In the previous chapter, tentative financial statements were prepared directly from a trial balance. However, a caution was issued about adjustments that may be needed to prepare a truly correct and up-to-date set of financial statements. In other words, the ongoing business activity brings about changes in account balances that have not been captured by a journal entry. Time brings about change, and an adjusting process is needed to cause the accounts to appropriately reflect those changes. This is consistent with the revenue and expense recognition rules.
Adjusting Entries
Accrued expenses are expenses incurred in a period but have yet to be 5 best tools for kickstarting operational collaboration recorded, and no money has been paid. Interest Receivable increases (debit) for $1,250 because interest has not yet been paid. Interest Revenue increases (credit) for $1,250 because interest was earned in the three-month period but had been previously unrecorded.
A contra account is an account paired with another account type, has an opposite normal balance to the paired account, and reduces the balance in the paired account at the end of a period. Let’s say a company paid for supplies with cash in the amount of $400. At the end of the month, the company took an inventory of supplies used and determined the value of those supplies used during the period to be $150. The required adjusting entries depend on what types of transactions the company has, but there are some common types of adjusting entries.
Adjusting Entries Take Two
Recall that depreciation is the systematic method to record the allocation of cost over a given period of certain assets. This allocation of cost is recorded over the useful life of the asset, or the time period over which an asset cost is allocated. The allocated cost up to that point is recorded in Accumulated Depreciation, a contra asset account.
By the end of the asset’s life, its cost has been fully depreciated and its net book value has been reduced to zero. Customarily the asset could then be removed from the accounts, presuming it is then fully used up and retired. The accounting period a company chooses to use for financial reporting will impact the types of adjustments they may have to make to certain accounts. Following the steps of analyzing transactions, recording entries, posting to ledgers and creating the trial balance the accounting cycle continues with steps 5-7 of the accounting cycle.
Insurance is typically purchased by prepaying for an annual or semi-annual policy. Or, rent on a building may be paid ahead of its intended use (e.g., most landlords require monthly rent to be paid at the beginning of each month). Another example of prepaid expense relates to supplies that are purchased and stored in advance of actually needing them. At the time of purchase, such prepaid amounts represent future economic benefits that are acquired in exchange for cash payments. This means that adjustments are needed to reduce the asset account and transfer the consumption of the asset’s cost to an appropriate expense account.
Even though not all of the $48,000 was probably collected on the same day, we record it as if it was for simplicity’s sake. For example, let’s say a company pays $2,000 for equipment that is supposed to last four years. The company wants to depreciate the asset over those four years equally.
Why Some Accounts Have Incorrect Balances on the Trial
- Cash basis accounting sometimes delays or accelerates revenue and expense reporting until cash receipts or outlays occur.
- Taxes are only paid at certain times during the year, not necessarily every month.
- Such receipt of cash is recorded by debiting the cash account and crediting a liability account known as unearned revenue.
- An accounting period breaks down company financial information into specific time spans, and can cover a month, a quarter, a half-year, or a full year.
- The amount of interest therefore depends on the amount of the borrowing (“principal”), the interest rate (“rate”), and the length of the borrowing period (“time”).
- These expenses are often recorded at the end of period because they are usually calculated on a period basis.
However, today it could sell for more than, less than, or the same as its book value. The same is true about just about any asset you can name, except, perhaps, cash itself. When a company purchases supplies, it may not use all supplies immediately, but chances are the company has used some of the supplies by the end of the period.
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Each entry has one income statement account and one balance sheet account, and cash does not appear in either of the adjusting entries. The salary the employee earned during the month might not be paid until the following month. For example, the employee is paid for the prior month’s work big four ww1 on the first of the next month.