Ch. 2 Financial Statements and Adjusting Entries
2.2 Adjusting Entries
Learning Objectives
After finishing this section, students will be able to:
- Understand the importance of adjusting entries.
- Create adjusting entries to update financial statements.
In your personal life, you operate on a cash basis. In the accounting world, we operate on an accrual basis which allows us to match revenues and expenses to the month that they happen not when cash is received or paid. We make these entries by using receivable and payable accounts to show future revenue and expenses.
Understanding Adjusting Entries
Public companies reporting their financial positions use either US generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS), as allowed under the Securities and Exchange Commission (SEC) regulations. The SEC is an independent agency of the federal government that provides oversight of public companies to maintain fair representation of company financial activities for investors to make informed decisions.
Companies, public or private, using US GAAP or IFRS prepare their financial statements using the rules of accrual accounting. Accrual accounting prescribes that revenues and expenses must be recorded in the accounting period in which they were earned or incurred, no matter when cash receipts or payments occur. It is because of accrual accounting that we have the revenue recognition principle and the expense recognition principle (also known as the matching principle). Often time accountings will refer to this process as “accrued expense”. Accrued expenses are expenses that a business has incurred but not yet paid for by the company.
The accrual method is considered to better match revenues and expenses and standardizes reporting information for comparability purposes. Having comparable information is important to external users of information trying to make investment or lending decisions, and to internal users trying to make decisions about company performance, budgeting, and growth strategies.
Some nonpublic companies may choose to use cash basis accounting rather than accrual basis accounting to report financial information. Cash basis accounting sometimes delays or accelerates revenue and expense reporting until cash receipts or outlays occur. With this method, cash flows are used to measure business performance in a given period and can be simpler to track than accrual basis accounting.
Adjusting entries depend on what types of transactions the company has, but there are some common types of adjusting entries. Several guidelines support the need for adjusting entries:
- Revenue recognition principle: Adjusting entries are necessary because the revenue recognition principle requires revenue recognition when earned, thus the need for an update to unearned revenues.
- Expense recognition (matching) principle: This requires matching expenses incurred to generate the revenues earned, which affects accounts such as insurance expense and supplies expense.
- Time period assumption: This requires useful information be presented in shorter time periods such as years, quarters, or months. This means a company must recognize revenues and expenses in the proper period, requiring adjustment to certain accounts to meet these criteria.
There are a few other guidelines that support the need for adjusting entries to update accounting records at the end of a period for any transactions that have not yet been recorded. These entries are necessary to ensure the income statement and balance sheet present the correct, up-to-date numbers. Adjusting entries are also necessary because the initial trial balance may not contain complete and current data due to several factors:
- The inefficiency of recording every single day-to-day event, such as the use of supplies.
- Some costs are not recorded during the period but must be recognized at the end of the period, such as depreciation, rent, and insurance.
- Some items are forthcoming for which original source documents have not yet been received, such as a utility bill.
Adjusting Entry Rules
There are three rules for adjusting entries:
- NEVER use cash. When adjusting entries are made, the bank account will have been reconciled to the bank statement. The bank will not let you change what is on the bank statement so you cannot change what is the accounting books cash account.
- ALWAYS include one Balance Sheet account. The purpose of adjusting entries is to make sure the balance sheet balances to a physical document sources.
- Examples of document sources are:
- Bank Statement proves the Cash balance.
- Counting inventory in the company and calculating the value proves the Inventory balance.
- A receipt or invoice proves the Equipment balance.
- Adding vendor statements together proves the Accounts Payable balance.
- Examples of document sources are:
- ALWAYS include one Income Statement account. The money adjusted from the balance sheet will become a revenue or expense on the income statement.
Horizontal Model
We will use Printing Plus’ horizontal model from the past section.
| Balance Sheet | Income Statement | Stmt of Cash Flows | ||||||||||||||||||||||
| Cash | + | Accounts Receivable | + | Inventory | + | Equipment | = | Accounts Payable | + | Unearned Revenue | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA | Description | ||
| 24,800 | + | 1,200 | + | 500 | + | 3,500 | = | 500 | + | 4,000 | + | 20,000 | + | 5,500 | 9,500 | – | 3,900 | = | 5,600 | 24,800 | Totals | |||
On January 31, 20X9, Printing Plus makes adjusting entries for the following transactions.
| Date | Transaction |
|---|---|
| Jan. 31a | On January 31, Printing Plus took a count of its inventory and discovered that $100 of inventory had been used during the month. |
| Jan. 31b | Printing Plus performed $600 of services during January for the customer from the January 9 transaction. |
| Jan. 31c | Employees earned $1,500 in salaries for the period of January 21–January 31 that had been previously unpaid and unrecorded. |
| Jan. 31d | Income Tax Expense is calculated at 21%. |
Transaction Jan. 31a
On January 31, Printing Plus took an counted its inventory and discovered that $100 of inventory had been used during the month.
Following the adjusting entry rules, we need to make sure the inventory amount on the balance sheet is correct.
- NEVER use cash. Easy enough!
- ALWAYS include one Balance Sheet account. The balance sheet account to use is inventory. When -$100 of inventory use is subtracted, inventory will be $400.
- ALWAYS include one Income Statement account. The income statement account associated with inventory is cost of good sold.
| Balance Sheet | Income Statement | Stmt of Cash Flows | ||||||||||||||||||||||
| Cash | + | Accounts Receivable | + | Inventory | + | Equipment | = | Accounts Payable | + | Unearned Revenue | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA | Description | ||
| 24,800 | + | 1,200 | + | 500 | + | 3,500 | = | 500 | + | 4,000 | + | 20,000 | + | 5,500 | 9,500 | – | 3,900 | = | 5,600 | 24,800 | Totals | |||
| a | – | -100 | = | -100 | – | 100 | = | -100 | – | COGS | ||||||||||||||
Transaction Jan. 31b
Printing Plus performed $600 of services during January for the customer from the January 9 transaction.
- NEVER use cash. Easy enough!
- ALWAYS include one Balance Sheet account. The balance sheet account to use is unearned revenue. This is the account that we originally recorded the money received from our customer.
- ALWAYS include one Income Statement account. The income statement account associated with unearned revenue is revenue.
| Balance Sheet | Income Statement | Stmt of Cash Flows | ||||||||||||||||||||||
| Cash | + | Accounts Receivable | + | Inventory | + | Equipment | = | Accounts Payable | + | Unearned Revenue | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA | Description | ||
| 24,800 | + | 1,200 | + | 500 | + | 3,500 | = | 500 | + | 4,000 | + | 20,000 | + | 5,500 | 9,500 | – | 3,900 | = | 5,600 | 24,800 | Totals | |||
| b | – | = | -600 | 600 | 600 | – | = | 600 | – | Revenue | ||||||||||||||
Transaction Jan. 31c
Employees earned $1,500 in salaries for the period of January 21–January 31 that had been previously unpaid and unrecorded.
- NEVER use cash. Easy enough!
- ALWAYS include one Balance Sheet account. The balance sheet account to use is salaries payable because we are obligated to pay our employees later.
- ALWAYS include one Income Statement account. The income statement account associated with salaries payable is salaries expense.
| Balance Sheet | Income Statement | Stmt of Cash Flows | ||||||||||||||||||||||||
| Cash | + | Accounts Receivable | + | Inventory | + | Equipment | = | Accounts Payable | + | Salaries Payable | + | Unearned Revenue | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA | Description | ||
| 24,800 | + | 1,200 | + | 500 | + | 3,500 | = | 500 | + | + | 4,000 | + | 20,000 | + | 5,500 | 9,500 | – | 3,900 | = | 5,600 | 24,800 | Totals | ||||
| c | – | = | 1,500 | -1,500 | – | 1,500 | = | -1,500 | – | Salaries Exp | ||||||||||||||||
Transaction Jan. 31d
Income Tax Expense is calculated at 21%. To calculate how much income tax is owed, calculate net income after the adjusting entries have been made. Revenue (9,500 + 600) minus Expenses (3,900 + 100 + 1,500) equals Net Income of $4,700. Net Income ($4,700) x income tax rate (21%) is an income tax expense of $987,
- NEVER use cash. Easy enough!
- ALWAYS include one Balance Sheet account. The balance sheet account to use is income tax payable.
- ALWAYS include one Income Statement account. The income statement account associated with income tax payable is income tax expense.
| Balance Sheet | Income Statement | Stmt of Cash Flows | ||||||||||||||||||||||||||
| Cash | + | Accounts Receivable | + | Inventory | + | Equipment | = | Accounts Payable | + | Salaries Payable | + | Unearned Revenue | + | Income Tax Payable | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA | Description | ||
| 24,800 | + | 1,200 | + | 500 | + | 3,500 | = | 500 | + | + | 4,000 | + | + | 20,000 | + | 5,500 | 9,500 | – | 3,900 | = | 5,600 | 24,800 | Totals | |||||
| a | – | + | + | -100 | + | = | + | + | + | + | + | -100 | – | 100 | = | COGS | ||||||||||||
| b | – | + | + | + | = | + | + | -600 | + | + | + | 600 | 600 | – | = | 600 | Revenue | |||||||||||
| c | – | + | + | + | = | + | 1,500 | + | + | + | + | – | 1,500 | = | -1,500 | – | Salaries Exp | |||||||||||
| d | – | + | + | + | = | + | + | + | 987 | + | + | -987 | – | 987 | = | -987 | Income Tax Exp | |||||||||||
Summary
When January transactions are put into the same horizontal model, the last row can be summed to find the account balances (in bold) that will appear on the financial statements. In the next section, we will create financial statements.
| Balance Sheet | Income Statement | Stmt of Cash Flows | ||||||||||||||||||||||||||
| Cash | + | Accounts Receivable | + | Inventory | + | Equipment | = | Accounts Payable | + | Salaries Payable | + | Unearned Revenue | + | Income Tax Payable | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA | Description | ||
| 24,800 | + | 1,200 | + | 500 | + | 3,500 | = | 500 | + | + | 4,000 | + | + | 20,000 | + | 5,500 | 9,500 | – | 3,900 | = | 5,600 | 24,800 | Totals | |||||
| a | – | + | + | -100 | + | = | + | + | + | + | + | -100 | – | 100 | = | COGS | ||||||||||||
| b | – | + | + | + | = | + | + | -600 | + | + | + | 600 | 600 | – | = | 600 | Revenue | |||||||||||
| c | – | + | + | + | = | + | 1,500 | + | + | + | + | -1500 | – | 1,500 | = | -1,500 | – | Salaries Exp | ||||||||||
| d | – | + | + | + | = | + | + | + | 987 | + | + | -987 | – | 987 | = | -987 | Income Tax Exp | |||||||||||
| 24,800 | + | 1,200 | + | 400 | + | 3,500 | = | 500 | + | 1,500 | + | 3,400 | + | 987 | + | 20,000 | + | 3,513 | 10,100 | – | 6,487 | = | 3,713 | 24,800 | Totals | |||
2.2a Example
Watch video from 10:47 to 17:24
On June 30, 20X6, Wood, Corp. makes adjusting entries for the following transactions.
| Date | Transaction Detail |
|---|---|
| June 30a | At the end of the month, inventory was counted and had a value of $125,000. |
| June 30b | Adjust the prepaid insurance account for the amount used during the month. |
| June 30c | All employees are paid once a month and receive their paycheck on the tenth of each month. Payroll Expense for the month was $150,000. |
| June 30d | Income Tax Expense is calculated at 21%. |
Instructions:
- Using the Horizontal Model from 2.1a Example, prepare adjusting entries.
2.2a Practice
Geller Enterprises needs to prepare adjusting entries as of December 31, Year 4. Using the Horizontal Model from 2.1 Practice, prepare adjusting entries for the below transactions.
| Date | Transaction Detail |
|---|---|
| Dec. 31a | Recognized accrued salaries expense of $4,800. |
| Dec. 31b | The land purchased this year has a market value of $48,000. |
| Dec. 31c | Recognized interest revenue of $116. |
| Dec. 31d & e | There are two entries that occurred during the year that need to be adjusted. Make the adjustments. |
Check Figures:
- Cash, $112,400
- Net Income, $52,616
- Solution (Excel file will download)
2.2a Homework
On August 31, 20X4, Grazy Stokes Glass Blowers makes adjusting entries for the following transactions.
| Date | Transaction Detail |
|---|---|
| Aug 31a | Recognized administrative salaries of $4,200. |
| Aug 31b | Inventory was counted and has a value of $7,500. |
| Aug 31c | It was found that $2,000 of product was sold to a customer and not billed. |
| Aug 31d | Rent was paid for the entire year. We only want one month of rent in the month of August. Make the appropriate entry. |
| Aug 31e | Income Tax Expense is calculated at 21%. |
Instructions:
- Using the Horizontal Model in 2.1a Homework, prepare adjusting entries.
Licensing and Attribution:
Content on this page is adapted from the following openly licensed resource(s):
Principles of Accounting, Volume 1: Financial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License
are expenses that a business has incurred but not yet paid for by the company.
