Why Current Records of the Ledger Need Adjustment.—At the end of the fiscal period the ledger does not present a true record of financial condition. The fixed assets of the business are constantly depreciating in value; merchandise tends to become out of date, shopworn, stale, or soiled; some merchandise has been sold, while some is still on hand; some of the accounts receivable may prove uncollectible, and some of the notes receivable may be dishonored. Also, at the end of the period liabilities such as taxes, salaries, rent, and the like may have been incurred, but because there is no creditor’s invoice or other business paper as evidence of such liability they are not usually entered on the books until payment is made.

Again, it may be that the services paid for during this period, as shown by the various expense accounts, have not been entirely used, as where a supply of coal for heating purposes remains on hand, or when, as in the case of insurance bought for a given period of time, a part of the protection period extends beyond the close of the current fiscal period. In these and similar cases, the items must be separated into their two component elements, one part belonging to the current period, and the other part to a later period. The part of the expense to be deferred and used up in a later period represents an asset at the close of the current period and must therefore appear on the balance sheet under the heading of “Deferred Charges.”

Similarly, income is sometimes received in advance to cover services which have not yet been rendered, or rendered only in part, as when rent is received in advance to cover a given number of months, some of which belong to the next fiscal period. Consequently, only a part of this income applies to the current period, the balance being deferred to later periods.

For these reasons certain asset accounts need to be adjusted and certain liability accounts must be opened to bring the ledger into accord with the actual condition of things and show the true financial status of the business. The entries required for this purpose are called “adjustment entries” to distinguish them from the closing or summarizing entries to be described later in this chapter.

First in importance among the adjusting entries are those required to show the correct value of the stock-in-trade, the fixed assets, and the accounts receivable. Whether the merchandise items are kept in one or several accounts, the value of the stock on hand is not shown at any given time during the fiscal period. Goods have been purchased at one price and sold at another, and no record of the value of the merchandise inventory on hand is available. Similarly, no current record has been made of the depreciation of buildings, furniture, fixtures, or other equipment, nor has any provision been made for the accounts receivable that may prove uncollectible.

Basis of Adjustment Entries.—These items, then, merchandise, asset depreciation, bad debts, prepaid and accrued expenses and income, are the occasion of the adjustment entries. An inventory is required to find the value of the stock-in-trade; an appraisal is made of the depreciating assets to determine the amount of depreciation for the current period; and proper consideration must be given to the prepaid and accrued income and expense items for the period under review. The following illustrations are concerned with the several classes of adjustment entries. The detail of the account is not shown in each case, but only the balance.

Adjusting and Closing the Merchandise Records.—Unlike the method shown in the debit and credit schedule for merchandise in Chapter XIII, the modern practice is to keep the merchandise record by means of the separate accounts used in the profit and loss statement, viz., Merchandise Inventory, Purchases, Inward Freight and Cartage, Returned Purchases, Purchases Rebates and Allowances, Sales, Returned Sales, and Sales Rebates and Allowances. It should be understood that this detailed record of merchandise transactions is preferable to the single merchandise account only because it gives more information. The detailed record does not in any way maintain a sharper separation of the asset and income elements of the merchandise transactions than does the single merchandise account. It does, however, make immediately available information as to volume of business, purchases, returns, and so forth—items which in any well-managed business are watched carefully. These detailed accounts taken together comprise the merchandise record and are equivalent to the single merchandise account.

It is apparent from a consideration of the single merchandise account that at any given time it includes these three items: (1) the net cost of the total goods to be accounted for; (2) the decrease in the asset merchandise brought about by sale; and (3) the profit on the goods sold. In order to bring about the separation of the merchandise records into the two elements (a) goods still on hand, that is, the asset element, and (b) the profit on goods sold, that is, the income element, it is necessary to bring the detailed accounts together for the purpose of summarization. This summarization is accomplished in much the same way as in the profit and loss statement. The net amount of sales and the net cost of goods sold are determined and set up against each other in order to indicate the gross profit. In arriving at the cost of goods sold it is necessary to bring together the opening inventory, the purchases, the inward freight and cartage, and from their sum to subtract the purchase returns, the purchase rebates and allowances, and the final inventory. How this is accomplished in the ledger is explained by an illustration, in which the adjustments or transfers between accounts are traced by means of cross-index letters.

Assume the following facts: Goods on hand January 1, 19—, $10,125.67; purchases for six months $47,897.42; inward freight and cartage $560.25; returned purchases $2,125.40; purchase rebates and allowances $267.92; sales $65,283.21; returned sales $3,924.83; sales rebates and allowances $392.48; and goods on hand June 30, 19—, $11,267.40. Each of these items appears as the first entry on the proper side of its account, and is distinguished by not being marked with a bracketed letter. The items comprise the ledger record previous to summarization at the close of the fiscal period.

To show the total cost of goods bought during the period, the freight-in of $560.25 is transferred or closed into Purchases. To show the “gross cost of goods to be accounted for,” amounting to $58,583.34, the inventory of January 1 of $10,125.67 is transferred to the debit side of Purchases account. To show the net cost of goods to be accounted for, the returned purchases and allowances are deducted from this gross cost by being transferred to the credit side of Purchases. The balance in Purchases account at this point, viz., $58,583.34 minus $2,393.32, or $56,190.02, indicates the net cost of goods to be accounted for.

This item of $56,190.02 is not indicated in the account, however, but is given here simply to make the discussion intelligible. Part of this $56,190.02 (net cost of goods to be accounted for), amounting to $11,267.40, is the cost value of the unsold goods according to the inventory of June 30, and the balance of $44,922.62 ($56,190.02 minus $11,267.40) constitutes therefore the cost of the goods sold. This final inventory is also shown as an asset on the debit side of Merchandise Inventory in the new section of the account, i.e., the portion of the account following the initial inventory section which has now been closed and ruled off as shown on page 118.

Put in a somewhat different form, we may say that the cost of goods sold is found by subtracting from the gross cost of goods to be accounted for, $58,583.34, first the returns and the rebates, $2,393.32, and then the amount of the closing inventory of June 30, $11,267.40. The balance left of $44,922.62 represents the cost of goods sold. This balance is now transferred to the debit of Profit and Loss account.

All the transfer entries given above have their debits and credits determined as explained in Chapter XIV. The student should note that the same additions and subtractions are thus brought about in the Purchases account as are made arithmetically in the section of the profit and loss statement given over to cost of goods sold.

The Sales account is debited with the balances of the Returned, Sales and Sales Rebates and Allowances, thus showing a balance of net income from sales which is transferred to the credit of Profit and Loss. The Profit and Loss account then shows net income from sales on the credit side, and cost of goods sold on the debit side. The difference between the two sides is gross profit on sales. All of the merchandise accounts, except the Inventory account, are now balanced, and should be ruled off in the manner explained in Chapter XIV.

The second illustration covers the case where the stock-in-trade record is kept in one mixed account called Merchandise. Using the same data as in the other illustration, the account appears as follows:

When the merchandise record is kept under separate accounts the freight-in is transferred to the debit of the Purchases account; but when a single mixed account is kept with merchandise, freight-in is usually entered directly to the debit of that account. To adjust the account when kept in this manner, the new inventory is entered to the credit of Merchandise. The balance of the Merchandise account now shows the gross profit on sales, $16,043.28. This is transferred to the credit of Profit and Loss. (It will be noted that this transferred item is identical with the balance of the Profit and Loss account of the first illustration.) The Merchandise account is now totaled and ruled off. On the debit side, beneath the ruling, the new inventory is entered, being the contra to the credit entry of $11,267.40 above the ruling. The equilibrium of debits and credits is thus maintained. In this open item of $11,267.40 the account shows an asset, the goods on hand June 30.

The handling of merchandise transactions according to the second illustration is not considered good accounting but is shown because it is frequently met with in bookkeeping practice.

Underlying Theory in the Adjustment of Merchandise Records.—Careful analysis and study of the adjustment of the merchandise records should be made in order to see the way in which the logic of the trading section of the profit and loss statement is worked out in the ledger. The record of the merchandise asset should be kept, in strict theory, in the same way as that of every other asset, namely, the accounts should be charged with the full cost of the asset and credited at cost price with the portion sold, the profit or loss on the sale being carried in a separate account. The balance of the Merchandise account would then show the value of the asset merchandise on hand at any time.

Theory, however, gives way to the practical difficulties of handling the account in this way. Therefore, periodically the mixture of asset decreases and income increases brought about through this practical method of handling merchandise records must be corrected, or “unmixed,” so that these elements will appear separately. The Purchases account, after the opening inventory, the inward freight, and the purchase returns, rebates, and allowances are transferred to it, gives the net total of the merchandise asset for the period. This net total represents two things: (1) merchandise still on hand, and (2) merchandise sold. By way of adjusting the records, the goods on hand, as shown by the physical inventory, are separated from the total and put into the Merchandise Inventory account, which shows by its title that it is an asset. That leaves in the Purchases account the cost of goods sold. The credits which should indicate the decrease in the asset, equal to the cost of goods sold, are found in the net merchandise sales, as shown by the Sales account after transferring to it the sales returns, rebates, and allowances. But these credits are here mixed with the gross profit. The portion of the net sales representing the cost of sales of merchandise should now, in strict theory, be transferred from the Sales account to the Purchases account. This transfer would effect the balancing of the Purchases account, indicating that there are no merchandise asset values in that account, these having been transferred to the Merchandise Inventory account. The result of this theoretically correct procedure would be to bring about a segregation of the merchandise records into their two elements, the asset element as shown by the Merchandise Inventory account and the income element as shown by the remaining balance in the Sales account.

Once again, however, strict theory gives place to the more practical need of requiring the accounts to give full information for management purposes. Accordingly, instead of handling them in the way just indicated, the adjustment procedure explained on pages 118 to 120 is followed.

Handling Depreciation of Fixed Assets.—As shown in Chapter XIII, the method of handling depreciation of assets consists of nothing more than separating the expense element from the asset element, both of which are carried currently under the title of the asset. For reasons explained in Chapter XIII, the credit to the asset which effects the separation is not recorded in the asset account but in a supplementary account entitled “Depreciation Reserve” for the particular asset. This reserve account is an integral part of the asset record and must always be considered in connection with the asset account in determining the value of the asset. The credit entry in the reserve account is a sort of suspended credit, recorded there temporarily for purposes of information. The offsetting debit to this credit is made in the expense account Depreciation.

The adjustment entry thus effects a separation of the asset account into the two elements, (1) present value of the asset as shown by the asset account and its depreciation reserve account, and (2) the expense element recorded under the Depreciation expense account. The following illustration indicates the bookkeeping procedure:

The asset Furniture and Fixtures, valued at $750 at the beginning of the year, is estimated by appraisal to have depreciated 10%, or $75, during the half-year. This cost or expense is charged to an account called Depreciation, and credited not to Furniture and Fixtures, but to the valuation account “Depreciation Reserve Furniture and Fixtures.” The Furniture and Fixtures account and its valuation account, taken together, show the appraisal value of $675. Thus the credit adjusting entry is made to record a decrease in asset values. The Depreciation account, carrying the debit of $75, is an expense account and is closed into Profit and Loss, just as any other expense account is closed.

The Estimate for Doubtful Accounts.—At the close of a fiscal period, when an accurate statement of the financial condition of the business is to be drawn up, all assets must be very carefully valued. The bookkeeping procedure necessary to show the correct value of fixed assets subject to depreciation has been explained. The outstanding claims against customers also require evaluation. Every business man knows from past experience that he will be unable to collect all of his outstanding accounts. He may not know which of the accounts will prove uncollectible, but he does know that there will be a loss in the sum total of these claims against customers. The amount of this estimate is based on past experience in each business.

A standard basis for the estimate is not possible because in some businesses credit is extended much more carefully than in other businesses and in some collections are followed up more vigorously than in others. In making the estimate two methods are used, one being a certain percentage of the outstanding accounts, the other being a certain percentage of the sales made during the period. Where experience shows the necessity, the loss from both outstanding accounts and notes receivable is provided for.

The same bookkeeping procedure is used here as with the estimate of depreciation. An expense account, usually entitled “Bad Debts,” is debited, and an account called “Reserve for Doubtful Accounts” is credited for the amount of the estimated loss. The effect of the entry is to separate the claims against customers into their two elements, namely, the true asset element, represented by the difference between the asset account and its valuation reserve account, and the expense element as indicated by the Bad Debts account.

The following illustration sets forth the method of handling bad debts on the books of account:

It is known, from past experience, that the asset Accounts Receivable, $100,000 in this instance, will not be collected in full. To bring this book value down to its real value, the estimated loss, which it is thought will be 2% of the outstanding accounts, is reserved from their value, that is, credited to a reserve account, which is to be taken in conjunction with the asset account. The offsetting debit is to Bad Debts, an expense account. It represents an expense which the current period has to bear, and is closed into Profit and Loss with other expense accounts.

Handling Prepaid and Accrued Expenses and Income.—The method of handling the estimates or inventories of prepaid and accrued expenses and income is very similar to that shown for handling the mixed Merchandise account. Illustrations follow:

The first account, Insurance, shows the method of handling a deferred or prepaid expense. At the close of the period the account is a mixed account, the unexpired portion of the insurance representing an asset to be shown on the balance sheet as a deferred charge, the expired or consumed portion representing an expense for the period to be closed into Profit and Loss. Insurance has been paid, in this case for a three-year term; hence only one-sixth of it is chargeable to the first half-year, the remainder being deferred to later periods. The amount of the inventory or unexpired portion is entered to the credit of the account in order to effect subtraction of the amount, the balance of $25 thereby showing the insurance cost for the current period. This balance is carried to Profit and Loss. After closing the account, the inventory is entered to the debit side below the ruling, thus showing the so-called “deferred asset” portion which will appear in the balance sheet.

The next account, Rent Income, is a mixed account with income and liability elements. It shows that rent has been received for a period which extends beyond the current fiscal period. On June 15, rent for the period of, say, June 15 to September 15 was received. Only one-sixth of this income applies to the term January 1 to June 30; therefore the balance of $250 must be deferred or carried over to the next fiscal period. The adjustment is made by an entry of $250 for unearned rent on the debit side to effect its subtraction from the earnings for the current period, thus reducing them to $50. This income of $50 is transferred to the credit of the Profit and Loss account. After the Rent account is ruled off, the deferred income is entered below the ruling on the credit side, forming a part of the earnings of the next period. It is shown among the liabilities in the balance sheet for the current period, usually under the caption of “Deferred Income.”

The third account, Wages, shows wages paid to June 30 of $2,125. At that date wages earned but not yet paid, perhaps because the pay-day did not coincide with the date of closing the books, amounted to $200. This item is obviously an expense of the current period incurred during the short interval between the last pay-day in June and June 30. The adjustment is therefore made by entering $200 on the debit side of the Wages account, to effect the addition of this sum to the expense already shown there. The total amount of the account is transferred to Profit and Loss and the account is ruled off. The amount of unpaid wages, $200, is shown on the credit side beneath the ruling. In the balance sheet it appears as a liability, usually under the caption of “Accrued Expense.”

Similarly with the fourth account, Interest Income. Income to date is $127.50; earned but not yet due on June 30, $17.50, showing full earnings of $145 for the current period. This total is transferred to Profit and Loss, the account is ruled off, and the earned but not received portion is shown as a debit beneath the ruling, and as an asset in the balance sheet.

Great care must be exercised in the adjustment of all inventories to maintain the equilibrium of the ledger by the entry of each amount to both the debit and credit sides.

Besides the four illustrations given above, there are many other accounts requiring the same kind of adjustment entries. In certain special cases it may be necessary to make adjustments on both sides, as for example in a general expense account or in a mixed interest account showing both interest income and interest expense. For illustration a mixed interest account is shown. The debit opening item of $100 in the new section of the account represents an asset, an interest claim against outsiders, while the credit opening item of $50 represents the liability to others for interest due them but not yet paid. For the sake of accuracy and clarity, however, the better bookkeeping practice is to keep separate accounts for Interest Income and Interest Cost.

Summarizing the Ledger—The Profit and Loss Account.—After all the types of adjustments have been made, the accounts in the ledger are restored to their fundamental classifications, namely, assets, liabilities, and proprietorship. There is now no intermixture of these basic elements. The proprietorship group of accounts shows both the vested proprietorship, that is, the capital at the beginning of the period, and the temporary proprietorship, that is, the increases and decreases (as indicated by the income and expense accounts) which have taken place during the current period.

At the close of the fiscal period, when the temporary proprietorship accounts have served their purpose by showing the day-to-day changes in proprietorship and the results must be summed up, these accounts are closed for the current period so as to keep the records separate from those of the next period. For the purpose of summarizing the profit and loss group of accounts, an account called Profit and Loss is opened in the ledger and to it the balances of all temporary proprietorship accounts are transferred.

The Profit and Loss account in the ledger must not be confused with the formal statement of profit and loss, made up outside the ledger just as is the balance sheet. On the credit side of Profit and Loss will appear all credit or income account balances, and on the debit side will appear all debit or expense account balances. Accordingly, if the balance of the Profit and Loss account is a credit balance, it shows a net profit for the period; if a debit balance, it shows a net loss for the period.

The net profit or net loss shown by the Profit and Loss account represents either an increase or decrease in proprietorship, and as such is transferred to the proprietor’s personal account. As explained in Chapter XII, this account usually shows his drawings during the period against these profits as they were assumed to be accruing. The personal account thus indicates whether the amount which he has drawn out is larger or smaller than the net profits as determined by the Profit and Loss account. If his profits are larger than his drawings, his capital has been increased by the amount of the credit balance in his personal account and the transfer of this balance to the credit side of his capital account will then show the total net worth of the business. If his drawings are larger than the profits, there is a decrease in capital, as shown by the debit balance of his personal account, and the transfer of this balance to the debit side of the capital account reduces the former capital amount.

The summarization of results at the close of a period is called “closing the ledger.” The procedure consists, first, in a transfer, i.e., in a closing out, of all the temporary proprietorship accounts to the Profit and Loss account; second, in the transfer of the balance of this account to the owner’s personal account; and third, in the transfer of the balance of the personal account to the owner’s capital account. After all temporary proprietorship accounts, the Profit and Loss account, and the owner’s personal account have been closed, the only accounts remaining open on the ledger are those showing either assets, liabilities, or capital. A formal statement of the balances of these accounts constitutes the balance sheet. The accounts through which the income and expense records of the business are closed, summarized, and transferred to the vested proprietorship account, are shown below, with typical entries: