CHAPTER XXVIII. Adjusting and Closing the Books

ADJUSTING AND CLOSING THE BOOKS

=Adjustment Entries—Kinds and Place of Record.=—In Chapter XV it was shown that the records as they are usually kept do not reflect the true condition of the business at any time during the fiscal period. For this reason before summarizing the book record for the current period it is necessary to bring onto the books a number of entries the purpose of which is to “adjust” the mixed accounts and thus make the ledger reflect the true condition. These adjustments may be effected by entry made directly on the face of the ledger, but it is better to run them through the journal, thus making it possible to give ample explanation. A further advantage of first recording the adjustment entries in the journal is that in this way all such entries appear in one place in the books of account. The ledger should always be kept as a book of secondary entry, with supporting data in some book of original entry.

Seven types of adjustment entries are needed for the ledger of a mercantile concern. They are:

1. Merchandise Inventory 2. Depreciation 3. Bad Debts 4. Accrued Income 5. Deferred Expenses 6. Accrued Expenses 7. Deferred Income

All such items must be given consideration and entered upon the books before the final results for the period can be correctly shown. It is oftentimes necessary to make correcting entries for items the improper entry or the omission of which are not detected until the close of the fiscal period. These errors, whenever discovered, should of course be corrected at once. Because entries of this kind are in the nature of adjusting entries, consideration of them is included in this chapter.

It may be observed here that if a business manager has an intelligent insight into the development of his enterprise, and carefully watches the volume of sales, purchases, and expenses, he may be able to forecast with some degree of accuracy the approximate results for a given period; but only by making the actual count of stock now on hand and by carefully estimating the classes of items just mentioned, can accurate and dependable results be assured.

All these types of adjustment entries are not always found in every such business, however. Each type will be discussed in turn.

=Inventory of Stock-in-Trade.=—One of the most important adjustment entries is that by which the inventory of stock-in-trade is set up separately on the books. By reference to Chapter XIII it will be seen that none of the accounts connected with merchandise, viz., purchases, sales, returns, etc., contain any definite and up-to-date information as to the value of merchandise on hand. To determine the gross profit on sales this value must be known, and until the gross profit is determined the net profit cannot be ascertained. The balance sheet, the statement of profit and loss, and the Profit and Loss account, call for this information. Therefore, before these statements are made, and before the books can be closed, the value of goods on hand must be determined. The process by which this is done is called “inventory-taking.”

Without discussing the detail of a system of inventory-taking, three fundamental principles can be stated relative thereto:

1. Make sure that all goods belonging to the firm on the date of the inventory are included.

2. Make equally sure that there is no duplication of count, i.e., that no goods are counted twice.

3. See that the condition of the goods, viewed from the standpoint of salability, is indicated.

Two factors of importance enter into the determination of the inventory, viz., the quantity of the goods on hand and their value per unit. Inaccuracy in either factor may lead to a gross error in the final amount. By falsifying the count of the goods the inventory can, of course, be inflated. A usual and more elusive method, often resorted to, consists in raising the price per unit, since the addition of even a fraction of a cent per unit may have the effect of converting an actual loss into an apparent profit. Without further indication of the reason for such valuation, it is now generally required that the inventory be valued on the basis of cost, or market if market is lower than cost. The term “cost” should include all costs, incurred up to the point of placing the goods in condition ready for sale, not only the purchase price, but also duties, freight, drayage, insurance during transit, etc.

After the amount of the inventory has been determined, it is placed on the books. However, before this is done it is necessary that the Merchandise Inventory account be cleared of the goods on hand at the beginning of the period by transferring the amount to Purchases. The following journal entry effects the transfer:

Purchases Merchandise Inventory To transfer the opening inventory to Purchases.

The posting of this entry automatically clears the Inventory account and, by its addition to Purchases, causes that account to show the “total goods to be accounted for.” Purchases, as it now stands, contains both the cost of goods which have been sold during the current period and those which are still on hand as shown by the inventory just taken. Accordingly, to separate the two items, the following journal entry is necessary:

Merchandise Inventory Purchases To set up the inventory of goods now on hand.

This entry when posted shows in the Merchandise Inventory account the asset element, and leaves in the Purchases account the cost of the merchandise sold. The effect of these two entries, then, is to adjust the books to true conditions so far as the merchandise is concerned.

=Depreciation, and Loss on Doubtful Accounts.=—As indicated in Chapter XV, the amount of depreciation of particular assets and the losses due to bad and doubtful accounts are carefully estimated at the close of the fiscal period. The individual depreciation items are all summarized in a single depreciation account—an expense account—whose total debit is closed out to Profit and Loss. The depreciation reserves, however, which are credit items, are handled under separate account titles, and constitute the valuation account of the corresponding assets. The journal entry covering depreciation reads as follows:

Depreciation Depreciation Reserve Buildings Depreciation Reserve Furniture and Fixtures Depreciation Reserve Delivery Equipment Depreciation Reserve Machinery

The Reserve for Doubtful Accounts is the valuation account of Accounts and Notes Receivable. Assume, for instance, that the debit balances of the latter two accounts are $15,900, and the credit balance of their valuation account is $600. The difference between these two accounts, viz., $15,300, represents the present estimated value of Accounts and Notes Receivable. The journal entry made periodically to record the estimated loss from uncollectible items is:

Bad Debts Reserve for Doubtful Accounts

When the two entries above, for estimated depreciation and bad debts, are posted, the present appraised values of those particular assets are brought on the ledger; i.e., from the values, as shown by the respective asset accounts, are taken the portions estimated to have been used up, lost through depreciation, or uncollectible. These lost portions are set up as expense items, leaving in the adjusted asset accounts true asset values as existing at the close of the period.

=Accrued Income.=—As to the asset portion of items of this kind, it is indicated in the account in a manner similar to deferred expenses, as explained on page 242. Take the case of interest income earned but not due. The entry for adjusting it is:

Interest Income (Accrued) Interest Income

The credit part is posted immediately, thereby showing an addition to the income already recorded as earned during the current period. The debit part is posted after the current account is adjusted and allowance made for the closing transfer entry to Profit and Loss. The debit part of the adjusting entry is then entered on the debit side of the new portion of the account. Assume this debit item to be $50, and the interest received during the next period to be $170. The new account will indicate a credit balance of $120, which is the amount actually earned during that period, since the previous period took credit for the $50 accrued or earned during that period.

=Deferred Expenses.=—When a part of the expense paid during the current period applies to the next period, the prepaid portion must be taken out of the current expenses and held over—deferred—as a charge to the expenses of the next period. Taking insurance as an example, the following journal entry effects the required adjustment:

Insurance (Deferred) Insurance

In posting this entry, the credit part is posted first in order to take out of the excessive cost shown chargeable to this period the portion equitably belonging to the next period. When this is done, the debit balance of the Insurance account indicates the amount to be charged to the current period and is the correct charge against the Profit and Loss for the period. After making allowance for the space needed for closing the account, the debit side of the above entry is posted, this debit becoming the first charge in the account for the next period. Note that the use of the bracketed “Deferred” is as a guide in posting. It indicates that that portion of the entry is not to be posted until provision has been made for closing the account. After posting is completed, the Insurance account appears as follows:

INSURANCE ==================================== Jan. 2 125.00 | Dec. 31 200.00 Apr. 10 250.00 | Aug. 15 300.00 | ------ | 675.00 | ====== | Jan. 1 200.00 |

There remains, of course, the transfer to Profit and Loss of the current balance before the account is closed. This closing work is treated later in the chapter.

=Accrued Expense Items.=—These items cover expenses which the business has incurred but has not yet paid, and which are properly chargeable to this period but have not yet been charged on the books. For instance, salaries earned up to the close of the period but not paid at its close constitute an additional charge to the period’s operations which must be entered on the books before they will show true conditions. This amount also constitutes a liability of the business. Accordingly, the journal entry is:

Salaries Salaries (Accrued)

thus charging the Salaries account with the amount due but not paid, and bringing this amount down as a credit balance to the new account for the next period. Assuming this unpaid amount to be $72, the account after closing will show this $72 as a liability on the closing date. Its effect, however, during the next period will be to reduce the amount charged to salaries during that period, because this $72, although paid during that period, has already been charged to the previous period.

The credit to Salaries, therefore, serves two purposes, viz., that of showing the outstanding liability at the close of the current period, and that of effecting a reduction of what would be, without this credit, an overcharge to next period’s salaries. For example, if the total salary paid during the next period is $600, the balance of $528 is the amount applicable to that period, although the amount actually paid is $600.

=Deferred Income.=—Income received by the business during the present period which, however, belongs to the subsequent period is called “deferred income,” as for instance, rent received in advance from a tenant. As to the liability portion of items of this kind, it is indicated in a manner similar to the accrued expense items. In this case the journal entry is:

Rent Income Rent Income (Deferred)

the effect being to decrease the amount of rent income for the current period and to show the portion belonging to the next period deferred to that period’s account.

=Corrections.=—When an error has been made in any entry on the books, it should not be erased or scratched out, because by so doing suspicion may be raised as to what was expunged. The wrong item should be ruled out and the correct item written above it or wherever it belongs. This applies particularly to books of original entry whose use as evidence has often been destroyed because many erasures appeared in them.

Another way of making a correction, when an amount has been posted to a wrong account, is first to cancel the wrong posting through a similar entry on the other side of the same account, and then to post it to the correct account. Cross-reference to the two accounts must be made.

When an amount has been posted to the wrong side of the correct account, e.g., $100 to the credit side of John Doe’s account, when it should have been posted to the debit side, the incorrect credit may be canceled by a debit of $100, and after this the original $100 should be entered on the debit side; or the cancellation and correction may be combined by entering $200 on the debit side. Better still, the incorrect posting may be ruled out and a correct posting made of the original entry whose wrong posting caused the error. Adequate cross-reference should be given so as to make the tracing of the items easy and to indicate exactly what was done.

As these entries are of a somewhat unusual nature, their exact purpose should be plainly indicated in the explanation columns. According to the methods mentioned above, the various correcting entries are made directly on the face of the ledger. It is often preferable, however, first to make the required correction entries in the journal with full explanation, and then to post them to the ledger.

=Adjusting Entries Illustrated.=—In order to indicate clearly the routine and method to be followed in summarizing the books at the close of the fiscal period, the formal adjusting and closing journal entries needed for the books of U. R. Smart will now be set up, the illustrative data being the same as were used for the work sheet in