Adjusting entries are made so that the financial statements reflect the accrual basis of accounting. (The accrual basis of accounting requires that revenues be reported on the income statement when they are earned, and expenses are reported on the income statement when they best match the revenues or expire. When the cash is received or paid is not relevant for reporting revenues and expenses.) Adjusting entries are often classified as accruals, deferrals, and other.
An accrual adjusting entry can involve revenues or expenses. A service company that has earned fees, but has not yet recorded the transaction, will accrue revenue. This is done by entering an accrual adjusting entry such as a debit to the asset Accounts Receivable and a credit to Service Revenues. An adjusting entry to accrue expense is needed when a company has received a service or goods from a vendor, but the expense and the liability are not yet recorded. Gas, electricity, water, telephone, wages, interest, and repairs are examples of expenses that will likely need an accrual adjusting entry. The accrual adjusting entry for these items will include a debit to an expense and a credit to a liability account.
A deferral type adjusting entry for revenues is necessary when a company has received money from a customer before it has been earned. The money received will be recorded in the Cash account at the time it is received, but the amount that has not yet been earned must be reported as a liability such as Unearned Fees, Unearned Revenues, or Customer Deposits. As the unearned amount is earned, an adjusting entry will debit the liability account and will credit a revenue account such as Service Revenues.
A deferral type adjusting entry for expenses is necessary if a payment overlaps accounting periods. For example, if a company prepays a six-month insurance premium and the company issues monthly financial statements, then a deferral adjusting entry will be necessary. The purpose of a deferral type adjusting entry for this situation is (1) to report Insurance Expense for the insurance cost that has expired during the accounting period, and (2) to report the amount of insurance cost that has not yet expired and will be reported on the balance sheet as the asset Prepaid Insurance.
Examples of other adjusting entries include depreciation and the allowance for doubtful accounts. The adjusting entry for depreciation is a debit to Depreciation Expense and a credit to Accumulated Depreciation. The adjusting entry for doubtful accounts will usually be a debit to Bad Debt Expense and a credit to Allowance for Doubtful Accounts.
You might have noticed that each of the adjusting entries involved one balance sheet account and one income statement account.
Sample Adjusting Entries Questions
1) Customer deposits for future services will be listed under which financial statement category? (assets, liabilities, expenses, etc.)
2) The accounting principle that requires expenses to be reported on the income statement when they occur rather than when they are paid.
3) A prepaid expense is reported as which type of account? (asset, liability, expense, etc.)
4) Depreciation is the systematic ________________ of the cost of an asset (used in a business) to expense over the useful life of the asset. (It is not a valuation technique.)
5) The time _________ assumption is also known as the periodicity assumption. It means that an ongoing business can be divided into years, quarters, months, etc.
6) On December 1 a company purchased $700 of supplies—approximately a three-month supply. On December 1 the asset Supplies was debited for $700. On December 31 the company needs to prepare a prepayment-type ___________ entry.
7) Adjusting entries are used to convert accounting information from the cash basis of accounting to the ______________ basis of accounting.
8) The typical number of accounts involved in an adjusting entry.
9) An adjusting entry to recognize that part of a customer's prepayment has been earned will include a __________ to a liability account.
10) The accrued interest that the bank has earned but has not yet ______________ is reported as a debit balance in the account Interest Receivable.