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In the previous article, we talked about the accounting cycle. One of the steps is to prepare adjusted trial balance before making financial statements. And to prepare adjusted trial balance, we need to make adjusting journal entries.
There are 5 types of Adjustments:
- prepaid assets/expenses: convert assets into expenses. Some assets are going to become expenses. Examples are prepaid insurance, prepaid rent.
- depreciation:
- unearned revenue:
- accrued revenues
- accrued expenses
We will discuss in detail about each of them in this article.
Prepaid
Let’s say your company bought insurance on December 31 for the next year of $12,00. The journal entry will look like this:
Debit Credit
Prepaid insurance 1,200
Cash 1,200
If your company create financial statements quarterly, then on March 31, you will need to create an adjusted journal entry:
Debit Credit
Insurance Expense 300
Prepaid insurance 300
Depreciation
Assets are the resources your company uses to generate revenue. When an asset can’t generate revenue, you convert them into expense, because you bought the asset with money.
For example, if your company bought a car in January this year for $20,000, the journal entry will look like this:
Debit Credit
Vehicle 20,000
Cash 20,000
Your total asset is the same. But let’s say the car can only be used for 5 years, so every year the vehicle asset depreciates $4,000. At the end of this year, you will have a journal entry like this:
Debit Credit Depreciation Expense 4,000 Accumulated depreciation 4,000
So your total assets are reduced by $4,000. Because you converted some assets into expenses, you lowered your tax bill.
Although a car will probably run longer than 5 years. The IRS anticipates a car will have a useful lifespan of 5 years. After 5 years, you will need to trade it in and get a new car. The book value of the car is zero, but the market value is probably something like $2000. and When you sell the car for $2000, you have a revenue.
debit credit cash 2,000 revenue 2,000
When you sell assets, the revenue is called non-operating revenue.
- Note: You can’t depreciate land, because you can always use the land to generate revenue. Its value never depreciates.
Depreciation methods
There are 4 common depreciation methods:
- straight-line: spreads out the cost of the fixed asset evenly over its useful life
- declining balance:
- sum-of-the-year’s digits
- units of production
Unearned Revenue
Let’s say your company receives payment of $10,000 in advance for 100 items. The journal entry looks like this:
Debit Credit Cash 10,000 Unearned Revenue 10,000
In December 31, your company only delivered 50 items to your customer. You need to make an adjusted journal entry:
Debit Credit
Unearned Revenue 5,000
Revenue 5,000
Accrued Revenues
Let’s say your business completed service for a client in December this year for $10,000, but the client will pay in January next year. On December 31, you need to make an adjusted journal entry:
Debit Credit
Accounts receivable 10,000
Revenue 10,000
If the client pays you on January 3rd next year, you will have a journal entry like this:
Debit Credit Cash 10,000 Accounts receivable 10,000
Accrued Expenses
Let’s say your company pays employees on the 1st day of each month. In December this year, you have an unpaid salary of $24,000. Your company will pay the $24,000 on January 1st next year. So on December 31, you need to make an adjusted journal entry:
Debit Credit
Salary expense 24,000
Salary payable 24,000
On January 1st next year, you will have a journal entry like this:
Debit Credit
Salary payable 24,000
Cash 24,000
Note: If your company hires independent contactor, then you have wage expense instead of salary expense.
