Chapter 6: Adjusting Entries

Adjusting entries are made at the end of an accounting period (e.g., month, quarter, or year) to ensure revenues and expenses are correctly recorded in the period they are earned or incurred, according to the matching principle. They help align financial statements with accrual accounting standards.

1. Prepaid Expenses, Accrued Revenues/Expenses

Prepaid Expenses

• Definition: Costs paid in advance of receiving the benefits. Common examples include prepaid rent, prepaid insurance, or annual software subscriptions.
• Initial Entry: When paid, record as an asset on the Balance Sheet (e.g., Prepaid Rent).
• Adjusting Entry: Gradually move the appropriate portion from the asset account to an expense account in each period the benefit is used.

Example

• 1. Initial Payment:
     • Debit Prepaid Rent
     • Credit Cash
  2. Monthly Adjustment: (If using up 1/12 each month)
     • Debit Rent Expense
     • Credit Prepaid Rent

Accrued Revenues

• Definition: Revenues earned but not yet recorded or received in cash by the period end (e.g., services provided but not yet billed).
• Adjusting Entry:
  • Debit Accounts Receivable (or another receivable account)
  • Credit Revenue

Result: Recognizes revenue in the correct period, even though cash hasn’t yet been received.

Accrued Expenses

• Definition: Expenses incurred but not yet paid in cash or recorded by the period end (e.g., wages payable, utilities not yet billed).
• Adjusting Entry:
  • Debit Expense (e.g., Salaries Expense)
  • Credit Payable (e.g., Salaries Payable)

Result: Recognizes the expense in the correct period, even though payment occurs later.

2. Depreciation Basics

What Is Depreciation?

• Definition: The systematic allocation of the cost of a tangible asset (e.g., machinery, vehicles, buildings) over its useful life. This reflects how the asset’s value is used up over time.
• Purpose: Matches the asset’s expense to the periods when it generates revenue, aligning with the matching principle.

Common Methods

1. Straight-Line Depreciation
   • Easiest and most common approach.
   • (Asset Cost – Salvage Value) ÷ Useful Life = Annual Depreciation.
2. Declining Balance Method
   • Accelerates depreciation in earlier years.
   • Often used for assets that lose value quickly (e.g., technology, vehicles).
3. Units of Production
   • Depreciation tied to usage rather than time (e.g., based on machine hours, mileage).

Recording Depreciation

• Adjusting Entry (Straight-Line Example):
  • Debit Depreciation Expense
  • Credit Accumulated Depreciation (a contra-asset account)

Effect on Financial Statements

• Depreciation Expense (Income Statement): Reduces net income for each period.
• Accumulated Depreciation (Balance Sheet): Lowers the book value of the asset, reflecting its decline in worth over time.

Key Takeaway

Adjusting entries ensure that revenues and expenses are recorded in the correct period, keeping financial statements accurate. Handling prepaid expenses and accruals properly prevents under- or over-reporting costs and revenues. Depreciation spreads the cost of long-lived assets over their useful life, giving a truer picture of operational costs and asset values.