Accounting records are kept on the accrual basis, except in the case of very small businesses. To accrue means to collect or accumulate. This means that revenue is recognized when earned, regardless of when cash is actually collected and expense is matched to the revenue, regardless of when cash is paid out. Most revenue is earned when goods or services are delivered. At this time, title to the goods or services is transferred and a legal obligation to pay for such goods or services is created. Some revenue, such as rental income, is recognized on a time basis, and is earned when the specified period of time has passed. The accrual concept demands that expenses be kept in step with revenue, so that each month sees only that month’s expenses applied against the revenue for that month. The necessary matching is brought about through a type of journal entry. In this post, we shall discuss these adjusting entries, and also the closing entries through which the adjusted balances are ultimately transferred to balance sheet accounts at the end of the fiscal year.
Adjusting Entries Covering Recorded Data
To adjust expense or income items that have already been recorded, a reclassification is required; that is, amounts have to be transferred from an asset, one of the prepaid expenses accounts (e.g., Prepaid Insurance), to an expense account (Insurance Expense). The following examples will show how adjusting entries are made for the principal types of recorded expenses.
Assume that on April 1, a business paid a $1,200 premium for one year’s insurance in advance. This represents an increase in one asset (prepaid expense) and a decrease in another asset (cash). Thus the entry would be:
[Debit]. Prepaid Insurance = $1,200
[Credit]. Cash = $1,200
At the end of April, one-twelfth of the $1,200, or $100, has expired. Therefore, an adjustment has to be made, decreasing or crediting Prepaid Insurance and increasing or debiting Insurance Expense. The entry would be:
[Debit]. Insurance Expense = $100
[Credit]. Prepaid Insurance = $100
Thus, $100 would be shown as Insurance Expense in the income statement for April and the balance of $1,100 would be shown as part of Prepaid Insurance in the balance sheet.
Another example: An insurance policy covering a two-year period was purchased on November 1 for $600. The amount was debited to Prepaid Insurance. The adjusting entry for the two-month period ending December 31 would be:
[Debit]. Insurance Expense = $50*
[Credit]. Prepaid Insurance = $50
* ($600/ 2 years) multiplied by (2/12) years equals $50
Assume that on April 1 a business paid $1,800 to cover the rent for the next three months. The full amount would have been recorded as a prepaid expense in April. Since there is a three-month period involved, the rent expense each month is $600. The balance of Prepaid Rent would be $1,200 at the beginning of May. The adjusting entry for April would be:
[Debit]. Rent Expense = $600
[Credit]. Prepaid Rent = $600
A type of prepayment that is somewhat different from those previously described is the payment for office supplies or factory supplies. Assume that on April 1, $400 worth of supplies were purchased. There were none on hand before. This would increase the asset Supplies and decrease the asset Cash. At the end of April, when expense and revenue were to be matched and statements prepared, a count of the supplies on hand will be made. Assume that the inventory count shows that $250 of supplies are still on hand. Then the amount consumed during April was $150. The two entries are as follows:
[Debit]. Supplies = $400
[Credit]. Cash = $400
[Debit]. Supplies Expense = $150
[Debit]. Supplies = $150
Supplies Expense of $150 will be included in the April income statement; Supplies of $250 will be included as an asset on the balance sheet of April 30.
In the previous three adjusting entries, the balances of the assets mentioned were all reduced. These assets usually lose their value in a relatively short period of time. However, assets that have a longer life expectancy (such as a building) are treated differently because the accounting profession wants to keep a balance sheet record of the equipment’s original, or historical, cost. Thus the adjusting entry needed to reflect the true value of the long-term asset each year must allocate its original cost, known as depreciation. In order to accomplish the objectives of keeping original cost of the equipment and also maintaining a running total of the depreciation allocated, we must create a new account entitled “Accumulated Depreciation“. This account, known as a contra asset (an asset that has the opposite balance to its asset), summarizes and accumulates the amount of depreciation over the equipment’s total useful life.
Example: Assume that machinery costing $15,000 was purchased on February 1 of the current year and was expected to last ten years. With the straight-line method of depreciation (equal charges each period), the depreciation would be $1,500 a year, or $125 a month. The adjusting entry would be as follows:
[Debit]. Depreciation Expense = $125
[Credit]. Accumulated Depreciation = $125
At the end of April, Accumulated Depreciation would have a balance of $375, representing three months’ accumulated depreciation. The account would be shown in the balance sheet as follows:
Less: Accumulated Depreciation $ 375
Machinery Book Value = $14,625
Another example: a machinery costing $12,000, purchased on November 30, is being depreciated at the rate of 10 percent per year. The adjusting entry for December 31 would be:
[Debit]. Depreciation Expense—Machinery = $100*
[Credit]. Accumulated Depreciation—Machinery = $100
*$12,000 times 10% per year times (1/12) year equals $100
Adjusting Entries Covering Unrecorded Data
In the previous section we discussed various kinds of adjustments to accounts to which entries had already been made. Now we consider those instances in which an expense has been incurred or an income earned but the applicable amount has not been recorded during the month.
Example: if salaries are paid on a weekly basis, the last week of the month may run into the next month. If April ends on a Tuesday, then the first two days of the week will apply to April and will be an April expense, whereas the last three days will be a May expense. To arrive at the proper total for salaries for the month of April, we must include, along with the April payrolls that were paid in April, the two days’ salary that was not paid until May. Thus, we make an entry to accrue the two days’ salary.
Assume that April 30 falls on Tuesday. Then, two days of that week will apply to April and three days to May. The payroll is $500 per day, $2,500 per week. For this example, $1,000 would thus apply to April and $1,500 to May. The entry would be as follows:
[Debit]. Salaries Expense = $1,000
[Credit]. Salaries Payable = $1,000
When the payment of the payroll is made—on May 8—the entry would be as follows:
[Debit]. Salaries Expense = $1,500
[Debit]. Salaries Payable = $1,000
[Credit]. Cash = $2,500
As can be seen above, $1,000 was charged to expense in April and $1,500 in May. The debit to Accrued Salaries Payable of $1,000 in May merely canceled the credit entry made in April, when the liability was set up for the April salaries expense.
After the income statement and balance sheet have been prepared, a summary account—known as “Income Summary“—is set up. Then, by means of closing entries, each expense account is credited so as to produce a zero balance, and the total amount for the closed-out accounts is debited to Income Summary. Similarly, the individual revenue accounts are closed out by debiting them and their total amount is credited to the summary account. Thus, the new fiscal year starts with zero balances in the income and expense accounts, whereas the Income Summary balance gives the net income or the net loss for the old year.
Let’s do one example for easier understanding. Below is Royal Bali Cemerlang’s trial balance:
The closing procedure and its steps are as follows:
Close out revenue accounts. Debit the individual income accounts and credit their total to Income Summary.
[Debit]. Fees Income = $2,500
[Credit]. Income Summary = $2,500
Close out expense accounts. Credit the individual expense accounts and debit their total to Income Summary.
[Debit]. Income Summary = $900
[Credit]. Rent Expense = $500
[Credit]. Salaries Expense = $200
[Credit]. Supplies Expense = $200
Close out the Income Summary account. If there is a profit, the credit made for total income in the first entry above will exceed the debit made for total expense in the second entry above. Therefore to close out the balance to zero, a debit entry will be made to Income Summary. A credit will be made to the capital account to transfer the net income for the period. If expenses exceed income, then a loss has been sustained and a credit will be made to Income Summary and a debit to the capital account. Based on the information given, the entry is:
[Debit]. Income Summary = $1,600
[Credit]. Capital Account or Retained Earning = $1,600
Close out the drawing account. The drawing account is credited for the total amount of the drawings for the period, and the capital account is debited for that amount. The difference between net income and drawing for the period represents the net change in the capital account for the period.
The net income of $1,600 less drawings of $400 results in a net increase of $1,200 in the capital account. The closing entry is as follows:
[Debit]. Capital Account = $300
[Credit]. Drawing Account = $300
After the posting of the closing entries, all revenue and expense accounts and the summary accounts are closed. When ruling an account where only one debit and one credit exist, a double rule is drawn below the entry across the debit and credit money columns. The date and reference columns also have a double rule, in order to separate the transactions from the period just ended and the entry to be made in the subsequent period.
Post-Closing Trial Balance
After the closing entries have been made and the accounts ruled, only balance sheet accounts—assets, liabilities, and capital—remain open. It is desirable to produce another trial balance to ensure that the accounts are in balance. This is known as a post-closing trial balance.