Chapter 4: Adjusting Entries

In this chapter you will see how accounting systems assure that the data reported in financial statements reflect actual business operations and resources. The process that results in reasonable dollar amounts being reported in financial statements is the adjusting process.

Steps in the accounting process (so far): the material in the first three chapters presented the following four steps in the accounting process.

1. Organize data by using a chart of accounts and a general ledger.

2. Analyze transactions and prepare journal entries.

3. Post journal entries to the general ledger.

4. Prepare a trial balance to verify that the total dollar amount of debits equals the total dollar amount of credits in the general ledger. Once the general ledger debits equal the general ledger credits, the financial statements can be prepared from the trial balance data. The resulting financial statements will tie together. Net income from the income statement will tie to the statement of retained earnings. The ending retained earnings balance from the statement of retained earnings will tie to the balance sheet. The balance sheet will balance: assets will equal liabilities plus stockholders' equity.

Needed: a process to guarantee that the dollar amounts reported on the financial statements are reasonable. Although the debits equals credits rule guarantees that the accounting equation will always be in balance, it does not guarantee that the information in the accounting system is reasonable. The process that guarantees that accounting information is reasonable requires that each account's balance be reviewed prior to the preparation of financial statements. If the review process suggests account balances are unreasonable, those balances should be changed to more reasonable balances through the preparation of adjusting journal entries. This process is called the adjusting process.

Below is the Guitar Lesson Corporation's December 31 trial balance prepared from the company's general ledger. Note that the trial balance heading includes the word "unadjusted." This means the data in the trial balance have not been reviewed for reasonableness, but resulted from normal, everyday transactions similar to those presented in previous chapters.

Guitar Lessons Corporation Unadjusted Trial Balance December 31
Acct. No.	Account	Debits	Credits
111	Cash	$9,750
112	Notes Receivable	3,000
113	Accounts Receivable	1,200
115	Supplies	600
119	Prepaid Insurance	1,000
211	Accounts Payable		$1,350
213	Unearned Fees Revenue		800
311	Common Stock		7,000
313	Retained Earnings		4,250
315	Dividends	150
411	Fees Revenue		3,200
517	Wages Expense	900
	Totals	$16,600	$16,600

Based on the above trial balance:

Net income = $2,300 ($3,200 fees revenue - $900 wages expense)

Retained Earnings = $6,400 ($4,250 retained earnings on December 1 + $2,300 net income - 150 dividends)

Assets = $15,550 ( cash + notes receivable + accounts receivable + supplies + prepaid insurance)

Liabilities = $2,150 (accounts payable + unearned fees revenue)

Stockholders' Equity = $13,400 ($7,000 common stock + $6,400 retained earnings)

Notice that since the Guitar Lessons Corporation's trial balance total debits equals its total credits, the accounting equation balances: assets ($15,550) = liabilities ($2,150) + stockholders' equity ($13,400).

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