The amount of the accrued income will also increase the corporation’s retained earnings. This occurs because the accrual adjusting entry included a credit to a revenue account—thereby increasing the corporation’s net income.

Learn more about Adjusting Entries.

The liability account Notes Payable reports the principal amount owed at the time. Interest that will occur in the future is not recorded at the time of the purchase. The reason is that the interest is not owed as of that date. Each month, one month’s interest on the note or loan will be recorded with a debit to Interest Expense and a credit to Cash or Interest Payable (if not paid). Any cash payments that exceed the amount of interest owed at that time will be debited to Notes Payable. The balance in the liability account Notes Payable should agree with the principal balance owed to lender. The balance in the liability account Interest Payable should agree with the interest due as of that date.

You can call your lender to verify the amount of principal and interest owed at a specific date and then compare the amounts to the balances in your general ledger accounts.

Land improvements are recorded in a general ledger asset account entitled Land Improvments. The depreciation of land improvements will result in depreciation expense on the company’s income tax return. This will reduce its taxable income and will reduce a profitable company’s income tax payments.

An example of a leasehold improvement is the permanent improvement to a building that is being rented under a 10 year lease. For instance, the tenant might construct permanent walls and offices inside of the warehouse that it leases from the owner. The lease will likely state that all improvements to the building will belong to the owner of the building. The amount spent by the tenant to improve the building will be recorded by the tenant in its asset account Leasehold Improvements. Generally, the amount of these leasehold improvements will be depreciated by the tenant over the useful life of the improvements or over the life of the lease, whichever is shorter. The depreciation expense associated with the leasehold improvements will reduce the tenant’s taxable income and its income tax payments if the company is profitable.

Learn more about Depreciation.

The principal balance on the mortgage loan already appears in the general ledger and on the balance sheet as the liability Mortgage Loan Payable. Therefore, there is no accrual needed for the principal portion of the loan payment due at December 31.

I recall being asked to reconcile the general ledger account Freight Payable. What I needed to do was provide documentation that the balance in Freight Payable was proper. I proceeded to look at the shipments of recent sales and then determined how much we would be obligated to pay for the freight on those sales. We then adjusted the balance in Freight Payable to my documented amount. This reconciliation was done to have the correct account balance and to provide the outside auditors with documentation which could easily be reviewed.

I also reconciled the balance in Utilities Payable by computing the daily cost of each utility that the company used. The cost per day was then multiplied by the number of days since the last meter reading date shown on the utility bills already entered in our accounting system. We then adjusted the Utilities Payable account balance to be equal to the documented amount.

Learn more about Adjusting Entries and Bank Reconciliation.

For example, if the annual subscription cost is $240 and it is paid in advance, you would initially debit Prepaid Expenses for $240 and credit Cash for $240. If your company issues monthly financial statements, then each month during the subscription period you would debit Subscription Expense for $20 and credit Prepaid Expenses for $20. This results in 1) the matching of $20 to expense on each of the monthly income statements, and 2) the balance sheet reporting the amount that is prepaid or not yet expired.

At a large company, the annual cost of $240 will usually be an immaterial amount. The materiality concept will allow you to violate the matching principle, and to avoid the monthly adjusting entry, by simply debiting Subscription Expense for the entire $240 at the beginning of the one-year subscription period.

Learn more about Adjusting Entries.

One way to enter the transaction is to debit the current asset Prepaid Subscriptions for $24 and to credit Cash for $24. At the end of each month you would make an adjusting entry to debit Subscriptions Expense for $2 and to credit Prepaid Subscriptions for $2. This approach would obviously match the annual cost to each of the 12 periods benefiting from the subscription. However, this is not practical given the small amount involved.

Thanks to the accounting concept of materiality, accountants can ignore the matching principle when the amount is insignificant in relationship to the company’s size. Since no investor or lender would be misled if the entire $24 appeared as an expense in one month and $0 appeared in the other 11 months, the following entry would be more practical: debit Subscriptions Expense for $24 and credit Cash for $24 at the time of entering the invoice into the accounting records.

If the annual subscription was $8,400 for a trade journal and other membership services, a small company will likely find that amount to be significant and should not expense the entire amount in one month.

Learn more about Adjusting Entries.

Now for the reason companies often record purchases in a purchases account. Generally, companies will have a relatively stable amount of inventory and the cost of its annual purchases will be many times the cost of its inventory. This means that most of the cost of its purchases will appear as the cost of goods sold on its income statement. For the minor change in the cost of inventory from the beginning to the end of the accounting period, an adjustment can be made. For example, let’s assume that the cost of purchases during the year amounted to $560,000. Let’s also assume that the inventory at the end of the year has a cost of $70,000 compared to the inventory cost of $67,000 at the end of the previous accounting year. An adjustment will be entered to debit the Inventory account for $3,000 which will increase the Inventory account balance from $67,000 to $70,000. The credit portion of the entry of $3,000 will cause the cost of goods sold to be reported as $557,000 ($560,000 of debits in the Purchases account during the year minus the amount that increased the cost of inventory: $3,000). After this adjustment, the balance sheet will report the true cost of the ending inventory of $70,000 and the income statement will report the true cost of goods sold of $557,000.

Learn more about Inventory and Cost of Goods Sold.

Let’s assume that the net cost of worker comp insurance after discounts and dividends is 5% of the wages and salaries of  direct and indirect manufacturing employees. If for the month of January the direct labor is $40,000, then $2,000 of the worker comp cost should be included as direct labor. If indirect labor for January is $60,000 then $3,000 of worker comp cost should be included as the cost of the indirect labor.

If the general office worker comp rates are 0.2% of the general office wages and salaries, then 0.2% of January’s general office wages and salaries will be expensed as worker comp insurance expense.

If the employer remits each month’s worker comp cost to its insurance company each accounting period, there will be no prepaid insurance nor will there be a liability for accrued worker comp expense.

If the employer remits worker comp premiums to the insurance company in advance of the cost associated with wages and salaries, the amount that is prepaid as of the balance sheet date should be reported as Prepaid Insurance, a current asset. If the employer has remitted less than the worker comp cost associated with the wages and salaries, the amount owed to the insurance company as of the balance sheet date is reported as a current liability such as Accrued Worker Comp Payable.

Learn more about accruals and deferrals under the topic Adjusting Entries.

A company has a cost of $6,000 for property insurance covering the next six months. Initially the cost of $6,000 is reported as the current asset Prepaid Insurance. However, in each of the following six months, the company will report Insurance Expense of $1,000—the amount that is expiring each month. The unexpired portion of the cost will continue to be reported as the asset Prepaid Insurance.

The cost of equipment used in manufacturing is initially reported as the long lived asset Equipment. However, in each accounting period the company will report part of the asset’s cost as Depreciation Expense.

A retailer’s purchase of merchandise is initially reported as the current asset Inventory. When the merchandise is sold, the cost of the merchandise sold is removed from Inventory and is reported on the income statement as the expense entitled Cost of Goods Sold.

The matching principle guides accountants as to when a cost will be reported as an expense.

Learn more about this topic at Accounting Principles and Adjusting Entries.

The definition of a short term or current asset is cash and other assets that will turn to cash or will be used up or consumed within one year of the balance sheet date. If a company’s operating cycle is longer than one year, the definition allows for assets turning to cash, used up, or consumed during the operating cycle to be reported as a current asset.

Often companies are billed in advance for insurance premiums covering a one year period or less. Hence the prepaid amount is usually a current asset.

If a company would have to pay an insurance premium in advance for a period longer than one year, the portion of the prepayments that will not turn to cash within one year (or the operating cycle if it is longer than one year) would be reported as a long term asset.

To learn about adjusting the amount of prepaid insurance see Adjusting Entries.

Here’s a brief explanation. If a company has a cost of goods available of $100,000 and it assigns too little of that cost to inventory, then too much of that cost will appear on the income statement as the cost of goods sold. Too much cost on the income statement will mean too little net income.

Another way to view this is through the accounting equation, Assets = Liabilities + Owner’s Equity. If you assign too little of the cost of goods available to Assets, then the amount of Owner’s Equity will be too little—caused by net income being too little.

Learn more about Inventory and Cost of Goods Sold.

AccountingCoach.com also has crossword and word scramble puzzles on inventory and cost of goods sold. 

For financial statements, you are guided by the matching principle. The objective is to match the cost of the asset to the accounting periods in which revenues were earned by using the asset. There are two estimates needed: 1) the number of years that the asset will be used, and 2) the salvage value at the end of the asset’s use. If an asset has a cost of $100,000 and is expected to be used for 10 years and then have no salvage value, most companies will depreciate the asset at the rate of $10,000 per year. This is known as the straight line method of depreciation.

For income tax purposes in the U.S., the Internal Revenue Service has determined the number of years that various assets will be useful and it assumes there will be no salvage value. The IRS also allows company’s to take larger depreciation deductions in the earlier years and smaller deductions in the later years of the assets’ lives. This is known as accelerated depreciation.

As you probably noted from the above information, in any one year the depreciation expense on the financial statements will be different from the depreciation expense on the income tax return. However, over the life of an asset, the total depreciation expense will be the same. Accountants refer to this as a timing difference.

Learn more about Depreciation Expense. You will also find Crossword Puzzles and Word Scramble Puzzles for depreciation on AccountingCoach.com.

It is acceptable and common for companies to depreciate its plant assets by using the straight line method on its financial statements, while using an accelerated method on its income tax return.

A company could also be depreciating its equipment over ten years for its financial statements, while using seven years for its income tax return.

Even the depreciation for financial statements could consist of some assets being depreciated using the units of production or units of activity method, while other assets are depreciated using the straight line method.

Learn more about Depreciation.

1. If a prepaid expense is recorded initially as an expense, then at the end of an accounting period, only the true expense amount for the period should remain in the expense account. The future expense (the portion that has not yet expired; the unexpired part) must be credited to the expense account and debited to the prepaid asset account.

2. If a prepaid expense is recorded initially in a prepaid asset account, the true expense of the period (the expired portion) needs to be removed and debited to the related expense account. The remaining amount in the prepaid asset account should be the unexpired portion.

Let’s illustrate these two possibilities by assuming that an insurance premium of $6,000 is paid on December 1. This cost covers the six month period of December 1 through May 31. As a result the monthly expense will be $1,000. Let’s also assume that the company did not have any insurance prior to December 1.

1. On December 1, the account Insurance Expense was initially debited for $6,000 and Cash was credited for $6,000. On December 31, an adjusting entry will be needed to debit Prepaid Insurance for $5,000 and to credit Insurance Expense for $5,000. After this adjusting entry is recorded, the balance in Insurance Expense will be December’s true expense of $1,000 (original debit of $6,000 minus the adjusting entry credit of $5,000) and the balance in Prepaid Insurance will be the debit of $5,000. This represents five months of cost that has not yet expired (5 months x $1,000 per month).

2. On December 1, the account Prepaid Insurance was initially debited for $6,000 and Cash was credited for $6,000. On December 31, an adjusting entry will be needed to debit Insurance Expense for $1,000 (the amount that expired during December) and to credit Prepaid Insurance for $1,000. After this adjusting entry is recorded, the balance in the asset Prepaid Insurance will be $5,000 (the initial debit of $6,000 minus the credit of $1,000; and the unexpired amount consisting of 5 months x $1,000 per month). The account Insurance Expense will report the debit of $1,000.

Usually there would be insurance coverage prior to December 1. In that case the year-to-date balance in the expense account should be equal to the expired insurance cost during the year-to-date period. If there is a conflict between getting the prepaid asset balance to be correct and the expense balance to be correct, make certain that the prepaid asset balance is correct.  

Learn more about Adjusting Entries.

Let’s illustrate this with a company that has an accounting year ending on December 31, 2007 and only one employee. The company’s handbook specifies that the employee’s vacation accrues monthly and that the vacation check will be paid on each July 1. Let’s assume that on July 1, 2008 the employee will be entitled to 80 hours of vacation pay at the employee’s pay rate on that date. On December 31, 2007 the employee’s pay rate is $15 per hour and the company’s liabilities include $600 for accrued vacations (80 hours X 6/12 year X $15). On June 30, 2008 the company will report an accrued liability of $1,200 (80 hours X $15). However, on June 10, 2008 the employee received a 3% pay rate increase. This means the employee’s vacation check on July 1, 2008 will be $1,236 ($15.45 X 80 hours). The difference of $36 ($1,236 v. $1,200) is simply charged to Vacation Expense in the period of the vacation pay entry. In other words, the vacation pay entry will include a debit to Vacations Payable or Accrued Vacations Liability for $1,200 (the amount that has been accrued in earlier periods) and a debit to Vacation Expense for $36. The credits will include the payroll withholdings and the liability for the net payroll amount or Cash.

As shown above, the additional $36 was simply debited to Vacation Expense in the period of the vacation pay entry. The past monthly accruals were not changed or restated as the they were estimates and the amount of difference is immaterial. 

The recording of wages that have been earned but not yet paid or processed through the routine payroll entries is referred to as accruing wages. This is done through an accrual-type adjusting entry.

Learn more about Payroll Accounting and Adjusting Entries. AccountingCoach.com also has FREE interactive crossword puzzles on each of these topics.

The amount reported in the Allowance for Doubtful Accounts is the estimated amount of the accounts receivable that will not be collected. The Allowance for Doubtful Accounts is a contra asset account or valuation account associated with the balance in Accounts Receivable. Since these two accounts are balance sheet accounts, their account balances must report the amounts that are relevant at a specific moment in time, namely the date of the balance sheet.

To illustrate, let’s assume that on December 31 a company had $100,000 in Accounts Receivable and its balance in Allowance for Doubtful Accounts was a credit balance of $3,000. For the first 30 days of January the company does not have any other information on bad accounts. Then on January 31 the company learns that an additional $1,000 of its accounts receivable will not be collectible. On January 31 the company will make an adjusting entry to debit Bad Debts Expense for $1,000 and to credit Allowance for Doubtful Accounts for $1,000. After this entry is recorded, the company’s income statement for the month of January will report Bad Debts Expense of $1,000 and its January 31 balance sheet will report a credit balance in Allowance for Doubtful Accounts in the amount of $4,000.

Learn more about Adjusting Entries. AccountingCoach.com also has three FREE interactive Crossword Puzzles on adjusting entries.

Let’s illustrate the difference with an example. A company has only one depreciable asset that was acquired three years ago at a cost of $120,000. The asset is expected to have a useful life of 10 years and no salvage value. The company uses straight-line depreciation on its monthly financial statements. In the asset’s 36th month of service, the monthly income statement will report depreciation expense of $1,000. On the balance sheet dated as of the last day of the 36th month, accumulated depreciation will be reported as $36,000. In the 37th month, the income statement will report $1,000 of depreciation expense. At the end of the 37th month, the balance sheet will report accumulated depreciation of $37,000.

Learn more about Depreciation.

AccountingCoach.com also has FREE interactive crossword puzzles on depreciation.

To illustrate the sum of the years’ digits method of depreciation, let’s assume that a plant asset is purchased at a cost of $160,000. The asset is expected to have a useful life of 5 years and then be sold for $10,000. This means that the asset’s depreciable amount will be $150,000 to be expensed over its useful life of 5 years.

Next the digits in the years of the asset’s useful life are summed: 1 + 2 + 3 + 4 + 5 = 15. In the first year of the asset’s life, 5/15 of the depreciable amount (5/15 of $150,000) or $50,000 will be debited to Depreciation Expense and $50,000 will be credited to Accumulated Depreciation. In the second year of the asset’s life, $40,000 (4/15 of $150,000) will be the depreciation amount. In the third year, $30,000 (3/15 of $150,000) will be the depreciation. The fourth year will be $20,000 (2/15 of $150,000) and the fifth year will be $10,000 (1/15 of $150,000). As indicated earlier, the total depreciation during the asset’s useful life needs to sum to the depreciable cost (in this case $150,000) regardless of the depreciation method used.

Instead of adding the individual digits in the years of the asset’s useful life, the following formula can be used: n(n+1) divided by 2. In this formula, n = the useful life in years. Let’s use the formula to check our calculation above. When the useful life is 5 years, the formula will be 5(5+1)/2 = 5(6)/2 = 30/2 = 15. If the useful life is 10 years, the formula will show 10(10+1)/2 = 10(11)/2 = 110/2 = 55. In the first year of the asset having a 10 year useful life, the depreciation will be 10/55 of the asset’s depreciable cost. The second year will be 9/55 of the asset’s depreciable cost. In the tenth year, the depreciation will be 1/55 of the asset’s depreciable cost.

Learn more about Depreciation from our explanations and drills. AccountingCoach.com also has FREE interactive Crossword Puzzles on depreciation.

An example of a contingent gain and contingent asset might be a lawsuit filed by Company A against Company B for infringement of Company A’s patent. If it is probable that Company A will win the lawsuit and receive an estimated amount of money, it has a contingent asset and a contingent gain. However, it will not report the asset and gain until the lawsuit is settled. (At most Company A will prepare a very carefully worded disclosure stating that it possibly could win the case.) On the other hand, Company B will need to make an entry in its accounts if the loss contingency is probable and the amount can be estimated. If one of those are missing, Company B will have to disclose the loss contingency in the notes to its financial statements.

To learn more about contingencies, see Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, at www.FASB.org/st.

Under the accrual basis of accounting (as opposed to the cash basis) commission revenues should be reported when the company earns the commissions. The commission expense should be reported when the company has incurred the expense and liability. (This would also be the time when the other party has earned the commissions and the right to receive them.)

The commission revenues would be reported as operating revenue (in the section where sales are reported), if the commissions are earned as a main activity of the company. If the commissions are incidental or involve a peripheral activity, these commission revenues would be reported as other income.

Commission expense would be reported as a selling expense along with other operating expenses when they are related to the company’s main activities. If a commission expense pertains to a peripheral activity, it would be reported as other expense.

The amount of the annual depreciation that is reported on the financial statements is an estimate based on the asset’s 1) cost, 2) estimated salvage value, and 3) useful life. Depreciation should be thought of as an allocation of the asset’s cost to expense (and not as a valuation technique). In other words, the accountant is matching the cost of the asset to the periods in which revenues are generated from the asset.

The amount of the annual depreciation reported on the U.S. income tax return is based on the tax regulations. Since depreciation is a deductible expense for income tax purposes, the corporation’s taxable income (and associated tax payments) will be reduced by its tax depreciation expense. (In any one year, the depreciation expense for taxes will likely be different from the amount reported on the financial statements.)

It should be noted that depreciation is viewed as a noncash expense. That is, the corporation’s cash balance is not changed by the annual depreciation entry. (Often the corporation’s cash is reduced for the asset’s entire cost at the time the asset is acquired.)

Learn more about Depreciation.

The word provision might appear in the title of a contra account as we just noted. In addition, provision will occasionally appear in the title of an expense account, such as Provision for Income Taxes.

To illustrate net of accumulated amortization let’s assume that five years ago a corporation incurred bond issue costs of $600,000 when it issued $50,000,000 in bonds that would mature 20 years later. The $600,000 is a deferred charge because it will be amortized to expense over the 20-year life of the bonds. Annually $30,000 ($600,000 divided by 20 years) will be debited to expense such as Bond Issue Expense or Amortization Expense and will be credited to Deferred Bond Issue Costs or Accumulated Amortization of Bond Issue Costs. After five years, the bond issue cost net of accumulated amortization will be $450,000. This is the original $600,000 of cost minus $150,000 of accumulated amortization (5 years X $30,000 per year).

Learn about Depreciation.

I associate unrecorded revenue with revenues that were earned, but not yet recorded in a company’s accounting records. For example, an electric utility will provide electricity to customers for up to one month before it reads the customers’ meters, calculates the bills and records the billings as revenues and accounts receivable. As a result, the electric utility will have up to one month of unrecorded revenue. At each balance sheet date, the utility should accrue for the revenues it earned but had not yet recorded. This is done through an adjusting entry that debits a balance sheet receivable account and credits an income statement revenue account.

Learn more about Adjusting Entries.

Because of double-entry accounting, accountants will draw a minimum of two T-accounts in order to visualize the complete impact of a transaction on the financial records. T-accounts allow the accountant to be certain that the proposed journal entry will have debit amounts equal to the credit amounts. In addition the accountant can see the account balances that will result from the proposed journal entry.

T-accounts are very helpful when preparing Adjusting Entries.

For example, the accrued payroll as of December 31 would include all of the wages that the hourly-paid employees have earned as of December 31, but will not be paid until the following pay day (perhaps January 5). The employer’s portion of the FICA, unemployment taxes, worker compensation insurance, and other benefits pertaining to those wages should also be included as accrued payroll in order to achieve the matching principle of accounting.

Learn more about Payroll Accounting.

Cycle and steps seem to be a carryover from the days of manual bookkeeping and accounting when transactions were first written into journals. In a separate step the amounts in the journal were posted to accounts. At the end of each month, the remaining steps had to take place in order to get the monthly, manually-prepared financial statements.

Today, most companies use accounting software that processes many of these steps simultaneously. The speed and accuracy of the software reduces the accountant’s need for a worksheet containing the unadjusted trial balance, adjusting entries, and the adjusted trial balance. The accountant can enter the adjusting entries into the software and can obtain the complete financial statements by simply selecting the reports from a menu. After reviewing the financial statements, the accountant can make additional adjustments and almost immediately obtain the revised reports. The software will also prepare, record, and post the closing entries.

To illustrate the units of production method, let’s assume that a production machine has a cost of $500,000 and its useful life is expected to end after producing 240,000 units of a component part. The salvage value at that point is expected to be $20,000. Under the units of production method, the machine’s depreciable cost of $480,000 ($500,000 minus $20,000) is divided by 240,000 units, resulting in depreciation of $2 per unit. If the machine produces 10,000 parts in the year 2007, the depreciation for the year will be $20,000 ($2 x 10,000 units). If the machine produces 50,000 parts in the next year, its depreciation for 2008 will be $100,000 ($2 x 50,000 units). The depreciation will be calculated similarly each year until the asset’s Accumulated Depreciation reaches $480,000.

The units of production method is also referred to as the units of activity method, since the method can be used for depreciating airplanes based on air miles, cars on miles driven, photocopiers on copies made, DVDs on number of times rented, and so on.

Depreciation is an allocation technique and the units of production method might do a better job of allocating/matching an asset’s cost to the proper period than the straight-line method, which is based solely on the passage of time.

Learn more on Depreciation.

A deferred credit is reported as a liability on the balance sheet. Depending on the specifics, the deferred credit might be a current liability or a noncurrent liability. In the past, it was common to see a noncurrent liability section with the heading Deferred Credits.

In the following accounting period, the accrual-type adjusting entries will usually be reversed. They are reversed or removed because the actual invoices or other documents containing the accrued revenues or expenses will be arriving and will be entered into the accounting records by the bookkeeper or the accounts payable clerk.

Learn more about Adjusting Entries.

If Provision for Doubtful Debts is the current period expense associated with the losses from normal credit sales, it will appear as an operating expense—usually as part of Selling, General and Administrative Expenses (SG&A). If the expense is associated with extending credit outside of a company’s main selling activities, the credit loss will be reported as a nonoperating (or other) expense.

To avoid the confusion with the use of the word “provision”, the accounting textbooks often refer to the contra-asset account associated with accounts receivable as Allowance for Doubtful Accounts. The current period expense pertaining to accounts receivable is referred to as Bad Debt Expense, an operating expense.

Learn more about the Income Statement.

To illustrate reversing entries, let’s assume that a retailer uses a temporary help service from December 15 - 31. The temp agency will bill the retailer on January 10 and the retailer agrees to pay the invoice by January 15. If the retailer’s accounting year ends on December 31, the retailer will make an accrual-type adjusting entry for the estimated amount. If the estimated amount is $18,000 the retailer will debit Temp Service Expense for $18,000 and will credit Accrued Expenses Payable for $18,000. This adjusting entry assures that the retailer’s income statement and balance sheet as of December 31 will include the temp service expense and obligation.

On January 1, the retailer enters the following reversing entry: debit Accrued Expenses Payable for $18,000 and credit Temp Service Expense for $18,000. When the actual invoice arrives from the temp agency on January 11, the retailer can simply debit the invoice amount to Temp Service Expense. If the invoice is $18,000 the Temp Service Expense will show $-0-. (The credit from the reversing entry and the debit from the invoice entry.) Thanks to the reversing entry, the retailer did not have to stop and consider whether the invoice amount pertains to December or January.

If the invoice amount is $18,180 the entire amount is debited to Temp Service Expense and $180 will appear as a January expense. This insignificant amount is acceptable since the adjusting entry amount was an estimate.

Learn more about Adjusting Entries.

Here is an example. A company borrowed $200,000 on December 1. The agreement requires that the $200,000 be repaid on February 28 along with $6,000 of interest for the three months of December through February. As of December 31 the company will not have an invoice or payment for the interest that the company is incurring. (The reason is that all of the interest will be due on February 28.)

Without an adjusting entry to accrue the interest expense that the company has incurred in December, the company’s financial statements as of December 31 will not be reporting the $2,000 of interest (one-third of the $6,000) that the company has incurred in December. In order for the financial statements to be correct on the accrual basis of accounting, the accountant needs to record an adjusting entry dated as of December 31. The adjusting entry will consist of a debit of $2,000 to Interest Expense (an income statement account) and a credit of $2,000 to Interest Payable (a balance sheet account).

Learn more on Adjusting Entries.

Here’s an example. Your company lent a supplier $100,000 on December 1. The agreement is for the $100,000 to be repaid on February 28 along with $3,000 of interest for the three months of December through February. As of December 31 your company will not have a transaction/invoice/receipt for the interest it is earning since all of the interest is due on February 28. Without an adjusting entry to accrue the revenue it earned in December, your company’s financial statements as of December 31 will not be reporting the $1,000 (one-third of the $3,000 of interest) that it has earned in December. In order for the financial statements to be correct on the accrual basis of accounting, the accountant needs to record an adjusting entry dated as of December 31. The adjusting entry will consist of a debit of $1,000 to Interest Receivable (a balance sheet account) and a credit of $1,000 to Interest Income or Interest Revenue (income statement accounts).

Learn more about Adjusting Entries.

To illustrate, let’s assume that a new retailer opens on September 1 and its electric meter will be read by the utility on the last day of every month. During September the retailer has incurred the cost of the electricity it used during September.

Under accrual accounting the retailer needs to report a liability on September 30 for the amount owed to the utility at that point. On its income statement for September, the retailer needs to report electricity expense equal to the cost of the electricity used during September. (The fact that the utility will not bill the retailer until October and will allow the retailer until November to make payment is not pertinent under accrual accounting.)

The matching principle requires that the costs incurred in September be matched with the revenues in September.

Learn more about the Income Statement.

As the prepaid amount expires, the balance in Prepaid Insurance is reduced by a credit to Prepaid Insurance and a debit to Insurance Expense. This is done with an adjusting entry at the end of each accounting period (e.g. monthly). One objective of the adjusting entry is to match the proper amount of insurance expense to the period indicated on the income statement. (The income statement should report the amount of insurance that has expired during the period indicated in the income statement’s heading.) Another objective is to report on the balance sheet the unexpired amount of insurance as the asset Prepaid Insurance.

If you can arrange for your insurance payments to be the amount applicable to each accounting period, you can simply debit Insurance Expense and credit Cash. For example, if the insurance premiums for one year amount to $12,000 and you can pay the insurance company $1,000 per month, then each monthly payment will be recorded with a debit to Insurance Expense and a credit to Cash. In this case $1,000 per month will be matched on the income statement and there will be no prepaid amount to be reported on the balance sheet.

Learn more about Adjusting Entries.

Provision for Bad Debts might also be an the income statement account also known as Bad Debt Expense or Uncollectible Account Expense. In this situation, the Provision for Bad Debts reports the credit losses that pertain to the period shown on the income statement.