Ok. So what’s the scoop. The first steps of the accounting cycle reflect the ways that
accountants go about the recording and accumulating of data. Once that data is captured,
the financial accountant goes on to prepare financial statements for issuance to external
users. Management may have different informational needs and the accumulated
accounting information may be viewed and massaged from a different perspective.
The basic example we have been looking at reflects a minimum number of transactions
that impact each of the major accounts that we want to make sure we understand at this
point: assets, liabilities, owners’ equity (owner investments and owner withdrawals),
revenues, and expenses. Plus the example presents two of the basic financial statements:
the income statement and balance sheet.
Although all the steps of the accounting cycle are presented, we have focused on the
initial data capture stage – recording transactions. In fact, we have gone through a
number of iterations simply to get to the preferred format – recording transaction in the
general journal by means of a general journal entry. At this point, you should have a
clear understanding of the material presented in the four PowerPoint presentations
concerning the accounting cycle. I want to go back now and address a gap that we had in
this example – that is – the preparation of financial statements from the trial balance.
Just think, the trial balance represents every financial item we have been keeping track of
the entire accounting period and the ending dollar amount to be reported for the item. In
some cases (assets, liabilities, capital), the account balance represents the amount the
company should report each it as of the end of the year. (How much cash the company
has on Dec 31, the amount of debts it owes on Dec 31, and the net worth of the owner.)
Some accounts (revenues and expenses) report the dollar amount of something for the
entire years. (The total revenues from fees earned for the year or the total amount of
utilities expense for the year.) An even though the accountant has recorded every
transaction exactly right – the right account title and the correct dollar amount – it is very
possible/probable that the amounts reported in the trial balance need to be adjusted
(updated) prior to begin reported on the financial statements. Consider the following
examples. (I think it may facilitate your understanding if you always look at a transaction
from the perspective of being the owner of the business who does his/her own accounting
work.)
On January 1, your company pays $2,400 to rent a building for the next two years to store
your equipment. From an accounting perspective, what just happened? A transaction
occurred that results in an impact on at least two accounts. In this case, your company
now has the right to use this building for the next two years and also now has less cash.
Because assets are defined as “all rights and properties owned by the business” or
“probable future economic benefits”, you now have an asset that you could appropriately
call “the right to use the building,” “building rights,” or any other title that conveys the
economic item that you are keeping track of – in this case we usually call it something
like PREPAID RENT. And, obviously your company has less assets in the form of cash.
The entry to record the transaction would be:
Debit
Credit
Prepaid Rent
Cash
$2,400
$2,400
Remember – accounts increase on the side in which they appear in the accounting
equation. A = L + C. Therefore assets increase on the left or debit side of the account
and logically would decrease on the other side of the account – the right or credit side.
If you posted this transaction to the accounts in the ledger, prepaid rent would be
increased by $2,400 (debit) and cash would decrease by that amount (credit), and this is
exactly right. The company does have the right to use the building for 2 years and the
monetary value assigned to this right is the cost of $2,400. And again, if you spent some
cash, the cash account should certainly be decreased by the amount of cash that is gone.
PERFECT.
Perfect that is on Jan 1 when the building was rented, the money was paid, and the
transaction was recorded. But what about on Dec 31, the last day of the accounting
period when the company is getting ready to prepare financial statements to report the
results of transactions for the year? Because the ledger contains a debit of $2,400 to
prepaid rent – the trial balance would also show prepaid rent at $2,400 (the monetary
value that was assigned to a two year right to use the building even though now on Dec
31, the right to use the building is only one more year? Is it now correct to report Prepaid
Rent of $2,400? On Dec 31, and the end of year one – as of this point in time – the
company now only has the right to use the building for 1 more year, which logically
should report a monetary value of one half the two year right, or $1200.
So what do we need to do? Prior to preparing the financial statements we need to adjust
the numbers so that we report two things that have happened to the business. WE HAVE
USED UP THE RIGHT TO USE THE BUILDING FOR THE ONE YEAR THAT JUST
PASSED. First, we need to reduce the dollar amount reported for prepaid rent so that it
reflects the monetary right assigned to using the building for the next one year, or $1,200.
And with double entry bookkeeping, at least two accounts have to change when a
transaction is being recorded. So what else changed? Think about the accounting
equation: an asset “prepaid rent” is being decreased. What else changes in the financial
position? Did any other assets change? That is, does the company have any other right
that increased because of the decrease in building use for one year? Or did it have any
other decreases in any other assets because of this? I can’t think of any. So, what about
Liabilities? Does using a building increase the amount you owe the bank or anyone else?
I don’t see how. So what’s left? Owner’s equity. If you decrease assets and you need to
adjust owner’s equity, it must have decreases also to keep the equation equal. And why
does owner’s equity decrease? Basically two ways, the owner takes money out of the
business for personal use or an expense. This certainly isn’t an owner’s withdrawal, so it
must an expense. The definition of an expense is basically the using up of the company’s
assets to operate the business. THEREFORE, rent expense for the period has increased
and prepaid rent has decreased. Rent Expense decreases owner’s equity which decreases
as a debit. Prepaid rent (an asset) decreases as a credit. So the adjusting entry is
Rent Expense
Prepaid Rent
1,200
1,200
It we posted that entry and balanced the accounts, where would we be? Prepaid rent
would now have a debit balance of $1,200 (the monetary value appropriate for the right
to use the building for one more year) and rent expense would report a debit balance of
$1,200 (the value of the asset “Prepaid Rent” that the company used up this year).
Prepaid Rent (+$2,400 - $1,200 = $1,200)
Rent Expense (+$1,200 = $1,200)
Cash (-$2,400)
Is this right? Did the company decrease cash by $2,400? Yes. Does $1,200 of this
amount go for rent expense for the first year? Yes. And does $1,200 still represent the
right to use the building for one more year – an asset? Yes.
This is just an example of one type of adjustment that may be required. The accountant
probably needs to make an adjusting entry in six different cases. That is, if any of the
following types of accounts/transactions exist in the unadjusted trial balance, there is a
distinct possibility that an adjusting entry is necessary.
Deferred Expenses (Prepaid Expenses)
Deferred Revenues (Unearned Revenues)
Accrued Expenses
Accrued Revenues
Valuation Accounts
Income Tax Expense