The Adjusting Process and Related Entries
In the previous chapter, you saw how tentative financial statements could be prepared directly from a trial balance. However, you were also cautioned about "adjustments that may be needed to prepare a truly correct and up-to-date set of financial statements." This occurs because:
• MULTI-PERIOD ITEMS: Some revenue and expense items may relate to more than one accounting period, or
• ACCRUED ITEMS: Some revenue and expense items have been earned or incurred in a given period, but not yet entered into the accounts (commonly called accruals).
In other words, the ongoing business activity brings about changes in economic circumstance that have not been captured by a journal entry. In essence, time brings about change, and an adjusting process is needed to cause the accounts to appropriately reflect those changes. These adjustments typically occur at the end of each accounting period, and are akin to temporarily cutting off the flow through the business pipeline to take a measurement of what is in the pipeline - consistent with the revenue and expense recognition rules described in the preceding portion of this chapter.
There is simply no way to catalog every potential adjustment that a business may need to make. What is required is firm understanding of a particular business's operations, along with a good handle on accounting measurement principles. The following discussion will describe "typical adjustments" that one would likely encounter. You should strive to develop a conceptual understanding based on these examples. Your critical thinking skills will then allow you to extend these basic principles to most any situation you are apt to encounter. Specifically, the examples will relate to:
It is quite common to pay for goods and services in advance. You have probably purchased insurance this way, perhaps 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. As such, the initial expenditure gives rise to an asset. As time passes, the asset is diminished. 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. As a general representation of this process, assume that you prepay $300 on June 1 for three months of lawn mowing service. As shown in the following illustration, this transaction initially gives rise to a $300 asset on the June 1 balance sheet. As each month passes, $100 is removed from the balance sheet account and transferred to expense (think: an asset is reduced and expense is increased, giving rise to lower income and equity - and leaving the balance sheet in balance):
$300 is paid in advance on June 1 for three months of lawn mowing service
Examine the journal entries for this cutting-edge illustration, and take note of the impact on the balance sheet account for Prepaid Mowing (as shown by the T-accounts at right):
Now that you have a general sense of the process of accounting for prepaid items, let's take a closer look at some specific illustrations.
Illustration of Prepaid Insurance
Insurance policies are usually purchased in advance. You probably know this from your experience with automobile coverage. Cash is paid up front to cover a future period of protection. Assume a three-year insurance policy was purchased on January 1, 20x1, for $9,000. The following entry would be needed to record the transaction on January 1:
By December 31, 20x1, $3,000 of insurance coverage would have expired (one of three years, or M of the $9,000). Therefore, an adjusting entry to record expense and reduce prepaid insurance would be needed by the end of the year:
As a result of the above entry and adjusting entry, the income statement for 20x1 would report insurance expense of $3,000, and the balance sheet at the end of 20x1 would report prepaid insurance of $6,000 ($9,000 debit less $3,000 credit). The remaining $6,000 amount would be transferred to expense over the next two years by preparing similar adjusting entries at the end of 20x2 and 20x3.