I imagine some of you are starting to wonder if there is an end to the types of journal entries in the accounting cycle! So far we have reviewed day-to-day journal entries and adjusting journal entries. Closing entries are the last step in the accounting cycle.
Closing entries serve two objectives. The first is to close all of the temporary accounts in order to start with zero balances for the next year. The second is to update the balance in Retained Earnings to agree to the Statement of Retained Earnings.
Note: Closing entries are always dated the first day of the next year. If the year end for the company is September 30, 2013, the closing entries would be dated October 1, 2013. If we closed the accounts as of September 30, we would lose the information we need to do the income statement and statement of retained earnings.
Permanent Versus Temporary Accounts
The chart of accounts can be broken down into two categories: permanent and temporary accounts. A permanent account is one where the balance carries over into the next year. A temporary account is one where the balance resets each year.
Think about some accounts that would be permanent accounts, like Cash and Notes Payable. While some businesses would be very happy if the balance in Notes Payable reset to zero each year, I am fairly certain they would not be happy if their cash disappeared. Assets, liabilities and most equity accounts are permanent accounts. The balances carry over from year-to-year.
Temporary accounts include revenue, expenses and dividends. Each of these accounts must be zeroed out so that on the first day of the year, we can start tracking these balances for the new fiscal year. Remember that the periodicity principle states that financial statements should cover a defined period of time, generally one year. If we do not close out the balances in the revenue and expense accounts, these accounts would continue to contain the revenue and expense balances from previous years and would violate the periodicity principle.
Updating the Balance in Retained Earnings
Think back to all the journal entries you’ve completed so far. Have you ever done an entry that included Retained Earnings? If you have only done journal entries and adjusting journal entries, the answer is no. Let’s look at the trial balance we used in the Creating Financial Statements post.
The balance in Retained Earnings was $8,200 before completing the Statement of Retained Earnings. According to the statement, the balance in Retained Earnings should be $13,000.
We need to complete entries to update the balance in Retained Earnings so it reflects the balance on the Statement of Retained Earnings. We know the change in the balance includes net income and dividends. Net income includes revenue and expenses. Therefore, we need to transfer the balances in revenue, expenses and dividends (the temporary accounts) into Retained Earnings to update the balance.
Using Income Summary in Closing Entries
Rather than closing the revenue and expense accounts directly to Retained Earnings and possibly missing something by accident, we use an account called Income Summary to close these accounts. Income Summary allows us to ensure that all revenue and expense accounts have been closed.
The first accounts to close are the revenue accounts. The trial balance above only has one revenue account, Landscaping Revenue. If the account has a $90,000 credit balance and we wanted to bring the balance to zero, what do we need to do to that account? In order to cancel out the credit balance, we would need to debit the account. Sometimes it helps to visualize this with a T-account.
Debiting the account will get the desired result:
The other account in the entry will be Income Summary.
Now that the revenue account is closed, next we close the expense accounts. You must close each account; you cannot just do an entry to “expenses”. You can, however, close all the expense accounts in one entry. If the balances in the expense accounts are debits, how do you bring the balances to zero? Credit them! We will also close these accounts to Income Summary. The debit to income summary should agree to total expenses on the Income Statement.
Here is the journal entry to close the expense accounts:
After these two entries, the revenue and expense accounts have zero balances. Let’s look at the T-account for Income Summary.
Notice the balance in Income Summary matches the net income calculated on the Income Statement. We know that all revenue and expense accounts have been closed. If we had not used the Income Summary account, we would not have this figure to check, ensuring that we are on the right path.
The next step is to close Income Summary. This account is a temporary equity account that does not appear on the trial balance or any of the financial statements. It is a helper account, aiding us in the closing process. To close Income Summary, we will debit the account. What is our credit in the entry? What did we do with net income when preparing the financial statements? We added it to Retained Earnings on the Statement of Retained Earnings. To add something to Retained Earnings, which is an equity account with a normal credit balance, we would credit the account.
What else went into the calculation of Retained Earnings? If you said Distributions, you are correct. We now close the Distributions account to Retained Earnings. Distributions has a debit balance so we credit the account to close it. Our debit, reducing the balance in the account, is Retained Earnings.
Our T-account for Retained Earnings now has the desired balance.
The trial balance, after the closing entries are completed, is now ready for the new year to begin. We call this trial balance the post-closing trial balance.
The balance in Retained Earnings agrees to the Statement of Retained Earnings and all of the temporary accounts have zero balances. Little Landscaping, LLC is now ready to start the new year.
When doing closing entries, try to remember why you are doing them and connect them to the financial statements. To update the balance in Retained Earnings, we must transfer net income and dividends/distributions to the account. Net income is simply revenue and expenses. By closing revenue, expense and dividend/distribution accounts, we get the desired balance in Retained Earnings.
The four basic financial statements are the income statement, the statement of retained earnings, the balance sheet and the statement of cash flows. Due to the complexity of the statement of cash flows, you can find information on that statement in a separate post. Our purpose here is to get a basic feel for what goes on each of the statements and the purpose of each statement.
The first thing you should do when starting any statement is the heading. The heading tells the reader what he or she is looking at. The heading for all statements is as follows:
Name of the Statement
The date can be a bit tricky but we will discuss that in the context of each of the statements.
You must prepare the financial statements in a particular order:
- Income Statement
- Statement of Retained Earnings
- Balance Sheet
- Cash Flow
The reason for this is because you will need information from the previous statement to complete the next one. You will see the flow of information as we complete an example. It is important to note that you will only use each number from the trial balance one time. Once a number has been used, it will not be used again. Notice that I did not write once you use an account, you will not use it again. There is one account that will be used on two different statements. Can you guess which one?
The Income Statement
From the name, you should be able to tell that the statement has something to do with income. Income makes me think of revenue, but when working with businesses, most of us think of income in terms of profit. Revenue is nice but at the end of the day, those of us who are small business owners don’t get to take home our revenue because we have to pay expenses. Another name for the income statement is the profit and loss statement. The basic format for the income statement is revenue – expenses = net income.
The income statement is like a movie that tells us everything that happened in the business for the year. It includes all revenue generated and all expenses incurred. We can tell if the business borrowed money at any point in the year by looking for interest expense. We can tell if the company owns or rents the space it occupies by looking for rent expense. Does the company have employees? Look for wage expense. The income statement covers the entire period, whether that is a month, a quarter or a year. Therefore, when completing the income statement, the date in the heading should be For the (month/quarter/year) ended (date). For financial statements generated for a year long period of time that ends on December 31, 2013, the date on the income statement would read For the year ended December 31, 2013.
Where do we get the information for the income statement? From the trial balance! I like to think of the trial balance was the primer for financial statement preparation. Here is the trial balance used in the post discussing them.
The trial balance is organized to help us prepare the financial statements. Notice that revenue and expenses are listed together to make preparation of the income statement fairly easy.
Notice in our statement, we listed revenue on top. If there were multiple revenue accounts, we would list them all and then get total revenue like we did for expenses. We then used our formula, revenue – expenses = net income to complete the statement.
Remember that this is a basic income statements. There are more complicated formats for the income statement but this is the basis for all income statements.
The Statement of Retained Earnings
The statement of retained earnings helps us update the balance in the retained earnings account. You will note that we have not completed a single journal entry to Retained Earnings through this process. We will use retained earnings in entries when we discuss closing entries. Because we have not entered any entries into the Retained Earnings accounts, the current balance in the account is last year’s balance. It has not yet been updated to reflect the change for this year. The statement of retained earnings is the first step in updating that balance.
Retained earnings is the amount of earnings that the company has kept (retained) over the years that the company has been in business. Each year the company generates earnings, also called net income. Some of these earnings may be paid out to the owners in the form of dividends or distributions. The difference between net income and distributions to owners is the amount that is added to the previous retained earnings balance. Therefore, the format for the statement of retained earnings is:
Beginning Balance, Retained Earnings (from the adjusted trial balance)
Plus: Net Income
Less: Dividends or Distributions
Equals: Ending Balance, Retained Earnings
Net income is taken from the income statement and dividends or distributions are taken from the trial balance.
Notice on our trial balance, the items we need are highlighted in blue. We look to the income statement which tells us our net income is $29,800. We have everything we need to complete the statement.
Note: For the date on the statement of retained earnings, we use “For the year ended December 31, 2013” because the income statement is involved in the statement. The statement of retained earnings covers all the changes to retained earnings over the course of the year, just like the income statement.
The Balance Sheet
If you look at the trial balance, you will notice that the only accounts we haven’t used are assets, liabilities and equity. Hopefully, this makes you think of the accounting equation, which states that Assets = Liabilities + Equity. We know that this equation always has to balance. The balance sheet is essentially the representation of the accounting equation. We are showing on a statement that assets do indeed equal liabilities and equity.
Unlike the income statement and statement of retained earnings, which tells us the story of the year, the balance sheet is a snapshot of the balances on the last day of the year. It is like a photograph rather than a movie. The balance sheet does not show us all the fluctuations in the balances throughout the year. It does not even show us the high and low balances for the year. It literally only shows us the balance on the last day. Therefore, when writing the date for the heading, we only put the last day. For the example we have been using, we would write “December 31, 2013”. That is all. No “For the year ended” here because it is not for the entire year, it is just for December 31.
At the beginning of the post, I stated that each statement would require something from the previous statement. What do we need from the statement of retained earnings? What type of account is retained earnings? It’s an equity account, which means that it needs to go on the balance sheet. I asked in the first section if you could guess which account is used on multiple statements. The answer is Retained Earnings, which appears on the statement of retained earnings and the balance sheet. Do not take the Retained Earnings balance from the trial balance. Use the ending balance from the statement of retained earnings.
Here is our basic balance sheet:
Notice that the equation does balance. The amount in Retained Earnings is the amount from the statement of retained earnings and not the trial balance. This is a basic, non-classified balance sheet. There are some balance sheets that show current and long-term assets, current and long-term liabilities and a separate equity section. More complex forms of the statements will be discussed in future posts.
Note: If your balance sheet does not balance, here are a few things to check:
- Did you only use revenue and expenses on your income statement? Remember that you can draw a line above your first income account and everything below that line should go on the income statement. Only the items below the line should go on the income statement.
- Did you subtract Dividends/Distributions on the statement of retained earnings?
- Did you use the ending Retained Earnings balance on your balance sheet?
A few other quick tips to keep in mind when preparing your statements.
- Prepaid Expenses are an asset, not an expense. It goes on the balance sheet!
- Accumulated Depreciation is a contra asset, not a liability. Subtract it from assets!
- Unearned Revenue is a liability, not revenue. It goes on the balance sheet!
Use your trial balance as a guide. Know where to separate the accounts and you will be much less likely to make a mistake.
Creating the Financial Statements
Journal entries are probably the most important part of any financial accounting class. They are the language of accounting.
This is a journal entry. It describes a transaction. The entry above tells us that on January 17, the company purchased land worth $100,000 and a building worth $225,000. The company put down $125,000 cash and took out a note with the bank for $200,000. Once you understand how journal entries are constructed, you will be able to read and write them yourself.
Debits and Credits
Debits and credits are the heart of the journal entry because they tell us if we are acquiring something or giving something up. Depending on the type of account, it will increase or decrease when it is debited or credited.
Remember the accounting equation? Assets = Liabilities + Equity. Just as we need to keep the accounting equation in balance, we must keep our debits and credit in balance. Each journal entry must contain equal debits and credits. Notice the entry above: $325,000 in debits and $325,000 in credits. In order for that to occur, each journal entry must have at least two accounts. You can never have a one line journal entry because it would not balance.
In accounting, we frequently refer to the normal balance in the account. The normal balance is a positive balance or what would need to be done to increase the balance.
Because the accounting equation tells us that assets must equal liabilities and equity, it makes sense that the normal balance for assets is a debit and the normal balance for liabilities and equity is a credit. Remember that normal balance means positive or increasing balance. What do you do to decrease the balance of an asset? If a debit increases the balance, than a credit to the account would decrease the balance. As we saw in the example entry above when we wanted to decrease cash, we credited the account.
What about revenue and expenses? Why is revenue’s normal balance a credit while expense’s is a debit? First, let’s discuss the relation these two accounts have to equity. Retained Earnings is a major component of equity. What causes retained earnings to increase? Profit. What causes profit to increase? Revenue. If revenue increases equity, then it should act the same way that equity does. Therefore, revenue has a credit balance. Since expenses decrease profit and equity, it makes sense that the normal balance is a debit.
If you still are not sure, put revenue or expenses in a journal entry with cash. Most people who study accounting quickly learn how cash behaves in most situations. If you know how cash will behave, you can figure out the other account. When a company does work and gets paid, cash increases so we debit cash. The other account, revenue, would be the credit. When a company pays for its rent, cash decreases so we credit Cash. To balance the entry, we debit Rent Expense.
Steps for Completing Journal Entries
- Read the transaction to get a feel for what is happening. Do you understand what happened? Try to put it into your own words.
- Identify the accounts you will put in your journal entry. Identify the type of account for each account used.
- For each account, determine if the balance is increasing or decreasing. Then determine if that increase or decrease is a debit or credit.
- Determine the amount that each account is changing.
On January 4, Lisa decides to start a bookkeeping business and invests $10,000 cash and $5,000 worth of computer equipment in exchange for stock in the company.
- The company received cash and computer equipment in exchange for stock.
- Cash (asset), Computer Equipment (asset) and Common Stock (equity).
- Cash – increasing, debit. Computer Equipment – increasing, debit. Common Stock – Increasing, credit.
- Cash – $10,000. Computer Equipment – $5,000. Common Stock – $15,000
This may seem like a lot of steps but when you are first learning how to do journal entries, it really helps to go through each of the steps as you write the entry. You don’t need to write out the answers to each of the steps as I did above, but you should do it mentally as you figure out the entry. I have had many students who will put the abbreviation for the account type next to the account name.
If you are going to do that, I recommend using Eq for equity and Ex for expense.
When learning to do journal entries, take your time and go through the steps. Make sure to learn the accounts and what type each account is. You may want to make flash cards with the name of the account on one side and the type of account on the other. You should also learn when to use a particular account, for example, when to use Unearned Revenue instead of Revenue or Prepaid Insurance rather than Insurance Expense.
This may seem difficult at first, but if you learn the terminology and practice, you will get better at it. For most students, a lightbulb goes off in their minds somewhere in the first six weeks of the course; everything clicks and they no longer need to use the steps above. Until you have your lightbulb moment, make sure to use the steps outlined above.
Basic Journal Entries Part 1
Basic Journal Entries Part 2
Loaning money contains risk. Every time a business extends payment terms to a customer, that business is taking on risk. Not every customer will pay on time, some may not pay at all. When a customer defaults on an amount due, this is called bad debt.
When an account is deemed to be uncollectible, the business must remove the receivable from the books and record an expense. This is considered an expense because bad debt is a cost of doing business. Part of the cost of allowing customers to borrow money, which is essentially what a customer is doing when the business allows the customer time to pay, is the expense related to uncollectible receivables. This expense is called Bad Debt Expense.
There are two ways a company can account for bad debt expense: the direct write-off method and the allowance method.
The Direct Write-off Method for Bad Debt
The direct write-off method allows a business to record Bad Debt Expense only when a specific account has been deemed uncollectible. The account is removed from the Accounts Receivable balance and Bad Debt Expense is increased.
Example #1: On March 2, Dependable Car Repair, Inc. has deemed that a $1,400 in Accounts Receivable, due from Joe Smith, is uncollectible and should be recorded as a bad debt.
Dependable must reduce Accounts Receivable by $1,400 and record the Bad Debt Expense.
What happens if the customer later sends payment? This happens fairly regularly in business. If the customer’s balance is written off as uncollectible, there is nothing to apply the payment against. If the company applies the balance against the customer’s account, the entry would cause a negative balance or an amount due to the customer. In order to accept the payment, the company must first restore the balance to the customer’s account. The company would debit Accounts Receivable. What would the credit be? It’s not revenue because the company has not done any work or sold anything. By receiving the payment, the company is acknowledging that the debt is actually not a bad debt after all. Therefore, the company should reduce Bad Debt Expense.
Example #2: On June 23, Dependable Car Repair received a check for $1,400 from Joe Smith, whose balance was written off as uncollectible on March 2.
This transaction requires two entries. The first entry will restore the balance in accounts receivable. The second entry will show the receipt of the payment. It seems counterintuitive to restore the balance to pay it off, but for recordkeeping purposes, it is necessary to restore the account balance and show the customer properly paid his debt. We must make sure to show that Joe Smith paid the amount he owed, not just the fact that the company received some cash.
The direct write-off method is an easy way to manage bad debt when nonpayment is rare. However, this method violates the matching principle which states that expenses must be matched with revenue. When companies extend credit to customers, it is fairly common that some percentage of those customers will not pay. It may take a long time before the company has exhausted all efforts to collect the debt. Typically, the write off occurs in a different fiscal year than the revenue was recorded. This is why direct write-off violates the matching principle. How can we match the bad debt expense to the revenue associated with it?
The Allowance Method for Bad Debt
The allowance method creates bad debt expense before the company knows specifically which customers will not pay. Based on prior history, the company knows the approximate percentage or sales or outstanding receivables that will not be collected. Using those percentages, the company can estimate the amount of bad debt that will occur. That allows us to record the bad debt but since accounts receivable is simply the total of many small balances, each belonging to a customer, we cannot credit Accounts Receivable when this entry is recorded.
We must create a holding account to hold the allowance so that when a customer is deemed uncollectible, we can use up part of that allowance to reduce accounts receivable. This holding account is called Allowance for Doubtful Accounts. Allowance for Doubtful Accounts is a contra-asset linked to Accounts Receivable. The allowance is used the reduce the net amount of receivables that are due while leaving all the customer balances intact.
To record the bad debt, which is an adjusting entry, debit Bad Debt Expense and credit Allowance for Doubtful Accounts. When a customer is identified as uncollectible, we would credit Accounts Receivable. We cannot debit bad debt because we have already recorded bad debt to cover the percentage of sales that would go bad, including this sale. Remember that allowance for doubtful accounts is the holding account in which we placed the amount we estimated would go bad. This amount is just sitting there waiting until a specific accounts receivable balance is identified. Once we have a specific account, we debit Allowance for Doubtful Accounts to remove the amount from that account. The net amount of accounts receivable outstanding does not change when this entry is completed.
Let’s say that the balance in Accounts Receivable is $10,000 (debit) and the balance in Allowance for Doubtful Accounts is $500 (credit). Net accounts receivable is $9,500. This is how it would be presented on the balance sheet:
If a customer who owed $100 was deemed uncollectible on April 7, we would credit Accounts Receivable to remove the customer’s balance and debit Allowance for doubtful Accounts to cover the loss.
What effect does this have on the balances in each account and the net amount of accounts receivable? The balance in Accounts Receivable drops to $9,900 and the balance in Allowance for Doubtful Accounts falls to $400. The net amount is still the same.
How is that possible? Allowance for Doubtful Accounts is where we store the nameless, faceless uncollectible amount. We know some accounts will go bad, but we do not have a name or face to attach to them. Once an uncollectible account has a name, we can reduce the nameless amount and decrease Accounts Receivable for the specific customer who is not going to pay.
What if the customer later pays the bill? We would need to restore the balance in accounts receivable. Because we identified the wrong account as uncollectible, we would also need to restore the balance in the allowance account. If the customer paid the bill on September 17, we would reverse the entry from April 7 and then record the payment of the receivable.
Calculating Bad Debt Under the Allowance Method
As stated previously, the amount of bad debt under the allowance method is based on either a percentage of sales or a percentage of accounts receivable. When doing the calculations, it is important to understand what the resulting number actually represents. Because one method relates to the income statement (sales) and the other relates to the balance sheet (accounts receivable), the calculated amount is related to the same statement. When using the percentage of sales method, the resulting amount is the amount of bad debt that should be recorded. When using the percentage of accounts receivable method, the amount calculated is the new balance in allowance for doubtful accounts.
Percentage of Sales Method
The percentage of sales method is based on the premise that the amount of bad debt is based on some measure of sales, either total sales or credit sales. Based on prior years, a company can reasonably estimate what percentage of the sales measure will not be collected. If a company takes a percentage of sales (revenue), the calculated amount is the amount of the related bad debt expense.
Example: The company estimates bad debt based on the percentage of sales method. Sales for the fiscal year ended December 31, 2013 were $3,400,000, while credit sales were $2,900,000. The company estimates that 1.5% of credit sales are uncollectible. Allowance for Doubtful Accounts has a credit balance of $17,000. Record the adjusting journal entry necessary to record bad debt.
First identify the accounts that will be used in the entry. We already know this is a bad debt entry because we are asked to record bad debt. The percentage of sales method is an allowance method. We are also told that the company is estimating bad debt, so this is clearly not a company that uses direct write-off. Therefore, we will be using Allowance for Doubtful Accounts and Bad Debt Expense.
Time to calculate the amount of the transaction. The company estimates that 1.5% of credit sales are uncollectible. Therefore, we will use credit sales.
$2,900,000 x 1.5% = $43,500
What is this number? When using the percentage of sales method, we multiply a revenue account by a percentage to calculate the amount that goes on the income statement. That means we are calculating bad debt expense. The amount of expense is proportional to the amount of revenue.
What is the balance in Allowance for Doubtful Accounts? The account had a credit balance of $17,000 before the adjustment. The entry from December 31 would be added to that balance, making the adjusted balance $60,500. The percentage of sales method does not factor in the existing balance in Allowance for Doubtful Accounts. Without careful monitoring, the balance in the account could grow indefinitely. It is important for management to monitor the balance to ensure the balance is reasonable.
Percentage of Receivables Method
The percentage of receivables method automatically monitors the balance in Allowance for Doubtful Accounts because each year the calculation gives us the amount that should be in the account based on the amount of receivables outstanding. The contra-asset, Allowance for Doubtful Accounts, is proportional to the balance in the corresponding asset, Accounts Receivable.
When using the percentage of receivables method, it is usually helpful to use T-accounts to calculate the amount of bad debt that must be recorded in order to update the balance in Allowance for Doubtful Accounts. This is very similar to the adjusting entries involving shop supplies or prepaid expenses. If the transaction tells you what the new balance in the account should be, we must calculate the amount of the change. The amount of the change is the amount of the expense in the journal entry.
Example: The company estimates bad debt based on the percentage of receivables method. The balance in Accounts Receivable on December 31, 2013 was $530,000. The company estimates that 6% of receivables are uncollectible. Allowance for Doubtful Accounts has a credit balance of $17,000. Record the adjusting journal entry necessary to record bad debt.
As in all journal entries, the first step is to figure out which accounts will be used. Because this is just another version of an allowance method, the accounts are Bad Debt Expense and Allowance for Doubtful Accounts.
On to the calculation, since the company uses the percentage of receivables we will take 6% of the $530,000 balance.
$530,000 x 6% = $31,800
Now to consider what this amount is. We used Accounts Receivable in the calculation, which means that the answer would appear on the same statement as Accounts Receivable. Therefore, we have to consider which of our accounts would appear on the balance sheet with Accounts Receivable. Allowance for Doubtful Accounts is a contra-asset account so that is what we calculated. The adjusted balance in Allowance for Doubtful Accounts should be $31,800. Since the current balance is $17,000, we need to increase the balance to $31,800. We do this by crediting the account $14,800. The $14,800 is the amount of Bad Debt Expense that must be recorded.
When using an allowance method, it is critical to know what you are calculating. If using sales in the calculation, you are calculating the amount of bad debt expense. If using accounts receivable, the result would be the adjusted balance in the allowance account.
Aging of Accounts Receivable Method
The aging method is a modified percentage of receivables method that looks at the age of the receivables. The longer a debt has been outstanding, the less likely it is that the balance will be collected. The aging method breaks down receivables based on the length of time each has been outstanding and applies a higher percentage to older debts.
Notice how the estimated percentage uncollectible increases quickly the longer the debt is outstanding. Judging the amount that is uncollectible based off an aging schedule is the most accurate way to calculate bad debt because history tells us that the longer a debt is outstanding, the less likely the company is to collect it.
Example: The company uses the Aging Method to calculate bad debts. The company produced the following aging schedule on December 31, 2013:
Allowance for Doubtful Accounts had a credit balance of $9,000 on December 31. Record the adjusting journal entry for bad debt.
As with every other entry we have completed, the first step is to identify the accounts. This is another variation of an allowance method so we will use Bad Debt Expense and Allowance for Doubtful Accounts.
The calculation here is a few more steps but uses the same methodology used in all the other methods. Multiply the percentage by the balance outstanding. In this case, we have a percentage for each outstanding period. Once you know how much from each time period, add them to get the total allowance balance.
The adjusted balance in Allowance for Doubtful Accounts is $14,360. Since the unadjusted balance is $9,000, we need to record bad debt of $5,360.
Can Allowance for Doubtful Accounts have a debit balance? How would that happen? Allowance for Doubtful Accounts is a holding account for potential bad debt. When an account is written off, the allowance is debited. If the company underestimates the amount of bad debt, the allowance can have a debit balance. If the company uses a percentage of sales method, it must ensure that there will be enough in Allowance for Doubtful Accounts to handle the amount of receivables that go bad during the year. One of the benefits of using a receivables method is that we are calculating the new balance in the allowance account or bring the allowance account up to the level needed for the percentage of receivables that are outstanding. This is not the case with the sales method.
Example: Record the adjusting entry assuming the same facts as above, except the Allowance for Doubtful Accounts has a debit balance of $2,000.
Since Allowance for Doubtful Accounts has a normal credit balance, a debit balance in the account is like overdrawing the account. We need to bring the account even, then add enough to get the balance to $14,360. Therefore, we want to add the amounts. You could also look at it like this:
New balance – old balance = amount of adjustment
$14,360 – $(-2,000) = $16,360
When you subtract a negative, you add the number. The amount of the entry will be $16,360.
The most important thing to remember when working with the allowance methods for bad debt is to know what you have calculated! Once you figure a dollar amount, ask yourself if that amount is the bad debt expense or the allowance. If it is the allowance, you must then figure out how much bad debt to record in order to get to that balance.
What are adjusting journal entries?
The matching principle states expenses must be matched with the revenue generated during the period. The purpose of adjusting entries is to ensure that all revenue and expenses from the period are recorded. Many adjusting entries deal with balances from the balance sheet, typically assets and liabilities, that must be adjusted. In addition to ensuring that all revenue and expenses are recorded, we are also making sure that all asset and liability accounts have the proper balances. Adjusting entries are dated for the last day of the period.
When analyzing adjusting entry transactions involving assets and liabilities, remember that you are recording the change in the balance, not the new balance in the account. Ask yourself “what must I do to the account to get the adjusting balance?”
As a business goes through the normal day-to-day operations, many transactions are recorded. When work is done and the company is paid, revenue is recorded. Revenue is also recorded when invoices (accounts receivable) are created. Expenses are recorded when bills (accounts payable) are received. If the company has already recorded all those things, then what could possibly be left to do? You would be surprised!
NOTE: Cash should never appear in an adjusting entry. Most adjusting entries are done after year end and backdated to the end of the year. When cash is spent, the transactions are recorded immediately. With electronic banking, we can instantly check cash transactions. There is no reason why a business shouldn’t know about transactions affecting its cash accounts. Cash is never an account in an adjusting entry.
If a business has done work for a client but has not yet created an invoice, there is unrecorded revenue that must be recorded. Maybe the business just hasn’t gotten around to completing the invoice yet, or maybe the work is partially done but not completely finished. This entry looks exactly like an entry to record work that has been completed but have not yet been paid for.
On December 31, KLI Video Production had completed $3,000 worth of work for clients which has not yet been billed.
Another type of unrecorded revenue deals with work the business was paid for before the work was completed (unearned revenue) which was completed by the end of the period. Transactions of this type can be written two different ways. We could be told how much revenue has been earned or we could be told the remaining balance in unearned revenue. Let’s look at how these transactions could be written so you can see the differences and identify which method to use.
Unearned revenue has an unadjusted balance of $4,000. An analysis of the account shows that $2,500 of the balance has been earned.
When looking at transactions like this one, we need to determine what we are being given. You want to ask yourself if the transaction is giving you the amount of the adjustment (revenue or expense to be recorded) or the adjusted (correct) balance in the asset or liability account. T-accounts are really helpful when doing adjusting entries because you can visualize what is happening. Here is the T-Account for unearned revenue.
We are told the account has an unadjusted balance of $4,000. Unearned revenue is a liability account and therefore the normal balance is a credit. We are told that $2,500 has been earned. Is that the new balance in the account? No, the $2,500 is the amount we need to remove from the account because it is no longer unearned. So if $2,500 is not the balance, then what is the balance? If the business has earned $2,500 of the $4,000, then the new balance is $1,500.
Now we can see the beginning balance and the ending balance in the T-account. Now, we have to determine how to get there. If we have a $4,000 credit balance and then have a $1,500 credit balance, the balance decreased by $2,500. How do we decrease an account with a credit balance? We debit the account. The $2,500 was given in the transaction, but now we know what to do with it. If you can predict what the balance should be in the account, you can do a T-account to make sure your entry will actually do what you predicted.
The credit in the entry is fees earned (revenue) because we were told that $2,500 had been earned. When you see earned, you should always think revenue unless the transaction states the money has not yet been earned. That statement should make you think of unearned revenue because it has not been earned.
The company had an unadjusted balance in unearned revenue of $4,000. An analysis of the account shows $1,500 is still unearned.
This transaction is worded a bit differently than the last. This transaction tells you what the ending balance in the account should be. Using a T-account in this scenario is a smart idea.
Notice, this example is exactly the same as Example #2. In order to get the balance from $4,000 credit to $1,500 credit, we need to debit unearned revenue $2,500.
Make sure to watch the wording in all adjusting entry transactions to ensure you understand what information you have.
Typically, when we are looking for unrecorded expenses, we look to the balance sheet. There are two types of unrecorded expenses: those that are related to assets that have been used up or need to be adjusted and those related to unrecorded liabilities.
Assets and Expenses
The definition of an asset is something the company owns or has the right to which it can use to generate revenue. When we were recorded journal entries, we recorded transactions to various asset accounts that when used up, will generate an expense. Some of those accounts were supplies, prepaid expenses and long-term asset accounts, like equipment and buildings.
Supplies are initially recorded as an asset, but they get used up over time. Rather than record an entry every time a ream of paper or a bag of mulch is removed from storage, we do an adjusting entry at the end of the period to record the amount of supplies that have been used up. Recording an entry every time something is removed from the stockroom or garage would violate the cost-benefit constraint. At the end of the period, the company counts up what is left for supplies. The difference between the balance in the account (unadjusted) and the amount that is left (adjusted) is the value used in the journal entry.
The balance in the supplies account at the end of the year was $5,600. A count of supplies shows that $1,400 worth of supplies are still on hand.
What does this transaction tell us? The unadjusted supplies balance is $5,600 but the adjusted balance should be $1,400. The transaction does not tell us the amount of the adjustment. That is something we will need to figure out. You may want to draw up a quick T-account to visualize the transaction.
To decrease the account balance, which is a debit balance, we need to credit the account. How much will we need to credit the account? What amount will bring the balance from $5,600 to $1,400? The difference is $4,200. So we need to credit the supplies account $4,200.
Where did the supplies go? They were used it. We call this supplies expense. Now we can write the journal entry.
Use the same methodology when doing entries involving prepaid expenses. Draw a T-account to help visualize what is happening.
Long-term assets and Expenses
When a company purchases a long-term asset, such as a vehicle to use in its business, we record the entire value of the purchase as an asset. That vehicle is used to generate revenue so shouldn’t that vehicle somehow be expensed? Yes, it should be. We call the expensing of a long-term asset depreciation. Do not confuse depreciation in accounting with how the term is used outside of accounting. Typically, we think of depreciation as a decline in market value. For example, I have heard it said many time that when you purchase a new car, it depreciates or loses 20% of its value when you drive off the lot. Depreciation in accounting has nothing to do with market value. Depreciation represents the using up of an asset to generate revenue.
The cost principle states that we must record assets at cost. In order to maintain that principle, when we record depreciation expense (which is a debit in the journal entry), we do not credit the asset directly. Instead we will use a contra account. A contra account is an account linked to another account but which has a normal balance opposite to the account it is linked to. A contra asset account would be linked to a specific asset account but would have a credit balance. For the vehicle described above, we would have a contra asset account called accumulated depreciation. This account would be linked to the vehicles account and would have a credit balance.
Some companies have one accumulated depreciation account used for all long-term assets and others have a separate accumulated depreciation account for each long-term asset account. In the next example, we will assume there is one accumulated depreciation account.
The company calculates that the current year depreciation is $12,000.
As with all adjusting entries, we need to determine if we are being given an account balance (asset or liability) or the amount of the expense. In this case, as with all depreciation entries, we are given the amount of the expense. Therefore, there is nothing to calculate here. No T-account is needed.
For more information about long-term assets and depreciation, see the posts on long-term assets and calculating depreciation.
Adjusting Entries Involving Liabilities
Some adjusting entries involve expenses that have not yet been paid for nor has the obligation been recorded. However, in these cases an expense has been generated. Examples include unrecorded bills and unpaid wages, interest, and taxes. This is not an exhaustive list but it does cover most of the transactions you will see. These entries require the recording of an expense and a liability.
The company received a bill for December’s utilities on January 5. The bill was for $235.
Although the bill was received in January, the utilities were used in December to generate revenue in December. The matching principle tells us that we must record the utilities expense in December.
The company pays its employees every two weeks. On December 31, the employees had worked four days for which they had not been paid. The amount due to the employees was $4,300.
Are you thinking matching principle here? Our employees help us generate revenue. The wages that we pay them must be matched to the revenue they are creating. Therefore, the $4,300 must be recorded in December. The wages have not been paid so we must show a liability. The liability used in this case will be wages payable.
Note: Accounts payable should only be used for routine bills (utilities, supply and inventory purchases). Other short-term payables should be named based on the expense they are related to. That is why wages payable was used in this case.
The company has a long-term note payable with Ginormic National Bank. As of December 31, $670 of interest had accrued on the loan but had not yet been paid.
Why do we have to record this? First, the interest is an expense for December even though it has not yet been paid. Second, to be accurate in our financial statements, the balance owed to the bank on December 31 includes not only the balance on the loan but also the unpaid interest. If we contact Ginormic National Bank to payoff the loan on December 31, we would need to pay the principal owed plus the $670 of interest. The interest is considered a separate payable and should not be added to the note payable.
The company estimates its profit to be $42,000 for the year and is in a 35% tax bracket.
When reading this transaction, it doesn’t even sound like something we would need to record. It just sounds like a statement, but the matching principle should set off an alarm. Why are we paying income taxes? The company had a profit for the year of $42,000. Income taxes are an expense of doing business. Should the expense fall in the year that is completed or the year we are currently in? The expense is related to the year that is completed and, therefore, must be recorded as an adjusting entry.
To figure out how much to record for taxes, we need to calculate 35% of the profit, which would be $14,700 ($42,000 x 0.35). Now we can record the entry.
Things to Remember
Treat adjusting entries just like you would treat normal entries. Use these steps when completing adjusting journal entries.
- Read the transaction to determine what is going on. Is an entry required?
- Identify the accounts you will use in your entry. Remember, cash is never used in adjusting entries!
- Determine the amount. Did the transaction give you the amount to use or do you need to calculate it? T-accounts are helpful here.
- Determine which account(s) to debit and which account(s) to credit.