Although the entries process or recorded with general journal nor special journal have done, the next step is posting all data from journal into ledger which we called “ POSTING PROCEDURE “ and followed with an UNADJUSTED TRIAL BALANCE at the end of each period.
The principal purposes of the trial balance
* To prove that debits and credits of an equal amount are in the ledger.
* It supplies a listing of open accounts and their balances for any adjustments.
One thing that should be remembered that a trial balance does not prove that all transactions have been recorded is correct, numerous errors may still exist even though the trial balance columns agree.
The trial balance may still balance even when a transaction is not journalized or a correct journal entry is not posted or a journal entry is posted twice or incorrect accounts are used in journalizing or posting.
As long as equal debits and credits are posted even to the wrong account or in the wrong amount, the total debits will equal the total credits. A trial balance may not contain up to date because of the following reasons :
* Consumption of supplies and earning of wages by employees are not journalized daily.
* The expiration of some costs such as building, equipment, rent and insurance is not journalized during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions.
* Some items such as the cost of utility service may be unrecorded because the bill of the service has not been received.
An essential starting point is an analysis of each account in the trial balace to determine whether it is up to date for financial statement purposes. Adjustments are often prepared after the balance sheet date, there are 5 basic adjustments as follow
1. Prepaid expenses or prepayments
All payments of expenses that give benefit more than one accounting period is prepaid expenses or prepayments. When a cost of prepayments or payments of expenses is incurred, an asset account is debited to show the service or benefit that will be received in the future. Prepayments are made when building and equipment are purchased.
* Insurance
* Supplies
* Advertising
* Rent
Are samples of prepayments or prepaid expenses. Prepaid expenses expire with the passage of time such as rent and insurance or through use and consumption such as supplies. At each statement date, adjusting entries are made to record the expenses applicable to the current accounting period and to show the unexpired costs in the asset accounts.Purchased insurance $1,500 cash on 2nd January 2011 for 3 years. The journal entry on 2nd January 2011 debited asset account called insurance $1,500 and credited asset account called cash $1,500 to pay that insurance.
At the end of each year, the adjustment amount to be made is $500 ($1,500 : 3 years) and the adjustment journal entry on 31st Dec 2011 debited prepaid expenses or prepayments called insurance expense $500 and credited asset account called insurance $500
The rest value of asset called insurance on balance sheet date 2nd January 2012 is $1,000 ($1,500 - $500). The value of $1,000 is unexpired costs in the asset accounts called insurance.
2. Unearned revenue
Revenue receives in cash and recorded as liabilities before they are earned. Receipts from the sale of airlines tickets as unearned revenue until the flight service is provided. A landlord will have unearned revenue from rent when a tenant has prepaid rent. Other samples of unearned revenue such as
* Rent received in advance
* Interest received in advance on notes receivable
* Subscriptions and advertising received in advance by publishers
* Deposits from customers in advance of delivery of merchandise
When the payment is received for services to be provided in a future accounting period, an unearned revenue called liability account should be credited to recognize the obligation that exists. The recognition of earned revenue is delayed until the adjustment process. An adjusting entry is made to record the revenue that has been earned and to show the liability that remains. The adjusting entry for unearned revenues is a debit to a libility account and a credit to a revenue account.
A business area rented part of a building for 3 years with $120,000 to a tenant who paid in advance on 2nd January 2011. The entry on 2nd January 2011 debited asset called cash $120,000 and credited liability called unearned rent revenue $120,000 because this unearned revenue comes from rent.
At the end of each year, the adjustment amount to be made is $40,000 ($120,000 : 3 years) and the adjustment journal entry on 31st Dec 2011 debited unearned rent revenues $40,000 and credited rent revenue $40,000 to recognize as revenue from rent during the year 2011.
The liability that remains after adjustment on unearned rent revenues on balance sheet date 2nd January 2012 is $80,000 ($120,000 - $40,000).
3. Accrued liabilities or expenses
Expenses incurred but unrecorded at the statement date are called accrued expenses or accrued liabilities. An accrued expense on the books of one company is an accrued revenue to another company.
Some examples of accrued expenses
* Interest
* Rent
* Taxes
* Salaries
When employees are paid on the last day of the month, there are no accrued wages and salaries at the end of the month or year because all employees will have been paid all amounts due to them.
When employees are paid on a weekly or biweekly basis, it is necessary to make an adjusting entry for wages and salaries earned but do not paid at the end of the period since the reporting period’s last day rarely lands on a payday.
A company pays their sales staff every Friday for a five day works in a week, total weekly payroll is $16,000 . Until Thursday 31st Dec, the employees have worked four-fifths of a week for which they have not been paid.
The adjusting entry on 31st Dec debit sales salaries expense $12,800 (4/5 x $16,000) and credit salaries payable $12,800
As a result of this entry, the income statement for the year includes the salaries earned by the sales staff during the last four days in the year and the balance sheet shows a liability account called salaries payable of $12,800
4. Accrued assets or revenues
Revenue earned but unrecorded at the statement date are known as accrued revenues or accrued receivables. As in the case of interest, rent, commissions and fees accrued revenues may accrue or accumulate with the passing of time or they may result from services that have been performed but neither billed nor collected.
They are unrecorded because the earning does not involve daily transactions or only a portion of the total service has been provided. An adjusting entry is required to show the receivable that still exists at the balance sheet date and to record the revenue that has been earned during the period. An adjusting entry for accrued revenues results in a debit to an asset account and a credit to a revenue account.
An office space is rented to a tenant at $1,000 per month and the tenant has paid the rent for the first 11 months of the year but he has paid no rent for Dec. The adjusting entry on 31st Dec debit rent receivable $1,000 and credit rent revenue $1,000
As a result of this adjusting entry, an asset of $1,000 rent receivable appears on the balance sheet date 31st Dec and the income statement discloses the $11,000 rent revenue for the first 11 months plus $1,000 for Dec entered by adjusting entry. The total rent revenue for the year in the income statement is $12,000
5. Estimated items
Estimated items are uncollectible accounts and depreciation of fixed assets because the amounts are not exactly determinable at the time they must be recorded.
Some account receivable arising from credit sales will prove to be uncollectible. To prevent an understatement of expenses and loss of the period, it is necessary to estimate and record the bad debts that are expected to result. This estimated items suitable for unknown future events and developments.
When a long live fixed asset is purchased, it is assumed that it will be scrapped or sold at a price below the purchase price. The difference between an asset’s cost and its scrap value represents an expense depreciation that should be apportioned over the asset’s useful life. By estimating the probable life of the fixed asset and its scrap value we can determine the expense that is charged in each period.
5a. Uncollectible accounts
Proper matching of revenue and expenses dictates recording bad debts as an expense of the period in which the sale is made not in the accounts or notes are written off. The proper valuation of the receivable balance requires recognition of uncollectible receivables. At the end of each period, an estimate is made of the amount that will be prove to be uncollectible. The estimate is based on the amount of bad debts experienced in past years, economic conditions, age of receivables and other factors of uncollectibility. The estimate using percentage of the sales on account for the period or a certain percent of the account receivable and notes receivable at the end of the period.
If the experience reveals that bad debts usually approximate one-half of one percent of the net sales on account and the net sales on account for the year are $500,000. The adjusting entry for bad debts on 31st Dec debit debt expense $2,500 ($500,000 x 0.005) and credit allowance for doubtful accounts $2,500
5b. Depreciation
Depreciation are similar for reducing the prepaid expenses. The principal difference for depreciation, the credit is made to a separate account called accumulated depreciation. In estimating depreciation of the property, we use the original cost of the property, its length of useful life and its estimated salvage value or trade in value.
A bus costing $60,000 estimated life 5 years, estimated trade in value $5,000 at the end of the period. Because the bus is expected to be worth $50,000 less at the time its disposal then it was at the time of its purchase.
The amount of $50,000 represents an expense that is apportioned over the 5 years of operations. If the straight line method of depreciation is used, each year shows as an expense one-fifth of $50,000 or $10,000
Each full year the bus is used, the following adjusting entry is made on 31st Dec with debit depreciation expense on transport equipment $10,000 and credit accumulated depreciation on transport equipment $10,000
In addition to five basic adjustments above, towards value of inventory that appear on a balance sheet also needs to be adjusted at the end of period however the procedure for doing on inventory account adjustment depend on what inventory system is in use. A PERPETUAL INVENTORY SYSTEM or a PERIODIC INVENTORY SYSTEM.
Perpetual inventory system
With a perpetual inventory system, purchase and issues are recorded directly in the inventory account. Therefore, the balance in the inventory account represent the ending inventory amount and no adjusting entries are needed. To ensure this accuracy, a physical count of the items in the inventory is made annually. No purchase account is used because the purchases are debited to inventory account and credited to cash or liability. Cost of goods sold account is used to accumulate the issuances from inventory so when inventory items are sold, debit cost of goods sold and credit to inventory.
Periodic inventory system
With a periodic inventory system, a purchase account is used and the inventory account is unchanged during the period. The inventory account represents the beginning inventory amount throughout the period. At the end of the accounting period the inventory account must be adjusted by closing out the beginning inventory amount and recording the ending inventory amount.
The ending inventory is determined by physically counting the items on hand to get units amount and valuing them at cost or at the lower of cost or market.
Cost of goods sold is determined by adding the beginning inventory with net purchases and deducting with the ending inventory.
As soon as these adjusting entries have been recorded and posted, another trial balance called ADJUSTED TRIAL BALANCE is prepared and used to prepare the financial statements.
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