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Information sheet 3.2.

Journal entries

Journalizing Adjusting Entries for Depletion

Plant assets and natural resources are tangible assets used by a company to
produce revenues. On the income statement, depreciation expense is recorded
for plant assets and depletion expense is recorded for natural resources. On
the balance sheet, accumulated depreciation appears with the related plant
asset account and accumulated depletion appears with the related natural
resource account.

Remember, the adjusting entry for depreciation, regardless of the method used
to calculate depreciation was:

Depreciation Expense Debit

Accumulated Depreciation Credit

For natural resources we will use Depletion Expense and Accumulated

Depletion and the units of production method for calculating depletion. The
journal entry to record depletion would be similar to depreciation:

Depletion Expense Debit

Accumulated Depletion Credit

The previous video gave us a demonstration of the accounting process for

depletion but we will review it here.

Computing periodic depletion cost To compute depletion charges, companies

usually use the units-of-production method. They divide total cost by the
estimated number of units—tons, barrels, or board feet—that can be
economically extracted from the property. This calculation provides a per-unit
depletion cost. For example, assume that in 2015 a company paid $ 650,000
for a tract of land containing ore deposits. The company spent $ 100,000 in
exploration costs. The results indicated that approximately 900,000 tons of ore
can be removed economically from the land, after which the land will be
worth $50,000. The company incurred costs of $200,000 to develop the site,
including the cost of running power lines and building roads. Total cost subject
to depletion is the net cost assignable to the natural resource plus the
exploration and development costs. When the property is purchased, a journal
entry assigns the purchase price to the two assets purchased—the natural
resource and the land. The entry would be:

Debit Credit

Land 50,000

Ore Deposits 600,000

Cash 650,000

To record purchase of land and mine.

After the purchase, an entry debits all costs to develop the site (including
exploration) to the natural resource account. The entry would be:

Debit Credit

Ore Deposits ($100,000 + $200,000) 300,000

Cash 300,000

To record costs of exploration and development.

Under the units of production method, we use a 2-step process:

1. Calculate depletion cost per unit (Cost – salvage or residual value) / total
amount expected to be used over its lifetime
2. Calculate depletion expense (units used this period x depletion per unit)

In some instances, companies buy only the right to extract the natural
resource from someone else’s land. When the land is not purchased, its
residual value is irrelevant and should be ignored. If there is an obligation to
restore the land to a usable condition, the firm adds these estimated
restoration costs to the costs to develop the site.

In the example where the land was purchased, the total costs of the mineral
deposits equal the cost of the site ($ 650,000) minus the residual value of land
($ 50,000) plus costs to develop the site ($ 300,000), or a total of $900,000.
The unit (per ton) depletion charge is $ 1 (or $ 900,000 cost /900,000 tons). If
100,000 tons are mined in 2015, this entry records the depletion cost
of $100,000 ($1 depletion per unit X 100,000 tons mined) for the period:

Debit Credit

Depletion Expense 100,000

Accumulated Depletion—Ore

To record depletion for 2015.

Adjusting Entries

Why adjusting entries are needed

In order for a company's financial statements to be complete and to reflect the
accrual method of accounting, adjusting entries must be processed before the
financial statements are issued. Here are three situations that describe why
adjusting entries are needed:

Situation 1
Not all of a company's financial transactions that pertain to an accounting
period will have been processed by the accounting software as of the end of the
accounting period. For example, the bill for the electricity used during
December might not arrive until January 10. (The reason for the 10-day lag is
that the electric utility reads the meters on January 1 in order to compute the
electricity actually used in December. Next the utility has to prepare the bill
and mail it to the company.)
Situation 2
Sometimes a bill is processed during the accounting period, but the amount
represents the expense for one or more future accounting periods. For example,
the bill for the insurance on the company's vehicles might be $6,000 and
covers the six-month period of January 1 through June 30. If the company is
required to pay the $6,000 in advance at the end of December, the expense
needs to be deferred so that $1,000 will appear on each of the monthly income
statements for January through June.
Situation 3
Something similar to Situation 2 occurs when a company purchases equipment
to be used in the business. Let's assume that the equipment is acquired, paid
for, and put into service on May 1. However, the equipment is expected to be
used for ten years. If the cost of the equipment is $120,000 and will have no
salvage value, then each month's income statement needs to report $1,000 for
120 months in order to report depreciation expense under the straight-line
These three situations illustrate why adjusting entries need to be entered in the
accounting software in order to have accurate financial statements.
Unfortunately the accounting software cannot compute the amounts needed for
the adjusting entries. A bookkeeper or accountant must review the situations
and then determine the amounts needed in each adjusting entry.

Steps for Recording Adjusting Entries

Some of the necessary steps for recording adjusting entries are

 You must identify the two or more accounts involved

o One of the accounts will be a balance sheet account
o The other account will be an income statement account
 You must calculate the amounts for the adjusting entries
 You will enter both of the accounts and the adjustment in the general
 You must designate which account will be debited and which will be

Types of Adjusting Entries

We will sort the adjusting entries into five categories.

1. Accrued revenues
Under the accrual method of accounting, a business is to report all of the
revenues (and related receivables) that it has earned during an accounting
period. A business may have earned fees from having provided services to
clients, but the accounting records do not yet contain the revenues or the
receivables. If that is the case, an accrual-type adjusting entry must be made
in order for the financial statements to report the revenues and the related
If a business has earned $5,000 of revenues, but they are not recorded as of
the end of the accounting period, the accrual-type adjusting entry will be as

2. Accrued expenses
Under the accrual method of accounting, the financial statements of a business
must report all of the expenses (and related payables) that it has incurred
during an accounting period. For example, a business needs to report an
expense that has occurred even if a supplier's invoice has not yet been
To illustrate, let's assume that a company utilized a worker from a temporary
personnel agency on December 27. The company expects to receive an invoice
on January 2 and remit payment on January 9. Since the expense and the
payable occurred in December, the company needs to accrue the expense and
liability as of December 31 with the following adjusting entry:

3. Deferred revenues
Under the accrual method of accounting, the amounts received in advance of
being earned must be deferred to a liability account until they are earned.
Let's assume that Servco Company receives $4,000 on December 10 for
services it will provide at a later date. Prior to issuing its December financial
statements, Servco must determine how much of the $4,000 has been earned
as of December 31. The reason is that only the amount that has been earned
can be included in December's revenues. The amount that is not earned as of
December 31 must be reported as a liability on the December 31 balance sheet.

If $3,000 has been earned, the Service Revenues account must include $3,000.
The remaining $1,000 that has not been earned will be deferred to the following
accounting period. The deferral will be evidenced by a credit of $1,000 in a
liability account such as Deferred Revenues or Unearned Revenues.

The adjusting entry for this deferral depends on how the receipt of $4,000 was
recorded on December 10. If the receipt of $4,000 was recorded with a credit to
Service Revenues (and a debit to Cash), the December 31 adjusting entry will

If the entire receipt of $4,000 had been credited to Deferred Revenues on

December 10 (along with a debit to Cash), the adjusting entry on December 31
would be:

4. Deferred expenses
Under the accrual method of accounting, any payments for future expenses
must be deferred to an asset account until the expenses are used up or have
To illustrate, let's assume that a new company pays $6,000 on December 27
for the insurance on its vehicles for the six-month period beginning January 1.
For December 27 through 31, the company should have an asset Prepaid
Insurance or Prepaid Expenses of $6,000.

In each of the months January through June, the company must reduce the
asset account by recording the following adjusting entry:

5. Depreciation expense
Depreciation is associated with fixed assets (or plant assets) that are used in
the business. Examples of fixed assets are buildings, machinery, equipment,
vehicles, furniture, and other constructed assets used in a business and
having a useful life of more than one year. (However, land is not depreciated.)
Depreciation allocates the asset's cost (minus any expected salvage value) to
expense in the accounting periods in which the asset is used. Hence, office
equipment with a useful life of 5 years and no salvage value will mean monthly
depreciation expense of 1/60 of the equipment's cost. A building with a useful
life of 25 years and no salvage value will result in a monthly depreciation
expense of 1/300 of the building's cost.
Closing Entries

Accounting Cycle

1. Analyze 5. Prepare Adjusting 9. Prepare Closing

Transactions Journal Entries Entries

2. Prepare Journal 6. Post Adjusting 10. Post Closing

Entries Journal Entries Entries

7. Prepare Adjusted 11. Prepare Post-

3. Post journal Entries
Trial Balance Closing Trial Balance

4. Prepare Unadjusted 8. Prepare Financial

Trial Balance Statements

Let’s review our accounting cycle again. We have completed the first two
columns and now we have the final column which represents the closing (or
archive) process.

Accounts are two different groups:

 Permanent – balance sheet accounts including assets, liabilities, and

most equity accounts. These account balances roll over into the next
period. So, the ending balance of this period will be the beginning balance
for next period.
 Temporary – revenues, expenses, dividends (or withdrawals)
account. These account balances do not roll over into the next period
after closing. The closing process reduces revenue, expense, and
dividends account balances (temporary accounts) to zero so they are ready
to receive data for the next accounting period.

Accountants may perform the closing process monthly or annually. The

closing entries are the journal entry form of the Statement of Retained
Earnings. The goal is to make the posted balance of the retained earnings
account match what we reported on the statement of retained earnings and
start the next period with a zero balance for all temporary accounts.

Remember how at the beginning of the course we learned that net income is
added to equity. This is the process to make that happen!

The following video summarizes how to prepare closing entries.

In accounting, we often refer to the process of closing as closing the books.
Only revenue, expense, and dividend accounts are closed—not asset, liability,
Common Stock, or Retained Earnings accounts. The four basic steps in the
closing process are:

 Closing the revenue accounts—transferring the credit balances in the

revenue accounts to a clearing account called Income Summary.
 Closing the expense accounts—transferring the debit balances in the
expense accounts to a clearing account called Income Summary.
 Closing the Income Summary account—transferring the balance of the
Income Summary account to the Retained Earnings account.
 Closing the Dividends account—transferring the debit balance of the
Dividends account to the Retained Earnings account.

Let’s review what we know about these accounts:

Increase with Decrease with

Revenue Credit Debit

Expense Debit Credit

Dividends Debit Credit

If we want to make the account balance zero, we will decrease the account. We
use a new temporary closing account called income summary to store the
closing items until we get close income summary into Retained Earnings. To
close means to make the balance zero. We will look at the following
information for MicroTrain from the adjusted trial balance:

Debit Credit

Retained Earnings $ 6,100

Service Revenue 36,500

Interest Revenue 600

Salaries Expense 18,360

Rent Expense 1,200

Utilities Expense 500

Insurance Expense 200

Supplies Expense 7,000

Depreciation Expense 750

Notice how the retained earnings balance is $6,100? On the statement of

retained earnings, we reported the ending balance of retained earnings to be
$15,190. We need to do the closing entries to make them match and zero out
the temporary accounts.

Step 1: Close Revenue accounts

Close means to make the balance zero. We see from the adjusted trial balance
that our revenue accounts have a credit balance. To make them zero we want
to decrease the balance or do the opposite. We will debit the revenue accounts
and credit the Income Summary account. The credit to income summary
should equal the total revenue from the income statement.

Debit Credit

Service Revenue 36,500

Interest Revenue 600

Income Summary 37,100

Step 2: Close Expense accounts

The expense accounts have debit balances so to get rid of their balances we will
do the opposite or credit the accounts. Just like in step 1, we will use Income
Summary as the offset account but this time we will debit income
summary. The total debit to income summary should match total expenses
from the income statement.

Debit Credit

Income Summary 28,010

Salaries Expense 18,360

Rent Expense 1,200

Utilities Expense 500

Insurance Expense 200

Supplies Expense 7,000

Depreciation Expense 750

Step 3: Close Income Summary account

At this point, you have closed the revenue and expense accounts into income
summary. The balance in income summary now represents $37,100 credit –
$28,010 debit or $9,090 credit balance…does that number seem familiar? It
should — income summary should match net income from the income
statement. We want to remove this credit balance by debiting income
summary. What did we do with net income? We added it to retained earnings
in the statement of retained earnings. How do we increase an equity account
in a journal entry? We credit!

Debit Credit

Income Summary (37,100 – 28,010) 9,090

Retained Earnings 9,090

If expenses were greater than revenue, we would have net loss. A net loss
would decrease retained earnings so we would do the opposite in this journal
entry by debiting Retained Earnings and crediting Income Summary.

Step 4: Close Dividends (or withdrawals) account

After we add net income (or subtract net loss) on the statement of retained
earnings, what do we do next? We subtract any dividends to get the ending
retained earnings. This will be the journal entry form of doing this calculation
but be careful because you do not want to use the amount of retained earnings
but DIVIDENDS. We want to decrease retained earnings (debit) and
remove the balance in dividends (credit) for the amount of the
dividends. MicroTrain did not pay dividends this year but the entry would
appear as:
Debit Credit

Retained Earnings Div Amt

Dividends Div Amt

Div Amt means we will use the DIVIDEND amount and not the balance in
retained earnings.

Anytime we complete journal entries, we always need to post to the same ledger
cards or T-accounts we have been using all along. When we post, we do not
change anything from the journal entries — we debit (left side) where we did in
the entries and credit (right side) wherever we did in the entries. The ledger
card for income summary and retained earnings would look like this:
Account: Income Summary Debit Credit Balance

(1) Close Revenues 37,100 37,100

(2) Close Expenses 28,010 9,090

(3) Close Income Summary 9,090 0

Account: Retained Earnings Debit Credit Balance

Beginning Balance 6,100

(3) Close Income Summary 9,090 15,190

(4) Close Dividends 0 15,190

The balance in dividends, revenues and expenses would all be zero leaving only
the permanent accounts for a post closing trial balance. The trial balance
shows the ending balances of all asset, liability and equity accounts
remaining. The main change from an adjusted trial balance is revenues,
expenses, and dividends are all zero and their balances have been rolled into
retained earnings. We do not need to show accounts with zero balances on the
trial balances.

MicroTrain’s post closing trial balance would be:

Debit Credit

Cash 10,000

Accounts Receivable 25,000

Interest Receivable 600

Supplies 1,500

Prepaid Insurance 2,200

Trucks 40,000

Accum. Depreciation-

Accounts Payable 25,000

Unearned Revenue 3,000

Salaries Payable 360

Common Stock 35,000

Retained Earnings 15,190

TOTALS 79,300 79,300

Notice how only the balance in retained earnings has changed and it now
matches what was reported as ending retained earnings in the statement of
retained earnings and the balance sheet.

Self-check 3.2.1

Answer key 3.2.1