Are you looking for interview preparation ways? Are you worried for job interview preparation? Then do not worry, we’ve a right answer for your job interview preparation. If you are preparing for Adjusting Entries job interview and don’t know how to crack interview and what level or difficulty of questions to be asked in job interviews then go through Wisdomjobs adjusting Entries interview questions and answers page to crack your job interview. Adjusting Entries are the journal entries that are recorded at the end of accounting period to modify the closure balances in other ledger accounts. Below are the list of frequently asked Adjusting Entries job interview questions and answers which can make you feel comfortable to face the interviews:
Under the accrual basis of accounting, revenues are reported on the income statement when they are earned. (Under the cash basis of accounting, revenues are reported on the income statement when the cash is received.) Under the accrual basis of accounting, expenses are matched with the related revenues and/or are reported when the expense occurs, not when the cash is paid. The result of accrual accounting is an income statement that better measures the profitability of a company during a specific time period.
For example, if I begin an accounting service in December and provide $10,000 of accounting services in December, but don't receive any of the money from the clients until January, there will be a difference in the income statements for December and January under the accrual and cash bases of accounting. Under the accrual basis, my income statements will show $10,000 of revenues in December and none of those services will be reported as revenues in January. Under the cash basis, my December income statement will show no revenues. Instead, the December services will be reported as January revenues under the cash method.
There will be a difference on the balance sheet, too. Under the accrual basis, the December balance sheet will report accounts receivable of $10,000 and the estimated true profit will be added to owner's equity or retained earnings. Under the cash basis, the $10,000 of accounts receivable will not be reported as an asset, and the true profit will not be included in owner's equity or retained earnings.
To illustrate a difference in expenses, we will assume that the heat and light expense that I used in my accounting service is metered by the utility on the last day of the month. The utilities that I used in December will appear on a bill that I receive in January and will pay on February 1. Under the accrual basis of accounting, the utilities that I used in December will be estimated and will be reported as an expense and a liability on the December financial statements. Under the cash basis of accounting, the utilities used in December will be recorded as an expense on February 1, when the utility bills are paid.
Accruals are adjustments for 1) revenues that have been earned but are not yet recorded in the accounts, and 2) expenses that have been incurred but are not yet recorded in the accounts. The accruals need to be added via adjusting entries so that the financial statements report these amounts.
An example of an accrual for revenue involves your electric utility company. The utility used coal and many employees in December to generate electricity that customers received in December. However, the utility doesn't bill the electric customers for the December electricity until the meters are read in January. To have the proper amounts on the utility's financial statements, there needs to be an adjusting entry to increase revenues that were earned in December and the receivables that the utility has a right to as of December 31.
An example of an accrual involving an expense is an employee's bonus that was earned in 2012, but will not be paid until 2013. The 2012 financial statements need to reflect the bonus expense and the bonus liability. Therefore, prior to issuing the 2012 financial statements an adjusting entry is prepared to record this accrual.
Accrued expenses are expenses that have occurred but are not yet recorded through the normal processing of transactions. Since these expenses are not yet in the accountant's general ledger, they will not appear on the financial statements unless an adjusting entry is entered prior to the preparation of the financial statements.
Here is an example. A company borrowed $200,000 on December 1. The agreement requires that the $200,000 be repaid on February 28 along with $6,000 of interest for the three months of December through February. As of December 31 the company will not have an invoice or payment for the interest that the company is incurring. (The reason is that all of the interest will be due on February 28.)
Without an adjusting entry to accrue the interest expense that the company has incurred in December, the company's financial statements as of December 31 will not be reporting the $2,000 of interest (one-third of the $6,000) that the company has incurred in December. In order for the financial statements to be correct on the accrual basis of accounting, the accountant needs to record an adjusting entry dated as of December 31. The adjusting entry will consist of a debit of $2,000 to Interest Expense (an income statement account) and a credit of $2,000 to Interest Payable (a balance sheet account).
The double declining balance method of depreciation, also known as the 200% declining balance method of depreciation, is a common form of accelerated depreciation. Accelerated depreciation means that an asset will be depreciated faster than would be the case under the straight line method. Although the depreciation will be faster, the total depreciation over the life of the asset will not be greater than the total depreciation using the straight line method. This means that the double declining balance method will result in greater depreciation expense in each of the early years of an asset's life and smaller depreciation expense in the later years of an asset's life as compared to straight line depreciation.
Under the double declining balance method, double means twice or 200% of the straight line depreciation rate. Declining balance refers to the asset's book value or carrying value at the beginning of the accounting period. Book value is an asset's cost minus its accumulated depreciation. The asset's book value will decrease when the contra asset account Accumulated Depreciation is credited with the depreciation expense of the accounting period.
Let's illustrate double declining balance depreciation with an asset that is purchased on January 1 at a cost of $100,000 and is expected to have no salvage value at the end of its useful life of 10 years. Under the straight line method, the 10 year life means the asset's annual depreciation will be 10% of the asset's cost. Under the double declining balance method the 10% straight line rate is doubled to be 20%. However, the 20% is multiplied times the asset's beginning of the year book value instead of the asset's original cost. At the beginning of the first year, the asset's book value is $100,000 since there has not yet been any depreciation recorded. Therefore, under the double declining balance method the $100,000 of book value will be multiplied by 20% for depreciation in Year 1 of $20,000. The journal entry will be a debit of $20,000 to Depreciation Expense and a credit to Accumulated Depreciation of $20,000.
At the beginning of the second year, the asset's book value will be $80,000. This is the asset's cost of $100,000 minus its accumulated depreciation of $20,000. The $80,000 of beginning book value multiplied by 20% results in $16,000. The depreciation entry for Year 2 will be a debit to Depreciation Expense for $16,000 and a credit to Accumulated Depreciation for $16,000.
At the beginning of Year 3, the asset's book value will be $64,000. This is the asset's cost of $100,000 minus its accumulated depreciation of $36,000 ($20,000 + $16,000). The book value of $64,000 X 20% = $12,800 of depreciation expense for Year 3.
At the beginning of Year 4, the asset's book value will be $51,200. This is the asset's cost of $100,000 minus its accumulated depreciation of $48,800 ($20,000 + $16,000 + $12,800). The book value of $51,200 X 20% = $10,240 of depreciation expense for Year 4.
As you can see, the amount of depreciation expense is declining each year. Over the remaining six years there can be only $40,960 of additional depreciation. This is the asset's cost of $100,000 minus its accumulated depreciation of $59,040. Some people will switch to straight line at this point and record the remaining $40,960 over the remaining 6 years in equal amounts of $6,827 per year. Others may choose to follow the original formula.
In manual accounting or bookkeeping systems, business transactions are first recorded in a journal...hence the term journal entry.
A manual journal entry that is recorded in a company's general journal will consist of the following:
These journalized amounts (which will appear in the journal in order by date) are then posted to the accounts in the general ledger.
Today, computerized accounting systems will automatically record most of the business transactions into the general ledger accounts immediately after the software prepares the sales invoices, issues checks to creditors, processes receipts from customers, etc. The result is we will not see journal entries for most of the business transactions.
However, we will need to process some journal entries in order to record transfers between bank accounts and to record adjusting entries. For example, it is likely that at the end of each month there will be a journal entry to record depreciation. (This will include a debit to Depreciation Expense and a credit to Accumulated Depreciation.) In addition, there will likely be a need for journal entry to accrue interest on a bank loan. (This will include a debit to Interest Expense and a credit to Interest Payable.)
Reconciling an account often means proving or documenting that an account balance is correct. For example, we reconcile the balance in the general ledger account Cash in Checking to the balance shown on the bank statement. The objective is to report the correct amount in the general ledger account Cash in Checking. You will often need to adjust the general ledger account balance for items appearing on the bank statement that were not entered in the general ledger account.
I recall being asked to reconcile the general ledger account Freight Payable. What I needed to do was provide documentation that the balance in Freight Payable was proper. I proceeded to look at the shipments of recent sales and then determined how much we would be obligated to pay for the freight on those sales. We then adjusted the balance in Freight Payable to my documented amount. This reconciliation was done to have the correct account balance and to provide the outside auditors with documentation which could easily be reviewed.
I also reconciled the balance in Utilities Payable by computing the daily cost of each utility that the company used. The cost per day was then multiplied by the number of days since the last meter reading date shown on the utility bills already entered in our accounting system. We then adjusted the Utilities Payable account balance to be equal to the documented amount.
Accounts receivable is the money that a company has a right to receive because it had provided customers with goods and/or services. For example, a manufacturer will have an account receivable when it delivers a truckload of goods to a customer on June 1 and the customer is allowed to pay in 30 days. From June 1 until the company receives the money, the company will have an account receivable (and the customer will have an account payable). Accounts receivables are also known as trade receivables.
Companies who sell on credit are unlikely to have liens on their customers' property. Hence, there is a risk that the full amount of their accounts receivable might not be collected. This means that companies need to cautious when granting credit and establishing an account receivable. If there is uncertainty of a potential (or existing) customer's credit worthiness, it is wise for the company to require the customer to pay with a credit card before delivering goods or services.
It is also important for a company to monitor its accounts receivable and to immediately follow up with any customer who has not paid as agreed. An aging of accounts receivable is a tool that will help and it is readily available with most accounting software. A general rule is that the older a receivable gets, the less likely it will be collected in full.
Accounts receivable are reported as a current asset on a company's balance sheet. Good accounting requires that an estimate be made for the amount that is unlikely to be collected. That estimate is reported as a credit balance in a related receivable account such as Allowance for Doubtful Accounts. Any adjustments to the Allowance balance will also be recorded in the income statement account Uncollectible Accounts Expense.
Prepaid expenses are future expenses that have been paid in advance. You can think of prepaid expenses as costs that have been paid but have not yet been used up or have not yet expired.
The amount of prepaid expenses that have not yet expired are reported on a company's balance sheet as an asset. As the amount expires, the asset is reduced and an expense is recorded for the amount of the reduction. Hence, the balance sheet reports the unexpired costs and the income statement reports the expired costs. The amount reported on the income statement should be the amount that pertains to the time interval shown in the statement's heading.
A common prepaid expense is the six-month premium for insurance on a company's vehicles. Since the insurance company requires payment in advance, the amount paid is often recorded in the current asset account Prepaid Insurance. If the company issues monthly financial statements, its income statement will report Insurance Expense that is one-sixth of the amount paid. The balance in the account Prepaid Insurance will be reduced by the amount that was debited to Insurance Expense.
Accrued vacation pay is the amount of vacation pay which has been earned by the employee but has not yet been paid to the employee.
To illustrate accrued vacation time and accrued vacation pay let's assume that the employee's contract guarantees 120 hours of paid vacation time per year (40 hour work week times 3 weeks). If the employee's hourly pay rate is $26 per hour, the employee is earning vacation pay of $3,120 per year (120 hours x $26), or $60 per week ($3,120 per year divided by 52 weeks). The company is also incurring vacation pay expense and a liability of $60 per week. In terms of vacation time, the employee is earning 2.31 hours of vacation time each week (120 hours per year divided by 52 weeks per year) or 2.45 hours based on 120 hours divided by the 49 weeks not on vacation.
At December 31 the company has a liability for the vacation hours and vacation pay that the employee has earned and is entitled to if the company were to close. If the employee has worked 20 weeks since the employee's anniversary date with the company and the last vacation payment, then the company should report a current liability of $1,200 (20 weeks x $60 per week.)
Stocks, or shares of stock, represent an ownership interest in a corporation. Bonds are a form of long-term debt in which the issuing corporation promises to pay the principal amount at a specific date.
Stocks pay dividends to the owners, but only if the corporation declares a dividend. Dividends are a distribution of a corporation's profits. Bonds pay interest to the bondholders. Generally, the bond contract requires that a fixed interest payment be made every six months.
Every corporation has common stock. Some corporations issue preferred stock in addition to its common stock. Many corporations do not issue bonds.
The stocks and bonds issued by the largest corporations are often traded on stock and bond exchanges. Stocks and bonds of smaller corporations are often held by investors and are never traded on an exchange.
The provision for bad debts might refer to the balance sheet account also known as the Allowance for Bad Debts, Allowance for Doubtful Accounts, or Allowance for Uncollectible Accounts. In this case Provision for Bad Debts is a contra asset account (an asset account with a credit balance). It is used along with the account Accounts Receivable in order to report the net realizable value of the accounts receivable.
Provision for Bad Debts might also be an the income statement account also known as Bad Debt Expense or Uncollectible Account Expense. In this situation, the Provision for Bad Debts reports the credit losses that pertain to the period shown on the income statement.
An accrual occurs before a payment or receipt. A deferral occurs after a payment or receipt. There are accruals for expenses and for revenues. There are deferrals for expenses and for revenues.
An accrual of an expense refers to the reporting of an expense and the related liability in the period in which they occur, and that period is prior to the period in which the payment is made. An example of an accrual for an expense is the electricity that is used in December, but the payment will not be made until January.
An accrual of revenues refers to the reporting of revenues and the related receivables in the period in which they are earned, and that period is prior to the period of the cash receipt. An example of the accrual of revenues is the interest earned in December on an investment in a government bond, but the interest will not be received until January.
A deferral of an expense refers to a payment that was made in one period, but will be reported as an expense in a later period. An example is the payment in December for the six-month insurance premium that will be reported as an expense in the months of January through June.
A deferral of revenues refers to receipts in one accounting period, but they will be earned in future accounting periods. For example, the insurance company has a cash receipt in December for a six-month insurance premium. However, the insurance company will report this as part of its revenues in January through June.
The sum of the years' digits, often referred to as SYD, is a form of accelerated depreciation. (A more common form of accelerated depreciation is the declining balance method used in tax depreciation.) The sum of the years' digits method will result in greater depreciation in the earlier years of an asset's useful life and less in the later years. However, the total amount of depreciation over an asset's useful life should be the same regardless of the depreciation method used. The difference is in the timing of the total depreciation.
To illustrate the sum of the years' digits method of depreciation, let's assume that a plant asset is purchased at a cost of $160,000. The asset is expected to have a useful life of 5 years and then be sold for $10,000. This means that the asset's depreciable amount will be $150,000 to be expensed over its useful life of 5 years.
Next the digits in the years of the asset's useful life are summed: 1 + 2 + 3 + 4 + 5 = 15. In the first year of the asset's life, 5/15 of the depreciable amount (5/15 of $150,000) or $50,000 will be debited to Depreciation Expense and $50,000 will be credited to Accumulated Depreciation. In the second year of the asset's life, $40,000 (4/15 of $150,000) will be the depreciation amount. In the third year, $30,000 (3/15 of $150,000) will be the depreciation. The fourth year will be $20,000 (2/15 of $150,000) and the fifth year will be $10,000 (1/15 of $150,000). As indicated earlier, the total depreciation during the asset's useful life needs to sum to the depreciable cost (in this case $150,000) regardless of the depreciation method used.
Instead of adding the individual digits in the years of the asset's useful life, the following formula can be used: n(n+1) divided by 2. In this formula, n = the useful life in years. Let's use the formula to check our calculation above. When the useful life is 5 years, the formula will be 5(5+1)/2 = 5(6)/2 = 30/2 = 15. If the useful life is 10 years, the formula will show 10(10+1)/2 = 10(11)/2 = 110/2 = 55. In the first year of the asset having a 10 year useful life, the depreciation will be 10/55 of the asset's depreciable cost. The second year will be 9/55 of the asset's depreciable cost. In the tenth year, the depreciation will be 1/55 of the asset's depreciable cost.
A trial balance is a bookkeeping or accounting report that lists the balances in each of an organization's general ledger accounts. (Accounts with zero balances will likely be omitted.) The debit balance amounts are listed in a column with the heading "Debit balances" and the credit balance amounts are listed in another column with the heading "Credit balances." The total of each of these two columns should be identical.
In a manual system a trial balance was commonly prepared by the bookkeeper in order to discover whether math errors and/or some posting errors were made. Today, bookkeeping and accounting software has eliminated those clerical errors. This means that the trial balance is less important for bookkeeping purposes since it is almost certain that the total of the debit and credit columns will be equal.
However, the trial balance continues to be useful for auditors and accountants who wish to show 1) the general ledger account balances prior to their proposed adjustments, 2) their proposed adjustments, and 3) all of the account balances after the proposed adjustments. These final balances are known as the adjusted trial balance, and these amounts will be used in the organization's financial statements.
Neither the unadjusted trial balance nor the adjusted trial balance is a financial statement and neither trial balance is distributed to anyone outside of the accounting and auditing staff. In other words, the trial balance is an internal document.
Depreciation on the income statement is the amount of depreciation expense that is appropriate for the period of time indicated in the heading of the income statement. The depreciation reported on the balance sheet is the accumulated or the cumulative total amount of depreciation that has been reported as expense on the income statement from the time the assets were acquired until the date of the balance sheet.
Let's illustrate the difference with an example. A company has only one depreciable asset that was acquired three years ago at a cost of $120,000. The asset is expected to have a useful life of 10 years and no salvage value. The company uses straight-line depreciation on its monthly financial statements. In the asset's 36th month of service, the monthly income statement will report depreciation expense of $1,000. On the balance sheet dated as of the last day of the 36th month, accumulated depreciation will be reported as $36,000. In the 37th month, the income statement will report $1,000 of depreciation expense. At the end of the 37th month, the balance sheet will report accumulated depreciation of $37,000.
Depreciation is the assigning or allocating of a plant asset's cost to expense over the accounting periods that the asset is likely to be used. For example, if a business purchases a delivery truck with a cost of $100,000 and it is expected to be used for 5 years, the business might have depreciation expense of $20,000 in each of the five years. (The amounts can vary depending on the method and assumptions.)
In our example, each year there will be an adjusting entry with a debit to Depreciation Expense for $20,000 and a credit to Accumulated Depreciation for $20,000. Since the adjusting entries do not involve cash, depreciation expense is referred to as a noncash expense.
Reversing entries are made on the first day of an accounting period in order to remove certain adjusting entries made in the previous accounting period. Reversing entries are used in order to avoid the double counting of revenues or expenses and to allow for the efficient processing of documents. Reversing entries are most often used with accrual-type adjusting entries.
To illustrate reversing entries, let's assume that a retailer uses a temporary help service from December 15 - 31. The temp agency will bill the retailer on January 10 and the retailer agrees to pay the invoice by January 15. If the retailer's accounting year ends on December 31, the retailer will make an accrual-type adjusting entry for the estimated amount. If the estimated amount is $18,000 the retailer will debit Temp Service Expense for $18,000 and will credit Accrued Expenses Payable for $18,000. This adjusting entry assures that the retailer's income statement and balance sheet as of December 31 will include the temp service expense and obligation.
On January 1, the retailer enters the following reversing entry: debit Accrued Expenses Payable for $18,000 and credit Temp Service Expense for $18,000. When the actual invoice arrives from the temp agency on January 11, the retailer can simply debit the invoice amount to Temp Service Expense. If the invoice is $18,000 the Temp Service Expense will show $0. (The credit from the reversing entry and the debit from the invoice entry.) Thanks to the reversing entry, the retailer did not have to stop and consider whether the invoice amount pertains to December or January.
If the invoice amount is $18,180 the entire amount is debited to Temp Service Expense and $180 will appear as a January expense. This insignificant amount is acceptable since the adjusting entry amount was an estimate.
Deferred revenue is not yet revenue. It is an amount that was received by a company in advance of earning it. The amount unearned (and therefore deferred) as of the date of the financial statements should be reported as a liability. The title of the liability account might be Unearned Revenues or Deferred Revenues.
When the deferred revenue becomes earned, an adjusting entry is prepared that will debit the Unearned Revenues or Deferred Revenues account and will credit Sales Revenues or Service Revenues.
Adjusting entries are usually made on the last day of an accounting period (year, quarter, month) so that the financial statements reflect the revenues that have been earned and the expenses that were incurred during the accounting period.
Sometimes an adjusting entry is needed because:
A common characteristic of an adjusting entry is that it will involve one income statement account and one balance sheet account. (The purpose of each adjusting entry is to get both the income statement and the balance sheet to be accurate.)
I would use the liability account Accounts Payable for suppliers' invoices that have been received and must be paid. As a result, the balance in Accounts Payable is likely to be a precise amount that agrees with supporting documents such as invoices, agreements, etc.
I would use the liability account Accrued Expenses Payable for the accrual type adjusting entries made at the end of the accounting period for items such as utilities, interest, wages, and so on. The balance in the Accrued Expenses Payable should be the total of the expenses that were incurred as of the date of the balance sheet, but were not entered into the accounts because an invoice has not been received or the payroll for the hourly wages has not yet been processed, etc. The amounts recorded in Accrued Expenses Payable will often be estimated amounts supported by logical calculations.
The accounting cycle is often described as a process that includes the following steps: identifying, collecting and analyzing documents and transactions, recording the transactions in journals, posting the journalized amounts to accounts in the general and subsidiary ledgers, preparing an unadjusted trial balance, perhaps preparing a worksheet, determining and recording adjusting entries, preparing an adjusted trial balance, preparing the financial statements, recording and posting closing entries, preparing a post-closing trial balance, and perhaps recording reversing entries.
Cycle and steps seem to be a carryover from the days of manual bookkeeping and accounting when transactions were first written into journals. In a separate step the amounts in the journal were posted to accounts. At the end of each month, the remaining steps had to take place in order to get the monthly, manually-prepared financial statements.
Today, most companies use accounting software that processes many of these steps simultaneously. The speed and accuracy of the software reduces the accountant's need for a worksheet containing the unadjusted trial balance, adjusting entries, and the adjusted trial balance. The accountant can enter the adjusting entries into the software and can obtain the complete financial statements by simply selecting the reports from a menu. After reviewing the financial statements, the accountant can make additional adjustments and almost immediately obtain the revised reports. The software will also prepare, record, and post the closing entries.
At the end of an accounting period (month, year, etc.) the inventory account is adjusted so that the balance sheet will report the cost (or lower) of the goods actually owned by the company.
When an adjusting entry is used, the related income statement account will be a cost of goods sold account. An example of such an account is Inventory Change or Inventory (Increase) Decrease.
To illustrate the inventory adjustment, let's assume that the cost of a company's actual inventory at the end of the year is $40,000. However, its general ledger asset account Inventory has a debit balance of $35,000. The company's inventory adjusting entry will 1) debit Inventory for $5,000 and 2) credit Inventory Change for $5,000. [You can think of the $5,000 credit balance in this income statement account as a reduction of the company's debit balance in its Purchases account. In other words, not all of the purchases should be matched with the period's sales since we know that the inventory has increased by $5,000.]
Next, let's assume that another company's cost of its actual ending inventory is $62,000. However, its inventory account has a debit balance of $70,000. This will require an adjusting entry to 1) credit Inventory for $8,000 and 2) debit Inventory Change for $8,000. The $8,000 debit in this income statement account will be an addition to the cost of the goods purchased. In other words, not only was it necessary to match the cost of purchases with sales, it was also necessary to match the additional $8,000 of cost that was removed from inventory.
Textbooks often change the balance in the account Inventory (under the periodic method) through closing entries. (One closing entry removes the amount of beginning inventory and one closing entry records the cost of the ending inventory. ) We believe that an adjusting entry is more logical and efficient, especially when monthly and year-to-date financial statements are prepared using accounting software.
Bad debts expense often refers to the loss that a company experiences because it sold goods or provided services and did not require immediate payment. The loss occurs when the customer does not pay the amount owed. In other words, bad debts expense is related to a company's current asset accounts receivable.
It is common to see two methods for computing the amount of bad debts expense:
The direct write-off method requires that a customer's uncollectible account be first identified and then removed from the account Accounts Receivable. This method is required for U.S. income taxes and results in a debit to Bad Debts Expense and a credit to Accounts Receivable for the amount that is written off.
The allowance method anticipates that some of the accounts receivable will not be collected. In other words, prior to knowing exactly which customers or clients will not be paying, the company will debit Bad Debts Expense and will credit Allowance for Doubtful Accounts for an estimated, anticipated amount. (The Allowance for Doubtful Accounts is a contra asset account that when combined with Accounts Receivable indicates a more realistic amount that will be turning to cash.)
Many believe that the allowance method is the better method since 1) the balance sheet will be reporting a more realistic amount that will be collected from the company's accounts receivable, and 2) the bad debts expense will be reported on the income statement closer to the time of the related credit sales.
Since insurance premiums are usually paid prior to the period covered by the payment, it is common to debit Prepaid Insurance and to credit Cash for the amount paid. (Prepaid Insurance is a current asset and is reported on the balance sheet after inventory.)
As the prepaid amount expires, the balance in Prepaid Insurance is reduced by a credit to Prepaid Insurance and a debit to Insurance Expense. This is done with an adjusting entry at the end of each accounting period (e.g. monthly). One objective of the adjusting entry is to match the proper amount of insurance expense to the period indicated on the income statement. (The income statement should report the amount of insurance that has expired during the period indicated in the income statement's heading.) Another objective is to report on the balance sheet the unexpired amount of insurance as the asset Prepaid Insurance.
If you can arrange for your insurance payments to be the amount applicable to each accounting period, you can simply debit Insurance Expense and credit Cash. For example, if the insurance premiums for one year amount to $12,000 and you can pay the insurance company $1,000 per month, then each monthly payment will be recorded with a debit to Insurance Expense and a credit to Cash. In this case $1,000 per month will be matched on the income statement and there will be no prepaid amount to be reported on the balance sheet.
Revenues received in advance are reported as a current liability if they will be earned within one year. The accounting entry is a debit to the asset Cash for the amount received and a credit to the liability account such as Customer Advances or Unearned Revenues.
As the amount received in advance is earned, the current liability account will be debited for the amount earned and the Revenues account reported on the income statement will be credited. This is done through an adjusting entry.
The term bad debts usually refers to accounts receivable (or trade accounts receivable) that will not be collected. However, bad debts can also refer to notes receivable that will not be collected.
The bad debts associated with accounts receivable is reported on the income statement as Bad Debts Expense or Uncollectible Accounts Expense.
When the allowance method is used, the journal entry to Bad Debts Expense will include a credit to Allowance for Doubtful Accounts, a contra account and valuation account to the asset Accounts Receivable. The allowance method anticipates the losses and therefore requires the use of estimates.
Under the direct write-off method, the Allowance for Doubtful Accounts is not used. Rather, Bad Debts Expense will be debited when an account receivable is actually written off. The credit in this entry will be to the asset Accounts Receivable.
In accounting the monthly close is the processing of transactions, journal entries and financial statements at the end of each month. Under the accrual method of accounting, it is imperative that the financial statements reflect only the transactions and journal entries having relevance to the current month's revenues and expenses, and end-of-the-month assets and liabilities. Expressed another way, the monthly close must achieve a proper cutoff of each month's financial activities.
To ensure that the monthly financial statements are accurate and timely, companies will use standard journal entries, recurring journal entries, and checklists for the tasks that must be completed.
If a company has inventories, its monthly close will be more challenging as it will have to be certain that the costs are recorded in the same month as the goods are added to the inventories. In short, the accrual of expenses becomes immensely important when goods are received and are sold.
Another important step in the monthly close is to compare the amounts and percentages on the current financial statements to those of earlier months. For example, if the current income statement shows the cost of goods sold as 88% instead of the typical 81%, the current month's amounts need to be reviewed before releasing the financial statements. Often the comparison of the balance sheet amounts to those of earlier months will provide insight as to unusual amounts shown on the income statement.
The term "deferred expense" is used to describe a payment that has been made, but it won't be reported as an expense until a future accounting period.
For example, a corporation might spend $500,000 in accounting, legal, and other fees in order to issue $40,000,000 of bonds payable. Rather than charging the $500,000 to expense in the year that the bonds are issued, the corporation will "defer" the $500,000 to a balance sheet account such as Bond Issue Costs. If the bonds mature in 25 years, the corporation will charge $20,000 of the bond issue costs ($500,000 divided by 25 years) to expense each year. This accounting treatment does a better job of matching the $500,000 to the periods when the company will be earning revenues from the use of the $40,000,000.
Another example of a deferred expense is the $12,000 insurance premium paid by a company on December 27 for insurance protection for the upcoming January 1 through June 30. On December 27 the $12,000 is deferred to the balance sheet account Prepaid Insurance. Beginning in January it will be expensed at the rate of $2,000 per month. Again, the deferral was necessary to achieve the matching principle.
As you can see from our examples, the word "deferred" overpowers the word "expense." A deferred expense is reported on the balance sheet as an asset until it expires. As it is expiring, it will be moving from the balance sheet to the income statement where it will be reported as an expense. The entries involving deferred expenses are called adjusting entries.
Interest expense is the cost of debt that has occurred during a specified period of time.
To illustrate interest expense under the accrual method of accounting, let's assume that a company borrows $100,000 on December 15 and agrees to pay the interest on the 15th of each month beginning on January 15. The loan states that the interest is 1% per month on the loan balance. The interest expense for the month of December will be approximately $500 ($100,000 x 1% x 1/2 month). The interest expense for the month of January will be $1,000 ($100,000 x 1%).
Since interest on debt is not paid daily, a company must record an adjusting entry to accrue interest expense and to report interest payable. Using our example above, at December 31 no interest was yet paid on the loan that began on December 15. However, the company did incur one-half month of interest expense. Therefore, the company needs to record an adjusting entry that debits Interest Expense $500, and credits Interest Payable for $500.
Balance sheet accounts are one of two types of general ledger accounts. (Income statement accounts make up the other type.) Balance sheet accounts are used to sort and store transactions involving assets, liabilities, and owner's or stockholders' equity. Examples of a corporation's balance sheet accounts include Cash, Accounts Receivable, Investments, Buildings, Equipment, Accumulated Depreciation, Notes Payable, Accounts Payable, Payroll Taxes Payable, Paid-in Capital, Retained Earnings, etc.
Balance sheet accounts are described as permanent or real accounts because at the end of the accounting year the balances in these accounts are not closed. Instead, the end-of-the-accounting-year balances will be carried forward to become the beginning balances in the next accounting year. (This is different from the income statement accounts, which begin each accounting year with zero balances.)
The balances in the balance sheet accounts are presented in a company's balance sheet, which is one of the main financial statements.
It will be helpful to keep in mind that every adjusting entry will require at least one balance sheet account and one income statement account.
You need to adjust the balance in the contra asset account Allowance for Doubtful Accounts to be your best estimate of the amount in Accounts Receivable which are not collectible. In other words, adjust the credit balance in the allowance account to become the amount of the receivables that is not expected to turn to cash.
If the Allowance for Doubtful Accounts presently has a credit balance of $2,000 and you believe there is a total of $2,900 of accounts receivable that will not be collected, you need to enter an additional credit of $900 into the Allowance for Doubtful Accounts, and you need to enter a debit of $900 into Bad Debts Expense.
The allowance account appearing on the balance sheet might be titled Allowance for Uncollectible Accounts, Provision for Bad Debts, or some combination of these. The income statement account might have a title such as Uncollectible Accounts Expense, Doubtful Accounts Expense, etc.
The units of production method of depreciation is based on an asset's usage, activity, or parts produced instead of the passage of time. Under the units of production method, depreciation during a given year will be very high when many units are produced, and it will be very low when only a few units are produced.
To illustrate the units of production method, let's assume that a production machine has a cost of $500,000 and its useful life is expected to end after producing 240,000 units of a component part. The salvage value at that point is expected to be $20,000. Under the units of production method, the machine's depreciable cost of $480,000 ($500,000 minus $20,000) is divided by 240,000 units, resulting in depreciation of $2 per unit. If the machine produces 10,000 parts in the first year, the depreciation for the year will be $20,000 ($2 x 10,000 units). If the machine produces 50,000 parts in the next year, its depreciation will be $100,000 ($2 x 50,000 units). The depreciation will be calculated similarly each year until the asset's Accumulated Depreciation reaches $480,000.
The units of production method is also referred to as the units of activity method, since the method can be used for depreciating airplanes based on air miles, cars on miles driven, photocopiers on copies made, DVDs on number of times rented, and so on.
Depreciation is an allocation technique and the units of production method might do a better job of allocating/matching an asset's cost to the proper period than the straight-line method, which is based solely on the passage of time.
The depreciation of assets such as equipment, buildings, furnishing, trucks, etc. causes a corporation's asset amounts, net income, and stockholders' equity to decrease. This occurs through an accounting adjusting entry in which the account Depreciation Expense is debited and the contra asset account Accumulated Depreciation is credited.
The amount of the annual depreciation that is reported on the financial statements is an estimate based on the asset's 1) cost, 2) estimated salvage value, and 3) useful life. Depreciation should be thought of as an allocation of the asset's cost to expense (and not as a valuation technique). In other words, the accountant is matching the cost of the asset to the periods in which revenues are generated from the asset.
The amount of the annual depreciation reported on the U.S. income tax return is based on the tax regulations. Since depreciation is a deductible expense for income tax purposes, the corporation's taxable income (and associated tax payments) will be reduced by its tax depreciation expense. (In any one year, the depreciation expense for taxes will likely be different from the amount reported on the financial statements.)
It should be noted that depreciation is viewed as a noncash expense. That is, the corporation's cash balance is not changed by the annual depreciation entry. (Often the corporation's cash is reduced for the asset's entire cost at the time the asset is acquired.)
Accrued interest is the amount of loan interest that has already occurred, but has not yet been paid to the lender by the borrower.
The accrued interest will be reported by the borrower as both
The accrued interest will be reported by the lender as both
Accrued interest is likely to require adjusting entries by both the borrower and the lender prior to issuing their financial statements.
Accrued expenses are reported in the current liabilities section of the balance sheet. Accrued expenses reported as current liabilities are the expenses that a company has incurred as of the balance sheet date, but have not yet been recorded or paid. Typical accrued expenses include wages, interest, utilities, repairs, bonuses, and taxes.
Accrued revenues are reported in the current assets section of the balance sheet. The accrued revenues reported on the balance sheet are the amounts earned by the company as of the balance sheet date that have not yet been recorded and the customers have not yet paid the company.
Accrued expenses and accrued revenues are also reflected in the income statement and in the statement of cash flows prepared under the indirect method. However, these financial statements reflect a time period instead of a point in time.
Prepaid insurance is the portion of an insurance premium that has been paid in advance and has not expired as of the date of the balance sheet. This unexpired cost is reported in the current asset account Prepaid Insurance.
As the amount of prepaid insurance expires, the expired cost is moved from the asset account Prepaid Insurance to the income statement account Insurance Expense. This is usually done at the end of each accounting period through an adjusting entry.
To illustrate prepaid insurance, let's assume that on November 20 a company pays an insurance premium of $2,400 for the six-month period of December 1 through May 31. On November 20, the payment is entered with a debit of $2,400 to Prepaid Insurance and a credit of $2,400 to Cash. As of November 30 none of the $2,400 has expired and the entire $2,400 will be reported as Prepaid Insurance. On December 31, an adjusting entry will debit Insurance Expense for $400 (the amount that expired: 1/6 of $2,400) and will credit Prepaid Insurance for $400. This means that the debit balance in Prepaid Insurance at December 31 will be $2,000 (5 months of insurance that has not yet expired times $400 per month; or 5/6 of the $2,400 insurance premium cost).
If the dollar amount of supplies is significant, the amount of unused supplies as of the balance sheet date should be reported in the asset account Supplies or Supplies on Hand. The supplies that have been used during the accounting period should be reported in the income statement account Supplies Expense. Basically, supplies are assets until they are used. When they are used, they become an expense.
When the dollar amount of supplies is not significant, many companies will simply debit Supplies Expense when the supplies are purchased. They will report no supplies on hand or a small constant amount. This less-than-perfect accounting treatment of an insignificant amount is allowed because of an accounting concept known as materiality.
Some people use Provision for Doubtful Debts to mean the contra-asset account reported on the balance sheet. Others use Provision for Doubtful Debts to mean the expense reported on the income statement.
If Provision for Doubtful Debts is the current period expense associated with the losses from normal credit sales, it will appear as an operating expense—usually as part of Selling, General and Administrative Expenses (SG&A). If the expense is associated with extending credit outside of a company's main selling activities, the credit loss will be reported as a nonoperating expense.
To avoid the confusion with the use of the word "provision", the accounting textbooks often refer to the contra-asset account associated with accounts receivable as Allowance for Doubtful Accounts. The current period expense pertaining to accounts receivable is referred to as Bad Debt Expense, an operating expense.
Income statement accounts are one of two types of general ledger accounts. (Balance sheet accounts make up the other type.) Income statement accounts are used to sort and store transactions involving revenues, expenses, gains, and losses. The income summary account is also an income statement account. The number of income statement accounts used at a large company could be in the thousands. A few examples of income statement accounts include Sales, Service Revenues, Salaries Expense, Rent Expense, Advertising Expense, Interest Expense, Gain on Disposal of Truck, etc.
Income statement accounts are described as temporary accounts because at the end of each accounting year the balances in the income statement accounts will be closed. This means that the balances will be combined and the net amount will be transferred to a balance sheet equity account. In the case of a corporation, the equity account is Retained Earnings. In the case of a sole proprietorship it is the owner's capital account.
The closing of the income statement accounts at the end of an accounting year means that the income statement accounts will begin the subsequent year with zero balances. As a result, the balances in the income statement accounts will be the year-to-date amounts.
It will be helpful to remember that every adjusting entry will require at least one income statement account and at lease one balance sheet account.
A prepaid expense might be recorded initially as 1) an expense, or 2) as an asset.
Let's illustrate these two possibilities by assuming that an insurance premium of $6,000 is paid on December 1. This cost covers the six month period of December 1 through May 31. As a result the monthly expense will be $1,000. Let's also assume that the company did not have any insurance prior to December 1.
Usually there would be insurance coverage prior to December 1. In that case the year-to-date balance in the expense account should be equal to the expired insurance cost during the year-to-date period. If there is a conflict between getting the prepaid asset balance to be correct and the expense balance to be correct, make certain that the prepaid asset balance is correct.
A noncash expense is an expense that is reported on the income statement of the current accounting period, but there was no related cash payment during the period.
A common example of a noncash expense is depreciation. For instance, if a company purchased equipment on December 31, 2012 for $200,000 cash, it could have Depreciation Expense of $20,000 in each of the next 10 years. As a result its income statement will report Depreciation Expense of $20,000 in each of the years 2013 through 2022. Since there is no cash payment in any of those years, each year's $20,000 of depreciation expense is referred to as a noncash expense.
Costs should be expensed when they are used up or have expired and when they have no future economic value which can be measured. For example, the August salaries of a company's marketing team should be charged to expense in August since the future economic value of their August salaries cannot be determined.
Costs should be capitalized or recorded as assets when the costs have not expired and they have future economic value. For example, on November 25 a company pays $12,000 for property insurance covering the six months of December through May. The $12,000 is initially recorded as the current asset Prepaid Insurance. On November 30 the company will report this asset at $12,000 since the $12,000 has a future economic value. (It will save making future payments of cash for insurance coverage.) On December 31 the asset will be reported as $10,000—the unexpired cost.
It will also report Insurance Expense for the month of December as $2,000—the cost that has expired during December. On January 31 the asset will be reported at the unexpired cost of $8,000. January's insurance expense will be $2,000—the amount that has expired during January.
Without the balance sheet account, Allowance for Uncollectible Accounts, all of the accounts receivable are assumed to be collectible and there is no bad debt expense reported on the income statement until an account receivable is written off. This approach is known as the direct write-off method. (When an account is written off, the entry will be a debit to Bad Debt Expense and a credit to Accounts Receivable.)
When the account Allowance for Uncollectible Accounts is reported on the balance sheet, the company anticipates that some of its accounts receivable will not be collected. In other words, without knowing specifically which account will not be collected, the company debits Bad Debt Expense and credits Allowance for Uncollectible Accounts. This results in an expense on the income statement (sooner than would occur under the direct write-off method) and a reduction of the current assets on the balance sheet. (When an account is written off under the "allowance" method, the entry will be a debit to Allowance for Uncollectible Accounts and a credit to Accounts Receivable.)
When loan costs are significant, they must be amortized because of the matching principle. In other words, all of the costs of a loan must be matched to the accounting periods when the loan is outstanding.
To clarify this, let's assume that a company incurs legal, accounting, and registration fees of $120,000 during February in order to obtain a $4 million loan at an annual interest rate of 9%. The loan will begin on March 1 and the entire $4 million of principal will be due five years later. The company's cost of the borrowed money will be $360,000 ($4 million X 9%) of interest each year for five years plus the one-time loan costs of $120,000.
It would be misleading to report the entire $120,000 of loan costs as an expense of one month. Hence, the matching principle requires that each month during the life of the loan the company should report $2,000 ($120,000 divided by 60 months) of interest expense for the loan costs in addition to the interest expense of $30,000 per month ($4 million X 9% per year = $360,000 per year divided by 12 months per year). The combination of the amortization of the loan cost plus the interest expense will mean a total monthly interest expense of $32,000 for 60 months beginning on March 1.
Accrued payroll would be wages, salaries, commissions, bonuses, and the related payroll taxes and benefits that have been earned by a company's employees, but have not yet been paid or recorded in the company's accounts.
For example, the accrued payroll as of December 31 would include all of the wages that the hourly-paid employees have earned as of December 31, but will not be paid until the following pay day (perhaps January 5). The employer's portion of the FICA, unemployment taxes, worker compensation insurance, and other benefits pertaining to those wages should also be included as accrued payroll in order to achieve the matching principle of accounting.
Unearned income or unearned revenue occurs when a company receives money before the money is earned. This is also referred to as deferred revenues or customer deposits. The unearned amount is recorded in a liability account such as Unearned Revenues, Deferred Revenues, or Customer Deposits. After the amount has been earned, the liability account is reduced and a revenue account is increased.
Example 1. A lawn service company offers customers a special package of five applications of fertilizers and weed treatments for $200 if the customer prepays in March. The service will be provided in April, May, June, July, and September. When the company receives $200 in March, it will debit the asset Cash for $200 and will credit the liability account Unearned Revenues. Since these are balance sheet accounts (and since no work has yet been performed), no revenue is reported in March. In April when the first service is provided, the company will debit the liability account Unearned Revenues for $40 and will credit the income statement account Service Revenues for $40. At the end of April, the balance sheet will report the company's remaining liability of $160. The income statement for April will report that $40 was earned. The $40 entry is referred to as an adjusting entry and the same entry will be recorded in May, June, July, and September.
Example 2. A company informs a customer that a $5,000 deposit is required before it will begin work on the customer's special order. The customer gives the company $5,000 on December 28 and the company will begin work on the special order on January 3. On December 28 the company will debit Cash for $5,000 and will credit a liability account, such as Customer Deposits (or Unearned Revenues or Deferred Revenues) for $5,000. No revenue is reported in December for this special order since the company did not perform any work. When the special order is completed in January the company will debit the liability account for $5,000 and will credit a revenue account.
Accrued income is an amount that has been 1) earned, 2) there is a right to receive the amount, and 3) it has not yet been recorded in the general ledger accounts. One example of accrued income is the interest earned on a bond investment.
To illustrate, let's assume that a company invested $100,000 on December 1 in a 6% $100,000 bond that pays $3,000 of interest on each June 1 and December 1. On December 31, the company will have earned one month's interest amounting to $500 ($100,000 x 6% per year x 1/12 of a year, or 1/6 of the semiannual $3,000). No interest will be received in December since it will be part of the $3,000 to be received on June 1. The $500 of interest earned during December, but not yet received or recorded as of December 31 is known as accrued income.
Under the accrual basis of accounting, accrued income is recorded with an adjusting entry prior to issuing the financial statements. In our example, there will need to be an adjusting entry dated December 31 that debits Interest Receivable (a balance sheet account) for $500, and credits Interest Income (an income statement account) for $500.
Inventory change is the difference between last period's ending inventory and the current period's ending inventory. If last period's ending inventory was $100,000 and the current period's ending inventory is $115,000, the inventory change is an increase of $15,000.
The inventory change is often presented as an adjustment to purchases in the calculation of the cost of goods sold. If purchases were $300,000 during the current period and the inventory amounts are those listed above, the cost of goods sold is $285,000. (Purchases of $300,000 minus the $15,000 increase in inventory. The logic is that not all $300,000 of purchases should be matched against sales, because $15,000 of the purchases went into inventory.) This is an alternative to the method used in introductory accounting: beginning inventory of $100,000 + purchases of $300,000 = $400,000 of cost of goods available – ending inventory of $115,000 = cost of goods sold of $285,000.
If last period's ending inventory was $100,000 and the current period's ending inventory is $93,000, the inventory change is a decrease of $7,000. Assuming purchases of $300,000 in the current period, the cost of goods sold is $307,000 ($300,000 of purchases plus the $7,000 decrease in inventory).
An expense will decrease the amount of assets or increase the amount of liabilities, and will reduce the amount of owner's or stockholders' equity.
For example an expense might 1) reduce a company's assets such as Cash, Prepaid Expenses, or Inventory, 2) increase the credit balance in a contra-asset account such as Allowance for Doubtful Accounts or Accumulated Depreciation, 3) increase the balance in the liability account Accounts Payable, or increase the amount of accrued expenses payable such as Wages Payable, Interest Payable, and so on.
In addition to the change in the assets or liabilities, an expense will reduce the credit balance in the Owner Capital account of a sole proprietorship, or will reduce the credit balance in the Retained Earnings account of a corporation.
Accrued revenues are fees and interest that have been earned and sales that occurred, but they have not yet been recorded through the normal invoicing paperwork. Since these are not yet in the accountant's general ledger, they will not appear on the financial statements unless an adjusting entry is entered prior to preparing the financial statements.
Here's an example. Your company lent a supplier $100,000 on December 1. The agreement is for the $100,000 to be repaid on February 28 along with $3,000 of interest for the three months of December through February. As of December 31 your company will not have a transaction/invoice/receipt for the interest it is earning since all of the interest is due on February 28. Without an adjusting entry to accrue the revenue it earned in December, your company's financial statements as of December 31 will not be reporting the $1,000 (one-third of the $3,000 of interest) that it has earned in December. In order for the financial statements to be correct on the accrual basis of accounting, the accountant needs to record an adjusting entry dated as of December 31. The adjusting entry will consist of a debit of $1,000 to Interest Receivable (a balance sheet account) and a credit of $1,000 to Interest Income or Interest Revenue (income statement accounts).
When an accountant states that a reported amount is overstated, it means two things:
For example, a company reports that its prepaid insurance is $8,000. However, the true or correct amount of prepaid insurance is only $7,000. The accountant will say that the reported amount for prepaid insurance is overstated by $1,000.
Because of double-entry accounting or bookkeeping, another general ledger account will also have a reporting error. In our example, if Prepaid Insurance is overstated (too much being reported) it is likely that Insurance Expense will be understated (too little is being reported).
Under the accrual basis of accounting, unpaid wages that have been earned by employees should be entered as 1) Wages Expense and 2) Wages Payable or Accrued Wages Payable. Wages Expense is an income statement account. Wages Payable is a current liability account that is reported on the balance sheet.
The recording of wages that have been earned but not yet paid or processed through the routine payroll entries is referred to as accruing wages. This is done through an accrual-type adjusting entry.
A cost might be an expense or it might be an asset. An expense is a cost that has expired or was necessary in order to earn revenues. We hope the following three examples will illustrate the difference between a cost and an expense.
A company has a cost of $6,000 for property insurance covering the next six months. Initially the cost of $6,000 is reported as the current asset Prepaid Insurance. However, in each of the following six months, the company will report Insurance Expense of $1,000—the amount that is expiring each month. The unexpired portion of the cost will continue to be reported as the asset Prepaid Insurance.
The cost of equipment used in manufacturing is initially reported as the long lived asset Equipment. However, in each accounting period the company will report part of the asset's cost as Depreciation Expense.
A retailer's purchase of merchandise is initially reported as the current asset Inventory. When the merchandise is sold, the cost of the merchandise sold is removed from Inventory and is reported on the income statement as the expense entitled Cost of Goods Sold.
The matching principle guides accountants as to when a cost will be reported as an expense.
Because of double-entry accounting and the accrual-basis of accounting, the cost of utilities (electricity, natural gas, sewer, water, etc.) will involve both an expense and a liability. For example, a retailer who is responsible for her store's heat and light will incur an expense for the amount of utilities used during the accounting period. The retailer will also have a liability for the utilities that were used but have not yet been paid. Since the utility company provides the electric and gas service before it bills the user, the retailer will be incurring an expense every day and will be incurring a liability every day. The amount of the liability increases each day and is reduced by the amount paid by the retailer. (When the retailer pays the amount billed by the utility for the previous month's usage, the retailer will still have a liability for the utilities used since last month.)
For a manufacturer, the cost of the utilities used in the factory will be assigned or allocated to the products as manufacturing overhead. If all of the products manufactured remain in inventory, the cost of the utilities used in the factory are embedded in the inventory's cost. When products are sold, the cost of utilities allocated to those products will automatically be expensed as part of the cost of goods sold. Under accrual accounting, the cost of the utilities that were used are included in the products' cost—whether or not the utilities have been paid. Because of double-entry accounting, the amount owed for the utilities that were used is also reported on the balance sheet as a liability.
Since natural gas, electricity, and other utilities are used before the meters are read and billed by the utility company, the company using the utilities will have to estimate (1) the amounts used during an accounting period, and (2) the amounts owed at the end of each accounting period. The amounts are entered into the accounting records through an accrual-type adjusting entry.
A contingent asset is a potential asset associated with a contingent gain. Unlike contingent liabilities and contingent losses, contingent assets and contingent gains are not recorded in accounts, even when they are probable and the amount can be estimated.
An example of a contingent gain and contingent asset might be a lawsuit filed by Company A against Company B for infringement of Company A's patent. If it is probable that Company A will win the lawsuit and receive an estimated amount of money, it has a contingent asset and a contingent gain.
However, it will not report the asset and gain until the lawsuit is settled. (At most Company A will prepare a very carefully worded disclosure stating that it possibly could win the case.) On the other hand, Company B will need to make an entry in its accounts if the loss contingency is probable and the amount can be estimated. If one of those are missing, Company B will have to disclose the loss contingency in the notes to its financial statements.
The amount reported in Bad Debts Expense is the loss that occurred from extending credit during the period of time indicated in the heading of the income statement. Bad Debts Expense is usually an estimated amount based on a company's credit sales during the period or the change in the collectibility of its accounts receivable.
The amount reported in the Allowance for Doubtful Accounts is the estimated amount of the accounts receivable that will not be collected. The Allowance for Doubtful Accounts is a contra asset account or valuation account associated with the balance in Accounts Receivable. Since these two accounts are balance sheet accounts, their account balances must report the amounts that are relevant at a specific moment in time, namely the date of the balance sheet.
To illustrate, let's assume that on December 31 a company had $100,000 in Accounts Receivable and its balance in Allowance for Doubtful Accounts was a credit balance of $3,000. For the first 30 days of January the company does not have any other information on bad accounts. Then on January 31 the company learns that an additional $1,000 of its accounts receivable will not be collectible. On January 31 the company will make an adjusting entry to debit Bad Debts Expense for $1,000 and to credit Allowance for Doubtful Accounts for $1,000. After this entry is recorded, the company's income statement for the month of January will report Bad Debts Expense of $1,000 and its January 31 balance sheet will report a credit balance in Allowance for Doubtful Accounts in the amount of $4,000.
The aging method usually refers to the technique used for determining the credit balance needed in the account Allowance for Doubtful (or Uncollectible) Accounts. This Allowance account is a contra asset account connected with Accounts Receivable. Usually when a credit adjustment is entered into the Allowance account, a corresponding debit amount is entered into Bad Debts Expense (or Uncollectible Accounts Expense).
The aging method takes place by sorting a company's accounts receivable according to the dates of these unpaid invoices. The invoice amounts that are not yet due are entered into the first of perhaps five columns. The invoice amounts that are 1-30 days past due are entered into the second column. Amounts that are 31-60 days past due are entered into the third column, and so on. (Accounting software will likely have a feature for generating an aging of accounts receivable.) The aging will be reviewed in order to determine the approximate amount of the receivables that may not be collected.
The goal of the aging method is to have the company's balance sheet report the true amount of the receivables that will be turning to cash. For example, if the company's Accounts Receivable has a debit balance of $89,400 but the company estimates (based on its aging) that only $82,000 will be collected, the Allowance account must report a credit balance of $7,400.
If a company fails to report a needed credit balance in its Allowance account, it will be overstating its assets, working capital, current ratio, retained earnings, and stockholders' equity. Its current period's earnings may also be overstated.
Adjusting entries are made at the end of the accounting period (but prior to preparing the financial statements) in order for a company's accounting records and financial statements to be up-to-date on the accrual basis of accounting. For example, each day the company incurs wages expense but the payroll involving workers' wages for the last days of the month won't be entered in the accounting records until after the accounting period ends. Similarly, the company uses electricity each day but receives only one bill per month, perhaps on the 20th day of the month. The electricity expense for the last 10-15 days of the month must get into the accounting records if the financial statements are to show all of the expenses and the amounts owed for the current accounting period. Other adjusting entries involve amounts that the company paid prior to amounts becoming expenses. For examples, the company probably paid its insurance premiums for a six month period prior to the start of the six month period. The company may have deferred the expense by recording the amount in the asset account Prepaid Insurance. During the accounting period some of those premiums expired (were used up) and need to appear as expense in the current accounting period and the asset balance reduced.
Closing entries are dated as of the last day of the accounting period, but they are entered into the accounts after the financial statements are prepared. For the most part, closing entries involve the income statement accounts. The closing entries set the balances of all of the revenue accounts and the expense accounts to zero. This means that the revenue and expense accounts will start the new year with nothing in the accounts—allowing the company to easily report the new year revenues and expenses. The net amount of all of the balances from the revenue and expense accounts at the end of the year will end up in retained earnings (for corporations) or owner's equity (for sole proprietorships). Thanks to accounting software, the closing entries are quite effortless.
Often a loan payment consists of both an interest payment and a payment to reduce the loan's principal balance. The interest portion is an expense whereas the principal portion is a reduction of a liability such as Loans Payable or Notes Payable.
If a company uses the accrual method of accounting, it is logical to record the interest expense and the interest liability at the end of each accounting period (instead of recording the interest expense when the payment is made). This is done with an adjusting entry in order to match the interest expense to the appropriate accounting period. It also results in the reporting of a liability for the amount of interest that the company owes as of the date of the balance sheet.
Sales commissions earned by a company would be reported as revenue in the company's income statement. Sales commissions that a company must pay to others are reported as an expense.
Under the accrual basis of accounting (as opposed to the cash basis) commission revenues should be reported when the company earns the commissions. The commission expense should be reported when the company has incurred the expense and liability. (This would also be the time when the other party has earned the commissions and the right to receive them.)
The commission revenues would be reported as operating revenue (in the section where sales are reported), if the commissions are earned as a main activity of the company. If the commissions are incidental or involve a peripheral activity, these commission revenues would be reported as other income.
Commission expense would be reported as a selling expense along with other operating expenses when they are related to the company's main activities. If a commission expense pertains to a peripheral activity, it would be reported as other expense.
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