You are on page 1of 19

CSS Accountancy & Auditing Adams Learning Centre, Lahore

Accounting Cycle & Adjusting Entries


Accounting Cycle
Accounting cycle is the financial process starting with recording business transactions and leading up to the preparation
of financial statements. This process demonstrates the purpose of financial accounting to create useful financial
information in the form of general-purpose financial statements. In other words, the sole purpose of recording
transactions and keeping track of expenses and revenues is turn this data into meaning financial information by
presenting it in the form of a balance sheet, income statement, statement of owner's equity, and statement of cash
flows.
The accounting cycle is a set of steps that are repeated in the same order every period. The culmination of these steps
is the preparation of financial statements. Some companies prepare financial statements on a quarterly basis whereas
other companies prepare them annually. This means that quarterly companies complete one entire accounting cycle
every three months while annual companies only complete one accounting cycle per year.

Accounting Cycle Steps


This cycle starts with a business event. Bookkeepers analyze the transaction and record it in the general journal with a
journal entry. The debits and credits from the journal are then posted to the general ledger where an unadjusted trial
balance can be prepared.

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.

1|Page By: Prof. Asif Masood Ahmad


0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

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.

Introduction to Adjusting Entries


Adjusting journal entries are made to update the accounts and bring them to their correct balances.

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.

Purpose of Adjusting Entries


The main purpose of adjusting entries is to update the accounts to conform the accrual concept. At the end of the
accounting period, some income and expenses may have not been recorded, taken up or updated; hence, there is a
need to update the accounts.

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.

Composition of an Adjusting Entry


Adjusting entries affect at least one nominal account and one real account.

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.

Types of Adjusting Entries


Generally, there are 4 types of adjusting entries. Adjusting entries are prepared for the following:

1. Accrued Income income earned but not yet received

2. Accrued Expense expenses incurred but not yet paid

3. Deferred Income income received but not yet earned

4. Prepaid Expense expenses paid but not yet incurred

Also, adjusting entries are made for:

5. Depreciation

6. Doubtful Accounts or Bad Debts, and other allowances

Adjusting Entry for Accrued Revenue


Accrued income (or accrued revenue) refers to income already earned but has not yet been collected. At the end of
every period, accountants should make sure that they are properly included as income.

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:

Mmm dd Receivable account* x,xxx.xx


Income account** x,xxx.xx

*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:

Dec 31 Accounts Receivable 300.00


Service Revenue 300.00
3|Page By: Prof. Asif Masood Ahmad
0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

Here are some more illustrations.

More Examples: Adjusting Entries for Accrued Income


Example 1: Company ABC leases its building space to a tenant. The tenant agreed to pay monthly rental fees of
$2,000 covering a period from the 1st to the 30th or 31st of every month. On December 31, 2014, ABC Company did
not receive the rental fee for December yet and no record was made in the journal.

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:

Dec 31 Rent Receivable 2,000.00


Rent Income 2,000.00

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:

Dec 31 Interest Receivable 75.00


Interest Income 75.00

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.

Adjusting Entry for Accrued Expenses


Accrued expenses refer to expenses that are already incurred but have not yet been paid. At the end of period,
accountants should make sure that they are properly recorded in the books of the company.

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.

If such has not been recognized, then an adjusting entry is necessary.

Pro-Forma Entry
The pro-forma adjusting entry to record an accrued expense is:

mmm dd Expense account* x,xxx.xx


Liability account** x,xxx.xx

*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

4|Page By: Prof. Asif Masood Ahmad


0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

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.

Dec 31 Utilities Expense 1,800.00


Utilities Payable 1,800.00

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.

Here are some more examples.

More Examples: Adjusting Entries for Accrued Expense


Example 1: VIRON Company entered into a rental agreement to use the premises of DON's building. The agreement
states that VIRON will pay monthly rentals of $1,500. The lease started on December 1, 2014. On December 31, the
rent for the month has not yet been paid and no record for rent expense was made.

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:

Dec 31 Rent Expense 1,500.00


Rent Payable 1,500.00

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.

Let's analyze the above transaction.

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:

Dec 31 Interest Expense 300.00


Interest Payable 300.00

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.

Adjusting Entry for Unearned Revenue


Unearned revenue (also known as deferred revenue/income) represents revenue already collected but not yet earned.

Hence, they are also called "advances from customers".

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.

Liability Method of Recording Unearned Revenue


Under the liability method, a liability account is recorded when the amount is collected. The common accounts used
are: Unearned Revenue, Deferred Income, Advances from Customers, etc. For this illustration, let us use Unearned
Revenue.

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:

Jan 10 Cash 30,000.00


Unearned Revenue 30,000.00

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:

Jan 31 Unearned Revenue 6,000.00


Service Income 6,000.00

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.

Income Method of Recording Unearned Revenue


Under the income method, the accountant records the entire collection under an incomeaccount. Using the same
transaction above, the initial entry for the collection would be:

Jan 10 Cash 30,000.00


Service Income 30,000.00

If at the end of the year the company earned 20% of the entire $30,000, then the adjusting entry would be:

Jan 31 Service Income 24,000.00


Unearned Income 24,000.00

6|Page By: Prof. Asif Masood Ahmad


0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

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.

Under the liability method, the initial entry would be:

Dec 1 Cash 60,000.00


Unearned Rent Income 60,000.00

On December 31, 2014, the end of the accounting period, 1/3 of the rent received has already been earned (prorated
over 3 months).

We should then record the income through this adjusting entry:

Dec 31 Unearned Rent Income 20,000.00


Rent Income 20,000.00

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:

Dec 1 Cash 60,000.00


Rent Income 60,000.00

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:

Dec 31 Rent Income 40,000.00


Unearned Rent Income 40,000.00

Conclusion

7|Page By: Prof. Asif Masood Ahmad


0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

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.

Adjusting Entries for Prepaid Expense


Prepaid expenses (a.k.a. prepayments) represent payments made for expenses which have not yet been incurred.

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:

Dec 7 Service Supplies 1,500.00


Cash 1,500.00

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.

8|Page By: Prof. Asif Masood Ahmad


0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

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:

Dec 31 Service Supplies Expense 900.00


Service Supplies 900.00

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:

Dec 7 Service Supplies Expense 1,500.00


Cash 1,500.00

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:

Dec 31 Service Supplies 600.00


Service Supplies Expense 600.00

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.

Under the asset method, the initial entry would be:

Sep 1 Prepaid Insurance 6,000.00


Cash 6,000.00

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:

Dec 31 Insurance Expense 4,000.00


Prepaid Insurance 4,000.00

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).

9|Page By: Prof. Asif Masood Ahmad


0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

If the company made use of the expense method, the initial entry would be:

Sep 1 Insurance Expense 6,000.00


Cash 6,000.00

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:

Dec 31 Prepaid Insurance 2,000.00


Insurance Expense 2,000.00

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.

Adjusting Entry for Depreciation Expense


When a fixed asset is acquired by a company, it is recorded at cost (generally, cost is equal to the purchase price of the
asset). This cost is recognized as an asset and not expense.

The cost is to be allocated as expense to the periods in which the asset is used. This is done by recording depreciation
expense.

There are two types of depreciation physical and functional depreciation.

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.

Understanding the Concept of Depreciation


There are several methods in depreciating fixed assets. The most common and simplest is the straight-line depreciation
method.

10 | P a g e By: Prof. Asif Masood Ahmad


0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

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.

Straight-line depreciation expense is computed using this formula:

Depreciable Cost Residual Value


Estimated Useful Life

Depreciable Cost: Historical or un-depreciated cost of the fixed asset


Residual Value or Scrap Value: Estimated value of the fixed asset at the end of its useful life
Useful Life: Amount of time the fixed asset can be used (in months or years)

In the above example, there is no residual value. Depreciation expense is computed as:

= $40,000 $0
5 years

= $8,000 / year

With Residual Value


What if the delivery van has an estimated residual value of $10,000? The depreciation expense then would be
computed as:

= $40,000 $10,000
5 years

= $30,000
5 years

= $6,000 / year

11 | P a g e By: Prof. Asif Masood Ahmad


0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

How to Record Depreciation Expense


Depreciation is recorded by debiting Depreciation Expense and crediting Accumulated Depreciation. This is recorded at
the end of the period (usually, at the end of every month, quarter, or year).

The entry to record the $6,000 depreciation every year would be:

Dec 31 Depreciation Expense 6,000.00


Accumulated Depreciation 6,000.00

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.

2012 2013 2014 2015 2016


Delivery Van - Historical Cost $40,000 $40,000 $40,000 $40,000 $40,000
Less: Accumulated Depreciation 6,000 12,000 18,000 24,000 30,000
Delivery Van - Carrying Value $34,000 $28,000 $22,000 $16,000 $10,000

Notice that at the end of the useful life of the asset, the carrying value is equal to the residual value.

Depreciation for Acquisitions Made Within the Period


The delivery van in the example above has been acquired at the beginning of 2012, i.e. January. Therefore, it is easy to
calculate for the annual straight-line depreciation. But what if the delivery van was acquired on April 1, 2012?

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.

Years 2013 to 2016 will have $6,000 annual depreciation expense.

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).

12 | P a g e By: Prof. Asif Masood Ahmad


0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

The depreciation expense for 2017 would be: $6,000 x 3/12 = $1,500, and thus completing the accumulated
depreciation of $30,000.

2012 (April to December) $ 4,500


2013 (entire year) 6,000
2014 (entire year) 6,000
2015 (entire year) 6,000
2016 (entire year) 6,000
2017 (January to March) 1,500
Total for 5 years $ 30,000

Adjusting Entry for Bad Debts Expense


Companies provide services or sell goods for cash or on credit. Allowing credit tends to encourage more sales.

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.

Net realizable value for accounts receivable is computed like this:

Accounts Receivable - Gross Amount $ 100,000


Less: Allowance for Bad Debts 3,000
Accounts Receivable - Net Realizable Value $ 97,000

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:

Dec 31 Bad Debts Expense xxx.xx


Allowance for Bad Debts xxx.xx

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.

13 | P a g e By: Prof. Asif Masood Ahmad


0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

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:

Dec 31 Bad Debts Expense 100.00


Allowance for Bad Debts 100.00

Again, you may use Doubtful Accounts. Just be sure to use a logical (and uniform) pair every time. For example:

Dec 31 Doubtful Accounts Expense 100.00


Allowance for Doubtful
100.00
Accounts

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.

Accounts Receivable (Gross Amount) $ 3,400


Less: Allowance for Bad Debts 100
Accounts Receivable - Net Realizable Value $ 3,300

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.

Relevant information for the preparation of adjusting entries of Company A


Office supplies having original cost $4,320 were unused till the end of the period. Office supplies having original cost of
$22,800 are shown on unadjusted trial balance.
Prepaid rent of $36,000 was paid for the months January, February and March.
The equipment costing $80,000 has useful life of 5 years and its estimated salvage value is $14,000. Depreciation is
provided using the straight line depreciation method.
The interest rate on $20,000 note payable is 9%. Accrue the interest for one month.
$3,000 worth of service has been provided to the customer who paid advance amount of $4,000.

The adjusting entries of Company A are:


Date Account Debit Credit
Jan 31 Supplies Expense 18,480
Office Supplies 18,480
Supplies Expense = $22,800 $4,320 = $18,480
Jan 31 Rent Expense 12,000
Prepaid Rent 12,000
Rent Expense = $36,000 3 = $12,000
Jan 31 Depreciation Expense 1,100
Accumulated Depreciation 1,100
Depreciation Expense = ($80,000 $14,000) (5 12) = $1,100
Jan 31 Interest Expense 150
Interest Payable 150
Interest Expense = $20,000 (9% 12) = $150
Jan 31 Unearned Revenue 3,000

14 | P a g e By: Prof. Asif Masood Ahmad


0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

Date Account Debit Credit


Service Revenue 3,000

Adjusted Trial Balance


An adjusted trial balance is prepared after adjusting entries are made and posted to the ledger.

This is the second trial balance prepared in the accounting cycle.

Its purpose is to test the equality between debits and credits after adjusting entries are entered into the books of the
company.

To illustrate how it works, here is a sample unadjusted trial balance:

Gray Electronic Repair Services


Unadjusted Trial Balance
December 31, 2014

Account Title Debit Credit


Cash $ 7,480.00
Accounts Receivable 3,400.00
Service Supplies 1,500.00
Furniture and Fixtures 3,000.00
Service Equipment 16,000.00
Accounts Payable $ 9,000.00
Loans Payable 12,000.00
Mr. Gray, Capital 13,200.00
Mr. Gray, Drawing 7,000.00
Service Revenue 9,550.00
Rent Expense 1,500.00
Salaries Expense 3,500.00
Taxes and Licenses 370.00
Totals $ 43,750.00 $ 43,750.00

At the end of the period, the following adjusting entries were made:

Dec 31 Accounts Receivable 300.00


Service Revenue 300.00

31 Utilities Expense 1,800.00


Utilities Payable 1,800.00

31 Service Supplies Expense 900.00


Service Supplies 900.00

31 Depreciation Expense 720.00


Accumulated Depreciation 720.00

15 | P a g e By: Prof. Asif Masood Ahmad


0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

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.

Adjusted Trial Balance Example


After incorporating the adjustments above, the adjusted trial balance would look like this. Just like in the unadjusted
trial balance, total debits and total credits should be equal.

Gray Electronic Repair Services


Adjusted Trial Balance
December 31, 2014

Account Title Debit Credit


Cash $ 7,480.00
Accounts Receivable 3,700.00
Service Supplies 600.00
Furniture and Fixtures 3,000.00
Service Equipment 16,000.00
Accumulated Depreciation $ 720.00
Accounts Payable 9,000.00
Utilities Payable 1,800.00
Loans Payable 12,000.00
Mr. Gray, Capital 13,200.00
Mr. Gray, Drawing 7,000.00
Service Revenue 9,850.00
Rent Expense 1,500.00
Salaries Expense 3,500.00
Taxes and Licenses 370.00
Utilities Expense 1,800.00
Service Supplies Expense 900.00
Depreciation Expense 720.00
Totals $ 46,570.00 $ 46,570.00

MCQs Practice for the Adjusting Entries


1. Accruals occur when cash flows:
A) Occur before expense recognition.
B) Occur after revenue or expense recognition.
16 | P a g e By: Prof. Asif Masood Ahmad
0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

C) Are uncertain.
D) May be substituted for goods or services.
Answer: B

2. An example of a contra account is:


A) Depreciation expense.
B) Accounts receivable.
C) Sales revenue.
D) Accumulated depreciation.
Answer: D

3. The purpose of closing entries is to transfer:


A) Accounts receivable to retained earnings when an account is fully paid.
B) Balances in temporary accounts to a permanent account.
C) Inventory to cost of goods sold when merchandise is sold.
D) Assets and liabilities when operations are discontinued.
Answer: B

4. Which of the following would not be used as an adjusting entry?


A) Prepaid Rent
Rent expense
B) Cash
Unearned revenue
C) Interest expense
Interest payable
D) Bad debt expense
Allowance for doubtful accounts
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?

A) Insurance expense 875


Prepaid insurance 875
B) Prepaid insurance 875
Insurance expense 875
C) Insurance expense 875
Prepaid insurance 3,325
Insurance payable 4,200
D) Prepaid insurance 3,325
Insurance expense 3,325
Answer: D

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

Rationale: Amount accrued: $32,000 x 7/10 = $22,400

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

Rationale: Allowance for Uncollectible


940 12/31/02
Write-Offs Bal.
? record BD
820 Exp.
1,140 12/31/03
Bal.

18 | P a g e By: Prof. Asif Masood Ahmad


0321 9842495
CSS Accountancy & Auditing Adams Learning Centre, Lahore

Bad debt expense = $1,140 + 820 - 940 = $1,020

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

19 | P a g e By: Prof. Asif Masood Ahmad


0321 9842495

You might also like