Chapter 5
Accrual Adjustments and Financial
Statement Preparation
Revenue recognition
Matching expenses to revenues
Expenses related to periods
1
The Measurement of Income
z
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major function of accounting Ö to monitor business
performance
one important way of doing it – measuring and
reporting a company‘s net income
Net income = revenues – expenses
Œ
Revenues: Value retrieved in exchange for goods sold or
services rendered to customers
ΠExpenses: cost of goods and services used in the process
of obtaining revenues
2
Impact of Basic Accounting Principles on
Income Measurement
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Periodicity assumption
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Going-concern assumption
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Businesses need regular progress reports, so accountants
prepare financial statements for specific periods and at
regular intervals.
• yearly - twelve-month accounting period is called a fiscal year
• quarterly / monthly - reporting periods are called interim
periods
allows cost allocation over several periods
Revenue Recognition and Matching Principle
Œ
Recognize revenues when earned and let cost follow the
revenues
3
Realization Principle
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Revenues of a transaction are realized when each of the
following conditions hold:
1.
2.
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the company is expected to receive economic benefits from the
transaction
the benefits and the costs from the transaction can reliably be
measured
In the case of sales of goods: economic ownership of the object
has been transferred to the customer
• „economic ownership“ means that the customer has acquired all
the property rights that have to be transferred according to the
contract and has taken over all the respective risks
Revenue realization usually is documented by sending an
invoice to the customer
Œ
Œ
when the customer remains silent after a due time, (s)he has
accepted that (s)he is in charge of the return; that‘s when the
revenue is realized
Long-term contracts: percentage of completion method:
realisation is assumed pro rata based on conditions 1. and 2.
4
Recognition of expenses
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Production costs are attributed to revenue
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Nonproduction costs are to be matched to an
indefinite set of future revenues
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they are matched with the revenue they were sacrificed for
they are recognized in the period in which they occurred
Modifying principle: Prudence (Conservatism)
Œ
expected losses are anticipated; they are recognized in the
period in which they come to be known
Πexample: a construction company has to deliver a project at
a fixed price, but it turns out that the costs will exceed the
price because of unexpected difficulties with the
underground; then the uncovered part of cost is expensed
as soon as possible: it is considered as a loss actually
obtained when the contract was signed
5
Accrual basis versus cash basis
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Instead of accrual basis accounting cash basis could
be used
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i.e. Revenues and Expenses are recognized when the
corresponding cash flows occur
Cash basis Accounting is less informative as a basis
for assessing regular performance and may be
outright misleading
Œ
cash flows occur far from the basic economic processes
e.g.
• purchasing durable equipment
• provisions of pension liabilities
• provisions for closing down a nuclear power plant
• revenues from long-term contracts
6
Trial Balance as the Starting Point of the
Adjustment Process
Trial Balance
ZiscoSys Magdeburg
Trial Balance
September 30, 2003
Cash
Accounts Receivable
Equipment
Supplies
Prepaid Insurance
Accounts Payable
Unearned Revenue
Owner's Investment
Owner's Withdrawal
Revenues
Rent Expense
Utility Expense
6.500
2.000
4.000
500
1.200
300
2.400
8.000
800
5000
500
200
15.700
15.700
7
The Adjustment Process
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adjusting entries to apply accrual accounting to transactions
that span more than one accounting period
z adjusting entries required whenever financial statements are
prepared
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Deferral: postponement of the recognition of an expense
already paid for or of a revenue already received
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examples: prepaid expenses, unearned revenues
Accrual: recognition of an expense or revenue that has arisen
but has not yet caused an expenditure (or receipt, respectively)
Œ
examples: accrued expenses, accrued revenues
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Adjusting entries accomplish four things:
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Deferrals
Œ
Apportion recorded costs among two or more accounting
periods
• prepaid expenses – e.g. cost of machinery, prepaid rent
ΠApportion recorded revenues among two or more
accounting periods
• unearned revenues – e.g. sale of a one-year contract for
wireless phone service
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Accruals
Œ
Record unrecorded expenses
• accrued expenses – e.g. interest payable on a loan
ΠRecord unrecorded revenues
• accrued revenues – e.g. fees earned but not yet billed to
customers
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How do we make the adjustment(s)?
(1)
(2)
record the transaction in the journal Ö journalizing
transfer the journal entry to the ledger account Ö
posting
... we basically run through
the accounting cycle again!
... that‘s why we need a
„new“ trial balance, the
adjusted trial balance!
10
Adjusting Entries for Deferrals
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deferral – expiry-of-asset / liability adjustment
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required to record the portion of the prepayment (deferral)
that represents the expense incurred or the revenue earned
in the current accounting period
Πdecrease a balance sheet account
Πincrease an income statement account
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Prepaid expenses:
adjusting entry Ö increase an expense account, decrease
an asset account
ΠUnearned revenues:
adjusting entry Ö increase a revenue account, decrease a
liability account
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Prepaid Expense
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... refers to expenses paid in cash and recorded as
assets before they are used or consumed
Œ
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initial account entry: debit an asset account
prepaid expenses expire in two ways:
Œ
with passage of time (e.g. prepaid rent and insurance)
Πthrough use or consumption (e.g. equipment, supplies)
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if used or expired Ö record the expenses that apply
to the current period & prepare adjusting entry
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Asset Account
Unadjusted
Balance
Expense Account
Adjusting
Entry
Credit
Adjusting
Entry
Debit
Amount equals cost of goods
or services used up or expired
Note: asset Æ expense relation
13
Adjustments for Supplies Used Up
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supplies used – difference between balance in the
supplies account and cost of supplies still in store
Œ
ZiscoSys had bought supplies for € 500 at the beginning of
September. At the end of September, supplies still on hand
are counted and valued at historical cost. Amount: € 300.
Hence, € 200 must be recorded as an expense.
Journal entry
Sept. 30
Supplies expense
Supplies
200
200
14
z
now we can
transfer the journal entry toSupplies
the ledger
Supplies
Expense
Sept. 8
500
Sept. 30 Bal.
300
Sept. 30 Adj.
200
Sept. 30 Adj.
200
adjustment
without adjusting entries:
(1) September expenses will be underand net income overstated by € 200
(2) both assets and owner‘s equity will
be overstated by € 200.
15
Adjustment for Insurance Expired
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insurance expired – equal to the insurance premium
times the length of the accounting period over the
entire term of coverage
Œ
ZiscoSys bought a one-year insurance policy. At the end of
September € 100 have expired (€ 1.200 * 1 month / 12 months).
Journal entry
Sept. 30
Insurance expense
Prepaid insurance
100
100
16
Prepaid Insurance
Sept. 2
1.200
Sept. 30 Bal.
1.100
Sept. 30 Adj.
Insurance Expense
100
Sept. 30 Adj.
100
adjustment
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without adjusting entries:
(1) September expenses will be under- and net income
overstated by € 100
(2) both assets and owner‘s equity will be overstated by € 100
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Adjustment for Depreciation
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depreciation – allocation of the cost of an asset to
expense over its useful life in a rational and
systematic manner
amount of depreciation is an estimate and not a
factual measurement
Œ
ZiscoSys invested € 4.000 in office equipment which will
provide service for four years, that means monthly
depreciation will be appr. € 84. (€ 4.000 / 48 months = € 84
per month)
Office Equipment
Sept. 2
4.000
Accumulated Depreciation Office Equipment
Sept. 30 Adj.
Depreciation Expense
84
Sept. 30 Adj.
84
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contra accounts
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„accumulated depreciation – office equipment“ is a
contra-asset account
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Why not credit the asset account directly?
Œ
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a valuation account that is paired with and deducted from a
related account in the financial statements
Because ...
... depreciation is an estimate, and
... to preserve original cost of the asset
separate „Accumulated depreciation“ accounts for
each long-lived asset
difference between cost of asset and accumulated
depreciation is called carrying value or book value
19
Balance sheet presentation of accumulated
depreciation
Plant and Equipment
Office Equipment
Less Accumulated Depreciation
Total Plant and Equipment
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€ 4.000
84
€ 3.916
the entries show:
Œ
original cost of € 4.000,
Œ cost that have expired to date (€ 84), and
Œ the balance left to be depreciated (€ 3.916)
20
Unearned Revenue
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... is an obligation arising from receiving cash before
providing a service
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initial account entry: debit a liability account
Πif a fraction of the service is rendered or goods are
delivered, the adjusting entry recognizes this revenue
Liability Account
Adjusting
Entry
Debit
Revenue Account
Unadjusted
Balance
Adjusting
Entry
Credit
Amount equals price of services
performed or goods delivered
Note: liability Æ revenue relation
21
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ZiscoSys received € 2.400 for maintenance work that should be
performed over the course of a year. At month-end of
September, € 200 were earned.
Unearned Revenue
Sept. 30 Adj.
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200
Service Revenue
Sept. 4
2.400
Sept. 30 Bal.
2.200
Sept. 10
Sept. 30 Adj.
5.000
200
without adjusting entries:
(1) September revenues and net income would be understated
by € 200 in the income statement
(2) liabilities would be over- and owner‘s equity will be
understated by
€ 200 on the balance sheet.
22
Adjusting Entries for Accruals
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accrual – passage of time adjustment
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accrued revenues:
Œ
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adjusting entry Ö increase an asset account, -increase a revenue
account
accrued expenses:
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required to record revenues earned and expenses incurred in the
current period that have not been recognized or recorded
adjusting entry for accruals will increase both a balance sheet and
an income statement account.
adjusting entry Ö increase an expense account, increase a liability
account
Note: The following examples do not pertain to the ZiscoSys
example and, thus, will not affect the adjusted trial balance.
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Accrued Revenues
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revenues for which services have been performed or
goods delivered but are unrecorded so far
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may accumulate with passing of time (interest, rent etc.) or
from services that are neither billed nor collected
Asset Receivable Account
Revenue Account
Adjusting
Entry
Debit
Adjusting
Entry
Credit
Amount equals price of
services performed
24
z
let‘s assume a company has provided a service worth € 750 to
a client that hasn‘t been billed to him/her. the following
adjusting entry would be made at month-end
Accounts Receivable
10/31 Adj.
z
750
Service Revenue
10/31
31
31 Adj.
10/31 Bal.
5.000
400
750
6.150
without adjustment Æ assets, owner‘s equity, revenues and
net income would all be understated
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Accrued Expenses
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expenses that have been incurred but not
yet recorded in the accounts
Œ
accrue from the same sources as accrued revenues
Expense Account
Liability Account
Adjusting
Entry
Debit
Adjusting
Entry
Credit
Amount equals cost of
expense incurred
Cisco Sysems Inc. reported accrued compensation of $ 1.3 billion and other
accrued liabilities of $ 1.5 billion on its 2000 balance sheet. Explain the
meaning of the numbers.
26
z
let‘s assume we have borrowed money for which
€ 100 interest accrues every month
Interest Expense
10/31 Adj.
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100
Interest Payable
10/31 Adj.
100
without adjusting entries:
(1) expenses and liabilities will be understated by
€ 100
(2) net income and owner‘s equity will be
overstated by € 100
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Summary of the adjusting entries
Type of
Adjustment
Reason for
Adjustment
Accounts before
Adjustment
Adjusting
Entry
1. Prepaid expenses
Prepaid expenses originally recorded in
asset accounts have been used
Assets overstated
Expenses understated
Dr. Expenses
Cr. Assets
2. Unearned revenues Unearned revenues initially recorded in
liability accounts have been earned
Liabilities overstated
Revenues understated
Dr. Liabilities
Cr. Revenues
3. Accrued revenues
Revenues have been earned but not yet
received in cash or recorded
Assets understated
Revenues understated
Dr. Assets
Cr. Revenues
4. Accrued expenses
Expenses have been incurred but not
yet paid in cash or recorded
Expenses understated
Liabilities understated
Dr. Expenses
Cr. Liabilities
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Summary of Adjusting Entries for ZiscoSys
General Journal
Date
2003
Account Titles and Explanation
Adjusting Entries
Sept. 30
30
30
30
Supplies Expense
Supplies
(to record supplies used)
Insurance Expense
Prepaid Insurance
(to record insurance expired)
Depreciation Expense
Accumulated Depreciation - Office Equipment
(to record monthly depreciation)
Unearned Revenue
Service Revenue
(to record revenue for service provided)
J2
Ref. Debit
a
c
c
o
u
n
t
Credit
200
200
100
100
n
u
m
b
e
r
s
84
84
200
200
29
z
Adjusted Trial Balance
The Adjusted Trial Balance
ZiscoSys Magdeburg
Adjusted Trial Balance
September 30, 2003
Cash
Accounts Receivable
Equipment
Supplies
Prepaid Insurance
Accumulated Depreciation - Office Equipement
Accounts Payable
Unearned Revenue
Owner's Investment
Owner's Withdrawal
Revenues
Supplies Expense
Rent Expense
Utility Expense
Insurance Expense
Depreciation Expense
6.500
2.000
4.000
300
1.100
84
300
2.200
8.000
800
5.200
200
500
200
100
84
15.784
Entries affected
by adjustments
are in bold
numbers.
The financial
statements can
be prepared
directly from the
adjusted trial
balance.
15.784
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Income Statement and
Owner‘s Equity Statement
ZiscoSys Magdeburg
Income Statement
For the Month Ended September 2003
Revenues
Service Revenues
5.200
Expenses
Rental Expense
Utility Expense
Supplies Expense
Insurance Expense
Depreciation Expense
Total Expenses
500
200
200
100
84
1.084
€ 4.116
Net Income
ZiscoSys Magdeburg
Statement of Owner's Equity
For the Month Ended September 2003
ZiscoSys Capital, September 1, 2003
Add: Owner's Investment
Net Income for the Month
Subtotal
Less: Withdrawal
ZiscoSys Capital, September 30, 2003
Recall the „unadjusted“
numbers:
0
8.000
4.116
12.116
12.116
800
€ 11.316
Net income: € 4.300
ZiscoSys Capital: €11.500
31
z
The Balance Sheet
ZiscoSys Magdeburg
Balance Sheet
September 30, 2003
Assets
Cash
Accounts Receivable
Supplies
Prepaid Insurance
Equipment
Less: Accumulated Depreciation
Total Assets
Liabilities
6.500
2.000
300
1.100
4.000
84
Accounts Payable
Unearned Revenue
300
2.200
Owner's Equity
ZiscoSys, Capital
11.316
3.916
€ 13.816
Total Liabilities and
Owner's Equity
€ 13.816
32
Alternative Treatment of Deferrals
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Prepaid expenses, usual treatment: debit an asset account
(initially)
z alternative treatment: debit an expense account (initially)
z Why? Because we expect to use up, say, the supplies
completely before the next financial statement date.
Œ
z
Advantage: We do not need to make adjusting entries (provided
that we in fact use up the supplies completely)!
If, however, we do not completely use up the supplies, we make
the following adjustments (numbers taken from our example):
Supplies
Sept. 30 Adj.
300
Supplies Expense
Sept. 8
500
Sept. 30 Bal.
200
Sept. 30 Adj.
300
33
Alternative treatment of Unearned Revenues
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Instead of crediting a liability account, we can
alternatively credit a revenue account.
Œ
Why? Because we expect to earn the revenue, e.g. perform
the service, until the next financial statement date.
ΠAdvantage: If we do earn the revenue until the next financial
statement date, no adjusting entry is needed.
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If, however, we do not fully earn the revenue until the
next financial statement day, we make the following
adjustment (numbers taken from our example):
Unearned Revenue
Sept. 30 Adj.
Service Revenue
2.200
Sept. 30 Adj.
2.200
Sept. 4
Sept. 30 Bal.
2.400
200
34