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Explain Adjustments


Office Supplies

Adjusting Journal Entry (1)
Office Supplies Inventory had a beginning of the year balance of $500. Purchases of an additional $1000 were made during the year and charged directly to the Office Supplies Inventory Account which resulted in the ending balance of $1500 in the Trial Balance. We counted and valued the actual office supplies we had on hand at year end. The ending value of the actual count was $300.

Type of Adjusting Entry: Inventory / Expense Accounts

Accounts Affected: Office Supplies Inventory / Office Supplies Expense

Office Supplies actually appear in our financial statements as two type of accounts. One is the Office Supplies Expense Account and the other is our Office Supplies Inventory Account.

During the year we have two options for initially recording our office supplies:
  1. Option 1-record all purchases of office supplies as inventory and adjust at the end of the period for the amount of supplies not actually used
  2. Option 2-record all purchases of office supplies as expenses and adjust at the end of the period for the amount of supplies not actually used.

Option 1
In our example, we recorded all our purchases in our Office Supplies Inventory Account (Option 1). In order to adjust our balances, we need to actually count and value the office supplies at the end of our period. This method of determining an inventory value is called the Periodic Method. Why periodic ? Because the only time that we actually know the actual amount of inventory on hand is when we do a count.

Ok let's do it for our example !
Beginning Inventory Value 500
Add:Purchases 1000
Total To Account For (Balance in Trial Balance) 1500
Subtract:Ending Inventory Value (Based On Our Countt) 300
Amount Actually Used During The Period 1200

You don't have to be a rocket scientist to do this simple calculation. A little logic and common sense will do quite nicely. We first calculated the Total Amount To Account For by adding our Beginning Inventory and Purchases for the period. If we didn't use any office supplies this would be our ending value. We know; however, that we used some of our office supplies during the period. We therefore subtract out what we have left (ending inventory) in order to determine what we used. Think of a fresh baked pie cut up into 8 slices (total to account for). We come back later and count the pie slices that are left. We find that we have 3 slices left (ending inventory). How many were used (eaten) ? Of course 5 slices were used (eaten). The same logic and common sense applies to our business example and is what the periodic inventory system is based on.

The current balance in our Office Supplies Inventory Account in our Trial Balance is $1,500. We need to adjust this balance to our actual balance which is $300 (based on our actual count). We do this by reducing our Office Supplies Inventory (Credit) 1,200 and charging our Office Supplies Expense Account (Debit) 1,200.

Our adjusting entry using Option 1 is an increase in our Expense Account Office Supplies (Debit) for $1, 200 and a decrease in our Asset Account Office Supplies Inventory (Credit) for $1,200.

What about Option 2 recording all our initial purchases in the Office Supplies Expense Account ? I'm sure you're familiar with the ole saying that there's more than one way to skin a cat. If we had used Option 2 during our period our Office Supplies Expense Account would have had an ending balance of $1,000 and our Office Supplies Inventory Account would still have that balance that it began the period with $500.

Inventory Balance in Trial Balance 500
Office Supplies Balance in Trial Balance 1000

Since the current balance in our Office Supplies Inventory Account in our Trial Balance is $500. We need to adjust this balance to our actual balance which is $300 (based on our actual count). Since we need to decrease this balance, we'll credit Office Supplies for $200 and increase (debit) Office Supplies Expenses for $200. After posting these adjustments the ending balance in the Office Supplies Inventory Account is $300 (500-200) and the ending balance of our Office Supplies Expense Account is $1,200 (1000+200).

By golly we end up with the same balances regardless of which method we use during the period.

If we had used Option 2 for recording our Office Supplies Inventory and Office Supplies Expenses we would have the following adjusting entry. Our adjusting entry using Option 2 is an increase in our Expense Account Office Supplies (Debit) for $200 and a decrease in our Asset Account Office Supplies Inventory (Credit) for $200.

Either option for your initial recording of your purchases is acceptable. Choose the one you're more comfortable with.

Unusual Events

Adjusting Entry (2)
We totalled our Accounts Receivable Subsidiary Ledger and the balance agreed with our Accounts Receivable Control Account. They both totalled $25,800. We also reviewed all of our customers and found that one of our customer accounts Joe The Dead Beat who owed us $1000 was very past due and went bankrupt.

Type of Adjusting Entry: Unusual Events

Accounts Affected: Accounts Receivable / Bad Debt Expense

Unfortunately, your business will occasionally have a customer like Joe The Dead Beat who can't or won't pay his bill. Our total amount due from all our customers is $25,800; however, Joe owes us $1000 of the total. Since we won't be able to collect this $1000, we need to adjust our accounting records.

Since we have a Control Account Accounts Receivable and an Accounts Receivable Subsidiary Ledger Account we need to adjust both the total amount included in the Control Account in our General Ledger and Joe's Account in the Subsidiary Ledger.

Our asset account Accounts Receivable needs to be decreased by a $1000. Should this part of the transaction be recorded as a debit or a credit ? I hope you said credit. The other account affected is bad debt expense which needs to be increased by $1000. As you know by now, an increase in an expense account is recorded as a debit.


Adjusting Entry (3)
We reviewed our insurance coverage and found that our premium for coverage for our entire year was $6000. The policy runs from January-December and we paid the full amount for the coverage in January.

Type of Adjusting Entry: Prepayments

Accounts Affected: Prepaid Insurance / Insurance Expense

Some costs/expenses that a business incurs provide benefit over an extended period of time. These type of expenditures are called Prepayments (Asset Account).

In our example we paid $6000 in January for coverage that actually provided insurance coverage benefits to each month during our year. We did a pretty good job by initially recording this transaction in our Asset Account- Prepaid Insurance; however, we were a little lax by not recording a portion of the expense in each month during our year.

What should we have been doing at the end of each month to accurately reflect the benefit of our insurance coverage provided to each month? Let's see.
Total Premium:$6000
Coverage Period:One Year-12 Months
Benefit To Each Month:$500 ($6000/12 months)

We should have been Debiting Insurance Expense $500 and Crediting Prepaid Insurance $500. We should have been making this adjusting entry at the end of each month during our year.

Shame on us. So what are we going to do now ? Actually, we should go back and adjust each month but I'm going to be kind and let us only make one adjusting entry for the entire year and record the total insurance expense in the month of December. Won't this distort our books ? Yes and no. Our totals for the year will be correct but December's profit/loss will be overstated by 5,500 and each of our other month's profit and loss will be overstated by $500. Since we now know better, next year we're going to properly handle our prepayments.

Our Adjusting Entry for this year.
Our Insurance Expense Account is increases by $6,0000 (Debit) and our Asset Prepaid Insurance Account is decreased (Credit).

Debit Insurance Expense 6000   
Credit-Prepaid Insurance 6000

Food for thought.
What if we paid the premium of $6000 for a years worth of coverage at the beginning of July and our policy ran from July of this year till the end of June of the next year ? Our monthly benefit would still be $500 ($6000/12) but only $3000 of our insurance coverage would be used up in our current year (July-December=6 months @ $500/per month) and the other $3000 (January-June=6 months @ $500/per month)would be used up during our next year.

If this were the case what ending balance would our Prepaid Insurance account have ? Our Prepaid Insurance Account would have an ending balance of $3000 that represents the future benefits of our insurance coverage (Total Policy Amount $6000 less 6 months of coverage @$500 per month).


Adjusting Entry (4)

Our Inventory for Resale is made up of all our computers, monitors, and printers. The balance in the Trial Balance is the balance as of the beginning of our year and was based on our prior year's count. We received our current year's count from our warehouse and arrived at a value (cost) of $8000 as of December 31, xxxx. Our purchases account in our trial balance shows that we purchased $70,000 worth of computer equipment during the year.

Type of Adjusting Entry: Inventory / Cost & Expense Accounts

Accounts Affected: Inventory / Cost Of Goods Sold
In our prior examples, we've dealt with service types of business that only sold services and did not sell any products. Not only is this example intended to illustrate an adjusting entry, but also to provide a brief introduction into how to account for and keep up with products and their costs.

Lets define some terms.

Periodic Inventory System-Method for keeping up with products and calculating the cost of products that were sold in a period. An actually count is periodically performed in order to determine the value of the inventory.

Purchase Account/Cost of Goods Sold/Inventory Accounts-General Ledger Accounts used to help keep up with products and aid in calculating the cost of products sold.
The Purchase Account is an account used only to record the cost of merchandise bought to be sold to your customers. Items that are purchased for use in your business such as office supplies and maintenance supplies are charged directly to an Inventory or Expense Account. See Adjusting Entry (1) for an example.

The Purchase Account is a temporary account that is adjusted at the end of an accounting period (month/year). Actually, you could record your Purchases of Products for Resale directly in your Products For Resale Inventory Account but by using the Purchases Account it provides you with a quick total of the amount you spent buying products during a period. Since purchasing products to sell is probably the biggest expenditure a business that sells products will incur during a period (month/year), we accountants (bean counters) feel it is worthy of an account of its own named Purchases.

The Cost Of Goods Sold is a special account that records the cost of the goods that were sold to your customers. If the Periodic Inventory System is used, this Account is adjusted with an adjusting journal entry.

The difference between your Sales and your Cost Of Goods Sold is referred to as your Gross Profit. Gross Profit = Sales - Cost Of Goods Sold

Of course your Inventory for Resale Account represents the quantities and value (cost) of the goods on hand and available for resale.

OK, how does all this stuff fit together ? Believe it or not, it's really not that bad ! Again a little common sense and logic will go a long way. Fasten your seat belt cause here we go.

Let's use a Calculation to help us see how all the pieces fit together and as an aid for preparing our adjusting entries.

Beginning Inventory Value- 10500
Add:Purchases (Transfer To Inventory Account From Purchases Account)- 70000
Total To Account For After Purchase Transfer- 80500
Subtract:Ending Inventory Value (Based On Our Count)- 8000
Cost of Goods Sold During The Period (Transfer to Cost Of Goods Sold Account From Inventory Account)- 72500

Does this calculation look a little bit familiar ? It should we used a very similar calculation to account for our Office Supplies in our Adjusting Entry (1).

Let's prepare our adjusting entries. We'll first make two journal entries in order to help us understand what is going on.

The first entry will transfer the balance from our Purchases Account to our Inventory For Resale Account.

Debit Inventory For Resale 70000
Credit Purchases 70000
Transfer Purchases To Inventory For Resale for the year.

The second entry will adjust our Ending Inventory Balance in our Inventory For Resale Account and record our Calculated Cost Of Goods Sold amount in our Cost Of Goods Sold Account.

Debit Cost Of Goods Sold 72500   
Credit Inventory For Resale 72500
Adjust Inventory Balance To Balance Per Physical Inventory and record Cost of Goods Sold for the year.

Our Actual Adjusting Entry
The actual entry we made in our worksheet combined all the entries that affected Inventory / Purchases / Cost Of Goods Sold accounts into one entry. This is what is called a Compound Entry. A compound entry is just an entry that contains more than one debit and one credit.

Compound Entry
Debit Inventory For Resale 70000
Debit Cost Of Goods Sold 72500  
Credit Purchases 70000   
Credit Inventory For Resale 72500

Explanation:Transfer Purchases, Adjust Inventory Balance To Amount Per Physical Inventory and record the Cost of Goods Sold for the year.

No big deal, we just combined all the entries into one Adjusting Journal Entry instead of two.

As I stated earlier, my objective was to introduce accounting for Product Inventories and you need to seek additional learning materials and guidance to fully understand all the ins and outs of properly accounting for Inventories.

Bank Charges

Adjusting Entry (5)
We reviewed our bank statements for the year and found that we had failed to record our monthly bank charges. The total of the charges for the year was $240.

Type of Adjusting Entry: Bank Charges & Credits

Accounts Affected: Bank Fees & Charges / Cash In Bank

Each month you or your bookkeeper should prepare a Bank Reconciliation to double check that all checks, fees, and deposits have been properly recorded in your books. Some entries such as fees for checks and monthly account charges have been recorded by your bank but often have not been recorded in your books. These fees need to be recorded with a journal entry in your General Journal. Although we're only going to make one adjusting entry for the entire year, these fees should be recorded with an adjusting entry each month.

Can you think of another type of bank charge that we want to avoid but does occur in the "real" world ? Yeah, those customers that send us checks and don't have the money in the bank to cover them cause us to be charged a bad check processing fee by our bank and additional work in trying to collect them.

Our entry that we need to record is a decrease in our Asset Account Cash (Credit) for $240 and an increase in our Expense Account Bank Charges (Debit) for $240.

Fixed Assets

Adjusting Entry (6)
The only property or equipment we have is a brand new delivery truck. The cost of the truck was $15,500 and is the amount shown in the Trial Balance Column. The truck was purchased at the beginning of January and we feel that we'll get 5 years of use from this vehicle.

Type of Adjusting Entry: Fixed Assets

Accounts Affected: Vehicles & Other Equipment / Depreciation Expense

Let's define depreciation. Depreciation is the expired portion of an Asset's (equipment used in a business) Original Cost. The logic behind the concept is quite simple. If you purchased a piece of equipment for $100,000 in a month, the expenditure provides benefit to not only the current month, but also future months and even future years. The cost (expenditure for the equipment) is originally recorded as an Asset and charged to a period's Expense Account when a portion or all of the benefit has been used.

In our example, we purchased a Truck for $15,500 in January. How much benefit from the truck do we receive in each year ? Since this is only an introductory tutorial, we're not going to explore all the different methods and rules for calculating depreciation. We're going to use what is called the Straight Line Method to calculate our depreciation expense.

We'll use the formula for the straight line method to calculate our depreciation.
Original Cost 15500
Less Estimated Salvage Value 0
Depreciable Cost15500
Divided By Estimated Number Of Periods Benefited 5 years
Depreciation Amount Per Period 3100 per year

Based on our calculation we receive a benefit of $3100 per year for the use of our truck. This is the amount of depreciation we need to record as an adjusting journal entry in our General Journal. This is recorded by increasing our Depreciation Expense Account (Debit) by $3100 and decreasing our Asset Account Truck (Credit) by $3100. We recorded the entire year's depreciation expense in the month of December.

What should we actually have done during our year ? If we were on our toes, we would have made an adjusting entry in each month increasing our Expense Account Depreciation Expense (Debit) for $258.33 and decreasing our Asset Account Truck (Credit) for $258.33. Where did we get the amount of $258.33 ? Simple math. We divided our yearly depreciation amount of $3,100 which is the amount for the entire year by the number of periods (months) in a year to arrive at the amount per month.


Adjusting Entry (7)

Adjusting Entry (7)

We reviewed our receiving reports and found that we had incurred a maintenance expense in December for $500 that had not yet been billed by WeFixIt Company.

Type of Adjusting Entry: Accruals- Unrecorded Expense

Accounts Affected: Expense Account / Other Liability

Here's an example of where those accrual and matching accounting rules come in to play. As you recall, the accrual basis records income in the period earned and all expenses in the period incurred (benefited). The matching concept is recording the revenues earned during a period and matching (offsetting) the revenues with the expenses incurred in generating this revenue.

At the end of each period we need to perform a review to determine if any financial transactions have occurred that we have not entered in our Special Journals. Our example is one instance of a transaction that has occurred where we have not received all the formal documents that represent the transaction. In this case, our supplier for maintenance services has not yet sent us a formal invoice. Can't we wait until we get the invoice to record this transaction ? You probably could, but if you want as accurate as possible information recorded you need to make an adjusting journal entry to record this transaction in the period that was benefited. If I don't have an invoice how do I know the cost ? In these type of instances a good estimate is better than not recording the transaction at all. Other source documents such as a purchase order may even have the necessary cost information. You could also obtain the necessary information by calling your supplier.

The adjusting entry needed to record this transaction is to increase our Expense Account Maintenance & Repairs (Debit) by $500 and increase our Liability Account Other Accruals (Credit) by $500.

Correcting Entries

Adjusting Entry (8)
During a review of our supplier's invoices, we found an invoice for $250 that was charged to Advertising Expense that should have been charged to Professional Fees.

Type of Adjusting Entry: Correcting Entries- Used to fix mistakes

Accounts Affected: Correct Expense Account / Wrong Expense Account

This type of mistake is only found by analyzing your accounts in order to see that all expenses and/or revenues were recorded in the proper accounts. One of the main purposes of maintaining our books is to provide us with accurate management information so we can take corrective actions when we need to. In this example, our professional fees would have been understated $250 and our advertising expenses would have been overstated $250. Since they offset each other, no big deal right ? Yes and no. Although our total debits and credits are in balance, I was taught as a kid that a job worth doing is worth doing right. We all know mistakes do happen (hopefully not often). Adjusting journal entries provide us a way of fixing them.

The adjusting entry needed to fix our error is to increase our Expense Account Professional Fees (Debit) by $250 and decrease our Expense Advertising Account (Credit) by $250.

No Entry Needed

Adjusting Entry (9)
Adjusting Entry (9)
On December 31, xxxx Smart Computerguy decided that he needed some additional help and hired two employees to begin working the following year.

Type of Adjusting Entry: I tried to trick you. There is no adjusting entry needed for recording the decision to hire two additional employees in the following year. If you recall, only financial transactions are recorded in our formal bookkeeping records.
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