Chapter 6

Adjusting the Books

In This Chapter

Going over types of accounting adjustments

Making adjustments for noncash transactions

Taking your adjustments for a trial (balance) run

During an accounting period, your bookkeeping duties focus on your business's day-to-day transactions. When the time comes to report transactions in financial statements, you must make some adjustments to your books. Your financial reports are supposed to report your company's financial condition, so your books must reflect any significant change in the value of your assets, even if that change doesn't involve the exchange of cash. Those changes are adjustments.

If you use cash-basis accounting, many adjustments aren't necessary because you record transactions only when cash changes hands. (See Book I, Chapter 4 to find out more about the two accounting methods: accrual and cash-basis.)

This chapter reviews the types of adjustments you need to make to the books before preparing financial statements. Adjustments include calculating asset depreciation, dividing prepaid expenses, updating inventory numbers, dealing with bad debt, and recognizing salaries and wages not yet paid.

Adjusting All the Right Areas

Even after testing your books by using the trial balance process explained in Chapter 5, you still need to make some adjustments before you're able to prepare accurate financial reports.

Adjusting entries can be grouped into four categories:

• Converting assets into expenses: This book defines assets as resources you use to make money in your business. As you use assets, those dollars become expenses. Assume that your company owns a truck. When you recognize depreciation on your truck, you make an adjusting entry to reduce the asset's value and post-depreciation expense.
• Converting liabilities into revenue: Unearned revenue is defined as payments you receive from customers before you provide a product or service. Unearned revenue is a liability account. If you don't deliver the product or service, you have to return the payment. When you pay for a one-year magazine subscription in advance, your payment represents unearned revenue to the magazine publisher. As the publisher delivers magazines to you, it moves some of your payment into earned revenue. That journal entry is an adjustment.
• Accruing unpaid expenses: When you owe money for an expense at the end of an accounting period, you make an adjustment to accrue the expense. Suppose you owe payroll to your staff for the last week of December. Your next payroll pay date is January 5. On December 31, you debit payroll expense and credit accrued payroll liability for December payroll.
• Accruing uncollected revenue: If you've earned revenue, but haven't yet received the payment in cash, you make an adjustment to accrue revenue. If you've earned interest on your bank balance, but haven't yet received interest from the bank, you make an adjustment. You debit (increase) accounts receivable and credit interest income (revenue) for the interest earned.

An adjusting entry always uses a balance sheet account and an income statement account. Keep that in mind when posting adjusting entries.

Here are three other specific adjustments you may make to your books:

• Prepaid expenses: Prepaid expenses are expenses incurred for benefits to be received in the future. This adjustment matches expenses incurred with the benefits received for a period of time. For example, if you pay an annual insurance premium with a single payment, you should move 1/12th of that payment to insurance expense each month of the year.
• Bad debts: Bad debt expense is posted to acknowledge that some customers will never pay. Accountants refer to the process as writing off a receivable account. You debit bad debt expense and credit (reduce) accounts receivable.
• Supplies: Many companies perform a count of the supplies they have on hand at the end of the month. They use that count to calculate the dollar amount of supplies used during the month. The adjustment is to debit supply expense and credit an asset account — supplies.

Depreciating assets

The largest noncash expense for many businesses is depreciation. Depreciation is an accounting chore that's important for every business because it reflects the use and decline in value of assets. (For more on depreciation and why you do it, check out Chapter 1.)

The time to adjust the books for depreciation is when you close the books for an accounting period. Some businesses record depreciation expenses every month to more accurately match monthly expenses with monthly revenues, but many business owners make depreciation adjustments only once a year, when they prepare their annual financial statements.

Depreciation doesn't involve the use of cash. By accumulating depreciation expenses on an asset, you're reducing the value of the asset as shown on the balance sheet (see Book IV, Chapter 4 for the lowdown on balance sheets).

Readers of your financial statements can get a good idea of the usefulness of your assets by reviewing your accumulated depreciation. If a financial statement shows that assets are close to being fully depreciated, readers know that you'll probably need to spend significant funds on replacing or repairing those assets sometime soon. As readers evaluate the financial health of the company, they take that future obligation into consideration before making a decision to loan money to the company or possibly invest in it.

Usually, you calculate depreciation for accounting purposes by using the straight-line depreciation method. This method is used to calculate an amount to be depreciated that will be equal each year based on the anticipated useful life of the asset.

For example, suppose your company purchases a car that costs $25,000. You anticipate that car will have a useful lifespan of five years and will be worth $5,000 after five years. Using the straight-line depreciation method, you first subtract $5,000 from the total car cost of $25,000 to find the value of the car during its five-year useful lifespan ($20,000). $20,000 represents the depreciable base. Next, you divide $20,000 by 5 to find your depreciation expense for the car ($4,000 per year). When adjusting the assets at the end of each year in the car's five-year lifespan, your entry to the books should look like this:

This entry increases depreciation expense, which appears on the income statement (see Book IV, Chapter 2). The entry also increases accumulated depreciation, which is the use of the asset and appears on the balance sheet directly below the vehicles asset line. The vehicle asset line always shows the value of the asset at the time of purchase (cost). So, the fixed asset section of your balance sheet after one year of vehicle depreciation would be:

You see several times in this book that you debit asset accounts to increase them. Accumulated depreciation is an exception to that rule — this account is a contra-asset account (an account with a normal balance that is the opposite of other accounts in the same category, as explained in Book IV, Chapter 3). In the previous journal entry, accumulated depreciation is credited for an increase in depreciation expense. Using a credit for accumulated depreciation allows you to present a reduction in the asset you're depreciating. So, the $25,000 vehicle has $5,000 in depreciation expense. Each asset in your fixed asset listing has its own accumulated depreciation account.

You can speed up depreciation if you believe that the asset will be used more heavily in the early years of ownership. Book III, Chapter 1 discusses alternative depreciation methods in greater detail.

If you use a computerized accounting system as opposed to keeping your books manually, you may not need to make this adjustment at the end of an accounting period. If your system is set up with an asset management feature, depreciation is automatically calculated, and you don't have to do it. Check with the person who set up the asset management feature before calculating and recording depreciation expenses.

Allocating prepaid expenses

Most businesses have to pay certain expenses at the beginning of the year even though they'll benefit from that expense throughout the year. Insurance is a prime example of this type of expense. Most insurance companies require you to pay the premium annually at the start of the year even though the value of that insurance protects the company throughout the year.

For example, suppose your company's annual car insurance premium is $1,200. You pay that premium in January in order to maintain insurance coverage throughout the year. For accounting purposes, you need to match the benefit you receive (insurance coverage) with the expense of that benefit (paying insurance premiums).

As a first step, you record the cost as an asset called prepaid expenses, and then you adjust the value of that asset to reflect that it's being used up. Prepaid expenses are assets, because they represent costs that are already paid for. In other words, you don't have to pay the cost later — and that's an asset to you. Your $1,200 annual insurance premium is actually valuable to the company for 12 months, so you calculate the actual expense for insurance by dividing $1,200 by 12, resulting in a monthly expense of $100. At the end of each month, you record the use of that asset by preparing an adjusting entry that looks like this:

This entry increases insurance expenses on the income statement and decreases the asset prepaid expenses on the balance sheet. No cash changes hands in this entry because cash was reduced when the insurance bill was paid, and the asset account prepaid expenses was increased in value at the time the cash was paid.

Counting inventory

Inventory is a balance sheet asset that needs to be adjusted at the end of an accounting period. During the accounting period, your company has several issues related to inventory:

• Beginning inventory: When you open your doors at the beginning of a period (month, year), you have a certain amount of inventory on hand, or beginning inventory.
• Purchases: During the month, you make purchases. You debit inventory and credit cash or accounts payable.
• Sales: When you sell inventory, you debit cash or accounts receivable and credit sales for the sale price. You also debit cost of sales (an expense account) and credit inventory for the cost of inventory. The difference between sales and cost of sales is your profit.

At the end of the accounting period, you adjust the inventory value to reflect your ending inventory balance. Here's the formula to calculate ending inventory:

• Beginning inventory + Purchases – Sales = Ending inventory

The steps for making proper adjustments to inventory in your books are as follows:

1. Perform a physical count of ending inventory.

   In addition to calculating ending inventory by using the previous formula, you should consider performing a physical count of inventory to be sure that what's on the shelves matches what's in the books. Try to perform the physical count as close as possible to the last day of the accounting period, so the physical inventory on hand will be close to your accounting record balance for the last day of the period.

2. Consider the value of your ending inventory.

   The value of ending inventory varies depending on the method your company chooses to use for valuing inventory. For more about inventory value and how to calculate the value of ending inventory, see Book II, Chapter 2. As mentioned in that chapter, you should apply the same valuation method for your inventory each year. If you choose to change the method, you need a justification.

3. Adjust the ending inventory balance.

   When you physically count the units of inventory and compute each unit's value, you add up the total. The total ending inventory value in the physical count may differ from that value in your accounting records. If the two values differ, you need to investigate. Either the accounting records are wrong, or your count had an error. You may need to adjust your inventory records, depending on the results of the count. That's another adjustment at the end of the period.

If you track inventory by using your computerized accounting system, the system makes adjustments to inventory as you record sales and make purchases. At the end of the accounting period, the value of your company's ending inventory should be adjusted in the books already.

Allowing for bad debts

No company likes to accept the fact that it will never see the money owed by some of its customers. Unfortunately, that's what happens to most companies that sell items on store credit. When your company determines that a customer who has bought products on store credit will never pay for them, you record the value of that purchase as a bad debt. (For an explanation of store credit, check out Book II, Chapter 3.) To find out more about accounting for bad debt, continue reading the sections that follow.

Using an aging report

At the end of an accounting period, you should list all outstanding customer accounts in an aging report (see Book II, Chapter 3). This report shows which customers owe you money, how much they owe, and for how long they've owed you. After a certain amount of time, you have to admit that some customers simply aren't going to pay. Each company sets its own determination of how long it waits before tagging an account as a bad debt. For example, your company may decide that when a customer is six months late with a payment, you're unlikely to ever see the money.

After you determine that an account is a bad debt, you should no longer include its value as part of your assets in accounts receivable. Including its value doesn't paint a realistic picture of your situation for the people reading your financial reports. Because the bad debt is no longer an asset, you reduce the value of your accounts receivable to reflect the loss of that asset.

Selecting a bad debt method

You can record bad debts (write them off) in a couple of ways:

• By customer: Some companies identify the specific customers whose accounts are bad debts and calculate the bad debt expense each accounting period based on specific customer accounts.
• By percentage: Other companies look at their bad-debts histories and develop percentages that reflect those experiences. Instead of taking the time to identify each specific account that qualifies as a bad debt, these companies record bad debt expenses as a percentage of their accounts receivable.

However you decide to record bad debts, you need to prepare an adjusting entry at the end of each accounting period to record bad debt expenses. Here's an adjusting entry to record bad debt expenses of $1,000:

You can't have bad debt expenses if you don't sell to your customers on store credit. You need to deal with bad debt only if you offer your customers the convenience of buying your products on store credit.

If you use a computerized accounting system, check the system's instructions for how to write off bad debt. The following steps walk you through the process of writing off a bad debt and present an example to put all the concepts in context:

1. Initial accounting entries for a sale. Suppose you sell $1,000 in goods to Acme Painting Company. You debit accounts receivable and credit sales for $1,000. Assume your inventory cost was $870. You make a second entry to debit cost of sales and credit (reduce) inventory for $870. Your profit is sales less cost of sales, or ($1,000 – $870 = $130).
2. Review your aging reports. You review an aging report for accounts receivable each month. As time goes on, you notice that the $1,000 Acme Painting receivable becomes older.
3. Attempt collection of the debt. Every company should have a process for following up on past due amounts. In your case, you send Acme letters requesting collection and make phone calls.
4. Determine whether the amount is collectable. Acme Painting goes out of business. Because the company has insufficient assets to pay its bills, you determine that the $1,000 receivable isn't collectible.
5. Post the bad debt expense entry. Knowing the specific debt isn't collectible; you debit bad debt expense and credit accounts receivable for the $1,000 Acme owed.

Consider the impact on your business. The bad debt means that you'll collect $1,000 less than you planned. If bad debt amounts are large, they can impact your cash flow planning. Check out Book IV, Chapter 3 for details on planning your cash flow.

Growing your sales and dealing with the issue of bad debt

Every company wants to grow, which means increasing sales. Selling more usually means selling to new customers. By definition, a new customer has no payment history, so do your homework. Many companies purchase data that documents the creditworthiness of various businesses. The data is similar to what you'd find in a personal credit report. Set financial guidelines for new clients. In addition to checking credit reports, insist that new customers pay on time. Until that client builds a track record of timely payments, you can't take the risk of the client paying late or not at all. If a new customer doesn't pay or pays late, consider whether continuing to do business with that customer is a good idea.

Suppose your company generates $1,000,000 in sales and has bad debts totaling 2 percent of sales ($20,000). Next year, you're able to grow sales by $200,000, with bad debt on your new sales of $10,000. A $10,000 bad debt level is 5 percent of your new sales ($10,000 ÷ $200,000). Your bad debt as a percentage of sales for the entire $1,200,000 is $30,000, or 2.5 percent. You sold more, but your bad debt expense (both in total dollars and as a percentage of sales) increased.

Increasing sales is good, but if your collections on the new total sales amount decline, you have a problem. A larger bad debt expense can result in lower profit. In the previous example, bad debt expense increased from 2 to 2.5 percent of sales. Profit declined by 0.5 percent for every dollar in sales revenue.

Recognizing unpaid salaries and wages

Not all pay periods fall at the end of a month. If you pay your employees every two weeks, you may end up closing the books in the middle of a pay period. For example, assume employees aren't paid for the last week of March until the end of the first week of April. Your fiscal period ends on March 31, which isn't a payroll pay date.

In this case, you need to make an adjusting entry to record the payroll expense incurred but not yet paid, also called accrued payroll. You estimate the amount of the adjustment based on what you pay every two weeks. Here's how you can accrue for payroll:

1. Calculate your daily payroll expense. Take your total payroll for the period (both before and after the end of the period) and divide that amount by the number of days in the pay period. Typically a pay period is two weeks. Assume your two-week payroll is $2,800. Your daily payroll accrual is ($2,800 ÷ 14 days = $200 per day).
2. Compute payroll accrual. Compute the number of days to be accrued. In this case, assume you need to accrue 7 days — the last week of March. Your payroll accrual is (7 days × $200 per day = $1,400).
3. Post your accrual entry. Here's the entry you post on March 31 to accrue unpaid March payroll:

After the cash is actually paid out, you reverse the accrual entry. You debit to reduce the liability account (accrued payroll expenses) and credit cash account, to account for the payment. Doing these extra entries may seem like a lot of extra work, but if you didn't match the payroll expenses for March with the revenues for March, your income statements wouldn't reflect the actual state of your affairs. Without the payroll accrual, your March payroll would be understated.

Testing an Adjusted Trial Balance

In Chapter 5, you find out why and how you run a trial balance on the accounts in your general ledger. Adjustments to your books call for another trial balance, the adjusted trial balance, to ensure that your adjustments are correct and ready to be posted to the general ledger. You track all the adjusting entries on a worksheet similar to the one shown in Chapter 5. You need to use this worksheet only if you're doing your books manually. It's not necessary if you're using a computerized accounting system.

The key difference in the worksheet for the adjusted trial balance is that additional columns must be added to the worksheet. Columns include

• Column 1: Account titles.
• Columns 2 and 3: Unadjusted trial balance — the trial balance before the adjustments are made — with Column 2 for debits and Column 3 for credits.
• Columns 4 and 5: Adjustments. All adjustments to the trial balance are listed in Column 4 for debits and Column 5 for credits.
• Columns 6 and 7: Adjusted trial balance. A new trial balance is calculated that includes all the adjustments. Be sure that the credits equal the debits when you total that new trial balance. If they don't, find any errors before posting entries to the balance sheet and income statement columns.
• Other columns: Use data from the adjusted trial balance columns and create columns for a balance sheet and an income statement.

When you're confident that all the accounts are in balance, post your adjustments to the general ledger so that all the balances in the general ledger include the adjusting entries. With the adjustments, the general ledger can be used to generate financial statements. After you finalize your general ledger for the year, you may want to make changes to your chart of accounts, which lists all the accounts in your accounting system. You may add or subtract accounts, depending on the activity in your business.