Adjusting and Closing Entries

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1 Adjusting and Closing Entries Adjusting and Closing entries tend to be difficult to grasp at first. A reason for this might be due to the type of transactions requiring adjustment, which tend to be unfamiliar. The key feature of this type of transaction is that they involve time. In one way or another, adjusting entries tend to have an initial transaction being made, but then things occur later for which entries will need to be made. In addition, the adjustments tend to be forced upon the accountant because the accounting cycle is coming to an end and the financial statements need to be prepared. Closing entries occur at the end of the accounting cycle as well. These entries are made in order to prepare for a new accounting cycle. For example, we do not want to carry over the amounts in cost of goods sold expense account into the next cycle. Rather, we want that account to start fresh from a zero balance. This is true for all of the accounts on the income statement (recall, this statement is a record of what happened during a period of time) as well as the dividend account. Accounts on the balance sheet, however, do not start over at the beginning of an accounting cycle. These accounts are termed real accounts and keeping a running balance of their activity during the entire life of the organization.

2 Assume you keep the books for a small engineering firm. Make the following journal entries for each transaction on the date it occurred and the adjusting entry at the end of the accounting period (e.g, Dec. 31) (1) On July 1, the firm signs a contract with a city planning department for $60,000 to design a bridge. The design work will be done in equal monthly installments and last one year. The city pays the full amount in advance on July 1. On July 1, the following would be recorded. Cash 60,000 Unearned Revenue 60,000 Unearned Revenue 30,000 Revenue 30,000 Six months have gone by and we ll assume the work has been occurring as planned. The firm is earning revenue of $5,000 per month.

3 (2) On Oct. 1, the firm pays the insurance premiums on its fleet of cars for the next 6 months. The monthly premiums run $300. On Oct. 1, the following would be recorded. Pre-Paid Insurance (an asset!) 1,800 Cash 1,800 Insurance Expense 900 Pre-Paid Insurance 900 Three months have past and the firm has incurred half the insurance expense it has previously paid for.

4 (3) On July 1, the firm pays the yearly dues of its 20 employees to the Academy of American Engineers. The yearly dues per employee are $100. On July 1, the following would be recorded. Pre-Paid Dues 2,000 Cash 2,000 Dues Expense 1,000 Pre-Paid Dues 1,000 Six months have passed and we want to show the dues as an expense for the firm.

5 (4) On May 15th, the firm purchases office supplies on credit in the amount of $5000. The inventory of office supplies on December 31st comes to $500. On May 15, the following would be recorded. Supplies (an asset!!) 5,000 Accounts Payable 5,000 Supplies Expense (or, SGA expense) 4,500 Supplies (asset) 4,500 Showing that $4,500 of our supplies (asset) are gone. Notice, the new balance sheet will have a $500 line item for supplies (asset).

6 The transactions in this section relate to a financial counseling service ( URMoney ) 1. URMoney pays salaries on the 15th of every month. The salaries amount to $1,000 each month. What will be the required adjusting entry on December 31? [I ll show more than is really required here to demonstrate the logic of the Dec. 31 entry] On Dec. 15 th 2008 (for example), the following would be recorded. Salaries (expense) 1,000 Cash 1,000 Salaries (expense) 500 Accounts Payable (or, salary payable) 500 Now, take a look at what will happen on the next 15 th of the month, when they actually pay the salary.

7 On Jan. 15 th 2009, the following would be recorded Salaries (expense) 500 Accounts Payable (or, salary payable) 500 Cash 1,000 We had already shown half the expense on Dec. 31 in order to make sure our income statement was correct. In addition, we had shown a $500 liability (accounts payable) for the salary expense. On Jan. 15 th we have made the full payment and meet the liability, and we are showing the salary expense incurred from Jan. 1 to Jan. 15 th.

8 2. On Oct. 1, URMoney received $4,000 to provide counseling services for the next four months. What will be the required adjusting entry on December 31? On Oct.. 1, the following would be recorded. Cash 4,000 Unearned Revenue 4,000 Unearned Revenue 3,000 Revenue 3,000 Consider what will show up on the firm s income statement and balance sheet. It will show additional revenue of $3,000 now (it has earned it). Also, the balance sheet will show only a $1,000 unearned revenue liability (it still has to perform these services). Hence, we have decreased the liability by $3,000 on Dec. 31. What is the balancing account? The recognition of revenue also increased the Retained Earnings account within the Equity on the balance sheet. Thus, liabilities went down by $3,000 and equity has increased by $3,000 the balance sheet should balance just fine.

9 3. On October 1, URMoney paid the yearly $1,200 premium for fire & theft insurance (or, $100 monthly premium). What will be the required adjusting entry on December 31? On Oct. 1, the following would be recorded. Pre-Paid Insurance (an asset!) 1,200 Cash 1,200 Insurance Expense 300 Pre-Paid Insurance 300

10 4. URMoney publishes financial statements on December 31. The statements indicate the following account balances: Cash $10,000; Building $50,000; Revenue $5,000; Notes Payable $12,000; Accounts Payable $2,000; Salary expenses $3,000; Accounts Receivable $500; Retained Earnings $100,000; Dividends $1,000. What are the closing entries required to prepare for the next accounting cycle? Revenue 5,000 Retained Earnings 5,000 Retained Earnings 3,000 Salary Expense 3,000 Retained Earnings 1,000 Dividends 1,000 So, all of this may appear quite strange debits/credits seem to be recorded wrong. However, keep in mind the purpose of these entries. We are attempting to prepare the income statement for the next year. We want the Revenue account to begin the new year (or, new accounting cycle) with a zero balance, same for the expense account and dividends. Revenues, expenses, and dividends are a record of things that have happened during a period of time (e.g., the accounting cycle, a year, a quarter, etc.). By debiting the full amount of revenues that had been earned, we are reducing the balance to zero for the new year. Where should the revenues go? We know that revenues add to equity (specifically, the retained earnings account). This is what we have done, same for expenses and dividends. Notice, on net, the retained earnings will go up by a $1,000 balance!!! A little more practice on this might be helpful.

11 More on Closing Entries (different company) Ledgers allow us to keep track of individual accounts. Your checking register (where you hopefully record when you write checks and receive money into your account) is a ledger for your checking account. If you are faithful in recording all checks written and deposits, then at any time you know your true balance (even if the check hasn t cleared yet). You could create ledgers for all sorts of accounts. For example, you could keep a Food Ledger in which you record all purchases of food. Thus, at the end of the month or year, you could go back and see just how much you spent on food. Moreover, at any specific time, you could see how much you have spent on food. Organizations will have ledgers for nearly all of their accounts. For example, the following could be a two ledgers for a small business actually, the ledgers would probably have a little more detail, but I want a simplified presentation. Accounts Cash: Receivable: Debit Credit Balance Debit Credit Balance $26,000 $4,500 $45,000 $71,000 $3,000 $7,500 $40,000 $31,000 $500 $8,000 $5,000 $36,000 $3,000 $5,000 $1,000 $37,000 $1,000 $36,000 $4,900 $31,100 $3,000 $34,100 $2,000 $32,100 The $26,000 balance on the first line of the Cash Ledger indicates what we started with, then each row is showing an individual transactions involving cash. Thus, we received $45,000 in cash at some point. All that is happening is that in addition to our normal recording transaction (debit cash $45,000) we are also putting each entry into a separate ledger. If we were at the end of the accounting cycle, then we could begin constructing the balance sheet quite easily. We just go to the Cash Ledger and see the current balance ($32,100 in this case), then put this on the balance sheet. Finally, notice that $3,000 entry for both ledgers. What might have happened? We received payment from a person that owed us ---- we have seen that when this occurs we Debit cash for the amount ($3,000) and Credit the accounts receivable account ($3,000). We could have ledgers for all of our asset account

12 ASSETS Cash: A/R: Supplies: Inventory: Land: Debit Credit Balance Debit Credit Balance Debit Credit Balance Debit Credit Balance Debit Credit Balance $26,000 $4,500 $0 $0 $0 $45,000 $71,000 $3,000 $7,500 $300 $300 $800 $800 $40,000 $40,000 $40,000 $31,000 $500 $8,000 $800 $0 $5,000 $36,000 $3,000 $5,000 $1,000 $37,000 $1,000 $36,000 $4,900 $31,100 $3,000 $34,100 $2,000 $32,100 and our liability accounts LIABILITIES Accounts Payable: Long-Term Debt: Debit Credit Balance Debit Credit Balance $2,000 $0 $300 $2,300 $45,000 $45,000 $800 $3,100 $1,000 $2,100 $200 $2,300 I have drawn a few arrows to indicate matching transactions. Thus, we must have borrowed $45,000 (debit cash, credit long-term debt). We must have purchased $300 worth of supplied but not paid for them at the time (debit supplies, credit accounts payable). We must have purchased $800 in inventory and not paid at the time (debit inventory, credit accounts payable). If we had included dates and names in the ledgers then we could reconstruct all the individual transaction, but this is not really the point of the ledgers. The ledgers show the balance on each account at any given point in time. Now, we return to the issue of closing entries. We need to look at the revenue, expense, dividends, and equity ledgers.

13 Prior to making an closing entries we have the following account balances at the end of the year (or, accounting cycle). Owners' Equity Revenue: Expenses: Dividends: Debit Credit Balance Debit Credit Balance Debit Credit Balance $0 $0 $0 $5,000 $5,000 $800 $800 $2,000 $2,000 $3,000 $8,000 $3,000 $3,800 $1,500 $9,500 $1,500 $5,300 $400 $5,700 $200 $5,900 Retained Earnings: Capital Stock: Debit Credit Balance Debit Credit Balance $18,500 $10,000 Before continuing, consider two questions? (1) What was the profit (or, net income) for the year? (2) What should be the balance of the retained earnings account on the ending balance sheet? (1) NET INCOME = Revenue Expenses = $9,500 - $5,900 = $3,600 (2) Ending Retained Earnings = Beginning Retained Earnings + Net Income Dividends = $18,500 + $3,600 - $2,000 = $20,100 How do we get to this retained earnings? Let s make the closing entries.

14 Revenue 9,500 Retained Earnings 9,500 Retained Earnings 5,900 Expenses 5,900 Retained Earnings 2,000 Dividends 2,000 Now, post each of the above to the ledgers.

15 Owners' Equity Revenue: Expenses: Dividends: Debit Credit Balance Debit Credit Balance Debit Credit Balance $0 $0 $0 $5,000 $5,000 $800 $800 $2,000 $2,000 $3,000 $8,000 $3,000 $3,800 $2,000 $0 $1,500 $9,500 $1,500 $5,300 $9,500 $0 $400 $5,700 $200 $5,900 $5,900 $0 Retained Earnings: Capital Stock: Debit Credit Balance Debit Credit Balance $18,500 $10,000 $9,500 $28,000 $5,900 $22,100 $2,000 $20,100 The $9,500 debit to revenue made the balance zero. Thus, we are ready to start recording new revenue for the coming year. We matched the $9,500 debit with a $9,500 credit to Retained Earnings, this increased our retained earnings. We performed similar operations with the expenses and dividends. Notice, the ending balance on the Retained Earnings account, we had calculated based on the net income and dividends that the company should have ending retained earnings of $20,100 and it does!!! This is the amount that will go on the new balance sheet.

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