Chapter 12 lecture notes
In this chapter you learn the difference between accrual and cash based
accounting. In cash basis accounting revenue is recorded when cash is
received; in accrual basis accounting revenue is recorded when it is earned.
Further, expenses are recorded when they are incurred, not when they are
paid, and follow the matching principle in which expenses are recorded when
the corresponding revenue is recorded.
The first adjustment introduced in the chapter deals with adjustments to
the merchandise inventory account. As you recall, during the accounting
period all purchases of inventory were debited to a purchases account and
sales of merchandise credited to the sales (revenue) account. At the end of
each period, then, the merchandise inventory account still shows the
beginning inventory balance – so adjustments must be made. These
adjustments are made by using the income summary account (remember this
from previous closing entries).
Adjustments are also made for uncollectible accounts. Because financial
statements are prepared using the accrual basis of accounting, the business
wants to match the expense for uncollectible accounts with the sales
revenue for the same period. This is accomplished by estimating the amount
that will be uncollectible, and debiting uncollectible accounts expense and
crediting allowance for doubtful accounts (a contra asset account).
Depreciation is brought up again in this chapter, and it is important to
remember that accumulated depreciation is a contra asset account.
Depreciation is used to allocate the cost of an item over its useful life;
however, land is not depreciated because it has an unlimited useful life.
The next four adjustments are accrued expenses and income, prepaid
expenses and unearned income.
Accrued expenses are expenses that relate to the current period but
haven’t been paid and are not yet recorded. An example is wages. When
someone has worked during the period, but will not be paid until the next
period, it is still necessary to record the salary expense in the period in
which they did the work. To make the adjustment you debit salary expense
and credit salary payable. Salary payable is a liability account – any time you
create an expense account for accrued expenses there will be a
corresponding payable account.
Accrued income is income which has been earned in the current period, but
not yet received or recorded. Interest income is an example of accrued
income, as interest payments do not always fall in the period in which they
were earned. To adjust for this you will create a receivable account (asset);
for interest you will debit interest receivable and credit interest income.
Prepaid expenses were introduced earlier and deal with expenses that you
paid in advance. Prepaid items such as prepaid rent will show as an asset on
the balance sheet, but as they are used up you will need to debit a related
expense account. For example, when you use one months rent you will debit
rent expense and credit prepaid rent to take the amount of rent used out of
the amount listed as an asset.
Unearned income is income that you receive before you earn it. For example,
if you give me $100 to walk your dogs for the month – I have not yet walked
the dogs, so I have not earned this money. When I receive the money I will
debit cash for $100 and credit unearned dog walking revenue; as I walk the
dogs and earn the money I will debit unearned dog walking revenue and
credit dog walking revenue.
Sometimes people are confused about interest expense and income, here is
some additional information:
Interest expense occurs when you borrow money and have to pay interest on
the amount you borrowed. When you take out a note payable, loan payable,
mortgage payable you are borrowing money with interest.
When you borrow the money this is your entry:
Cash
500
Note payable
500
You debit cash because you are receiving cash, and credit note payable
because you owe money. This is a 4 month note with 10% interest … so the
interest is figured here: 500 x .10 x 4/12 = 16.67
As you pay on the loan this is your entry:
Note payable
500.00
Interest expense
16.67
Cash
516.67
You debit note payable to remove the 500 from the note payable account;
you debit interest expense because this is an expense account; you credit
cash because you are paying out cash.
Interest income occurs when you loan money out (or give credit to a
customer) and they will pay you back with interest. The note payable
belongs to the customer in this case, and you have a notes receivable (similar
to accounts receivable but with interest). Notes receivable can replace an
accounts receivable that the customer cannot pay within their time limit
(terms). If the customer cannot pay their account, they may be issued a
note with interest.
The original entry when the customer buys something is:
Accounts receivable
500
Equipment
500
You debit accounts receivable because they purchased the equipment on
credit, and credit equipment because that is what you sold.
The entry to replace the accounts receivable with a notes receivable is:
Notes receivable
500
Accounts receivable
500
You debit notes receivable to put the amount owed to you in that account
and credit accounts receivable to remove the amount from that account.
When the customer pays their note payable (your note receivable) it is:
Cash
516.67
Notes receivable
500.00
Interest income
16.67
You debit cash for the total amount of cash that you receive; you credit
notes receivable for the amount of the note to remove the amount from the
account; you credit interest income for the amount of interest you earned
from the transaction – it is a credit because interest income is a revenue
account.
*Remember that the debits must equal the credits!