Year-End Adjusting Entries at Rowan Tileworks
Rowan Tileworks has a 31 December year end. The bookkeeper produced a draft trial balance but posted no adjusting entries. The following items are all still open and, unless noted, are material: (1) the December electricity invoice for $4,800 arrived on 6 January and was recorded then; (2) on 1 November a customer paid $12,000 for twelve months of service starting 1 November, and the full amount was credited to Service Revenue; (3) inventory costing $85,000 has a net realisable value of $72,000 because a tile line was discontinued; (4) the final December payroll of $9,400, covering 26-31 December, is paid on 3 January; (5) equipment bought for $60,000 on 1 April with an eight-year life and no residual value has not been depreciated; (6) a $3,000 insurance premium covering January to March of next year was paid in December and expensed.
1. Prepare the six adjusting entries, stating accounts, amounts and direction, and give the reasoning for each amount.
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1. Electricity (accrued expense). Dr Utilities expense 4,800 / Cr Accrued liabilities 4,800. The consumption happened in December; the date the invoice arrives does not decide the period.
2. Unearned revenue. Two of the twelve months (November, December) are earned = $12,000 x 2/12 = $2,000. Defer $10,000: Dr Service Revenue 10,000 / Cr Unearned Revenue 10,000. The credit balance is a real obligation to provide ten more months of service, not merely a timing difference.
3. Inventory write-down. Cost $85,000 exceeds net realisable value $72,000, so write down the difference: Dr Inventory write-down (cost of sales) 13,000 / Cr Inventory 13,000. Inventory is carried at the lower of cost and NRV, so the loss belongs in the period the decline occurred.
4. Wages accrual. The whole $9,400 was earned in December: Dr Wages expense 9,400 / Cr Accrued wages 9,400. Payment date is irrelevant to the expense period.
5. Depreciation. $60,000 / 8 years = $7,500 per year; 9 months used (April-December) = $7,500 x 9/12 = $5,625: Dr Depreciation expense 5,625 / Cr Accumulated depreciation 5,625.
6. Prepaid insurance. Three months belong to next year: Dr Prepaid insurance 3,000 / Cr Insurance expense 3,000.
2. Compute the total net effect of the adjustments on the draft profit before tax, and explain which items move profit and which do not.
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| Item | Effect on draft profit |
|---|---|
| Electricity accrual | -4,800 |
| Revenue deferral | -10,000 |
| Inventory write-down | -13,000 |
| Wages accrual | -9,400 |
| Depreciation | -5,625 |
| Prepaid insurance | +3,000 |
| Net | -39,825 |
Draft profit falls by $39,825.
Reasoning: every item moves profit because each one either recognises an expense the draft omitted (electricity, wages, depreciation, write-down) or removes an amount that does not belong to this period (the $10,000 of unearned revenue and the $3,000 of prepaid insurance, both of which were originally recorded in the wrong direction). Note that the insurance reversal is a positive adjustment: the draft overstated expense, so removing it raises profit.
If the entity instead only asked for the balance sheet impact, the same entries would move accrued liabilities +$4,800, unearned revenue +$10,000, inventory -$13,000, accrued wages +$9,400, accumulated depreciation +$5,625 and prepaid insurance +$3,000, with retained earnings absorbing the $39,825.
3. The owner argues: "Nothing is lost by recording all of this in January - it is only timing." Evaluate that claim for the revenue item and the payroll item.
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The claim confuses cash timing with recognition. Two points decide it:
Materiality and the accrual basis. The combined effect is $39,825 against draft profit, and the two items the owner singles out are $10,000 of revenue and $9,400 of wages. Unless the entity has a documented materiality threshold far above these amounts, deferring them misstates profit, the liability position, and any covenant, tax or bonus calculation that depends on profit.
The revenue item is not timing at all. The $10,000 is not revenue that will simply be recorded a bit later - it is consideration for a service the entity still owes. Recording it in January as revenue would still be wrong. The only correct treatment at any date is a liability until the service is delivered, released month by month.
The payroll item. Wages for 26-31 December are earned in December. Recording them in January would overstate December profit and understate liabilities at the reporting date, and would also misstate the payroll tax accrual that follows from those wages.
A defensible position exists only for genuinely immaterial amounts, and even then the entity should apply a consistent policy rather than decide item by item after seeing the profit figure. Here the practical answer is to post the adjustments.