The Nature of Adjusting Entries - Essay Example

of the of the Submitted The Nature of Adjusting Entries Introduction Accounting, as they say, is the language of business. Just as we can find out about the health of a person by taking his temperature and having other tests such as X-rays, cardiograms and body mass index calculated, we can also determine the health of a business by looking at the financial statements and cash flows, sales and profits or calculate ratios that will help us figure out how well or badly the firm is doing versus the others in the industry. Accounting may be on cash or accrual basis. Cash basis accounting assumes that no credit will be given or received- but it is difficult to do business like this always. Accrual basis of accounting assumes that business will be done by both cash and credit. In these circumstances, there might be some unfinished or incomplete transactions at the end of every month or year. For example, salaries to workers are paid every Thursday evening but the present year ends on Tuesday, Dec 31. In such a circumstance, salary from last Friday to this Tuesday (5 days) has been earned by the workers, although we will pay them next Thursday 02 Jan. If we want to provide an accurate picture of the accounts as of Dec 31, we will take 5 days salary as payable up to Dec 31 and 2 days payable in the New Year. This accrual of 5 days salaries as of Dec 31 is an adjusting entry which helps us record salaries payable to workers as of that date. Under cash basis accounting this entry would be unnecessary since no cash would have been paid out till Jan 02 of the New Year (Accounting Coach, 1). Discussion From the above, it is abundantly clear about the nature and need for adjusting entries. Adjusting entries are needed to reflect a correct picture of the accounts as of the end of the year (Meigs et al, 153). Since most businesses have Dec 31 as the closing date for the year, this is the date at which their adjusting entries are made. However the accounts may be closed at any other date during the year, June 30 or Sep 30 for example and so adjustments are typically made at that date for these businesses. There may be different types of adjusting entries required. The following are the most usual kinds of adjusting entries that are seen in the business arena: 1. Adjustments for Accrued Expenses 2. Adjustments for Accrued Revenues 3. Adjustments for Prepaid Expenses 4. Adjustments for Unearned Revenues 5. Adjustments for Depreciation (Peaver, 1) One important peculiarity is that it is often seen that under the double entry system of accounting, where every debit has a credit, of the two accounts used in an adjusting entry, one is typically an Income Statement account while the other will be a Balance Sheet account. We usually have to create one of these accounts to record the complete adjusting entry. For instance in the above example, while the business will already have a Salaries Expense Account for the payment of salaries to workers during the year, the year end adjusting entry as discussed above will require that a Salaries Payable Account be opened up to reflect the firm’s liability towards the workers for the five days ending on Dec 31, the closing date or year end. If we suppose for simplicity sake that the weekly expense for salaries was $7,000, then $5,000 or 5 days salary needs to be recorded as earned and payable as of Dec 31. The rest 2 days salary will be payable on Jan 02. The adjusting entry will be: Dec 31 Salaries Expense $5,000 Salaries Payable $5,000 (To record salaries earned but not paid as of Dec 31). If we look at the Salaries Expense (Income Statement account) and Salaries Payable (Balance Sheet Account) as of Dec 31, they will reflect that salaries for 5 days have been earned but not paid as of Dec 31, which is the correct state of affairs as of this date. Then when salaries are eventually paid on Jan 2 next year, we will liquidate the payable account as under: Jan 02 Salaries Payable $5,000 Salaries Expense $2,000 Cash $7,000 This shows that salaries expense for the last week of Dec was split into $5,000 as reported on the Income Statement for the period ending Dec 31 and $2,000 for the 2 days of the new year till Thursday Jan 02, being the first payment period in the new year. At the same time, a liability of $5,000 was reported on Dec 31 which was offset when payment was made on Jan 02. The net effect of all these entries is that Salaries Payable stands nullified as of Jan 02, while Salaries Expense of $5000 was recorded as of Dec 31 but not paid till Jan 02, and Salaries Expense of $2000 was recorded and paid in the new year (Gilbertson & Lehman, 2008, 203). Quite a similar story would unfold in the case of Accrued Revenues. When for instance a law firm that receives fees for services rendered will bill clients but not be able to collect all dues as of Dec 31. Fees due from clients who have not paid up at the end of the accounting period would be treated as Fees Receivable on the Balance Sheet, while a corresponding effect would be created in terms of fees earned but not received. The adjusting entry would be: Dec 31 Fees Receivable-Various Clients $ 12,000 Fees Income $12,000 The amount of Fees Receivable would reduce as amounts are collected in the next period. Meanwhile, this adjusting entry means that both fees receivable (on the Balance Sheet) and fees income (on the Income Statement) are correctly reported as of Dec 31, the year in which they have been earned. Let us now look at adjusting entries for Prepaid Expenses. When expenses are paid in advance, such as Advance Rent, they can be recorded as Rent Paid in Advance, which is an asset on the Balance Sheet. Meanwhile, as the rent becomes due and is earned by the landlord, the amount of advance rent is reduced. For instance let us say that rent for 3 months at the rate of $900 per month was paid in advance on Nov 1 of the year. As of Dec 31, only 2 months rent or $600 will have been earned by the landlord while $300 would still be an advance payment. Entries and adjustments would be as under: Nov 1 Rent Paid in Advance $2,700 Cash $2,700 (Rent paid in advance for 3 months @$900 per month) Dec 31 Rent Expense $1,800 Rent Paid in Advance $1,800 (Rent expense for 2 months @$900 per month) The effect of this adjusting entry as of Dec 31 is that both rent expense is correctly recorded as $1,800 and rent paid in advance is correctly reflected at $900. This amount would become the expense for rent in Jan. There is one more adjusting entry that we must discuss and that pertains to depreciation. Depreciation is the normal wear and tear of an asset over its useful life. While there are many methods of calculating depreciation expense, it is at best an estimate. The most simple formula is the Straight Line method, in which accountants estimate the number of years of useful life of the asset, as well as the probable salvage value it will realize at the end of its use. The formula for yearly depreciation would be: Annual Depreciation= (Cost – Residual Value)/ Life in years For a photocopier machine costing $3000 with a salvage value of $300 and a 3 year life, the annual depreciation under straight line method would be $900, calculated as: ($3000-$300)/ 3 years, or $900 per year. The entry to record annual depreciation for the year, assuming the machine was purchased on Jan 1 of that year, would be: Dec 31 Depreciation Expense $900 Accumulated Depreciation $900 (Being depreciation expense for the first year) The effect of this entry would be to show a recording of depreciation expense of $900 for the year (Income Statement), while accumulated depreciation would be deducted from the original cost of the asset to reflect its true value on the books (Balance Sheet). Conclusion We have now seen the effect of the adjusting entries on the income statement and the balance sheet and will agree that adjusting entries are needed to reflect the correct picture of these accounts as at year end of any business enterprise. Suggested Areas for Further Research The nature of adjusting entries to be passed in the books at accounting year end would also depend on whether we record an initial expense as an Asset or a Liability i.e. Rent Paid in Advance or Rent Expense. There are other entries called Reversing Entries that are made at the beginning of the year in order to simplify things (Cliffnotes, 1). This is simply a reversal of the adjusting entry made. If Salaries Payable of $5000 were reversed on Jan 1, then when paying out salaries on Jan 02, we would simply debit salaries expense and credit cash by $7000, as normally done every week. Works Cited Accounting Coach.com. Adjusting Entries. Accessed on 08 Dec 2011 at http://www.accountingcoach.com/online-accounting-course/08Xpg01.html Cliffnotes.com. Reversing Entries. Accessed on 08 Dec 2011 at http://www.cliffsnotes.com/study_guide/Reversing-Entries.topicArticleId-21081,articleId-21029.html Gilbertson, C. & Lehman, M. Fundamentals of Accounting. Course 1 Advantage. South Western Educational Publishers, 2008. Meigs, R.; Meigs, M.; Bettner, M. & Whittington, R. Financial Accounting, 9th ed. Richard D. Irwin. 1997. Peaver, Rosemary. How to Make Adjusting Entries. Adjusting Entries in your Accounting Journals. From About.com. Accessed on 08 Dec 2011 at http://bizfinance.about.com/od/bookkeepingessentials/a/Adjusting_Entries.htm Read More