ADJUSTMENTS

By Jeff Boulton

home

 

TOPICS:

What are Adjustments and Why are They a Concern?
 
1. Late Invoices

2. Accruals

3. Allocations and Amortization

a. Bad Debt
b. Supplies
c. Amortization - What is it?

d. Amortization - How do you Amortize?

i. The Straight-Line method
ii. The Declining Balance method

 

 

 

 

 

 

 

What are Adjustments?

back to top

Adjustment are exactly what the name suggests: they are adjustments made to the books of a company at the end of the accounting cycle. Adjustments are made to ensure that financial information adheres to GAAPs.

 

Why are they a concern?

Without adjustments, accounting for many companies would not adhere to GAAPs, and therefore wouldn’t 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 things “build up” (or accrue) over time but are never billed in the current period. An example of this would be salaries, which may be earned late in December of this year, but not paid until early next year.

It is because of these kinds of events that adjustments must occur.

back to top

 


 

 

 

 


1. LATE INVOICES

back to top

 

We will begin by looking at the concept of the late invoice.

On January 10th, of this year, we received a purchase invoice from J. Simmons Inc. for repair services that were done on December 29th of last year.

This is a late invoice requiring an adjustment. The journal entry to record this adjustment is the same as it would be if the invoice arrived on time.

 

 

 

 

 

 

 

2. ACCRUALS

back to top

 

Accruals are something that build up or accumulate. All that is necessary for an accrual to be earned or incurred, is FOR THE PASSAGE OF TIME. We will examine the following four types of accruals:

a. Prepaid Expenses
b. Unearned Revenues
c. Interest
d. Salaries and Wages

 

 

 

 

 

 

 

 

 

 

 


a. Prepaid Expenses

back to top

 

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.

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. The journal entry would look like this on January 1st.


However, on January 31st, one month’s worth of rent has been used up (i.e. one’s month’s worth of rent expense has accrued). If this company were preparing adjustments at the end of January, the entry to adjust prepaid rent would be:

($1,000 of rent is what the company pays each month)

 

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

 

1. The prepaid expense account – this is a current asset as it hasn’t been consumed yet (because if the company moved for example, they’d get it back)
2. 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.

 


A prepaid expense usually appears on the balance sheet right after supplies and any inventory items as show below.


back to top

 

 

 

 

 

 

 


b. Unearned Revenue

back to top

 

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:

 

1. The unearned revenue account – this is a current liability account (again, because if you end up not earning the revenue, you have to give the prepaid funds back to the customer)
2. The revenue account – where the liability goes once the revenue has been earned.

 

If we return to our example of prepaid rent, we will now examine what our prepaid rent looks like in the accounts of the landlord.

 

On January 1st when we prepaid the year’s rent of $12,000, the landlord would have recorded the following transaction:

Then, at the end of the month (if the landlord does adjustments then), when we showed an accrued rent expense of $1,000, the landlord would record the following transaction to show accrued revenue:

 

 

Practice Exercise - Do it on your own first!

 

Ed’s Shoppe pays rent of $1,750 per month, and pays business insurance premiums of $950 per month. If Ed’s Shoppe pays for these costs for a year in advance on January 1st of this year, make the entry on January 1st to record the payment, and on January 31st to record the adjustment for:

a) Ed’s Shoppe
b) The Landlord
c) The Insurance Company

Answer - Do it on your own first!

 

 

back to top

 

 

 

 

 

 

 

 

 

 


c. Interest

back to top


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 your accounting period, which may be the 31st of the month.

 

Observe:

 

The reason can also be shown visually as follows:

 

 

Since half the interest period falls in July, half the interest expense must be recorded in July.


In the images above, assume our company acquired a $100,000 Bank Loan at 6% interest on July 15th. We must make adjustments for interest accrued (but NOT PAID)on July 31st at the end of our accounting period, and we are required to pay our first month's interest payment of $500 on August 15th, one month later. ($100,000 x 0.06 ÷ 12 = $500)

 

The entry to show us acquiring the loan is as follows.


If our accounting period ends on July 31st, no interest payment will have been recorded. However, July 31st is half way to our first interest payment, therefore we have accrued half of that interest expense and the entry would be as follows:


Note: no cash is paid on this date. This is because the interest payment is not due on July 31st. It isn't due until August 15th. Only the obligation to pay is recorded on the July 31st adjustment date.

 


On August 15th, our first interest payment is made. We must record the interest earned 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. The entry looks like this:

 

 

Now take a look at these same events and compare them with the books of the bank from which you borrowed the money. You'll see that an interest expense to us, is interest revenue to a bank. Interest to be paid (payable) is interest to be received by the bank. Observe:

 

 

 

Practice Exercise - Do it on your own first!

 

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.

Answer - Do it on your own first!

 

 

 

 

Practice Exercise - Do it on your own first!

 

Now 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.

 

Answer - Do it on your own first!

 

 

Note how 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.

 

back to top

 

 

 

 

 

 

 

 

 


d. Salaries and Wages

back to top

 

Note: salaries and wages are not the same thing. Wages are based on how many hours you work, salaries are generally fixed.

 

However, salaries and wages work in a similar fashion to interest. As employees earn their pay, a company earns 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 two Wednesdays. In this example, the last pay day was July 24th. The events evolve as follows in the image below:

 


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’s not a pay day, so no payment would be made. Observe:

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

 

 

 

Practice Exercise - Do it on your own first!

 

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

Answer - Do it on your own first!

 

 

back to top

 

 

 

 

 

 

 

 

 

3. ALLOCATIONS and AMORTIZATION

back to top

 

Allocations and amortization are the conversion of asset value into expense. They are done to make the accounting records more accurately reflect what is happening, but there is no magical way to get a 100% accurate value. They are estimations; they are guesses, and they are arbitrary in many ways. There are, however, set methods of coming up with the adjustment value.The following three types will be examined:

a. Bad Debt

b. Supplies

c. Amortization

i The Straight-line method

ii The Declining balance method

 

 


So, what is an allocation?

 

When we're talking about cost, "allocating" means taking some of the value of an asset and turning it into an expense in the period using a prescribed method (such as the straight-line method of amortization). This cost allocation may or may not truly reflect how an asset’s value is expiring over time.

Before we look at our three types of allocations, we must start with the concept of the contra-account.

 

Contra Accounts

 

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 a drawings of cash by the owner:

 


A contra account is shown together with its main account on the financial statements. When added together, the two accounts produce the total net value for that account. The concept of the contra account (and its associated account) is important, because there are adjustments that are involved with a number of them.

 

Below is a list of all the contra accounts you’ll encounter in this course.

 

 

back to top

 

 

 

 

 

 

 

 

a. Bad Debt

back to top

 

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. You would be telling them that you expect to collect all of your accounts receivable, when really, you know you will not. Therefore an allocation for bad debt must be made. It is an adjustment.

 

There are two steps in the bad debt process:

 

1. Make an allowance as soon as there is a possibility that customers may not pay. This is when you recognize the expense.
2. Remove the accounts receivable when you are sure they will not pay.

 

There are three accounts involved with Accounts Receivable:

1, Accounts Receivable (an asset)

2. Allowance for Doubtful Accounts (a contra-asset - this offsets Accounts Receivable)

3. Bad Debt Expense (an expense - to show the loss from customers not paying)

 

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 net sales on credit. The senior accountant thinks that history will repeat itself, and orders an allowance of 2% of net sales. (2% x $100,000 = $2,000). This is step 1 above.

 

The entry to record the adjustment for step 1 is:


This insures that the cost of bad debt is recorded in the period with the sales from which the bad debt originated; this adheres to the Matching Principle.

 

After this first adjustment, the presentation of Accounts Receivable on the Balance Sheet would look like this (assume we didn't collect any of our $100,000 in credit sales).

 

 

See how we are no longer showing $100,000 as our expected Accounts Receivable? This would be misleading to do when we know that we likely won't collect all of them; it's not realistic. Instead, we expect - on average - to collect only $98,000.

 

 

Later on, once the accountant is certain the delinquent accounts will not be paid, step 2 is carried out and they are ‘written off’ as follows:

Notice how no expense is recorded above when the accounts receivable is written off. It was recorded earlier when you first thought you'd have bad debt and made the allowance. This places the actual expense in the period when it was really earned (i.e. when you made the bad sale on account to a deliquent customer), and that ensures that the Matching Principle is followed. You are then free to 'write off' the Accounts Receivable whenever you feel it is appropriate, with no further effect on Net Income.

 

 

Practice Exercise - Do it on your own first!

 

Sales 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.

Answer - Do it on your own first!

 

 

back to top

 

 

 

 

 

 

 


b. Supplies

back to top

 


No one creates a source document, and then records a journal entry every time somebody goes to the supply room and takes a 1¢ pencil. That would be moronic.

 

Instead, a count is made (and often is estimated) of the value of supplies remaining in the storeroom at the end of the accounting cycle. What’s missing is allocated to supplies expense (even if some of it may have been stolen and not used in the business).

 

For example, an organization started this year with $1,500 of supplies. They 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 was made of the supply storeroom and found that only $1,200 remained. The journal entry to record the adjustment will be ($3,000 - $1,200 = $1,800):

This entry will record the missing $1,800 as expense, and lower the value of the supplies account from $3,000 to $1,200, which is the current level of supplies on hand.

 

 

 

Practice Exercise - Do it on your own first!

 

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 remain in the storeroom. Make the adjusting entry for December 31st.

Answer - Do it on your own first!

 

 

back to top

 

 

 

 

 

 

c. Amortization

back to top

 

What is Amortization?

Amortization is the allocation of the cost of a fixed asset to expense at a pre-determined rate over time. (If you just said “huh?” read this: Amortization takes value away from a fixed asset, and turns it into an expense. This is done to reflect the wearing out of the asset over time.)

 

Think about it: if we waited until the day a piece of equipment broke down for good, before we recorded the loss of that asset’s total value, we would show an enormous loss in the period that it broke, rather than showing the wearing out of the asset over time, which is what really happens.

 

Below is a comparison of a $40,000 piece of equipment that runs for four years then unexpectedly breaks in year 5. First you can see how it is reported on the Balance Sheet and Income Statement without Amortization. Below that you can see what it looks like with Amortization.

 

Follow the big orange numbers to examine the comparison closely.

 

 

back to top

 

 

 

 

 

 

 

 

 

 

How do you amortize?

back to top

 

Amortization is calculated on ALL fixed assets except land, and must always be up to date on an asset before that asset is sold or disposed of.

 

NOTE: The adjusting journal entry for Amortization is always structured the same. However, there are two methods of calculating the value of amortization. Both are acceptable under GAAPs. They are:

i. The Straight-line method
ii. The Declining balance method

 

Regardless of the method above, there are three accounts associated with every long-term asset (except land) :

 

1. The Asset Account - (i.e. Equipment, Machinery, etc.)

2. Accumulated Amortization - (the contra asset account - offsets the asset's value)

3. Amortization Expense - (the expense account)

 

The expense account is where the value of the asset is expensed to. The accumulated amortization account is where you accumulate all the amortization to date.

 

The journal entry is structured like this (every time, for every long term asset):


NOTE: the original asset account is NOT TOUCHED! All amortization amounts are accumulated to the contra asset account called Accumulated Amortization. This is so that a comparison can be made between the original purchase price, and total amortization to date. The higher the Amortization, the older the asset. This is important information that would not be revealed if you removed amortization from the original asset account.

 

Look at the following comparison for a $100,000 piece of equipment with $30,000 of accumulated amortization expense over the years:


 

The difference in size between the original asset account and the Accumulated Amortization to date gives us an indication of the age of these assets. The greater the amortization, the older the assets. This is why we have an accumulated amortization account. It provides us with valuable information.

 

back to top

 

 

 

 

 

 

 

 

 

Amortization: The Straight-line method:

back to top

 

Remember: the journal entry to record the amortization adjustment is always the same. However, the way of finding the amortization amount can differ.

 

The straight-line method uses the following formula:

 

Note that this method of amortization will produce exactly the same amortization expense amount for each year of the asset’s life.

 

Observe the following:

 

An asset purchased for $20,000, with a salvage value of $3,000, and a useful life of 10 years will have an annual rate of amortization of:

 

Then record the journal entry as follows (as always):

 

Over five years, its amortization schedule looks like this:

Note how amortization expense is exactly the same every year.

 

back to top

 

 

 

 

 

 

 

 

 

 

 


Amortization: The Declining Balance method:

back to top

 

Under the declining balance method, the same asset will be amortized differently. Remember: the journal entry to record the amortization adjustment is always the same. Just the amortization amount will differ.

 

Let's use the same asset which was purchased for $20,000, with a salvage value of $3,000, and a useful life of 10 years, except this time, we'll say we're going to use an amortization rate of 20% per year. This means it will have an annual rate of amortization of:

 

Note for declining balance, the amortization expense will change every year. This is because it is based on a rate. That rate is multiplied by a continuously falling book value balance. (Hence the name: declining balance).

 

Note though, that to record the journal entry the process is the same. Only the amount changes:

 

Now, in year two with declining balance, the value changes, as 20% of a different book value, is a different amount. Year 2 amortization expense is calculated as follows:

Note how now in year 2 with the declining balance method, the amortization expense is lower.

 


The process continues. Each year will produce a different (and smaller) amortization expense. The schedule for the first five years of amortization using declining balance is:

You can see that Amortization expense falls every year. Once again, this is because it is based on a constant rate that is multiplied by a continuously falling book value.


What’s the point?

 

If you graph the schedules of the two amortization methods, you’ll notice that straight-line amortizes the equipment evenly, and declining balance amortizes the asset more quickly in the beginning than in the end.


Thus, management should select the amortization method that best represents how they feel the asset will actually wear out over time. For example: a vehicle loses a large portion of its value early in its life, therefore declining balance may be the best choice for this type of asset.

 

 

Practice Exercise - Do it on your own first!

 

Complete the following chart of amortization schedules.

 

Answer - Do it on your own first!

 

 

back to top