Adjusting Entries

Adjusting Entries in the Accounting Cycle

Adjusting entries are made to account for transactions that occurred during the period but were not yet recorded. Adjusting entries are classified as prepayments, accruals, and estimated items.

Prepayments are transactions in which the company acquired an asset before its use. For example, Sunny Sunglasses Shop paid for one year of insurance and recorded it as prepaid expense, an asset, because it was purchased for the year. Every month, Sunny will expense this item to record the portion that the company used for the month.

An accrual represents transactions that have already occurred, but were not yet recorded. An example of an accrual is the recording of interest expense owed on a loan for the month.

An estimate adjusts an account balance to better represent the income for the period. Two main estimate items are depreciation and bad debt expense. Depreciation spreads the use of a long-term asset over its useful life by expensing a portion of it for each period.

For example, if Sunny purchased a car for $10,000 on January 1 with an estimated life of 10 years, he would enter a depreciation expense of $1,000 for the year (10,000/10). If his reporting period were monthly, he would enter $83 each month (1,000/12).

Bad debt expense is an expense resulting from the uncollectible portion of accounts receivable. Sunny estimates that 1% of his total credit sales will not be collected, or an estimated $700 for the year. Sunny records the adjusting entry in bad debt expense for January and the other half of the adjusting entry to accounts receivable, allowance for doubtful accounts.

Prepayments are transactions already recorded, but require an end of period adjustment to accurately reflect the current balance. Examples of Prepayments include the following: Prepaid Insurance Prepaid Rent Accruals are transactions not yet recorded, and require an end of period adjustment to accurately reflect its occurrence. Examples of accruals include the following: Interest owed on a loan. Wages owed for the period. Revenue earned, but not yet recorded. Estimated Items are adjustments to accounts to more accurately reflect income for the period. Examples of estimated items include the following: Depreciation expense to record a portion of a long-term asset used for the period. An estimate for uncollectible accounts receivable.

For example, on January 1 Sunny Sunglasses Shop purchased insurance for the year for $2,400. Sunny recorded the transaction by debiting the asset, prepaid insurance, and crediting cash, for $2,400.

Date	Account and Explanation	Reference	Debits	Credits
Jan 1	Prepaid Insurance	150	$2,400	–
Jan 1	Cash	100	–	$2,400

Because the month of January has been completed, Sunny makes the following adjusting entry for prepaid insurance:

Date	Account and Explanation	Reference	Debits	Credits
Jan 31	Insurance Expense	545	$200	–
Jan 31	Prepaid Insurance	150	–	$200

The company used one month of the insurance, or $200 (2,400/12) and recorded the portion of insurance consumed as an expense for January. This transaction increased the insurance expense by $200, and reduced the prepaid expense account by $200 (debits increase expenses and assets, credits reduce expenses and assets). The insurance expense of $200 represents the portion of the prepaid expense consumed in January, leaving a balance left in prepaid expenses of $2,200 to cover the next 11 months.

If Sunny had originally recorded the insurance as an expense, the original entry and the adjusting entry would appear as follows:

Date	Account and Explanation	Reference	Debits	Credits
Jan 1	Insurance Expense	545	$2,400	–
Jan 1	Cash	100	–	$2,400

Adjusting entry to report January insurance expense:

Date	Account and Explanation	Reference	Debits	Credits
Jan 31	Prepaid Insurance	150	$2,200	–
Jan 31	Insurance Expense	545	–	$2,200

Both methods result in a balance of $200 for the insurance expense, and $2,200 in prepaid insurance at the end of January.

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