Adjusting entries

In depth

Prepaid expenses: insurance and supplies

A prepaid expense is a cost paid in advance for benefits the business will receive in later periods; until then it is an asset. Lantern’s policy cost $1,800 for 12 months from 1 March. By 31 March one month has expired, so $1{,}800 \div 12 = 150$ becomes insurance expense (a1). The other $1,650 is still an asset: cover Lantern will receive from April 2026 to February 2027.

Supplies work the same way but are measured by counting. Lantern doesn’t record each cup and bag of beans as it is used; that would cost more than the information is worth. Instead it counts what is left at the end of the month and works out what must have been used: supplies used = supplies at the start + purchases − supplies on hand, here $0 + 1{,}500 - 600 = 900$ (a2). After the adjustment the Supplies account shows $600, the amount actually on the shelves.

Depreciation

Depreciation is the allocation of the cost of a long-lived asset, less its residual value, over its useful life. The residual value is what the business expects to get for the asset at the end of the time it plans to use it; the useful life is how long it expects to use it. Depreciation applies the expense recognition principle: the machine helps earn revenue for years, so each period bears part of its cost. It is not an attempt to measure what the asset is worth today.

The straight-line method charges the same amount every period: cost minus residual value, divided by useful life. Lantern’s $12,000 of equipment is expected to last five years with no residual value, so depreciation is $(12{,}000 - 0) \div 5 = 2{,}400$ a year, or $2{,}400 \div 12 = 200$ a month (a3). Lantern’s policy takes a full month in the month of purchase, so March bears the whole $200 although the machine arrived on 3 March.

The credit doesn’t go to Equipment. It goes to Accumulated Depreciation—Equipment, a contra account with a credit balance that collects all the depreciation recorded so far: its total is the asset’s accumulated depreciation. Equipment keeps showing the original cost of $12,000, and the two together give the book value (called the carrying amount under IFRS): $12{,}000 - 200 = 11{,}800$ at 31 March. After 12 months accumulated depreciation will be $2,400 and book value $9,600. After 60 months, at the end of February 2031, the machine will be fully depreciated, with a book value of zero, its expected residual value. Keeping cost and accumulated depreciation apart shows a reader both how much was invested and roughly how much of the asset’s life has been used.

Unearned revenue

Harbor Tech paid $2,400 on 8 March for three events, and Lantern recorded the deposit as Unearned Revenue, a liability. In lesson 8 the five-step model showed that $800 was earned on 26 March, when the first event was catered. The adjustment (a4) moves that $800 from the liability to Catering Revenue; the remaining $1,600 stays as a liability until the April events.

Accrued revenue

Accrued revenue is revenue earned in the period but not yet recorded, because no invoice has been sent or no payment is due yet. Lantern catered Pier Nine Studio’s breakfast on 31 March and will send the $600 invoice on 2 April. The performance obligation has been satisfied, so March has earned the revenue, and Lantern has a right to be paid: an account receivable (a7). Sending the invoice in April records nothing new, because the receivable already exists; when Pier Nine pays, Lantern debits Cash and credits Accounts Receivable. Interest earned on money Lantern had lent would be accrued the same way, through Interest Receivable and Interest Revenue.

Accrued expenses: wages and interest

An accrued expense is an expense incurred in the period but not yet paid or recorded. The baristas were paid on 20 March for 1–15 March. By 31 March they have earned another $1,400 for 16–31 March, to be paid on 5 April. March used their work, so March bears the expense; Lantern owes the money, so a liability, Wages Payable, appears (a5). On 5 April Lantern will debit Wages Payable and credit Cash for $1,400: the payment settles the liability and is not a second expense.

Interest builds up day by day on a loan. Simple interest for part of a year is $I = P \times r \times t$: principal times the annual rate times the time in years. Lantern’s $10,000 note at 6% a year accrues $10{,}000 \times 0.06 \times \tfrac{1}{12} = 50$ in March (a6). The first payment, due on 1 June, will cover three months: $10{,}000 \times 0.06 \times \tfrac{3}{12} = 150$. If Lantern accrues $50 at the end of March, April and May, Interest Payable will stand at $150 on 31 May, and the payment on 1 June (debit Interest Payable, credit Cash) clears it without any new expense. Loan agreements may also measure time in days over a 360-day or 365-day year; the contract says which.

The adjusted trial balance

After the seven adjustments are journalised and posted, Lantern lists every account again. The adjusted trial balance shows each account’s balance after the adjustments; it checks that debits still equal credits and is the source from which the financial statements are prepared in lesson 10.

Retained Earnings has a zero balance because March is Lantern’s first month, so it is not listed.

The total rose from $46,860 to $49,110, by $2,250, although the adjustments add up to $4,100. Three of them only move an amount between two accounts on the same side: a1 and a2 move debit balance from an asset to an expense, and a4 moves credit balance from a liability to a revenue, so they leave the totals unchanged. The other four add a new amount to both sides: $200 + 1{,}400 + 50 + 600 = 2{,}250$. A balanced adjusted trial balance shows only that each adjustment was recorded with equal debits and credits; it can’t show that an adjustment was forgotten.

If an adjustment is missed

An omitted adjustment leaves out both its debit and its credit, so the trial balance still balances and the error has to be found by thinking, not by adding up. Each omission misstates an income statement total and a balance sheet total by the same amount, and until the books are closed, equity is misstated by the same amount as net income.

“Over” means the reported figure would be too high; “under”, too low; “—”, no effect. Each row keeps the equation in balance: for a5, assets 0 = liabilities −1,400 + equity +1,400.

Two patterns make the table easy to rebuild. Leaving out an expense overstates net income and equity; leaving out revenue understates them. Omitted deferral adjustments leave a balance sheet figure too high (an asset not yet used up, a liability not yet earned off), while omitted accruals leave one too low (a receivable or payable that is missing). With all seven left out, Lantern would report net income of $2,290 instead of $990, total assets of $43,150 instead of $42,500, liabilities of $21,160 instead of $21,810 and equity of $21,990 instead of $20,690.

Estimates and judgement

Several adjustments rest on estimates: the machine’s five-year life and nil residual value, the supplies count, the date on which an event counts as delivered. If Ana later expects the machine to last only four years, the depreciation charge changes from then on; later courses show how. Estimates should be reasonable, supported by evidence and applied consistently. They are also where auditors look hardest, because a small change in a useful life or an accrual can move profit without any cash changing hands.