Adjusting Entries

On occasion in your GBD Fits merch business, you run into situations where an action results in revenues or expenses being received or paid in different periods than which the resulting action occurs.

In these situations, an adjusting entry is necessary. Why?

Because we operate in the accrual-basis accounting system!

The accrual basis accounting system states that revenues and expenses must be recorded in the period in which they were truly earned or paid.

There's two main types of adjusting entries that we'll deal with:

Deferrals are when payment is made before the action occurs.
Accruals are when payment is made after the action occurs.

To be candid: you will typically be working with deferrals. That's why we'll start with them!

Deferrals explained

Imagine the following scenario:

Scenario: On March 1st, you buy insurance for your printing press so that if it breaks, you're not screwed. You buy their 6 month insurance package for $120. Write the March 1st initial entry, as well as the adjusting journal entry for March 31st.

The initial entry

Okay, so to start, we must understand that the March 1st journal entry is going to look like so:

TransactionDebitCredit
Prepaid Insurance$120
     Cash$120

Why? Because on March 1st, we're paying out $120 to the insurance company in cash (therefore decreasing an asset account, resulting in a credit)...

TransactionDebitCredit
Prepaid Insurance$120
     Cash$120

...for insurance that hasn't been "put into action" yet. It's for the 6 months into the future. That's why it's Prepaid Insurance. We're paying for that 6 months of insurance ahead of time.

TransactionDebitCredit
Prepaid Insurance$120
     Cash$120

For clarity, Prepaid Insurance is an asset. It's providing us with the economic value of insurance. Just because that insurance is "prepaid" for the future, doesn't mean it doesn't provide us with economic value!

Therefore, since we're increasing our Prepaid Insurance asset account, that means we must debit it to show that increase.

The adjusting entry

Imagine that March 31st has arrived. This means that in our general journal, we must take into account that we've gone through one month of our (prepaid) printing press insurance package!

If we've gone through a month of our prepaid printing press package, that means that we are essentially decreasing our Prepaid Insurance account.

How so? Well, now that insurance is no longer "prepaid". The "action" of insurance being implemented has been going on for this past month of March! We need to record that "action" so that we follow the accrual basis accounting system.

If the insurance is no longer "prepaid", we need to decrease our Prepaid Insurance account. That account is an asset, which means we'll decrease it with a credit.

TransactionDebitCredit
??????
     Prepaid Insurance???

By how much are we going to credit it? Well, we paid $120 for 6 months of insurance, which results in:

$120 / 6 months = $20 per month

Therefore, let's credit Prepaid Insurance by $20.

TransactionDebitCredit
??????
     Prepaid Insurance$20

Okay... so what account is going to be debited?

Well, whenever an asset is used up, it creates an expense. The expense created here will be called Insurance Expense. Since we're increasing our expenses by utilizing this insurance, we'll debit Insurance Expense. (Remember: expenses have a normal debit balance!)

TransactionDebitCredit
Insurance Expense???
     Prepaid Insurance$20

We're going to debit Insurance Expense by $20, since that's the amount of Prepaid Insurance (from the 6-month package deal for $120) that we'll be utilizing this month of March.

TransactionDebitCredit
Insurance Expense$20
     Prepaid Insurance$20

What happens the remaining months?

So we've written our first adjusting entry for this 6-month package deal of insurance that we purchased for the printing press. This exact same journal entry...

TransactionDebitCredit
Insurance Expense$20
     Prepaid Insurance$20

...is going to occur for the remaining 5 months that we have insurance for (April through August), until there is no more Prepaid Insurance left!

Think about it: we started with $120 in Prepaid Insurance, and then we're going to subtract $20 from it for each month that we use it, until there's none left!

$120 (Prepaid Insurance) - $20 (March) - $20 (April) - $20 (May) - $20 (June) - $20 (July) - $20 (August) = $0 (Prepaid Insurance)

Now that we've understood deferrals and how they operate, let's check out a quick accruals example!

Accruals explained

Just to be clear: deferrals will be emphasized more heavily on your exam. They're a little more challenging than accruals.

We've actually already dealt with accruals with the following scenario from Journal Entries & General Journal:

Scenario: On March 5th, Johnny buys a GBD hoodie. The hoodie costs $50, and Johnny pays you $20 cash at the time of purchase. He promises to pay back the remaining $30 at a later date.

How is this an accrual? Because we're providing the hoodie to Johnny without receiving (complete) payment for it yet!

The initial entry

In Journal Entries & General Journal, we determined that this scenario could be represented with the following journal entry:

TransactionDebitCredit
Cash$20
Accounts Receivable$30
     Sales Revenue$50

Now that we've got the initial entry, what would the adjusting entry look like for this?

The adjusting entry

Consider the following scenario:

Scenario: On March 14th, Johnny pays you back for the rest of his GBD hoodie with $30 cash.

In this case, we need to make an adjusting entry to account for the fact that Johnny has finally paid for his hoodie that we gave him. He's making payment after the action occurred of us giving him his hoodie, and we need to adjust for that.

To start...

Scenario: On March 14th, Johnny pays you back for the rest of his GBD hoodie with $30 cash.

...he's paying us back. This means he's removing his Accounts Receivable amount that was created from this part of the March 5th transaction...

Scenario: On March 5th, Johnny buys a GBD hoodie. The hoodie costs $50, and Johnny pays you $20 cash at the time of purchase. He promises to pay back the remaining $30 at a later date.

...which was written into our journal entry here:

TransactionDebitCredit
Cash$20
Accounts Receivable$30
     Sales Revenue$50

Since he's removing this Accounts Receivable amount, we need to decrease Accounts Receivable with a credit (since it's an asset, and assets have a normal debit balance).

TransactionDebitCredit
??????
     Accounts Receivable???

How much will we credit Accounts Receivable? By $30, since Johnny's paying off his debt to us.

TransactionDebitCredit
??????
     Accounts Receivable$30

Next, what account will we debit? Well, looking at the scenario...

Scenario: On March 14th, Johnny pays you back for the rest of his GBD hoodie with $30 cash.

...Johnny is paying us back for his debt to us with cash. This means the Cash account will increase, and since Cash is an asset, that means we'll debit it.

TransactionDebitCredit
Cash???
     Accounts Receivable$30

We'll debit Cash by $30, since he's paying us $30 cash!

TransactionDebitCredit
Cash$30
     Accounts Receivable$30

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