# Adjusting entries

> Five entries nobody sends an invoice for, made on the last day of the month, that turn a record of transactions into a set of accounts.

Source: https://lopifi.com/learn/adjusting-entries
Part of: Lopifi — US GAAP books on autopilot, checked by a CPA (https://lopifi.com)

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**What are adjusting entries and why are they needed at month end?** Five entries nobody sends an invoice for, made on the last day of the month, that turn a record of transactions into a set of accounts.

By 30 September every transaction is recorded, and the books are still wrong. Five things happened during the month that no document announced: a month of the insurance was used up, a month of the van's life was used up, the power was consumed but never billed, Northwind's own payroll taxes fell due on the wages it paid, and some of what customers owe is not going to arrive. [Adjusting entries](https://lopifi.com/md/glossary/adjusting-entry) record all five.

*[The accounting cycle, at: adjust]*

They come in two flavours, and the words are worth getting right because the whole close is organised around them. A [Deferral](https://lopifi.com/md/glossary/deferral) is cash that moved before the value did — the insurance, the customer's deposit. An [Accrual](https://lopifi.com/md/glossary/accrual) is value that moved before the cash — the unbilled power.

| Kind | What moved first | Northwind | The month-end entry |
| --- | --- | --- | --- |
| [[prepaid-expense|Prepaid expense]] — a deferral | Cash out | JE-3, the insurance | Debit expense, credit the prepaid asset, for what was used (AJE-1) |
| [[deferred-revenue|Deferred revenue]] — a deferral | Cash in | JE-12, the deposit | Nothing yet — debit deferred revenue, credit revenue when October's delivery is made |
| [[accrued-liability|Accrued expense]] — an accrual | Value consumed | AJE-3, the power; AJE-4, the employer's payroll taxes | Debit expense, credit a liability — accrued liabilities, or payroll liabilities for the tax |
| [[accrued-revenue|Accrued revenue]] — an accrual | Value delivered | None in September | Debit an [[unbilled-receivable|unbilled receivable]], credit revenue — what lesson 8's hypothetical (goods delivered on the 29th, invoiced in October) would need; Northwind's actual September book has none |

The four kinds of timing gap, and where Northwind meets each one.

Depreciation sits beside them as the third kind of adjustment, an *allocation*: cash moved long ago, and the cost is spread over the periods the asset serves. And one of September's adjustments is a fourth kind, an *estimate*: nothing has happened yet, and the books still have to say what is expected to.

*[Journal entries: AJE-1, AJE-2, AJE-3, AJE-4, AJE-5]*

September's five adjustments. No cash moves in any of them.

## Every adjustment needs a schedule behind it

$600 is not a judgment call — it is $7,200 ÷ 12, and the schedule that produces it is the [Evidence](https://lopifi.com/md/glossary/evidence) for the entry. The same for the van: $24,000 over 48 months. A schedule has one non-negotiable property, which is that it sums back to the amount it is spreading, to the cent. A schedule that misses by three cents is a journal that will not post in its final month.

*[Interactive figure: prepaid expense]*

The van's schedule rests on three choices, and each is a policy someone has to own: a [useful life](https://lopifi.com/md/glossary/useful-life) of 48 months, a [salvage value](https://lopifi.com/md/glossary/salvage-value) of zero, and the straight-line method with a full month charged in the month it went into service. Change any of them and the monthly charge changes; the van does not. After September its [net book value](https://lopifi.com/md/glossary/net-book-value) is $23,500.

It is worth being precise about what the van's $500 a month *is*. It is not an estimate of how much value the van lost in September, and a schedule is not a valuation. GAAP says so in as many words.

> “Depreciation accounting is a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation, not of valuation.”

© Financial Accounting Foundation. All rights reserved.

— [ASC 360-10-35-4](https://asc.fasb.org/360/tableOfContent), Depreciation allocates cost; it does not measure value

**Exercise — Write the two schedules September needs.** The van cost $24,000 and will serve 48 months, with nothing left at the end. The insurance cost $7,200 and covers 12 months. Each needs a schedule before it can become an adjusting entry — and each schedule has to sum back to what was paid, to the cent. Type it in the workbook at https://lopifi.com/playground.

> **What happens when the power bill arrives.** In October the utility bills, say, a little more than $450. Many teams post a [reversing entry](https://lopifi.com/md/glossary/reversing-entry) on 1 October that cancels AJE-3, then book the real bill as normal; the difference lands in October as a small [True-up](https://lopifi.com/md/glossary/true-up). Either way September keeps the estimate it made in good faith — an accrual is not wrong because the bill differed by a few dollars.

## The employer's share of payroll

AJE-4 finishes lesson 5's payroll. The $1,692.60 withheld was the employees' money. Northwind's *own* share of Social Security and Medicare, $642.60, is a cost of employing them, on top of the gross wage. Nobody bills it — it is worked out from the payroll register and deposited with the withholding in October — so it is accrued at month end: payroll tax expense, against the same [payroll liabilities](https://lopifi.com/md/glossary/payroll-liabilities) account. Payroll tax is not [income tax](https://lopifi.com/md/glossary/income-tax-expense): it is owed on wages whether the company makes a profit or not.

## An estimate: the allowance for credit losses

AJE-5 is a different kind of adjustment. Nothing timed out and nothing was consumed: Northwind looked at the $8,000 its customers owe and expects 2% of it — $160 — never to arrive. Nothing is overdue, and the estimate is still required: under the [current expected credit loss](https://lopifi.com/md/glossary/cecl) model, a receivable carries an allowance for the losses expected over its whole life from the day it is booked, not only for losses that have already happened. The debit is [bad debt expense](https://lopifi.com/md/glossary/bad-debt-expense). The credit goes to [1290 Allowance for credit losses](https://lopifi.com/md/glossary/allowance-for-credit-losses) — a contra asset older books call the allowance for doubtful accounts — and not to the receivable, because no customer has defaulted. The balance sheet shows $8,000 owed, less $160 expected to be lost: $7,840 expected to be collected.

> “The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset(s) to present the net amount expected to be collected on the financial asset. At the reporting date, an entity shall record an allowance for credit losses on financial assets within the scope of this Subtopic. An entity shall report in net income (as a credit loss expense) the amount necessary to adjust the allowance for credit losses for management’s current estimate of expected credit losses on financial asset(s).”

© Financial Accounting Foundation. All rights reserved.

— [ASC 326-20-30-1](https://asc.fasb.org/326/tableOfContent), The allowance presents receivables at the amount expected to be collected

When a particular invoice does go bad — the customer goes under in November, say — it is [written off](https://lopifi.com/md/glossary/write-off) against the allowance: debit the allowance, credit the receivable. Both lines of that entry are on the balance sheet, so the write-off has no effect on profit; the expense was taken when the loss was expected. The next month-end estimate then tops the allowance back up to what the remaining receivables need, and only the top-up is expense.

**Wrong:** Dr 6600 Bad debt expense
   Cr 1200 Accounts receivable
Booked the day the customer goes under.

**Right:** Dr 1290 Allowance for credit losses
   Cr 1200 Accounts receivable
The expense was taken in the estimate.

Writing a bad invoice straight off to expense — the direct write-off method — charges the loss to the month the customer failed rather than the month the sale was made, and leaves the receivables overstated until then. It is not GAAP where expected losses are material.

## The adjusted trial balance

Post the five and prove the books again. Eight accounts exist now that did not exist an hour ago — and this is the version the statements are built from.

*[Adjusted trial balance]*

Northwind at 30 September, adjusted. Twenty-four accounts, still tying, now accrual-complete.

> **Adjusting entries never touch cash. If your adjusting entry has a bank account in it, it is not an adjusting entry — it is a transaction you forgot to record.**

**Check yourself.** If Northwind skipped the adjusting entries, what net income would September report?

- $1,747.40 — That is the adjusted figure. Without the five entries, five expenses are missing from it.

- $4,100 — Profit overstated by $2,352.60: a month of insurance, a month of the van, the power, the employer's payroll taxes and the expected credit losses, none of which any invoice mentioned. That is what skipping the adjustments does to a P&L.

- $605.20 — Wrong direction. Every adjustment this month is an expense, so leaving them out makes profit higher, not lower.

- **Lesson:** 9 of 13 — 15 min
- **Terms taught:** [Adjusting entry](https://lopifi.com/md/glossary/adjusting-entry), [Accrual](https://lopifi.com/md/glossary/accrual), [Deferral](https://lopifi.com/md/glossary/deferral), [Prepaid expense](https://lopifi.com/md/glossary/prepaid-expense), [Deferred revenue](https://lopifi.com/md/glossary/deferred-revenue), [Accrued liability](https://lopifi.com/md/glossary/accrued-liability), [Depreciation](https://lopifi.com/md/glossary/depreciation), [Amortization](https://lopifi.com/md/glossary/amortization), [Useful life](https://lopifi.com/md/glossary/useful-life), [Salvage value](https://lopifi.com/md/glossary/salvage-value), [Net book value](https://lopifi.com/md/glossary/net-book-value), [Reversing entry](https://lopifi.com/md/glossary/reversing-entry), [Roll-forward](https://lopifi.com/md/glossary/roll-forward), [Accrued revenue](https://lopifi.com/md/glossary/accrued-revenue), [Payroll liabilities](https://lopifi.com/md/glossary/payroll-liabilities), [Allowance for credit losses](https://lopifi.com/md/glossary/allowance-for-credit-losses), [Bad debt expense](https://lopifi.com/md/glossary/bad-debt-expense), [CECL](https://lopifi.com/md/glossary/cecl), [Write-off](https://lopifi.com/md/glossary/write-off)
- **Previous:** [Cash, accrual and cut-off](https://lopifi.com/md/learn/cash-versus-accrual)
- **Next:** [The income statement](https://lopifi.com/md/learn/the-income-statement)
- **The course:** https://lopifi.com/learn