Making Adjusting Entries

Sometimes transactions take place in one period but impact another. Other times, you know a transaction will be finalized in the future, but at least some part of it has ties to the current period. These two situations are the main reason for adjusting entries, which are entries that account for transactions that occur in one period but affect another. You have to record these out-of-time entries as you get ready to close one accounting cycle to make sure they have been included in the right period.

The two main types of adjusting entries are deferrals and accruals. These are mostly used in accrual basis accounting systems, but some entries can apply to people who use the cash basis as well; depreciation is the most common example. Accrual entries are used to record transactions that haven't actually happened yet, at least on the money side (these will be explained in more detail in the next section). Deferral entries are pretty much the opposite: they record expenses that you paid in advance but haven't incurred until now, or revenues that you've been paid for already but haven't yet earned.

Deferral entries are sort of like postponed transactions; the money part has already happened, but the income statement impact was put off until later. Remember those two balance sheet accounts, prepaid expenses and unearned revenues? Here is where these two accounts make a transformation from balance sheet to income statement. Prepaid expenses turn into current expenses, and unearned revenues turn into current revenues.

Insurance expense is a perfect example of a prepaid expense. You probably paid your business insurance premium in one lump at the beginning of the year, but that coverage isn't just for the month you sent the check; it's for the whole year. When you paid the bill, you made an entry in the prepaid insurance account. Now you have used up part of that premium, and you have to make an adjusting entry to reflect that. Depreciation is another major form of expense deferral, and it is recorded as part of the adjusting entries.

The flip side of prepaid expense is unearned revenue, meaning that a customer has paid you for something you didn't do yet. Any time a customer gives you a down payment, a deposit, an advance, or a retainer, they all hit the same unearned revenue account. When you got that advance money, you recorded a liability on your books; what you owed was goods or services instead of money. Now, when you have completed the work or delivered the product, that revenue has been earned. An adjusting entry is called for to show that.

Adjusting for Your Deferred Expenses

Two kinds of asset accounts are involved in the deferral adjusting entries:prepaid expenses and fixed assets. These are assets that are used up over time; these entries show just how much was used up during this period.

First, the prepaid expense account. In this example, your company paid a $1,200 premium in January to your insurance company for the whole year's worth of business coverage. That works out to $100 per month throughout the year ($1,200 divided by 12 months). This is what the adjusting entry looks like:

March 31, 2006

Insurance Expense

To recognize one month of insurance expense.

$100.00

Prepaid Insurance

$100.00

The adjusting entry for depreciation looks somewhat similar, but it has one big difference. Instead of posting a credit to the fixed-asset account, you use that contra account for accumulated depreciation instead. In this example, your company has one fixed asset that you bought for $6,000 and depreciate over five years (sixty months) using the straight-line method. Your monthly depreciation expense would be $100 ($6,000 over sixty months).

This is what that entry looks like:

March 31, 2006

Depreciation Expense

To record monthly depreciation.

$100.00

Accumulated Depreciation

$100.00

Deferred Revenue Adjustment

Deferred revenue is a good kind to have: your company gains the positive cash flow from the customer's advance payment but doesn't have to record any taxable revenue at that time. Adjustments come when you begin earning that money, by delivering goods or services. When that happens you shift all or part of your liability account to your revenue account.

For this example, suppose a client paid you a $3,000 retainer to be used for legal fees. In this period, you performed three hours of legal work for him at your standard rate of $250 per hour, or a total of $750. Here's what the adjusting entry would look like:

March 31, 2006

Unearned Revenue

To recognize legal fees earned in March 2006.

$750.00

Revenue

$750.00

Don't Forget Inventory

At the end the accounting period, you also need to adjust the inventory you have recorded on the books to match the inventory you actually have. This includes the inventory you have for resale (even if it isn't in finished form yet), but it may also include some other kinds of inventory. For example, if you keep a large amount of office supplies on hand, you may have chosen to record that initially as an asset. When that's the case, at the end of the period you have to make an adjusting entry for the part that you've used up during the period.

As for merchandise inventory, you can't prepare an income statement without knowing how much inventory you have now (that's called your ending inventory). That's why you need to do the count and adjust the general ledger balance. Even if you use a perpetual inventory system, you may still need to adjust inventory to account for broken or spoiled items. At the end of the period, your inventory balance — the number that will show up on your financial statements — should reflect usable inventory only.

The journal entry here will look just like a prepaid expense entry. For regular inventory, you would debit cost of goods sold and credit your inventory asset account. For other kinds of inventory, such as office supplies, you would debit supplies expense and credit the office supplies asset account.

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