Adjusting entries II: accruals, depreciation and the adjusted trial balance

Deferrals, covered in lesson 5, deal with cash that moved before the revenue or expense. Accruals deal with the opposite case: revenue earned or expense incurred before any cash has moved and before any document has been recorded. Depreciation spreads the cost of long-lived assets over the periods that use them. This lesson covers accrued revenues, accrued expenses and depreciation, completes the May adjustments for Birchwood Bikes, and prepares the adjusted trial balance from which lesson 7 builds the financial statements.

Accrued revenues

An accrued revenue is revenue earned in the period but not yet recorded, usually because the customer has not yet been billed. Work completed in the last days of the month, interest earned on a savings account or a loan made to someone else, and rent earned on property leased to a tenant who pays later are typical examples. The adjusting entry debits a receivable and credits revenue. When the bill is later sent and paid, the receipt is recorded as cash in and receivable out, with no further revenue.

Accrued expenses

An accrued expense is an expense incurred in the period but not yet recorded or paid. The most common are wages earned by employees since the last payday, interest that has built up on a loan since the last payment, and services such as utilities or professional fees used but not yet billed. The adjusting entry debits the expense and credits a liability such as Wages payable or Interest payable.

Interest is calculated with the simple interest formula: interest equals principal times annual rate times the fraction of the year. Banks and loan agreements specify whether the fraction is counted in months or days and whether a year has 360 or 365 days; in this course, months are used unless a day count is given.

Depreciation

Equipment, vehicles, buildings and other long-lived assets help earn revenue for many years, so their cost is spread over their useful lives. This allocation is called depreciation (for physical assets; the equivalent for intangible assets is amortization). Depreciation is not an attempt to measure the asset's market value; it is a systematic way of matching cost with the periods that benefit. Land is not depreciated because its useful life is not limited.

The depreciation adjustment debits Depreciation expense and credits Accumulated depreciation, a contra asset account. A contra account has a balance opposite to the account it relates to and is reported as a deduction from it. Using a contra account keeps the original cost visible in the Equipment account while accumulating the depreciation recorded to date. Cost less accumulated depreciation is the asset's carrying amount (also called book value or net book value).

# Straight-line versus double-declining-balance depreciation (illustrative)
cost, residual, life = 18000, 0, 5

print("Year  Straight-line  Double-declining  DDB carrying amount")
carrying = cost
rate = 2 / life
for year in range(1, life + 1):
    sl = (cost - residual) / life
    ddb = carrying * rate
    if year == life:                 # final year: take whatever brings it to residual
        ddb = carrying - residual
    carrying -= ddb
    print(f"{year:>4}{sl:>15,.0f}{ddb:>18,.0f}{carrying:>21,.0f}")

Year  Straight-line  Double-declining  DDB carrying amount
   1          3,600             7,200               10,800
   2          3,600             4,320                6,480
   3          3,600             2,592                3,888
   4          3,600             1,555                2,333
   5          3,600             2,333                    0

Both methods depreciate the full $18,000 over five years; they differ only in timing. Double-declining balance records $7,200 in the first year and much less later. Which method to use is an accounting policy choice: standards require the method that best reflects the pattern in which the asset's benefits are consumed. Tax rules are separate.

For income tax, the US uses the Modified Accelerated Cost Recovery System (MACRS), with prescribed recovery periods, plus bonus depreciation and Section 179 expensing that let many businesses deduct equipment costs immediately. A business keeps its book depreciation and its tax depreciation separately; the difference creates the deferred taxes studied in ACCT-212. FIN-201 lesson 8 shows how tax deductions affect project cash flows.

The adjusted trial balance

After all adjustments are journalized and posted, a new trial balance, the adjusted trial balance, is prepared. It contains every balance needed for the financial statements. Here are Birchwood Bikes' six May adjustments together.

# Apply adjusting entries to the unadjusted trial balance (illustrative)
tb = {"Cash": 37800, "Accounts receivable": 1000, "Supplies": 1500,
      "Prepaid insurance": 3600, "Equipment": 18000,
      "Accumulated depreciation": 0, "Accounts payable": 850,
      "Wages payable": 0, "Interest payable": 0, "Note payable": 20000,
      "Share capital": 40000, "Dividends": 500, "Service revenue": 7000,
      "Rent expense": 2000, "Wages expense": 3100, "Utilities expense": 350,
      "Insurance expense": 0, "Supplies expense": 0,
      "Depreciation expense": 0, "Interest expense": 0}
debit_normal = {"Cash", "Accounts receivable", "Supplies", "Prepaid insurance",
                "Equipment", "Dividends", "Rent expense", "Wages expense",
                "Utilities expense", "Insurance expense", "Supplies expense",
                "Depreciation expense", "Interest expense"}
adjustments = [("Insurance expense", "Prepaid insurance", 300),
               ("Supplies expense", "Supplies", 600),
               ("Depreciation expense", "Accumulated depreciation", 300),
               ("Wages expense", "Wages payable", 420),
               ("Interest expense", "Interest payable", 100),
               ("Accounts receivable", "Service revenue", 1200)]

def post(acct, amt, side):
    sign = 1 if (side == "Dr") == (acct in debit_normal) else -1
    tb[acct] += sign * amt

for dr, cr, amt in adjustments:
    post(dr, amt, "Dr"); post(cr, amt, "Cr")

dr_total = sum(v for k, v in tb.items() if k in debit_normal)
cr_total = sum(v for k, v in tb.items() if k not in debit_normal)
for k, v in tb.items():
    side = "Dr" if k in debit_normal else "Cr"
    print(f"{k:<26}{v:>8,} {side}")
print(f"Totals: debits {dr_total:,}  credits {cr_total:,}")

Cash                        37,800 Dr
Accounts receivable          2,200 Dr
Supplies                       900 Dr
Prepaid insurance            3,300 Dr
Equipment                   18,000 Dr
Accumulated depreciation       300 Cr
Accounts payable               850 Cr
Wages payable                  420 Cr
Interest payable               100 Cr
Note payable                20,000 Cr
Share capital               40,000 Cr
Dividends                      500 Dr
Service revenue              8,200 Cr
Rent expense                 2,000 Dr
Wages expense                3,520 Dr
Utilities expense              350 Dr
Insurance expense              300 Dr
Supplies expense               600 Dr
Depreciation expense           300 Dr
Interest expense               100 Dr
Totals: debits 69,870  credits 69,870

The adjusted trial balance totals $69,870 on each side. Compared with the unadjusted trial balance, revenue has risen by $1,200 and expenses by $1,720, so the adjustments reduced May's net income by $520. That is typical for a new business: costs such as depreciation, interest and accrued wages are easy to forget, and without adjustments a business can believe it is more profitable than it is.

Reversing entries

Some businesses make optional reversing entries on the first day of the new period to undo certain accruals. If the 31 May wages accrual is reversed on 1 June (debit Wages payable 420, credit Wages expense 420), the payroll clerk can record the 7 June payroll in the usual way as a $960 debit to Wages expense, and June's expense will still come out right at $540. Reversing entries are a convenience for routine recording; they are not required, and the financial statements are the same with or without them. Accounting software often offers an 'auto-reverse' option for accruals.

Estimates and judgment

Adjusting entries depend on estimates: the useful life and residual value of equipment, the percentage of a job completed, the amount of an unbilled utility bill. Estimates must be reasonable, supported and applied consistently, and when better information arrives they are revised going forward rather than by restating past periods, unless an error was made. Because estimates affect profit, they are another place where pressure to show good results can creep in. Stretching an asset's estimated life from five years to ten halves its annual depreciation and raises reported profit, without any change in the business.