Question

• What is an adjusting entry?
  • Why do we do adjustments?
  • Give an example of an adjusting entry.
• Can you explain the steps in the closing process?

Answer 1

Adjusting entries are prepared at the end of period before preparing the financial statements in order to have correct balances.

Adjustments are required to do at the end of the period in order to adjust the accounts which has accrual impact.

For example, rent for the 1 year with amount of $15,000 is paid at the beginning of the year and at that time, the prepaid rent account is debited with $15,000 and cash account is credited. At the end of the first month, the company is preparing the monthly financial statements. By reaching the end of the first month, the rent expense for the first month gets accrued or expires so the rent expense should be created so in order to do that, the adjusting entry should be prepared so the adjusting entry includes the rent expense account with amount $1,250 ($15,000/12 months) is debited and Prepaid rent with the same amount credited in order to decrease the account.

So in the financial statements, the rent expense with $1,250 is shown in the monthly income statement and prepaid rent with balance of $13,750 ($15,000 - $1,250) is shown on the currents assets side of the balance sheet.

Therefore, without preparing the adjusting entries, the account balances can not be adjusted and the accounts with wrong balances will be used to prepare the financial statements.

Therefore, adjusting entries are very important to have correct balances in the accounts.

Steps in the Closing Process:

Step 1 - Income Summary account is created by crediting from the balance of all the revenue accounts like sales revenue, service revenue, rent revenue etc., for this, all such revenue accounts are debited in order to close all revenue accounts.

Step 2 - All the expense accounts like salaries expense account, rent expense account etc. are credited in order to close all expense accounts and the total of such expenses account is debited to Income Summary account.

Step 3 - The balance in the income summary account (all revenues less expenses) is transferred to Retained Earnings account by crediting the Retained earnings account (if the result is profit) and the income summary account is debited and if it is a loss then Retained earnings account is debited and income summary account is credited.

Step 4 - If there any dividends expenses then such dividend expenses will be credited and retained earnings will be debited in order to close the dividends expense.

Step 5 - The final balance in the retained earnings account is shown under the stockholders' equity section in the balance sheet in order to transfer to next year or next period.