Study: Identify Accounts Needing Adjustments
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Slides 1-3 (1m:16s)
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Slide 1
Welcome to Introduction to Accounting Preparing for a User’s Perspective. Identify accounts needing adjustments.
Slide 2
You’ve already learned about the full accounting cycle in prior videos. In the prior videos we went through this first row here, where we went and identified the original transactions, and prepared the pre-adjusted trial balance. Now the question is here what we have to do to this pre-adjusted trial balance to adjust it so that we can then prepare our financial statements. We are sitting right here on the identification process of identifying accounts needing adjustment.
Slide 3
This is another way of looking at that same cycle. We’ve already gone through this cycle once with the original transactions. Now we are going to go through with round two where we are going to go through those same steps but dealing with adjusting entries. We’ll need to identify the accounts needing adjustment. Once we identify them: we will analyze them, record them, post them to the ledgers, and prepare an adjusted trial balance which we’ll use to prepare the financial statements.
Slide 4 (1m:38s)
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Slide 4
How do companies identify what needs to be adjusted? Companies have their own various systems but in general you’ll see the following approaches:
- they create a checklist of common adjusting entries which enables them to remember to accrue interest on notes payable, adjust prepaid expenses for the portion used up, count inventory and make appropriate adjustments, estimate the realizable value of their accounts receivable, etc. So there’s a big long checklist, they work through that list so that they won’t forget to adjust an account because if you forget to adjust an account that account and a related account will be over or under stated thus misstating the financial statements as a whole.
- they can also program the adjusting entries into their computer system. For example: when they prepay for 6 months of insurance, they can program the computer to expense 1/6th of that prepaid insurance (which is an asset) to the insurance expense account every month so that by the end of the 6 month period the prepaid insurance expense is $0 and they will have recognized 6 months of insurance expense. That’s the easy way. If you can program your adjusting entries into your computer that will make the adjusting entry problems quite pleasant, but not all are that straight forward so there will be additional work that needs to be done to properly adjust the accounts.
- they review the pre-adjusted trial balance in detail looking for additional accounts requiring adjustment. That’s what we’re going to focus on in this particular video, is the thought processes that you would go through as you review the pre-adjusted trial balance.
Slide 5-22 (4m:48s)
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Slide 5
Here’s the pre-adjusted trial balance that we created in the first round of the full accounting cycle as we recorded the original transactions. In this second phase, when we deal with adjusting entries, we will review this pre-adjusted trial balance and its account balances to determine which of these accounts will be need to be adjusted to comply with the accrual accounting. (i.e. revenue recognition and matching principle).
As we review these accounts we may discover that some of these accounts are overstated and need to be decreased. Some accounts may be understated and need to be increased. In addition, some adjustments may result in accounts being added to the list because their pre-adjusted balance was zero. For example, you don’t see any interest expense here, but since you have a note payable the adjusting entry to accrue interest expense will result in an interest payable and an interest expense account, which currently isn’t on the list, that may result in some accounts being added. What we are now going to do is go through each of these accounts one-by-one and talk about the potential processes for coming up with the proper adjusted entries.
Slide 6
Cash
Perform a bank reconciliation. By performing a bank reconciliation you’ll be able to identify unrecorded interest income, unrecorded deposits, bank errors (which could increase or decrease the account balance), company errors that we’ve made on our own accounts that we need to adjust to increase or decrease our cash, unrecorded interest expense, unrecorded bank service charges, unrecorded NSF (that’s non-sufficient funds, that’s a bounced-check) and fees, and unrecorded check printing fees. By going through the bank reconciliation we could properly adjust the cash count and some of these other accounts will also be adjusted because, as you recall, any journal entry will have a debit side and a credit side.
Slide 7
Marketable equity securities
To adjust marketable equity securities one thing you might do is obtain the current market values of marketable equity securities to identify unrealized gains or unrealized losses. This is one situation where you can actually write up the value of this asset, and if the value has gone down you would have to write it down, and record a related unrealized gain or loss.
Slide 8
Accounts receivable
You need to estimate the collectability of the accounts receivable to identify necessary adjustments related to uncollectible accounts. So although people said they promised to pay you a thousand $ what if you think that you will only collect $800 so you’d only have to create an allowance for $200 to write this [$1,000 account receivable] down to only $800.
Slide 9
Financial goods inventory
You will need to evaluate and count the company’s inventory to identify:
- unrecorded sales
- unrecorded theft
- unrecorded damage
- errors (either in the cost or in the units)
- obsolescence because maybe the value has dropped (in US GAAAP inventory is accounted for at the lower cost of market which we will discuss in a later accounting course if you choose to major in accounting)
- misapplication of manufacturing costs (if this were a manufacturer all the overhead costs of creating inventory would need to be applied properly to the inventory), and unrecorded purchases on account.
Slide 10
Prepaid insurance
You would need to compute the amount of prepaid insurance that has been used up and expense it accordingly and review amounts expensed and verify down below that we didn’t expense TOO much thus requiring an adjusting entry to increase prepaid expenses and decrease the expense.
Slide 11
Equipment and building
Determine the amount of depreciation that should be recognized on the equipment and on the building. So that part of this can be effectively expensed so that you’d have a depreciation expense down below. Determine whether the equipment or building has been permanently impaired and needs to be written down.
Slide 12
Accounts payable
Determine whether: any accrued expenses need to be recognized, any unrecorded inventory purchases need to be recorded.
Slide 13
Commissions payable
Determine whether any sales have been recognized for which the commission has not yet been recognized.
Slide 14
Utilities payable
Determine whether any utilities have been received and not yet been recognized.
Slide 15
Notes payable
Determine the amount of interest that should have been accrued and adjust accordingly.
Slide 16
Capital stock
Ensure all issued and outstanding stock has been properly accounted for.
Slide 17
Dividends
Ensure all dividend declarations have been accounted for.
Slide 18
Sales Revenues
Review long-term contracts, agreements, shipping documents to ensure all revenues that should have been recognized are recognized.
Slide 19
Costs of goods sold
Update COGS for what was learned during the review of inventory as well as during review of sales revenue.
Slide 20
Commission expense
Verify that all commission expense has been recorded based on adjusted sales revenues.
Slide 21
Utilities expense
Verify that all utilities expense has been recorded up to period-end.
Slide 22
Slides 23-24 (1m:08s)
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Slide 23
Summary
- The pre-adjusted trial balance is almost ALWAYS wrong because the proper adjusting entries have not been recorded yet.
- Adjusting entries are needed to ensure revenues and expenses are recorded in the correct accounting period at the correct amounts per accrual accounting.
- Some adjustments are needed because NOTHING has been recorded yet.
- Other adjustments are needed because something was recorded BUT the related revenues or expenses were not recorded in the correct accounting period.
- Adjusting entries related to accruals and deferrals will affect a balance sheet account and an income statement account.
- Some adjusting entries, such as a purchase of inventory on account, may only affect the balance sheet.
- Wise management uses an organized “adjusting entry process” to ensure they IDENTIFY all accounts needing adjustment.
Slide 24
Hopefully this video has helped you understand the process that companies go through to identify accounts needing adjustments. We will now move on to how we analyze that information and record the appropriate adjusting journal entries. Good luck on the quiz.