Fse2200 -ACCOUNTING CH 4

Recording Adjusting, Closing, and Reversing Entries

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Adjusting Entries

• Business transactions that have been recorded represent activities that affect the accounting period in which they are recorded.

• There may be transactions, however, that will not only affect the current period, but possible a prior or future period. In order for the ledger accounts to properly reflect the activities for the current accounting period it may be necessary for the accountant to prepare adjusting entries

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Adjusting Entries

• Adjusting Entry• Journal entries that are recorded in order to properly reflect

the appropriate balances in the various ledger accounts for a specific accounting period.

• Usually prepared at the end of the accounting period, they could be prepared at any time it is appropriate to do so.

• We will assume these will be done at the end of an accounting period

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Types of Adjusting Entries

• Two types• Accruals

• Deferrals

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Accrual Basis

• Most businesses use this

• Assumes that revenue is recognized when earned, regardless of when the revenue is actually received in the form of cash and that expenses are recognized when incurred regardless of when payment is actually made.

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Accrual Basis

• Known as the Principle of Matching Costs and Revenue

• Individuals are on a Cash Basis• Revenue is recognized when received and expenses are

recognized when paid.

• We will assume that all businesses are on an accrual basis, even though there may be times in real life when that is not the case.

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Accruals

• Accrual means to accumulate

• It is necessary to recognize that although things may have been accumulated, they may not have been recognized.

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Accrued Expenses

• Expense items have been incurrent but have not necessarily been recorded either because the business is not obligated to pay the expense yet or has failed to do so.

• When this occurs, it is necessary to record an adjusting entry.

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Accrued Expenses

• Rent Example:• Rent for December isn’t paid for by December 31.

• Debit Rent Expense

• Credit Rent Payable

• This allows us to recognize an expense that was incurred during the accounting period even though the actual expense will not be paid until the next accounting period.

• The Principle of Matching Costs and Revenues has been met.

• In the new year when it is paid• Debit Rent Payable

• Credit Cash

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Accrued Expenses

• Supplies Example

• Current Asset is one that will be used up or converted to cash within a year or less.

• If an accountant takes a physical count at the end of an accounting period, this count will probably represent a dollar cost assigned to the supplies that is less than the value as stated in the ledger account due to use.

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Accrued Expenses

• A supply that is used up is considered to have become an expense.

• It becomes necessary to recognize this expense on the books• Debit Supplies Expense

• Credit Supplies

• This allows you to show the true value of supplies on hand

• These are examples of Unrecorded Expenses that are adjusted at the end of an accounting period.

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Accrued Expenses

• Any current asset that is subject to use and thus becomes an expense is treated in the same manner.

• When an expense has been incurred, but not yet paid, it is treated in a similar fashion. • It may be necessary to set up a liability account if one does not

already exist

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EXERCISE 1• Record the appropriate

adjusting journal entries for the following situations. Assume that the accounting period ends on Dec. 31, 2008 and all entries are made of that date.

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EXERCISE 1• 1. A physical count of

office supplies indicates that $250 worth of office supplies had been used up during the accounting period

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EXERCISE 1• 2. Rent totaling $800 for

the months of November and December has not been paid by December 31, 2008.

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EXERCISE 1• 3. You received a bill for

advertisements placed in the newspaper during the second week of November. The bill is for $200, not to be paid until January 15, 2009.

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EXERCISE 1• 4. You borrowed $1,000

from First City Bank. Interest is at 10% on the obligation and not to be repaid for 90 days. Record the adjusting entry to recognize the interest expense on the loan from Dec. 1 to Dec. 31, 2008

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EXERCISE 1• 5. On July 1, 2008 you

took out a fire insurance policy. You recorded this insurance premium in an asset account entitled prepaid insurance for the amount of the yearly premium of $600. On Dec. 31, 2008 record the adjusting entry for this asset. (C

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EXERCISE 1• 6. Salaries are paid on

Fridays for the week ending on the same day. The salaries for the week amounts to $5,000. The last day of the accounting period is Wednesday, Dec. 31, 2008. Record the adjusting entry necessary to recognize the salaries expense for the last three days of they year. Payment will not take place until Jan. 2, 2009.

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Accrued Revenues

• Service is provided but payment is not due from the customer so we record the transaction as a credit sale of services.

• This is how we accrue revenue

• This kind of transaction is not normally considered an adjusting entry as this is how most businesses operate

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Accrued Revenues

• It is important to record the revenue and resulting accounts or note receivable so that we have a record of who owes us money as a result of the credit sale.

• Unrecorded revenue• Accrued revenue that has been accumulated during an

accounting period but whose payment will be receiving in a future accounting period.

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Loan Example

• Customer borrows $1,000 from you on a 90 day promissory note with an annual rate of interest at 8% on December 1, 2008.

• The interest isn’t due until the note is due, but we must record the accrued interest• Debit Interest Receivable

• Credit Interest Income

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Loan Example

• We do not change the Note receivable because the face value of the note has not changed - $1000

• When note becomes due on March 1, 2009 the following entry is made• Debit Cash 1,020.00

• Credit Interest Receivable 6.67

• Credit Interest Income 13,33

• Credit Notes Receivable 1,000

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Loan Example

• If it had become due DURING the same accounting period, no adjusting entry would be necessary.

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Deferrals

• A postponement of the recognition of either an expense or a revenue item.

• Certain transaction may be interpreted differently depending on the accountant, philosophy of the business, as well as the nature of the transaction.

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Example : Rent payment Theories• Theory 1 - Rent payment represents a right to use property

that will be used up at the end of each month, the rent should initially be recorded as an expense

• Theory 2 - Rent payment represents a right to use property and that property has a money value, the rent can be considered a form of an asset. Since rent is usually payable at the beginning of the month and the rights to use the property extend to the end of the month, it is an asset.

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Example – Theory 1

• One year lease was signed and become effective November 1, 200-. Rent is $6,000 and to be paid in two installments of 50% each. First installment is due November 1. The entry made to reflect this is• Debit Rent Expense 3,000

• Credit Cash 3,000

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Example – Theory 1

• The rent payment is for 6 months, but there is only 2 more months left in the accounting period so on December 31, 200- we record• Debit Prepaid Rent Expense 2,000

• Credit Rent Expense 2,000

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Example – Theory 1

• Credit to rent expense reduces the expense to be recognized for the accounting period (postponement). The debit entry converts the expense to an account that is known as a “prepaid expense”• Prepaid Expense

• An expense that was paid in advance

• Since it is paid for, and not used up, it is considered an asset

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Example Theory 2

• This assumes the rent payment was IMMEDIATELY an asset or a prepaid expense

• 200- November 1• Debit Prepaid Rent (Rent) 3,000

• Credit Cash 3,000

• 200- December 31• Debit Rent Expense 1,000

• Credit Prepaid Rent 1,000

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Example Theory 2

• When an expense previously paid has not been fully used up, it is necessary to defer that portion not used and convert it to an asset. • This is usually indicated by the word “Prepaid” in the name

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Unearned Revenue• Revenue received but not earned within the accounting period

and must be deferred.

• You receive a rent check from your tenant on November 1, 2008 for $800 for four months rent beginning with November. The recorded transaction was• Debit Cash 800

• Credit Income from Rental 800

• On December 31 you have the following entry• Debit Income from Rental 400

• Credit Unearned Rental Income 400 (C) 2

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Unearned Revenue

• Deferral of income permits the income to be properly stated and also results in the recognition of a liability for the income received but at this point not earned. • The landlord has an obligation to supply the premises for

January and February.

• During the next accounting period when the income is earned:• Debit Unearned Rental Income 400

• Credit Income from Rent 400

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EXERCISE 2• Record the following

adjusting entries to reflect the accrual and deferral of expenses and revenue for the calendar year ending December 31 of the current year.

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EXERCISE 2• 1. Recognized the

interest income accumulated on a $5,000 note bearing interest of 9% dated November 2.

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EXERCISE 2• 2. Recorded an

adjusting entry to recognize that the income from commissions previously received by not yet earned to the extent of 40% of the $800 commission.

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EXERCISE 2• 3. Determined that the

balance in the ledger account for office supplies was $990, but that an inventory showed only $260 worth of office supplies remaining.

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EXERCISE 2• 4. Accrued Salaries for

the last three days in the old year amounting to $1,500.

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EXERCISE 2• 5. Showed a balance of

$2,270 in the prepaid insurance account. Insurance records indicate that $1,245 of the insurance expired during the year.

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EXERCISE 2• 6. Borrowed $6,000 for

90 days with interest payable at an annual rate of 12%. Loan was taken out 45 days before the end of the accounting period and is due to be paid in full forty five days into the new year.

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Adjusting Noncurrent Assets

• Noncurrent, or plant, assets are subject to a loss in value due to the item being used.

• The loss in value of plant assets is not obvious because the asset still exists in its complete form at the end of the accounting period.

• Depreciation• The loss of value due to use of a plant asset due to wear and

tear over its useful life.

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Adjusting Noncurrent Assets

• When depreciation is recognized as an adjusting entry at the end of the accounting period, an expense is charged.

• Since the expense does NOT represent an actual outlay of cash, and the cost principle prevents us from reducing the value of the asset directly, it becomes necessary to credit a new account called “Accumulated Depreciation”.

• The purpose of this account is merely to offset the plant asset account• The net, or book value, of the plant asset will be determined

by subtracting the accumulated depreciation account from the value of the plant asset.

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Straight Line depreciation

• Most common form used

• Value of asset is divided by its useful life to determine the amount of depreciation annually

• Example:• A truck costs $20,000. Expected life is 10 years and then it will

have no value.

• 20,000 / 10 = 2,000 a year depreciation.

• To find a value for a specific month, divide the yearly amount by 12. (C

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Straight Line depreciation

• If a plant asset is to have a residual value (scrap value) at the end of its life that must be subtracted from the usable amount.

• Let’s assume the $20,000 truck has a scrap value of $1,000 after 10 years of use. • (20,000 – 1,000) / 10 = 1,900 a year depreciation

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EXERCISE 3

• Office equipment was purchased at a cost of $3,400. It has an expected useful life of 6 years and after it has been fully depreciated, it will have a scrap value of $400.

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EXERCISE 3

• 1. How much of the asset is subject to depreciation?

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EXERCISE 3

• 2. What will be the annual depreciation recognized?

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EXERCISE 3

• 3. Assuming that the asset was acquired at the beginning of the year, record the adjusting entry to recognize depreciation for the first full year.

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EXERCISE 3

• 4. Determine the book value of the asset after the first year’s adjusting entry.

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EXERCISE 3

• 5. What is the book value of the asset after it has been depreciated for six years?

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EXERCISE 3

• 6. What happens to the book value for the asset during each year of its useful life? Why?

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EXERCISE 3

• 7. When recording annual depreciation, why doesn’t the accountant credit the asset account directly?

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Recording Adjusting Entries

• To expedite the preparation of financial statements and the preparation of adjustments prior to statement preparation the worksheet is prepared.

• The trial balance is prepared and becomes the backbone of the worksheet.

• A worksheet can be defined as an expanded trial balance.

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Recording Adjusting Entries

• Worksheet is only used/viewed by the accountant.

• Form consists of a column to list the accounts from the ledger followed by eight money columns.

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Recording Adjusting Entries

• Preparation of the worksheet precedes the recording of adjusting entries.• Trial balance is prepared on the worksheet

• Necessary adjusting entries are recorded on the worksheet using the adjustments column

• Information is extended along with the trial balance info to the remaining two sets of the worksheet columns (Income Statement and Balance Sheet)

• Assets, liabilities, permanent capital, and proprietor’s drawing account are extended from the trial balance columns through the adjustments column and recorded to the appropriate income statement columns

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Recording Adjusting Entries

• Function of the adjustments column is to adjust the valances in the ledger accounts to match costs and revenue for the specific accounting period covered.

• No journal entries or relating postings are made at this time, although these adjusting entries made on the worksheet will later become the basis for recording adjusted journal entries and related postings at the end of the accounting period.

• If the accountant is preparing interim statements, no adjusting journal entries or postings would be made.

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EXERCISE 4

• Record, in journal form, the following adjusted entries using the information provided in the worksheet previously presented (C

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EXERCISE 4

• A. Depreciation for the year amounting to $500.

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EXERCISE 4

• B. Daily payroll amounts to $130. Record adjusting entry to recognize the accrual of salaries for four days.

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EXERCISE 4

• C. Included in the rental income account is income received by not yet earned amounting to $1,200

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EXERCISE 4

• D. Supplies recognized as an expense amounting to $600 have not been used up during the current accounting period. Make the necessary adjustment.

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EXERCISE 4• 1. Record the journalized entries to the adjustment columns

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EXERCISE 4• 2. Total Both columns to verify the agreement

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EXERCISE 4• 3. Extend the trial balance amounts through the adjustment

columns of either the income statement or the balance sheet.

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EXERCISE 4• 4. Summarize the last four columns. Difference Should be the

same

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EXERCISE 4• 5. Show the difference in the amounts in the column with the

smaller total then double underscore the two amounts in each set of columns that now agree.

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EXERCISE 4• 6. Compare your worksheet against this master.

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How to Record Adjusting Entries on the worksheet• Trial balance only contains those accounts that have

balances

• When adjusting are recorded to the worksheet where accounts are needed then the needed account is added below the trial balance. • Letters are used to relate debit adjustments to corresponding

credits

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How to Record Adjusting Entries on the worksheet• Once the adjustments have been recorded, foot the

adjustments column then double underscore the values.

• Accounts not having adjustments are just extended.

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How to Record Adjusting Entries on the worksheet• Assets and proprietor’s drawing account are extended to

the debit column of the balance sheet.

• Liabilities and proprietor’s capital are extended to the credit column of the balance sheet.

• Revenue and expense accounts that were not adjust are extended to the credit and debit columns respectively

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How to Record Adjusting Entries on the worksheet• Extensions of the accounts that were affected by the

adjustments are treated according to the specific adjustment. Accounts that had no modification are extended.

• Following the extensions of the trial balance and adjustments the four remaining columns are footed. Results of the footing cause 4 different totals• This is a result of the net profit / net loss.

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Using the completed worksheet• If the accountant has been asked to prepare interim

financial statements, information is pulled from the worksheet. • Do not post adjusting entries for interim statements

• Financial Statement preparation is greatly expedited by the preparation of the worksheet.

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Using the completed worksheet• Actual adjustments can take place at any future time

without holding up the interim statements.

• Columns provide the information for the respective documents (statement of income, balance sheet, etc.)

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EXERCISE 5

• Due to the extensiveness of this example it will not be covered in class – please take the time to do this on your own.

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Chart of Accounts

• In organizing a ledger there will be a chart of accounts, which is comparable to a table of contents.

• Purpose of the chart of accounts is to provide the user of the ledger with a means of determining the accounts found in the ledger and their location within the ledger.

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Chart of Accounts

• The organization of the chart of accounts follows the accounting equation format very closely listing assets first, liabilities second, and capital third. • There is also numbering of accounts 100 series, 200 series, 300

series depending on type of account.

• Although numbers may be used, sequential numbering within a series is not necessary (301, 302, 305, 310, 322, etc) to allow for future expansion.

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Closing Entries

• Temporary accounts are eventually eliminated and the contents transferred to permanent capital. • This is accomplished by preparing a statement of capital.

• This is necessary to prepare financial statements and must be reflected in the various ledger accounts.

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Closing Entry

• Transfers the values of the temporary capital accounts to the proprietor’s permanent capital account. • This is accomplished by the use of a debit or credit to

eliminate the balance and a corresponding entry made in a special temporary account exclusively for that purpose called the Income Summary or Net Earnings Summary

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Closing Entry• The name(closing entry) can change from business to business

or place to place but the process is the same:• All revenue accounts are closed to the income summary account

• All expense accounts are closed to the income summary account

• Proprietor’s drawing account is closed to the income summary account

• Income summary account is closed to the proprietor’s permanent capital account

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Closing Entry

• After closing entries have been journalized and posted, the only accounts that will have balances will be the permanent accounts• The temporary accounts will still be in the ledger but will have

no balance (or a zero balance).

• These closing entries ONLY take place at the end of the accounting period when the ledger is closed. The ledger will be reopened in a new accounting period with the proper balances ready to start again.

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EXERCISE 6

• Exercise 6 is mostly dependent on Exercise 5, however we will look at the postings to the journal and the closing entries.

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EXERCISE 6

• A. Analysis indicates there is a balance in the insurance account of $400. Trial Balance indicates $600. (write off $200)

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EXERCISE 6

• B. Supplies used during the year amounts to $175.

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EXERCISE 6

• C. Depreciation expense on the furniture amounted to $500 for the year.

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EXERCISE 6

• D. Of the service revenue recorded, it has been determined that $400 has not been earned for the year.

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EXERCISE 6

• E. Salaries earned but not paid for the last week in the fiscal year amounted to $300.

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EXERCISE 6

• F. Interest expense incurred but not yet paid on a promissory note amounted to $40.

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EXERCISE 6

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• Post Closing Entries using the worksheet from Exercise 5.

EXERCISE 6

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• Posting revenue to income summary account.

EXERCISE 6

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• Posting Expenses to Income Summary

EXERCISE 6

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• Posting Owner’s drawing account to Income Summary

EXERCISE 6

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• Posting the net income / net loss to the owner’s capital account.

Post Closing Trial Balance

• The adjusting and closing process has a dramatic effect on the ledger in that the trial balance prepared to verify the ledger was in balance is no longer valid.

• It becomes necessary to prove the ledger is still in balance so the accountant will prepare another trial balance that is called the Post Closing Trial Balance• These accounts reflect the adjusting entries that have been

made and its temporary accounts no longer have balances.

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Post Closing Trial Balance

• The successful completion of the post closing trial balance will prove that the ledger is in balance at the end of the accounting period.

• Prior to recording ANY business transactions for the new accounting period, this post closing trial balance must be prepared.

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EXERCISE 7

• Prepare a post closing trial balance for the Beldon Service Company

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EXERCISE 7

• Cash does not have any adjustment – as there is nothing to adjust regarding cash on hand.

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EXERCISE 7

• Accounts receivable will not change as the total amounts are still due.

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EXERCISE 7

• Prepaid insurance showed the amount used up ($200).

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EXERCISE 7

• Supplies needed to be adjusted for those supplies on hand.

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EXERCISE 7

• Furniture face value does not change as we cannot change the beginning value of the asset.

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EXERCISE 7

• We reflect the loss of value of an asset through the use of the accumulated depreciation account.

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EXERCISE 7

• We then extend out the new accounts used after adjusting and prove that the adjustments are accurate and that the temporary accounts have been closed out

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Steps in the Accounting Cycle• Journalize daily business transactions

• Post to the various ledger account

• Prepare trial balance monthly

• Prepare worksheet with necessary adjusting entries at the end of the accounting period

• Prepare financial statements

• Journalize and post adjusting entries

• Journalize and post closing entries

• Prepare a post closing trial balance. (C) 2

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Reversing Entries

• The process of recording adjusting entries creates certain ledger accounts that are not normally recorded in the accounting period.• An example of this is salaries payable

• While salaries payable is listed on chart of accounts and an page for it will be found in the ledger, no entries are normally made in this account during the year with the exception of the adjusting entry just illustrated.

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Reversing Entries

• The payroll clerk in charge of preparing the payroll at the end of the week is familiar with the basic procedure of recording the salaries expense and reducing the amount of cash.

• As a result of closing the ledger at the end of the accounting period salaries expense will have a zero balance going into the new accounting period. We recognize that salaries payable will appear on the post closing trial balance and will have a balance at the beginning of the new accounting period. We must then reverse it as the first day of the new accounting period to put it back in the Salaries Expense.

• A Reversing entry is the exact opposite of an adjusting entry.

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When to use reversing entries

• A reversing entry is required whenever an adjusting entry results in the establishment of an account on the books that normally does not carry a balance during the year.

• It must take place on the first day of the new accounting period and will be the exact reverse of the adjusting entry.

• Process• Record Adjusting entry

• Record the closing entry necessary based on the information provided

• Record the reversal entry

• It is not mandatory to use reversing entries but it IS advisable.

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EXERCISE 8

• 1. Salaries amounted to $3,500. For the week ending January 4, record the adjusting entry needed for the old year.

• (1 day is $700 and we are computing Dec. 31 to Jan. 1)

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EXERCISE 8

• 2. Office supplies balance is $530, Inventory is at $160.

• ($530-$160=$370)

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EXERCISE 8

• 3. Insurance expense has a balance of $1,350. An analysis shows $450 in unexpired premiums remain.

• (Nothing to add or subtract – they stated what the balance remaining to be used is)

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EXERCISE 8

• 4. You sign a new lease with a tenant that requires that the tenant pay up front for 6 months at $100 a month which began in November.

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EXERCISE 8

• For 1. we need to recognize the reversing entry for the salary.

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EXERCISE 8

• For 3 we have to recognize the amount remaining on the insurance.

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EXERCISE 8

• For 4 we have to recognize the remaining amount on the prepaid rent.

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EXERCISE 8

• Notice the date on all these transactions

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