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After accountants and management analyze the balances on the unadjusted trial balance, they can then make end of
period adjustments like depreciation expense and expense accruals. These adjusted journal entries are posted to the
trial balance turning it into an adjusted trial balance.
Now that all the end of the year adjustments are made and the adjusted trial balance matches the subsidiary accounts,
financial statements can be prepared. After financial statements are published and released to the public, the company
can close its books for the period. Closing entries are made and posted to the post closing trial balance.
At the start of the next accounting period, occasionally reversing journal entries are made to cancel out the accrual
entries made in the previous period. After the reversing entries are posted, the accounting cycle starts all over again
with the occurrence of a new business transaction.
Here is a simplified summary of the steps in a traditional accounting cycle. Some textbooks list more steps than this,
but I like to simplify them and combine as many steps as possible.
1. -- Identify business events, analyze these transactions, and record them as journal entries
2. -- Post journal entries to applicable T-accounts or ledger accounts
3. -- Prepare an unadjusted trial balance from the general ledger
4. -- Analyze the trial balance and make end of period adjusting entries
5. -- Post adjusting journal entries and prepare the adjusted trial balance
6. -- Use the adjusted trial balance to prepare financial statements
7. -- Close all temporary income statement accounts with closing entries
8. -- Prepare the post-closing trial balance for the next accounting period
9. -- Prepare reversing entries to cancel temporary adjusting entries if applicable
Flow Chart
After this cycle is complete, it starts over at the beginning. Here is an accounting cycle flow chart.
As you can see, the cycle keeps revolving every period. Note that some steps are repeated more than once
during a period. Obviously, business transactions occur and numerous journal entries are recording during one
period. Only one set of financial statements is prepared however.
Throughout this section, we'll be looking at the business events and transactions that happen to Paul's Guitar
Shop, Inc. over the course of its first year in business. Let's take a look at how Paul starts his accounting cycle
below.
The preparation of adjusting entries is an application of the accrual concept of accounting and the matching principle.
The accrual concept states that income is recognized when earned regardless of when collected and expense is
recognized when incurred regardless of when paid.
The matching principle aims to align expenses with revenues. Expenses should be recognized in the period when the
revenues generated by such expenses are recognized.
If adjusting entries are not prepared, some income, expense, asset, and liability accounts may not reflect their true
values when reported in the financial statements. For this reason, adjusting entries are necessary.
A nominal account is an account whose balance is measured from period to period. Nominal accounts include all
accounts in the Income Statement, plus owner's withdrawal. They are also called temporary accounts or income
statement accounts.
Examples of nominal accounts are: Service Revenue, Salaries Expense, Rent Expense, Utilities Expense, Mr. Gray
Drawing etc.
A real account has a balance that is measured cumulatively, rather than from period to period. Real accounts include
all accounts in the balance sheet. They are also called permanent accounts or balance sheet accounts.
2|Page By: Prof. Asif Masood Ahmad
0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore
Examples of real accounts are: Cash, Accounts Receivable, Rent Receivable, Accounts Payable, and Owners Capital etc.
All adjusting entries include at least a nominal account and a real account.
5. Depreciation
When a company has performed services or sold goods to a customer, it should be recognized as income even if the
amount is still to be collected at a future date.
If no journal entry was ever made for the above, then an adjusting entry is necessary.
Pro-Forma Entry
The adjusting entry to record accrued revenue is:
*Appropriate receivable account such as Accounts Receivable, Rent Receivable, Interest Receivable, etc.
**Income account such as Service Revenue, Rent Income, Interest Income, etc.
Here's an Example
In our previous set of transactions, assume this additional information:
On December 31, 2014, Gray Electronic Repair Services rendered $300 worth of services to a client. However, the
amount has not yet been collected. It was agreed that the customer will pay the amount on January 15, 2015. The
transaction was never recorded in the books of the company.
In this case, we should make an adjusting entry to recognize the income since it has already been earned. The
adjusting entry would be:
Under the accrual basis, the rent income above should already be recognized because it has already been earned even
if it has not yet been collected. The adjusting journal entry would be:
Example 2: ABC Company lent $9,000 at 10% interest on December 1, 2014. The amount will be collected after 1
year. At the end of December, no entry was entered in the journal to take up the interest income.
Interest is earned through the passage of time. In the case above, the $9,000 principal plus a $900 interest will be
collected by the company after 1 year. The $900 interest pertains to 1 year.
However, 1 month has already passed. The company is already entitled to 1/12 of the interest, as prorated. Therefore
the adjusting entry would be to recognize $75 (i.e. $900 x 1/12) as interest income:
The basic concept you need to remember is recognition of income. When is income recognized? Under the accrual
concept of accounting, income is recognized when earned regardless of when collected.
If the company has already earned the right to it and no entry has been made in the journal, then an adjusting entry to
record the income and a receivable is necessary.
Here's the rule. If a company incurred, used, or consumed all or part of an expense, that expense or part of it should
be properly recognized even if it has not yet been paid.
Pro-Forma Entry
The pro-forma adjusting entry to record an accrued expense is:
*Appropriate expense account (such as Utilities Expense, Rent Expense, Interest Expense, etc.)
**Appropriate liability account (Utilities Payable, Rent Payable, Interest Payable, Accounts Payable, etc.)
For Example
For the month of December 2014, Gray Electronic Repair Services used a total of $1,800 worth of electricity and water.
The company received the bills on January 10, 2015. When should the expense be recorded, December 2014 or
January 2015?
Answer in December 2014. According to the accrual concept of accounting, expenses are recognized when incurred
regardless of when paid. The amount above pertains to utilities used in December. Therefore, if no entry was made for
it in December then an adjusting entry is necessary.
In the adjusting entry above, Utilities Expense is debited to recognize the expense and Utilities Payable to record a
liability since the amount is yet to be paid.
In this case, VIRON Company already incurred (consumed/used) the expense. Even if it has not yet been paid, it should
be recorded as an expense. The necessary adjusting entry would be:
Example 2: VIRON Company borrowed $6,000 at 12% interest on August 1, 2014. The amount will be paid after 1
year. At the end of December, the end of the accounting period, no entry was entered in the journal to take up the
interest.
VIRON will be paying $6,000 principal plus $720 interest after a year. The $720 interest covers 1 year. At the end of
December, a part of that is already incurred, i.e. $720 x 5/12 or $300. That pertains to interest for 5 months, from
August 1 to December 31. The adjusting entry would be:
Expenses are recognized when incurred regardless of when paid. What you need to remember here is this: when it has
been consumed or used and no entry was made to record the expense, then there is a need for an adjusting entry.
It is to be noted that under the accrual concept, income is recognized when earned regardless of when collected.
And so, unearned revenue should not be included as income yet; rather, it is recorded as a liability. This liability
represents an obligation of the company to render services or deliver goods in the future. It will be recognized as
income only when the goods or services have been delivered or rendered.
5|Page By: Prof. Asif Masood Ahmad
0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore
At the end of the period, unearned revenues must be checked and adjusted if necessary. The adjusting entry for
unearned revenue depends upon the journal entry made when it was initially recorded.
There are two ways of recording unearned revenue: (1) the liability method, and (2) the income method.
Suppose on January 10, 2015, ABC Company made $30,000 advanced collections from its customers. If the liability
method is used, the entry would be:
Take note that the amount has not yet been earned, thus it is proper to record it as a liability. Now, what if at the end
of the month, 20% of the unearned revenue has been rendered? This will require an adjusting entry.
The adjusting entry will include: (1) recognition of $6,000 income, i.e. 20% of $30,000, and (2) decrease in
liability (unearned revenue) since some of it has already been rendered. The adjusting entry would be:
We are simply separating the earned part from the unearned portion. Of the $30,000 unearned revenue, $6,000 is
recognized as income. In the entry above, we removed $6,000 from the $30,000 liability. The balance of unearned
revenue is now at $24,000.
If at the end of the year the company earned 20% of the entire $30,000, then the adjusting entry would be:
By debiting Service Income for $24,000, we are decreasing the income initially recorded. The balance of Service Income
is now $6,000 ($30,000 - 24,000), which is actually the 20% portion already earned. By crediting Unearned Income, we
are recording a liability for $24,000.
Notice that the resulting balances of the accounts under the two methods are the same (Cash: $30,000; Service
Income: $6,000; and Unearned Income: $24,000).
Another Example
On December 1, 2014, DRG Company collected from TRM Corp. a total of $60,000 as rental fee for three months
starting December 1.
On December 31, 2014, the end of the accounting period, 1/3 of the rent received has already been earned (prorated
over 3 months).
In effect, we are transferring $20,000, one-third of $60,000, from the Unearned Rent Income (a liability) to Rent
Income (an income account) since that portion has already been earned.
If the company made use of the income method, the initial entry would be:
In this case, we must decrease Rent Income by $40,000 because that part has not yet been earned. The income
account shall have a balance of $20,000. The amount removed from income shall be transferred to liability (Unearned
Rent Income). The adjusting entry would be:
Conclusion
If you have noticed, what we are actually doing here is making sure that the earned part is included in income and the
unearned part into liability. The adjusting entry will always depend upon the method used when the initial entry was
made.
If you are having a hard time understanding this topic, I suggest you go over and study the lesson again. Sometimes, it
really takes a while to get the concept. Preparing adjusting entries is one of the most challenging (but important) topics
for beginners.
In other words, these are "advanced payments" by a company for supplies, rent, utilities and others that are still to be
consumed.
Expenses are recognized when they are incurred regardless of when paid. Expenses are considered incurred when they
are used, consumed, utilized or has expired.
Because prepayments they are not yet incurred, they are not recorded as expenses. Rather, they are classified
as current assets.
Prepaid expenses may need to be adjusted at the end of the accounting period. The adjusting entry for prepaid
expense depends upon the journal entry made when it was initially recorded.
There are two ways of recording prepayments: (1) the asset method, and (2) the expense method.
Asset Method
Under the asset method, a prepaid expense account (an asset) is recorded when the amount is paid. Prepaid expense
accounts include: Office Supplies, Prepaid Rent, Prepaid Insurance, and others.
In one of our previous illustrations (if you have been following our comprehensive illustration for Gray Electronic Repair
Services), we made this entry to record the purchase of service supplies:
Take note that the amount has not yet been incurred, thus it is proper to record it as an asset.
Suppose at the end of the month, 60% of the supplies have been used. Thus, out of the $1,500, $900 worth of
supplies have been used and $600 remain unused. The $900 must then be recognized as expense since it has already
been used.
In preparing the adjusting entry, our goal is to transfer the used part from the asset initially recorded into expense for
us to arrive at the proper balances shown in the illustration above.
The adjusting entry will include: (1) recognition of expense and (2) decrease in the asset initially recorded (since some
of it has already been used). The adjusting entry would be:
The "Service Supplies Expense" is an expense account while "Service Supplies" is an asset. After making the entry, the
balance of the unused Service Supplies is now at $600 ($1,500 debit and $900 credit). Service Supplies Expense now
has a balance of $900. Now, we've achieved our goal.
Expense Method
Under the expense method, the accountant initially records the entire payment as expense. If the expense method was
used, the entry would have been:
Take note that the entire amount was initially expensed. If 60% was used, then the adjusting entry at the end of the
month would be:
This time, Service Supplies is debited for $600 (the unused portion). And then, Service Supplies Expense is credited
thus decreasing its balance. Service Supplies Expense is now at $900 ($1,500 debit and $600 credit).
Notice that the resulting balances of the accounts under the two methods are the same (Cash paid: $1,500; Service
Supplies Expense: $900; and Service Supplies: $600).
Another Example
GVG Company acquired a six-month insurance coverage for its properties on September 1, 2014 for a total of $6,000.
On December 31, 2014, the end of the accounting period, part of the prepaid insurance already has expired (hence,
expense is incurred). The expired part is the insurance from September to December. Thus, we should make the
following adjusting entry:
Of the total six-month insurance amounting to $6,000 ($1,000 per month), the insurance for 4 months has already
expired. In the entry above, we are actually transferring $4,000 from the asset to the expense account (i.e., from
Prepaid Insurance to Insurance Expense).
If the company made use of the expense method, the initial entry would be:
In this case, we must decrease Insurance Expense by $2,000 because that part has not yet been incurred (not
used/not expired). Insurance Expense shall then have a balance of $4,000. The amount removed from the expense
shall be transferred to Prepaid Insurance. The adjusting entry would be:
Conclusion
What we are actually doing here is making sure that the incurred (used/expired) portion is included in expense and the
unused part into asset. The adjusting entry will always depend upon the method used when the initial entry was made.
If you are having a hard time understanding this topic, I suggest you go over and study the lesson again. Sometimes, it
really takes a while to get the concept. Preparing adjusting entries is one of the challenging (but important) topics for
beginners.
The cost is to be allocated as expense to the periods in which the asset is used. This is done by recording depreciation
expense.
Physical depreciation results from wear and tear due to frequent use and/or exposure to elements like rain, sun and
wind.
Functional or economic depreciation happens when an asset becomes inadequate for its purpose or becomes obsolete.
In this case, the asset decreases in value even without any physical deterioration.
Under the straight line method, the cost of the fixed asset is distributed evenly over the life of the asset.
For example, ABC Company acquired a delivery van for $40,000 at the beginning of 2012. Assume that the van can be
used for 5 years. The entire amount of $40,000 shall be distributed over five years, hence depreciation expense of
$8,000 each year.
In the above example, there is no residual value. Depreciation expense is computed as:
= $40,000 $0
5 years
= $8,000 / year
= $40,000 $10,000
5 years
= $30,000
5 years
= $6,000 / year
The entry to record the $6,000 depreciation every year would be:
Depreciation Expense: An expense account; hence, it is presented in the income statement. It is measured from
period to period. In the illustration above, the depreciation expense is $6,000 for 2012, $6,000 for 2013, $6,000 for
2014, etc.
Accumulated Depreciation: A balance sheet account that represents the accumulated balance of depreciation. It is
continually measured; hence the accumulated depreciation balance is $6,000 at the end of 2012, $12,000 in 2013,
$18,000 in 2014, $24,000 in 2015, and $30,000 in 2016.
Accumulated depreciation is a contra-asset account. It is presented in the balance sheet as a deduction to the related
fixed asset. Here's a table illustrating the computation of the carrying value of the delivery van.
Notice that at the end of the useful life of the asset, the carrying value is equal to the residual value.
In this case we cannot apply the entire annual depreciation in the year 2012 because the van has been used only for 9
months (April to December). We need to prorate.
For 2012, the depreciation expense would be: $6,000 x 9/12 = $4,500.
In 2017, the van will be used for 3 months only (January to March) since it has a useful life of 5 years (i.e. April 1, 2012
to March 31, 2017).
The depreciation expense for 2017 would be: $6,000 x 3/12 = $1,500, and thus completing the accumulated
depreciation of $30,000.
However, businesses that allow credit are faced with the risk that their receivables may not be collected.
Accounts receivable should be presented in the balance sheet at net realizable value, i.e. the most probable amount
that the company will be able to collect.
Allowance for Bad Debts (also often called Allowance for Doubtful Accounts) represents the estimated portion of the
Accounts Receivable that the company will not be able to collect.
Take note that this amount is an estimate. There are several methods in estimating doubtful accounts.The estimates
are often based on the company's past experiences.
To recognize doubtful accounts or bad debts, an adjusting entry must be made at the end of the period. The adjusting
entry for bad debts looks like this:
Bad Debts Expense a.k.a. Doubtful Accounts Expense: An expense account; hence, it is presented in the income
statement. It represents the estimated uncollectible amount for credit sales/revenues made during the period.
Allowance for Bad Debts a.k.a. Allowance for Doubtful Accounts: A balance sheet account that represents the total
estimated amount that the company will not be able to collect from its total Accounts Receivable.
What is the difference between Bad Debts Expense and Allowance for Bad Debts?
Bad Debts Expense is an income statement account while the latter is a balance sheet account. Bad Debts Expense
represents the uncollectible amount for credit sales made during the period. Allowance for Bad Debts, on the other
hand, is the uncollectible portion of the entire Accounts Receivable.
You can also use Doubtful Accounts Expense and Allowance for Doubtful Accounts in lieu of Bad Debts Expense and
Allowance for Bad Debts. However, it is a good practice to use a uniform pair. Some say that Bad Debts have a higher
degree of uncollectibility that Doubtful Accounts. In actual practice, however, the distinction is not really significant.
Here's an Example
Gray Electronic Repair Services estimates that $100.00 of its credit revenue for the period will not be collected. The
entry at the end of the period would be:
Again, you may use Doubtful Accounts. Just be sure to use a logical (and uniform) pair every time. For example:
If the company's Accounts Receivable amounts to $3,400 and its Allowance for Bad Debts is $100, then the Accounts
Receivable shall be presented in the balance sheet at $3,300 the net realizable value.
Example
This example is a continuation of the accounting cycle problem we have been working on. In the previous step we
prepared an unadjusted trial balance. Here we will pass adjusting entries.
Its purpose is to test the equality between debits and credits after adjusting entries are entered into the books of the
company.
At the end of the period, the following adjusting entries were made:
After posting the above entries, the values of some of the items in the unadjusted trial balance will change. Take the
first adjusting entry. Accounts Receivable is debited hence is increased by $300. Service Revenue is credited for $300.
The balance of Accounts Receivable is increased to $3,700, i.e. $3,400 unadjusted balance plus $300 adjustment.
Service Revenue will now be $9,850 from the unadjusted balance of $9,550.
Next entry. Utilities Expense and Utilities Payable did not have any balance in the unadjusted trial balance. After posting
the above entries, they will now appear in the adjusted trial balance.
Third. Service Supplies Expense is debited for $900. Service Supplies is credited for $900. The Service Supplies account
had a debit balance of $1,500. After incorporating the $900 credit adjustment, the balance will now be $600 (debit).
And fourth. There were no Depreciation Expense and Accumulated Depreciation in the unadjusted trial balance.
Because of the adjusting entry, they will now have a balance of $720 in the adjusted trial balance.
C) Are uncertain.
D) May be substituted for goods or services.
Answer: B
5. The adjusting entry required when amounts previously recorded as unearned revenues are earned
includes:
A) A debit to a liability.
B) A debit to an asset.
C) A credit to a liability.
D) A credit to an asset.
Answer: A
6. Bland Foods purchased a two-year fire and extended coverage insurance policy on August 1, 2003, and
charged the $4,200 premium to Insurance expense. At its December 31, 2003, year-end, Bland Foods
would record which of the following adjusting entries?
Rationale:
Entry on 8/1: Insurance expense 4,200
17 | P a g e By: Prof. Asif Masood Ahmad
0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore
Cash 4,200
Unused at 12/31: $4,200 x 19/24 = $3,325
7. The employees of Neat Clothes work Monday through Friday. Every other Friday the company issues
payroll checks totaling $32,000. The current pay period ends on Friday, July 3. Neat Clothes is now
preparing quarterly financial statements for the three months ended June 30. What is the adjusting entry
to record accrued salaries at the end of June?
A) Salaries expense 22,400
Prepaid salaries 9,600
Salaries payable 32,000
B) Salaries expense 6,400
Salaries payable 6,400
C) Prepaid salaries 9,600
Salaries payable 9,600
D) Salaries expense 22,400
Salaries payable 22,400
Answer: D
8. On September 1, 2003, Time Magazine sold 600 one-year subscriptions for $81 each. The total amount
received was credited to Unearned subscriptions revenue. What would be the required adjusting entry at
December 31, 2003?
A) Unearned subscriptions revenue 48,600
Subscriptions revenue 16,200
Prepaid subscriptions 32,400
B) Unearned subscriptions revenue 16,200
Subscriptions revenue 16,200
C) Unearned subscriptions revenue 16,200
Subscriptions payable 16,200
D) Unearned subscriptions revenue 32,400
Subscriptions revenue 32,400
Answer: B
Rationale:
Entry on 9/1: Cash 48,600
Unearned subscriptions revenue 48,600
Amount earned: $48,600 x 4/12 = $16,200
9. On December 31, 2002, Typical Fashions had balances in its Accounts receivable and Allowance for
uncollectible accounts of $48,400 and $940, respectively. During 2003, Typical Fashions wrote off $820
in Accounts receivable and determined that there should be an Allowance for uncollectible accounts of
$1,140 at December 31, 2003. Bad debt expense for 2003 would be:
A) $ 320.
B) $1,140.
C) $ 820.
D) $1,020.
Answer: D
10. Fink Insurance collected premiums of $18,000,000 from its customers during the current year. The
adjusted balance in the Unearned premiums account increased from $6 million to $8 million dollars
during the year. What was Fink's revenues from earned insurance premiums for the current year?
A) $10,000,000.
B) $16,000,000.
C) $18,000,000.
D) $20,000,000.
Answer: B
Rationale:
Cash collections $18,000,000
Deduct increase in unearned 2,000,000
premiums
Premiums earned $16,000,000