2012 Wiley Cpa Review

Topics: Generally Accepted Accounting Principles, Depreciation, Expense Pages: 14 (4472 words) Published: June 18, 2013
Adjusting Entries
Step 5 of the accounting process involves the preparation of adjusting entries. Adjusting entries are made to update the accounts and bring them to their correct balances. The preparation of adjusting entries is an application of the accrual concept of accounting and the matching principle. The accrual concept states that revenues (or income) are recognized when earned regardless of when collected and expenses are recognized when incurred regardless of when paid. The matching principle aims to align expenses with revenues; meaning, expenses should be reported when the revenue earned with it is reported. Why Are Adjusting Entries Necessary

The purpose of adjusting entries is to update the accounts. At the end of the accounting period, some income and expenses may have not been recorded or taken up; hence, there is a need to update the accounts. If adjusting entries are not prepared, some income, expense, asset, and liability accounts might not reflect their correct values when reported in the financial statements. For this reason, adjusting entries are necessary. Types of Adjusting Entries

Generally, there are 4 types of adjusting entries. Adjusting entries are prepared for the following:
1. Accrued Income – income earned but not yet received
2. Accrued Expense – expenses incurred but not yet paid
3. Deferred Income – income received but not yet earned
4. Prepaid Expense – expenses paid but not yet paid
Also, adjusting entries are made for:
5. Depreciation Expense, and
6. Doubtful Accounts Expense or Bad Debts Expense
Composition of an Adjusting Entry
Adjusting entries affect at least one nominal account and one real account. A nominal account is an account whose balance is measured from period to period. Nominal accounts include all accounts in the Income Statement, plus owner's withdrawal. Therefore, they are also called temporary accounts and income statement accounts. Examples are Service Revenue, Salaries Expense, Rent Expense, Utilities Expense, Mr. Gray Drawing, etc. A real account has balance that is not measured from period to period; rather, it is measured cumulatively. Real accounts include all accounts in the balance sheet. They are also called permanent accounts and balance sheet accounts. Examples include Cash, Accounts Receivable, Rent Receivable, Accounts Payable, Mr. Gray Capital, and others. All adjusting entries include at least a nominal account and a real account. NOTE: "Adjusting entries" refer to the 6 entries mentioned above. However, in some branches of accounting (especially auditing), the term adjusting entries could refer to any entry that aims to adjust incorrect account balances. As a result, there is little distinction between "adjusting entries" and "correcting entries" today. In the traditional sense, however, adjusting entries are those made at the end of the period to take up accruals, deferrals, prepayments, depreciation and other allowances. In the next lessons, we will illustrate how to prepare adjusting entries for each type and provide examples as we go. Adjusting Entries for Accrued Income

Accrual of income is recorded though adjusting entries. At the end of the period, some revenues (or income) may have not been recorded in the accounting system. Even if they are not yet collected, if the company earned the right to collect from the customer, they should be included as income. Therefore, an adjusting entry is necessary. The pro-forma entry for accrued income is: mmm| dd| Receivable account*| x,xxx.xx|  |

| |       Income account**|  | x,xxx.xx|
*Appropriate receivable account,e.g. Accounts Receivable, Rent Receivable, Interest Receivable, etc.  **Income account such as Service Revenue, Rent Income, Interest Income, etc. Here's an Example

To illustrate an adjusting entry for accrual of income, in our previous set of transactions assume this additional information: On March 31, 2011, Gray Specialty Repairs and Installation performed...
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