Introduction to adjusting entries
Over the course of the fiscal period, certain assets lose value as they are used up or consumed by the business, while other assets lose value as they expire or deteriorate over time.
Obviously it would be very difficult to record all of these daily changes in value as they occur. As a result, the rules of accounting permit the values of these items to remain inaccurate over the course of the fiscal period.
Accordingly. an adjusting entry is a journal entry recorded on the last day of the fiscal period for the purpose of updating (or adjusting) the balances of certain accounts that have become inaccurate or out-of-date over the course of the period.
There are five types of adjusting entries discussed in this chapter:
(1) Office supplies
(2) Prepaid expenses (insurance, rent, licenses)
(3) Depreciable fixed assets
(4) Accrued revenues and expenses
(5) Late-arriving purchase invoices
Please note that all adjusting entries (other than accrued revenues and expenses and late-arriving purchase invoices) possess the following characteristics:
1. Each account involved is both an asset account and an expense account.
2. You buy the asset, you use up the expense.
3. The amount used up over the course of the period (determined by math) is the figure included in the adjusting entry at the end of the period.
4. You always debit an expense account and credit an asset account in an adjusting entry.
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Adjusting entries explained
Over the course of the fiscal period, certain assets lose value as they are used up or consumed by the business, while other assets lose value as they expire or deteriorate over time. Examples include office supplies, prepaid expenses (rent, licenses and insurance) and certain depreciable fixed assets (building, equipment, automobile).
Obviously it would be near impossible and highly inconvenient to record all of these daily changes in value as they occur. As a result, the rules of accounting permit the book values of these items in the ledger to remain inaccurate over the course of the fiscal period.
That said, given that the balance sheet and income statement are always prepared at the end of each fiscal period, it is imperative that the accounts of the business be brought up to date at the close of each period prior to the preparation of said financial statements. To that end, adjusting entries are used to ensure that all account balances are accurate and up-to-date as of the last day of the fiscal period so that reliable financial statements may be prepared.
Put another way, adjusting entries are simply journal entries prepared as of the last day of the fiscal period so that the balances of certain accounts can be brought up to date.
Coincidentally, most adjusting entries (other than accrued revenues and expenses and late-arriving purchase invoices) deal with items that are both asset accounts (items of value owned by a business) and expense accounts (normal costs of doing business) at the same time. In order to take account of this hybrid or dual nature of certain accounts, the amount of the asset that is used up or expires over the course of the period is allocated to an expense account by way of an adjusting entry at the end of each fiscal period.
In terms of the following examples of adjusting entries (other than accrued revenues and expenses and late-arriving purchase invoices) it may also be helpful to remember that a business purchases an asset but uses up or consumes an expense.
Furthermore, you may notice that all adjusting entries (other than accrued revenues and expenses and late-arriving purchase invoices) involve a debit to an expense account and a credit to an asset account.
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Section 9.1 - Adjusting for supplies
Office supplies are both an asset and an expense. Accordingly, the value of supplies that are physically used up over the course of the fiscal period must be allocated to an expense account at the end of each period.
As you know, the accounting entry for the initial (or additional) purchase of office supplies is as follows:
18 - Supplies (asset) - dr -100
----------- Cash / A/P - cr - 100
Purchased supplies
Now let’s assume that a business had $100 of supplies on hand at the start of the period, purchased an additional $50 of supplies over the course of the period, while a year-end physical inventory count determined $70 of supplies to be on hand as of the last day of the period. The adjusting entry is as follows:
31 - Supplies Expense - dr - 80
---------------- Supplies - cr - 80
Adjusting entry for supplies
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Section 9.2 - Adjusting for prepaid expenses
Sometimes a business will pay for the entire cost of an item prior to the actual use of or benefit derived from that item. Insurance policies, rental agreements and professional and commercial licenses all fall into this category of unique accounts known as prepaid expenses.
Like supplies, all prepaid expenses are both assets and expenses. That may explain why prepaid expenses are also known as prepaid assets given the dual nature of these items.
Now let’s assume that a business with a fiscal year-end of December 31 purchases a fully prepaid 12-month property insurance policy for $1200 on September 1. The initial purchase of the insurance policy on September 1 appears as follows:
1 - Prepaid Insurance (asset) - dr - 1200
-------------------------- Cash/AP - cr - 1200
Purchased insurance
A simple calculation reveals that the business has used up 4/12 (September 1 - December 31) or $400 of the $1200 insurance policy as of the last day of the fiscal period. Accordingly, the adjusting entry prepared on the last day of the period, indicating the amount of insurance that has expired (or been used up) during the period is as follows:
31 - Insurance Expense - dr - 400
---------- Prepaid Insurance - cr - 400
Adjusting entry for insurance
The same calculations and entries would be used for the initial purchase and year-end adjustment of rent (Prepaid Rent and Rent Expense) and licenses (Prepaid Licenses and License Expense).
Please note that prepaid expenses are usually grouped together and appear as a single current asset on the balance sheet.
And finally, you may have already recognized that Supplies is essentially a tangible prepaid expense, while insurance, rent and licenses are simply intangible prepaid expenses. In other words, the adjusting entry rules for Suppies are exactly the same as the adjusting entry rules for prepaid expenses given that they are essentially one and the same.
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Section 9.3 - Adjusting for depreciable fixed assets
While not as obvious as the previous scenarios involving supplies and prepaid expenses, the year-end calculation of depreciation on certain fixed assets is also properly classified as an adjusting entry.
In general, fixed assets like automobiles or buildings depreciate, or lose value over time. This is because most fixed assets break down or become obsolete with the passage of time. (The only exception to this general rule is Land.)
(As an aside, depreciation of intangible items is sometimes referred to as amortization.)
Like supplies and prepaid expenses, these fixed assets, known as depreciable assets, function both as assets and expenses of the business.
And more importantly, the values of such depreciable fixed assets will hardly be accurate as of the last day of each fiscal period unless the gradual loss in value of these aging assets is properly accounted for via the calculation of year-end depreciation.
Two methods of calculating annual depreciation will be studied in this chapter:
(i) straight-line method and
(ii) declining balance method
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(a) Straight-line method of depreciation
The straight-line method of depreciation is the easiest method for calculating the gradual loss in value of depreciable assets over time.
Using this method, the amount of annual depreciation expense is exactly the same (straight) from year to year.
The formula for straight-line depreciation is as follows:
annual depreciation expense (ADE) using straight-line method (SLM)
= cost of asset - estimated residual value of asset / estimated useful life of asset (in years)
The cost of an asset is the original purchase price paid by the business for that asset.
The estimated residual value (ERV) of an asset is the predicted scrap (parts) or resale value of that asset once it is no longer operational at the end of its life.
The estimated useful life (EUL) of an asset is the predicted life of that asset (in years) before it is expected to break down and lose all functionality.
And finally please note that as two of the variables necessary to calculate annual depreciation under this method are merely estimates (or educated guesses), ultimately the calculation of annual depreciation is essentially an estimate, as well.
Hypothetical example of straight-line method
Let’s assume that a piece of equipment is purchased for $10,000 with an estimated residual value of $1,000 and an estimated useful life of 3 years.
ADE SLM = Cost - ERV
EUL (years)
= $10,000 - $1,000
3 years
= $3,000 / year
The adjusting entry in each and every year is as follows:
31 - Depreciation Expense - Equipment - dr - 3000
---------- Accumulated Depreciation - Equipment - cr - 3000
Adjusting entry for equipment
(b) Declining balance method of depreciation
For income tax purposes, the Canada Revenue Agency (CRA) prefers a different method of calculating annual depreciation expense. This method is known as the declining balance method of depreciation and results in increasingly smaller and smaller (i.e., declining) annual depreciation expense figures for all depreciable fixed assets. In other words, the amount of annual depreciation expense calculated withunder this method will decrease from year to year.
The formula for declining balance depreciation is as follows:
annual depreciation expense (ADE) using declining balance method (DBM)
= net book value of asset x CRA annual fixed rate (%) of depreciation
The net book value (NBV) of an asset represents the current or up-to-date or remaining or undepreciated value of the asset. Net book value can easily be calculated by subtracting the accumulated depreciation from the original purchase price. Net book value can also be calculated by subtracting the previous year's annual depreciation expense from the previous year's updated net book value.
The annual fixed rate of depreciation to be employed under this method refers to the estimated annual rate (percentage) of capital cost allowance or CCA (or depreciation) established by the Canada Revenue Agency for each available class of fixed asset: https://shorturl.at/bnvG2
And once again please note that as the CRA annual depreciation figure necessary to calculate the loss in value under this method is merely an estimate (or educated guess), ultimately the calculation of annual depreciation is essentially an estimate, as well.
Hypothetical example of declining balance method over first two years
Let’s assume that a piece of equipment is purchased for $10,000 with a CRA annual rate of depreciation of 10%.
(i) ADE DBM (year one) = NBV x CRA annual fixed rate of depreciation
= $10,000 (NBV year one = purchase price) x 10%
= $1,000 (year one depreciation)
The adjusting entry in year one is as follows:
31 - Depreciation Expense - Equipment - dr - 1000
---------- Accumulated Depreciation - Equipment - cr - 1000
Adjusting entry for equipment
(ii) ADE DBM (year two) = NBV x CRA annual fixed rate of depreciation
= $9,000 (NBV year one minus year one depreciation) x 10%
= $900 (year two depreciation)
The adjusting entry in year two is as follows:
31 - Depreciation Expense - Equipment - dr - 900
---------- Accumulated Depreciation - Equipment - cr - 900
Adjusting entry for equipment
Depreciation Accounts
Depreciation Expense - (name of asset) is a regular expense account that must be included on the income statement for each depreciable fixed asset held by the company.
Meanwhile, as the Cost Principle demands that financial statements list all assets at their original purchase price, a new account, Accumulated Depreciation - (name of asset), must be used to record the adjusting entry for depreciation at the end of each fiscal period. Accumulated Depreciation represents the accumulated (total) loss in value (depreciation) of the asset from the original date of purchase. As you know, at the end of every period the Accumulated Depreciation account is credited by the amount of the annual depreciation as calculated using one of the two formulas discussed in this chapter. This new account is properly classified as a contra asset account because it is an asset account with a credit balance (contrary to the rules of debit-credit theory) that appears just below each corresponding depreciable fixed asset on the balance sheet and trial balance.
Partial Balance Sheet
Fixed Assets
Equipment (original cost)................................................ 10,000
Less Accumulated Depreciation - Equipment..... 9,000
Net book value - Equipment............................................. 1,000
Furniture (original cost).................................................. 80,000
Less Accumulated Depreciation - Furniture......... 8,000
Net book value - Furniture............................................. 72,000
To summarize, you should once again notice that the adjusting entry for depreciation of equipment (and all depreciable fixed assets) involves a debit to an expense and a credit to an asset. You may also notice that equipment (and all depreciable fixed assets) is both an asset and an expense. And, of course, the amount of the equipment used up (or depreciated) over the course of the period is the amount included in the adjusting entry for depreciation of the equipment.
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Part-year depreciation under straight-line method (year one only)
Please note that under the straight-line method, depreciation of assets purchased midway through the fiscal period should be prorated (adjusted for time) in year one only of the asset’s life in order to take into account the actual purchase date of the asset and the precise loss in value during that first year.
Example of straight-line method using part-year depreciation
Let’s assume that an automobile is purchased on October 1 for $24,000 with an estimated residual value of $4000 and an estimated useful life of 10 years. The business uses a fiscal year end of December 31. Annual depreciation expense for the asset would normally be $2000 (24,000 - 4,000 / 10).
The adjusting entry in year one, taking into account the precise date of purchase of the asset (part-year depreciation), is as follows:
31 - Depreciation Expense - Automobile - dr - 500 (3/12 of $2,000)
---------- Accumulated Depreciation - Automobile - cr - 500
Adjusting entry for automobile
The adjusting entry in year two and each subsequent year is as follows:
31 - Depreciation Expense - Automobile - dr - 2000
---------- Accumulated Depreciation - Automobile - cr - 2000
Adjusting entry for automobile
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50 % Rule under declining balance method (year one only)
You should also be aware that the CRA requires the use of the “50% Rule” (or "half-year rule) under the declining balance method for asset purchases carried out midway through the fiscal period (p. 347). This rule requires year one depreciation only to be prorated by 50%, regardless of the actual date of purchase in year one, so as to take into account the approximate loss of value of the asset in its first year of use.
Example of declining balance method using 50% Rule
Now let’s assume that an automobile is purchased on October 1 for $20,000 and the Canada Revenue Agency recommends a 10% CCA or annual rate of depreciation. The business uses a fiscal year end of December 31.
The adjusting entry in year one, taking into account the 50% Rule, is as follows:
31 - Depreciation Expense - Automobile - dr - 1000 ($20,000 x 10% x 50%)
---------- Accumulated Depreciation - Automobile - cr - 1000
Adjusting entry for automobile
The adjusting entry in year two is as follows:
31 - Depreciation Expense - Automobile - dr - 1900 ($19,000 x 10%)
---------- Accumulated Depreciation - Automobile - cr 1900
Adjusting entry for automobile
Click here for slideshow summary of depreciation calculations
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** And keep in mind that the use of part-year depreciation or the 50% Rule has an impact on the NBV-ADE-AD charts described above.
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Section 9.4 - Adjusting for accrued revenues and accrued expenses
Accruals are adjustments for
(a) revenues that have been earned but not yet recorded (or collected) in the accounts as of the last day of the period, and
(b) expenses that have been incurred but not yet recorded (or paid) in the accounts as of the last day of the period
These accruals need to be added via adjusting entries at the end of each fiscal period so that the income statement accurately incorporates these various revenue and expense figures. (http://www.accountingcoach.com/blog/what-are-accruals)
(a) Accrued revenues
For example, let's assume that a law firm has earned (but has yet to bill) $800 in fees from a particular client of the firm as of the last day of the fiscal period, December 31. The adjusting entry for the accrued revenue is as follows:
31 - Accounts Receivable - dr - 800
-------------------- Fees Earned - cr - 800
Adjusting entry for accrued revenue
(b) Accrued expenses
Now let's assume that the same law firm has incurred (but has yet to pay) $500 in wages to a particular employee of the firm as of the last day of the fiscal period, December 31. The adjusting entry for the accrued expense is as follows:
31 - Wages Expense - dr - 500
---------------- Wages Payable - cr - 500
Adjusting entry for accrued expense
Please note that Wages Payable is a current liability account that appears on the period-ending balance sheet.
(And please note that you can not use Accounts Payable in these questions as that account can only be used with money owing to creditor suppliers.)
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Section 9.5 - Adjusting for late-arriving purchase invoices
The GAAP known as the Matching Principle states that expenses must be recorded in the same fiscal period as the revenue they helped to generate. In other words, expenses should be recorded when they are first incurred, and not necessarily when the bill (invoice) finally arrives demanding payment. Accordingly, the adjusting entry for late-arriving purchase invoices requires businesses to backdate invoices (bills) that arrive just after the close of a fiscal period but which represent expenses incurred just prior to the close of that same period. In other words, the business may act as if the late-arriving invoice arrived just prior to the close of the period and record that invoice as if it had arrived on the final day of the previous period.
Now let’s assume that two purchase invoices (bills) arrive on January 3 representing advertising services and hydro usage incurred in the month of December for a business with a fiscal year end of December 31. The adjusting entry, backdated and recorded as of December 31, is as follows:
31 Advertising Expense - dr - 400
Hydro Expense - dr - 200
------------------- Accounts Payable - cr - 600
Adjusting entry for late-arriving purchase invoices
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Summary of adjusting entries
To summarize then, an adjusting entry is a journal entry recorded on the last day of the fiscal period for the purpose of updating (or adjusting) the balances of certain accounts that have become inaccurate or out-of-date over the course of the period.
Once again, all adjusting entries (other than accrued revenues and expenses and late-arriving purchase invoices) possess the following characteristics:
1. Each account involved is both an asset account and an expense account at the same time.
2. You buy the asset, you use up the expense.
3. The amount used up over the course of the period is the figure included in the adjusting entry at the end of the period. (math)
4. You must debit the expense and credit the asset in the adjusting entry.