Adjusting Entries

When transactions span more than one accounting period, accrual accounting
requires the use of adjusting entries.
 Type 1. Allocating recorded costs between two or more accounting
periods. Examples of these costs are prepayments of rent, insurance, and
supplies and the depreciation of plant and equipment. The adjusting entry in
this case involves an asset account and an expense account.

 Type 2. Recognizing unrecorded, incurred expenses. Examples of

these expenses are wages and interest that have been incurred but are not
recorded during an accounting period. The adjusting entry involves an
expense account and a liability account.

 Type 3. Allocating recorded, unearned revenues between two or more

accounting periods. Examples include cash received in advance and deposits
made on goods or services. The adjusting entry involves a liability account
and a revenue account.

 Type 4. Recognizing unrecorded, earned revenues. An example is revenue

that a company has earned for providing a service but for which it has not
billed or collected a fee by the end of the accounting period. The adjusting
entry involves an asset account and a revenue account.
 Adjusting entries are either deferrals or accruals.
 A deferral is the postponement of the recognition of an
expense already paid (Type 1 adjustment) or of revenue
received in advance (Type 3 adjustment). The cash
payment or receipt is recorded before the adjusting entry
is made.
 An accrual is the recognition of a revenue (Type 4
adjustment) or expense (Type 2 adjustment) that has
arisen but not been recorded during the accounting
period. The cash receipt or payment occurs in a future
accounting period, after the adjusting entry has been
made.
Type 1 Adjustment: Allocating Recorded
Costs (Deferred Expenses)

 Companies often make expenditures that benefit more than one

period. These costs are debited to an asset account. At the end of an
accounting period, the amount of the asset that has been used is
transferred from the asset account to an expense account. Two
important adjustments of this type are for prepaid expenses and the
depreciation of plant and equipment.
 Prepaid Expenses: Companies customarily pay some expenses,
including those for rent, supplies, and insurance, in advance. These
costs are called prepaid expenses. By the end of an accounting
period, a portion or all of prepaid services or goods will have been
used or have expired. The required adjusting entry reduces the asset
and increases the expense,
 If adjusting entries for prepaid expenses are not made at
the end of an accounting period, both the balance sheet
and the income statement will present incorrect
information. The company’s assets will be overstated, and
its expenses will be understated. Thus, owner’s equity on
the balance sheet and net income on the income
statement will be overstated.
 At the beginning of July, Miller Design Studio paid two
months’ rent in advance. The advance payment resulted
in an asset consisting of the right to occupy the office for
two months. As each day in the month passed, part of the
asset’s cost expired and became an expense. By July 31,
one-half of the asset’s cost had expired and had to be
treated as an expense. The adjustment is as follows:
Adjustment for Prepaid Rent
 July 31: Expiration of one month’s rent, $1,600.
 Analysis: Expiration of prepaid rent decreases the asset account Prepaid Rent
with a credit and increases the owner’s equity account Rent Expense with a
debit.
Adjustment for Supplies
 July 31: Consumption of supplies, $1,540
 Analysis: Consumption of office supplies decreases the asset account Office
Supplies with a credit and increases the expense account Office Supplies
Expense with a debit.
Depreciation of Plant and Equipment
 When a company buys a long-term asset—such as a
building, truck, computer, or store fixture—it is, in effect,
prepaying for the usefulness of that asset for as long as it
benefits the company. Because a long-term asset is a
deferral of an expense, the accountant must allocate the
cost of the asset over its estimated useful life. The
amount allocated to any one accounting period is called
depreciation, or depreciation expense. Depreciation, like
other expenses, is incurred during an accounting period to
produce revenue.
 To maintain historical cost in specific long-term asset
accounts, separate accounts—called Accumulated
Depreciation accounts—are used to accumulate the
depreciation on each long-term asset. These accounts,
which are deducted from their related asset accounts on
the balance sheet, are called contra accounts. A contra
account is a separate account that is paired with a
related account—in this case, an asset account. The
balance of a contra account is shown on a financial
statement as a deduction from its related account. The
net amount is called the carrying value, or book value, of
the asset. As the months pass, the amount of the
accumulated depreciation grows, and the carrying value
of the asset declines.
Adjustment for Plant and Equipment
 July 31: Depreciation of office equipment, $300
 Analysis: Depreciation decreases the asset account Office Equipment
by increasing the contra account Accumulated Depreciation–Office
Equipment with a credit and increasing the owner’s equity account
Depreciation Expense–Office Equipment with a debit.
Type 2 Adjustment: Recognizing Unrecorded,
Incurred Expenses (Accrued Expenses)
 Usually, at the end of an accounting period, some
expenses incurred during the period have not been
recorded in the accounts. These expenses require
adjusting entries. One such expense is interest on
borrowed money. Each day, interest accumulates on the
debt. At the end of the accounting period, an adjusting
entry is made to record the accumulated interest, which
is an expense of the period, and the corresponding
liability to pay the interest. Other common unrecorded
expenses are wages and utilities. As the expense and the
corresponding liability accumulate, they are said to
accrue—hence, the term accrued expenses.
 By the end of business on July 31, Miller’s assistant will
have worked three days (Monday, Tuesday, and
Wednesday) beyond the last pay period. The employee has
earned the wages for those days but will not be paid until
the first payday in August. The wages for these three days
are rightfully an expense for July, and the liabilities
should reflect that the company owes the assistant for
those days. Because the assistant’s wage rate is $2,400
every two weeks, or $240 per day ($2,400 /10 working
days), the expense is $720 ($240 3 days).
Adjustment for Unrecorded Wages
 July 31: Accrual of unrecorded wages, $720
 Analysis: Accrual of wages increases the owner’s equity account Wages
Expense with a debit and increases the liability account Wages Payable with a
credit.
Type 3 Adjustment: Allocating Recorded,
Unearned Revenues (Deferred Revenues)
 Just as expenses can be paid before they are
used, revenues can be received before they are
earned. When a company receives revenues in
advance, it has an obligation to deliver goods or
perform services. Unearned revenues are
therefore shown in a liability account.
 During July, Miller Design Studio received $1,400
from another firm as advance payment for a
series of brochures. By the end of the month, it
had completed $800 of work on the brochures,
and the other firm had accepted the work.
Adjustment for Unearned Revenue
 July 31: Performance of services for which cash was received in
advance, $800
 Analysis: Performing the services for which cash was received in
advance increases the owner’s equity account Design Revenue with a
credit and decreases the liability account Unearned Design Revenue
with a debit.
Type 4 Adjustment: Recognizing Unrecorded,
Earned Revenues (Accrued Revenues)
 Accrued revenues are revenues that a company has earned by
performing a service or delivering goods but for which no entry has
been made in the accounting records. Any revenues earned but not
recorded during an accounting period require an adjusting entry that
debits an asset account and credits a revenue account.
 For example, the interest on a note receivable is earned day by day
but may not be received until another accounting period. The Interest
Receivable account should be debited and the Interest Income
account should be credited for the interest accrued at the end of the
current period. When a company earns revenue by performing a
service—such as designing a series of brochures or developing
marketing plans—but will not receive the revenue for the service until
a future accounting period, it must make an adjusting entry. This type
of adjusting entry involves an asset account and a revenue account.
 During July, Miller Design Studio agreed to create two
advertisements for Maggio’s Pizza Company. It also agreed
that the first advertisement would be finished by July 31.
By the end of the month, Miller had earned $400 for
completing the first advertisement. The client will not be
billed until the entire project has been completed.
Adjustment for Design Revenue
 July 31: Accrual of unrecorded revenue, $400
 Analysis: Accrual of unrecorded revenue increases the owner’s equity
account Design Revenue with a credit and increases the asset account
Accounts Receivable with a debit.
Using the Adjusted Trial Balance to Prepare
Financial Statements

 After adjusting entries have been recorded and posted, an

adjusted trial balance is prepared by listing all accounts
and their balances. If the adjusting entries have been
posted to the accounts correctly, the adjusted trial
balance will have equal debit and credit totals.