GB518 Unit 3 Adjusting Entries Problem Example

A Loss Before Adjustments, a Profit After: A Unit 3 Adjusting Entries Problem for a Subscription Software Firm

[Student Name]

Purdue University Global

GB518: Financial Accounting Principles and Analysis

Unit 3 Adjusting Entries Problem

[Instructor Name]

[Date]

The software firm and every figure are composite and illustrative; the standards and sources cited are real.

The Facts at Month End

Ledgerline Software sells project scheduling software to construction firms on annual subscriptions billed in advance. Its unadjusted trial balance at January 31 shows, among other accounts, deferred subscription revenue of $288,000, prepaid hosting of $18,000, office equipment of $72,000, a term loan of $150,000 and accounts receivable of $96,000. Unadjusted revenue for the month, from setup and training fees, was $31,500, and unadjusted expenses were salaries of $29,000, rent of $6,500 and marketing of $4,200, for an unadjusted net loss of $8,200.

The month-end facts, as the controller received them:

Subscriptions. On January 1, 24 clients were billed $12,000 each for a year's subscription, recorded as deferred revenue.

Loan. The $150,000 term loan carries 7 percent annual interest, paid quarterly; none has been paid yet.

Hosting. Six months of server hosting, $18,000, was prepaid on January 1.

Equipment. Office equipment costing $72,000 has a four-year life and no salvage value.

Commission. A salesperson earned a 6 percent commission on $40,000 of new contracts signed in January, payable in February.

Receivables. Based on experience, about 2 percent of receivables will not be collected.

The Adjusting Entries

Adjustment 1: subscription revenue earned. One month of 24 subscriptions at $12,000 a year is $288,000 divided by 12, or $24,000. Debit deferred subscription revenue $24,000; credit subscription revenue $24,000. Under ASC 606, revenue from a subscription is recognized as the service is delivered over time (Financial Accounting Standards Board, 2014).

Adjustment 2: interest accrued. $150,000 times 7 percent divided by 12 is $875. Debit interest expense $875; credit interest payable $875.

Adjustment 3: hosting used. $18,000 divided by 6 months is $3,000. Debit hosting expense $3,000; credit prepaid hosting $3,000.

Adjustment 4: depreciation. $72,000 divided by 48 months is $1,500. Debit depreciation expense $1,500; credit accumulated depreciation $1,500.

Adjustment 5: commission earned but unpaid. 6 percent of $40,000 is $2,400. Debit commission expense $2,400; credit commissions payable $2,400.

Adjustment 6: estimated bad debts. 2 percent of $96,000 is $1,920. Debit bad debt expense $1,920; credit allowance for doubtful accounts $1,920.

Reconciling Unadjusted to Adjusted Net Income

Starting from the unadjusted net loss of $8,200: add subscription revenue of $24,000 to reach $15,800; subtract interest of $875 to reach $14,925; subtract hosting of $3,000 to reach $11,925; subtract depreciation of $1,500 to reach $10,425; subtract commission of $2,400 to reach $8,025; subtract bad debts of $1,920 to reach adjusted net income of $6,105.

Without adjustments, the firm reports a loss in a month when it earned $24,000 of subscription revenue, because that revenue was billed in advance and still sits in a liability account.

Adjusted Trial Balance

After posting, deferred subscription revenue falls to $264,000, prepaid hosting to $15,000 and accounts receivable, net of the allowance, to $94,080. New liabilities appear for interest payable of $875 and commissions payable of $2,400, and accumulated depreciation of $1,500 is set against equipment. Debits and credits remain equal, since each adjustment has matching sides (Kieso et al., 2022).

Effect on the Balance Sheet

The adjustments change the balance sheet as much as the income statement. Liabilities fall by $24,000 as deferred revenue becomes earned revenue, and rise by $3,275 for interest and commissions now owed. Assets fall by $6,420: $3,000 of prepaid hosting used, $1,500 of equipment depreciated and $1,920 of receivables reserved against. A lender reading the unadjusted balance sheet would have seen more deferred revenue and fewer obligations than the firm actually has at month end.

Contractual or Estimated

Fixed by contract: subscription revenue, set by the subscription agreements; interest, set by the loan agreement; hosting, set by the hosting contract; and commission, set by the sales commission plan. A different manager would compute the same figures.

Resting on an estimate: depreciation, which depends on management's estimate of a four-year life; and bad debts, which depend on management's judgment that 2 percent of receivables will go uncollected.

Robert Libby, Patricia Libby and Frank Hodge note that estimates such as useful lives and collectibility give management discretion over reported earnings, which is why analysts read the notes that explain them (Libby et al., 2023). Here the two estimates total $3,420, more than half of the month's adjusted profit, so a modest change in either would move the result noticeably.

What a Manager Should Take From This

The unadjusted figures would have told Ledgerline's chief executive that January lost money. The adjusted figures show the business earned a profit once revenue and costs are matched to the month. Subscription businesses are especially exposed to this gap, because they bill large amounts in advance. Monthly adjusting entries are what turn cash and billing activity into a measure of performance, and the two estimates deserve a line in every monthly report so the chief executive knows how much of the profit rests on judgment.

References

Financial Accounting Standards Board. (2014). Revenue from contracts with customers (Topic 606) (Accounting Standards Update No. 2014-09).

Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2022). Intermediate accounting (18th ed.). Wiley.

Libby, R., Libby, P. A., & Hodge, F. (2023). Financial accounting (11th ed.). McGraw Hill.