Mastering Adjusting Entries American Institute of Professional Bookkeepers © American Institute of Professional Bookkeepers, 2010 Mastering Adjusting Entries

Mastering Adjusting Entries Cash v. Accrual Basis Cash basis Revenues recognized when cash is received Expenses recognized when cash is paid Accrual basis Revenues recognized when earned Expenses recognized when incurred Mastering Adjusting Entries 9 9

Mastering Adjusting Entries Cash v. Accrual Basis In 2008, PubCo offers 2-year subscriptions to New Magazine, for $20 (8 quarterly issues @ $2.50) and collects $20,000. Cost: $6 a year per subscriber, which is paid at the time of publication. PubCo takes out a 2-year loan for $10,000 at 10% simple interest rate. Both interest and principal are payable at the end of 2 years. Mastering Adjusting Entries

Mastering Adjusting Entries Cash v. Accrual Basis Cash basis Accrual basis 20X8 20X9 20X8 20X9 Revenue Publishing Expense Interest $20,000 $ - 0 - $10,000 $10,000 6,000 6,000 6,000 6,000 - 0 - 2,000 1,000 1,000 Profit $14,000 ($8,000) $3,000 $3,000 Total profit for 2 years is the same under both methods: $6,000 But, the timing of those profits may be different. Mastering Adjusting Entries

Mastering Adjusting Entries Cash v. Accrual Basis Cash basis Revenues recognized when cash is received Expenses recognized when cash is paid Accrual basis Revenues recognized when earned Expenses recognized when incurred Earnings = cash received – expenses paid. (When revenues are earned or expenses incurred is irrelevant.) Earnings = revenues earned – expenses incurred (When cash is received or expenses paid is irrelevant.) Mastering Adjusting Entries 9 9

Mastering Adjusting Entries Cash v. Accrual Basis Cash basis Revenues recognized when cash is received Expenses recognized when cash is paid Accrual basis Revenues recognized when earned Expenses recognized when incurred NOT GAAP Earnings = cash received – expenses paid. (When revenues are earned or expenses incurred is irrelevant.) Earnings = revenues earned – expenses incurred (When cash is received or expenses paid is irrelevant.) Mastering Adjusting Entries 9 9

Mastering Adjusting Entries Cash v. Accrual Basis You are a caterer. The transactions you are about to see occur in March. What should you report as March revenues and expenses under: cash basis accounting? accrual basis accounting? Mastering Adjusting Entries

Mastering Adjusting Entries Cash v. Accrual Basis Cash Accrual Prepay $2,400 rent for 4 months (includes the current month). Receive $300 cash for catering services. Cater a luncheon and submit an invoice for $1,200 that will be settled next month. Receive a $200 utility bill that you will pay next month. Receive $1,000 from a customer for a function catered last month. Receive a $500 deposit on a wedding you will cater later in the year. $2,400 $ 600 $ 300 $ 300 $ 0 $1,200 $ 0 $ 200 $1,000 $ 0 $ 500 $ 0 Mastering Adjusting Entries

Mastering Adjusting Entries Here are the principles of adjusting entries: Recognition of revenues and expenses is unrelated to receipt or payment of cash. Cash may be received before or after the service is performed (or goods are sold). Cash may be paid before or after the expense is incurred. Adjusting entries are used when cash is received or paid at a different time from when the service is performed (or goods are sold) or the expense is incurred. Mastering Adjusting Entries

Mastering Adjusting Entries In 2008, PubCo offers 2-year subscriptions to New Magazine, for $20 (8 quarterly issues @ $2.50) and collects $20,000. Cash 20,000 or Cash 20,000 Revenue 20,000 Unearned Revenue 20,000 But neither entry records the amount of revenue earned in 20X8 on the accrual basis: $10,000. How can this be corrected? An adjusting journal must be recorded. Mastering Adjusting Entries

Mastering Adjusting Entries Adjusting entries apply the accrual method to transactions when cash flows and earnings (revenues less expenses) are not simultaneous. Accrual Deferral Cash flows AFTER the revenue is earned or expense is incurred Cash flows BEFORE the revenue is earned or expense is incurred Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Deferral Cash flows AFTER the revenue is earned or expense is incurred Cash flows BEFORE the revenue is earned or expense is incurred Accrued Revenues Accrued Expenses Unearned Revenues Prepaid Expenses Revenues earned, but cash not yet received Expenses incurred, but not yet paid Cash received, but not yet earned Expenses paid, but not yet incurred Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Deferral Cash flows AFTER the revenue is earned or expense is incurred Cash flows BEFORE the revenue is earned or expense is incurred Accrued Revenues Accrued Expenses Unearned Revenues Prepaid Expenses Revenues earned, but cash not yet received Expenses incurred, but not yet paid Cash received, but not yet earned Expenses paid, but not yet incurred Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Revenues ComCo lends ZyCo $10,000 on July 1 and will be repaid the $10,000 principal + $1,200 interest on June 30 of the following year. Revenues earned, but cash not yet received What adjustment must ComCo make on Dec. 31 (its year end)? Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Revenues ComCo lends ZyCo $10,000 on July 1 and will be repaid the $10,000 principal + $1,200 interest on June 30 of the following year. Revenues earned, but cash not yet received ComCo earns revenue each month the loan is not repaid. As of Dec. 31, it has earned 6 months’ interest. To compute: $1,200/12 months = $100 a month  6 months = $600 earned revenue Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Revenues ComCo lends ZyCo $10,000 on July 1 and will be repaid the $10,000 principal + $1,200 interest on June 30 of the following year. Revenues earned, but cash not yet received ComCo records an adjusting entry to show that it earned $600 revenue: Interest Receivable 600 Interest Revenue 600 Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Revenues Thus, the adjusting entry to accrue revenue is: ____ Receivable Revenues earned, but cash not yet received ____ Revenue In addition to interest, other common accrued revenues include commissions, royalties and rent. Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Revenues Thus, the adjusting entry to accrue revenue is: ____ Receivable Revenues earned, but cash not yet received ____ Revenue This adjusting entry increases assets . . . and increases revenues/net income. Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Revenues Thus, the adjusting entry to accrue revenue is: ____ Receivable Revenues earned, but cash not yet received ____ Revenue What happens to the financial statements if the AJE is not made? Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Revenues Thus, the adjusting entry to accrue revenue is: ____ Receivable Revenues earned, but cash not yet received ____ Revenue Because this entry increases assets, if it is omitted, assets will be UNDERSTATED. Because the entry increases income, if it is omitted, net income will be UNDERSTATED. Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Deferral Cash flows AFTER the revenue is earned or expense is incurred Cash flows BEFORE the revenue is earned or expense is incurred Accrued Revenues Accrued Expenses Unearned Revenues Prepaid Expenses Revenues earned, but cash not yet received Expenses incurred, but not yet paid Cash received but not yet earned Expenses paid but not yet incurred Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Expenses KTC pays its office staff $5,000 every 2 weeks. The final payday for the year ended Oct. 31, 20X1, is Friday, Oct. 24. What adjustment is needed on Oct. 31 (the company’s year end)? Expenses incurred, but not yet paid Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Expenses KTC pays its office staff $5,000 every 2 weeks. The final payday for the year ended Oct. 31, 20X1, is Friday, Oct. 24. What adjustment is needed on Oct. 31 (the company’s year end)? Expenses incurred, but not yet paid 24 25 Paid 26 27 28 29 30 31 Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Expenses KTC pays its office staff $5,000 every 2 weeks. The final payday for the year ended Oct. 31, 20X1, is Friday, Oct. 24. What adjustment is needed on Oct. 31 (the company’s year end)? Expenses incurred, but not yet paid 24 25 Paid 26 27 28 29 30 31 For these days, labor costs were incurred . . . Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Expenses KTC pays its office staff $5,000 every 2 weeks. The final payday for the year ended Oct. 31, 20X1, is Friday, Oct. 24. What adjustment is needed on Oct. 31 (the company’s year end)? Expenses incurred, but not yet paid 24 25 Paid 26 27 28 29 30 31 but not paid by year end Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Expenses KTC pays its office staff $5,000 every 2 weeks. The final payday for the year ended Oct. 31, 20X1, is Friday, Oct. 24. What adjustment is needed on Oct. 31 (the company’s year end)? Expenses incurred, but not yet paid KTC must record an adjusting entry to recognize 1 week’s wage expense. Wages Expense 2,500 Wages Payable 2,500 Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Expenses Thus, the adjusting entry to accrue expenses is ____ Expense Expenses incurred, but not yet paid ____ Payable In addition to wages, other common accrued expenses include rent, commissions, royalties, utilities, and interest. Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Expenses Thus, the adjusting entry to accrue expenses is ____ Expense Expenses incurred, but not yet paid ____ Payable This adjusting entry increases expenses (and therefore reduces net income) . . . and increases liabilities. Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Expenses Thus, the adjusting entry to accrue expenses is ____ Expense Expenses incurred, but not yet paid ____ Payable What happens to the financial statements if this AJE is not made? Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Cash flows AFTER the revenue is earned or expense is incurred Accrued Expenses Thus, the adjusting entry to accrue expenses is ____ Expense Expenses incurred, but not yet paid ____ Payable Because this entry reduces net income, if it is omitted, net income will be OVERSTATED. Because this entry increases liabilities, if it is omitted, liabilities will be UNDERSTATED. Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Deferral Cash flows AFTER the revenue is earned or expense is incurred Cash flows BEFORE the revenue is earned or expense is incurred Accrued Revenues Accrued Expenses Unearned Revenues Prepaid Expenses Revenues earned, but cash not yet received Expenses incurred, but not yet paid Cash received, but not yet earned Expenses paid, but not yet incurred Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred Unearned Revenues On March 1, StorageCo rents out a unit and receives $900 for the first 3 months’ rent. The company has a year end of April 30. Cash received, but not yet earned What adjustment must StorageCo make on April. 30 (its year-end)? Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred Unearned Revenues On March 1, StorageCo rents out a unit and receives $900 for the first 3 months’ rent. The company has a year end of April 30. Cash received, but not yet earned The $900 payment received in advance can be recorded in two ways: Cash 900 Cash 900 or Unearned Rent 900 Rent Revenue 900 What should the April 30 account balance be in Unearned Revenue? in Revenue? Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred Unearned Revenues On March 1, StorageCo rents out a unit and receives $900 for the first 3 months’ rent. The company has a year end of April 30. Cash received, but not yet earned The $900 payment received in advance can be recorded in two ways: Cash 900 Cash 900 or Unearned Rent 900 Rent Revenue 900 2 months 1 month ( 2/3 ) earned ( 1/3 ) unearned 3/1 4/30 5/31 Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred Unearned Revenues On March 1, StorageCo rents out a unit and receives $900 for the first 3 months’ rent. Cash received, but not yet earned Rent Revenue Unearned Rent 3/1 900 if initially recorded an unearned rent 600 600 600 should be 300 2/ 3 1 / 3 Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred Unearned Revenues On March 1, StorageCo rents out a unit and receives $900 for the first 3 months’ rent. Cash received, but not yet earned Rent Revenue Unearned Rent 3/1 900 if initially recorded as unearned rent 600 600 Unearned Rent 600 600 300 Rent Revenue Should Be 600 Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred Unearned Revenues On March 1, StorageCo rents out a unit and receives $900 for the first 3 months’ rent. Cash received, but not yet earned Rent Revenue Unearned Rent 3/1 900 if initially recorded as rent revenue 300 300 600 should be 300 2/ 3 1 / 3 Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred Unearned Revenues On March 1, StorageCo rents out a unit and receives $900 for the first 3 months’ rent. Cash received, but not yet earned Rent Revenue Unearned Rent 3/1 900 if initially recorded as rent revenue 300 300 Rent Revenue 300 600 300 Unearned Rent Should Be 300 Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred How the AJE is made depends on how receipt of the $900 payment was recorded. It could be: Unearned Revenues Unearned ___ Rev. ___ Revenue Cash received, but not yet earned or ___ Revenue Unearned ___ Rev. This is the AJE if the cash was recorded as unearned revenue This is the AJE if the cash was recorded as revenue Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred How the AJE is made depends on how receipt of the $900 payment was recorded. It could be: Unearned Revenues Unearned ___ Rev. ___ Revenue Cash received, but not yet earned or ___ Revenue Unearned ___ Rev. This AJE reduces liabilities . . . This AJE reduces net income . . . . . . and increases net income . . . and increases liabilities Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred How the AJE is made depends on how receipt of the $900 payment was recorded. It could be: Unearned Revenues Unearned ___ Rev. ___ Revenue Cash received, but not yet earned or ___ Revenue Unearned ___ Rev. What happens to the financial statements if the AJE is not recorded? Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred How the AJE is made depends on how receipt of the $900 payment was recorded. It could be: Unearned Revenues Unearned ___ Rev. Cash received, but not yet earned ___ Revenue This AJE reduces liabilities—without it, liabilities will be OVERSTATED This entry increases net income—without it, net income will be UNDERSTATED Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred How the AJE is made depends on how receipt of the $900 payment was recorded. It could be: Unearned Revenues ___ Revenue Cash received, but not yet earned Unearned ___ Rev. This AJE increases liabilities; without it, liabilities will be UNDERSTATED This entry reduces net income—without it, net income will be OVERSTATED Mastering Adjusting Entries

Mastering Adjusting Entries Accrual Deferral Cash flows AFTER the revenue is earned or expense is incurred Cash flows BEFORE the revenue is earned or expense is incurred Accrued Revenues Accrued Expenses Unearned Revenues Prepaid Expenses Revenues earned, but cash not received Expenses incurred, but not paid Cash received, but not yet earned Expenses paid, but not yet incurred Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred On Sept. 1, NewCo, a calendar year company, purchases a 1-year insurance policy for $600. Prepaid Expenses Expenses paid, but not yet incurred What must happen on Dec. 31? Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred On Sept. 1, NewCo, a calendar year company, purchases a 1-year insurance policy for $600. Prepaid Expenses Expenses paid, but not yet incurred The $600 paid on Sept. 1 can be recorded in two ways: Prepaid Ins. 600 Insurance Exp. 600 or Cash 600 Cash 600 What should the Dec. 30 balance be in Prepaid Ins.? in Insurance Exp.? Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred On Sept. 1, NewCo, a calendar year company, purchases a 1-year insurance policy for $600. Prepaid Expenses Expenses paid, but not yet incurred The $600 paid on Sept. 1 can be recorded in two ways: Prepaid Ins. 600 Insurance Exp. 600 or Cash 600 Cash 600 4 months 8 months ( 1/3 ) used ( 2/3 ) unused 9/1 12/31 8/31 Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred On Sept. 1, NewCo, a calendar year company, purchases a 1-year insurance policy for $600. Prepaid Expenses Expenses paid, but not yet incurred Insurance Expense Prepaid Insurance 9/1 600 if initially recorded as prepaid insurance 200 200 200 400 should be 1 / 3 2 / 3 Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred On Sept. 1, NewCo, a calendar year company, purchases a 1-year insurance policy for $600. Prepaid Expenses Expenses paid, but not yet incurred Insurance Expense Prepaid Insurance 9/1 600 if initially recorded as prepaid insurance 200 200 Insurance Expense 200 200 400 should be Prepaid Insurance 200 Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred On Sept. 1, NewCo, a calendar year company, purchases a 1-year insurance policy for $600. Prepaid Expenses Expenses paid, but not yet incurred Insurance Expense Prepaid Insurance 9/1 600 if initially recorded as insurance expense 400 400 200 400 should be Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred On Sept. 1, NewCo, a calendar year company, purchases a 1-year insurance policy for $600. Prepaid Expenses Expenses paid, but not yet incurred Insurance Expense Prepaid Insurance 9/1 600 if initially recorded as insurance expense 400 400 Prepaid Insurance 400 200 400 should be Insurance Expense 400 Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred How the AJE is made depends on how the $600 payment was recorded. It could be: Prepaid Expenses ____ Expense Prepaid Exp. Expenses paid, but not yet incurred or Prepaid Exp. ____Expense This is the AJE if the payment was recorded in a asset account This is the AJE if the payment was recorded in an expense account Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred How the AJE is made depends on how the $600 payment was recorded. It could be: Prepaid Expenses ____ Expense Prepaid Exp. Expenses paid, but not yet incurred or Prepaid Exp. ____Expense This AJE reduces net income . . . This AJE increases assets . . . . . . and reduces assets . . . and increases net income Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred How the AJE is made depends on how the $600 payment was recorded. It could be: Prepaid Expenses ____ Expense Prepaid Exp. Expenses paid, but not yet incurred or Prepaid Exp. ____Expense What happens to the financial statements if the AJE is not recorded? Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred How the AJE is made depends on how the $600 payment was recorded. It could be: Prepaid Expenses ____ Expense Expenses paid, but not yet incurred Prepaid Exp. This AJE increases expenses—without it, net income will be OVERSTATED It also reduces assets—without it, assets will be OVERSTATED Mastering Adjusting Entries

Mastering Adjusting Entries Deferral Cash flows BEFORE the revenue is earned or expense is incurred How the AJE is made depends on how the $600 payment was recorded. It could be: Prepaid Expenses Prepaid Exp. Expenses paid, but not yet incurred ____Expense This entry increases assets—without it, assets will be UNDERSTATED It also reduces expenses —without it, net income will be UNDERSTATED Mastering Adjusting Entries

Basic Adjustments--Summary Type of Adj. AJE Financial Statement Effect if AJE not Made Expense Accrued Expense Expenses are understated and net income is overstated. Liability Liabilities are understated. Asset Accrued Revenue Assets are understated. Revenue Revenues and net income are understated. Expense Prepaid Expense Expenses are understated and net income is overstated. Asset Assets are overstated. Asset Assets are understated. Expense Expenses are overstated and net income is understated. Liability Deferred Revenue Liabilities are overstated. Revenue Revenues and net income are understated. Revenue Revenues and net income are overstated. Liability Liabilities are understated. Mastering Adjusting Entries

Mastering Adjusting Entries In addition to the AJEs needed for routine accruals and deferrals, there are other end-of-period adjusting entries, including: depreciation expense bad debt expense Mastering Adjusting Entries

Mastering Adjusting Entries Depreciation Expense The AJE to recognize depreciation for the period is: Depreciation Expense xxx Accumulated Depreciation xxx This entry increases expenses. It also reduces assets because the year-end balance in Accumulated Depreciation is subtracted from the related asset account to arrive at that asset’s net book value. Mastering Adjusting Entries

Mastering Adjusting Entries Depreciation Expense Straight-line depreciation expense is calculated as follows: Cost - Residual value = Annual depreciation expense Estimated useful life (in years) Mastering Adjusting Entries

Mastering Adjusting Entries Depreciation Expense PatCo purchases for its business equipment that costs $25,000. PatCo estimates that the equipment will have a useful life of 6 years and, at the end of its life will have a residual value of $1,000. 25,000 6 1,000 Residual value Cost Annual depreciation expense = Estimated useful life $4,000 Each year, Patco will make the following adjusting entry: Depreciation Expense 4,000 Accumulated Depreciation 4,000 Mastering Adjusting Entries

Mastering Adjusting Entries Depreciation Expense Each year, the balance in Accumulated Depreciation increases as follows: Accumulated Depreciation Equipment 25,000 4,000 Yr 1 4,000 Yr 2 4,000 Yr 3 12,000 At the end of Year 3, PatCo will report on its balance sheet: Equipment - At Cost Less: Accumulated Depreciation Equipment (net) 25,000 12,000 13,000 Mastering Adjusting Entries

Mastering Adjusting Entries Bad Debt Expense The matching principle requires an attempt to match costs with the revenues that the costs helped produce. One application of the matching principle is bad debt. The matching principle requires companies to estimate bad debt (a cost), then match the bad debt to its related noncash sales (revenue). Mastering Adjusting Entries

Mastering Adjusting Entries Bad Debt Expense The entry to record bad debt expense is: Bad Debt Expense xxx Allowance For Doubtful Accounts xxx This entry reduces income and reduces assets (the credit to Allowance For Doubtful Accounts is subtracted from Accounts Receivable). The difference between the ending balances in Accounts Receivable and Allowance For Doubtful Accounts is the net realizable value. Accounts Receivable Less: Allowance For Doubtful Accts Net Realizable Value 35,000 4,200 30,800 Mastering Adjusting Entries

Estimating Bad Debt Expense Bad debt for book purposes can be estimated in either of two ways: as a percentage of credit sales; or as the percentage of accounts receivable that the company estimates it will not be able to collect. Mastering Adjusting Entries

Estimating Bad Debt Expense 1. As a percentage of credit sales. A firm estimates the percentage of credit sales it will not collect and each year takes that amount as bad debt expense. Driscoll Co. estimates that each year 2% of its credit sales will be uncollectible. Credit sales for 20X8 are $200,000. 2% 200,000  = 4,000 Please change “A company estimates” to “ComCo” estimates” and correct the double image on “2%” The adjusting entry to record bad debt expense for 20X8 is: Bad Debt Expense 4,000 Allowance For Doubtful Accounts 4,000 Mastering Adjusting Entries

Estimating Bad Debt Expense 1. As a percentage of credit sales. A firm estimates the percentage of credit sales it will not collect and each year takes that amount as bad debt expense. Note that when using the percentage of credit sales method, the balance in Allowance For Doubtful Accounts is irrelevant to the AJE. Mastering Adjusting Entries

Estimating Bad Debt Expense 2. As a percentage of A/R estimated to be uncollectible. At year-end, the balance in Allowance account is adjusted to reflect the percentage of accounts receivable estimated to be uncollectible. Potage’s A/R has a year-end balance of $20,000. It estimates that 3% of this amount will be uncollectible. The Allowance For Doubtful Accounts currently has a $400 credit balance. 20,000 3% 400 Allowance For Doubtful Accounts  = 600 current balance So, the Allowance account must be adjusted to end with a $600 credit balance. 600 Mastering Adjusting Entries

Estimating Bad Debt Expense 2. As a percentage of A/R estimated to be uncollectible. At year-end, the balance in Allowance account is adjusted to reflect the percentage of accounts receivable estimated to be uncollectible. Potage’s A/R has a year-end balance of $20,000. It estimates that 3% of this amount will be uncollectible. The Allowance For Doubtful Accounts currently has a $400 credit balance. Allowance For Doubtful Accounts Bad Debt Exp. 200 400 Allowance 200 200 adjustment 600 Mastering Adjusting Entries

Estimating Bad Debt Expense 2. As a percentage of A/R estimated to be uncollectible. At year-end, the balance in Allowance account is adjusted to reflect the percentage of accounts receivable estimated to be uncollectible. Allowance For Doubtful Accounts This account may currently have a debit balance or a credit balance x,xxx x,xxx x,xxx Ending balance (based on calculation) Mastering Adjusting Entries

Estimating Bad Debt Expense StoreCo’s Accounts Receivable currently has a balance of $50,000. Its Allowance account has a $3,000 debit balance. StoreCo estimates that 5% of accounts receivable will be uncollectible. Bad Debt Expense Allowance For Doubtful Accounts 3,000 Current balance 5,500 5,500 Adjustment 5,500 2,500 required balance ($50,000  5%) Bad Debt Expense 5,500 Allowance For Doubtful Accounts 5,500 Mastering Adjusting Entries

Estimating Bad Debt Expense StoreCo’s Accounts Receivable currently has a balance of $50,000. Its Allowance account has a $3,000 debit balance. StoreCo estimates that 5% of accounts receivable will be uncollectible. Allowance For Doubtful Accounts Why is there a debit balance in this account? 3,000 Current balance 2,500 required balance Mastering Adjusting Entries

Estimating Bad Debt Expense Once a customer’s account is deemed uncollectible, it is taken off the books: Allowance For Doubtful Accounts xxx Accounts Receivable xxx This entry has no effect on total assets because it reduces Accounts Receivable and its offsetting Allowance account by the same amount. Writing off an amount greater than the balance in the Allowance account results in a debit balance. Mastering Adjusting Entries

Tips on Adjusting Journal Entries Every AJE must include at least: one income statement account (revenue or expense) and one balance sheet account (asset or liability) Never cash! Mastering Adjusting Entries

Mastering Adjusting Entries The Chart of Accounts Companies generally number GL accounts. Each category of accounts is given a series of numbers. For example: Assets 100 – 199 Liabilities 200 – 299 Owners Equity 300 – 399 Revenue 400 – 499 Expense 500 - 599 Mastering Adjusting Entries

Mastering Adjusting Entries Normal Balances All accounts have a normal balance  e.g., for A/R a debit balance is normal. The normal balance is the side (debit or credit) on which an increase is recorded. For example, to increase Cash, you debit it, so Cash normally has a debit balance. To increase Revenue, you credit it, so Revenue normally has a credit balance. Mastering Adjusting Entries

Mastering Adjusting Entries Normal Balances Owners’ Equity Assets Liabilities increases increases increases normal balance normal balance normal balance Revenues Expenses increases increases normal balance normal balance Mastering Adjusting Entries

Normal Balances: Exercise Account type Normal bal. Debit Credit Account Cash Accounts Receivable Inventory Prepaid Rent Accumulated Depreciation Accounts Payable Unearned Revenue Equipment Cost of Goods Sold Rent Expense Sales Revenue Owner, Capital Allowance For Doubtful Accounts Land Building Asset DR Asset DR Asset DR Asset DR Asset CR Liability CR Liability CR Asset DR Expense DR Expense DR Revenue CR O/E CR Asset CR Asset DR Asset DR Mastering Adjusting Entries

Mastering Adjusting Entries The Worksheet Trial balance Accounts Dr Cr The first step in the trial balance is the unadjusted trial balance. Under Accounts, list each account title. Under Trial balance, enter that account’s balance in the appropriate column. Mastering Adjusting Entries

Mastering Adjusting Entries The Worksheet Trial balance Adjustments Accounts Dr Cr Dr Cr Under Adjustments enter any end-of-period adjustment to the account—an accrual, deferral or other adjustment. Mastering Adjusting Entries

Mastering Adjusting Entries Trial balance Adjustments Adjusted TB Accounts Dr Cr Dr Cr Dr Cr Under Adjusted trial Balance, enter the adjusted account balance (i.e., including any accrual, deferral or other adjustment). Mastering Adjusting Entries

unadjusted trial balance Mastering Adjusting Entries Funkytime Worksheet For the year ended July 31, 2009 Adjusted Trial balance Adjustments trial balance Account Title Debit Credit Debit Credit Debit Credit Cash 3,000 Accounts Receivable 2,200 Supplies 2,000 Prepaid Insurance 2,400 Land 18,000 Office Equipment 1,800 Accounts Payable 1,900 Unearned Rent 300 Bert Weems, Capital 24,000 Bert Weems, Drawing 3,000 Fees Earned 15,300 Wages Expense 4,275 Rent Expense 2,600 Supplies Expense 800 Utilities Expense 985 Insurance Expense 440 minus 1,600 400 The first step it is the unadjusted trial balance plus 1,600 2,400 Example: Supplies Expense must be adjusted to show that only $400 worth of supplies are on hand at year end. 41,500 41,500 Mastering Adjusting Entries

Mastering Adjusting Entries Funkytime Worksheet For the year ended July 31, 2009 Adjusted Trial balance Adjustments trial balance Account Title Debit Credit Debit Credit Debit Credit Cash 3,000 Accounts Receivable 2,200 Supplies 2,000 1,600 400 Prepaid Insurance 2,400 Land 18,000 Office Equipment 1,800 Accounts Payable 1,900 Unearned Rent 300 Bret Weems, Capital 24,000 Bret Weems, Drawing 3,000 Fees Earned 15,300 Wages Expense 4,275 Rent Expense 2,600 Supplies Expense 800 1,600 2,400 Utilities Expense 985 Insurance Expense 440 minus 400 2,000 plus 400 840 Example: The 12- month insurance policy was purchased on June 1. 41,500 41,500 Mastering Adjusting Entries

Mastering Adjusting Entries Funkytime Worksheet For the year ended July 31, 2009 Adjusted Trial balance Adjustments trial balance Account Title Debit Credit Debit Credit Debit Credit Cash 3,000 Accounts Receivable 2,200 Supplies 2,000 1,600 400 Prepaid Insurance 2,400 400 2,000 Land 18,000 Office Equipment 1,800 Accounts Payable 1,900 Unearned Rent 300 Bret Weems, Capital 24,000 Bret Weems, Drawing 3,000 Fees Earned 15,300 Wages Expense 4,275 Rent Expense 2,600 Supplies Expense 800 1,600 2,400 Utilities Expense 985 Insurance Expense 440 400 840 When all the adjustments are entered in the Adjustments columns, the new balances are entered in the Adjusted trial balance columns Mastering Adjusting Entries

Mastering Adjusting Entries Funkytime Worksheet For the year ended July 31, 2009 Adjusted Trial balance Adjustments trial balance Account Title Debit Credit Debit Credit Debit Credit Cash 3,000 3,000 Accounts Receivable 2,200 2,200 Supplies 2,000 1,600 400 Prepaid Insurance 2,400 400 2,000 Land 18,000 18,000 Office Equipment 1,800 1,800 Accounts Payable 1,900 1,900 Unearned Rent 300 120 180 Bret Weems, Capital 24,000 24,000 Bret Weems, Drawing 3,000 3,000 Fees Earned 15,300 15,300 Wages Expense 4,275 375 4,650 Rent Expense 2,600 2,600 Supplies Expense 800 1,600 2,400 Utilities Expense 985 985 Insurance Expense 440 400 840 Wages Payable 375 375 Rent Revenue 120 120 Depreciation Exp. 100 100 Accumulated Depr. 100 100 41,500 41,500 2,595 2,595 41,975 41,975 Mastering Adjusting Entries

Mastering Adjusting Entries Funkytime Worksheet For the year ended July 31, 2009 Mastering Adjusting Entries

Mastering Adjusting Entries Funkytime Worksheet For the year ended July 31, 2009 Adjusted Income Balance trial balance statement sheet Account Title Debit Credit Debit Credit Debit Credit Cash 3,000 Accounts Receivable 2,200 Supplies 400 Prepaid Insurance 2,000 Land 18,000 Office Equipment 1,800 Accounts Payable 1,900 Unearned Rent 180 Bret Weems, Capital 24,000 Bret Weems, Drawing 3,000 Fees Earned 15,300 Wages Expense 4,650 Rent Expense 2,600 Supplies Expense 2,400 Utilities Expense 985 Insurance Expense 840 Wages Payable 375 Rent Revenue 120 Depreciation Exp. 100 Accumulated Depr. 100 The revenue and expense balances are extended from the Adjusted trial balance columns to the Income statement columns, and . . . 41,975 41,975 Mastering Adjusting Entries

Mastering Adjusting Entries Funkytime Worksheet For the year ended July 31, 2009 Adjusted Income Balance trial balance statement sheet Account Title Debit Credit Debit Credit Debit Credit Cash 3,000 Accounts Receivable 2,200 Supplies 400 Prepaid Insurance 2,000 Land 18,000 Office Equipment 1,800 Accounts Payable 1,900 Unearned Rent 180 Bret Weems, Capital 24,000 Bret Weems, Drawing 3,000 Fees Earned 15,300 Wages Expense 4,650 Rent Expense 2,600 Supplies Expense 2,400 Utilities Expense 985 Insurance Expense 840 Wages Payable 375 Rent Revenue 120 Depreciation Exp. 100 Accumulated Depr. 100 The asset, liability and owner’s equity balances are extended from the Adjusted trial balance to the Balance sheet columns. 41,975 41,975 Mastering Adjusting Entries

Mastering Adjusting Entries Funkytime Worksheet For the year ended July 31, 2009 Adjusted Income Balance trial balance statement sheet Account Title Debit Credit Debit Credit Debit Credit Cash 3,000 Accounts Receivable 2,200 Supplies 400 Prepaid Insurance 2,000 Land 18,000 Office Equipment 1,800 Accounts Payable 1,900 Unearned Rent 180 Bret Weems, Capital 24,000 Bret Weems, Drawing 3,000 Fees Earned 15,300 Wages Expense 4,650 Rent Expense 2,600 Supplies Expense 2,400 Utilities Expense 985 Insurance Expense 840 Wages Payable 375 Rent Revenue 120 Depreciation Exp. 100 Accumulated Depr. 100 3,000 2,200 400 2,000 18,000 1,800 1,900 180 24,000 15,300 4,650 2,600 2,400 985 840 375 120 100 41,975 41,975 11,575 15,420 30,400 26,555 Mastering Adjusting Entries

Mastering Adjusting Entries Funkytime Worksheet For the year ended July 31, 2009 Adjusted Income Balance trial balance statement sheet Account Title Debit Credit Debit Credit Debit Credit 15,300 4,650 2,600 2,400 985 840 375 120 100 Fees Earned 15,300 Wages Expense 4,650 Rent Expense 2,600 Supplies Expense 2,400 Utilities Expense 985 Insurance Expense 840 Wages Payable 375 Rent Revenue 120 Depreciation Exp. 100 Accumulated Depr. 100 41,975 41,975 11,575 15,420 30,400 26,555 3,845 3,845 15,420 15,420 30,400 30,400 As a check, net income is added to the Income statement Debit column and Balance sheet Credit column. The difference between the Income statement Debit and Credit columns is net income. Mastering Adjusting Entries