Journal entries are recorded throughout the accounting period as and when financial transactions occur. However, at the end of an accounting period, some adjustments are often required to the accounting records to meet the requirements of accrual basis of accounting. These adjustments are made through journal entries called adjusting entries.
Purpose of recording these adjusting entries and following accrual basis of accounting is to report the numbers that accurately represent the financial position and financial performance of a business. By doing so, income that has been earned and expenses that have been incurred by a business in an accounting period are reported in the income statement. Furthermore, by recording adjusting entries, assets and liabilities accurately reflect the financial position of a business at the end of an accounting period.
Best way to proceed is to prepare a preliminary balance sheet and income statement, and then go through each financial statement line item and evaluate whether it reflects the true picture or is there any adjustment required. Let’s go through an illustrative balance sheet and income statement and understand the adjusting entries with the help of following example.
Example
Preliminary balance sheet and income statement Ricardo Garments Inc. are given below. We’ll go through each financial statement line item and discuss the adjusting entries.
Ricardo Garments Inc.
Balance sheet
As at 31 December 20xx
| US Dollars | |
| ASSETS | |
| Non-current assets | |
| Fixed assets | 805,000 |
| Current assets | |
| Inventory | 12,000 |
| Trade receivables | 15,500 |
| Advances and prepayments | 3,600 |
| Cash and bank balances | 30,205 |
| 61,305 | |
| Total assets | 866,305 |
| EQUITY AND LIABILITIES | |
| Owner’s equity | |
| Capital | 600,000 |
| Retained earnings | 181,155 |
| 781,155 | |
| Non-current liabilities | |
| Long term loan payable | 50,000 |
| Current liabilities | |
| Short term loan payable | 10,000 |
| Deferred income | 4,000 |
| Trade and other payables | 21,150 |
| 35,150 | |
| Total equity and liabilities | 866,305 |
Ricardo Garments Inc.
Income statement
For the year ended 31 December 20xx
| US Dollars | |
| Income | |
| Cash sales | 80,000 |
| Credit sales | 20,000 |
| 100,000 | |
| Expenses | |
| Material cost | 30,000 |
| Selling and administrative expenses | 5,500 |
| Salaries and wages | 22,000 |
| Utilities | 7,108 |
| 64,608 | |
| Net profit | 35,392 |
Adjustments
- Fixed assets are evaluated, and it is noted that depreciation for the year has not been recorded. Accountant of Ricardo Garments Inc. has calculated the depreciation which comes out to be $18,000.
- Inventory balance is checked and compared with physical stock count done at year end. The accountant is confident that the balance accurately reflects the inventory in hand as at 31 December 20xx, so no adjustment is required.
- To evaluate the accounts receivable balance, party wise ageing analysis is done to identify any doubtful balances. It was estimated that the Company might not be able to recover $500 against which a provision for doubtful debt will be required.
- Advances do not require any adjustment, whereas prepayments will be discussed later along with accruals.
- The accountant has made a bank reconciliation and the balance of bank in the ledger account matches with that of bank reconciliation, so no adjustment is required.
- All liabilities are stated accurately, however, some accruals are not recorded, so trade and other payables need adjustment to include these accruals.
Accruals and prepayments
Accruals and prepayments are explained separately as usually adjusting entries are required for them and it is important to understand these two concepts.
Accruals
Accruals can be related to revenues as well as expenses. For expenses, it refers to those expenses which have been incurred but have not been billed by the vendor or which have not been paid till the reporting date. For example, Ricardo Garments Inc. has used the electricity and water facilities in the month of December, however, the utility bill for the month of December will be received in January. As the expense is incurred in December, so it should be recorded in December as accrued utility expense. Similarly, wages of workers for the month of December will be processed and paid in January, but as they have worked in December, so their wages should be recorded as expense in the month of December. Adjustments of $2,500 and $4,000 are required for recording accrued utility expenses and accrued wages, respectively.
Similarly, accruals for revenue refer to such revenue or income which has been earned but not yet billed or received. For example, at the end of November 20xx, Ricardo Garments Inc. started a project to provide embroidery services to one of its major customers. It was a big project which was expected to be completed in February of next year. At year end, 50% work is done, however, invoice will be issued at the completion of project. Total agreement is for $25,000. In this case, the Company has done half of the work and in other words, earned 50% of the contract value. Therefore, regardless of the invoicing, $12,500 should be recorded as services income as per accrual method of accounting.
Prepayments
Prepayments can also be related to revenues as well as expenses. If it is related to an expense and payment is made by an entity, it is called a prepaid asset. Whereas if it is related to income and payment is received by an entity, it is called deferred income, which is a liability.
Prepaid assets
When an entity pays an amount as consideration for some services which will be used over a period of time, that payment is not recorded as expense at the time of payment. It is recorded as a prepaid asset and is charged to income statement over the period of time for which that service is used. For example, Ricardo Garments Inc. has paid an insurance premium of $3000 on 1 October. Term of insurance coverage is one year. It is recorded as prepaid insurance at the time of payment. At year end, three months have been passed, that means 25% of the total term of insurance has been passed, so 25% of $3,000 (i.e. $750) should recorded as insurance expense and prepaid insurance asset should be reduced accordingly. Another common example of prepayments is prepaid rent which is also initially recorded as prepaid asset and is charged to income statement as rent expense over the term of prepayment.
Deferred income
When an entity receives an amount as consideration for some services which will be provided by the entity over a period of time, that amount is not recorded as income at the time of receipt. It is recorded as deferred income and is transferred to income statement over the period of time for which that service is related to. For example, Ricardo Garments Inc. has started a stitching and designing training course of 6 months for people who want to learn this trade. The course started on 1 October and the Company received $4,000 as advance fee for the course. At the time of receipt, it is not recorded as income as related service will be provided by the Company over the next 6 months. It is recorded as a liability called deferred income. At year end, half of the course is completed, so 50% of deferred income (i.e. $2,000) should be transferred to income statement as training fee income and deferred income (liability) should be reduced accordingly.
Based on the above information, some adjustments are required in the books of Ricardo Garments Inc. Let’s take a look at the adjusting entries related to above information.
Adjusting entries
| Date | Accounts | Debit | Credit |
| 31 Dec | Depreciation | 18,000 | |
| Accumulated depreciation | 18,000 | ||
| (Recording depreciation of fixed assets) | |||
| 31 Dec | Provision for doubtful debts expense | 500 | |
| Provision for doubtful debts | 500 | ||
| (Recording provision for doubtful debts, a contra asset account which will reduce the balance of receivables) | |||
| 31 Dec | Utility expenses | 2,500 | |
| Accrued liabilities | 2,500 | ||
| (Recording accrued utility expenses) | |||
| 31 Dec | Staff cost | 4,000 | |
| Accrued liabilities | 4,000 | ||
| (Recording accrued wages) | |||
| 31 Dec | Accounts receivable | 12,500 | |
| Services income | 12,500 | ||
| (Recording accrued income related to embroidery services rendered) | |||
| 31 Dec | Insurance expense | 750 | |
| Prepaid insurance | 750 | ||
| (Recording insurance expense based on the proportion of insurance term that has been passed) | |||
| 31 Dec | Deferred income | 2,000 | |
| Training fee income | 2,000 | ||
| (Recording training fee income based on the proportion of completion of the course) |
After incorporating the adjusting entries, adjusted trial balance is prepared based on which following balance sheet and income statement is formulated.
Ricardo Garments Inc.
Balance sheet
As at 31 December 20xx
| US Dollars | |
| ASSETS | |
| Non-current assets | |
| Fixed assets | 787,000 |
| Current assets | |
| Inventory | 12,000 |
| Trade receivables | 27,500 |
| Advances and prepayments | 2,850 |
| Cash and bank balances | 30,205 |
| 72,555 | |
| Total assets | 859,555 |
| EQUITY AND LIABILITIES | |
| Owner’s equity | |
| Capital | 600,000 |
| Retained earnings | 169,905 |
| 769,905 | |
| Non-current liabilities | |
| Long term loan payable | 50,000 |
| Current liabilities | |
| Short term loan payable | 10,000 |
| Deferred income | 2,000 |
| Trade and other payables | 27,650 |
| 39,650 | |
| Total equity and liabilities | 859,555 |
Ricardo Garments Inc.
Income statement
For the year ended 31 December 20xx
| US Dollars | |
| Income | |
| Cash sales | 80,000 |
| Credit sales | 20,000 |
| Services income | 12,500 |
| Training fee income | 2,000 |
| 114,500 | |
| Expenses | |
| Material cost | 30,000 |
| Selling and administrative expenses | 5,500 |
| Salaries and wages | 26,000 |
| Depreciation expense | 18,000 |
| Utilities | 9,608 |
| Insurance expense | 750 |
| Provision for doubtful debts | 500 |
| 90,358 | |
| Net profit | 24,142 |