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:

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:

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 Chapter XXVII to which reference should be made. In connection with the work sheet it was stated that the adjustment columns of the work sheet are used as a guide to making the adjusting entries. As to sequence in the journal, these follow immediately, without break, the last current entry for the month. The adjusting entries for U. R. Smart are:

Purpose of Summarizing.—After the adjusting entries are posted, the ledger reflects the true financial condition as of the date of these entries. However, at this stage the information contained in the ledger is usually scattered over a large number of accounts. To obtain a concise view of the results of the business, it is necessary to summarize this information. The Profit and Loss account is the means by which the temporary proprietorship accounts are summarized and the net results as to profits or losses are indicated.

In this connection it will be remembered that the adjusting entries have already effected a separation of the elements of the mixed accounts, so that the temporary proprietorship items—expenses and income—applicable to the current period are now separately shown. The transfer of these temporary proprietorship items to the vested proprietorship accounts constitutes the work of closing. The use of the Profit and Loss account as a place of summary—a clearing house—through which the net result can be passed on or transferred to the vested proprietorship accounts, constitutes a part of the method or technique of closing.

The Closing Entries.—The student is already familiar with the principles of debit and credit involved in making the closing entries. As indicated above, these are transfer entries and merely effect a transfer of all temporary proprietorship items to the Profit and Loss account for summary there and for the transfer of the net result to some vested proprietorship account or accounts. Like all other entries, these are made first in the journal and are posted from there to the ledger. The current sections of the various expense and income accounts are then ruled off and the ledger is said to be “closed.”

Method of Closing the Books.—As explained on page 129, the Profit and Loss account in the ledger is used for summarizing the temporary proprietorship accounts before transferring them, i.e., their net result, to the vested proprietorship accounts. The use of Purchases and Sales accounts for a partial summarization of the various merchandise accounts has also been explained. After this partial summarization has been made, the debit balance of the Purchases account, showing cost of goods sold, is transferred to the Profit and Loss account; and similarly, the credit balance of the Sales account, representing net sales, is transferred to the Profit and Loss account. Profit and Loss then shows on the credit side net sales and on the debit cost of goods sold, the difference being the income portion, i.e., the gross profit of the merchandising activities for the period. If it is desired to show on the face of the account the actual figure of gross profit, the Profit and Loss account may be balanced at this stage, though this is not usually done. The rest of the work of summarization is accomplished directly through the Profit and Loss account.

Closing Entries Illustrated.—The formal journal entries necessary to effect this summarization in the ledger are given below, being based on the illustration used for the work sheet and being made up directly from the various sections of the formal profit and loss statement shown on page 234. The way in which this is done should be carefully noted. As to their sequence in the journal, these closing entries will, of course, immediately follow the formal adjusting entries illustrated above.

It will be noted that after the net sales and cost of goods sold are transferred to the Profit and Loss account, all expenses directly connected with sales, such as Salesmen’s Salaries, Advertising, Delivery Expense, Depreciation of Delivery Equipment, of Store Furniture and Fixtures, and similar items, are closed into the Profit and Loss account.

The groups of accounts closed next are those covering General Administrative Expenses, Financial Management Expenses, Financial Management Income, Non-Operating Expense, and Non-Operating Income. It will be noticed that the order of closing follows the order in which the same items appear in the profit and loss statement.

The Profit and Loss account now shows on the credit side the items of income and on the debit side the costs and expenses applicable to the current period. Its balance then gives the net profit (or loss) covering the period’s transactions.

Throughout the period, as the profit accrues, the proprietor may have drawn against it for personal use, as shown in his Personal account. To show the amount of profit remaining in the business, the balance of the Profit and Loss account is transferred to the Personal account, the balance of which then gives the amount of undrawn or overdrawn profit. The balance of the Personal account is closed into the Capital account, the credit balance of which then represents the net worth of the business at the end of this period and at the commencement of the next.

The Profit and Loss Account.—In posting the closing journal entries to the Profit and Loss account in the ledger, usually only the group totals as indicated by the entry will appear. In small concerns where expenses and income are not classified in much detail, the individual items composing the group total are often shown. These items are, of course, the same as appear in the part of the journal entry which is contra to the group total charged or credited to Profit and Loss. The ledger Profit and Loss account for the illustration will appear as follows when completely posted:

Profit and Loss Not an Account for Current Entry.—It should be kept clearly in mind that the process of closing the books is merely a method or device by which the transactions for the year are summarized and the net result determined. This net result, whether a profit or a loss, belongs to the proprietor and must ultimately be shown in his account. It is, therefore, manifest that the Profit and Loss account is only a summary account and should never be used for current entry. It is the means by which the temporary proprietorship accounts are summarized and the medium through which the net result is cleared into some vested proprietorship account or accounts.

Effect of Closing the Ledger.—The transfer of net profit to a vested proprietorship account completes the work of closing the ledger, all temporary proprietorship accounts for the current period being closed out. All open balances now shown on the ledger constitute either assets, liabilities, or vested proprietorship. A post-closing trial balance contains only the accounts shown on the corresponding balance sheet. The income and expense accounts, having been cleared of their current record, are prepared to receive the record of the next period. The business cycle for this particular business has been completed and its correct history recorded.