Accounting: The Language of Business (Part 14)

“To be successful, you should concentrate on the world of companies, not arcane accounting mathematics.” —Warren Buffett

The Matching Concept and the Adjusting Process (Part C)

by

Charles Lamson

Recording Adjusting Entries

The examples of adjusting entries in the following paragraphs are based on the ledger of NetSolutions as reported in the December 31, 2022 real balance in Exhibit 2. The adjusting entries are shown in color in T accounts to separate them from other transactions. An expanded chart of accounts for NetSolutions is shown in Exhibit 3. The additional accounts that will be used in the next few posts are shown in color.

EXHIBIT 2

Deferred Expenses (Prepaid Expenses)

The concept of adjusting the accounting records was introduced in part 10 in the illustration for NetSolutions. In that illustration, supplies were purchased on November 10 (transaction c). The supplies used during November were recorded on November 31 (transaction g).

Entry C

Entry G

The balance in NetSolutions supplies account on December 31 is $2,000. Some of these supplies (paper, envelopes, etc.) were used during December, and some are still on hand (not used). If either amount is known, the other can be determined. It is normally easier to determine the cost of the supplies on hand at the end of the month than it is to keep a daily record of those used. Assuming that on December 31 the amount of supplies on hand is $760, the amount to be transferred from the asset account to the expense account is $1,240 computed as follows:

As we discussed in part 10, increases in expense accounts are recorded as debits and decreases in asset accounts are recorded as credits. Hence, at the end of December, the supplies expense account should be debited for $1,240, and the supplies account should be credited for $1,240 to record the supplies used during December. The adjusting journal entry and T accounts for supplies and supplies expense are as follows:

After the adjustment has been recorded and posted, the supplies account has a debit balance of $760. This balance represents an asset that will become an expense in a future period.

The debit balance of $2,400 in NetSolution's prepaid insurance account represents a December 1 prepayment of insurance for 24 months. At the end of December, the insurance expense account should be increased (debited), and the prepaid insurance account should be decreased (debited), and the prepaid insurance account should be decreased (credited) by $100, the insurance for one month. The adjusting journal entry and T accounts for prepaid insurance and insurance expense are as follows.

After the adjustment has been recorded and posted, the prepaid insurance account has a debit balance of $2,300. this balance represents an asset that will become an expense in future periods. The insurance expense account has a debit balance of $100, which is an expense of the current period.

What is the effect of omitting adjusting entries? If the preceding adjustments for supplies ($1,240) and insurance ($100) are not recorded, the financial statements prepared as of December 31 will be misstated. On the income statement, Supplies Expense and Insurance Expense will be understated by a total of $1,340, and net income will be overstated by $1,340. On the balance sheet, Supplies and Prepaid Insurance will be overstated by a total of $1,340. Since net income increases owner's equity, Chris Clark, Capital will also be overstated by $1,340 on the balance sheet. The effects of omitting these adjusting entries on the income statement and balance sheet are shown below.

Arrow (1) indicates the effect of the understated expenses on assets. Arrow (2) indicates the effect of the overstated net income on owner's equity.

Prepayments of expenses are sometimes made at the beginning of the period in which they will be entirely consumed. On December 1, for example, NetSolutions paid rent of $800 for the month. On December 1, the rent payment represents the asset prepaid rent. The prepaid rent expires daily, and at the end of December, the entire amount has become an expense (rent expense). In cases such as this, the initial payment is recorded as an expense rather than as an asset. Thus, if the payment is recorded as a debit to rent expense, no adjusting entry is needed at the end of the period. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21 ED., PP. 104-107*

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