Chapter 3

Adjusting Accounts For Financial Statements

Importance of Periodic Reporting and Accrual Accounting

Accounting Period

• Time Period Assumption: an organization’s activities can be divided into specific periods such as a month, a three-month quarter, a six-month interval, or a year

• Annual Financial Statements: covering a one-year period

• Fiscal Year: consecutive 12-month (or 52 weeks)

• Periodic Reporting: Essential for providing timely financial information.

• Accrual Basis Accounting: records revenues when services and products are delivered and records expenses when incurred (matched with revenues)

Accrual Basis vs. Cash Basis

• Accrual Basis:

  • Revenue recorded upon delivery of goods/services.

  • Expenses recorded when incurred.

  • Unexpired premium is reported as a Prepaid Insurance asst on the accrual basis balance sheet

• Example: When prepaid insurance is bought for three years, it is expensed/allocated at the end of each month for each of the three years.

• Cash Basis:

  • Revenues are recorded when cash is received.

  • Expenses are recorded when money is paid.

  • Cash basis balance sheet never reports a prepaid insurance asset since it is immediately expensed

• Example: If insurance expense is paid for over three years, the amount is paid in the same year and for the next two years $0 is paid.

Revenue Recognition Principle

• Revenue Recognition: Revenue is recorded when goods/services are provided at an amount expected to be received from customers

  • Adjustments ensure that revenue is recognized (reported) in the time period when those services and products are provided.

Expense Recognition Principle

• Matching Principle: Expenses recorded in the same period as the revenues they help generate.

Framework for Adjustments

Types of Adjustments

• Adjustment Entry (journal entry): at the end of an accounting period to bring an asset or liability account to its proper amount and update the related expense or revenue account

• Process for Adjusting Entries

  • Step 1: Determine what the current account balance equals.

  • Step 2: Determine what the current account balance should equal.

  • Step 3: Record adjusting entry to get from step 1 to step 2.

Deferral of Expenses

Prepaid Expenses

• Definition: Payments made in advance for benefits to be received later.

• Examples: Prepaid insurance, prepaid rent, supplies.

Adjusting for Prepaid Insurance

• Prepaid insurance expires with time

• Prepaid insurance credited; Insurance expense debited

• Process:

  • Step 1: Record total prepaid insurance at a given amount for a specific period of policy.

  • Step 2: Adjust monthly insurance expense to recognize the portion used.

  • Step 3: Report remaining prepaid insurance on the Balance Sheet and insurance expense on the Income Statement.

Adjustments for Supplies

• Supplies are counted at period-end

• Steps:

  • Step 1: Record purchased supplies.

  • Step 2: Conduct a physical count to determine the remaining supplies. (Take total supplies and subtract by unused supplies)

  • Step 3: Adjust supplies and recognize expired supplies on financial statements.

    • Reduce supplies account, as well as T-account postings

Depreciation

Plant Assets: a special category of prepaid expenses (Property, Plant, Equipment)

• It is long-term tangible assets used to produce and sell products and services

• Provide benefits for more than one period

• All plant assets (excluding land) wear out or become less useful

• Example: buildings, machines, vehicles, equipment

• reported on the balance sheet

• Cost of plant assets are reported as expenses in the income statement over the assets’ useful lives (benefit periods)

Depreciation Definfition

• It is the allocation of the costs of these assets over their expected useful lives (does not measure decline in market value)

• Depreciation expense is recorded with an adjusting entry similar to prepaid expenses

Straight-Line Depreciation Formula

• Depreciation Formula:

  • Asset Cost - Salvage Value / useful life

• Depreciation Adjustment:

  • using straight-line depreciation, which allocates equal amounts of the asset’s net cost to depreciation during its useful life

  • Net cost / useful life (months) = depreciation expense.

• Accumulated Depreciation: a separate contra account and has a normal credit balance

  • Contra account: linked with another account, and has an opposite normal balance, it is reported as a subtraction from that other account’s balance

    • allows the original cost to remain in the books while showing the reduction in value seperately

  • Book value: Accumulated Depreciation is subtracted by asset cost to get the book value or net amount

Deferral of Revenues

Unearned Revenue

• Definition: Cash received before services are provided.

  • this is recorded as a liability

  • when cash is accepted, an obligation to provide products or services is accepted

  • recorded revenue is delayed until the product or service is provided

• Adjusting Entries:

  • decrease liability (debit) (balance sheet)

  • increase revenue (credit) (income statement)

• Example:

  • Step 1: record advance payment which increases cash; record increase in liability over the specified time customer payed for

  • Step 2: recognize revenue as the service is performed, adjusting the revenue account while decreasing the liability account to reflect the fulfillment of the obligation.

    • Example: if work was completed 5 days of out 60 days of work that needed to be done, you record the revenue by (Asset x 5/60) = unearned revenue

  • Step 3: Adjust the entry to reduce liability account and recognize revenue

Accrued Expenses

Definition

• Accrued Expenses: Costs incurred in a period that are both unpaid and unrecorded

• Adjusting Journal Entry: Increase liability (Credit) and expense (Debit) accounts appropriately at period end.

Salaries Expense

• Total debited salaries expense is reported on the income statement

• Total credited salaries payable is reported on the balance sheet

Interest Expense

• incurred as time passes

• unless interest is paid on the day of an accounting period, it needs to be adjuted for interest expense but not yet paid

• interest costs must be accrued from the most recent payment date up till the end of the period

• Accrued Interest Formula: principal amount owed x Annual interest rate x fraction of year since last payment

  • Example: If a company has a loan of $10,000 from a bank with an annual interest rate of 5%, then 30 days’ accrued interest expense would be calculated as follows: $10,000 x 0.05 x (30/360) = $41.67.

  • Key: interest computations use a 360-day year, called the bankers’ rule

Future Cash Payment of Accrued Expenses

• Salaries payable decreases (debited)

• Salaries expense decreases (debited)

• Cash is decreased (credited)

Accrued Revenues

Definition and Example

• Accrued Revenues: Revenues earned but not yet recorded.

  • Accrued Revenues = accrued assets

    • Example: A technician who bills customers after the job is done. If one-third of the job is complete by the end of a period, then the technician must record one-third of the expected billing as revenue in that period, although there is no billing or collection

Framework

• Increases a revenue (income statement) account; and increases an asset (balance sheet) account

• Usually, it comes from services, products, interest, and rent

• An asset is debited and revenue is credited

• Adjusting Entry: Increase accounts receivable and revenue when services have been performed.

Accrued Services Revenue

• revenues are earned but unrecorded because either the buyer has not yet paid or the seller has not yet billed the buyer

• accounts receivable increases and consulting revenue increases

Accrued Interest Revenue

• adjusting entry is similar to accruing service revenue

• Interest receivables are (debited) and Interest revenue (credited)

Preparing Financial Statements from Adjusted Trial Balance

• Adjusted trial balance is prepared after adjusting entries have been recorded and posted

Profit Margin

• a useful measure of a company’s operating results is the ratio of its net income to net sales, which is called profit margin

• Formula:

  • Profit Margin = Net Income / Net Sales

Summary of Adjustments