Accounting Adjustments


Notes on the role of adjustments in accounting.

A transaction is any economic event that affects the financial status of the firm and thus should be recorded. External transactions are events between the firm and other economic entities resulting in journal entries during the year. Adjustments are internal transactions, events within the firm that require recording for firms on the accrual basis. There are four types of adjustments

Using Up an Asset

  • Assets are unexpired costs carried on the balance sheet until they are used to produce revenue
  • Record the utilization of assets to generate current period revenue
    • Depreciation (e.g., buildings, equipment)
    • Amortization (e.g., goodwill, intangibles)
    • Prepaid operating costs (e.g., rent, insurance)
    • Inventory (becomes cost of goods sold)
  • Asset (unexpired cost, balance sheet) ⇒ Expenses (income statement)
  • Depreciation – spreading the cost of a long-lived asset over its estimated life (i.e., including a proportionate amount of the cost of a long-lived asset as an expense in the income statement)
    • Depreciation is credited to “accumulated depreciation”
    • Accumulated depreciation is a contra-asset, subtracted from property, plant and equipment on the balance sheet to give net property
    • Assume equipment is owned originally costing $100,000. The equipment is expected to be useful for 10 years. The equipment is in its third year of use. Journal entry for depreciation expense in year 3 (12-31-yr3):
    • Depreciation expense 10,000
      Accumulated depreciation 10,000

      Balance sheet disclosure:
      Property, plant and equipment $ 100,000
      Less: accumulated depreciation (30,000)
      Net property, plant and equipment $ 70,000

Accruing Previously Unrecorded Expenses

“Recognition of accrued expense and payables”

  • Expenses are incurred and liabilities arise during an accounting period even though no external transaction occurs
  • Accrue – the liability grows as time passes or as services are used
  • Adjustment brings the expense and corresponding liability account up to date
    • Wage expense ⇒ wages payable
    • Interest expense ⇒ interest payable
    • Tax expense ⇒ taxes payable

Accruing Previously Unrecorded Revenues

“Recognition of accrued revenues and receivables”

  • Revenue that has been earned but not yet recorded (or received in cash)
    • Interest revenue ⇒ interest receivable

Earning Previously Recorded Deferred Revenue

“Valuation of liabilities”

  • Deferred (unearned) revenue that is collected in advance of being earned must be allocated to the time period when goods are delivered or services performed
  • A deferred revenue (liability) to the seller is a prepaid expense (asset) to the buyer who makes an adjustment to record the initial cost as an expense in the period of used
    • Deferred (unearned) rent revenue ⇒ rent revenue
    • Deferred (unearned) subscription revenue ⇒ subscription revenue
    • Liability (deferred revenue, balance sheet) ⇒ Revenue (income statement)

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