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Chapter 5 Accrual Adjustments and Financial Statement Preparation

Revenue recognitionMatching expenses to revenues

Expenses related to periods

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The Measurement of Income

major function of accounting to monitor business performanceone important way of doing it – measuring and reporting a company‘s net income

Net income = revenues – expensesRevenues: Value retrieved in exchange for goods sold orservices rendered to customersExpenses: cost of goods and services used in the processof obtaining revenues

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Impact of Basic Accounting Principles on Income Measurement

Periodicity assumptionBusinesses 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 is called interim reporting

Going-concern assumptionallows cost allocation over several periods

Revenue Recognition and Matching PrincipleRecognize revenues when earned and let cost follow therevenues

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Realization Principle

Revenues of a transaction are realized when each of the following conditions hold:1. the company is expected to receive economic benefits from the

transaction2. the benefits and the costs from the transaction can reliably be

measuredIn 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 thecontract and has taken over all the respective risks

Revenue realization usually is documented by sending an invoice to the customer

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.

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Recognition of expenses

Production costs are attributed to revenuethey are matched with the revenue they were sacrificed for

Nonproduction costs are to be matched to an indefinite set of future revenues

they are recognized in the period in which they occurredModifying principle: Prudence (Conservatism)

expected losses are anticipated; they are recognized in the period in which they come to be knownexample: 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

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Accrual basis versus cash basis

Instead of accrual basis accounting cash basis could be used

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

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

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Trial Balance as the Starting Point of theAdjustment Process

Trial Balance ZiscoSys Magdeburg Trial Balance September 30, 2003

Cash 6.500Accounts Receivable 2.000Equipment 4.000Supplies 500Prepaid Insurance 1.200Accounts Payable 300Unearned Revenue 2.400Owner's Investment 8.000Owner's Withdrawal 800 Revenues 5000Rent Expense 500Utility Expense 200

15.700 15.700

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The Adjustment Process

adjusting entries to apply accrual accounting to transactions that span more than one accounting periodadjusting entries required whenever financial statements are prepared

Deferral: postponement of the recognition of an expense already paid for or of a revenue already received

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)

examples: accrued expenses, accrued revenues

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Adjusting entries accomplish four things:

DeferralsApportion recorded costs among two or more accounting periods • prepaid expenses – e.g. cost of machinery, prepaid rent

Apportion recorded revenues among two or more accounting periods • unearned revenues – e.g. sale of a one-year contract for

wireless phone service

AccrualsRecord unrecorded expenses• accrued expenses – e.g. interest payable on a loan

Record 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) record the transaction in the journal journalizing(2) transfer the journal entry to the ledger account

posting

... we basically run through the accounting cycle again!

... that‘s why we need a „new“ trial balance, the adjusted trial balance!

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Adjusting Entries for Deferrals

deferral – expiry-of-asset / liability adjustmentrequired to record the portion of the prepayment (deferral) that represents the expense incurred or the revenue earned in the current accounting perioddecrease a balance sheet accountincrease an income statement account

Prepaid expenses: adjusting entry increase an expense account, decrease an asset accountUnearned revenues: adjusting entry increase a revenue account, decrease a liability account

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Prepaid Expense

... refers to expenses paid in cash and recorded as assets before they are used or consumed

initial account entry: debit an asset accountprepaid expenses expire in two ways:

with passage of time (e.g. prepaid rent and insurance)through use or consumption (e.g. equipment, supplies)

if used or expired record the expenses that apply to the current period & prepare adjusting entry

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Asset Account Expense Account

Unadjusted Adjusting AdjustingBalance Entry Entry

Credit Debit

Amount equals cost of goodsor services used up or expired

Note: asset expense relation

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Adjustments for Supplies Used Up

supplies used – difference between balance in the supplies account and cost of supplies still in store

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 200 Supplies 200

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now we can transfer the journal entry to the ledger

without adjusting entries: (1) September expenses will be under-and net income overstated by € 200

(2) both assets and owner‘s equity will be overstated by € 200.

Supplies Supplies Expense

Sept. 8 500 Sept. 30 Adj. 200 Sept. 30 Adj. 200

Sept. 30 Bal. 300

adjustment

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Adjustment for Insurance Expired

insurance expired – equal to the insurance premium times the length of the accounting period over the entire term of coverage

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 100Prepaid insurance 100

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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

Prepaid Insurance Insurance Expense

Sept. 2 1.200 Sept. 30 Adj. 100 Sept. 30 Adj. 100

Sept. 30 Bal. 1.100

adjustment

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Adjustment for Depreciation

depreciation – allocation of the cost of an asset to expense over its useful life in a rational and systematic manneramount of depreciation is an estimate and not a factual measurement

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 Depreciation Expense

Sept. 30 Adj. 84 Sept. 30 Adj. 84

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contra accounts

„accumulated depreciation – office equipment“ is a contra-asset account

a valuation account that is paired with and deducted from a related account in the financial statements

Why not credit the asset account directly?Because ...... depreciation is an estimate, and... to preserve original cost of the asset

separate „Accumulated depreciation“ accounts for each long-lived assetdifference between cost of asset and accumulated depreciation is called carrying value or book value

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Balance sheet presentation of accumulateddepreciation

the entries show:original cost of € 4.000,cost that have expired to date (€ 84), andthe balance left to be depreciated (€ 3.916)

Plant and Equipment Office Equipment € 4.000 Less Accumulated Depreciation 84 Total Plant and Equipment € 3.916

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Unearned Revenue

... is an obligation arising from receiving cash before providing a service

initial account entry: credit a liability accountif a fraction of the service is rendered or goods are delivered, the adjusting entry recognizes this revenue

Note: liability revenue relation

Liability Account Revenue Account

Adjusting Unadjusted AdjustingEntry Balance EntryDebit Credit

Amount equals price of servicesperformed or goods delivered

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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.

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.

Unearned Revenue Service Revenue

Sept. 30 Adj. 200 Sept. 4 2.400 Sept. 10 5.000 Sept. 30 Adj. 200

Sept. 30 Bal. 2.200

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Adjusting Entries for Accruals

accrual – passage of time adjustmentrequired to record revenues earned and expenses incurred in the current period that have not been recognized or recordedadjusting entry for accruals will increase both a balance sheet and an income statement account.

accrued revenues: adjusting entry increase an asset account, -increase a revenue account

accrued expenses: adjusting entry increase an expense account, increase a liability account

Note: The following examples do not pertain to the ZiscoSysexample and, thus, will not affect the adjusted trial balance.

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Accrued Revenues

revenues for which services have been performed or goods delivered but are unrecorded so far

may accumulate with passing of time (interest, rent etc.) or from services that are neither billed nor collected

Asset Receivable Account Revenue Account

Adjusting AdjustingEntry EntryDebit Credit

Amount equals price of services performed

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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

without adjustment assets, owner‘s equity, revenues and net income would all be understated

Accounts Receivable Service Revenue

10/31 Adj. 750 10/31 5.000 31 400

31 750 10/31 6.150

Adj.Bal.

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Accrued Expenses

expenses that have been incurred but notyet recorded in the accounts

accrue from the same sources as accrued revenues

Expense Account Liability Account

Adjusting AdjustingEntry EntryDebit Credit

Amount equals cost of expense incurred

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let‘s assume we have borrowed money for which€ 100 interest accrues every month

without adjusting entries:(1) expenses and liabilities will be understated by

€ 100(2) net income and owner‘s equity will be

overstated by € 100

Interest Expense Interest Payable

10/31 Adj. 100 10/31 Adj. 100

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Summary of the adjusting entries

Type of Reason for Accounts before AdjustingAdjustment Adjustment Adjustment Entry

1. Prepaid expenses Prepaid expenses originally recorded in Assets overstated Dr. Expensesasset accounts have been used Expenses understated Cr. Assets

2. Unearned revenues Unearned revenues initially recorded in Liabilities overstated Dr. Liabilities liability accounts have been earned Revenues understated Cr. Revenues

3. Accrued revenues Revenues have been earned but not yet Assets understated Dr. Assetsreceived in cash or recorded Revenues understated Cr. Revenues

4. Accrued expenses Expenses have been incurred but not Expenses understated Dr. Expensesyet paid in cash or recorded Liabilities understated Cr. Liabilities

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General Journal J2

Date Account Titles and Explanation Ref. Debit Credit

2003 Adjusting Entries

Sept. 30 Supplies Expense 200 Supplies 200 (to record supplies used)

30 Insurance Expense 100 Prepaid Insurance 100 (to record insurance expired)

30 Depreciation Expense 84 Accumulated Depreciation - Office Equipment 84 (to record monthly depreciation)

30 Unearned Revenue 200 Service Revenue 200 (to record revenue for service provided)

account

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Summary of Adjusting Entries for ZiscoSys

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The Adjusted Trial BalanceAdjusted Trial Balance ZiscoSys Magdeburg Adjusted Trial Balance September 30, 2003

Cash 6.500Accounts Receivable 2.000Equipment 4.000Supplies 300Prepaid Insurance 1.100Accumulated Depreciation - Office Equipement 84Accounts Payable 300Unearned Revenue 2.200Owner's Investment 8.000Owner's Withdrawal 800Revenues 5.200Supplies Expense 200Rent Expense 500Utility Expense 200Insurance Expense 100Depreciation Expense 84

15.784 15.784

Entries affectedby adjustmentsare in boldnumbers.

The financialstatements canbe prepareddirectly from theadjusted trialbalance.

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ZiscoSys MagdeburgIncome Statement

For the Month Ended September 2003

Revenues Service Revenues 5.200

Expenses Rental Expense 500 Utility Expense 200 Supplies Expense 200 Insurance Expense 100 Depreciation Expense 84 Total Expenses 1.084

Net Income 4.116€

ZiscoSys MagdeburgStatement of Owner's Equity

For the Month Ended September 2003

ZiscoSys Capital, September 1, 2003 0Add: Owner's Investment 8.000 Net Income for the Month 4.116 12.116Subtotal 12.116Less: Withdrawal 800ZiscoSys Capital, September 30, 2003 11.316€

Income Statement and Owner‘s Equity Statement

Recall the „unadjusted“numbers:

Net income: € 4.300

ZiscoSys Capital: €11.500

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The Balance SheetZiscoSys MagdeburgBalance Sheet

September 30, 2003

Assets Liabilities

Cash 6.500 Accounts Payable 300Accounts Receivable 2.000 Unearned Revenue 2.200Supplies 300 Prepaid Insurance 1.100 Owner's EquityEquipment 4.000 ZiscoSys, Capital 11.316 Less: Accumulated Depreciation 84 3.916

Total Liabilities andTotal Assets 13.816 Owner's Equity 13.816

€ €

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Alternative Treatment of Deferrals

Prepaid expenses, usual treatment: debit an asset account (initially)alternative treatment: debit an expense account (initially)Why? Because we expect to use up, say, the supplies completely before the next financial statement date.

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 Supplies Expense

Sept. 30 Adj. 300 Sept. 8 500 Sept. 30 Adj. 300

Sept. 30 Bal. 200

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Alternative treatment of Unearned Revenues

Instead of crediting a liability account, we can alternatively credit a revenue account.

Why? Because we expect to earn the revenue, e.g. performthe service, until the next financial statement date.

Advantage: If we do earn the revenue until the next financialstatement date, no adjusting entry is needed.

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 Service Revenue

Sept. 30 Adj. 2.200 Sept. 30 Adj. 2.200 Sept. 4 2.400

Sept. 30 Bal. 200