5.1 The Need for Adjusting Entries
At the end of this section, students should be able to meet the following objectives:
- Explain the purpose and necessity of adjusting entries.
- List examples of several typical accounts that require adjusting entries.
- Provide examples of adjusting entries for various accrued expenses.
Accounting for the Passage of Time
Question: The first two steps of the accounting process were identified in Chapter 4 "How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?" as “analyze” and “record.” A transaction occurs and the resulting financial effects are ascertained through careful analysis. Once determined, the monetary impact on specific accounts is recorded in the form of a journal entry. Each of the debits and credits is then posted to the corresponding T-accounts located in the ledger. As needed, current balances can be determined for any of these accounts by netting the debits and credits. It is a system as old as the painting of the Mona Lisa.
The third step in this process was listed as “adjust.” Why do ledger account balances require adjustment? Why are the T-account totals found in the trial balance at the end of Chapter 4 "How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?" (Figure 4.21 "Lawndale Company Trial Balance (after all journal entries have been posted)—December 31, Year Four") not simply used by the accountant to produce Year Four financial statements for that business (Lawndale Company)?
Answer: Financial events take place throughout the year. As indicated, journal entries record the individual debit and credit effects that are then entered into the proper T-accounts. However, not all changes in these balances occur as the result of physical events. Some accounts increase or decrease because of the passage of time. The impact can be so gradual that producing individual journal entries is not reasonable.
For example, salary is earned by employees every day (actually every minute), but payment is not made until the end of the week or month. Many other expenses, such as utilities, rent, and interest, are incurred over time in much the same way. Accounting for supplies such as pens and envelopes is only slightly different. This asset is slowly depleted because of usage rather than time, but the impact on accounts is basically the same. As indicated in Chapter 4 "How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?", unless an accounting system is programmed to record tiny incremental changes, none of these financial effects is captured as they occur.
Following each day of work, few companies take the trouble to record the equivalent amount of salary, rent, or other expense along with the related liability. When a pad of paper is consumed within an organization, debiting supplies expense for a dollar and crediting supplies for the same amount hardly seems worth the effort.
Therefore, prior to producing financial statements, the accountant must search for any such changes that have not yet been recognized. These incremental increases or decreases must also be recorded in a debit and credit format (called adjusting entriesChanges in account balances recorded prior to preparing financial statements to update T-accounts because some amounts have increased or decreased over time but have not been recorded through a journal entry. rather than journal entries) with the impact then posted to the appropriate ledger accounts. The updating process continues until all balances are presented fairly. These adjustments are a prerequisite step in the preparation of financial statements. They are physically identical to the journal entries recorded for transactions, but they occur at a different time and for a different reason.
On Monday morning, a company hires a person and promises to pay $300 per day for working Monday through Friday. The first payment of $1,500 is made at the end of the workday on Friday. The person quits on Saturday. Which of the following statements is true?
- An adjusting entry is needed when the person is hired if financial statements are prepared at that time.
- An adjusting entry is needed at the end of work on Monday if financial statements are prepared at that time.
- An adjusting entry is needed at the end of work on Friday when payment is made if financial statements are prepared at that time.
- An adjusting entry is needed on Saturday when the person quits if financial statements are prepared at that time.
The correct answer is choice b: An adjusting entry is needed at the end of work on Monday if financial statements are prepared at that time.
When financial statements are prepared, adjusting entries recognize changes created by the passage of time. Hiring an employee creates no change; money has not been earned. Payment is an actual transaction recorded by a journal entry. The person quitting requires no entry because further work was not done after Friday’s payment. When an employee works on Monday, salary is owed for that day. The amount is probably not recorded by the accounting system, so an adjusting entry is needed.
Examples of Adjusting Entries
Question: Adjusting entries update ledger accounts for any financial changes that occur gradually over time so that they are not recorded through a journal entry. Large companies will make hundreds, if not thousands, of adjustments at the end of each fiscal period. What kinds of adjustments are normally needed before a set of financial statements is prepared?
Answer: A variety of adjusting entries will be examined throughout the remainder of this textbook. One of the accountant’s primary responsibilities is the careful study of all financial information to ensure that it is presented fairly before being released. Such investigation can lead to the preparation of numerous adjusting entries. Here, in Chapter 5 "Why Is Financial Information Adjusted Prior to the Production of Financial Statements?", only the following four general types of adjustments are introduced to demonstrate the process and also reflect the importance of the revenue recognition principle and the matching principle. In later chapters, additional examples will be described and analyzed.
- Accrued expenses (also referred to as accrued liabilities)
- Prepaid expenses (including supplies)
- Accrued revenue
- Unearned revenue (also referred to as deferred revenue)
Usually, at the start of the adjustment process, the accountant prepares an updated trial balance to provide a visual, organized representation of all ledger account balances. This listing aids the accountant in spotting figures that might need adjusting in order to be fairly presented. Therefore, Figure 4.21 "Lawndale Company Trial Balance (after all journal entries have been posted)—December 31, Year Four" is replicated here in Figure 5.1 "Updated Trial Balance for the Lawndale Company" because this trial balance holds the December 31, Year Four, account balances for the Lawndale Company determined at the end of Chapter 4 "How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?". All transactions have been recorded and posted, but no adjustments have yet been made.
Figure 5.1 Updated Trial Balance for the Lawndale Company
Adjusting Entry to Recognize an Accrued Expense
Question: The first type of adjustment listed is an accrued expenseExpenses (and related liabilities) that grow gradually over time; if not recognized automatically by the accounting system, the monetary impact is recorded prior to preparing the company’s financial statements by means of an adjusting entry.. Previously, the word “accrue” was defined as “to grow.” Thus, an accrued expense is one that increases gradually over time. As has been indicated, some companies program their accounting systems to record such expenses as incurred. This accrual process eliminates the need for subsequent adjusting entries. Other companies make few, if any, accruals and update all balances through numerous adjustments when financial statements are to be prepared.
The mechanical recording process for such expenses should be designed to meet the informational needs of company officials. Some prefer to have updated balances readily available in the ledger at all times while others are inclined to wait for periodic financial reports to be issued. What are some typical accrued expenses, and what is the appropriate adjusting entry if they are not recorded as incurred by the accounting system?
Answer: If a reporting company’s accounting system recognizes an expense as it grows, no adjustment is necessary. The balances are recorded properly. They are ready to be included in financial statements. Thus, when statements are prepared, the accountant only needs to search for accrued expenses that have not yet been recognized.
Numerous expenses get slightly larger each day until paid, including salary, rent, insurance, utilities, interest, advertising, income taxes, and the like. For example, on its December 31, 2010, balance sheet, The Hershey Company reported accrued liabilities of approximately $593 million. In the notes to the financial statements, this amount was explained as debts owed by the company on that day for payroll, compensation and benefits ($219 million), advertising and promotion ($211 million), and other accrued expenses ($163 million).
Assume, for illustration purposes, that the accountant reviews the trial balance presented in Figure 5.1 "Updated Trial Balance for the Lawndale Company" and realizes that utility expenses (such as electricity and water) have not been recorded since the most recent payment early in December of Year Four. Assume that Lawndale Company currently owes $900 for those utilities. The following adjustment is needed before financial statements can be created. It is an adjusting entry because no physical event took place. This liability simply grew over time and has not yet been paid.
Figure 5.2 Adjusting Entry 1: Amount Owed for Utilities
A company owes its employees $7,300 at the end of Year One, which it pays on January 8, Year Two. This balance was not accrued by the company’s accounting system in Year One, nor was it recorded as an adjusting entry on December 31, Year One. Which of the following is not true for the Year One financial statements?
- Reported expenses are too low by $7,300.
- Reported net income is too high by $7,300.
- Reported total assets are too high by $7,300.
- Reported total liabilities are too low by $7,300.
The correct answer is choice c: Reported total assets are too high by $7,300.
Neither the expense nor the payable was recorded in Year One, and those reported balances are too low. Because the expense was too low, reported net income will be overstated by $7,300. This accrual does not impact an asset until paid in Year Two. Therefore, the Year One asset balance is properly stated.
Adjusting entries are often necessary to update account balances before financial statements can be prepared. These adjustments are not the result of physical events or transactions but are caused by the passage of time or small changes in account balances. The accountant examines all current account balances as listed in the trial balance to identify amounts that need to be changed prior to the preparation of financial statements. Although numerous adjustments are studied in this textbook, four general types are especially common: accrued expenses, prepaid expenses, accrued revenues, and unearned revenues. Any expense (such as salary, interest, or rent) that grows gradually over time but has not yet been paid is known as an accrued expense (or accrued liability). If not automatically recorded by the accounting system as incurred, the amount due must be entered into the records by adjustment prior to producing financial statements.