BAF3M Adjustments. What are adjustments? Adjustments are exactly what the name suggests: they are...

BAF3M

Adjustments

What are adjustments?

Adjustments are exactly what the name suggests: they are adjustments made to the accounting records of a company at the end of the accounting cycle. Adjustments are made to ensure that financial information adheres to GAAP and are accurate for the users of the financial statements.

Why are they a concern?

Without adjustments, accounting for many companies would not adhere to GAAP, and therefore would not reflect the actual performance of a business.

The revenue recognition and matching principles state that revenues and expenses that are earned in one period should be recorded in that period, regardless of whether payment is made or invoices are received!

In the real world, transactions that take place in one accounting period sometimes are not invoiced until the next period, or an invoice may arrive late. As well, some expenses or revenues “build up” (or accrue) over time but are not billed in the current period. An example of this would be wages, which may be earned late in December of this year, but not paid until early January of the next fiscal period.

Adjusting entries made at the end of the year help to ensure that the accounts are brought up to date and the company is adhering to GAAP.

In this activity, you will look at the following three general types of adjustments:

1. Late invoices

2. Accruals:a) Prepaid Expensesb) Unearned Revenuec) Interestd) Salaries and Wages

3. Allocations and Amortization:a) Bad Debtsb) Suppliesc) Amortization:

i) Straight-Lineii) Declining Balance

1. LATE INVOICES

On January 10th, of this year, we received an invoice from J. Simmons Inc. for $750 repair services that were done on December 29th of last year. Our year-end is December 31st.

What do we do?

This is a late invoice requiring an adjustment. The journal entry to record a late invoice is the same as it would be if the invoice arrived on time; however, the date must be recorded as if we received the invoice at the end of the year.

2. ACCRUALS

Accruals are expenses or revenues that build up or accumulate. We will examine the following four (4) types of accounting accruals and one type of personal accrual:

Prepaid ExpensesUnearned RevenuesInterestSalaries and Wages

a. Prepaid Expenses

In some cases, it makes sense for a company to pay in advance for routine expenses it has every month. This can save time and money. Examples include Rent and Insurance.

The prepaid rent or insurance is considered an asset when the amount is paid because the expense has not occurred yet. If we sold the company that amount that was prepaid, it would have value and is, therefore, an asset.

Example: A company that pays rent of $1,000 a month pays for its rent for a full year in advance on January 1st of this year.

But what happens to this asset one month after it has been paid?

On January 31st, one month's worth of rent has been used up (e.g., one month's worth of rent expense has accrued).

When the company prepares adjustments at the end of January, here is the entry to adjust prepaid rent (remember that $1,000 of rent is what the company expenses each month.

In this case, the asset has decreased in value by $1,000 because the company has accrued $1,000 worth of rent expense on January 31st so we decrease the value of the asset by $1,000 and record the corresponding expense.

Note: with every expense a company prepays, there will be two corresponding accounts:

The prepaid expense account – this is a current asset as it hasn't been consumed yet (because if the company was sold, it would get the money for the prepaid back).

The expense account – as the expense accrues, value is moved from the prepaid account to the expense account. All that is needed for these expenses to accrue is for time to pass.

b. Unearned Revenue

Unearned revenue is very similar to prepaid expenses. For every revenue item that is prepaid by a customer, a business will also have two accounts:

The unearned revenue account – this is a current liability account because if you end up not providing the service to the customer by the end of the fiscal period, you still owe them your service in the next fiscal period, which means that it is a liability.

The revenue account – where the liability goes once the revenue has been earned.

Ex: On January 1st, when we prepaid the year's rent of $12,000, what would the property owner have recorded to show accrued revenue?

Ex: On January 1st, when we prepaid the year's rent of $12,000, what would the property owner have recorded to show accrued revenue?

At the end of the month (if the property owner shows adjustments), when we showed an accrued expense of $1,000, the property owner would have entered a transaction to show accrued revenue.

At the end of the month (if the property owner shows adjustments), when we showed an accrued expense of $1,000, the property owner would have entered a transaction to show accrued revenue.

Let's try one for practice:

Ed's Shoppe pays rent of $1,750 per month and pays business insurance premiums of $950 per month. Ed's Shoppe pays for these costs for a year in advance on January 1st.

What is the entry on January 1st to record the full-year's payment for each of the following? What is the adjusting entry on January 31st to record the adjustment for the month of January?

a. Ed's Shoppe b. The Landlord (property owner) c. The Insurance Company

c. INTEREST

Interest is the price of money; it is the cost of borrowing funds. It is stated as a percentage cost on a yearly basis; however, it is usually paid monthly. For example, 4% interest means to borrow $100 it would cost you $4 per year.

Like other accruals, all that has to happen for interest to accumulate is for time to pass. The problem is that interest is paid at fixed points in time (say, the 15th of the month).

However, this date may not necessarily correspond to the end of our accounting period, which may be the 31st of the month.

In the image above, assume our company took out a $100,000 Bank Loan at 6% interest on July 15th. How much will we pay in interest that month?

Formula for simple interest:

Principle amount of loan X annual interest rate X number of months / 12 months.

Formula for simple interest:

Principle amount of loan X annual interest rate X number of months / 12 months.

$100,000 x 0.06 x 1/12 = $500

Accounting for interest:

The first entry would be to show us acquiring the loan.

Accounting for interest:

The first entry would be to show us acquiring the loan.

Interest to be paid on August 15th is $500. However, our accounting period ends on July 31st. That means we have earned half of our way to our first interest payment; therefore, we have accrued half of that interest expense.

Here is the July 31st entry to show that we have accrued half of the interest expense.

On August 15th, our first interest payment is made. We must record the interest accrued from August 1st to August 15th (we only recorded half a month above; the other half must now be recorded).

We must also pay the interest and reverse the interest payable from the July 31st entry.

Here is the entry to pay the interest and reverse the interest payable from the July 31st entry.

PRACTICE QUESTION:

1. XYZ Inc takes out a loan on July 1st for $30,000 at 5% interest per year. Record the entry on July 1st and the adjusting entry on July 31st

PRACTICE QUESTION:

1. XYZ Inc takes out a loan on July 1st for $30,000 at 5% interest per year. Record the entry on July 1st and the adjusting entry on July 31st

2. What happens if a loan is taken out on a day other than July 1st? Assume now, that XYZ Inc takes out a loan on July 15th for $30,000 at 5% interest per year. Record the entry on July 15th and the adjusting entry on July 31st.

2. What happens if a loan is taken out on a day other than July 1st? Assume now, that XYZ Inc takes out a loan on July 15th for $30,000 at 5% interest per year. Record the entry on July 15th and the adjusting entry on July 31st.

Note: there is no payment on July 31st this time. The first interest payment is due at the end of the 30-day period after the loan was taken out. That is August 15th, not July 31st.

4. Salaries and Wages

Salaries and wages are not the same thing. Wages are based on how many hours an employee works and salaries are generally a fixed amount paid out every payday.

However, salaries and wages work in a similar fashion to interest. As employees earn their pay, a company accumulates a salaries or wages expense. If employees have earned money but haven't been paid on the last day of the accounting period, an adjustment must be made.

Example: Employees are paid every second Wednesday. In this example, the last payday was July 24th.  

If the salaries expense every two weeks is $10,000, then the journal entry on July 31st would recognize one half of the regular salary expense. It's half way through the pay period. However, it is not a payday, so no payment would be made. But we still need to show that the money is owed via an adjustment.

What would our journal entry look like for this adjustment?

When will the employees get paid for this period? What would the journal entry look like for this payment?

On August the 7th, you would pay the employees the regular amount and record the second week's salary expense.

SAMPLE WAGES QUESTION 1. Salaries of $30,000 are paid on the 21st of each month. Record the adjusting journal entry on June 30th.

SAMPLE WAGES QUESTION 1. Salaries of $30,000 are paid on the 21st of each month. Record the adjusting journal entry on June 30th.

3. ALLOCATIONS

In reference to cost, it means assigning a portion of the asset's value to become an expense in the period using a prescribed method. This cost allocation may or may not truly reflect how an asset's value is expiring over time.

Before you look at three (3) types of allocations, you must start with the concept of the contra-account.

Contra accounts receive their name from the fact that they act in a contrary manner to the accounts with which they are associated.

You already know one contra account: it's the drawings account. Recall how to record drawings of cash by the owner

a. BAD DEBTS

Our first allocation is bad debt. Part of the cost of selling on credit is acquiring bad debt – that is – customers who do not pay.

To ignore that some of your accounts receivable will not be collected is to mislead the users of your financial statements. Therefore, an allocation for bad debt must be made. It is an adjustment.

There are two (2) steps in the bad debt process:

1. Make an allowance (estimate) as soon as there is a possibility that the customer may not pay.

2. Remove the accounts receivable when you are sure they will not pay.

STEP 1:

Assume a company made $100,000 of sales on credit in the current year.

Historically speaking, this firm has encountered bad debt at a rate equal to 2% of sales on credit.

The senior accountant thinks that history will repeat itself, and orders an allowance of 2% of sales. (2% x $100,000 = $2,000).

Bad Debt is an account that appears as an expense on the Income Statement.

This insures that the portion of the accounts receivable that is considered a bad debt is recorded in the period with the sales from which the bad debt originated; this adheres to the Matching Principle.

The allowance for doubtful accounts is a contra asset account and it allows the user of the financial statement to see how much of the accounts receivable are considered uncollectible.

STEP 2Later on, once the accountant is certain the delinquent accounts will not be paid, Step 2 is carried out and they are "written off".

STEP 2Later on, once the accountant is certain the delinquent accounts will not be paid, Step 2 is carried out and they are "written off".

In this transaction, we are not writing off the specific accounts receivable that will not be collectible. This transaction only affects asset accounts because we have already expensed the bad debt in the period in which the sales occurred.

We can now reduce our accounts receivable value and the amount we have set aside for an allowance.

SAMPLE QUESTIONSales on account this year were $250,000, and normally we experience a rate of bad debt of about 2% of sales on account. Make the adjusting journal entry for December 31st.

SAMPLE QUESTIONSales on account this year were $250,000, and normally we experience a rate of bad debt of about 2% of sales on account. Make the adjusting journal entry for December 31st.

b. SUPPLIESNo one creates a source document and records a journal entry every time somebody goes to the supply room and takes a 10¢ pencil. That would be impractical.

Instead, a count is made of the value of supplies remaining in the storeroom at the end of the accounting cycle. What is missing is allocated to supplies expense.

For example, an organization started this year with $1,500 of supplies. It purchased $800 and $700 of supplies at two points during the year. By the end of the year, the supplies account shows a balance of $3,000.

A count of supplies was made of the supply storeroom and found that only $1,200 of supplies remained.

The journal entry to record the adjustment will be ($3,000 - $1,200 = $1,800).

A count of supplies was made of the supply storeroom and found that only $1,200 of supplies remained.

The journal entry to record the adjustment will be ($3,000 - $1,200 = $1,800).

SAMPLE QUESTION

Supplies on January 1st were $2,900. Purchases were made in March, June, and October for $1,000 each month. An inventory count on December 31st reveals that only $1,900 of supplies remains in the storeroom.

Make the adjusting entry for December 31st.

SAMPLE QUESTION

Supplies on January 1st were $2,900. Purchases were made in March, June, and October for $1,000 each month. An inventory count on December 31st reveals that only $1,900 of supplies remains in the storeroom.

Make the adjusting entry for December 31st.