Recordingjournal entries as transactions occur and posting them to the general ledger are rou- tine accounting tasks. When a company gets ready to prepare financial statements at the end of the accounting period, there are more journal entries needed. These are not routine journal
L.O-3
ldentify the adjustments needed before preparing financial statements and make those adjustments.
EXHIBIT 8.5
Clint's Consulting Company, Inc. T-Accounts Cash (asset)
Cash (asset)
Supplies (asset)
Notes payable Qiability) 400
500 350 4,150
600 1-1 2,000
1-2 4,000 1-5 9,000
Common stock (shareholder's equity)
1-3 4oo I
Consulting fees (revenue)
r-7 4,ooo I a,ooo L-2
Advertising expense (expense) l-3
1 l
1-6 t-7 1-8
I r-4
| 2,000 l-1
Dividends (shareholder's equity
temporary account)
I n,ooo l-b
Interest expense (expense)
5oo I
Salary errpense (expense)
1-8 600 | r-7 150 | 1-6 350 |
5 8 4 A P P E N D I X B . T H E M E C H A N I C S O F A N A C C O U N T I N G S Y S T E M
E X H I B I T 8 . 5
Account
Advertising expense... 500
Interest expense 150
Salary expense. ... 350
$11.000 DR CR
C l i n t ' s C o n s u l t i n g C o m p a n y , In c . U n a d j u s t e d T r i a l B a l a n c e a t
D e c e m b e r 3 1 , 2 0 0 6
$11.000
entries; they are called adjusting joumal entries. As we discussed in Chapter 3, there are four situations that require adjustments before the financial statements are prepared. We need to a-djust our records for accrued revenues, accrued expenses, deferred revenues, and deferred expenses. Let's look at an example of each of those adjustments in a general ledger system' Accruals. Accrued Revenue. Suppose Clint's Consulting Company did some consult- ing for a fee of $3,000, but the company has not billed the client yet so the revenue has not been recognized-when it is recognized, it is put on the income statement. At December 31, Clint will adjust the company's records to recognize this revenue, even though he has not collected the cash. First, notice the effect ofthe adjustment on the accounting equation.
Assets Liabilities + Contributed capital(CC) + Retained earnings +3,000 Accounts
receivable + 3 , 0 0 0 C o n s u l t i n g f e e s The transaction increases assets-accounts receivable (AR). That means Clint would debit AR, because assets are increased with debits. Clint has also increased a revenue ac- count, consulting fees. (The $3,000 is recorded in a revenue account, not directly into the retained earnings account. However, the revenue will end up increasing retained earnings on our balance sheet.) Revenue accounts increase with credits, so we would credit the revenue account consulting fees for $3,000' The accounting equation is inbalance and debits : credits for our transaction. Here's what the journal entry would look like:
Transaction Debit Credit
Date
12t31t06 Accounts receivable Consulting fees
3,000
3,000 A - 1 To accrue revenue earned in 2006
Accrued Expenses Another situation that requires an adjustment is accrued expenses. If we have incurred an expense (the dollar amount that will be paid for an item or a service that has already been used to produce revenue), the matching principle requires us to put the expenses on the same income statement as the revenue it helped generate.
Sometimes matching an expense with a specific revenue is impossible to do. In that case, we record the expense in the time period when the expense item was used. For exam- ple, it is often impossible to match an employee's work with specific revenue the company earns. So the cost of the work done by an employee is put on the income statement as an expense in the accounting period when the work was done.
Let's look at an example of recording salary expense in the period in which the work was done. When companies pay their employees-on normal paydays during the year- they debit the account salary expense and credit the account cash. The salary expense ac- count may have a significant balance at year-end because the company has been recording salary expense as the employees have been paid throughout the year. To make sure we've
A P P E N D I X B . T H E A C C O U N T I N G C Y C L E included all the salary expense for the year, we must examine the time our employees have
worked near the end of the year. The purpose is to be sure to include the cost of all wotk done during a year in the salary expense on that year's income statement.
If we owe employees for work done in December 2006 but we will not pay them until January 2007, we have to accrue salary expense when we are adjusting our accounts at December 31,2006. Suppose Clint's owes its employee $50 for work done in2o06, but the next payday is in 2ff)7. To get this salary expense on the income statement for the year, Clint must debit salary expense for $50 and credit salaries payable for $50. The salary expense on the income statement for the year ended December 31, 2006 will now include this $50. Salaries payable on the balance sheet at December 3l,2006 will show the $50 obligation. Look at the adjustment in the accounting equation, and then look at the joumal entry. Notice that in the ad- justing entry, just like in a routine journal entry, debits : credits. The accounting equation re- mains in balance.
Assets Liabilities Retained earnings
s85
+ 5 0 S a l a r i e s p a y a b l e (50) Salary expense
Date Transaction Debit Credit
12t31106 Salary expense
S a l a r i e s p a y a b l e
50 To accrue salary expense at year-end
50 A-2 Suppose a company owes employees $300 on December 31,2007, the date of the financial statements; and the next payday is January 3, 2008. Give the ad- justing journal entry necessary on December 31,2007. How much salary expense willthe company recognize when it actually pays the $300 to the employees on January 3, 2OO8? Give the iournal entry for the payment on January 3, 2008.
Deferrals. Deferred Revenue Deferred revenue is revenue that hasn't been earned yet, so it is recorded as a liability in a company's leselds-4n obligation-when the cash is col- lected. Because cash has been collected, it must be recorded; but the goods or services have not yet been provided. The company must defer-put off-recognizing the revenue. When the cash is received, the company increases cash and increases a liability called unearned revenue. In a general ledger system, the amount of cash received is recorded in the cash ac- count, where it is shown as a debit-that's an increase because assets are increased with debits. The journal entry is balanced with a credit to unearned revenue-that's an increase because liabilities are increased with credits.
Suppose Clint had received $4,000 on May 1 for consulting services to be provided over the next 16 months. This is how the receipt of the $4,000 cash for services to be pro- vided in the future affects the accounting equation, followed by the journal entry for the re- ceipt ofthe $4.000 cash.
Liabilities Retained earnings
Your Turn B-2 WMm-ww'" ffi,ww-m'w
cc
+4,000 cash +4,000
U n e a r n e d c o n s u l t i n g f e e s
Date Transaction Debit Credit
511106 Cash 4,000
U n e a r n e d c o n s u l t i n g f e e s To record the receipt of cash for services to be provided
4,000 1-9
585 A P P E N D I X B . T H E M E C H A N I C S O F A N A C C O U N T I N G S Y S T E M
Notice that this is not an adjusting entry; it's a regular journal entry-made when it oc- curs during the year-to record the receipt of cash. When we look at the T-accounts again, we'll see it posted with the transactions we posted previously.
Whenever a company has recorded unearned revenue during the year, an adjustment will be necessary at year-end to recognize the portion ofthe revenue that has been earned during the time between when the cash was received and year-end. If, on that basis, any of the unearned revenue becomes earned revenue by year-end, the unearned revenue account will be decreased and the revenue account will be increased with an adjustment. In terms of debits and credits, the unearned revenue account, which is a liability, will be decreased with a debit. In Clint's case, the credit corresponding to that debit will go to consulting fees, which means that the earned revenue will now show up on the income statement with the other consulting fees Clint has earned during the year. This adjustment is necessary to be sure all the earned revenue for the year is recognized-meaning, put on the income state- ment. Suppose Clint had earned half of the unearned revenue at year-end. The adjustment in the accounting equation and the corresponding journal entry for this adjustment follow:
Assets Liabilities cc Retained earnings
(2,000) Unearned consulting fees
+2,000 Consulting fees
Date Transaction Debit Credit
12131106 2,000
To record earned revenue at year-end
2,000 A-3 Deferred Expenses Deferred expenses may need to be adjusted before the financial state- ments are prepared. Recall, a deferred expense is something the company paid for in ad- vance. One example is supplies, discussed in Chapter 3. Clint paid $400 for supplies during the year, and he recorded them as an asset. At the end of the year, he must determine how many supplies are left and how many he used. He counts the supplies on hand and then sub- tracts that amount from the amount he purchased. Suppose Clint finds that there is $75 worth of supplies left in the supply closet on December 31. Since he purchased $400 worth, that means he must have used $325 worth of supplies during the year. He wants to show supplies expense of $325 on the year's income statement; and he wants the asset supplies to show $75 on the balance sheet at year end. This is the adjustment to get the accounts to their correct year-end balances, first in the accounting equation and then as ajournal entry:
Assets Liabilities Retained earnings
Unearned consulting fees C o n s u l t i n g f e e s
cc
( 3 2 5 ) S u p p l i e s (325) Supplies expense
Date Transaction Debit Credit
12t31t06 S u p p l i e s E x p e n s e S u p p l i e s To record supplies expense for the year
325
A t r i a l b a l a n c e i s a l i s t o f a l l the accounts, each with its debit balance or its credit balance" An unadjusted trial balance is prepared before any adjustments have been made. An adjusted trial balance is prepared after adjustments have been made, and it can be used to prepare the f inancial statements.
325 A-4 The T-accounts with the adjusting entries posted to them are shown in Exhibit 8.7.