Where We’ve Been

We’ve been working our way through a complete accounting cycle. Specifically, we have learned to:

· Analyze business transactions

· Journalize the transactions in a journal

· Post the transactions to a ledger (or to t-accounts to save time)

· Prepare a trial balance

Where We’re Going

We will continue the accounting cycle in the next few chapters as follows:

· Gather adjustments and prepare a worksheet This chapter

· Prepare financial statements This chapter (& previous ones)

· Journalize and post adjustments This chapter

· Journalize and post closing entries Chapter 6

· Prepare a post closing trial balance Chapter 6

You are well on your way to completing a full accounting cycle!

Trial Balance - The Starting Point

You already know how to do this. If you look at the worksheet, you will notice the first columns are the same trial balance that we have already started with. Make sure the debits equal the credits prior to making the adjustments.

Adjustments

Adjustments are needed because certain accounts in the trial balance do not contain accurate balances. That is, certain accounts are not up-to-date. Adjustments are internal transactions that need to be recorded to bring the ledger accounts up to date. They are called internal transactions because there are no outside source documents which tell the accountant that an economic transaction has taken place. All adjustments in this chapter will record the usage or expiration of a cost. All adjustments will include a debit to an expense account and a credit to a balance sheet account. This means that all these adjustments will have a direct impact on all of the financial statements. For this reason, they are very important to understand. This chapter introduces three basic adjustments that almost all firms must make. We will discuss these adjustments in detail in class.

The Adjustment to Prepaids

As you will recall, we have learned to debit a prepaid when we pay for something more than one month in advance. The problem occurs because as time passes, the company no longer has an asset of value. Instead they have an expired cost. The adjustment removes the worthless asset from the balance sheet and places an expense on the books. The journal entry is:

Dr. Insurance Expense (or advertising expense or rent expense depending on the item prepaid)

Cr. Prepaid Insurance (or advertising or rent)

The effect of not making the entry is that net income is overstated and so are assets. For professional service businesses, like doctor’s, lawyers, accountants, appraisers, etc. insurance costs are exorbitant and failure to make this adjustment could mean a very large misstatement on the financial statements.

Depreciation of Equipment

Fixed or Plant Assets are assets that last longer than one year. Popular kinds of fixed assets are property, plant and equipment. (You will have several chapters on this topic in BUSA 11 next semester.) Eventually these assets wear out and are used up. However, if no adjustment is made, the asset will continue to be carried on the books at its original cost. The accountant’s answer to this dilemma is depreciation. Depreciation is the systematic allocation of the asset’s cost over its useful life. We will only learn one method of depreciation, although there are many to choose from. The one we will learn is called straight-line deprecation. We will calculate it as follows:

Cost – Estimated Salvage Value = Depreciation

Life

Most companies record this on a monthly basis, so the “Life” is usually expressed in terms of the number of months in the asset’s life.

The journal entry is:

Dr. Depreciation Expense

Cr. Accumulated Depreciation

The Accum. Depn account is a contra asset account. This means that it works contrary to a normal asset balance. The plus and minus signs are the reverse of a normal asset. As the name implies, this account keeps track of the accumulated depreciation of the asset. It grows every year. On the balance sheet, assets are presented at their net book value, which means that you show the asset’s cost less its accumulated depreciation. The difference is termed the book value.

The effect of not recording this asset is that net income is overstated and assets are overstated.

The Supplies Adjustment
In previous chapters, we learned that when supplies are purchased, the asset account "supplies" is debited to reflect the increase in supplies. However, as you know, supplies are used up in the course of doing business. The cost of supplies used represents an operating expense that has not been recorded. The adjustment for supplies is based on USAGE. This means that often we must look at the balance in the account and compare it to the actual amount of supplies on hand. The difference between these two amounts represents the amount of supplies used up and the amount of the adjustment to be recorded.

The journal entry is:

Dr. Supplies Expense
Cr. Supplies

The effect of not recording this asset is that net income is overstated and assets are overstated.

The Worksheet – A helpful tool for adjustments

The worksheet is an internal document. It stays within the accounting department. It is not a formal financial statement. It is used to help gather the data so that the appropriate adjustments can be made.

The first few columns of the worksheet are for the normal trial balance that we learned in the last chapter. Instead of preparing the trial balance on a separate sheet, as we have been doing, it will be the starting point for the worksheet. The adjustments that were just discussed are dropped into the appropriate debit or credit adjustment column. The next set of columns are called the adjusted trial balance columns. This is just a horizontal math exercise. Take the trial balance columns and extend the adjustments across. The debits must still equal the credits when you are done footing the columns. From that point on, all one must do is drop the amounts into the appropriate income statement or balance sheet columns. The only accounts that go on the income statement columns are revenues and expenses. All the rest go in the balance sheet columns. The balancing figure that must match on both sets of columns is the resulting net income or loss. There are transparancies in your text, located after page 144, that will walk you through the preparation of a worksheet step by step. We will also cover this in class.

Completing the financial statements

You have already learned how to do a complete set of financial statements consisting of an income statement, a statement of owner’s equity and a balance sheet. Nothing new here, except perhaps the presentation of fixed assets on the balance sheet. You can see a good presentation of financial statements in figure 5.8G in your text. The only difference is now you will be pulling the amounts from the income statement and balance sheet columns of the worksheet. That’s it!

What’s left?

Once the financial statements are prepared, everything balances out, and all are happy, we must get those adjustments from the informal worksheet and into the formal accounting system. The hard part is done. All the calculations are done. All you have to do now is journalize the adjustments in the journal. They are handled in the same manner, except the word “Adjusting” is placed above the entries in the journal. They are also posted to the ledger in the same manner, except that you write in “adjusting” in the item column of the ledger.