4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
Types of Adjusting Entries
There are four main types of adjusting entries:
- Prepaid Expenses (Deferred Expenses)
- Unearned Revenues (Deferred Revenues)
- Accrued Expenses (Accrued Liabilities)
- Accrued Revenues (Accrued Assets)
Additionally, there are: 5. Depreciation (special type of prepaid expense) 6. Bad Debts (allowance for doubtful accounts)
Let's examine each type in detail.
Type 1: Prepaid Expenses (Deferred Expenses)
Definition: Expenses paid in advance that will benefit future periods.
Examples:
- Prepaid insurance
- Prepaid rent
- Supplies on hand
- Prepaid advertising
Initial Recording: Recorded as an asset when paid
Adjusting Entry: Transfer portion used/expired to expense
Example 1: Prepaid Insurance
Situation: Marie pays €1,200 for one year of insurance on January 1, 2024. The policy covers January 1 through December 31.
Initial Entry (January 1):
613000 Prepaid Insurance (Asset) €1,200
510000 Cash €1,200
To record payment of annual insurance
Adjusting Entry (End of each month): Each month, €100 (€1,200 ÷ 12 months) expires and becomes an expense.
Adjusting Entry (End of November):
613000 Insurance Expense €100
613000 Prepaid Insurance (or 460000) €100
To record insurance expense for November
(€1,200 ÷ 12 months = €100/month)
PCN Accounts:
- 613000: Insurance Expense (Class 6)
- 460000: Prepaid Expenses (Class 4) or keep as 613000 with separate tracking
After Adjustment:
- Prepaid Insurance (Asset): €200 remaining (€1,200 - €1,000 used)
- Insurance Expense: €100 for November
Example 2: Prepaid Rent
Situation: Restaurant pays €2,400 for three months' rent in advance on November 1.
Initial Entry (November 1):
460000 Prepaid Rent (Asset) €2,400
510000 Cash €2,400
To record prepayment of three months' rent
Adjusting Entry (End of November): One month (€800) has been used.
612000 Rent Expense €800
460000 Prepaid Rent €800
To record rent expense for November
(€2,400 ÷ 3 months = €800/month)
PCN Accounts:
- 612000: Rent Expense (Class 6)
- 460000: Prepaid Expenses (Class 4)
Type 2: Unearned Revenues (Deferred Revenues)
Definition: Cash received in advance for services to be provided in the future.
Examples:
- Advance payments for services
- Gift certificates sold
- Subscription revenue received in advance
- Deposits received
Initial Recording: Recorded as a liability when cash is received
Adjusting Entry: Transfer portion earned to revenue
Example: Unearned Service Revenue
Situation: Restaurant receives €3,000 on November 1 for catering services to be provided over three months (November, December, January).
Initial Entry (November 1):
510000 Cash €3,000
470000 Unearned Revenue (Liability) €3,000
To record advance payment for catering services
Adjusting Entry (End of November): One month (€1,000) has been earned.
470000 Unearned Revenue €1,000
701000 Service Revenue €1,000
To record revenue earned in November
(€3,000 ÷ 3 months = €1,000/month)
PCN Accounts:
- 470000: Unearned Revenue/Deferred Income (Class 4)
- 701000: Service Revenue (Class 7)
After Adjustment:
- Unearned Revenue (Liability): €2,000 remaining
- Service Revenue: €1,000 earned in November
Type 3: Accrued Expenses (Accrued Liabilities)
Definition: Expenses incurred but not yet paid or recorded.
Examples:
- Accrued salaries/wages
- Accrued interest
- Accrued utilities
- Accrued taxes
Initial Recording: No entry made (expense not yet recorded)
Adjusting Entry: Record expense and liability
Example 1: Accrued Salaries
Situation: Restaurant pays employees every two weeks. The pay period ends on November 30, but employees won't be paid until December 5. Salaries for the last week of November total €1,500.
Adjusting Entry (End of November):
620000 Salaries Expense €1,500
440000 Salaries Payable (Liability) €1,500
To record accrued salaries for last week of November
PCN Accounts:
- 620000: Salaries Expense (Class 6)
- 440000: Salaries Payable (Class 4)
Payment Entry (December 5):
440000 Salaries Payable €1,500
510000 Cash €1,500
To record payment of accrued salaries
Example 2: Accrued Interest
Situation: Restaurant has a €20,000 bank loan at 6% annual interest. Interest is paid quarterly, but we need to accrue interest for November.
Calculation:
- Annual interest: €20,000 × 6% = €1,200
- Monthly interest: €1,200 ÷ 12 = €100
Adjusting Entry (End of November):
660000 Interest Expense €100
450000 Interest Payable (Liability) €100
To record accrued interest for November
PCN Accounts:
- 660000: Interest Expense (Class 6)
- 450000: Other Payables (Class 4) or specific interest payable account
Type 4: Accrued Revenues (Accrued Assets)
Definition: Revenues earned but not yet received or recorded.
Examples:
- Services provided but not yet billed
- Interest earned but not yet received
- Rent earned but not yet collected
Initial Recording: No entry made (revenue not yet recorded)
Adjusting Entry: Record revenue and asset (receivable)
Example: Accrued Service Revenue
Situation: Restaurant provides catering services in November but won't bill the client until December. The service is worth €2,000.
Adjusting Entry (End of November):
410000 Accounts Receivable (Asset) €2,000
701000 Service Revenue €2,000
To record revenue earned but not yet billed
PCN Accounts:
- 410000: Accounts Receivable (Class 4)
- 701000: Service Revenue (Class 7)
Billing Entry (December):
410000 Accounts Receivable €2,000
701000 Service Revenue €2,000
(Already recorded, or create invoice)
Type 5: Depreciation
Definition: Systematic allocation of the cost of a long-term asset over its useful life.
Why it's needed: Assets like equipment lose value over time. Depreciation allocates this cost to the periods that benefit from the asset.
Characteristics:
- Non-cash expense
- Reduces asset value (via accumulated depreciation)
- Matches expense with revenue generated by asset
Example: Equipment Depreciation
Situation: Restaurant has equipment costing €30,000 with a useful life of 5 years (60 months). Using straight-line depreciation.
Calculation:
- Monthly depreciation: €30,000 ÷ 60 months = €500/month
Adjusting Entry (End of each month):
640000 Depreciation Expense €500
241000 Accumulated Depreciation - Equipment €500
To record monthly depreciation on equipment
PCN Accounts:
- 640000: Depreciation Expense (Class 6)
- 241000: Accumulated Depreciation - Equipment (Class 2)
Note: The equipment account (223000) stays at original cost. Accumulated Depreciation is a contra-asset account that reduces the asset's book value.
Balance Sheet Presentation:
Equipment (223000) €30,000
Less: Accumulated Depreciation (5,500) (11 months × €500)
Book Value €24,500
Type 6: Bad Debts (Allowance for Doubtful Accounts)
Definition: Estimated amount of accounts receivable that may not be collected.
Why it's needed: Some customers may not pay. The allowance method estimates uncollectible accounts and matches the expense with the period of sale.
Example: Allowance for Doubtful Accounts
Situation: Restaurant has €10,000 in accounts receivable. Based on past experience, 2% may be uncollectible.
Calculation:
- Estimated bad debts: €10,000 × 2% = €200
Adjusting Entry (End of period):
650000 Bad Debt Expense €200
490000 Allowance for Doubtful Accounts €200
To record estimated uncollectible accounts
PCN Accounts:
- 650000: Bad Debt Expense (Class 6)
- 490000: Allowance for Doubtful Accounts (Class 4 - contra-asset)
Balance Sheet Presentation:
Accounts Receivable (410000) €10,000
Less: Allowance for Doubtful Accounts (200)
Net Accounts Receivable €9,800
Summary of Adjusting Entry Types
| Type | Initial Entry | Adjusting Entry | Accounts Affected |
|---|---|---|---|
| Prepaid Expense | Asset | Asset ↓, Expense ↑ | Asset, Expense |
| Unearned Revenue | Liability | Liability ↓, Revenue ↑ | Liability, Revenue |
| Accrued Expense | None | Expense ↑, Liability ↑ | Expense, Liability |
| Accrued Revenue | None | Asset ↑, Revenue ↑ | Asset, Revenue |
| Depreciation | Asset (at cost) | Expense ↑, Contra-Asset ↑ | Expense, Accumulated Depreciation |
| Bad Debts | None | Expense ↑, Contra-Asset ↑ | Expense, Allowance |
Luxembourg Compliance Note
All adjusting entries in Luxembourg must:
- Follow accrual basis accounting
- Use proper PCN account classifications
- Be supported by calculations
- Be documented and retained
- Be made before filing financial statements
Think It Through
A business pays €6,000 for six months of rent in advance on October 1. What adjusting entry is needed at the end of October? What accounts are affected, and what are the PCN account numbers?