Adjusting process illustrated: The adjusting process begins with a review of each account balance on the unadjusted trial balance. If the review process suggests that account balances are unreasonable, those balances are changed to more reasonable balances through the preparation of adjusting journal entries. As an illustration of the adjusting process, information relating to the Guitar Lessons Corporation's December 31 unadjusted trial balance is presented below.
 

Review of supplies: December 31 supplies on hand are $200, not $600.

The Guitar Lessons Corporation's December 31 unadjusted trial balance reports $600 of supplies. This suggests the company's resources on December 31 include supplies of $600. If, as part of the review process, management examines the company's actual supplies on hand and determines that such available supplies cost the company only $200, what does this suggest about the company and the company's unadjusted trial balance data?

If management's review of supplies reveals $200 of supplies on hand, the company should report an asset (resource) of $200 on December 31, not the $600 as shown on its unadjusted trial balance. Remember assets (resources) include things the company owns and can use in the future. Since the company owns only $200 of supplies not $600, it should report only the $200 supplies as an asset on December 31. Thus, the $600 of supplies on the unadjusted trial balance must be changed, or adjusted, to the more reasonable $200.

Since the unadjusted trial balance reported supplies of $600 but management's review revealed only $200, what happened to the other $400 of supplies ($600 - $200)? Usually in business, supplies are purchased to be used in the operation of the business. Thus, since $400 of supplies are gone, it is reasonable to assume that supplies of $400 were used up in management's providing of services to clients. For example, in providing guitar lessons, the Guitar Lessons Corporation may have used up guitar picks and strings, sheet music, as well as paper, pens, and envelopes. When resources, such as supplies, are used up in management's operation of a company, the result is a reduction of resources and an equal reduction of sources of resources. The resource that decreases is supplies and the source of resources that decreases is stockholders' equity. The specific stockholders' equity account affected is supplies expense, as shown below.

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

$15,550

=

$2,150

+

$7,000

+

$6,400

- $400
supplies

=

 

 

 

 

- $400
supplies expense

$15,150

=

$2,150

+

$7,000

+

$6,000

 

Remembering (1) in each journal entry the total dollar amount of debits must equal the total dollar amount of credits and (2) assets increase with debits, how is the December 31 supplies adjusting entry recorded in the general journal?

Since supplies are assets (resources) and assets increase through debits, the $400 decrease in supplies would be recorded as a $400 credit to supplies. The required debit of $400 would be to supplies expense. Supplies expense is debited because management's using up of resources reduced stockholders' equity. Since stockholders' equity increases with credits, it must decrease with debits. If you also remember from previous chapters that expenses increase with debits, you support this debit to supplies expense because supplies expense did increase by $400. Once again, it is important you notice that as expenses get larger through debits, total stockholders' equity gets smaller because stockholders' equity decreases through debits. Since expenses are reductions in stockholders' equity due to management using up some resources, it is logical to record increases in expenses as debits. This event would be recorded in the general journal as follows.

Date

Description

Post.
Ref.

Debits

Credits

Dec. 31

Supplies Expense

511

400

 

 

     Supplies

115

 

400

 

December supplies used

 

 

 

 

As a result of the above entry, the adjusted balance in supplies is $200. This $200 balance represents the $200 of supplies the Guitar Lessons Corporation has on hand on December 31 ($600 unadjusted debit balance - $400 credit in the above adjusting entry). The adjusted balance in supplies expense is $400. This $400 represents the total dollar amount of supplies used up by the company in December.


** You now have the background to do text exercises 4.1 and 4.2.
 

Review of insurance: insurance of $250 has been used up in December.

To protect themselves from such things as fire, theft, customer accidents, and employee errors, companies usually purchase insurance. As a general rule, companies must pay for such insurance protection before it is provided by the insurance companies. If you own a car, you are familiar with this because you probably pay for your auto insurance at least three months in advance.

The Guitar Lessons Corporation's December 31 unadjusted trial balance reports $1,000 of prepaid insurance. This suggests the company's resources on December 31 include insurance protection of $1,000. If, as part of the review process, management examines the company's insurance policies and determines that the $1,000 of insurance protection applies to the months of December, January, February, and March, what does this suggest about the company and the company's unadjusted trial balance data?

The Guitar Lessons Corporation's insurance policies show that it cost the company $250 per month for insurance protection ($1,000 / 4 months = $250 per month). If management's review of the company's insurance policies shows that the protection applies to December, January, February, and March, the company should report a prepaid insurance asset (resource) of only $750 on December 31, not the $1,000 as shown on its unadjusted trial balance. Remember assets (resources) include things the company owns and can use in the future. Since on December 31, the company owns insurance protection for only three months (January, February, and March), it should report only three months' protection as an asset on December 31. Remember, by December 31, December's insurance protection has been used up. Such protection is no longer a resource because it is gone. Thus, the $1,000 of prepaid insurance on the unadjusted trial balance must be changed, or adjusted, to the more reasonable $750.

Since the unadjusted trial balance reported prepaid insurance of $1,000 but management's review revealed only $750, what happened to the other $250 of prepaid insurance ($1,000 - $750). As discussed above, since the insurance protection applied to December, the $250 of insurance protection was used up by December 31. When resources, such as prepaid insurance, are used up in management's operation of a company, the result is a reduction of resources and an equal reduction of sources of resources. The resource that decreases is prepaid insurance and the source of resources that decreases is stockholders' equity. The specific stockholders' equity account affected is insurance expense, as shown below.

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

$15,150

=

$2,150

+

$7,000

+

$6,000

- $250
prepaid insurance

=

 

 

 

 

- $250
insurance expense

$14,900

=

$2,150

+

$7,000

+

$5,750

 

Remembering (1) in each journal entry the total dollar amount of debits must equal the total dollar amount of credits and (2) assets increase with debits, how is the December 31 insurance adjusting entry recorded in the general journal?

Since prepaid insurance is an asset (resource) and assets increase through debits, the $250 decrease in prepaid insurance would be recorded as a $250 credit to prepaid insurance. The required debit of $250 would be to insurance expense. Insurance expense is debited because management's using up of resources reduced stockholders' equity. Since stockholders' equity increases with credits, it must decrease with debits. If you also remember from previous chapters that expenses increase with debits, you support this debit to insurance expense because insurance expense did increase by $250. This event would be recorded in the general journal as follows.

Date

Description

Post.
Ref.

Debits

Credits

Dec. 31

Insurance Expense

521

250

 

 

     Prepaid Insurance

119

 

250

 

December insurance used

 

 

 

 

As a result of the above entry, the adjusted balance in prepaid insurance is $750. This $750 balance represents the $750 insurance protection the company still has available on December 31 ($1,000 unadjusted debit balance - $250 credit in the above adjusting entry). The adjusted balance in insurance expense is $250. This $250 represents the total dollar amount of insurance protection used up by the company in December.


** You now have the background to do text exercises 4.3, 4.4, 4.5, and 4.6.

 

 

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