Professional Documents
Culture Documents
theaccrual basis of accounting. A reasonable way to begin the process is by reviewing the amount or
balance shown in each of the balance sheet accounts. We will use the following preliminary balance
sheet, which reports the account balances prior to any adjusting entries:
Parcel Delivery Service
Preliminary Balance Sheetbefore adjusting entries
December 31, 2011
ASSETS
Cash
Accounts receivable
Supplies
Prepaid insurance
Equipment
Accumulated depreciation
Total Assets
$ 1,800
4,600
1,100
1,500
25,000
(7,500)
$26,500
LIABILITIES
Notes payable
Accounts payable
Wages payable
Unearned revenues
Total liabilities
$ 5,000
2,500
1,200
1,300
10,000
OWNER'S EQUITY
Mary Smith, capital
16,500
$26,500
Cash $1,800
The Cash account has a preliminary balance of $1,800the amount in the general ledger. Before
issuing the balance sheet, one must ask, "Is $1,800 the true amount of cash? Does it agree to the amount
computed on the bank reconciliation?" The accountant found that $1,800 was indeed the true balance. (If
the preliminary balance in Cash does not agree to the bank reconciliation, entries are usually needed. For
example, if the bank statement included a service charge and a check printing chargeand they were not
yet entered into the company's accounting recordsthose amounts must be entered into the Cash
account. See the major topic Bank Reconciliation for a thorough discussion and illustration of the likely
journal entries.)
review indicates that the preliminary balance in Accounts Receivable of $4,600 is accurate as far as the
amounts that have been billed and not yet paid.
However, under the accrual basis of accounting, the balance sheet must report all the amounts the
company has an absolute right to receivenot just the amounts that have been billed on a sales invoice.
Similarly, the income statement should report all revenues that have been earnednot just the revenues
that have been billed. After further review, it is learned that $3,000 of work has been performed (and
therefore has been earned) as of December 31 but won't be billed until January 10. Because this $3,000
was earned in December, it must be entered and reported on the financial statements for December. An
adjusting entry dated December 31 is prepared in order to get this information onto the December
financial statements.
To assist you in understanding adjusting journal entries, double entry, and debits and credits, each
example of an adjusting entry will be illustrated with a T-account.
Preliminary Balance
ADJUSTING ENTRY
Correct Balance
Credit
Decreases an asset
4,600
3,000
7,600
Credit
Increases Revenues
60,234
3,000
63,234
Preliminary Balance
ADJUSTING ENTRY
Correct Balance
The adjusting entry for Accounts Receivable in general journal format is:
Date
Account Name
Debit
Accounts Receivable
Service Revenues
3,000
Credit
3,000
Notice that the ending balance in the asset Accounts Receivable is now $7,600the correct amount that
the company has a right to receive. The income statement account balance has been increased by the
$3,000 adjustment amount, because this $3,000 was also earned in the accounting period but had not yet
been entered into the Service Revenues account. The balance in Service Revenues will increase during
the year as the account is credited whenever a sales invoice is prepared. The balance in Accounts
Receivable also increases if the sale was on credit (as opposed to a cash sale). However, Accounts
Receivable will decrease whenever a customer pays some of the amount owed to the company.
Therefore the balance in Accounts Receivable might be approximately the amount of one month's sales, if
the company allows customers to pay their invoices in 30 days.
At the end of the accounting year, the ending balances in the balance sheet accounts (assets and
liabilities) will carry forward to the next accounting year. The ending balances in the income statement
accounts (revenues and expenses) are closed after the year's financial statements are prepared and
these accounts will start the next accounting period with zero balances.
Although the Allowance for Doubtful Accounts does not appear on the preliminary balance sheet,
experienced accountants realize that it is likely that some of the accounts receivable might not be
collected. (This could occur because some customers will have unforeseen hardships, some customers
might be dishonest, etc.) If some of the $4,600 owed to the company will not be collected, the company's
balance sheet should report less than $4,600 of accounts receivable. However, rather than reducing the
balance in Accounts Receivable by means of a credit amount, the credit amount will be reported in
Allowance for Doubtful Accounts. (The combination of the debit balance in Accounts Receivable and the
credit balance in Allowance for Doubtful Accounts is referred to as the net realizable value.)
Let's assume that a review of the accounts receivables indicates that approximately $600 of the
receivables will not be collectible. This means that the balance in Allowance for Doubtful Accounts should
be reported as a $600 credit balance instead of the preliminary balance of $0. The two accounts involved
will be the balance sheet account Allowance for Doubtful Accounts and the income statement account
Bad Debts Expense.
Debit
Decreases a contra asset
Credit
Increases a contra asset
Preliminary Balance
600
ADJUSTING ENTRY
600
Correct Balance
Debit
Increases an expense
Credit
Decreases an expense
Preliminary Balance
ADJUSTING ENTRY
600
Correct Balance
600
The adjusting journal entry for Allowance for Doubtful Accounts is:
Date
Account Name
Debit
Credit
600
600
It is possible for one or both of the accounts to have preliminary balances. However, the balances are
likely to be different from one another. Because Allowance for Doubtful Accounts is a balance sheet
account, its ending balance will carry forward to the next accounting year. Because Bad Debts Expense is
an income statement account, its balance will not carry forward to the next year. Bad Debts Expense will
start the next accounting year with a zero balance.
Supplies $1,100
The Supplies account has a preliminary balance of $1,100. However, a count of the supplies actually on
hand indicates that the true amount of supplies is $725. This means that the preliminary balance is too
high by $375 ($1,100 minus $725). A credit of $375 will need to be entered into the asset account in order
to reduce the balance from $1,100 to $725. The related income statement account is Supplies Expense.
Debit
Increases an asset
Preliminary Balance
Credit
Decreases an asset
1,100
375
Correct Balance
725
ADJUSTING ENTRY
Debit
Increases an expense
Credit
Decreases an expense
Preliminary Balance
1,600
ADJUSTING ENTRY
375
Correct Balance
1,975
Date
Account Name
Supplies Expense
Supplies
Debit
Credit
375
375
Notice that the ending balance in the asset Supplies is now $725the correct amount of supplies that the
company actually has on hand. The income statement account Supplies Expense has been increased by
the $375 adjusting entry. It is assumed that the decrease in the supplies on hand means that the supplies
have been used during the current accounting period. The balance in Supplies Expense will increase
during the year as the account is debited. Supplies Expense will start the next accounting year with a zero
balance. The balance in the asset Supplies at the end of the accounting year will carry over to the next
accounting year.
The $1,500 balance in the asset account Prepaid Insurance is the preliminary balance. The correct
balance needs to be determined. The correct amount is the amount that has been paid by the company
for insurance coverage that will expire after the balance sheet date. If a review of the payments for
insurance shows that $600 of the insurance payments is for insurance that will expire after the balance
sheet date, then the balance in Prepaid Insurance should be $600. All other amounts should be charged
to Insurance Expense.
Debit
Increases an asset
Credit
Decreases an asset
Preliminary Balance
1,500
900
Correct Balance
ADJUSTING ENTRY
600
Debit
Increase an expense
Credit
Decreases an expense
Preliminary Balance
1,000
ADJUSTING ENTRY
900
Correct Balance
1,900
Date
Account Name
Insurance Expense
Prepaid Insurance
Debit
Credit
900
900
Note that the ending balance in the asset Prepaid Insurance is now $600the correct amount of
insurance that has been paid in advance. The income statement account Insurance Expense has been
increased by the $900 adjusting entry. It is assumed that the decrease in the amount prepaid was the
amount being used or expiring during the current accounting period. The balance in Insurance Expense
starts with a zero balance each year and increases during the year as the account is debited. The
balance at the end of the accounting year in the asset Prepaid Insurance will carry over to the next
accounting year.
Equipment $25,000
Equipment is a long-term asset that will not last indefinitely. The cost of equipment is recorded in the
account Equipment. The $25,000 balance in Equipment is accurate, so no entry is needed in this account.
As an asset account, the debit balance of $25,000 will carry over to the next accounting year.
Accumulated Depreciation - Equipment is a contra asset account and its preliminary balance of $7,500
is the amount of depreciation actually entered into the account since the Equipment was acquired. The
correct balance should be the cumulative amount of depreciation from the time that the equipment was
acquired through the date of the balance sheet. A review indicates that as of December 31 the
accumulated amount of depreciation should be $9,000. Therefore the account Accumulated Depreciation
- Equipment will need to have an ending balance of $9,000. This will require an additional $1,500 credit to
this account. The income statement account that is pertinent to this adjusting entry and which will be
debited for $1,500 is Depreciation Expense - Equipment.
Debit
Decreases a contra asset
Credit
Increases a contra asset
7,500
Preliminary Balance
1,500
ADJUSTING ENTRY
9,000
Correct Balance
Debit
Increases an expense
Credit
Decreases an expense
Preliminary Balance
ADJUSTING ENTRY
1,500
Correct Balance
1,500
The adjusting entry for Accumulated Depreciation in general journal format is:
Date
Account Name
Debit
1,500
Credit
1,500
The ending balance in the contra asset account Accumulated Depreciation - Equipment at the end of the
accounting year will carry forward to the next accounting year. The ending balance in Depreciation
Expense - Equipment will be closed at the end of the current accounting period and this account will begin
the next accounting year with a balance of $0.