ADJUSTING ENTRIES:

THE NEXT STEP IN THE ACCOUNTING CYCLE

Many transactions affect the revenue or expense of more than one accounting period.
For example, a business may purchase office supplies that will last for several
months. Such asset is gradually used up—that is, it becomes expense.
How are the cost of such asset allocated to expense over a span of several
accounting periods?
The answer is by making adjusting entries at the end of each accounting period.

There are several different types of adjusting entries; in fact, a business may make a
dozen or more adjusting entries each period.
However, we now introduce the concept of tend-of-period adjustments with the two
most common types of adjusting entries:
1. Adjusting entries made to recognize depreciation expense and
2. Adjusting entries made to recognize income taxes expense.

The Concept of Depreciation

Depreciable assets are physical objects which retain their size and shape, but
which eventually wear out or become obsolete.
o They are not physically consumed, but their economic usefulness is “used up”
overtime.
o Examples of depreciable assets include buildings, all types of equipment,
fixtures, and furnishings.
Each period, a portion of a depreciable asset’s usefulness expires. Therefore, a
corresponding portion of its cost is recognized as depreciation expense.

What is Depreciation?

In accounting, the term depreciation means the systematic allocation of the cost
of an asset to expense
Depreciation is not an attempt to record changes in the asset’s market value. In
the short run, the market value of some depreciable assets may even increase, but
the process of depreciation continues anyway.
The rationale for depreciation lies in the matching principle.
 Our goal is to offset a reasonable portion of the asset’s cost against revenue in
each period of the asset’s useful life.

Depreciation Is Only an Estimate The “appropriate amount” of

depreciation expense is only an estimate. After all, we cannot look at a building or
a piece of equipment and determine precisely how much of its economic
usefulness has expired during the current period.

The most widely used means of estimating periodic depreciation expense is the
straight-line method.
Under the straight-line approach, an equal portion of the asset’s cost is allocated
to depreciation expense in every period of the asset’s estimated useful life.

The formula for computing depreciation expense by the straight-line method is:

Depreciation expense (per period)= Cost of the asset_

Estimated useful life
 The use of an estimated useful life is the major reason why depreciation expense
is only an estimate.

Recording Depreciation Expense: An Illustration

Faahiye Real Estate owns two categories of depreciable assets:

1. buildings, and
2. office equipment.
Because these categories of assets have different useful lives, depreciation must be
computed separately for each category. Faahiye company would use the straight-line
method of depreciation for both categories of the depreciable assets.

Depreciation on the Building Faahiye purchased its building for $36,000.

the company’s management estimates that it has a remaining useful of only 20
years. Thus, Faahiye will recognize annual depreciation expense of $18,00
(36,000÷20 year-estimated useful life).
On monthly basis, the depreciation expense amounts to $150 per month(1800÷12
months).
The adjusting entry to record depreciation on this building for the month of
November appears below:

GENERAL JOURNAL page 2

LP Debit Credit
2008
Nov. 30 Depreciation Expense: Building 76 150
Accumulated Depreciation: Building 23 150
To record depreciation of building for the
month of November.

Depreciation on the Office Equipment Faahiye Real Estate also must record
depreciation on its office equipment. This equipment cost $12,000, and management
estimates that it will remain in service for about 10 years. Thus the monthly
depreciation expense amounts to $100 ($12,000 cost ÷ 120 months). The adjusting
entry to recognize this monthly expense is:
GENERAL JOURNAL page 2
LP Debit Credit
2008
Nov. 30 Depreciation Expense: Office Equipment 78 100
Accumulated Depreciation: Office Equipment 26 100
To record depreciation on office equipment for
November.

Accounting for Corporate Income Taxes

Profitable businesses that are organized as corporations must file income tax
returns and pay income taxes equal to a percentage of their taxable income.
These taxes represent an expense of the business organization.
 Income taxes are usually in four quarterly instalments; however, if we are to
properly “match” income taxes with the related revenue, income taxes expense
should be recognized (or accrued) in the periods in which the taxable income is
earned.
This is accomplished by making an adjusting entry at the end of each accounting
period.

Computing Income Taxes Expense

Income taxes expense is determined by applying the current tax rate to the
taxpayer’s taxable income.
 This relationship is summarized below:

Income taxes expense = Taxable income X Tax rate

Taxable income is NOT the same as “net income”.

 Taxable income is computed in conformity with income tax regulations, rather
than generally accepted accounting principles.
 In its simplest case, taxable income equals to revenue less all expenses other than
income taxes expense.
The tax rate is the percentage of taxable income that must be paid as income
taxes.
 Tax rates are different from country to other and change from year to year, and
also vary depending upon the amount of taxable income.

For purposes of illustration, we will assume a corporate income tax rate of 40%.
Under the assumptions stated above, Faahiye’s income tax expense for November
amounts to $1,600, determined as follows:

Sales commissions earned....................................................... $12,124

Less: Deductible expense:.......................................................
Advertising expense........................................................... $ 630
Salaries expense................................................................. 7,100
Telephone........................................................................... 144
Depreciation expense: Building......................................... 150
Depreciation expense: Office equipment........................... 100
Total deductible expenses.................................................. 8,124
Taxable income....................................................................... $ 4,000
Income taxes expense($4,000 taxable income X 40%).......... $ 1,600

Recording Income Taxes Expense

Income taxes expense accrues each month but it is not payable until dates which
are specified by income tax authorities. Therefore, monthly income taxes expense
is recorded by an adjusting entry, such as the one shown below:

GENERAL JOURNAL page 2

LP Debit Credit
2008
Nov. 30 Income taxes expense 80 1,600
Income taxes payable 35 1,600
To record income taxes expense for November.
 The amount of income taxes expense will appear in Faahiye’s November income
statement.
The amount of income taxes payable is short-term liability that will appear in the
balance sheet.
Income taxes expense differs from other business expenses in several ways.
 First, only business organized as corporations incur income taxes expense.
Un incorporated businesses, such as sole proprietorships and partnerships, do not pay
income taxes. The taxable incomes earned by unincorporated businesses are taxable
directly to the owners of these businesses, and not to the business entities themselves.
 Also, paying income taxes does not help produce revenue. For this reason
income taxes expense usually are shown separately from other expenses in
the income statement—often following a subtotal called income (or loss)
before income taxes.

Posting Adjusted Accounts

Income taxes payable Account No. 35
Date Explanation Ref Debit Credit Balance
2008
Nov. 30 2 1,600 1,600

Accumulated Depreciation: Building Account No. 23

Date Explanation Ref Debit Credit Balance
2008
Nov. 30 2 150 150

Accumulated Depreciation: Office Equipment Account No. 26

Date Explanation Ref Debit Credit Balance
2008
Nov. 30 2 100 100

Depreciation expense: Building Account No.76

Date Explanation Ref Debit Credit Balance
2008
Nov. 30 2 150 150

Depreciation expense: Office Equipment Account No. 78

Date Explanation Ref Debit Credit Balance
2008
Nov. 30 2 100 100
 Income taxes expense Account No. 80
Date Explanation Ref Debit Credit Balance
2008
Nov. 30 2 1,600 1,600

The Adjusted Trial Balance

After all the necessary adjusting entries have been journalized and posted, an
adjusted trial balance is prepared to prove that the ledger is still in balance.
It also provides a complete listing of the account balances to be used in preparing
the financial statements. Faahiye’s adjusted trial balance for the month of
November is shown below:
FAAHIYE REAL ESTATE
Adjusted Trial Balance
November 30, 2008

Cash................................................................ $10,074
Accounts Receivable...................................... 9,590
Land................................................................ 52,000
Building.......................................................... 36,000
Accumulated Depreciation: building............. $ 150
Office Equipment........................................... 12,000
Accumulated Depreciation: Office Equipment 100
Accounts Payable........................................... 37,414
Income taxes payable..................................... 1,600
Capital Stock.................................................. 80,000
Retained Earnings.......................................... -0-
Dividends........................................................ 2,000
Sales Commissions Earned............................ 12,124
Advertising Expense....................................... 630
Salaries Expense............................................. 7,100
Telephone Expense......................................... 144
Depreciation expense: Building..................... 150
Depreciation expense: Office Equipment........ 100
Income taxes expense..................................... 1,600
$131,388 $131,388

PREPARING A “SET” OF FINANCIAL STATEMENTS

Now that Faahiye Real Estate has been operating for a month, managers and outside
parties will want to know more about the company than just its financial position.
To provide this additional information, we will prepare a more complete set of
financial statements, consisting of an income statement, a statement of retained
earnings, and a balance sheet.
 FAAHIYE REAL ESTATE
Income Statement
For the Month Ended November 30, 2008
Revenue:
Sales Commissions earned......................................................................... $12,124
Expenses:
Advertising expense............................................................... $ 630
Salaries expense..................................................................... 7,100
Telephone expense................................................................. 144
Depreciation expense: Building............................................. 150
Depreciation expense: Office Equipment.............................. 100 8,124
Income before income taxes..................................................... $4,000
Income taxes expenses............................................................ 1,600
Net Income................................................................................................. $2,400

FAAHIYE REAL ESTATE

Statement of Retained Earnings
For the Month Ended November 30, 2008

Retained earnings, October 31,2008 ........................................................... $ -0-

Net income for November.................................................................... 2400
Subtotal........................................................................................ $24,00
Less: Dividends.................................................................................... 2,000
Retained earnings, November 30,2008................................................ _$400

FAAHIYE REAL ESTATE

Balance Sheet
For the Month Ended November 30, 2008
Assets
Cash .......................................................................................... $ 10,074
Accounts Receivable................................................................. 9,590
Land.......................................................................................... 52,000
Building............................................................. ...........$36,000
Less: Accumulated Depreciation: building ........... 150 35,850
Office Equipment......................................................... $12,000
Less: Accumulated Depreciation: Office Equipment 100 11,900
Total Assets................................................................................ $119,414
Liabilities & Stockholders’ Equity
Liabilities:
Accounts Payable........................................................................ $37,414
Income taxes payable.................................................................. 16,00
Total liabilities............................................................................ $39,014

Stockholders’ equity:
Capital Stock...........................................................................................$80,000
Retained earnings.................................................................................... 400
Total Stockholders’ equity................................................................................... 80,400
Total liabilities & Stockholders’ equity............................................................... $119,414
The Income Statement

The revenue and expenses shown in the income statement are taken directly form
the company’s adjusted trial balance.
The income statement of Faahiye Real Estate shows that revenue earned in
November exceeds the expenses of the month, thus producing a net income of
$2,400.

The Statement of Retained Earnings

Retained earnings is that portion of the stockholders’ equity created by earning

net income and retaining the related resources in the business.
The statement of retained earnings summarizes the increases and decreases in
retained earnings resulting from the business operations of the accounting period.
Increases in retained earnings result from earning net income; decreases result
from net losses and from the declaration of dividends.
The format of this financial statement is based upon the following relationship:

Retained Earnings Retained Earnings

at the beginning + Net = at the end
of the period Income of the period

The amount of retained earnings at the beginning of the period is shown at top of
the statement.
Next, the income for the period is added (or net loss subtracted).
Any dividends declared during the period are deducted.
The result of this short computation determines the amount of retained earnings at
the end of the accounting period.

The Balance Sheet

The balance sheet lists the amounts of the company’s assets, liabilities, and
owners’ equity at the end of the accounting period.
The balances of the asset, capital stock, and liability accounts are taken directly
from the adjusted trial balance.
The amount of retained earnings at the end of the period was determined in the
statement of retained earnings.

Relationship among the Financial Statements

Income statement, statement of retained earnings, and the balance sheet are all
related to one another. These relationships are emphasized by the arrows in the
right-hand margin of our illustrated financial statements.
Closing The
Temporary Accounts

As previously stated, revenue increases retained earnings, and expenses and dividends
decrease retained earnings.
Theses revenue, expense, and dividends accounts are called temporary accounts,
because they accumulate the transactions of only one accounting period.
 At the end of this accounting period, the changes in retained earnings accumulated
in these temporary accounts are transferred into the retained earnings account.
This process serves two purposes:
 First, it updates the balance of the retained earnings account for changes in
retained earnings occurring during the accounting period.
 Second, it returns the balances of the temporary accounts to zero, so that they
are ready for measuring the revenue, expenses, and dividends of the next
accounting period.

The retained earnings account and other balance sheet accounts are called
permanent accounts, because their balances continue to exist beyond the current
accounting period.
 The process of transferring the balances of the temporary accounts into the
retained earnings account is called closing the accounts.
 The journal entries made for the purpose of closing the temporary accounts are
called closing entries.

Revenue and expense accounts are closed at the end of each accounting period by
transferring their balances to a summary account called Income Summary.
When the credit balances of the revenue accounts and the debit balances of the
expense accounts have been transferred into one summary account, the balance of
this Income Summary will be the net income or net loss for the period.
 If the revenue (credit balances) exceeds the expenses (debit balances), the Income
Summary account will have a credit balance representing net income.
 Conversely, if expenses exceed revenue, the Income Summary will have a debit
balance representing net loss.
 This is consistent with the rule that increases in owners’ equity are recorded by
credits and decreases are recorded by debits.

Summary of the Closing Process

1. Close the various revenue accounts by transferring their balances into the
income Summary account.
2. Close the various expense accounts by transferring their balances into the
Income Summary account.
3. Close the Income Summary account by transferring its balance into the
Retained Earnings account.
4. Close the Dividends account by transferring its balance into the Retained
Earnings account.
Closing Entries for Revenue Accounts

Revenue accounts have credit balance. Therefore, closing a revenue account

means transferring its credit balance to the Income Summary account.
 This transfer is accomplished by a journal entry debiting the revenue account in an
amount equal to its credit balance, with an offsetting credit to the Income
Summary account.
 The debit portion of this closing entry returns the balance of the revenue account
to zero; the credit portion transfers the former balance of the revenue account into
the Income Summary account as illustrated below:

GENERAL JOURNAL page 3

LP Debit Credit
2008
Nov. 30 Sales Commissions Earned 60 12,124
Income Summary 53 12,124
To close the Sales Commissions Earned account.

Posting to Ledger Accounts:

Income Summary Account No. 53

Date Explanation Ref Debit Credit Balance
2008
Nov. 30 3 12,124 12,124

Sales Commissions Earned Account No. 60

Date Explanation Ref Debit Credit Balance
2008
Nov. 6 2 3,734 3,734
20 2 8,390 12124
30 To close 3 12,124 -0-

Closing Entries for Expense Accounts

Expense accounts have debit balances. Closing an expense account means transferring
its debit balance to the Income Summary account.
The Journal entry to close an expenses account, therefore, consists of a credit to
the expense account in an amount equal to its debit balance, with an offsetting
debit to the Income Summary account. Following is the journal entry to close the
expense accounts.
 GENERAL JOURNAL page 3
LP Debit Credit
2008
Nov. 30 Income Summary 53 9,724
Advertising Expense 70 630
Salaries Expense 72 7,100
Telephone Expense 74 144
Depreciation Expense: Building 76 150
Depreciation Expense: Office Supplies 78 100
Income Taxes Expense 80 1,66
To close the expense accounts.

Posting to Ledger Accounts:

Advertising Expense Account No. 60
Date Explanation Ref Debit Credit Balance
2008
Nov. 1 2 360 360
16 2 270 630
30 To close 3 630 -0-

Salaries Expense Account No.72

Date Explanation Ref Debit Credit Balance
2008
Nov. 30 2 7,100 7,100
30 3 7,100 -0-

Telephone Expense Account No.74

Date Explanation Ref Debit Credit Balance
2008
Nov. 30 2 144 144
3 144 -0-

Depreciation expense: Building Account No.76

Date Explanation Ref Debit Credit Balance
2008
Nov. 30 2 150 150
30 3 150 -0-

Depreciation expense: Office Equipment Account No. 78

Date Explanation Ref Debit Credit Balance
2008
Nov. 30 2 100 100
30 To close 3 100 -0-
 Income taxes expense Account No. 80
Date Explanation Ref Debit Credit Balance
2008
Nov. 30 2 1,600 1,600
30 To close 3 1,600 -0-

Income Summary Account No. 53

Date Explanation Ref Debit Credit Balance
2008
Nov. 30 3 12,124 12,124
30 3 9,724 2,400

Closing the Income Summary Account

 The net income of $2,400 earned during November causes the owners’ equity to
increase.
 The credit balance of the Income Summary account is, therefore, transferred to
Retained Earnings account by the following closing Entry.

GENERAL JOURNAL page 3

LP Debit Credit
2008
Nov. 30 Income Summary 53 2,400
Retained Earnings 51 2,400
To Close the Income Summary account.

Posting to the general ledger accounts:

Income Summary Account No. 53

Date Explanation Ref Debit Credit Balance
2008
Nov. 30 Revenue 3 12,124 12,124
30 Expenses 3 9,724 2,400
30 To close 3 2,400 -0-

Retained Earnings Account No. 51

Date Explanation Ref Debit Credit Balance
2008
Nov. 30 Net income 3 2,400 2,400

Closing the Dividends Account

Since dividends do not constitute an expense, the Dividends account is not
closed into the Income Summary Account.
 Instead, dividends are closed directly to the Retained Earnings account,
as shown by the following journal entry:
 GENERAL JOURNAL page 3
LP Debit Credit
2008
Nov. 30 Retained Earnings 51 2,000
Dividends 52 2,000
To Close the Dividends Account.

Posting to ledger accounts:

Retained Earnings Account No. 51

Date Explanation Ref Debit Credit Balance
2008
Nov. 30 Net income 3 2,400 2,400
30 Dividends 3 2,000 400

Dividends Account No. 52

Date Explanation Ref Debit Credit Balance
2008
Nov. 30 2 2,000 2,000
30 To close 3 2,000 -0-

After Closing Trial Balance

After the revenue and expense accounts have been closed, it is desirable to prepare an
after-closing trial balance, which of course will consist of balance sheet accounts.

FAAHIYE REAL ESTATE

After-closing Trial Balance
November 30, 2008

Cash................................................................ $10,074
Accounts Receivable...................................... 9,590
Land................................................................ 52,000
Building.......................................................... 36,000
Accumulated Depreciation: building............. $ 150
Office Equipment........................................... 12,000
Accumulated Depreciation: Office Equipment 100
Accounts Payable........................................... 37,414
Income taxes payable..................................... 1,600
Capital Stock.................................................. 80,000
Retained Earnings.......................................... 400