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
18,48
Jan 31 Supplies Expense
0
Office Supplies 18,480
Supplies Expense = $22,800 − $4,320 = $18,480
12,00
Jan 31 Rent Expense
0
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
Service Revenue 3,000
Adjusting Entries
Home » Accounting Cycle » Adjusting Entries
What are Adjusting Journal Entries (AJE)?
Adjusting entries, also called adjusting journal entries, are journal entries made
at the end of a period to correct accounts before the financial statements are
prepared. This is the fourth step in the accounting cycle. Adjusting entries are
most commonly used in accordance with the matching principle to match
revenue and expenses in the period in which they occur.
Types of Adjusting Entries
There are three different types of adjusting journal entries as follows:
1. Prepayments
2. Accruals
3. Non-cash expenses
Each one of these entries adjusts income or expenses to match the current
period usage. This concept is based on the time period principle which states
that accounting records and activities can be divided into separate time
periods.
In other words, we are dividing income and expenses into the amounts that
were used in the current period and deferring the amounts that are going to be
used in future periods.
Why are Adjusting Entries Necessary?
What Does an Adjusting Journal Entry Record?
Here are the main financial transactions that adjusting journal entries are used
to record at the end of a period.
Prepaid expenses or unearned revenues – Prepaid expenses are goods or
services that have been paid for by a company but have not been consumed
yet. Insurance is a good example of a prepaid expense. Insurance is usually
prepaid at least six months. This means the company pays for the insurance
but doesn’t actually get the full benefit of the insurance contract until the end
of the six-month period. This transaction is recorded as a prepayment until the
expenses are incurred. The same is true at the end of an accounting period.
Only expenses that are incurred are recorded, the rest are booked as prepaid
expenses.
Unearned revenues are also recorded because these consist of income
received from customers, but no goods or services have been provided to
them. In this sense, the company owes the customers a good or service and
must record the liability in the current period until the goods or services are
provided.
Accrued expenses and accrued revenues – Many times companies will
incur expenses but won’t have to pay for them until the next month. Utility bills
are a good example. December’s electric bill is always due in January. Since
the expense was incurred in December, it must be recorded in December
regardless of whether it was paid or not. In this sense, the expense is accrued
or shown as a liability in December until it is paid.
Non-cash expenses – Adjusting journal entries are also used to record paper
expenses like depreciation, amortization, and depletion. These expenses are
often recorded at the end of period because they are usually calculated on a
period basis. For example, depreciation is usually calculated on an annual
basis. Thus, it is recorded at the end of the year. This also relates to the
matching principle where the assets are used during the year and written off
after they are used.
How to Record Adjusting Entries
Recording AJEs is quite simple. Here are the three main steps to record an
adjusting journal entry:
1. Determine current account balance
2. Determine what current balance should be
3. Record adjusting entry
These adjustments are then made in journals and carried over to the account
ledgers and accounting worksheet in the next accounting cycle step.
Example
Following our year-end example of Paul’s Guitar Shop, Inc., we can see that
his unadjusted trial balance needs to be adjusted for the following events.
— Paul pays his $1,000 January rent in December.
— Paul’s December electric bill was $200 and is due January 15th.
— Paul’s leasehold improvement depreciation is $2,000 for the year.
— On December 31, a customer prepays Paul for guitar lessons for the next 6
months.
— Paul’s employee works half a pay period, so Paul accrues $500 of wages.
