Section 9.1 - 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. Examples include office supplies, prepaid expenses (rent, licenses and insurance) and certain depreciable fixed assets. Obviously it would be near impossible and highly inconvenient to record all of these daily changes in value as they occurred. 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, the accounts of the business must be brought up to date at the close of each period prior to the preparation of the financial statements. To that end, adjusting entries are used to ensure that all account balances are current and accurate 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 that are designed to bring the balances of certain accounts up to date.
Coincidentally, most adjusting entries deal with accounts that are both assets (items of value owned by a business) and expenses (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 expires or is used up over the course of the period is allocated to an expense account at the end of each fiscal period.
In terms of the following examples it may be helpful to remember that a business purchases an asset but uses up or consumes an expense.
You may also notice that most adjusting entries involve a debit to an expense and a credit to an asset.
There are four types of adjusting entries discussed in this chapter:
(i) Office supplies
(ii) Prepaid expenses (insurance, rent, licenses)
(iii) Depreciation of fixed assets
(iv) Accrued revenues and expenses
(i) Adjusting for office supplies
Office supplies (paper, pencils, ink cartridges, etc.) 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. And once again, don’t forget that a business purchases an asset but uses up or consumes an expense.
As you know, the accounting entry for the initial (or additional) purchase of office supplies is as follows:
18 - Office Supplies (asset) - dr -100
---------- Bank / A/P - cr - 100
Purchased supplies
Now in order to determine the dollar value of supplies used up or consumed over the course of the period, the business must conduct a physical inventory count (pic) of remaining supplies on hand as of the last day of the period. Then the remaining inventory on hand is subtracted from the inventory of supplies on hand at the beginning of the period, plus any additional purchases of supplies over the course of the period, in order to arrive at the amount of supplies used up or consumed throughout the period. That figure is then employed in the adjusting entry prepared on the final day of the period representing the amount of supplies used up or consumed over the course of the period.
For example, 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 on hand as of the last day of the period. The adjusting entry is as follows:
31 - Supplies Expense - dr - 80
----------- Office Supplies - cr - 80
Adjusting entry for supplies
Notice that the name of the expense account representing supplies consumed (Supplies Expense) is not the same as the name of the asset account used for the purchase and year-end adjustment of supplies (Office Supplies).
In general then: Initial inventory of asset supplies (start of period) + additional purchases of asset supplies (during period) – ending inventory of asset supplies (determined via year-end physical inventory count) = supplies used up or consumed (expensed) during period
(ii) Adjusting for prepaid expenses - insurance, rent, licenses
Sometimes a business will pay for the entire cost of an item prior to the actual use or benefit of that item. Insurance policies, rental or lease 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 (something owned with value) and expenses (ordinary costs of doing business). That may explain why prepaid expenses are also known as prepaid assets given the dual nature of these items. (Interestingly each of these examples of prepaid expenses may also be classified as an intangible asset, but we will leave that observation for another lesson.)
The asset value of insurance is the peace of mind it provides.
The asset value of rent is the right to possess another's property.
The asset value of a license is the right to practice one's vocation or operate one's business.
And as these items are typically purchased in the middle of a fiscal period, their values must be updated at the end of each period in order to recognize the gradual expiry of these accounts over time and to ensure the accuracy of the financial statements at the close of each period.
And once again, don’t forget that a business purchases an asset but uses up or consumes an expense.
For example, 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 (an asset) appears as follows:
1 - Prepaid Insurance - dr - 1200
---------------- Bank/AP - cr - 1200
Purchased insurance policy
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 during the period (an expense) is as follows:
31 - Insurance Expense - dr - 400
------------ Prepaid Insurance - cr - 400
Adjusting entry for insurance
Once again, notice the different names given to the asset (Prepaid Insurance) and expense (Insurance Expense) accounts for insurance. The same is true for the initial purchase and year-end adjustment of rent (Prepaid Rent and Rent Expense) and licenses (Prepaid License and License Expense). And please note that our textbook will typically assume that insurance, rent and licenses are prepaid for exactly one year (or sometimes two years) in advance.
And by this point you may have already recognized that office supplies (introduced earlier) is essentially a tangible prepaid expense, whereas all of our examples of prepaid expenses - license, rent and insurance - are essentiallly intangible items.
And finally it should be noted that 'prepaid expenses' are often referred to as 'prepaid assets', given the hybrid or dual nature of said accounts.
(iii) Adjusting for depreciation of 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. (Depreciation of intangible items such as patents and trademarks is sometimes referred to as amortization.)
In general, fixed assets like equipment or buildings lose value, or depreciate, 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, which typically appreciates, or rises in value, over time.) Put another way, most fixed assets lose value (depreciate) over time as they are slowly used up or consumed by their owners, not unlike supplies or prepaid expenses.
And like supplies and prepaid expenses, these fixed assets, known as depreciable assets, function both as assets and expenses of the business.
And most importantly, the values of such fixed assets will hardly be accurate as of the last day of each fiscal period unless the steady loss in value of these aging assets is properly accounted for via the calculation of year-end depreciation.
(In fact, this end-of-period update of depreciable asset values is very much in keeping with a Generally Accepted Accounting Principle known as the Lower of Cost or Market (LCM) Principle which states that inventory items and short term (temporary) investments should always be listed on the balance sheet at the lower of their cost [original purchase] or market [current resale or purchase] price.)
Methods of depreciation and adjusting entries
But exactly how much do these depreciable fixed assets lose in value over the course of each fiscal period? Of course the precise loss in value per period is impossible to calculate, and so accountants must employ mathematical formulae designed to estimate the decline in value of these assets over time.
There are two common methods of calculating annual depreciation used by accountants today:
(a) straight-line method and
(b) declining-balance method.
You will notice that the straight-line method results in identical annual depreciation figures over the life of the asset, while the declining-balance method results in decreasing annual depreciation figures over the life of the asset, hence the term ‘declining-balance.’
And as we proceed, it may be helpful to remember the following maxim: A business purchases a fixed asset, but it expenses the depreciation, or loss in value of that asset, over time.
Of course, with respect to depreciable fixed assets, it is also accurate to once again state that a business purchases an asset but uses up or consumes an expense.
(a) Straight-line Method of Depreciation
The straight-line method of depreciation is the easiest method for calculating the loss in value of depreciable fixed assets over time. Using this method, the annual depreciation expense is identical (same or straight) from year to year (p. 346). The formula is as follows:
annual depreciation expense (ade) using straight-line method (slm) =
cost of asset - estimated residual value (erv) of asset
estimated useful life (eul) 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 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 of an asset is the predicted life of that asset (in years) before it is expected to break down and lose all functionality.
Part-year depreciation
Please note that under the straight-line method, depreciation of assets purchased midway through the fiscal period should be prorated (adjusted for time) in both year one and the final year of the asset’s life in order to take into account the precise loss in value and date of purchase of the asset.
Depreciation Accounts
Depreciation Expense - (name of asset) is a regular expense account that must be included on the income statement (p. 343) 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. This new account is properly classified as a contra asset account because it is an asset account with a credit balance that appears just below each corresponding depreciable fixed asset on the balance sheet (p. 344) and trial balance (p. 351).
Fixed Assets
Furniture.........................................................................80,000
Less Accumulated Depreciation - Furniture.......................8,000
Net book value - Furniture..............................................72,000
Equipment....................................................................140,000
Less Accumulated Depreciation - Equipment..................30,000
Net book value - Equipment.........................................110,000
Example of straight-line depreciation with part-year depreciation
Now 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 this asset would then be calculated at $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 - see above), is as follows:
31 - Depreciation Expense - Automobile - dr - 500 (3/12 of $2,000)
---------- Accumulated Depreciation - Automobile - cr - 500
Adjusting entry for depreciation
The adjusting entry in year two is as follows:
31 - Depreciation Expense - Automobile - dr - 2000
---------- Accumulated Depreciation - Automobile - cr - 2000
Adjusting entry for depreciation
(b) Declining-balance Method of Depreciation
The other method of estimating annual depreciation of fixed assets is known as the declining-balance method of depreciation and results in declining annual depreciation expense figures for all depreciable assets. In other words, annual depreciation expense will be lower and lower from year to year under this method. For income tax purposes, the Canada Revenue Agency (CRA) actually requires businesses to employ this somewhat more complicated method of calculating annual depreciation expense.
The formula is as follows:
annual depreciation expense (ade) using declining-balance method =
net book value (nbv) of asset x CRA fixed rate of annual depreciation
The net book value (NBV) of an asset represents the current or up-to-date or remaining or undepreciated value of the asset in the books of the company. 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.
In this chapter, the fixed rate of annual depreciation to be employed under this method refers to the specific rate (percentage) of capital cost allowance or CCA (depreciation) established by the Canada Revenue Agency for each available class of depreciable fixed asset (see chart on p. 345).
Note that the estimated residual value and estimated life of the asset are not required under the declining-balance method. That said, the year-end adjusting entries recorded under the declining-balance method are still identical to those under the straight-line method in terms of the accounts to be debited and credited (namely Depreciation Expense and Accumulated Depreciation).
(Please note that while Canadian businesses are free to employ the declining-balance method of calculating depreciation for accounting purposes, the overwhelming majority of them prefer the straight-line method. However when Canadian businesses do elect to use the declining-balance method for accounting purposes, they do not utilize the CRA's fixed rates of depreciation but instead employ other methods of determining annual rates of depreciation which you will learn in grade 12 accounting.)
The 50% Rule
You should also be aware that for income tax purposes the CRA requires the use of something called the "half-year rule" or “50% Rule” under the declining-balance method in the year in which an asset purchase is made (p. 347). This rule requires year one depreciation to be prorated by exactly 50%, regardless of the actual date of purchase, so as to take into account the approximate loss of value of a depreciable asset in its first year of usage. Please note that the 50% Rule is only employed in the adjusting entry for year one of the asset's life.
Example of declining-balance depreciation with 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 depreciation
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 depreciation
Sample depreciation question using both methods of depreciation
BJG Enterprises makes a cash purchase of Office Furniture on September 1, Year 1 for $12000 (cost). The business employs a fiscal year end of December 31. The furniture has an estimated useful life (eul) of 10 years with an estimated residual value (erv) of $2000. Canada Revenue Agency (CRA) stipulates an annual rate of depreciation or capital cost allowance (CCA) of 20%.
Calculate the amount of annual depreciation (expense), accumulated or total depreciation (contra asset) and net book value (updated value / current value / remaining value / undepreciated value) in each of the following scenarios over three years.
(1) Straight-line method (cost - erv / eul) ignoring part-year depreciation
(2) Straight-line method including part-year (Sept 1 - Dec 31) depreciation
(3) Declining-balance method (nbv x CRA fixed %) ignoring 50% rule
(4) Declining-balance method including 50% rule
Below journalize both the cash purchase of the furniture in year one and the adjusting entry for depreciation of the furniture in year three of scenario four above.
Yr 1 - Sept 1 - Furniture - dr - 12,000
---------- Bank - cr - 12,000
Cash purchase of furniture
Yr 3 - Dec 31 - Depreciation Expense - Furniture - dr - 1,728
---------- Accumulated Depreciation - Furniture - cr - 1,728
Adjusting entry for depreciation
(iv) Adjusting for accrued revenues and expenses
Accruals are period-ending adjusting entries for
(1) revenues that have been earned but not yet recorded in the accounts as of the last day of the fiscal period, and
(2) expenses that have been incurred but not yet recorded in the accounts as of the last day of the fiscal 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)
And other than the fact that they are recorded at the end of each period in order to update the balances of certain accounts, you should note that adjusting entries for accrued revenues and expenses do not follow the same rules of adjusting entries as all of the other examples cited in this chapter.
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
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 liability account that appears on the period-ending balance sheet.
Summary of adjusting entry key points (other than accrued revenues and expenses)
1. Adjusting entries are always recorded at the end of the fiscal period
2. All adjusting entries involve hybrid/dual nature accounts that are simultaneously both assets and expenses (supplies, prepaid insurance, automobile, etc.)
3. With respect to each hybrid/dual nature account under discussion, we can say that a business buys the asset but uses up the expense
4. Adjusting entries record the dollar amount of the asset that has been used up (or has expired) over the course of the fiscal period, which is always recorded as an expense
5. All adjusting entries involve a debit to an expense and a credit to an asset
Section 9.2- Adjusting entries and the eight-column work sheet
And once again, don’t forget that all of the above adjusting entries will usually first be recorded on the eight-column work sheet (p. 317 & p. 342) and not in the general journal as one would expect.
As you already know, there is even a set of columns specifically designed for the recording of adjustments on the eight-column work sheet that we will now be working with. Adjusting figures are recorded in these special "adjustments" columns before the accounts are recalculated and then extended to the appropriate financial statement columns to the right.
Eventually the adjusting entries will be recorded in the general journal before being posted to the corresponding ledger accounts.
Section 9.3 – Closing Entries (R/E/D)
Certain accounts in the ledger do not carry forward into the next fiscal period. These accounts are known as temporary, or nominal, accounts. Revenues, expenses and drawings (r/e/d) are all temporary accounts. These accounts are used to measure net income or assets withdrawn from the business over a specified period of time. This means that these types of accounts must begin each new fiscal period with a zero balance. As a result, at the close of every fiscal period, these accounts must be brought to zero by way of closing entries.
On the other hand, assets, liabilities and capital are all known as permanent, or real, accounts because their balances always continue into the next fiscal period.
Given that the three temporary accounts are all equity accounts (r/e/d), it only makes sense to close out those three accounts at the end of each period into the fourth equity account - Capital - which just happens to be a permanent account.
Closing out the accounts is the next-to-last step in the accounting cycle.
Closing out the accounts involves three journal entries (r/e/d) known as the closing entries. Each closing entry is dated as of the final day of the fiscal period.
(1) Fees Earned - dr - 1600
Sales - dr - 800
---------- B. Gold, Capital - cr - 2400
Closing entry for revenues
(2) B. Gold, Capital - dr - 1800
---------- Advertising Expense - cr - 400
---------- Telephone Expense - cr - 600
---------- Wages Expense - cr - 800
Closing entry for expenses
(3) B. Gold, Capital - dr - 250
----------- B. Gold, Drawings - cr - 250
Closing entry for drawings
We sometimes summarize the three-step (RED) closing entries process as follows:
(1) R into C
(2) E into C
(3) D into C
Journalizing the closing entries actually serves two purposes:
(1) to close out all of the temporary accounts (RED) at the end of each fiscal period and
(2) to update the capital account at the end of each fiscal period via the equity equation (BC + NI [R - E] - DR = EC).
Essentially, the period-ending balance in the Capital account (and the corresponding value of the business) is being updated with the revenues, expenses and drawings from the period just completed. Put another way, the recording of the three closing entries on the final day of the period represents the bookkeeping equivalent of the equity equation (BC + R - E - DR = EC).
Tip: It is always helpful to create a T-account for Capital (with Beginning Capital already in place) in order to complete the closing entries.
Tip: Please note that when using an eight-column worksheet to close the accounts, always use the revenue, expenses and drawings balances from the Income Statement and Balance Sheet columns to the right of the worksheet.
Sections 9.3 – Alternate Method of Closing Entries using Income Summary Account (R/E/I/D)
Certain accounts in the ledger do not carry forward into the next fiscal period. These accounts are known as temporary, or nominal, accounts. Revenues, expenses and drawings (r/e/d) are all temporary accounts. These accounts are used to measure net income or assets withdrawn from the business over a specified period of time. This means that these types of accounts must begin each new fiscal period with a zero balance. As a result, at the close of every fiscal period, these accounts must be brought to zero by way of closing entries.
On the other hand, assets, liabilities and capital are all known as permanent, or real, accounts because their balances always continue into the next fiscal period.
Given that the three temporary accounts are all equity accounts (r/e/d), it only makes sense to close out those three accounts at the end of each period into the fourth equity account - Capital - which just happens to be a permanent account.
Closing out the accounts is the next-to-last step in the accounting cycle.
Please note that closing the accounts requires the (entirely unnecessary) use of another temporary account, known as Income Summary.
The Income Summary account is only used when the temporary accounts are closed at the end of each fiscal period.
Closing out the accounts therefore involves four journal entries (r/e/i/d) known as closing entries. Each closing entry is dated as of the final day of the fiscal period.
(1) Fees Earned - dr - 1600
Sales - dr - 800
---------- Income Summary - cr - 2400
Closing entry for revenues
(2) Income Summary - dr - 1800
---------- Advertising Expense - cr - 400
---------- Telephone Expense - cr - 600
---------- Wages Expense - cr - 800
Closing entry for expenses
(3) Income Summary - dr - 600
---------- B. Gold, Capital - cr - 600
Closing entry for income summary (IS is equal to net income [R-E] for the year)
(4) B. Gold, Capital - dr - 250
----------- B. Gold, Drawings - cr - 250
Closing entry for drawings
We sometimes summarize the four-step (REID) closing entries process as follows:
(1) R into I
(2) E into I
(3) I into C
(4) D into C
Journalizing the closing entries actually serves two purposes:
(1) to close out all of the temporary accounts (REID) at the end of each fiscal period and
(2) to update the capital account at the end of each fiscal period via the equity equation (BC + NI [R - E] - DR = EC).
Tip: It is always helpful to create T-accounts for both Income Summary and Capital (with Beginning Capital already in place) in order to complete the closing entries.
Tip: Please note that when using an eight-column worksheet to close the accounts, always use the revenue, expenses and drawings balances from the Income Statement and Balance Sheet columns to the right of the worksheet.
Section 9.4 - Post Closing Trial Balance
Once the closing entries have been posted to the ledger accounts, the balances in all revenue, expense and drawings accounts should be zero. Thereafter, the final step in the accounting cycle involves the preparation of a post-closing trial balance (see p. 333). The only accounts which should appear on this statement are assets, liabilities and the updated capital figure (BC + NI - DR = EC), so that A (dr) = L + C (cr).
................Goldkind & Goldkind
.............Post Closing Trial Balance
.................December 31, 2013
Accounts..................Debit.....Credit
Cash.........................12000
Supplies.................... 1000
Accounts Payable.................... 2000
Bank Loan............................... 4000
B. Gold, Capital....................... 7000
...............................13000.....13000
Tip: Please note that when using an eight-column worksheet to prepare a post-closing trial balance (PCTB), always use the asset and liability balances from the Balance Sheet columns to the right of the worksheet. That said, do not use the Capital figure that appears in the worksheet when preparing the PCTB as that Capital balance has yet to be updated via the closing of the accounts.
Section 9.5 - Completing the Accounting Cycle
The complete accounting cycle is now as follows:
1. Business transactions occur daily
2. Accounting entries recorded (journalized) daily in general journal via source documents
3. Journal entries posted daily to ledger accounts
4. Ledger balanced by means of trial balance at close of fiscal period
5. Eight-column worksheet prepared with adjustments (e.g., supplies, prepaid expenses, accrued revenues/expenses, depreciation of fixed assets) at close of fiscal period
6. Adjusting entries journalized and posted at close of fiscal period
7. Formal income statement and balance sheet prepared at close of fiscal period
8. Closing entries (r/e/d) journalized and posted at close of fiscal period
9. Post-closing trial balance (a/l/c) prepared at close of fiscal period