Chapter 3: Accrual Accounting Principles
- 1 Learning Objectives
- 2 3.1 - Business Transactions
- 3 3.2 - Financial Ledgers
- 4 3.3 - Double-Entry Accounting
- 5 3.4 - Transaction Analysis: Service Business Example
- 6 3.5 - Adjusting Entries
- 7 3.6 - Transaction Analysis: Adjusting Entries
- 8 3.7 - Closing Entries
- 9 3.8 - Summary of The Accounting Cycle
- 10 3.9 - Correcting Entries
- Learn about business transactions
- Learn about financial accounts and ledgers
- Learn double-entry accounting rules
- Use double-entry accounting to record transactions
- Learn about adjusting entries and how to use them
- Learn about the closing process and how to post closing entries
- Review of the accounting cycle
- Learn how to correct errors with correcting entries
3.1 - Business Transactions
To begin our study of the application of accounting principles, we begin by learning about economic transactions. Economic transactions are business events that must be recorded in a company’s accounting records. Not all business events are the same. Some events must be recorded while other events do not need to be. The key is in the concept of being able to reliably measure the transaction and determining if it affects the accounting equation. To provide accurate accounting records, we need to only record transactions that are measurable and quantifiable. Let’s think about this in more detail with an example. Just imagine you are a bookkeeper and your manager tells you that they have hired a new employee. Should this business event be recorded in the financial records? A business event such as hiring an employee should not be recorded because the event is too vague and it does not affect any of the accounts in the accounting equation. Instead we would record business events that are quantifiable. With the employee example, we would instead record all wages paid to the employee or accrue for wage expense. The simple act of hiring someone should not be recorded in the accounting records.
When an exchange of resources occurs, the transaction is considered to be recognizable. Measuring the transaction should be in terms of monetary units like the country's national currency or equivalent unit (monetary unit assumption).
For accountants, certain transactions are difficult to measure due to uncertainty. The accounting profession has had great difficulty in determining how to measure uncertainty and how it should be handled. Uncertainty is difficult for accountants because such transactions become difficult to measure in exact terms. The standard setters have established specific guidelines to provide guidance on how to record such transactions. We will continue our study primarily on routine business transactions.
Transaction analysis is the process of determining if a business transaction should be recorded in the financial records of a company. The best way to learn and fully understand transaction analysis is by example. Therefore, we will review a variety of basic business transactions to determine what impact, if any, the business transaction will have on the financial records. Before we can jump into transaction analysis, it is best to cover the basics of financial accounts and ledgers.
Recall from chapter 1 that the three-step process for the purpose of accounting is the following: identification and measurement, recording and communicating. Transaction analysis involves the first two steps.
3.2 - Financial Ledgers
Financial Accounts: A business may generate thousands or millions of transactions per month. To help organize all of these transactions we summarize them and record them by type (e.g. asset, liability, expense etc.). For example, we might place all transactions that increase revenue or decrease revenue into an account called revenue. Likewise, we might place all expenses into an account called expenses. We could also create more specific accounts like rent expense or service revenue. A group of accounts will form a ledger. Depending on the size of the ledger, the ledger may have subsidiary ledgers which contain specific accounts within the ledger. All of these accounts are designed to organize and summarize the data. Transactions are originally recorded by using a journal entry. The journal entry could impact one account or multiple accounts. The summary of the account by total activity is reported in the financial statements after adjusting entries have been posted. For example, if the revenue for the period was $1,000,000 then the income statement would report $1,000,000 for revenue. The financial statement user would only have the summary information for the account. If the user wanted more detailed information, they would need to go to the account ledgers to find details on how the $1,000,000 was earned on a transaction by transaction basis. Accounts often have standardized naming conventions (i.e. revenue, insurance expense, rental income etc.).
As we will learn later, accounts can either be permanent accounts or temporary accounts. A permanent account is an account that flows from one period to the next and is never closed out. Permanent accounts are often associated with the balance sheet. For example, asset accounts would be permanent accounts because they are reported on the balance sheet and are not closed out at the end of the accounting period. A temporary account on the other hand is zeroed out at the end of the accounting period and the activity in that account is moved to another account that is used for summarizing a group of transactions. Temporary accounts are often associated with income statement accounts because the income statement reports activity over a period of time. An example of a temporary account is the revenue account. At the end of the accounting period, the revenue account would be zeroed out and the results of that account would be moved to another account called income summary.
Chart of Accounts: The chart of accounts is simply a recording system for organizing the various accounts that a company will have. The creation of the chart of accounts has to be very specific and often utilizes a numbering system to organize the accounts by type. The example below shows a chart of accounts.
As we can see from the above, assets start with 1, liabilities start with 2 and so on which forms a similar pattern to a balance sheet (assets, liabilities and owner's equity) followed by the income statement accounts (revenue and expenses). Gaps in the number system allow for the addition of new accounts as the company grows. The company can evaluate their chart of accounts periodically to make changes as necessary. The amount of accounts can vary. Smaller businesses will often use 50 or less accounts while large businesses will use thousands of accounts.
3.3 - Double-Entry Accounting
The double-entry system comes into play by the fact that the accounting equation must always stay in balance. With that being said, there must be two entries per journal entry. The reason for the two entries is to ensure proper recording of both sides of the transaction. Remember, the accounting equation is Assets = Liabilities + Owner's Equity. The following list has some examples of how the accounting equation can always stay in balance with the use of the double-entry system.
1. Increase in assets and decrease in assets (of same amount). For example, you could buy a new office desk for $500 paid in cash. Your asset, cash, would decline but at the same time your office equipment account (an asset) would increase for the same amount.
2. An increase in assets and an increase in liabilities (of same amount). For example, you could buy the new office desk for $500 but instead agree to repay the $500 in the form of an account payable. Your asset increases by $500 and so does your liabilities. The equation remains in balance.
3. An increase in assets and an increase in owner's equity. For example, an owner might contribute $500 to the company. The $500 cash is recorded as an increase in cash and at the same time owner's equity increases by $500.
To help illustrate the use of double-entry accounting, we use t-accounts.
T-accounts: A t-account is a simplified visual way of showing how transactions will affect a specific account. The account name is on the top of the T-account with debits on the left and credits on the right. Understanding how to effectively use a t-account will be extremely helpful as it can be used to determine the correct amounts for unknown values. At this point, the t-account will simply be used to show how journal entries affect various accounts. The t-account is also useful for showing the accumulation of accounting transactions that affect an account.
Debit and Credit: The terms debit and credits are used to describe the left or right side of an account. When you debit an account, you are adding the amount to the left side of the account while a credit is placed on the right side of the account. Debit does not mean add and credit does not mean subtract. The terms are simply used to describe which side to place the amount.
Normal balance: The normal balance of an account is how we figure out how a debit or credit will affect the account in terms of increasing the account or decreasing it. An account can have either a debit or credit normal balance. For accounts with a normal balance of debit, debiting the account will increase the account while credits will decrease the account. To fully understand this let's imagine that you purchased an asset and the end result is that you want to increase the amount of the asset account. Since an asset account has a normal balance of debit then we would debit the cost of the asset to the asset account. For accounts with a credit normal balance a debit will decrease the account while a credit will increase it. To fully explain this concept, let's imagine that instead of paying cash for the asset you instead purchase it on account and want to show that your liabilities are increasing. In this case, since a liability account has a credit normal balance we would increase the liabilities account by crediting the account.
Below is a summary chart for account normal balances. Memorizing this chart is highly recommended.
|Account||Normal Balance||A Debit:||A Credit:|
|Owner's Capital/Common Stock||Credit||Decreases||Increases|
Here is a visualized way of looking at how the T-accounts and normal balances work. The beginning balance is the amount in the account before any transactions have been posted. The ending balance is the balance after all transactions have been factored in.
A simple way to remember this is that anything on the left side of the account equation (assets) have a debit normal balance while anything on the right side of the accounting equation (liabilities + owner's equity) has a credit normal balance. Revenue accounts have a credit normal balance and expenses a debit. Owner's Drawing has a debit balance and owner's capital has a credit balance. Students are encouraged to memorize the normal balances for accounts as it is used extensively in accounting.
Sample Transaction: Trinity Corporation used $15,000 cash to purchase a vehicle for the company. This transaction would be displayed using t-accounts as follows:
Explanation: Cash and the vehicle account are both asset accounts. Since we gave cash for the vehicle we would credit the cash account which decreases the account and then debit the vehicle account which would increase that account. Remember, assets have a normal balance of debit so a debit will increase the account while a credit will decrease it.
Second Sample Transaction: Trinity Corporation sold their old vehicle for $3,500 cash (which was also the net book value of the asset).
As you can see, we add the transactions to the previous accounts used in the first transactions. T-accounts can record multiple entries or continuous entries over a period of time. Each account can also be summarized by referring to what the balance of the account is. In this case, the cash account has a credit balance of $11,500 ($3,500 debit minus $15,000 credit) and the vehicle account has a debit balance of $11,500 ($15,000 debit minus $3,500 credit). We add all the debits then subtract the total amount of credits to get the account's balance. The two accounts shown above are asset accounts. Since asset accounts have a debit normal balance it means that a debit increases the account while credits decrease the account. If the accounts were credit normal balance then the opposite would be true, a debit would decrease the account while a credit would increase it. As you can see, knowing the normal balance of the account is critical for being able to properly calculate the account's ending balance.
You will also need to be able to properly classify accounts as asset, liability or owner's equity accounts. The following chart shows the type of account for most major accounts:
|Account Name||Account Type|
|Common Stock||Owner's Equity|
|Retained Earnings||Owner's Equity|
|Additional Paid-In Capital||Owner's Equity|
|Cost of Goods Sold||Expense|
Four-Column Account: A four-column account is a more formal tool used to record transactions in the account. The four-column account includes additional details such as a reference column to the journal where the transaction is posted as well as a running balance for the account after each transaction is made. The following is an example of a four-column account being used for the cash account.
Record in General Journal Then to Ledgers: Companies will generate many transactions. When these transactions are first created they are recorded in the general journal. The general journal may also be referred to as the book of original entry. The entries are recorded by date and each journal entry must be kept in balance to ensure we do not violate the balancing rule of the accounting equation. Depending on the company's accounting information structure, the company may have specialized journals for purchasing, sales or expenses. The overall structure of a general journal begins with the date of the transaction, the names of the accounts being debited or credited, the amounts of the debits/credits as well as a narrative memo entry to elaborate on the specific details of the transaction. The use of general journals is also helpful when errors are discovered as it can allow for easier detection or discovery of errors. When a bookkeeper enters a transaction into the journals the process is referred to as journalizing. When a transaction affects three or more accounts the journal entry is referred to as a compound entry. Periodically the entries in the general journal will be transferred to a more formal document called the general ledger. This process is called posting. The difference between a general journal and general ledger is that the general ledger contains all entries for specific accounts grouped together while the general journal contains entries in a chronological order. The following is a typical general journal and general ledger.
Sample Journal Entries: We will now cover some sample journal entries using debit and credit rules. Accounting is a very formal and standardized process so all transactions should be recorded accurately. Putting dates, account names, and number amounts in the correct place is important.
Entry #1: On December 31st, 2016, New American Corporation sold 50,000 shares of common stock which resulted in $50,000 cash.
The journal entry above shows the standard and proper format for a journal entry. The date of the transaction is recorded on the left with the account names next to it. The debit entry is the first account followed by the credit entries. For easier readability, the credit account is indented. The debit amount is shown to the left of the credit amount. A memo entry is not required but is recommended to help understand the nature of the transaction. Since this is the first entry of this transaction, it is recorded in the general journal and then will be recorded to the general ledger in the posting process. The cash entry would be moved to the cash general ledger and the common stock entry would be recorded to the common stock general ledger.
All journal entries should be recorded using a standard process as follows:
1) Determine what accounts will be affected by the transaction and determine what is the normal balance for those accounts.
2) Using the normal balance rules, determine if a credit or debit is required to increase or decrease the account.
3) Verify for accuracy by ensuring that the entry balances. All journal entries must have equal debits and credits. If the entry does not balance then the entry is wrong.
Entry #2: On January 2nd, 2017, New American Corporation purchased $20,000 worth of inventory from Plastic Corporation. New American paid 10,000 cash and agreed to pay $10,000 on account with payment terms of 2/10 net 30.
This journal entry has some interesting elements to it. To begin, this entry is affecting 3 accounts. When an entry affects 3 or more accounts it is referred to as a compound entry. If the entry affects only 2 accounts then it is referred to as a simple entry. Also important to note is the terms "2/10 net 30." These terms are credit payment terms. The term 2/10 means that if the borrower (New American Corporation) repays the account within 10 days then they will receive a 2% discount ($200 in this case). If New American decides to pay between 10 to 30 days then they will have to pay the full amount or the net amount. After 30 days has passed the account is considered past due.
Trial Balances: At the end of the accounting period, we will calculate the credit or debit balance for each account in the general ledger. The final total for each account is called the trial balance. A formal trial balance document will be prepared that lists all the general ledger accounts followed by their debit or credit trial balance. To ensure accuracy of our accounting system, the debits and credits for all the general ledger accounts should be compared to make sure that debits equal credits. It is important to note that equality of the debits and credits does not guarantee that your accounting records are mathematically correct. However, if the debits and credits do not equal then we know that there are errors in the accounting records that should be investigated and corrected. There are several issues that could lead to a trial balance not detecting the error:
- An error in the original entry. If you debit or credit the transaction in the reverse order of what they should be then the debits and credits will remain in balance even though the entry is incorrect.
- An error of omission. If the transaction is never recorded then the trial balance will not detect this error.
- An error of the wrong amount. If you debit or credit for the wrong amount, the trial balance will remain in balance even though you debited/credited for the wrong amount.
- An error to the wrong account. If your debits and credits are correct but the accounts are incorrect then the trial balance will not detect this error.
- An error of principle. If your debits and credits are correct but the wrong account type is used then the trial balance will not detect this error.
- A compensation error is made. If two or more incorrect entries compensate for each other (cancel each other out) then the trial balance will not detect this error.
The above is a trial balance that has been prepared. As you can see, the sum of the debits and credits is equal and therefore agrees with general accounting principles. To prepare the trial balance, it is important to follow the company's chart of accounts numbering system. The assets are listed first, followed by liabilities, revenues and finally expenses.
3.4 - Transaction Analysis: Service Business Example
We will now review some accounting transactions related to forming and running a service business. All of the following journal entries would be recorded directly to the general journal by transaction date. We will also show the accounting equation impact to show that the accounting equation rules are always being applied to every entry.
1. Transaction #1 (T1): January 1st, 2016 - Bill Simmons contributed $5,000 cash to form a car wash called Auto Car Wash Center Inc. He formed it as a corporation and the corporation issued $5,000 in common stock in exchange for Simmon's cash (capital). The journal entry is recorded as follows:
|Common Stock (Owner's Equity)||$5,000|
|Assets =||Liabilities +||Owner's Equity|
In the above example, we can see that cash is being increased by $5,000 and common stock is being increased by a $5,000 credit. Remember, the normal balance of owner's equity accounts is credit. Crediting an owner's equity account increases the account while a debit decreases the account. In this case, the $5,000 credit to common stock shows us that the account increased by $5,000. Understanding the concept of normal balance is essential to performing correct bookkeeping entries.
2. Transaction #2 (T2): January 2nd, 2016 - Auto Car Wash Center uses $1,000 of the cash to purchase a building for their first location. The transaction is recorded as follows:
|Assets =||Liabilities +||Owner's Equity|
In this transaction we can see that cash, an asset, was used to purchase another asset. As one asset was decreasing, another asset was increasing and therefore the accounting equity remains in balance.
3. Transaction #3 (T3): January 3rd, 2016 - Auto Car Wash Center decides they need some miscellaneous office supplies (folders, paper, pencils etc.). Instead of paying in cash, they decide to open a credit account with the local office supply store. The office supply store agrees and offers a credit line of $1,000. Auto Car Wash Center purchases $750 worth of office supplies and pays with their new store credit line.
|Assets =||Liabilities +||Owner's Equity|
In this case, the office supplies are an asset and a debit increases assets while account payable is liability which is increased by a credit. Remember, a liability account has a normal balance of credit so a credit to the account increases the account.
4. Transaction #4 (T4): January 7th, 2016 - Auto Car Wash Center has its first successful day of operations and was able to generate service revenue of $1,000. The customers paid $900 cash while one customer paid by opening a client account for a $100 purchase. The credit customer agreed to pay the amount in full after 30 days.
|Assets =||Liabilities +||Owner's Equity|
Cash increases by $900 with a debit and service revenue also increases by $1,000 with a credit. The account receivable account is an asset and increases with a debit. Service revenue (owner's equity account) has a credit normal balance. Even though one customer paid by credit, we still record their share of service revenue at $100 since the revenue was earned.
5. Transaction #5 (T5): January 7th, 2016 - Auto Car Wash Center pays their employees daily after each shift. For this shift, the company paid employee wages of $500 and also paid their rental bill of $300 (due from last month).
|Assets =||Liabilities +||Owner's Equity|
The normal balance for expenses is a debit so a debit to expense accounts increases expenses. The credit to cash decreases cash since cash is an asset.
6. Transaction #6 (T6): January 10th, 2016 - The company repaid the office store account payable with $750 cash.
|Assets =||Liabilities +||Owner's Equity|
The account payable is paid off with a $750 debit and cash is credited for $750.
7. Transaction #7 (T7): January 11th, 2016 The large customer from transaction #4 paid their bill in full by sending you a check for $100.
|Assets =||Liabilities +||Owner's Equity|
Both of these accounts are assets and have a debit normal balance. Therefore, a debit increases the account while a credit decreases the account. Note that the service revenue is not affected at this point due to the fact that we are recording transactions based on accrual basis. Service revenue is recorded at the moment revenue has been earned.
8. Transaction #8 (T8): January 25th, 2016 - The company declared a $1,000 dividend payable in cash. The dividend will be paid on February 25th, 2016.
|Assets =||Liabilities +||Owner's Equity|
The dividend payable account has a credit normal balance and is therefore increased by a credit. Retained earnings is decreased by using a debit. Retained earnings has a credit normal balance. The retained earnings account will be covered in detail shortly.
Now that we have completed all our transactions. We can now post these transactions to the general ledger, as shown below:
The next step is to create the trial balance from the general ledger ending balances. The trial balance for the above transaction is shown below. Take note that the trial balance debits and credits are equal.
3.5 - Adjusting Entries
Beginning where we left off with the trial balance. We refer to the trial balance we previously created as an unadjusted trial balance because all the account balances might not be completely accurate based on the matching principle, revenue recognition and the time period concept (accrual accounting). If an account is reported at an amount that is higher than it should be then it is called being overstated. If an account is reported at a lower amount than it should be then it is called being understated. To make sure we do not violate any of these principles and concepts, we must use the process of adjusting each account to make sure the correct balance is presented for assets and liabilities at the date the financial statements are prepared. We also need to adjust accounts to make sure expenses are recognized when incurred and to ensure that we can properly calculate net income. The reason we use the adjusting process on a periodic basis is due to the cost vs benefit principle. Just imagine an account like office supplies. Every day, the administrative offices of the company will use a certain amount of pencils, paper and printer ink. The daily cost of obtaining accurate records for all the supplies on hand would not justify the benefits. Therefore, we perform adjusting entries at a specific accounting period date, usually monthly. Also important to note is that adjusting entries are internal events designed to make sure our financial accounting information is not deceptive to external users. Therefore, an adjusting entry will never affect the cash account and each entry will affect one income statement account (revenue or expense) and one balance sheet account (asset or liability). Overall, adjusting entries fall into two categories: accruals and deferrals. Let's examine each type.
Deferrals (Prepaid Expense/Unearned Revenue): Certain types of transactions will involve buying a prepaid product that will be used as time passes or expires with usage. Some examples of prepaid products or services might be: prepaid insurance, prepaid rent, or prepaid cleaning services. When these products are purchased, they are considered an asset because they are able to provide future benefit to the company. As the product is used up we will record that usage by expensing it in the period incurred by recording an adjusting journal entry. The asset reported on the balance sheet is considered an unexpired cost and the expensed amount on the income statement is considered an expired cost. The most common way to show how to record a prepaid expense is through an insurance contract. Just imagine that you operate a company and have decided to purchase a 12 month insurance contract for $1,200 on January 1st. You have decided a reasonable allocation method is to expense the contract on a monthly basis using an adjusting entry. At the end of every month, you will make an adjusting entry for $100. The purchase of the insurance contract and the January 31st adjusting entry is shown below:
After the January 31st adjusting entry, the prepaid insurance account will be reported as $1,100. As you can see every month, the adjusting entry will remove $100 from the prepaid insurance asset account (balance sheet account) and move that amount to the insurance expense account (income statement account). Other asset accounts will follow a similar methodology for the adjusting entry.
Another example of an asset adjusting entry involves the supplies account. Most companies will purchase a large amount of supplies to have on hand. For example, the company will purchase pens, paper and pencils in bulk. Those supplies will be stored in the office supply cabinet and will be used by employees when those supplies are needed. To perform an adjusting entry for the supplies account we will need to determine how many remaining supplies are still in the cabinet. To do this we will need to manually count the amount of supplies and determine how many supplies have been used. When that amount is determined we will record the reduced amount of supplies by using an adjusting entry similar to the entry for prepaid insurance.
At this point, you are probably wondering how we perform adjusting entries for high-value assets such as buildings, equipment and vehicles. To account for the loss of value on these assets we use a process called depreciation. Depreciation essentially allows us to recognize the loss in usefulness of an asset as it is used. Special rules apply for depreciation and the calculations tend to be slightly more complex. We will cover depreciation calculations in Chapter 6: Long-Term Assets.
We also have adjusting entries involving a deferral of revenue. Initially deferred revenue is recorded as an unearned revenue because the customer has paid the invoice but the service has not been earned by the business. When the business earns the revenue, an adjusting entry is made to adjust the revenue and unearned revenue accounts to show that revenue has been earned. When this transaction is made, revenue is recognized on the income statement. The following journal entries show the initial signing of the contract (customer paid contact in full upon signing) and subsequent earning of the service revenue on January 15th and January 31st.
It is important to note that the unearned revenue account is a liability because it is possible that the customer could request a refund. Special rules apply to how we recognize revenue which will be covered in a future chapter.
Accruals (Accrued Expense, Accrued Revenue): Accruals are the exact opposite of a deferral. In the case of an accrued expense, the expense is incurred first before it is recorded (ie. a utility bill). For accrued revenues the revenue is earned before it is recorded. In terms of accounting, the term accrue means to record the revenue or expense immediately. While a deferral means to defer the revenue or expense to a future date.
An example of an accrued expense would be a utility service. Just think of your electric bill. You first use a certain amount of electricity and then the electric company sends you a bill based on how much you used. In other words, you accrued the electric expense and then paid for it in a future period. As the company uses the electricity, the company is creating a liability to the electric company in the form of an account payable. Prior to the payment of the electric bill, the company would have a liability and the liability would be removed when the bill is paid in full. When the bill is paid in full, we create an adjusting entry to remove the liability. The following journal entries show the creation of the accrued expense and payment of the liability.
Another example of an accrued expense would be interest that is payable to external investors. As you hold the loan, interest is accruing daily and those investors are paid at the end of the month.
Accrued revenues are when the service has been earned by the business before the payment has been received. For example, in many wholesale businesses, the goods will be shipped to the retailer first and then the retailer will sell the goods. After the retailer sells the goods, the retailer will pay the wholesaler. For the merchandising businesses, the wholesaler recognizes revenue upon shipment of the goods to the retailer even though the retailer won't pay the invoice for several weeks or months. When the retailer pays the invoice, the business will create an adjusting entry to remove the account receivable. The following journal entries show the sale of goods to a customer and the subsequent payment for those goods.
For both the accrued expense and accrued revenue example, the adjusting entry is the entry recorded on January 1st.
Estimates (Amortization/Depreciation): The transactions mentioned above all involve transactions where the expense or revenue will be recognized within 12 months (called current assets or current liabilities). For long-term liabilities and assets, we must use an estimate of how much revenue or expense to recognize. For long-term assets, we recognize the expense of the asset using depreciation. Depreciation is the gradual decline is value due to use of the asset. With long-term assets, we purchase the asset upfront and then recognize the expense over the economic life of the asset through depreciation. The calculation of deprecation will be covered in Chapter 6. The concept of amortization will be covered in chapter 12.
Adjusted Trial Balance: After all adjusting entries are entered into the books, we prepare the adjusted trial balance. Similar to how we prepare the unadjusted trial balance, we begin by listing all accounts followed by their total debit or credit balance. Worthy of note is that the adjusted trial balance will include accounts used in the adjusting process. We then add up the debit and credit columns to check for equality. If the debits and credits are equal then we can move on to preparing the financial statements using the adjusted trial balances. Each account will only be used once when preparing any of the financial statements. This is because the financial statements flow into each other. How to prepare financial statements will be covered in the next chapter.
3.6 - Transaction Analysis: Adjusting Entries
Adjusting entries can be quite complex to understand the full details of the entries. To fully understand adjusting entries we need to dive in deeper to see the overall impact of adjusting entries. Reviewing some example adjusting entries in detail will show us the inner workings of adjusting entries. To start off we will be using the following unadjusted trial balance which was prepared on December 31st:
Our task is to prepare the monthly adjusting entries that are to be recorded on January 31st.
Deferral Adjusting Entry: Prepaid Expenses:
Prepaid expenses are when a company pays for a product or service that will be used in the future. For example, a company could purchase an insurance contract that covers the company for the next 6 months. If the company pays for the insurance in full upon purchase then the company has created an asset called prepaid insurance. It is an asset because the company will receive future benefit from the insurance contract.
Another typical prepaid expense is the purchase of supplies. When supplies are purchased they are often purchased in bulk to reduce the work required to continually restock supplies. As these supplies are used up, it becomes necessary to periodically check the amount of supplies on hand and then adjust the account to the correct balance using an adjusting entry. To perform the calculation of the adjusting entry, we first need to determine how many supplies we have on hand. To know this information we need to do an inventory of what supplies we have currently in stock and determine the cost value of those supplies. Once we have this information we compare it to the reported amount for supplies and then calculate the adjusting entry. For example, if our supplies are reported as $1,500 while the inventory on hand is valued at $500 then we need to apply an adjusting entry of $1,000 to reduce the value of the supplies to the correct value. Our adjusting entry would debit supplies expense for $1,000 and credit the supplies account for $1,000.
After reviewing the unadjusted trial balance we can see that we have a a supplies account and a prepaid insurance account. Both of these accounts need to be examined to make sure the correct adjusting entries are performed to make sure the accounts are properly stated.
Supplies account: We can see that our supplies account has a balance of $5,000. After counting the supplies we have on hand we see that the cost of those supplies is $3,000. Based on this examination, an adjusting entry is required. In this case, we used a total of $2,000 of supplies during the month (5,000 original balance at the beginning of the month - $3,000 balance at the end of the month). To account for this, we perform the following adjusting entry:
After this entry is applied, the supplies account will have the correct balance of $3,000.
Prepaid insurance: We can see that our insurance account has a balance $6,000. After examining the insurance contracts related to this account, we can see that one insurance control is active. The insurance plan is for 6 months of coverage from January 1st to June 30th. Therefore, on January 31st, one month of the insurance has been used. Therefore, we need to reduce the balance of the prepaid insurance by one month worth of use. In this case, the value of month is $1,000 ($6,000 / 6). The following adjusting entry needs to be performed:
After this adjusting entry is applied, the prepaid insurance account will have the correct balance of $5,000.
Since we only have supplies account and a prepaid insurance account, no additional entries beyond the above two entries are required for prepaid expenses.
If the above adjusting entries are not applied then expenses will be understated and net income will be overstated (because expenses are understated). On the balance sheet, assets will be overstated because the insurance and supplies accounts are assets (which are overstated). Stockholder's equity will be overstated because retained earnings is overstated due to net income being overstated.
Deferral Adjusting Entry: Unearned Revenue:
The basic premise of unearned revenue is the payment for the good or service has been received before the company has completed the earnings process for the revenue. After reviewing our unadjusted trial balance we can see that we have recorded a liability for unearned service revenue of $5,000. When the adjusting entry process is being performed we will review this account to determine if any of the revenue should be recognized.
Upon further investigation of this account you determine that this $5,000 relates to a monthly service contract that is performed over a 5 month period. The contract requires a monthly inspection and repair of equipment at the client's manufacturing facility. When the contract was formed, on December 31st, the client paid the contract in full for $5,000. On January 31st, exactly one month of the contract has been completed and therefore we can recognize $1,000 as revenue. To record this, we must use an adjusting journal entry, shown below:
After this adjusting journal entry is posted our unearned service revenue account will have the correct balance of $4,000 credit while the revenue account will be $1,000 higher. Prior to this journal entry, the unearned service revenue account is considered overstated while the revenue account is understated. As the service contract is performed additional revenue will be recognized using adjusting journal entries.
Failure to properly record the above adjusting journal entries will cause the financial statements to be misstated which means to be inaccurate. If the above adjusting journal entry is not recorded then it will have the following impact:
- The revenue account will be understated by $1,000
- Net income will be understated by $1,000. Remember, net income is calculated as revenue - expenses so if revenue is understated by $1,000 then net income will also be understated by $1,000.
- Liabilities will be overstated by $1,000 because unearned revenue is a liability account, which is overstated by $1,000.
- Stockholder's equity will be understated by $1,000 because revenue was understated by $1,000.
- Balance sheet accounts will not be impacted.
Accrual Adjusting Entry: Accrued Expense:
Accrued expenses are expenses that are recorded before they are paid. We accrue expenses in order to properly match expenses to revenue in order to not violate the matching principle. For these types of expenses, an adjusting entry is required to make sure expenses and liabilities are correctly stated.
Reviewing the unadjusted trial balance and the company's business documents, you notice the company has an electric service being used during the month of January. At the end of January, the electric service sends a bill for $200 for the company's electric use during the month of January. The electric bill is to be paid within 30 days of being received. At the end of January, the company has a bill but the bill has not been paid. In this case, an adjusting entry is required to record the unpaid bill. The following entry would be recorded to accrue for the utility expense:
When the utility bill is paid then the following entry would be recorded:
Failure to property record the adjusting entry on January 31st would result in expenses being understated and ultimately net income being overstated. Liabilities would be understated and stockholder's equity/owner's equity would be overstated.
Accrual Adjusting Entry: Accrued Revenue:
Accrued revenues are recorded when revenues are earned before payment is received. When adjusting entries are prepared, the accounting records must be evaluated to make sure any revenues that have been earned are recorded correctly in the period they are earned.
After evaluating the accounting records and associated business documents, we find that the company provided contract services to a client for a total billable rate of $250. Since these services have been completed they are considered to be earned by the company. The company customarily bills the client on January 31st for services provided during January. Based on this information, an adjusting entry is required to make sure the income statement and balance sheet are properly stated. The following adjusting entry is required:
So what is the impact if the adjusting entry is not correctly recorded? Not recording the service revenue will result in revenue and net income being understated which causes the income statement to be understated. For the balance sheet, not recording the debit to accounts receivable means assets are understated and the balance sheet is understated. Retained earnings (stockholder's equity) will also be understated due to net income being understated.
3.7 - Closing Entries
After we have completed compiling the financial statements, we must move on to the final process called the closing process. During the closing process we basically close temporary accounts into permanent accounts. Temporary accounts are accounts that will be closed out to zero balance and reset for the next accounting cycle to begin. The amounts in the temporary accounts will flow into permanent accounts. Permanent accounts are accounts that flow from one accounting cycle to the next.
The overall goal of the closing process is to close out temporary income statement accounts (revenue and expense accounts) into the retained earnings account which is a permanent account. The dividend account is also a temporary account which will be closed out to retained earnings. When the next accounting cycle begins, revenue, expense and dividend accounts will begin with a zero balance.
To help streamline the process, the closing process utilizes a new temporary account called income summary. Income summary will be used to accumulate revenue and expense accounts as they are closed out which will allow us to easily calculate net income for the period. Income summary will then be closed out to retained earnings. Also important to note is that the income summary account is also a temporary account that is used only for the closing process. The income summary account begins with a zero balance and ends with a zero balance once the closing process is completed. To fully illustrate the process, we will begin by preparing the journal entries for each account. Overall there are four closing entries, which are the following:
- Close Revenue Accounts: Close each revenue account directly to income summary by debiting the revenue account for the balance in the account. The journal entry will be balanced out by crediting income summary for the balance of each revenue account.
- Close Expense Accounts: Close each expense account directly to income summary by crediting the expense account for the balance in the account. The journal entry will be balanced out by debiting income summary for the balance of each expense account.
- Close the Income Summary Account: Close the income summary with either a debit or credit depending on the balance of the account. Debit or credit retained earnings for the amount in income summary. The income summary account should have a zero balance after this journal entry is applied.
- Close the Dividend Account: The dividend account is closed by crediting the account for the balance of the account. The debit will go to directly to retained earnings.
For each revenue account, the following journal entry would be used to close the revenue account to income summary:
After this entry is made, the service revenue account will have a balance of 0 and will be ready for the next accounting cycle.
For each expense account, the following journal entry would be used to close the expense account to income summary:
After this entry is made, the salary expense account will have a balance of 0 and will be ready for the next accounting cycle. The same procedure is done for all expense accounts. Remember revenue accounts have a debit normal balance and expenses have a credit normal balance.
The balance of income summary would be calculated and then income summary would be closed out to retained earnings using the following journal entry:
In this case, our revenue is more than our expenses which results in a net income or net profit for the period. If our expenses were greater than our revenue then we would have the opposite of this transaction (a credit for income summary and a debit for retained earnings). A net loss would reduce retained earnings.
The dividend account will be closed out directly to retained earnings, as follows:
This transaction would also be applied to any owner's withdrawals (ie. for proprietorships or partnerships). The net effect of this transaction is that it zeros out the dividend account and reduces retained earnings.
The overall flow of accounting information can be represented by this flow chart:
After all closing entries have been posted, we prepare a post-closing trial balance to ensure that our debits equal credits. Important to note is that the post-closing trial balance only lists permanent accounts (balance sheet accounts) since all the temporary accounts have been closed out during the closing process. After the post-closing trial balance has been completed, the accounting cycle has ended and the books are prepared for the next accounting cycle.
3.8 - Summary of The Accounting Cycle
Now that we have covered all of the steps in the accounting cycle in detail, we can quickly review the accounting cycle. The following are the steps in the accounting cycle:
1) Analyze and journalize business transactions: Relevant business transactions are reviewed and determined if they should be recorded in the accounting records. If the transaction is selected to be recorded then the amounts of the transactions are determined and the accounts to debit and credit are selected. Recording the proper amounts and selecting the correct accounts are critical to ensure that accounting data is of the highest quality possible.
2) Post journal entries to general ledger: After recording our journal entries, we will move those journal entries to the general ledger to create a summarized version of our journal entries.
3) Prepare unadjusted trial balance: The unadjusted trial balance is prepared based on the amounts in the general ledger. This is to ensure that debits equal credits and is used as a way to check for possible errors.
4) Journalize and post adjusting entries: Relevant accounts are selected for adjustments and the related adjusting entries are posted.
5) Prepare adjusted trial balance: The adjusted trial balance is prepared to ensure that debits equal credits and is used as a way to detect possible errors.
6) Prepare financial statements: The financial statements are prepared using the amounts in the adjusted trial balance.
7) Journalize and post-closing entries: The closing entries are prepared and posted. The closing entries are essentially preparing the temporary accounts for the next accounting cycle.
8) Prepare post-closing trial balance: The post-closing trial balance is used to check the equality of debits and credits as well as a way to detect possible errors.
3.9 - Correcting Entries
Occasionally journal entries will be posted which are not correct. When these erroneous entries are identified they must be reversed. The correct journal entry must be performed. Being able to identify incorrect entries requires a strong mastery of fundamental accrual accounting principles since you must be able to identify the entry is wrong and be able to know what the correct entry should be. Errors might also be detected when performing ancillary accounting functions and noticing that the math simply does not add up. The best way to learn about reversing entries and correcting entries is by practicing example problems. The following examples will help you to think about accrual accounting and why the following entries are wrong and how to correct them. At this point, we know the basics of accrual accounting and how to record basic transactions. Our examples at this point are relatively simple. As you progress through this course, you will learn more complicated material and we will practice more complicated correcting entries.
Debbie, the company's accounting clerk, is told that the company paid an employee, Scott Miller, $2,000 in cash for wages paid in December. She journalizes the following entry:
The first step is to analyze the journal entry to see if it is correct. In this, the entry is incorrect because Debbie debited the employee's name instead of the wage expense account. The second step is to determine how we will correct this entry. In this case, we correct the entry by posting a reversing entry to debit wage expense for $2,000 and to credit Scott Miller for $2,000. The Scott Miller account should also be removed from the accounting system if the account still exists with a zero balance.
After the above entry is posted, the error will have been corrected. The Scott Miller account will now have a zero balance and can be removed from the accounting records.
Example #2: Debbie receives a source document which notes that the company purchased a new copy machine for $5,000. Debbie, incorrectly makes the following entry:
As we can see from the above journal entry. The entry was only recorded for $500 which is $4,500 short of what should have been recorded. In this case, Debbie simply needs to record the following entry to correct the previous entry. In this case, a reversing entry is not necessary.
After the above entry is journalized, the office equipment and cash account would correctly report the impact of the transaction at $5,000.
That concludes our discussion of accrual accounting principles. In the next chapter we will learn about financial statements.