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121 Adjusting and Closing Entries Number of weeks Work days per week Number of employees Rate per day 2 5 3 200 Total payroll 6,000 It doesn’t matter that the payroll on January 8 crosses years. The employees expect two weeks’ worth of wages. Separating the payroll between the two years (2002 and 2003) is a job for the accountant making the adjusting entries. When the company pays the payroll on January 8, the entry is: 01/08/03 Salaries payable Payroll expense Cash To record payroll 5,400 600 6,000 Only $600 is shown as expense in 2003, which is correct, since the employees worked only one day in 2003 that is included in the payroll of January 8 (the one day of work in this payroll that falls in 2003 is January 1). Reversing Entries Reversing entries are an efficient way to make sure that entries that cross periods are always correctly handled. Throughout the year, the company will make the same entry for payroll 25 times: XX/XX/XX Payroll expense Cash To record payroll 6,000 6,000 122 Accounting Demystified However, look at the entry we made on January 8. The first payroll of the year is the one time that the usual entry is not made. Someone in the accounting department has to remember to make the entry a little differently. Reversing entries are a quick and simple way to allow the company to make the usual entry 26 times (meaning every time) and still get the payroll expense into the correct periods. The reversing entry is the exact opposite of the accrual entry, and it is made on the first day of the next period. The accrual entry made on December 31 was: 12/31/02 Payroll expense Salaries payable 5,400 5,400 To record accrued payroll The reversing entry on January 1 (the first day of the next period) is: 01/01/03 Salaries payable Payroll expense 5,400 5,400 To reverse accrual entry for payroll After the entry on January 1 is made, Salaries payable is wiped out (the credit of $5,400 is offset by a debit of $5,400), and the Payroll expense account has a credit balance of $5,400. When the standard entry is made on January 8, a debit of $6,000 will be made to the Payroll expense account. The debit of $6,000 and the credit of $5,400 produce a debit balance of $600 in the Payroll expense account, exactly the amount that should show as expense after the first payroll of 2003. 123 Adjusting and Closing Entries Interest Expense Interest expense is the cost associated with the use of borrowed money. There may not be a bill received at the end of an accounting period that indicates how much interest expense was incurred during that accounting period. The company will have to compute this amount itself. The general way to compute interest expense is to take the amount of the loan (called the principal), multiply it by the interest rate, and then prorate the result for the portion of the year that the amount is outstanding. For example, if a company borrowed $100,000 on July 1 for the term of one year and pays interest at the rate of 10 percent (interest rates are annual amounts unless stated otherwise), how much interest should be accrued at the Balance Sheet date (December 31)? Principal 100,000 Interest rate 10% Prorate for time outstanding 50% Interest to be accrued 5,000 The entry to record the accrued interest is: 12/31/02 Interest expense Accrued interest payable 5,000 5,000 To record accrued interest At such time as the interest is paid, the payable is debited and Cash is credited. If the loan matures on June 30, 2003, the entry to record the payment is: 124 Accounting Demystified 06/30/03 Loan payable Accrued interest payable 100,000 5,000 Interest expense Cash To record loan repayment 5,000 110,000 A B C A. Recorded when we made the initial entry for the loan: 07/01/02 Cash Loan payable To record loan proceeds 100,000 100,000 B. From the 12/31/02 entry to accrue interest expense C. Interest for the period 1/01/03 through 6/30/03 Unearned Revenue There are times when a customer will prepay for goods or services. In our everyday lives, we do this often—we pay annually for a magazine subscription, for instance. The company cannot record the money as revenue when it is received, since the company still has to provide the goods or services. If a customer prepaid for services in the amount of $10,000, the entry to record the receipt of the money is: XX/XX/XX Cash 10,000 Unearned revenue 10,000 To record receipt of unearned revenue At the end of the period, the company has to determine whether any of these goods or services have been provided. If 125 Adjusting and Closing Entries this is a magazine company and the unearned revenue is for subscriptions, the company will count how many issues were sent and make an adjusting entry to remove this amount from Unearned revenue (and move it to Revenue). So, continuing with our example, assume that at year-end the company determines that 40 percent of the prepaid services have been provided. The adjusting entry would be: 12/31/02 Unearned revenue Revenue To record revenue earned 4,000 4,000 Prepaid Expenses At the end of each period, the company needs to review each item that was recorded as a prepaid expense to determine whether any of this expense has been used up. If so, the company should debit the expense and credit the prepaid expense for the portion used up. The balance remaining in Prepaid expense should represent the amount of expense left to be used. Closing Entry After the financial statements have been prepared, the last step in the accounting process is to close the books. This is done with the use of the closing entry. The closing entry takes all the income and expense accounts and makes their balance zero (0). The income and expense accounts are known as temporary accounts, since the balance is reset to zero each year. Balance sheet accounts are known as permanent accounts, since their balances carry over from year to year. 126 Accounting Demystified The temporary accounts are those accounts that are contained on the Income Statement and the Dividend account from the Statement of Retained Earnings. These statements cover a period of time, so the accounts have to be reset to zero so that the next period’s transactions can be entered without commingling the transactions for the two periods. The process of making the closing entry is extremely simple: You debit all the accounts with credit balances and credit all the accounts with debit balances. Any amount necessary to balance the entry will be put to Retained earnings. Figure 18-1 gives the Income Statement from Chapter 2. The entry to close the accounts would be: FIGURE 18-1 Jeffry Haber Company Income Statement For the Year Ended December 31, 2002 Revenues: Sales Interest income $250,000 500 Total revenue $250,500 Expenses: Payroll Payroll taxes Rent Telephone Office supplies $125,000 20,000 10,000 7,000 3,000 Total expenses $165,000 Net income $ 85,500 127 Adjusting and Closing Entries 12/31/02 Sales Interest income Payroll Payroll taxes Rent Telephone Office supplies Retained earnings To close the accounts 250,000 500 125,000 20,000 10,000 7,000 3,000 85,500 Notice that the amount of the credit to Retained earnings is the same as the net income for the year. The net income was brought to the Statement of Retained Earnings as an increase to the beginning balance. Figure 18-2 shows the Statement of Retained Earnings from Chapter 2. The entry to close the Dividends account is: 12/31/02 Retained earnings 35,500 Dividends 35,500 To close the Dividends account FIGURE 18-2 Jeffry Haber Company Income Statement For the Year Ended December 31, 2002 Beginning balance, January 1, 2002 $100,000 Add: Net income 85,500 Less: Dividends 35,500 Ending balance, December 31, 2002 $150,000 128 Accounting Demystified The beginning balance in the general ledger for Retained earnings was $100,000. During the year, no entries have been made to the Retained earnings account. The financial statements indicate that the balance in Retained earnings should be $150,000 (see both the Statement of Retained Earnings and the Balance Sheet). The closing entries get the Retained earnings account to the correct ending balance of $150,000. In the closing entry for income and expense, we increase Retained earnings by $85,500, and in the entry to close the Dividends account, we reduce Retained earnings by $35,500. The ending balance is $150,000: Beginning balance Closing entries: Increase Decrease Ending balance $100,000 85,500 35,500 $150,000 The closing entries make the income, expense, and Dividends accounts go to zero and simultaneously get the Retained earnings account balance to the amount shown as the ending balance on both the Statement of Retained Earnings and the Balance Sheet. C H A P T E R 19 Specialized Journals In order to make the operation of the accounting department flow smoothly and efficiently, specialized journals are used. The purpose of the specialized journals is to allow for segregation of duties (so that different people in the department are assigned tasks that do not overlap), to keep details out of the general ledger, and to permit employees to work simultaneously. Segregation of duties is a key ingredient in the internal control design of an accounting department. Think of a fastfood restaurant—if a bunch of employees are all using the same cash register, can the supervisor blame anyone in particular if the register comes out short? Probably not. That is why it is a good internal control to have one employee responsible for the register—if anything goes wrong with it, management knows whom to hold responsible. Segregation of duties in an accounting department is based on the same idea. When duties are segregated, each person is responsible for a specific 129 130 Accounting Demystified task. One person might be responsible for recording the transactions in the Cash account, while someone else actually receives the money for deposit, and yet a third person is responsible for the checks that will come out of the account. Management assigns tasks in such a way that no one employee has access to both the records of an asset and the physical asset. The balance of every account is maintained in the general ledger. In order to streamline the general ledger and keep it easy to use, it is common to put in less detail and make fewer entries that will clutter it up. It would not be unusual for there to be one monthly posting from each specialized journal to the general ledger. As an example, one of the specialized journals is the sales journal. All of the sales for the month will be listed in the sales journal. The totals from the journal are what will be posted to the general ledger. There might be 100,000 entries in the monthly sales journal, but there will just be one monthly entry in the general ledger. Each company has only one general ledger. If there were no subsidiary journals, then only one person could work with the general ledger at a time. Having specialized journals allows employees to work simultaneously. Cash Receipts Journal The cash receipts journal is used to record the receipt of money (checks and cash) for deposit to the Cash (checking) account. Any item that will result in a debit to the Cash account can be put in the cash receipts journal. The columns generally utilized will include Date, Name/Description, Check Number, Amount, Accounts Receivable (for companies that sell on credit), Sales, and Other.