if the Expense Method is used.

Recording reverse the adjusting entries recorded in prior year.