Question

Year one is the first year of business renting apartments to students at the edge of USC's main campus. At the end of the year maintenance personnel had earned $400 for which they were never paid. Also at the end of year one, tenants had rented out several of the apartments but never paid the $800 rent. In year two maintenance personnel earned another $500 of wages and still did not get paid. New students moved in but never paid their $1,200 in total rent for the year. At the end of year two, no rent was ever collected nor were any wages paid since the business began. Requirement: Record the adjusting entries (if any) for each year to account for the described events. Do the year end closing entries for each of the two years. Post to the ledger for each year. Indicate with year numbers all transactions on the T accounts. Label each T account according to the proper account classification in parenthesis (ie. Asset, liability, revenue, etc.) Label adjusting journal entries (adj) and closing journal entries (cls). Required: Produce the Income statement for each year. Why do we do adjusting entries (think of how the income statement and balance sheet are off if we do not do adjusting entries)? What does this problem teach you about revenue and expense recognition relative to cash disbursement and cash receipt? What happens to your balance sheet accounts versus your income statement accounts each year?

Answer 1

Adjusting entries:
Date	General Journal	Debit	Credit
Year 1
Adj. 1	Wages expense	400
	Wages payable		400
	(To record wages accrued but not paid)
Adj. 2	Accounts receivable	800
	Rent revenue		800
	(To record rent accrued but not received)
Year 2
Adj. 1	Wages expense	500
	Wages payable		500
	(To record wages accrued but not paid)
Adj. 2	Accounts receivable	1200
	Rent revenue		1200
	(To record rent accrued but not received)
Closing entries:
Date	General Journal	Debit	Credit
Year 1
Cls. 1	Rent revenue	800
	Income summary		800
	(To close revenue account)
Cls. 2	Income summary	400
	Wages expense		400
	(To close expense account)
Cls. 3	Income summary	400
	Retained earnings		400
	(To close income summary)
Year 2
Cls. 1	Rent revenue	1200
	Income summary		1200
	(To close revenue account)
Cls. 2	Income summary	500
	Wages expense		500
	(To close expense account)
Cls. 3	Income summary	700
	Retained earnings		700
	(To close income summary)

T-accounts:

Accounts receivable (Asset)					Wages Payable (Liability)
Year 1 adj. 2	800						400	Year 1 adj. 1
Year 1 End. Bal.	800				Year 1 End. Bal.		400
Year 2 Beg. Bal.	800				Year 2 Beg. Bal.		400
Year 2 adj. 2	1200				Year 2 adj. 1		500
Year 2 End. Bal.	2000				Year 2 End. Bal.		900
Rent revenue (Revenue)					Wages Expense (Expense)
Year 1 cls. 1	800	800	Year 1 adj. 2		Year 1 adj. 1	400	400	Year 1 cls. 2
Year 1 End. Bal.		0			Year 1 End. Bal.	0
Year 2 Beg. Bal.		0			Year 2 Beg. Bal.	0
Year 2 cls. 1	1200	1200	Year 2 adj. 2		Year 2 adj. 1	500	500	Year 2 cls. 2
Year 2 End. Bal.		0			Year 2 End. Bal.	0
Income Summary (Temporary)					Retained Earnings (Equity)
Year 1 cls. 2	400	800	Year 1 cls. 1				400	Year 1 cls. 3
Year 1 cls. 3	400
Year 1 End. Bal.		0			Year 1 End. Bal.		400
Year 2 Beg. Bal.		0			Year 2 Beg. Bal.		400
Year 2 cls. 2	500	1200	Year 2 cls. 1				700	Year 2 cls. 3
Year 2 cls. 3	700
Year 2 End. Bal.		0			Year 2 End. Bal.		1100

Income Statement
	Year 1	Year 2
Rent revenue	800	1200
Less:
Wages expense	400	500
Net income	400	700

Adjusting entries are prepared to convert the accounts from cash basis to accrual basis by recognizing all revenues that have been earned but not received and all expenses that have been incurred but not paid.

Without adjusting entries, the income statement would not give a correct picture of the net income earned during the year and the balance sheet would not reflect the correct financial position of the business. For example, in Year 1 and 2 above, there would be no net income since no revenue is received or expense paid.

Revenue and expense recognition is independent of the cash receipt and cash disbursement. Revenue is recognized when earned irrespective of when cash for the same is received. Similarly, expenses are recognized when incurred irrespective of when cash disbursement for the same is made.

The ending balance in the balance sheet accounts is carried over to the next financial period while the income statement accounts are closed at the end of every period and start with a nil balance in the next period.