Cortina Company accumulates the following adjustment data at December 31.
Indicate (1) the type of adjustment (prepaid expense, accrued revenue, and so on) and (2) the status of the accounts before adjustment (for example, ‘assets understated and revenues understated).
- (a) Supplies of $400 are on hand. Supplies account shows $1600 balance.
- (b) Services performed but unbilled total $700.
- (c) Interest of $300 has accumulated on a note payable.
- (d) Rent collected in advance totaling $1100 has been earned.
The correct answer and explanation is:
Here’s the correct answer to the adjustments:
(a) Type of adjustment: Prepaid Expense (Supplies Used)
Status before adjustment: Assets overstated, Expenses understated
(b) Type of adjustment: Accrued Revenue (Unbilled Services)
Status before adjustment: Assets understated, Revenues understated
(c) Type of adjustment: Accrued Expense (Interest Payable)
Status before adjustment: Liabilities understated, Expenses understated
(d) Type of adjustment: Unearned Revenue (Rent Earned)
Status before adjustment: Liabilities overstated, Revenues understated
Explanation
Adjusting entries are crucial in accrual accounting because they ensure that revenues and expenses are recorded in the correct accounting period. Let’s analyze each case:
(a) The company has $400 of supplies remaining but recorded $1,600 in the Supplies account. This means $1,200 ($1,600 – $400) worth of supplies have been used, but no expense has been recorded yet. Without an adjustment, assets are overstated, and expenses are understated.
(b) The company has performed services worth $700 but has not yet billed the customer. This means revenue has been earned but not recorded, making both assets (Accounts Receivable) and revenues understated. The adjustment ensures the revenue is recognized in the correct period.
(c) Interest of $300 has accrued on a note payable but has not yet been recorded. This means an expense has been incurred without being recognized. Adjusting this will increase expenses and liabilities, preventing understatement.
(d) The company initially recorded $1,100 as unearned revenue, meaning it had received payment before performing the service. However, now the revenue has been earned, so an adjustment is necessary to transfer it from a liability to a revenue account. Without this, liabilities would be overstated, and revenues understated.