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chapter
4
ACCRUAL ACCOUNTING
CONCEPTS
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162
study objectives
Read A Look at IFRS p. 224
1 Explain the revenue recognition principle and the expense
recognition principle.
2 Differentiate between the cash basis and the accrual basis of
accounting.
3 Explain why adjusting entries are needed, and identify the
major types of adjusting entries.
4 Prepare adjusting entries for deferrals.
5 Prepare adjusting entries for accruals.
6 Describe the nature and purpose of the adjusted trial balance.
7 Explain the purpose of closing entries.
8 Describe the required steps in the accounting cycle.
9 Understand the causes of differences between net
income and cash provided by operating activities.
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feature story
The accuracy of the financial reporting system de-
most common abuses of financial accounting. Xerox
pends on answers to a few fundamental questions. At
admitted reporting billions of dollars of lease revenue
what point has revenue been earned? At what point
in periods earlier than it should have been reported.
is the earnings process complete? When have ex-
And WorldCom stunned the financial markets with its
penses really been incurred?
admission that it had boosted net income by billions
During the 1990s, the stock prices of dot-com companies boomed. Many dot-com companies earned most
of their revenue from selling advertising
space on their websites. To boost reported revenue, some dot-coms began
swapping website ad space. Company
of dollars by delaying the recognition of expenses until later years.
W HAT WAS
YO U R P R O FIT?
Unfortunately, revelations such as
these have become all too common in
the corporate world. It is no wonder that
the U.S. Trust Survey of affluent Ameri-
A would put an ad for its website on company B’s web-
cans reported that 85 percent of its respondents be-
site, and company B would put an ad for its website on
lieved that there should be tighter regulation of finan-
company A’s website. No money ever changed hands,
cial disclosures, and 66 percent said they did not trust
but each company recorded revenue (for the value of
the management of publicly traded companies.
the space that it gave up on its site). This practice did
Why did so many companies violate basic financial
little to boost net income and resulted in no additional
reporting rules and sound ethics? Many speculate that
cash flow—but it did boost reported revenue. Regula-
as stock prices climbed, executives were under increas-
tors eventually put an end to the practice.
ing pressure to meet higher and higher earnings expec-
Another type of transgression results from compa-
tations. If actual results weren’t as good as hoped for,
nies recording revenue or expenses in the wrong year.
some gave in to temptation and “adjusted” their num-
In fact, shifting revenues and expenses is one of the
bers to meet market expectations.
INSIDE CHAPTER 4 . . .
●
●
●
●
Cooking the Books? (p. 166)
Reporting Revenue Accurately (p. 167)
Turning Gift Cards into Revenue (p. 174)
Cashing In on Accrual Accounting (p. 178)
163
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preview of chapter 4
As indicated in the Feature Story, making adjustments is necessary to avoid misstatement of revenues and
expenses such as those at Xerox and WorldCom. In this chapter, we introduce you to the accrual accounting
concepts that make such adjustments possible.
The organization and content of the chapter are as follows.
Accrual Accounting Concepts
The Basics of
Adjusting Entries
Timing Issues
• Revenue recognition
principle
• Expense recognition
principle
• Accrual versus cash
basis of accounting
• Types of adjusting
entries
• Adjusting entries for
deferrals
• Adjusting entries for
accruals
• Summary of basic
relationships
The Adjusted Trial
Balance and Financial
Statements
• Preparing the
adjusted trial balance
• Preparing financial
statements
Closing the Books
• Preparing closing
entries
• Preparing a postclosing trial balance
• Summary of the
accounting cycle
Quality of Earnings
• Earnings management
• Sarbanes-Oxley
Timing Issues
study objective
1
Explain the revenue
recognition principle and
the expense recognition
principle.
Helpful Hint An accounting time
period that is one year long is
called a fiscal year.
Revenue Recognition
Service
performed
Customer
requests
service
Cash
received
Revenue should be recognized in the accounting
period in which it is earned
(generally when service is
performed).
164
Most businesses need immediate feedback about how well they are doing. For
example, management usually wants monthly reports on financial results, most
large corporations are required to present quarterly and annual financial statements to stockholders, and the Internal Revenue Service requires all businesses
to file annual tax returns. Accounting divides the economic life of a business
into artificial time periods. As indicated in Chapter 2, this is the periodicity
assumption. Accounting time periods are generally a month, a quarter, or
a year.
Many business transactions affect more than one of these arbitrary time periods. For example, a new building purchased by Citigroup or a new airplane
purchased by Delta Air Lines will be used for many years. It doesn’t make
sense to expense the full cost of the building or the airplane at the time of
purchase because each will be used for many subsequent periods. Instead, we
determine the impact of each transaction on specific accounting periods.
Determining the amount of revenues and expenses to report in a given accounting period can be difficult. Proper reporting requires an understanding of
the nature of the company’s business. Two principles are used as guidelines: the
revenue recognition principle and the expense recognition principle.
THE REVENUE RECOGNITION PRINCIPLE
The revenue recognition principle requires that companies recognize revenue
in the accounting period in which it is earned. In a service company, revenue
is considered to be earned at the time the service is performed. To illustrate, assume Conrad Dry Cleaners cleans clothing on June 30, but customers do not
claim and pay for their clothes until the first week of July. Under the revenue
recognition principle, Conrad earns revenue in June when it performs the service, not in July when it receives the cash. At June 30, Conrad would report a
receivable on its balance sheet and revenue in its income statement for the service performed. The journal entries for June and July would be as follows.
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Timing Issues
June
July
Accounts Receivable
Service Revenue
xxx
Cash
Accounts Receivable
xxx
165
xxx
xxx
DECISION TOOLKIT
DECISION CHECKPOINTS
INFO NEEDED FOR DECISION
TOOL TO USE FOR DECISION
At what point should the company
record revenue?
Need to understand the nature of
the company’s business
Record revenue when earned. A
service business earns revenue
when it performs a service.
HOW TO EVALUATE RESULTS
Recognizing revenue too early
overstates current period revenue;
recognizing it too late understates
current period revenue.
THE EXPENSE RECOGNITION PRINCIPLE
In recognizing expenses, a simple rule is followed: “Let the expenses follow the
revenues.” Thus, expense recognition is tied to revenue recognition. Applied to
the preceding example, this means that the salary expense Conrad incurred in
performing the cleaning service on June 30 should be reported in the same period in which it recognizes the service revenue. The critical issue in expense
recognition is determining when the expense makes its contribution to revenue.
This may or may not be the same period in which the expense is paid. If Conrad does not pay the salary incurred on June 30 until July, it would report salaries
payable on its June 30 balance sheet.
The practice of expense recognition is referred to as the expense recognition principle (often referred to as the matching principle). It dictates that
efforts (expenses) be matched with results (revenues). Illustration 4-1 shows
these relationships.
Illustration 4-1 GAAP
relationships in revenue
and expense recognition
Periodicity Assumption
Economic life of business
can be divided into
artificial time periods
Revenue Recognition
Principle
Expense Recognition
Principle
Revenue recognized in
the accounting period in
which it is earned
Expenses matched with revenues
in the period when efforts are
expended to generate revenues
Revenue and Expense
Recognition
In accordance with generally
accepted accounting principles
(GAAP)
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chapter 4 Accrual Accounting Concepts
DECISION TOOLKIT
DECISION CHECKPOINTS
INFO NEEDED FOR DECISION
TOOL TO USE FOR DECISION
At what point should the company
record expenses?
Need to understand the nature of
the company’s business
Expenses should “follow”
revenues—that is, match the
effort (expense) with the result
(revenue).
HOW TO EVALUATE RESULTS
Recognizing expenses too early
overstates current period
expense; recognizing them too
late understates current period
expense.
Ethics Insight
Cooking the Books?
Allegations of abuse of the revenue recognition principle have become all too
common in recent years. For example, it was alleged that Krispy Kreme sometimes doubled the number of doughnuts shipped to wholesale customers at the end of a quarter
to boost quarterly results. The customers shipped the unsold doughnuts back after the
beginning of the next quarter for a refund. Conversely, Computer Associates International
was accused of backdating sales—that is, saying that a sale that occurred at the beginning of one quarter occurred at the end of the previous quarter in order to achieve the
previous quarter’s sales targets.
?
study objective
2
Differentiate between the
cash basis and the accrual
basis of accounting.
International Note Although
different accounting standards are
often used by companies in other
countries, the accrual basis of
accounting is central to all of
these standards.
What motivates sales executives and finance and accounting executives to participate
in activities that result in inaccurate reporting of revenues? (See page 223.)
ACCRUAL VERSUS CASH BASIS OF ACCOUNTING
Accrual-basis accounting means that transactions that change a company’s financial statements are recorded in the periods in which the events occur,
even if cash was not exchanged. For example, using the accrual basis means that
companies recognize revenues when earned (the revenue recognition principle), even if cash was not received. Likewise, under the accrual basis, companies recognize expenses when incurred (the expense recognition principle),
even if cash was not paid.
An alternative to the accrual basis is the cash basis. Under cash-basis
accounting, companies record revenue only when cash is received. They
record expense only when cash is paid. The cash basis of accounting is prohibited under generally accepted accounting principles. Why? Because it
does not record revenue when earned, thus violating the revenue recognition
principle. Similarly, it does not record expenses when incurred, which violates
the expense recognition principle.
Illustration 4-2 compares accrual-based numbers and cash-based numbers.
Suppose that Fresh Colors paints a large building in 2011. In 2011, it incurs and
pays total expenses (salaries and paint costs) of $50,000. It bills the customer
$80,000, but does not receive payment until 2012. On an accrual basis, Fresh Colors reports $80,000 of revenue during 2011 because that is when it is earned. The
company matches expenses of $50,000 to the $80,000 of revenue. Thus, 2011 net
income is $30,000 ($80,000 ⫺ $50,000). The $30,000 of net income reported for
2011 indicates the profitability of Fresh Colors’ efforts during that period.
If, instead, Fresh Colors were to use cash-basis accounting, it would report
$50,000 of expenses in 2011 and $80,000 of revenues during 2012. As shown in
Illustration 4-2, it would report a loss of $50,000 in 2011 and would report net
income of $80,000 in 2012. Clearly, the cash-basis measures are misleading because the financial performance of the company would be misstated for both
2011 and 2012.
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The Basics of Adjusting Entries
167
Illustration 4-2 Accrualversus cash-basis
accounting
2011
Bob's
Bait B
arn
arn
Bob's Bait B
Fresh
Colors
P AIN T
P AIN T
P
$
Bob's Bait Barn
$
Activity
2012
AIN T
Purchased paint, painted building, paid employees
Accrual
basis
Revenue
Expense
Net income
Cash
basis
Revenue
Expense
Net loss
$80,000
50,000
$30,000
$
0
50,000
$( 50,000 )
Received payment for work done in 2011
Revenue
Expense
Net income
$
Revenue
Expense
Net income
$80,000
0
$80,000
$
0
0
0
Investor Insight
Reporting Revenue Accurately
Until recently, electronics manufacturer Apple was required to spread the
revenues earned from iPhone sales over the two-year period following the sale of the
phone. Accounting standards required this because it was argued that Apple was obligated to provide software updates after the phone was sold. Therefore, since Apple
had service obligations after the initial date of sale, it was forced to spread the revenue
over a two-year period. However, since the company received full payment upfront, the
cash flows from iPhones significantly exceeded the revenue reported from iPhone sales
in each accounting period. It also meant that the rapid growth of iPhone sales was not
fully reflected in the revenue amounts reported in Apple’s income statement. A new accounting standard now enables Apple to report nearly all of its iPhone revenue at the
point of sale. It was estimated that 2009 revenues would have been about 17% higher,
and earnings per share would have been almost 50% higher, under the new rule.
?
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? (See page 223.)
The Basics of Adjusting Entries
In order for revenues to be recorded in the period in which they are earned, and
for expenses to be recognized in the period in which they are incurred, companies make adjusting entries. Adjusting entries ensure that the revenue recognition and expense recognition principles are followed.
Adjusting entries are necessary because the trial balance—the first pulling
together of the transaction data—may not contain up-to-date and complete data.
This is true for several reasons:
1. Some events are not recorded daily because it is not efficient to do so. Examples are the use of supplies and the earning of wages by employees.
study objective
3
Explain why adjusting
entries are needed, and
identify the major types of
adjusting entries.
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International Note Internal
controls are a system of checks
and balances designed to detect
and prevent fraud and errors. The
Sarbanes-Oxley Act requires U.S.
companies to enhance their
systems of internal control.
However, many foreign companies
do not have to meet strict internal
control requirements. Some U.S.
companies believe that this gives
foreign firms an unfair advantage
because developing and maintaining
internal controls can be very
expensive.
Illustration 4-3
Categories of adjusting
entries
2. Some costs are not recorded during the accounting period because these
costs expire with the passage of time rather than as a result of recurring
daily transactions. Examples are charges related to the use of buildings and
equipment, rent, and insurance.
3. Some items may be unrecorded. An example is a utility service bill that will
not be received until the next accounting period.
Adjusting entries are required every time a company prepares financial
statements. The company analyzes each account in the trial balance to determine whether it is complete and up to date for financial statement purposes.
Every adjusting entry will include one income statement account and one
balance sheet account.
TYPES OF ADJUSTING ENTRIES
Adjusting entries are classified as either deferrals or accruals. As Illustration 4-3
shows, each of these classes has two subcategories.
Deferrals:
1. Prepaid expenses: Expenses paid in cash and recorded as assets before they are
used or consumed.
2. Unearned revenues: Cash received and recorded as liabilities before revenue is
earned.
Accruals:
1. Accrued revenues: Revenues earned but not yet received in cash or recorded.
2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.
Subsequent sections give examples of each type of adjustment. Each example
is based on the October 31 trial balance of Sierra Corporation, from Chapter 3,
reproduced in Illustration 4-4. Note that Retained Earnings, with a zero balance,
has been added to this trial balance. We will explain its use later.
Illustration 4-4
balance
Trial
SIERRA CORPORATION
Trial Balance
October 31, 2012
Debit
Cash
Supplies
Prepaid Insurance
Equipment
Notes Payable
Accounts Payable
Unearned Service Revenue
Common Stock
Retained Earnings
Dividends
Service Revenue
Salaries Expense
Rent Expense
Credit
$15,200
2,500
600
5,000
$ 5,000
2,500
1,200
10,000
0
500
10,000
4,000
900
$28,700
$28,700
We assume that Sierra Corporation uses an accounting period of one month.
Thus, monthly adjusting entries are made. The entries are dated October 31.
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The Basics of Adjusting Entries
ADJUSTING ENTRIES FOR DEFERRALS
To defer means to postpone or delay. Deferrals are costs or revenues that are
recognized at a date later than the point when cash was originally exchanged.
Companies make adjusting entries for deferrals to record the portion of the deferred item that was incurred as an expense or earned as revenue during the
current accounting period. The two types of deferrals are prepaid expenses and
unearned revenues.
study objective
169
4
Prepare adjusting entries
for deferrals.
Prepaid Expenses
Companies record payments of expenses that will benefit more than one accounting period as assets called prepaid expenses or prepayments. When expenses are prepaid, an asset account is increased (debited) to show the service
or benefit that the company will receive in the future. Examples of common prepayments are insurance, supplies, advertising, and rent. In addition, companies
make prepayments when they purchase buildings and equipment.
Prepaid expenses are costs that expire either with the passage of time
(e.g., rent and insurance) or through use (e.g., supplies). The expiration of these
costs does not require daily entries, which would be impractical and unnecessary. Accordingly, companies postpone the recognition of such cost expirations
until they prepare financial statements. At each statement date, they make adjusting entries to record the expenses applicable to the current accounting period and to show the remaining amounts in the asset accounts.
Prior to adjustment, assets are overstated and expenses are understated.
Therefore, as shown in Illustration 4-5, an adjusting entry for prepaid expenses
results in an increase (a debit) to an expense account and a decrease
(a credit) to an asset account.
Illustration 4-5 Adjusting
entries for prepaid expenses
Prepaid Expenses
Asset
Unadjusted Credit
Balance
Adjusting
Entry (–)
Expense
Debit
Adjusting
Entry (+)
Let’s look in more detail at some specific types of prepaid expenses, beginning with supplies.
Supplies
Oct. 5
SUPPLIES. The purchase of supplies, such as paper and envelopes, results in an
increase (a debit) to an asset account. During the accounting period, the company uses supplies. Rather than record supplies expense as the supplies are used,
companies recognize supplies expense at the end of the accounting period. At
the end of the accounting period, the company counts the remaining supplies.
The difference between the unadjusted balance in the Supplies (asset) account
and the actual cost of supplies on hand represents the supplies used (an expense)
for that period.
Recall from Chapter 3 that Sierra Corporation purchased supplies costing $2,500 on October 5. Sierra recorded the purchase by increasing (debiting)
the asset Supplies. This account shows a balance of $2,500 in the October 31
trial balance. An inventory count at the close of business on October 31 reveals
that $1,000 of supplies are still on hand. Thus, the cost of supplies used is
Supplies purchased;
record asset
Oct. 31
Supplies used;
record supplies expense
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$1,500 ($2,500 ⫺ $1,000). This use of supplies decreases an asset, Supplies.
It also decreases stockholders’ equity by increasing an expense account, Supplies Expense. This is shown in Illustration 4-6.
Illustration 4-6
Adjustment for supplies
The expense Supplies Expense is increased $1,500, and the asset
Supplies is decreased $1,500.
Basic
Analysis
Equation
Analysis
(1)
Debit–Credit
Analysis
Assets
Supplies
–$1,500
=
Liabilities
+
=
Stockholders’ Equity
Supplies Expense
–$1,500
Debits increase expenses: debit Supplies Expense $1,500.
Credits decrease assets: credit Supplies $1,500.
Journal
Entry
Oct. 31 Supplies Expense
Supplies
(To record supplies used)
1,500
1,500
Supplies Expense
Supplies
Posting
Oct. 5
Oct. 31
2,500 Oct. 31
Bal. 1,000
Adj. 1,500
Oct. 31
Oct. 31
Adj. 1,500
Bal. 1,500
After adjustment, the asset account Supplies shows a balance of $1,000,
which is equal to the cost of supplies on hand at the statement date. In addition, Supplies Expense shows a balance of $1,500, which equals the cost of supplies used in October. If Sierra does not make the adjusting entry, October
expenses will be understated and net income overstated by $1,500. Moreover, both assets and stockholders’ equity will be overstated by $1,500 on
the October 31 balance sheet.
Insurance
Oct. 4
ins 1 yea
u
r
po ranc
$6 licy e
00
Insurance purchased;
record asset
Insurance Policy
Oct Nov Dec
$50 $50 $50
Feb March April
$50
$50 $50
June July
Aug
$50
$50
$50
1 YEAR $600
Jan
$50
May
$50
Sept
$50
Oct. 31
Insurance expired;
record insurance expense
INSURANCE. Companies purchase insurance to protect themselves from losses
due to fire, theft, and unforeseen events. Insurance must be paid in advance, often
for more than one year. The cost of insurance (premiums) paid in advance is
recorded as an increase (debit) in the asset account Prepaid Insurance. At the
financial statement date, companies increase (debit) Insurance Expense and
decrease (credit) Prepaid Insurance for the cost of insurance that has expired
during the period.
On October 4, Sierra Corporation paid $600 for a one-year fire insurance policy. Coverage began on October 1. Sierra recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in the October 31
trial balance. Insurance of $50 ($600 ⫼ 12) expires each month. The expiration of
prepaid insurance decreases an asset, Prepaid Insurance. It also decreases stockholders’ equity by increasing an expense account, Insurance Expense.
As shown in Illustration 4-7, the asset Prepaid Insurance shows a balance of
$550, which represents the unexpired cost for the remaining 11 months of coverage. At the same time, the balance in Insurance Expense equals the insurance
cost that expired in October. If Sierra does not make this adjustment, October
expenses are understated by $50 and net income is overstated by $50. Moreover,
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The Basics of Adjusting Entries
171
as the accounting equation shows, both assets and stockholders’ equity will be
overstated by $50 on the October 31 balance sheet.
Illustration 4-7
Adjustment for insurance
Basic
Analysis
Equation
Equation
Analysis
Analysis
The expense Insurance Expense is increased $50, and the asset
Prepaid Insurance is decreased $50.
(2)
Debit–Credit
Analysis
= Liabilities +
=
Stockholders’ Equity
Insurance Expense
⫺$50
Debits increase expenses: debit Insurance Expense $50.
Credits decrease assets: credit Prepaid Insurance $50.
Journal
Entry
Posting
Assets
Prepaid Insurance
⫺$50
Oct. 31 Insurance Expense
Prepaid Insurance
(To record insurance expired)
Oct. 4
Oct. 31
Prepaid Insurance
600 Oct. 31
Bal. 550
50
50
Insurance Expense
Adj. 50
Oct. 31
Oct. 31
Adj. 50
Bal. 50
DEPRECIATION. A company typically owns a variety of assets that have long lives,
such as buildings, equipment, and motor vehicles. The period of service is referred to as the useful life of the asset. Because a building is expected to provide service for many years, it is recorded as an asset, rather than an expense,
on the date it is acquired. As explained in chapter 2, companies record such assets at cost, as required by the cost principle. To follow the expense recognition
principle, companies allocate a portion of this cost as an expense during each
period of the asset’s useful life. Depreciation is the process of allocating the cost
of an asset to expense over its useful life.
Need for adjustment. The acquisition of long-lived assets is essentially a
long-term prepayment for the use of an asset. An adjusting entry for depreciation
is needed to recognize the cost that has been used (an expense) during the period
and to report the unused cost (an asset) at the end of the period. One very
important point to understand: Depreciation is an allocation concept, not a
valuation concept. That is, depreciation allocates an asset’s cost to the
periods in which it is used. Depreciation does not attempt to report the
actual change in the value of the asset.
For Sierra Corporation, assume that depreciation on the equipment is $480
a year, or $40 per month. As shown in Illustration 4-8 (page 172), rather than decrease (credit) the asset account directly, Sierra instead credits Accumulated Depreciation—Equipment. Accumulated Depreciation is called a contra asset account.
Such an account is offset against an asset account on the balance sheet. Thus, the
Accumulated Depreciation—Equipment account offsets the asset Equipment. This
account keeps track of the total amount of depreciation expense taken over the life
of the asset. To keep the accounting equation in balance, Sierra decreases stockholders’ equity by increasing an expense account, Depreciation Expense.
The balance in the Accumulated Depreciation—Equipment account will increase $40 each month, and the balance in Equipment remains $5,000.
Depreciation
Oct. 2
Equipment purchased;
record asset
Equipment
Oct Nov Dec Jan
$40 $40 $40 $40
Feb March April May
$40 $40 $40 $40
June July
Aug Sept
$40 $40 $40 $40
Depreciation = $480/year
Oct. 31
Depreciation recognized;
record depreciation expense
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chapter 4 Accrual Accounting Concepts
Illustration 4-8
Adjustment for depreciation
Basic
Analysis
The expense Depreciation Expense is increased $40, and the contra asset
Accumulated Depreciation—Equipment is increased $40.
Assets
Accumulated
Depreciation—Equipment
Equation
Analysis
⫺$40
= Liabilities +
Stockholders’ Equity
Depreciation Expense
⫺$40
=
Debits increase expenses: debit Depreciation Expense $40.
Credits increase contra assets: credit Accumulated
Depreciation—Equipment $40.
Debit–Credit
Analysis
Oct. 31 Depreciation Expense
Accumulated Depreciation—
Equipment
(To record monthly
depreciation)
Journal
Entry
Oct. 2
Oct. 31
40
40
Equipment
5,000
Bal. 5,000
Posting
Accumulated Depreciation—Equipment
Oct. 31
Adj. 40
Oct. 31
Bal. 40
Helpful Hint All contra accounts
have increases, decreases, and
normal balances opposite to the
account to which they relate.
Illustration 4-9 Balance
sheet presentation of
accumulated depreciation
Oct. 31
Oct. 31
Depreciation Expense
Adj. 40
Bal. 40
Statement presentation. As noted above, Accumulated Depreciation—
Equipment is a contra asset account. It is offset against Equipment on the
balance sheet. The normal balance of a contra asset account is a credit. A
theoretical alternative to using a contra asset account would be to decrease
(credit) the asset account by the amount of depreciation each period. But using
the contra account is preferable for a simple reason: It discloses both the original
cost of the equipment and the total cost that has expired to date. Thus, in the
balance sheet, Sierra deducts Accumulated Depreciation—Equipment from the
related asset account, as shown in Illustration 4-9.
Equipment
Less: Accumulated depreciation—equipment
$ 5,000
40
$4,960
Alternative Terminology Book
value is also referred to as
carrying value.
Book value is the difference between the cost of any depreciable asset and
its related accumulated depreciation. In Illustration 4-9, the book value of the
equipment at the balance sheet date is $4,960. The book value and the fair value
of the asset are generally two different values. As noted earlier, the purpose of
depreciation is not valuation but a means of cost allocation.
Depreciation expense identifies the portion of an asset’s cost that expired
during the period (in this case, in October). The accounting equation shows that
without this adjusting entry, total assets, total stockholders’ equity, and net income are overstated by $40 and depreciation expense is understated by $40.
Illustration 4-10 summarizes the accounting for prepaid expenses.
Unearned Revenues
Companies record cash received before revenue is earned by increasing (crediting) a
liability account called unearned revenues. Items like rent, magazine subscriptions,
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ACCOUNTING FOR PREPAID EXPENSES
Examples
Insurance, supplies,
advertising, rent,
depreciation
Reason for
Adjustment
Accounts Before
Adjustment
Adjusting
Entry
Prepaid expenses
recorded in asset
accounts have
been used.
Assets
overstated.
Expenses
understated.
Dr. Expenses
Cr. Assets
and customer deposits for future service may result in unearned revenues. Airlines
such as United, American, and Delta, for instance, treat receipts from the sale of tickets as unearned revenue until the flight service is provided.
Unearned revenues are the opposite of prepaid expenses. Indeed, unearned
revenue on the books of one company is likely to be a prepaid expense on the books
of the company that has made the advance payment. For example, if identical
accounting periods are assumed, a landlord will have unearned rent revenue
when a tenant has prepaid rent.
When a company receives payment for services to be provided in a future accounting period, it increases (credits) an unearned revenue (a liability) account to
recognize the liability that exists. The company subsequently earns revenues by providing service. During the accounting period it is not practical to make daily entries
as the company earns the revenue. Instead, we delay recognition of earned revenue
until the adjustment process. Then the company makes an adjusting entry to record
the revenue earned during the period and to show the liability that remains at the
end of the accounting period. Typically, prior to adjustment, liabilities are overstated
and revenues are understated. Therefore, as shown in Illustration 4-11, the adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.
Liability
Debit
Adjusting
Entry (–)
Unadjusted
Balance
Illustration 4-10
Accounting for prepaid
expenses
Unearned Revenues
Oct. 2
Thank you
in advance for
your work
I will finish
by Dec. 31
$1,2
00
Cash is received in advance;
liability is recorded
Oct. 31
Some service has been
provided; some revenue
is recorded
Illustration 4-11
Adjusting entries for
unearned revenues
Unearned Revenues
Revenue
Credit
Adjusting
Entry (+)
Sierra Corporation received $1,200 on October 2 from R. Knox for guide services for multi-day trips expected to be completed by December 31. Sierra credited
the payment to Unearned Service Revenue, and this liability account shows a balance of $1,200 in the October 31 trial balance. From an evaluation of the service
Sierra performed for Knox during October, the company determines that it has
earned $400 in October. The liability (Unearned Service Revenue) is therefore decreased, and stockholders’ equity (Service Revenue) is increased.
As shown in Illustration 4-12 (page 174), the liability Unearned Service Revenue now shows a balance of $800. That amount represents the remaining guide
services expected to be performed in the future. At the same time, Service Revenue shows total revenue earned in October of $10,400. Without this adjustment,
revenues and net income are understated by $400 in the income statement.
173
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Illustration 4-12 Service
revenue accounts after
adjustment
Moreover, liabilities are overstated and stockholders’ equity is understated
by $400 on the October 31 balance sheet.
The liability Unearned Service Revenue is decreased $400, and the revenue
Service Revenue is increased $400.
Basic
Analysis
Assets
=
Equation
Analysis
Debit–Credit
Analysis
Debits decrease liabilities: debit Unearned Service Revenue $400.
Credits increase revenues: credit Service Revenue $400.
Oct. 31 Unearned Service Revenue
Service Revenue
(To record revenue earned)
Journal
Entry
Posting
+ Stockholders’ Equity
Liabilities
Unearned
Service Revenue
Service Revenue
⫺$400
⫹$400
Oct. 31
Unearned Service Revenue
Adj. 400 Oct. 2
Oct. 31
400
400
Service Revenue
Oct. 3
10,000
31 Adj. 400
1,200
Bal. 800
Oct. 31
Bal. 10,400
Illustration 4-13 summarizes the accounting for unearned revenues.
Illustration 4-13
Accounting for unearned
revenues
ACCOUNTING FOR UNEARNED REVENUES
Examples
Reason for
Adjustment
Accounts Before
Adjustment
Adjusting
Entry
Rent, magazine
subscriptions,
customer deposits
for future service
Unearned revenues
recorded in liability
accounts have been
earned.
Liabilities
overstated.
Revenues
understated.
Dr. Liabilities
Cr. Revenues
Accounting Across the Organization
Turning Gift Cards into Revenue
Those of you who are marketing majors (and even most of you who are not)
know that gift cards are among the hottest marketing tools in merchandising today. Customers purchase gift cards and give them to someone for later use. In a recent year,
gift-card sales topped $95 billion.
Although these programs are popular with marketing executives, they create accounting questions. Should revenue be recorded at the time the gift card is sold, or
when it is exercised? How should expired gift cards be accounted for? In its 2009 balance sheet, Best Buy reported unearned revenue related to gift cards of $479 million.
Source: Robert Berner, “Gift Cards: No Gift to Investors,” Business Week (March 14, 2005), p. 86.
?
Suppose that Robert Jones purchases a $100 gift card at Best Buy on December 24,
2011, and gives it to his wife, Mary Jones, on December 25, 2011. On January 3,
2012, Mary uses the card to purchase $100 worth of CDs. When do you think
Best Buy should recognize revenue and why? (See page 223.)
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175
before you go on...
Do it!
The ledger of Hammond, Inc., on March 31, 2012, includes these selected accounts before adjusting entries are prepared.
Debit
Prepaid Insurance
Supplies
Equipment
Accumulated Depreciation—Equipment
Unearned Service Revenue
ADJUSTING ENTRIES
FOR DEFERRALS
Credit
$ 3,600
2,800
25,000
$5,000
9,200
An analysis of the accounts shows the following.
1.
2.
3.
4.
Insurance expires at the rate of $100 per month.
Supplies on hand total $800.
The equipment depreciates $200 a month.
One-half of the unearned service revenue was earned in March.
Prepare the adjusting entries for the month of March.
Solution
1. Insurance Expense
Prepaid Insurance
(To record insurance expired)
2. Supplies Expense
Supplies
(To record supplies used)
100
100
2,000
2,000
3. Depreciation Expense
Accumulated Depreciation—Equipment
(To record monthly depreciation)
4. Unearned Service Revenue
Service Revenue
(To record revenue earned)
200
200
Action Plan
• Make adjusting entries at the
end of the period for revenues
earned and expenses incurred
in the period.
• Don’t forget to make adjusting
entries for deferrals. Failure to
adjust for deferrals leads to
overstatement of the asset or
liability and understatement of
the related expense or revenue.
4,600
4,600
Related exercise material: BE4-4, BE4-5, BE4-6, BE4-7, and Do it! 4-1.
ADJUSTING ENTRIES FOR ACCRUALS
The second category of adjusting entries is accruals. Prior to an accrual adjustment, the revenue account (and the related asset account) or the expense account
(and the related liability account) are understated. Thus, the adjusting entry for
accruals will increase both a balance sheet and an income statement account.
Accrued Revenues
Revenues earned but not yet recorded at the statement date are accrued revenues.
Accrued revenues may accumulate (accrue) with the passing of time, as in the
case of interest revenue. These are unrecorded because the earning of interest
does not involve daily transactions. Companies do not record interest revenue
on a daily basis because it is often impractical to do so. Accrued revenues also
may result from services that have been performed but not yet billed nor collected, as in the case of commissions and fees. These may be unrecorded because only a portion of the total service has been provided and the clients won’t
be billed until the service has been completed.
An adjusting entry records the receivable that exists at the balance sheet date
and the revenue earned during the period. Prior to adjustment, both assets and
revenues are understated. As shown in Illustration 4-14 (page 176), an adjusting entry for accrued revenues results in an increase (a debit) to an asset
account and an increase (a credit) to a revenue account.
study objective
5
Prepare adjusting entries
for accruals.
Accrued Revenues
Oct. 31
My fee
is $200
Revenue and receivable
are recorded for
unbilled services
Nov. 10
$
Cash is received;
receivable is reduced
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Illustration 4-14 Adjusting
entries for accrued revenues
Accrued Revenues
Asset
Debit
Adjusting
Entry (+)
Helpful Hint For accruals, there
may have been no prior entry, and
the accounts requiring adjustment
may both have zero balances prior
to adjustment.
Ethics Note Computer Associates
International was accused of
backdating sales—that is, saying
that a sale that occurred at the
beginning of one quarter occurred
at the end of the previous quarter,
in order to achieve the previous
quarter’s sales targets.
Illustration 4-15
Adjustment for
accrued revenue
Revenue
Credit
Adjusting
Entry (+)
In October, Sierra Corporation earned $200 for guide services that were not
billed to clients on or before October 31. Because these services are not billed,
they are not recorded. The accrual of unrecorded service revenue increases an
asset account, Accounts Receivable. It also increases stockholders’ equity by increasing a revenue account, Service Revenue, as shown in Illustration 4-15.
Basic
Analysis
The asset Accounts Receivable is increased $200, and the revenue Service
Revenue is increased $200.
Assets
Accounts
Receivable
⫹$200
Equation
Analysis
Debit–Credit
Analysis
=
Liabilities
+
Stockholders’ Equity
Debits increase assets: debit Accounts Receivable $200.
Credits increase revenues: credit Service Revenue $200.
Oct. 31 Accounts Receivable
Service Revenue
(To record revenue earned)
Journal
Entry
Oct. 31
Accounts Receivable
Adj. 200
Oct. 31
Bal. 200
Posting
Equation analyses
summarize the effects
of transactions on the three elements
of the accounting equation, as well as
the effect on cash flows.
A
⫹200
⫺200
Cash Flows
⫹200
=
L
+
SE
Service Revenue
⫹$200
200
200
Service Revenue
Oct. 3
10,000
31
400
31 Adj. 200
Oct. 31
Bal. 10,600
The asset Accounts Receivable shows that clients owe Sierra $200 at the balance sheet date. The balance of $10,600 in Service Revenue represents the total
revenue Sierra earned during the month ($10,000 ⫹ $400 ⫹ $200). Without the
adjusting entry, assets and stockholders’ equity on the balance sheet and
revenues and net income on the income statement are understated.
On November 10, Sierra receives cash of $200 for the services performed in
October and makes the following entry.
Nov. 10
Cash
Accounts Receivable
(To record cash collected on account)
200
200
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The Basics of Adjusting Entries
177
The company records the collection of the receivables by a debit (increase)
to Cash and a credit (decrease) to Accounts Receivable.
Illustration 4-16 summarizes the accounting for accrued revenues.
ACCOUNTING FOR ACCRUED REVENUES
Examples
Interest, rent,
services performed
but not collected
Reason for
Adjustment
Accounts Before
Adjustment
Adjusting
Entry
Revenues have been
earned but not yet
received in cash
or recorded.
Assets
understated.
Revenues
understated.
Dr. Assets
Cr. Revenues
Accrued Expenses
Expenses incurred but not yet paid or recorded at the statement date are called
accrued expenses. Interest, taxes, and salaries are common examples of accrued
expenses.
Companies make adjustments for accrued expenses to record the obligations
that exist at the balance sheet date and to recognize the expenses that apply to
the current accounting period. Prior to adjustment, both liabilities and expenses
are understated. Therefore, an adjusting entry for accrued expenses results
in an increase (a debit) to an expense account and an increase (a credit)
to a liability account.
Ethics Note 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.
Illustration 4-17
Adjusting entries for
accrued expenses
Accrued Expenses
Expense
Illustration 4-16
Accounting for accrued
revenues
Liability
Debit
Adjusting
Entry (+)
Credit
Adjusting
Entry (+)
Let’s look in more detail at some specific types of accrued expenses, beginning with accrued interest.
ACCRUED INTEREST. Sierra Corporation signed a three-month note payable in
the amount of $5,000 on October 1. The note requires Sierra to pay interest at
an annual rate of 12%.
The amount of the interest recorded is determined by three factors: (1) the
face value of the note; (2) the interest rate, which is always expressed as an
annual rate; and (3) the length of time the note is outstanding. For Sierra, the
total interest due on the $5,000 note at its maturity date three months in the
3
future is $150 ($5,000 ⫻ 12% ⫻ 12
), or $50 for one month. Illustration 4-18 shows
the formula for computing interest and its application to Sierra Corporation for
the month of October.
Face Value
of Note
ⴛ
Annual
Interest
Rate
$5,000
⫻
12%
ⴛ
Time in
Terms of
One Year
ⴝ
Interest
⫻
1
12
⫽
$50
Illustration 4-18 Formula
for computing interest
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chapter 4 Accrual Accounting Concepts
Helpful Hint In computing
interest, we express the time
period as a fraction of a year.
Illustration 4-19
Adjustment for
accrued interest
As Illustration 4-19 shows, the accrual of interest at October 31 increases a
liability account, Interest Payable. It also decreases stockholders’ equity by increasing an expense account, Interest Expense.
The expense Interest Expense is increased $50, and the liability Interest
Payable is increased $50.
Basic
Analysis
Assets =
Equation
Analysis
Debit–Credit
Analysis
Liabilities
Interest Payable
⫹$50
+
Stockholders’ Equity
Interest Expense
⫺$50
Debits increase expenses: debit Interest Expense $50.
Credits increase liabilities: credit Interest Payable $50.
Journal
Entry
Oct. 31 Interest Expense
Interest Payable
(To record interest on notes
payable)
Interest Expense
Posting
Oct. 31
Oct. 31
Adj. 50
Bal. 50
50
50
Interest Payable
Oct. 31
Oct. 31
Adj. 50
Bal. 50
Interest Expense shows the interest charges for the month of October. Interest Payable shows the amount of interest the company owes at the statement
date. Sierra will not pay the interest until the note comes due at the end of three
months. Companies use the Interest Payable account, instead of crediting Notes
Payable, to disclose the two different types of obligations—interest and principal—
in the accounts and statements. Without this adjusting entry, liabilities and
interest expense are understated, and net income and stockholders’ equity
are overstated.
International Insight
Cashing In on Accrual Accounting
The Chinese government, like most governments, uses cash accounting. It
was therefore interesting when it was recently reported that for about $38 billion of expenditures in a recent budget projection, the Chinese government decided to use accrual accounting versus cash accounting. It decided to expense the amount in the year
in which it was originally allocated rather than when the payments would be made. Why
did it do this? It enabled the government to keep its projected budget deficit below a
3% threshold. While it was able to keep its projected shortfall below 3%, China did suffer some criticism for its inconsistent accounting. Critics charge that this inconsistent
treatment reduces the transparency of China’s accounting information. That is, it is not
easy for outsiders to accurately evaluate what is really going on.
Source: Andrew Batson, “China Altered Budget Accounting to Reduce Deficit Figure,” Wall Street Journal
Online (March 15, 2010).
?
Accrual accounting is often considered superior to cash accounting. Why, then,
were some people critical of China’s use of accrual accounting in this instance? (See
page 223.)
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The Basics of Adjusting Entries
179
ACCRUED SALARIES. Companies pay for some types of expenses, such as employee salaries and commissions, after the services have been performed. Sierra
paid salaries on October 26 for its employees’ first two weeks of work; the next
payment of salaries will not occur until November 9. As Illustration 4-20 shows,
three working days remain in October (October 29–31).
October
S
M
1
7 8
14 15
21 22
28 29
Start of
pay period
Tu
2
9
16
23
30
W
3
10
17
24
31
November
Th F S
4 5 6
11 12 13
18 19 20
25 26 27
Adjustment period
Illustration 4-20 Calendar
showing Sierra Corporation’s
pay periods
S
M Tu W Th F S
1 2 3
4 5 6 7 8 9 10
11 12 13 14 15 16 17
18 19 20 21 22 23 24
25 26 27 28 29 30
Payday
Payday
At October 31, the salaries for these three days represent an accrued expense
and a related liability to Sierra. 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 ⫻ 3). This accrual increases a liability, Salaries Payable. It also
decreases stockholders’ equity by increasing an expense account, Salaries
Expense, as shown in Illustration 4-21.
The expense Salaries Expense is increased $1,200, and the liability account
Salaries Payable is decreased $1,200.
Basic
Analysis
Assets =
Equation
Analysis
Debit–Credit
Analysis
Liabilities
Salaries Payable
⫹$1,200
+
Stockholders’ Equity
Salaries Expense
⫺$1,200
Debits increase expenses: debit Salaries Expense $1,200.
Credits increase liabilities: credit Salaries Payable $1,200.
Journal
Entry
Posting
Illustration 4-21
Adjustment for accrued
salaries
Oct. 31 Salaries Expense
Salaries Payable
(To record accrued salaries)
Oct. 26
31
Salaries Expense
4,000
Adj. 1,200
Oct. 31
Bal. 5,200
1,200
1,200
Salaries Payable
Oct. 31
Adj. 1,200
Oct. 31
Bal. 1,200
After this adjustment, the balance in Salaries Expense of $5,200 (13 days ⫻
$400) is the actual salary expense for October. The balance in Salaries Payable
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chapter 4 Accrual Accounting Concepts
of $1,200 is the amount of the liability for salaries Sierra owes as of October 31.
Without the $1,200 adjustment for salaries, Sierra’s expenses are understated $1,200 and its liabilities are understated $1,200.
Sierra Corporation pays salaries every two weeks. Consequently, the next payday is November 9, when the company will again pay total salaries of $4,000. The
payment consists of $1,200 of salaries payable at October 31 plus $2,800 of salaries
expense for November (7 working days, as shown in the November calendar ⫻
$400). Therefore, Sierra makes the following entry on November 9.
Nov. 9
Salaries Payable
Salaries Expense
Cash
(To record November 9 payroll)
1,200
2,800
4,000
This entry eliminates the liability for Salaries Payable that Sierra recorded in
the October 31 adjusting entry, and it records the proper amount of Salaries
Expense for the period between November 1 and November 9.
Illustration 4-22 summarizes the accounting for accrued expenses.
Illustration 4-22
Accounting for accrued
expenses
ACCOUNTING FOR ACCRUED EXPENSES
Examples
Reason for
Adjustment
Interest, rent, Expenses have been
salaries
incurred but not yet paid
in cash or recorded.
Accounts Before
Adjustment
Adjusting
Entry
Expenses understated. Dr. Expenses
Liabilities understated.
Cr. Liabilities
before you go on...
ADJUSTING ENTRIES
FOR ACCRUALS
Do it!
Micro Computer Services Inc. began operations on August 1, 2012. At
the end of August 2012, management attempted to prepare monthly financial statements.
The following information relates to August.
1. At August 31, the company owed its employees $800 in salaries that will be paid on
September 1.
2. On August 1, the company borrowed $30,000 from a local bank on a 15-year mortgage. The annual interest rate is 10%.
3. Revenue earned but unrecorded for August totaled $1,100.
Action Plan
• Make adjusting entries at the
end of the period for revenues
earned and expenses incurred
in the period.
• Don’t forget to make adjusting
entries for accruals. Adjusting
entries for accruals will increase
both a balance sheet and an
income statement account.
Prepare the adjusting entries needed at August 31, 2012.
Solution
1. Salaries Expense
Salaries Payable
(To record accrued salaries)
800
2. Interest Expense
Interest Payable
(To record accrued interest:
1
$30,000 ⫻ 10% ⫻ 12
⫽ $250)
250
3. Accounts Receivable
Service Revenue
(To record revenue earned)
800
250
1,100
Related exercise material: BE4-8, Do it! 4-2, E4-8, E4-9, E4-10, and E4-11.
1,100
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The Basics of Adjusting Entries
181
SUMMARY OF BASIC RELATIONSHIPS
Illustration 4-23 summarizes the four basic types of adjusting entries. Take some
time to study and analyze the adjusting entries. Be sure to note that each adjusting entry affects one balance sheet account and one income statement
account.
Type of Adjustment
Accounts Before Adjustment
Adjusting Entry
Prepaid expenses
Assets overstated
Expenses understated
Dr. Expenses
Cr. Assets
Unearned revenues
Liabilities overstated
Revenues understated
Dr. Liabilities
Cr. Revenues
Accrued revenues
Assets understated
Revenues understated
Dr. Assets
Cr. Revenues
Accrued expenses
Expenses understated
Liabilities understated
Dr. Expenses
Cr. Liabilities
Illustration 4-23
Summary of adjusting
entries
Illustrations 4-24 and 4-25 (page 182) show the journalizing and posting of
adjusting entries for Sierra Corporation on October 31. When reviewing the general ledger in Illustration 4-25, note that for learning purposes, we have highlighted the adjustments in color.
GENERAL JOURNAL
Date
2010
Account Titles and Explanation
Debit
Credit
Adjusting Entries
Oct. 31
31
31
31
31
31
31
Supplies Expense
Supplies
(To record supplies used)
1,500
1,500
Insurance Expense
Prepaid Insurance
(To record insurance expired)
50
Depreciation Expense
Accumulated Depreciation—Equipment
(To record monthly depreciation)
40
50
40
Unearned Service Revenue
Service Revenue
(To record revenue earned)
400
Accounts Receivable
Service Revenue
(To record revenue earned)
200
Interest Expense
Interest Payable
(To record interest on notes payable)
Salaries Expense
Salaries Payable
(To record accrued salaries)
400
200
50
50
1,200
1,200
Illustration 4-24 General
journal showing adjusting
entries
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chapter 4 Accrual Accounting Concepts
Illustration 4-25 General
ledger after adjustments
GENERAL LEDGER
Cash
Oct. 1
1
2
3
10,000
5,000
1,200
10,000
Common Stock
Oct. 2
3
4
20
26
Oct. 1
5,000
900
600
500
4,000
Oct. 31 Bal. 10,000
Retained Earnings
Oct. 31
Oct. 31 Bal. 15,200
200
Oct. 31
Bal. 200
Oct. 20
500
Oct. 31
Bal. 500
Service Revenue
Supplies
Oct. 5
2,500
Oct. 31
Bal. 1,000
Oct. 31
Oct. 3
31
31
1,500
600
Oct. 31
Bal. 550
Oct. 31
5,000
Oct. 31
Bal. 5,000
Salaries Expense
50
Oct. 26
31
Equipment
Oct. 2
Supplies Expense
Oct. 31
1,500
Oct. 31 Bal. 1,500
Oct. 31
40
Oct. 31
Bal. 40
Rent Expense
Oct. 3
900
Oct. 31
Bal. 900
Notes Payable
Insurance Expense
Oct. 1
5,000
Oct. 31
50
Oct. 31 Bal. 5,000
Oct. 31
Bal. 50
Accounts Payable
Interest Expense
Oct. 5
2,500
Oct. 31
50
Oct. 31 Bal. 2,500
Oct. 31
Bal. 50
Interest Payable
Depreciation Expense
Oct. 31
50
Oct. 31
40
Oct. 31
Bal. 50
Oct. 31
Bal. 40
Unearned Service Revenue
400
4,000
1,200
Oct. 31 Bal. 5,200
Accumulated Depreciation—
Equipment
Oct. 31
Oct. 2
1,200
Oct. 31
Bal. 800
Salaries Payable
Oct. 31
10,000
400
200
Oct. 31 Bal. 10,600
Prepaid Insurance
Oct. 4
Bal. 0
Dividends
Accounts Receivable
Oct. 31
10,000
1,200
Oct. 31 Bal. 1,200
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The Adjusted Trial Balance and Financial Statements
183
The Adjusted Trial Balance and
Financial Statements
After a company has journalized and posted all adjusting entries, it prepares
another trial balance from the ledger accounts. This trial balance is called an
adjusted trial balance. It shows the balances of all accounts, including those
adjusted, at the end of the accounting period. The purpose of an adjusted trial
balance is to prove the equality of the total debit balances and the total credit
balances in the ledger after all adjustments. Because the accounts contain all
data needed for financial statements, the adjusted trial balance is the primary
basis for the preparation of financial statements.
study objective
Describe the nature and
purpose of the adjusted
trial balance.
PREPARING THE ADJUSTED TRIAL BALANCE
Illustration 4-26 presents the adjusted trial balance for Sierra Corporation prepared from the ledger accounts in Illustration 4-25. The amounts affected by the
adjusting entries are highlighted in color.
Illustration 4-26
Adjusted trial balance
SIERRA CORPORATION
Adjusted Trial Balance
October 31, 2012
Dr.
Cash
Accounts Receivable
Supplies
Prepaid Insurance
Equipment
Accumulated Depreciation—Equipment
Notes Payable
Accounts Payable
Interest Payable
Unearned Service Revenue
Salaries Payable
Common Stock
Retained Earnings
Dividends
Service Revenue
Salaries Expense
Supplies Expense
Rent Expense
Insurance Expense
Interest Expense
Depreciation Expense
Cr.
$ 15,200
200
1,000
550
5,000
$
40
5,000
2,500
50
800
1,200
10,000
0
500
10,600
5,200
1,500
900
50
50
40
$30,190
$30,190
6
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PREPARING FINANCIAL STATEMENTS
Companies can prepare financial statements directly from an adjusted trial
balance. Illustrations 4-27 and 4-28 present the interrelationships of data in the
adjusted trial balance of Sierra Corporation. As Illustration 4-27 shows, companies prepare the income statement from the revenue and expense accounts. Similarly, they derive the retained earnings statement from the retained earnings account, dividends account, and the net income (or net loss) shown in the income
statement. As Illustration 4-28 shows, companies then prepare the balance sheet
from the asset, liability, and stockholders’ equity accounts. They obtain the
amount reported for retained earnings on the balance sheet from the ending balance in the retained earnings statement.
Illustration 4-27
Preparation of the income
statement and retained
earnings statement from
the adjusted trial balance
SIERRA CORPORATION
Adjusted Trial Balance
October 31, 2012
Account
Debit
Cash
Accounts Receivable
Supplies
Prepaid Insurance
Equipment
Accumulated Depreciation—
Equipment
Notes Payable
Accounts Payable
Interest Payable
Unearned Service Revenue
Salaries Payable
Common Stock
Retained Earnings
Dividends
Service Revenue
Salaries Expense
Supplies Expense
Rent Expense
Insurance Expense
Interest Expense
Depreciation Expense
$15,200
200
1,000
550
5,000
Credit
SIERRA CORPORATION
Income Statement
For the Month Ended October 31, 2012
Revenues
Service revenue
$
40
5,000
2,500
50
800
1,200
10,000
0
Expenses
Salaries expense
Supplies expense
Rent expense
Insurance expense
Interest expense
Depreciation expense
$10,600
$5,200
1,500
900
50
50
40
7,740
Total expenses
$ 2,860
Net income
500
10,600
5,200
1,500
900
50
50
40
$30,190
SIERRA CORPORATION
Retained Earnings Statement
For the Month Ended October 31, 2012
$30,190
Retained earnings, October 1
Add: Net income
Less: Dividends
Retained earnings, October 31
To balance sheet
$
0
2,860
2,860
500
$ 2,360
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The Adjusted Trial Balance and Financial Statements
185
Illustration 4-28
Preparation of the balance
sheet from the adjusted
trial balance
SIERRA CORPORATION
Adjusted Trial Balance
October 31, 2012
Account
Debit
Cash
$15,200
Accounts Receivable
200
Supplies
1,000
Prepaid Insurance
550
Equipment
5,000
Accumulated Depreciation—
Equipment
Notes Payable
Accounts Payable
Interest Payable
Unearned Service Revenue
Salaries Payable
Common Stock
Retained Earnings
Dividends
500
Service Revenue
Salaries Expense
5,200
Supplies Expense
1,500
Rent Expense
900
Insurance Expense
50
Interest Expense
50
Depreciation Expense
40
$30,190
SIERRA CORPORATION
Balance Sheet
October 31, 2012
Credit
$
40
5,000
2,500
50
800
1,200
10,000
0
10,600
$30,190
Assets
Cash
Accounts receivable
Supplies
Prepaid insurance
Equipment
Less: Accumulated
depreciation—equipment
Total assets
$15,200
200
1,000
550
$5,000
40
4,960
$21,910
Liabilities and Stockholders’ Equity
Liabilities
$ 5,000
Notes payable
2,500
Accounts payable
1,200
Salaries payable
800
Unearned service revenue
50
Interest payable
Total liabilities
$ 9,550
Stockholders’ equity
10,000
Common stock
2,360
Retained earnings
Total stockholders' equity
12,360
Total liabilities and stockholders’ equity $21,910
Balance at Oct. 31 from
Retained Earnings Statement
in Illustration 4-27
before you go on...
Do it!
Skolnick Co. was organized on April 1, 2012. The company prepares
quarterly financial statements. The adjusted trial balance amounts at June 30 are shown
below:
Debits
Credits
Cash
$ 6,700
Accounts Receivable
600
Prepaid Rent
900
Supplies
1,000
Equipment
15,000
Dividends
600
Salaries and Wages Expense 9,400
Rent Expense
1,500
Depreciation Expense
850
Supplies Expense
200
Utilities Expense
510
Interest Expense
50
Accumulated Depreciation—Equipment $ 850
Notes Payable
5,000
Accounts Payable
1,510
Salaries and Wages Payable
400
Interest Payable
50
Unearned Rent Revenue
500
Common Stock
14,000
Service Revenue
14,200
Rent Revenue
800
Total debits
Total credits
$37,310
$37,310
TRIAL BALANCE
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chapter 4 Accrual Accounting Concepts
(a) Determine the net income for the quarter April 1 to June 30.
(b) Determine the total assets and total liabilities at June 30, 2012 for Skolnick Co.
Action Plan
• In an adjusted trial balance, all
asset, liability, revenue, and
expense accounts are properly
stated.
• To determine the ending
balance in Retained Earnings,
add net income and subtract
dividends.
(c) Determine the amount that appears for Retained Earnings.
Solution
(a) The net income is determined by adding revenues and subtracting expenses. The net
income is computed as follows.
Revenues
Service revenue
Rent revenue
$14,200
800
Total revenues
$15,000
Expenses
Salaries and wages expense
Rent expense
Depreciation expense
Utilities expense
Supplies expense
Interest expense
Total expenses
$ 9,400
1,500
850
510
200
50
12,510
Net income
$ 2,490
(b) Total assets and liabilities are computed as follows.
Assets
Cash
Accounts receivable
Supplies
Prepaid rent
Equipment
Less: Accumulated
depreciation—
equipment
Liabilities
$ 6,700
600
1,000
900
15,000
850
Retained earnings, June 30
$5,000
1,510
500
Total liabilities
$7,460
400
50
14,150
Total assets
(c) Retained earnings, April 1
Add: Net income
Less: Dividends
Notes payable
Accounts payable
Unearned rent revenue
Salaries and wages
payable
Interest payable
$23,350
$
0
2,490
600
$1,890
Related exercise material: BE4-9, BE4-10, BE4-11, BE4-12, Do it! 4-3, E4-12, E4-13, E4-15,
and E4-16.
Closing the Books
Alternative Terminology
Temporary accounts are sometimes
called nominal accounts, and
permanent accounts are sometimes
called real accounts.
study objective
Explain the purpose of
closing entries.
7
In previous chapters, you learned that revenue and expense accounts and the dividends account are subdivisions of retained earnings, which is reported in the
stockholders’ equity section of the balance sheet. Because revenues, expenses, and
dividends relate to only a given accounting period, they are considered temporary accounts. In contrast, all balance sheet accounts are considered permanent
accounts because their balances are carried forward into future accounting
periods. Illustration 4-29 identifies the accounts in each category.
PREPARING CLOSING ENTRIES
At the end of the accounting period, companies transfer the temporary account
balances to the permanent stockholders’ equity account—Retained Earnings—
through the preparation of closing entries. Closing entries transfer net income
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Closing the Books
Temporary
Illustration 4-29
Temporary versus
permanent accounts
Permanent
All revenue accounts
All expense accounts
Dividends
187
All asset accounts
All liability accounts
Stockholders’ equity accounts
(or net loss) and dividends to Retained Earnings, so the balance in Retained
Earnings agrees with the retained earnings statement. For example, notice that
in the adjusted trial balance in Illustration 4-24 (page 183). Retained Earnings
has a balance of zero. Prior to the closing entries, the balance in Retained Earnings will be its beginning-of-the-period balance. (For Sierra, this is zero because
it is Sierra’s first month of operations.)
In addition to updating Retained Earnings to its correct ending balance, closing entries produce a zero balance in each temporary account. As a result,
these accounts are ready to accumulate data about revenues, expenses, and dividends that occur in the next accounting period. Permanent accounts are not
closed.
When companies prepare closing entries, they could close each income statement account directly to Retained Earnings. However, to do so would result in
excessive detail in the retained earnings account. Accordingly, companies close
the revenue and expense accounts to another temporary account, Income Summary, and they transfer only the resulting net income or net loss from this account to Retained Earnings. Illustration 4-30 depicts the closing process. While
it still takes the average large company seven days to close, some companies
such as Cisco employ technology that allows them to do a so-called “virtual close”
almost instantaneously any time during the year. Besides dramatically reducing
the cost of closing, the virtual close provides companies with accurate data for
decision making whenever they desire it.
Illustration 4-30
closing process
Revenue
Accounts
Income
Summary
Expense
Accounts
Dividends
Retained
Earnings
The
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chapter 4 Accrual Accounting Concepts
Illustration 4-31 shows the closing entries for Sierra Corporation. Illustration 4-32 diagrams the posting process for Sierra Corporation’s closing entries.
Illustration 4-31 Closing
entries journalized
GENERAL JOURNAL
Date
Helpful Hint Income Summary is
a very descriptive title: Companies
close total revenues to Income
Summary and total expenses to
Income Summary. The balance in
the Income Summary is a net
income or net loss.
2012
Oct. 31
31
31
31
Account Titles and Explanation
Debit
Credit
Closing Entries
(1)
Service Revenue
Income Summary
(To close revenue account)
(2)
Income Summary
Salaries Expense
Supplies Expense
Rent Expense
Insurance Expense
Interest Expense
Depreciation Expense
(To close expense accounts)
(3)
Income Summary
Retained Earnings
(To close net income to retained earnings)
(4)
Retained Earnings
Dividends
(To close dividends to retained earnings)
10,600
10,600
7,740
5,200
1,500
900
50
50
40
2,860
2,860
500
500
PREPARING A POST-CLOSING TRIAL BALANCE
After a company journalizes and posts all closing entries, it prepares another trial
balance, called a post-closing trial balance, from the ledger. A post-closing trial
balance is a list of all permanent accounts and their balances after closing entries
are journalized and posted. The purpose of this trial balance is to prove the
equality of the permanent account balances that the company carries forward into the next accounting period. Since all temporary accounts will have
zero balances, the post-closing trial balance will contain only permanent—
balance sheet—accounts.
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Illustration 4-32
of closing entries
Posting
Salaries
Expense
4,000
1,200
(2)
5,200
5,200
5,200
2
Supplies
Expense
1,500
(2)
1,500
Income
Summary
(2)
(3)
Rent
Expense
900
(2)
7,740
2,860
(1)
Service
Revenue
10,600
1
(1)
10,600
10,600
10,600
10,600
900
10,000
400
200
10,600
3
Insurance
Expense
50
(2)
Retained
Earnings
50
(4)
2
Interest
Expense
50
(2)
500
(3)
–0–
2,860
Bal.
2,360
50
4
Depreciation
Expense
40
(2)
Dividends
40
500
(4)
500
before you go on...
Do it!
After making entries to close its revenue and expense accounts to Income
Summary, Hancock Company has the following balances.
Dividends
Retained Earnings
Income Summary
$15,000
42,000
18,000 (credit balance)
Prepare the closing entries at December 31 that affect the stockholders’ equity accounts.
Solution
Dec. 31
31
CLOSING ENTRIES
Income Summary
Retained Earnings
(To close net income to retained
earnings)
18,000
Retained Earnings
Dividends
(To close dividends to retained
earnings)
15,000
18,000
Action Plan
• Close Income Summary to
Retained Earnings.
• Close Dividends to Retained
Earnings.
15,000
Related exercise material: BE4-13, BE4-14, Do it! 4-4, E4-14, and E4-18.
189
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study objective
8
Describe the required steps
in the accounting cycle.
SUMMARY OF THE ACCOUNTING CYCLE
Illustration 4-33 shows the required steps in the accounting cycle. You can see
that the cycle begins with the analysis of business transactions and ends with
the preparation of a post-closing trial balance. Companies perform the steps in
the cycle in sequence and repeat them in each accounting period.
Illustration 4-33
Required steps in the
accounting cycle
1
Analyze business
transactions
9
2
Prepare a post-closing
trial balance
Journalize the
transactions
8
3
Journalize and post
closing entries
Post to
ledger accounts
7
4
Prepare financial
statements:
Income statement
Retained earnings statement
Balance sheet
Prepare a
trial balance
5
6
Prepare an adjusted
trial balance
Helpful Hint Some companies
prefer to reverse certain adjusting
entries at the beginning of a new
accounting period. The company
makes a reversing entry at the
beginning of the next accounting
period; this entry is the exact
opposite of the adjusting entry
made in the previous period.
Journalize and post
adjusting entries:
Deferrals/Accruals
Steps 1–3 may occur daily during the accounting period, as explained in
Chapter 3. Companies perform Steps 4–7 on a periodic basis, such as monthly,
quarterly, or annually. Steps 8 and 9, closing entries and a post-closing trial
balance, usually take place only at the end of a company’s annual accounting
period.
Quality of Earnings
“Did you make your numbers today?” is a question asked often in both large and
small businesses. Companies and employees are continually under pressure to
“make the numbers”—that is, to have earnings that are in line with expectations.
As a consequence it is not surprising that many companies practice earnings
management. Earnings management is the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. The quality of
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Quality of Earnings
191
earnings is greatly affected when a company manages earnings up or down to
meet some targeted earnings number. A company that has a high quality of
earnings provides full and transparent information that will not confuse or mislead users of the financial statements. A company with questionable quality of
earnings may mislead investors and creditors, who believe they are relying on
relevant and reliable information. As a consequence, investors and creditors lose
confidence in financial reporting, and it becomes difficult for our capital markets to work efficiently.
Companies manage earnings in a variety of ways. One way is through the
use of one-time items to prop up earnings numbers. For example, ConAgra
Foods recorded a nonrecurring gain from the sale of Pilgrim’s Pride stock for
$186 million to help meet an earnings projection for the quarter.
Another way is to inflate revenue numbers in the short-run to the detriment of the long-run. For example, Bristol-Myers Squibb provided sales incentives to its wholesalers to encourage them to buy products at the end of the quarter (often referred to as channel-stuffing). As a result Bristol-Myers was able to
meet its sales projections. The problem was that the wholesalers could not sell
that amount of merchandise and ended up returning it to Bristol-Myers. The result was that Bristol-Myers had to restate its income numbers.
Companies also manage earnings through improper adjusting entries. Regulators investigated Xerox for accusations that it was booking too much revenue
up-front on multi-year contract sales. Financial executives at Office Max resigned
amid accusations that the company was recognizing rebates from its vendors
too early and therefore overstating revenue. Finally, WorldCom’s abuse of adjusting entries to meet its net income targets is unsurpassed: It used adjusting entries to increase net income by reclassifying liabilities as revenue and reclassifying expenses as assets. Investigations of the company’s books after it went
bankrupt revealed adjusting entries of more than a billion dollars that had no
supporting documentation.
The good news is that, as a result of investor pressure as well as the SarbanesOxley Act, many companies are trying to improve the quality of their financial
reporting. For example, hotel operator Marriott is now providing detailed information on the write-offs it has on loan guarantees it gives hotels. General Electric
has decided to provide more detail on its revenues and operating profits for
individual businesses it owns. IBM is attempting to provide a better breakdown
of its earnings. At the same time, regulators are taking a tough stand on the issue of quality of earnings. For example, one regulator noted that companies may
be required to restate their financials every single time that they account for any
transaction that had no legitimate purpose but was done solely for an accounting purpose, such as to smooth net income.
In this chapter, you learned that adjusting entries are used to adjust numbers
that would otherwise be stated on a cash basis. Sierra Corporation’s income
statement (Illustration 4-27, page 184) shows net income of $2,860. The statement of cash flows reports a form of cash basis income referred to as “Net cash
provided by operating activities.” For example, Illustration 1-8 (page 15), which
shows a statement of cash flows, reports net cash provided by operating activities of $5,700 for Sierra. Net income and net cash provided by operating activities often differ. The difference for Sierra is $2,840 ($5,700 ⫺ $2,860). The following summary shows the causes of this difference of $2,840.
KEEPING AN EYE
ON CASH
study objective
9
Understand the causes of
differences between net
income and cash provided
by operating activities.
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chapter 4 Accrual Accounting Concepts
Computation of
Computation
Net Cash Provided by
of
Operating Activities
Net Income
(1) Cash received in advance from customer
(2) Cash received from customers for services
provided
(3) Services provided for cash received
previously in (1)
(4) Services provided on account
(5) Payment of rent
(6) Purchase of insurance
(7) Payment of employee salaries
(8) Use of supplies
(9) Use of insurance
(10) Depreciation
(11) Interest cost incurred, but not paid
(12) Salaries incurred, but not paid
$ 1,200
$
0
10,000
10,000
0
0
(900)
(600)
(4,000)
0
0
0
0
0
400
200
(900)
0
(4,000)
(1,500)
(50)
(40)
(50)
(1,200)
$ 5,700
$ 2,860
For each item included in the computation of net cash provided by operating
activities, you should confirm that cash was either received or paid. For each
item in the income statement, the company should confirm that revenue was
earned (even when cash was not received) or that an expense was incurred (even
when cash was not paid).
USING THE DECISION TOOLKIT
Humana Corporation provides managed health care services to approximately 7
million people. Headquartered in Louisville, Kentucky, it has over 13,700 employees
in 15 states and Puerto Rico. A simplified version of Humana’s December 31, 2009,
adjusted trial balance is shown at the top of the next page.
Instructions
From the trial balance, prepare an income statement, retained earnings statement,
and classified balance sheet. Be sure to prepare them in that order, since each
statement depends on information determined in the preceding statement.
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Using the Decision Toolkit
HUMANA CORPORATION
Adjusted Trial Balance
December 31, 2009
(in millions)
Account
Cash
Short-Term Investments
Receivables
Other Current Assets
Property and Equipment, Net
Long-Term Investments
Goodwill
Other Long-Term Assets
Benefits Payable
Accounts Payable
Other Current Liabilities
Long-Term Debt
Common Stock
Dividends
Retained Earnings
Revenues
Medical Cost Expense
Selling, General, and Administrative Expense
Depreciation Expense
Interest Expense
Income Tax Expense
Dr.
Cr.
$ 1,613
6,190
824
626
679
1,307
1,993
921
$ 3,222
1,308
730
3,117
1,690
0
3,046
30,960
24,775
4,227
250
106
562
$44,073
$44,073
Solution
HUMANA CORPORATION
Income Statement
For the Year Ended December 31, 2009
(in millions)
Revenues
Medical cost expense
Selling, general, and administrative expense
Depreciation expense
Interest expense
Income tax expense
$30,960
$24,775
4,227
250
106
562
Net income
29,920
$ 1,040
HUMANA CORPORATION
Retained Earnings Statement
For the Year Ended December 31, 2009
(in millions)
Beginning retained earnings
Add: Net income
Less: Dividends
$3,046
1,040
0
Ending retained earnings
$4,086
193
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chapter 4 Accrual Accounting Concepts
HUMANA CORPORATION
Balance Sheet
December 31, 2009
(in millions)
Assets
Current assets
Cash
Short-term investments
Receivables
Other current assets
Total current assets
Long-term investments
Property and equipment,
net of accumulated depreciation
Goodwill
Other long-term assets
$ 1,613
6,190
824
626
$9,253
1,307
679
1,993
921
Total assets
$14,153
Liabilities and Stockholders’ Equity
Liabilities
Current liabilities
Accounts payable
Benefits payable
Other current liabilities
$1,308
3,222
730
Total current liabilities
Long-term debt
$5,260
3,117
Total liabilities
8,377
Stockholders’ equity
Common stock
Retained earnings
1,690
4,086
Total stockholders’ equity
Total liabilities and stockholders’ equity
5,776
$14,153
Summary of Study Objectives
1
Explain the revenue recognition principle and the
expense recognition principle. The revenue recognition
principle dictates that companies recognize revenue
in the accounting period in which it is earned. The expense recognition principle dictates that companies
recognize expenses when expenses make their contribution to revenues.
2
Differentiate between the cash basis and the accrual
basis of accounting. Under the cash basis, companies
record events only in the periods in which the company receives or pays cash. Accrual-based accounting
means that companies record, in the periods in which
the events occur, events that change a company’s
financial statements even if cash has not been
exchanged.
3
Explain why adjusting entries are needed, and identify
the major types of adjusting entries. Companies make
adjusting entries at the end of an accounting period.
These entries ensure that companies record revenues
in the period in which they are earned and that companies recognize expenses in the period in which they
are incurred. The major types of adjusting entries are
prepaid expenses, unearned revenues, accrued revenues, and accrued expenses.
4
Prepare adjusting entries for deferrals. Deferrals are
either prepaid expenses or unearned revenues. Companies make adjusting entries for deferrals at the statement date to record the portion of the deferred item
that represents the expense incurred or the revenue
earned in the current accounting period.
5
Prepare adjusting entries for accruals. Accruals are
either accrued revenues or accrued expenses. Adjusting entries for accruals record revenues earned
and expenses incurred in the current accounting period that have not been recognized through daily
entries.
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Appendix 4A: Adjusting Entries in an Automated World—Using a Worksheet
6
7
Describe the nature and purpose of the adjusted trial
balance. An adjusted trial balance is a trial balance
that shows the balances of all accounts, including
those that have been adjusted, at the end of an accounting period. The purpose of an adjusted trial balance is to show the effects of all financial events that
have occurred during the accounting period.
Explain the purpose of closing entries. One purpose of
closing entries is to transfer net income or net loss for
the period to Retained Earnings. A second purpose is
to “zero-out” all temporary accounts (revenue accounts, expense accounts, and dividends) so that they
start each new period with a zero balance. To accomplish this, companies “close” all temporary accounts
at the end of an accounting period. They make separate entries to close revenues and expenses to Income
Summary; Income Summary to Retained Earnings;
DECISION TOOLKIT
195
and Dividends to Retained Earnings. Only temporary
accounts are closed.
8
Describe the required steps in the accounting cycle. The
required steps in the accounting cycle are: (a) analyze
business transactions, (b) journalize the transactions,
(c) post to ledger accounts, (d) prepare a trial balance,
(e) journalize and post adjusting entries, (f) prepare
an adjusted trial balance, (g) prepare financial statements, (h) journalize and post closing entries, and
(i) prepare a post-closing trial balance.
9
Understand the causes of differences between net income and net cash provided by operating activities. Net
income is based on accrual accounting, which relies on
the adjustment process. Net cash provided by operating
activities is determined by adding cash received from
operating the business and subtracting
cash expended during operations.
A SUMMARY
DECISION CHECKPOINTS
INFO NEEDED FOR DECISION
TOOL TO USE FOR DECISION
HOW TO EVALUATE RESULTS
At what point should the company
record revenue?
Need to understand the nature of
the company’s business
Record revenue when earned. A
service business earns revenue
when it performs a service.
Recognizing revenue too early
overstates current period revenue;
recognizing it too late understates
current period revenue.
At what point should the company
record expenses?
Need to understand the nature of
the company’s business
Expenses should “follow”
revenues—that is, match the effort
(expense) with the result
(revenue).
Recognizing expenses too early
overstates current period
expense; recognizing them too
late understates current period
expense.
appendix 4A
Adjusting Entries in an Automated
World—Using a Worksheet
In the previous discussion, we used T accounts and trial balances to arrive at the
amounts used to prepare financial statements. Accountants frequently use a
device known as a worksheet to determine these amounts. A worksheet is a
multiple-column form that may be used in the adjustment process and in preparing financial statements. Accountants can prepare worksheets manually, but today
most use computer spreadsheets.
As its name suggests, the worksheet is a working tool for the accountant. A
worksheet is not a permanent accounting record; it is neither a journal nor
a part of the general ledger. The worksheet is merely a supplemental device used
to make it easier to prepare adjusting entries and the financial statements. Small
companies with relatively few accounts and adjustments may not need a worksheet. In large companies with numerous accounts and many adjustments, a
worksheet is almost indispensable.
study objective
10
Describe the purpose
and the basic form of a
worksheet.
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chapter 4 Accrual Accounting Concepts
Illustration 4A-1 Form
and procedure for a
worksheet
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SIERRA CORPORATION
Worksheet
For the Month Ended October 31, 2012
Trial Balance
Adjusted
Trial Balance
Adjustments
Income
Statement
Account Titles
Dr.
Cash
Supplies
Prepaid Insurance
Equipment
Notes Payable
Accounts Payable
Unearned Service Revenue
Common Stock
Retained Earnings
Dividends
Service Revenue
15,200
2,500
600
5,000
Salaries Expense
Rent Expense
Totals
4,000
(g) 1,200
900
28,700 28,700
5,200
900
5,200
900
(a) 1,500
50
(b)
1,500
50
1,500
50
Cr.
Dr.
Cr.
Dr.
Cr.
Dr.
Cr.
15,200
(a) 1,500 1,000
(b)
50
550
5,000
5,000
2,500
1,200 (d)
10,000
–0–
500
(d)
(e)
(c)
(c)
(f)
(e)
40
50
200
400
200
5,000
2,500
800
10,000
–0–
500
10,600
40
Net Income
Totals
2.
Enter
adjustment
data
10,600
40
40
50
200
(f)
50
50
(g) 1,200
1,200
3,440
3,440 30,190 30,190
1.
Prepare a
trial balance
on the
worksheet
Cr.
15,200
1,000
550
5,000
500
Supplies Expense
Insurance Expense
Accum. Depreciation—
Equipment
Depreciation Expense
Interest Expense
Accounts Receivable
Interest Payable
Salaries Payable
Totals
Dr.
5,000
2,500
800
10,000
–0–
400
10,000
Balance
Sheet
3.
Enter
adjusted
balances
40
40
50
200
7,740
50
1,200
10,600 22,450 19,590
2,860
10,600
2,860
10,600 22,450 22,450
4.
Extend adjusted
balances to appropriate
statement columns
5.
Total the statement columns,
compute net income
(or net loss), and
complete worksheet
Illustration 4A-1 shows the basic form of a worksheet. Note the headings:
The worksheet starts with two columns for the Trial Balance. The next two
columns record all Adjustments. Next is the Adjusted Trial Balance. The last two
sets of columns correspond to the Income Statement and the Balance Sheet. All
items listed in the Adjusted Trial Balance columns are included in either the Income Statement or the Balance Sheet columns.
Summary of Study Objective for Appendix 4A
10
Describe the purpose and the basic form of a worksheet. The worksheet is a device to make it easier to
prepare adjusting entries and the financial statements. Companies often prepare a worksheet on a
computer spreadsheet. The sets of columns of the
worksheet are, from left to right, the unadjusted trial
balance, adjustments, adjusted trial balance, income
statement, and balance sheet.
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Comprehensive Do it!
197
Glossary
Accrual-basis accounting (p. 166) Accounting basis in
which companies record, in the periods in which the
events occur, transactions that change a company’s financial statements, even if cash was not exchanged.
Accrued expenses (p. 177) Expenses incurred but not
yet paid in cash or recorded.
Accrued revenues (p. 175) Revenues earned but not
yet received in cash or recorded.
Adjusted trial balance (p. 183) A list of accounts and
their balances after all adjustments have been made.
Adjusting entries (p. 167) Entries made at the end of
an accounting period to ensure that the revenue recognition and expense recognition principles are followed.
Book value (p. 172) The difference between the cost of a
depreciable asset and its related accumulated depreciation.
Cash-basis accounting (p. 166) Accounting basis in
which a company records revenue only when it receives
cash, and an expense only when it pays cash.
Closing entries (p. 186) Entries at the end of an accounting period to transfer the balances of temporary accounts to a permanent stockholders’ equity account, Retained Earnings.
Contra asset account (p. 171) An account that is offset against an asset account on the balance sheet.
Income Summary (p. 187) A temporary account used
in closing revenue and expense accounts.
Periodicity assumption (p. 164) An assumption that
the economic life of a business can be divided into artificial time periods.
Permanent accounts (p. 186) Balance sheet accounts
whose balances are carried forward to the next accounting period.
Post-closing trial balance (p. 188) A list of permanent
accounts and their balances after a company has journalized and posted closing entries.
Prepaid expenses (prepayments) (p. 169) Assets that
result from the payment of expenses that benefit more
than one accounting period.
Quality of earnings (p. 191) Indicates the level of full
and transparent information that a company provides to
users of its financial statements.
Revenue recognition principle (p. 164) The principle
that companies recognize revenue in the accounting period in which it is earned.
Reversing entry (p. 190, in margin) An entry made at
the beginning of the next accounting period; the exact opposite of the adjusting entry made in the previous period.
Depreciation (p. 171) The process of allocating the
cost of an asset to expense over its useful life.
Temporary accounts (p. 186) Revenue, expense, and
dividend accounts whose balances a company transfers
to Retained Earnings at the end of an accounting period.
Earnings management (p. 190) The planned timing of
revenues, expenses, gains, and losses to smooth out
bumps in net income.
Unearned revenues (p. 172) Cash received before a
company earns revenues and recorded as a liability until
earned.
Expense recognition principle (matching principle)
(p. 165) The principle that dictates that companies
match efforts (expenses) with results (revenues).
Useful life (p. 171)
tive asset.
Fiscal year (p. 164, in margin)
that is one year long.
Comprehensive
An accounting period
The length of service of a produc-
Worksheet (p. 195) A multiple-column form that companies may use in the adjustment process and in preparing financial statements.
Do it!
Terry Thomas and a group of investors incorporate the Green Thumb Lawn Care
Corporation on April 1. At April 30, the trial balance shows the following balances for
selected accounts.
Prepaid Insurance
Equipment
Notes Payable
Unearned Service Revenue
Service Revenue
$ 3,600
28,000
20,000
4,200
1,800
Analysis reveals the following additional data pertaining to these accounts.
1. Prepaid insurance is the cost of a 2-year insurance policy, effective April 1.
2. Depreciation on the equipment is $500 per month.
3. The note payable is dated April 1. It is a 6-month, 12% note.
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chapter 4 Accrual Accounting Concepts
4. Seven customers paid for the company’s 6-month lawn service package of $600 beginning in April. These customers received the first month of services in April.
5. Lawn services performed for other customers but not billed at April 30 totaled $1,500.
Instructions
Action Plan
• Note that adjustments are being
made for one month.
• Make computations carefully.
• Select account titles carefully.
• Make sure debits are made first
and credits are indented.
• Check that debits equal credits
for each entry.
Prepare the adjusting entries for the month of April. Show computations.
Solution to Comprehensive
Do it!
GENERAL JOURNAL
Date
Account Titles and Explanation
Debit
Credit
Adjusting Entries
Apr. 30
30
30
30
30
Insurance Expense
Prepaid Insurance
(To record insurance expired:
$3,600 ⫼ 24 ⫽ $150 per month)
Depreciation Expense
Accumulated Depreciation—Equipment
(To record monthly depreciation)
Interest Expense
Interest Payable
(To accrue interest on notes payable:
$20,000 ⫻ 12% ⫻ ᎏ11ᎏ2 ⫽ $200)
Unearned Service Revenue
Service Revenue
(To record revenue earned: $600 ⫼ 6 ⫽ $100;
$100 per month ⫻ 7 ⫽ $700)
Accounts Receivable
Service Revenue
(To accrue revenue earned but not billed
or collected)
150
150
500
500
200
200
700
700
1,500
1,500
Self-Test, Brief Exercises, Exercises, Problem Set A, and many
more resources are available for practice in WileyPLUS
Self-Test Questions
Answers are on page 223.
(SO 1)
1. What is the periodicity assumption?
(a) Companies should recognize revenue in the
accounting period in which it is earned.
(b) Companies should match expenses with revenues.
(c) The economic life of a business can be divided
into artificial time periods.
(d) The fiscal year should correspond with the
calendar year.
(SO 1)
2. Which principle dictates that efforts (expenses) be
recorded with accomplishments (revenues)?
(a) Expense recognition principle.
(b) Cost principle.
(c) Periodicity principle.
(d) Revenue recognition principle.
3.
Which one of these statements about the (SO 2)
accrual basis of accounting is false?
(a) Companies record events that change their financial statements in the period in which events
occur, even if cash was not exchanged.
(b) Companies recognize revenue in the period in
which it is earned.
(c) This basis is in accord with generally accepted
accounting principles.
(d) Companies record revenue only when they
receive cash, and record expense only when they
pay out cash.
(SO 3)
4. Adjusting entries are made to ensure that:
(a) expenses are recognized in the period in which
they are incurred.
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Questions
(b) revenues are recorded in the period in which
they are earned.
(c) balance sheet and income statement accounts
have correct balances at the end of an accounting
period.
(d) All of the above.
(SO 4, 5)
5. Each of the following is a major type (or category)
of adjusting entry except:
(a) prepaid expenses.
(c) accrued expenses.
(b) accrued revenues.
(d) earned expenses.
(SO 4)
6. The trial balance shows Supplies $1,350 and Supplies Expense $0. If $600 of supplies are on hand at
the end of the period, the adjusting entry is:
(a) Supplies
600
Supplies Expense
600
(b) Supplies
750
Supplies Expense
750
(c) Supplies Expense
750
Supplies
750
(d) Supplies Expense
600
Supplies
600
(SO 4)
(SO 4)
(SO 4)
7. Adjustments for unearned revenues:
(a) decrease liabilities and increase revenues.
(b) increase liabilities and increase revenues.
(c) increase assets and increase revenues.
(d) decrease revenues and decrease assets.
8. Adjustments
(a) decrease
(b) decrease
(c) decrease
(d) decrease
for prepaid expenses:
assets and increase revenues.
expenses and increase assets.
assets and increase expenses.
revenues and increase assets.
9. Queenan Company computes depreciation on delivery
equipment at $1,000 for the month of June. The adjusting entry to record this depreciation is as follows:
(a) Depreciation Expense
1,000
Accumulated Depreciation—
Queenan Company
1,000
(b) Depreciation Expense
1,000
Equipment
1,000
(c) Depreciation Expense
1,000
Accumulated Depreciation—
Equipment
1,000
(d) Equipment Expense
1,000
Accumulated Depreciation—
Equipment
1,000
(SO 5) 10. Adjustments for accrued revenues:
(a) increase assets and increase liabilities.
(b) increase assets and increase revenues.
(c) decrease assets and decrease revenues.
(d) decrease liabilities and increase revenues.
199
11. Colleen Mooney earned a salary of $400 for the last (SO 5)
week of September. She will be paid on October 1.
The adjusting entry for Colleen’s employer at September 30 is:
(a) No entry is required.
(b) Salaries and Wages Expense
400
Salaries and Wages Payable
400
(c) Salaries and Wages Expense
400
Cash
400
(d) Salaries and Wages Payable
400
Cash
400
12. Which statement is incorrect concerning the ad- (SO 6)
justed trial balance?
(a) 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.
(b) The adjusted trial balance provides the primary
basis for the preparation of financial statements.
(c) The adjusted trial balance does not list temporary accounts.
(d) The company prepares the adjusted trial balance after it has journalized and posted the
adjusting entries.
13. Which account will have a zero balance after a com- (SO 7)
pany has journalized and posted closing entries?
(a) Service Revenue.
(b) Supplies.
(c) Prepaid Insurance.
(d) Accumulated Depreciation.
14. Which types of accounts will appear in the post- (SO 7)
closing trial balance?
(a) Permanent accounts.
(b) Temporary accounts.
(c) Expense accounts.
(d) None of the above.
15. All of the following are required steps in the accounting cycle except:
(SO 8)
(a) journalizing and posting closing entries.
(b) preparing an adjusted trial balance.
(c) preparing a post-closing trial balance.
(d) reversing entries.
Go to the book’s companion website,
www.wiley.com/college/kimmel, to access
additional Self-Test Questions.
Note: All asterisked Questions relate to material in the appendix to the chapter.
Questions
1. (a) How does the periodicity assumption affect an
accountant’s analysis of accounting transactions?
(b) Explain the term fiscal year.
2. Identify and state two generally accepted accounting
principles that relate to adjusting the accounts.
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3.
4.
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chapter 4 Accrual Accounting Concepts
Don Wishne, a lawyer, accepts a legal engagement in March, performs the work in April, and
is paid in May. If Wishne’s law firm prepares monthly
financial statements, when should it recognize revenue from this engagement? Why?
In completing the engagement in question
3, Wishne pays no costs in March, $2,500 in April,
and $2,200 in May (incurred in April). How much expense should the firm deduct from revenues in the
month when it recognizes the revenue? Why?
5. “The cost principle of accounting requires adjusting
entries.” Do you agree? Explain.
6. Why may the financial information in an unadjusted
trial balance not be up-to-date and complete?
7. Distinguish between the two categories of adjusting
entries, and identify the types of adjustments applicable to each category.
8. What types of accounts does a company debit and
credit in a prepaid expense adjusting entry?
9. “Depreciation is a process of valuation that results in
the reporting of the fair value of the asset.” Do you
agree? Explain.
10. Explain the differences between depreciation expense
and accumulated depreciation.
11. Greenstreet Company purchased equipment for
$15,000. By the current balance sheet date, the company had depreciated $7,000. Indicate the balance
sheet presentation of the data.
12. What types of accounts are debited and credited in
an unearned revenue adjusting entry?
13. Data Technologies provides maintenance service for
computers and office equipment for companies
throughout the Northeast. The sales manager is
elated because she closed a $300,000 three-year maintenance contract on December 29, 2011, two days
before the company’s year-end. “Now we will hit this
year’s net income target for sure,” she crowed. The
customer is required to pay $100,000 on December 29
(the day the deal was closed). Two more payments of
$100,000 each are also required on December 29,
2012 and 2013. Discuss the effect that this event will
have on the company’s financial statements.
14. ValuMart, a large national retail chain, is nearing its
fiscal year-end. It appears that the company is not going to hit its revenue and net income targets. The
company’s marketing manager, Chris Ahrentzen, suggests running a promotion selling $50 gift cards for
$45. He believes that this would be very popular and
would enable the company to meet its targets for revenue and net income. What do you think of this idea?
15.
A company fails to recognize revenue
earned but not yet received. Which of the following
types of accounts are involved in the adjusting entry:
(a) asset, (b) liability, (c) revenue, or (d) expense? For
the accounts selected, indicate whether they would
be debited or credited in the entry.
16.
A company fails to recognize an expense incurred but not paid. Indicate which of the following
types of accounts is debited and which is...