Adjusting Journal Entries and Closing Journal Entries :Accounting records are not kept up to date at all times. To do so would be a waste of time, effort, and money because much of the information is not needed for day-to-day decisions. Adjusting entries is a step taken to recognize financial events that have occurred prior to the financial statements’ issuance date but which have not been recorded in the journal. These are not transactions with a particular date attached, but they are financial realities which require documentation in order to maintain accurate records. In the case of the Solana Beach Bicycle Company there are five items that need to be adjusted at the end of each month: Accumulated Depreciation on the building and on the truck, Prepaid Insurance, Interest on the mortgage, and the portion of account receivables that the company does not believe it will ever be able to collect (bad debts). After the adjusted journal entries are recorded in the journal, they must be posted to the accounts in the general ledger, just like the earlier journal entries.
Prepaid Insurance
Remember in this post, Prepaid Insurance is listed on the Balance Sheet as an Asset. This came about because Solana Beach Bicycle Company bought insurance in advance of using it. By the end of January, one thirty-sixth of the three-year policy had been used up and became an Expense. To recognize the “using up” of this Asset (called Prepaid Insurance), an Expense called Insurance Expense is increased by $41.67 ($1,500/36 months).
The Asset itself is no longer worth the full amount paid, since it now only represents the remaining thirty-five months. If you think back to the accounting equation again—A = L + OE—the left-hand side of the equation is reduced by $41.67 (because the Asset called Prepaid Insurance has decreased), and the right side is also reduced by the same amount because of insurance Expense (which causes a reduction in Owner’s Equity). An adjustment for this amount will be made in the journal.
Depreciation Expense
Long-Term Assets like the building and truck have a finite life. Their original (historical) cost is therefore spread over their useful lives. This process is called depreciation. In order to depreciate these two Assets, you need to know what the life expectancy of each is, that is how long these Assets will produce income for the business. In our example, you can assume that the building has a life expectancy of twenty-five years, and the truck of five years. To depreciate these two Assets, you can divide the historical cost by the life expectancy.
Truck:
$8,000 (historical cost)/5 years (life expectancy) = $1,600 Depreciation per year
Building:
$25,000 (historical cost)/25 years (life expectancy) = $1,000 Depreciation per year
Since you are only looking for the depreciation adjustment for these two Assets for the month of January, each number would be divided by twelve (months) to arrive at depreciation adjustment for the month of January.
Truck = $1,600 (depreciation per year)/12 (months per year) = $133.33 per month
Building = $1,000 (depreciation per year)/12 (months per year) = $33.33 per month
QUICK Tip :
The Life Expectancy of an Asset: One of the assumptions you as the owner of a business need to make is what the life expectancies of Long-Term Assets are. How should you do this? The easiest way is to estimate based on your experience of similar Assets used in the business in the past. You can also get information from the library on what averages are used for similar Assets in your industry. Finally, the IRS has a schedule of Long-Term Assets, with life expectancy figures that they will accept. The final decision is yours, and if reasonable, it is acceptable.
Interest Expense
As you remember, Solana Beach Bicycle Company has to pay interest on the mortgage that it took out on the land and building. The mortgage was for $20,000 for ten years at 8 percent per year. The total interest per year is $1,600 ($20,000 x 8 percent).Therefore, each month the business owes the mortgage company one-twelfth of the year’s total interest or $133.33 ($1,600/12 months). Since the cash is not owed until the end of the year, Solana Beach Bicycle Company has created another Liability called Interest Payable that is due at the end of the year. The amount of this Liability is the same as the Interest Expense of $133.33 for the month of January.
Accounts Receivable Write-Offs
At the end of January, the company assumed that it was not going to be able to collect $50 from some of the customers that had promised to pay. (This was a guesstimate or assumption, since the company will not know until next month who is going to pay and who is not.) In order to recognize this assumption on the financial statements, Sam created an Expense category called Bad Debts Expense.
The other half of this entry is to increase an account called “Allowance for Doubtful Accounts.” This account is called a “contra-Asset”; it is a reduction to Accounts Receivable that factors in the expectation that certain Accounts Receivable will not be paid and keeps the Balance Sheet in balance. You should note that even though the Bad Debt Expense does not use cash, it reduces the Net Income in the same way as other Expenses that do use cash. In the case of Bad Debt Expense, the Asset reduced is Accounts Receivable (rather than cash).
QUICK Tip :
Estimating Bad Debts: Like depreciation, the management of the company mustestimate bad debts for the period. This estimation can be done based on past experience that a certain percent of receivables cannot be collected. It is also possible that management has specific information on particular accounts that will not be collected and can incorporate this data into the adjustments.
Trial Balance After Adjustments
After the adjusting entries are posted to the journal, the accountant may prepare another trial balance to help in the preparation of the actual financial statements, or the accountant may be able to prepare the statements by using the general ledger only. A trial balance prepared at the end of January 2006 would look like Figure 6.14:
There are some differences between this trial balance and the one on page 86, which shows the trial balance before the adjusting journal entries. First, four new accounts have been created: Insurance Expense, Depreciation Expense, Accumulated Depreciation, and Interest Expense.
The account called Insurance Expense represents the amount of the used up Prepaid Insurance for one month. It was increased by $41.67 at the same time that Prepaid Insurance (the Asset) was decreased by the same amount.
The Depreciation Expense account was created to represent the depreciation on the two Long-Term Assets, truck, and building. Instead of reducing the Long-Term Assets directly as they get older, accountants set up another separate contra-Asset account. This, like the one discussed above for Allowance for Doubtful Accounts, was a reduction to Accounts Receivable. For Long-Term Assets the contra account is called Accumulated Depreciation. Each Long-Term Asset has a separate contraAsset account. (Accumulated Depreciation-Truck and Accumulated Depreciation-Building.) On the Balance Sheet, the contra-Assets would appear like those shown in Figure 6.15 below:
Land, even though it is a Long-Term Asset, does not depreciate and does not have an accumulated depreciation contra-Asset account.
The last new account is Interest Expense. This account represents the amount of interest that has been paid. In our example, this is $133.33 per month on the Mortgage.
Closing Journal Entries
In general, accounting records are closed at the end of the year. After the closing journal entries have been made and posted, all the Income Statement accounts (also called temporary accounts) begin the new year with a zero balance. For example, next year we want to accumulate and show in the sales account the total sales made during that year and that year only; to do this, the sales account must have a zero balance at the beginning of the year so the figures from the previous year don’t carry over.
When Solana Beach Bicycle Company decides to make the financial statements for the end of the month, the accountant would make the following entries in the general journal as shown in Figure 6.16 to close the records for January, 2006:
Each Revenue and Expense account is closed (brought to a zero balance) by (1) determining the balance of the account and (2) placing this amount (the account balance) on the opposite side of the account; that is, a debit balance for an account is balanced out on the credit side of the journal, and a credit balance is balanced out on the debit side. For example, prior to closing, the sales account had a credit balance of $5,500. To close the sales account it was debited for $5,500 to achieve the desired zero balance. The Cost of Goods Sold account had a debit balance of $2,200; thus, to close this account it was credited for $2,200.
After all of the Revenues and Expenses have been closed (made to have a zero balance), and the debits and credits are added in the journal, there will be a dollar difference. In the example, this difference is the difference between the sales debit and the credits for the various Expenses: $2,808.34. This represents Net Income for the month of January. In order to make the closing entry balance an additional credit is needed; this credit is to Retained Earnings. As you learned in previous lessons, Retained Earnings is the account where profits are accumulated from year to year.
QUICK Tip :
Handling Revenue and Expense Accounts: Revenue and Expense accounts are temporary accounts. You can close them any time you want summarized information about their financial position. At the end of the accounting period all Revenue and Expense accounts are closed into the Retained Earnings account. This leaves all of the Revenue and Expense accounts with a zero balance after the closing process and lets the statement reader know how much profit or loss has been created by the business.
Before posting the closing entries, the sales and Cost of Goods Sold accounts (for example) looked like Figure 6.17:
After posting the closing entries, the sales and Cost of Goods Sold accounts would look like Figure 6.18:
Notice that in the trial balance in Figure 6.19, there are no Revenue or Expense accounts listed. However, the difference between the Revenue and Expenses prior to their closing has now been closed and appears in the Retained Earnings account.
The double lines drawn across the accounts in Figure 6.18 are meant to indicate that the accounts are closed. Entries for the following period (in this example, February 2006) would be posted to these accounts in the spaces under the double lines. All of the accounts that were closed would look like the sales and Cost of Goods Sold accounts illustrated above in that the debits and credits would balance, except, of course, the dates and dollars figures would be different.
Often accountants will prepare an after-closing trial balance to see that the debits and credits are still in balance and to see that all the temporary accounts have been closed. Solana Beach Bicycle Company’s after-closing trial balance would look like Figure 6.19. Notice that accumulated depreciation is listed as a subtraction on the debit side.
The closing process is a fairly routine one. It merely reverses the balances in the Income Statement accounts, bringing the ending balances to zero. Thus, since sales has a credit balance at the end of the accounting period, to close this account you must debit it to bring its balance to zero. Just the opposite happens with Cost of Goods Sold and all of the other Expenses; that is, they normally have a debit balance and to close them, they are credited for the same amount. Once all these debits and credits from the closed accounts are totaled on the trial balance, the difference should be a credit that is applied to Retained Earnings. This credit balance represents Net Income. If for some reason the debits are greater than the credits from the closed accounts this amount will represent a Net Loss.
In this article you have learned how to record business transactions into the original book of entry—the General Journal. You have also learned how to post to the accounting ledgers and how to make adjusting entries. Finally, you have learned how to close the accounting records of a company.
Glossary :
Accounts Receivable Write-Offs: The process of identifying an account receivable that is never going to be paid and taking it off the books. These accounts are written off to an Expense account with the amount being estimated by management based on past experiences of collection rates. When the entry is made, two accounts are created, an Expense account called Bad Debts Expense and a contra-Asset account (contra to Accounts Receivable).
Adjusting Journal Entries: Journal entries made at the end of the accounting period (month, quarter, and/or year) to recognize transactions that have occurred prior to the statements’ issue date, but which have not yet been recorded in the journal. Examples of these entries include: depreciation; salaries earned, but not yet paid; adjustments to prepaid items, like insurance and interest on the mortgage which has not yet been paid.
Chart of Accounts: A listing of account numbers for each of the accounts. These numbers are usually divided into five groups; 100s for Assets, 200s for Liabilities, 300s for Owner’s Equity, 400s for Revenues, and 500s for Expenses. Every time any accounting entry is made, the accountant will use the same account number for that particular Asset, Liability, Owner’s Equity, Revenue, or Expense.
Closing Journal Entries: The process required to bring all accounts to a zero balance. This process is done at the end of the period (month, quarter, or year) prior to the preparation of the financial statements. Only Revenues and Expenses (also called temporary accounts) are closed and the difference between Revenues and Expenses is recorded as Net Income or net loss.
Credit: The right side of the amount column in a journal or ledger. Credits are recorded when Assets and Expenses are reduced and when Liabilities, Owner’s Equity, and Revenue accounts are increased.
Debit: The left side of the amount column in a journal or ledger. Debits are recorded when Assets and Expenses are increased and when Liabilities, Owner’s Equity, and Revenue accounts are decreased.
Depreciation: The process of spreading the historical cost of a LongTerm Asset over its useful life. In order to determine this amount, management must make an assumption as to the life of all of the Long-Term Assets. The historical cost is then spread evenly over this life expectancy. When this method of depreciation is used (evenly spread over the life) it is called the straight-line method of depreciation.
General Journal: The book in which transactions are first recorded, often referred to as “the book of original entry.” As soon as a business transaction takes place, it is recorded in the general journal. The accounts impacted by the transaction: the date, the debits, credits, and an explanation of the transaction are also recorded.
General Ledger: A book containing a page (or pages) for every account in the business. After a transaction is recorded in the general journal, the components are then transferred (or posted) to the individual accounts in the general ledger. Thus, at any one time, one can review the individual accounts in the general ledger to determine their current balances.
Journal Entries: As soon as a business transaction occurs, an entry is made in the general journal to recognize this transaction. A debit (or debits) and a credit (or credits) will be made to the accounts that are impacted by this transaction. The debits and credits for each transaction will always be equal.
Posting: The process of transferring the information in the general journal to the individual accounts in the general ledger. At any time, one can review the individual accounts in the general ledger to determine their balances.
Trial Balance: A list of all accounts in the general ledger that have a balance other than zero. This is prepared right before the financial statements to make sure that the accounts are in balance and that all journal entries have been prepared correctly and accurately. If the trial balance does not balance (that is, debits do not equal credits), it indicates that there has been an error made in either the recording of the transactions, in the general journal, or in the posting of those transactions to the general ledger. (This does not include a trial balance, which has been completed after the closing of accounts.)