Adjusting the Accounts

Adjusting the Accounts

• Financial and Managerial Accounting, Weygandt, Kimmel, Mitchell 4th Edition.
• Chapter 3: Adjusting the Accounts.

Learning Objectives

• LO 1: Explain the accrual basis of accounting and the reasons for adjusting entries.
• LO 2: Prepare adjusting entries for deferrals.
• LO 3: Prepare adjusting entries for accruals.
• LO 4: Describe the nature and purpose of an adjusted trial balance.

Time Period Assumption (LO 1)

• Accountants divide the economic life of a business into artificial time periods.
• Generally:
  • A month.
  • A quarter.
  • A year.
• Alternative Terminology: The time period assumption is also called the periodicity assumption.

Fiscal and Calendar Years (LO 1)

• Monthly and quarterly time periods are called interim periods.
• Most large companies must prepare both quarterly and annual financial statements.
• Fiscal Year: Accounting time period that is one year in length.
• Calendar Year: January 1 to December 31.

Time Period Assumption Question

The time period assumption states that:

• revenue should be recognized in the accounting period in which it is earned.
• expenses should be matched with revenues.
• the economic life of a business can be divided into artificial time periods.
• the fiscal year should correspond with the calendar year.

Time Period Assumption Answer

The time period assumption states that the economic life of a business can be divided into artificial time periods.

Accrual-Versus Cash-Basis Accounting (LO 1)

Accrual-Basis Accounting

• Transactions are recorded in the periods in which the events occur.
• Companies recognize revenues when they perform services (rather than when they receive cash).
• Expenses are recognized when incurred (rather than when paid).

Cash-Basis Accounting

• Revenues are recorded when cash is received.
• Expenses are recorded when cash is paid.
• Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).

Recognizing Revenues and Expenses (LO 1)

Revenue Recognition Principle

• Recognize revenue in the accounting period in which the performance obligation is satisfied.

Expense Recognition Principle

• Match expenses with revenues in the period when the company makes efforts to generate those revenues.
• “Let the expenses follow the revenues.”

Accrual Basis of Accounting Question

One of the following statements about the accrual basis of accounting is false. That statement is:

• Events that change a company’s financial statements are recorded in the periods in which the events occur.
• Revenue is recognized in the period in which the performance obligation is satisfied.
• The accrual basis of accounting is in accordance with generally accepted accounting principles.
• Revenue is recorded only when cash is received, and expenses are recorded only when cash is paid.

Accrual Basis of Accounting Answer

Revenue is recorded only when cash is received, and expenses are recorded only when cash is paid.

Investor Insight: Apple Inc. Reporting Revenue Accurately

• Until recently, Apple was required to spread the revenues from iPhone sales over the two-year period following the sale of the phone due to obligations to provide software updates.
• A new accounting standard now enables Apple to report much more of its iPhone revenue at the point of sale.
• It was estimated that under the new rule, revenues would have been about 17% higher and earnings per share almost 50% higher.

Investor Insight: Apple Inc. (Question and Answer)

In the past, why was it argued that Apple should spread the recognition of iPhone revenue over a two-year period, rather than recording it upfront?

• Answer: Apple promises to provide software updates over the life of the phone's use. Because this represents an unfulfilled performance obligation, it was argued that Apple should spread its revenue recognition over a two year estimated life of the phone.

The Need for Adjusting Entries (LO 1)

• Ensure that the revenue recognition and expense recognition principles are followed.
• Necessary because the trial balance may not contain up-to-date and complete data.
• Required every time a company prepares financial statements.
• Will include one income statement account and one balance sheet account.

Adjusting Entries Question

Adjusting entries are made to ensure that:

• expenses are recognized in the period in which they are incurred.
• revenues are recorded in the period in which services are performed.
• balance sheet and income statement accounts have correct balances at the end of an accounting period.
• all of the above.

Adjusting Entries Answer

All of the above.

Types of Adjusting Entries (LO 1)

Deferrals

• Prepaid Expenses: Expenses paid in cash before they are used or consumed.
• Unearned Revenues: Cash received before services are performed.

Accruals

• Accrued Revenues: Revenues for services performed but not yet received in cash or recorded.
• Accrued Expenses: Expenses incurred but not yet paid in cash or recorded.

Trial Balance

• Each account is analyzed to determine whether it is complete and up-to-date for financial statement purposes.

Timing Concepts

• Accrual-basis accounting: Companies record transactions in the period in which the events occur.
• Calendar year: An accounting time period that starts on January 1 and ends on December 31.
• Time period assumption: Accountants divide the economic life of a business into artificial time periods.
• Expense recognition principle: Efforts (expenses) should be matched with results (revenues).

Adjusting Entries for Deferrals (LO 2)

Deferrals are expenses or revenues that are recognized at a date later than the point when cash was originally exchanged.

• Prepaid expenses
• Unearned revenues

Prepaid Expenses (LO 2)

Payments of expenses that will benefit more than one accounting period.

• Cash Payment BEFORE Expense Recorded
• Examples:
  • Insurance
  • Supplies
  • Advertising
  • Rent
  • Buildings and equipment

Prepaid Expenses Adjusting entry (LO 2)

• Costs that expire either with the passage of time or through use.
• Adjusting entry:
  • Increase (debit) to an expense account and
  • Decrease (credit) to an asset account.

Prepaid Expenses Example: Supplies (LO 2)

Pioneer Advertising Inc. purchased supplies costing $2,500$ on October 5. An inventory count at the close of business on October 31 reveals that $1,000$ of supplies are still on hand.

• Oct. 31 Supplies Expense $1,500$
  Supplies $1,500$

Prepaid Expenses Example: Insurance (LO 2)

Pioneer Advertising Inc. paid $600$ for a one-year fire insurance policy. Coverage began on October 1. Insurance of $50$ ($600 ÷ 12$) expires each month.

• Oct. 31 Insurance Expense $50$
  Prepaid Insurance $50$

Depreciation (LO 2)

• Buildings, equipment, and motor vehicles (assets that provide service for many years) are recorded as assets, rather than an expense, on the date acquired.
• Depreciation is the process of allocating the cost of an asset to expense over its useful life.
• Depreciation does not attempt to report the actual change in the value of the asset.

Depreciation Adjusting Entry (LO 2)

For Pioneer Advertising, assume that depreciation on the equipment is $480$ a year, or $40$ per month.

• Oct. 31 Depreciation Expense $40$
  Accumulated Depreciation-Equipment $40$
• Accumulated Depreciation is called a contra asset account.
• Helpful Hint: All contra accounts have increases, decreases, and normal balances opposite to the account to which they relate.

Statement Presentation (LO 2)

• Accumulated Depreciation is a contra asset account (credit).
• Appears just after the account it offsets (Equipment) on the balance sheet.
• Book value is the difference between the cost of any depreciable asset and its accumulated depreciation.
• Example:
  • Equipment $5,000$
  • Less: Accumulated depreciation–equipment $40$
  • $4,960$

Accounting for Prepaid Expenses (LO 2)

Prepaid expenses originally recorded in asset accounts have been used. Assets overstated. Expenses understated.

• Dr. Expenses
• Cr. Assets or Contra Assets

Unearned Revenues (LO 2)

Receipt of cash that is recorded as a liability because the service has not been performed.

• Cash Received BEFORE Revenue Earned
• Examples:
  • Rent
  • Airline tickets
  • Magazine subscriptions
  • Customer deposits

Unearned Revenues Adjusting Entry (LO 2)

• Adjusting entry is made to record the revenue for services performed during the period and to show the liability that remains at the end of the accounting period.
• Results in a decrease (debit) to a liability account and an increase (credit) to a revenue account.

Unearned Revenues Example (LO 2)

Pioneer Advertising received $1,200$ on October 2 from R. Knox for advertising services expected to be completed by December 31. Analysis reveals that the company performed $400$ of services in October.

• Oct. 31 Unearned Service Revenue $400$
  Service Revenue $400$

Accounting for Unearned Revenues (LO 2)

Unearned revenues recorded in liability accounts are now recognized as revenue for services performed. Liabilities overstated. Revenues understated.

• Dr. Liabilities
• Cr. Revenues

Accounting Across the Organization: Best Buy Turning Gift Cards into Revenue (LO 2)

• Gift cards are a popular marketing tool.
• In a recent year, gift card sales were expected to exceed $124$ billion.
• Accounting questions arise: When should revenue be recorded (at the time of sale or exercise)? How should expired gift cards be accounted for?
• Best Buy reported unearned revenue related to gift cards of $427$ million.

Unearned Revenues Question to Ponder (LO 2)

Suppose that Robert Jones purchases a $100$ gift card at Best Buy on December 24, 2021, and gives it to his wife, Mary Jones, on December 25, 2021. On January 3, 2022, Mary uses the card to purchase $100$ worth of CDs. When do you think Best Buy should recognize revenue and why?

Unearned Revenues Answer to Question to Ponder (LO 2)

Companies should recognize revenue when the performance obligation is satisfied. In this case, revenue results when Best Buy provides the goods.

• Best Buy receives cash in exchange for the gift card on December 24, 2021, it should recognize a liability, Unearned Sales Revenue, for $100$.
• On January 3, 2022, when Mary Jones exchanges the card for merchandise, Best Buy should recognize revenue and eliminate $100$ from the balance in the Unearned Sales Revenue account.

Adjusting Entries for Deferrals - Example: Hammond Inc. (LO 2)

• Insurance expires at the rate of $100$ per month.
  • Insurance Expense $100$
    Prepaid Insurance $100$
• Supplies on hand total $800$. Initial supplies balance was $2,800$.
  • Supplies Expense ($2,800 - 800$) $2,000$
    Supplies $2,000$
• The equipment depreciates $200$ a month.
  • Depreciation Expense $200$
    Accumulated Depreciation—Equipment $200$
• During March, services were performed for $4,000$ of the unearned service revenue. Initial unearned service revenue was $9,200$.
  • Unearned Service Revenue $4,000$
    Service Revenue $4,000$

Adjusting Entries for Accruals (LO 3)

Accruals are made to record:

• Revenues for services performed but not yet recorded at the statement date (accrued revenues).
• Expenses incurred but not yet paid or recorded at the statement date (accrued expenses).

Accrued Revenues (LO 3)

Revenues for services performed but not yet received in cash or recorded.

• Service Performed BEFORE Cash Received
• Examples:
  • Rent
  • Interest
  • Services performed

Accrued Revenues Adjusting Entry (LO 3)

• Adjusting entry records the receivable that exists at the balance sheet date and the revenue for services performed during the period.
• Adjusting entry:
  • Increases (debits) an asset account and
  • Increases (credits) a revenue account.

Accrued Revenues Example (LO 3)

Pioneer Advertising Inc. performed services worth $200$ that were not billed to clients in October.

• Oct. 31 Accounts Receivable $200$
  Service Revenue $200$

On November 10, Pioneer receives cash of $200$ for the services performed in October.

• Nov. 10 Cash $200$
  Accounts Receivable $200$

Accounting for Accrued Revenues (LO 3)

Services performed but not yet received in cash or recorded. Assets understated. Revenues understated.

• Dr. Assets
• Cr. Revenues

Ethics Note (LO 3)

A report released by Fannie Mae’s board of directors stated that improper adjusting entries at the mortgage-finance company resulted in delayed recognition of expenses caused by interest rate changes. The motivation for such accounting apparently was the desire to hit earnings estimates.

Accrued Expenses (LO 3)

Expenses incurred but not yet paid in cash or recorded.

• Expense Recorded BEFORE Cash Payment
• Examples:
  • Interest
  • Taxes
  • Salaries

Accrued Expense Adjusting Entry (LO 3)

• Adjusting entry records the obligation and recognizes the expense.
• Adjusting entry:
  • Increase (debit) an expense account and
  • Increase (credit) a liability account.

Accrued Expenses Example: Interest (LO 3)

Pioneer Advertising signed a three-month note payable in the amount of $5,000$ on October 1. The note requires Pioneer to pay interest at an annual rate of 12%.

• Oct. 31 Interest Expense $50$
  Interest Payable $50$

Accrued Expenses Example: Salaries (LO 3)

Pioneer paid salaries and wages on October 26 for the first two weeks (October 15-26). The next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000$ for a five-day work week, or $400$ per day. Thus, accrued salaries at October 31 are $1,200$ ($400 \times 3$ days).

Accounting for Accrued Expenses (LO 3)

Expenses have been incurred but not yet paid in cash or recorded. Expenses understated. Liabilities understated.

• Dr. Expenses
• Cr. Liabilities

People, Planet, and Profit Insight (LO 3)

• Approximately 163,000 computers and televisions become obsolete each day.
• In a recent year, only 11% of computers were recycled.
• Estimated that 75% of all computers ever sold are sitting in storage somewhere, waiting to be disposed of.
• Each of these old TVs and computers is loaded with lead, cadmium, mercury, and other toxic chemicals.
• Companies have the same problem, but their discarded materials may include lead paint, asbestos, and other toxic chemicals.

People, Planet, and Profit Insight (Question and Answer) (LO 3)

What accounting issue might this cause for companies?

• Answer: The balance sheet should provide a fair representation of what a company owns and what it owes. If significant obligations of the company are not reported on the balance sheet, the company's net worth (its equity) will be overstated.
• It seems reasonable to accrue for environmental costs. Recognition of these liabilities provides a more accurate picture of the company's financial position. It also has the potential to improve the environment.

Summary of Basic Relationships (LO 3)

Adjusting Entries for Accruals - Example: Micro Computer Services (LO 3)

• Salaries and Wages Expense $800$
  Salaries and Wages Payable $800$
• Interest Expense $250$
  Interest Payable $250$ annual interest rate is 10% and the borrowed $30,000$ from the bank
• Accounts Receivable $1,100$
  Service Revenue $1,100$

Adjusted Trial Balance (LO 4)

• Prepared after all adjusting entries are journalized and posted.
• Purpose is to prove the equality of debit balances and credit balances in the ledger after all adjustments.
• Is the primary basis for the preparation of financial statements.

Adjusted Trial Balance Question (LO 4)

Which of the following statements is incorrect concerning the adjusted trial balance?

• An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made.
• The adjusted trial balance provides the primary basis for the preparation of financial statements.
• The adjusted trial balance lists the account balances segregated by assets and liabilities.
• The adjusted trial balance is prepared after the adjusting entries have been journalized and posted.

Adjusted Trial Balance Answer (LO 4)

The adjusted trial balance lists the account balances segregated by assets and liabilities.

Preparing Financial Statements (LO 4)

Financial Statements are prepared directly from the Adjusted Trial Balance.

• Income Statement
• Retained Earnings Statement
• Balance Sheet

Alternative Treatment of Deferrals (Appendix 3A - LO 5)

• When a company prepays an expense, it debits that amount to an expense account.
• When it receives payment for future services, it credits the amount to a revenue account.

Additional Adjustments Relationships (Appendix 3A - LO 5)

Financial Reporting Concepts (Appendix 3B - LO 6)

Qualities of Useful Information

Fundamental Qualities

Relevance:

• Make a difference in a business decision.
• Provides information that has predictive value and confirmatory value.
• Materiality is a company-specific aspect of relevance.
  • An item is material when its size makes it likely to influence the decision of an investor or creditor.

Faithful Representation:

• Information accurately depicts what really happened.
• Information must be:
  • complete (nothing important has been omitted),
  • neutral (is not biased toward one position or another), and
  • free from error.

Enhancing Qualities

• Comparability results when different companies use the same accounting principles.
• Information is verifiable if independent observers, using the same methods, obtain similar results.
• Information has the quality of understandability if it is presented in a clear and concise fashion.
• Consistency means that a company uses the same accounting principles and methods from year to year.
• For accounting information to have relevance, it must be timely.

Assumptions in Financial Reporting

• Monetary Unit: Requires that only those things that can be expressed in money are included in the accounting records.
• Economic Entity: States that every economic entity can be separately identified and accounted for.
• Time Period: States that the life of a business can be divided into artificial time periods.
• Going Concern: The business will remain in operation for the foreseeable future.

Principles of Financial Reporting

• Historical Cost: Or cost principle, dictates that companies record assets at their cost.
• Fair Value: Indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).
• Revenue Recognition Principle: Requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied.
• Expense Recognition Principle: Dictates that efforts (expenses) be matched with results (revenues). Thus, expenses follow revenues.
• Full Disclosure Principle: Requires that companies disclose all circumstances and events that would make a difference to financial statement users.

Cost Constraint

Accounting standard-setters weigh the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.

A Look at IFRS (LO 7)

Similarities

• Companies applying IFRS also use accrual-basis accounting.
• Similar to GAAP, cash-basis accounting is not in accordance with IFRS.
• IFRS also divides the economic life of companies into artificial time periods (time period assumption).
• The general revenue recognition principle required by GAAP is similar to that used under IFRS.

Differences

• Under IFRS, revaluation (using fair value) of items such as land and buildings is permitted. IFRS allows depreciation based on revaluation of assets, which is not permitted under GAAP.
• The terminology used for revenues and gains, and expenses and losses, differs somewhat between IFRS and GAAP.
• Under IFRS, expenses include both those costs incurred in the normal course of operations as well as losses that are not part of normal operations. This is in contrast to GAAP, which defines each separately.