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c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 162 chapter 4 ACCRUAL ACCOUNTING CONCEPTS the navigator Scan Study Objectives Read Feature Story Scan Preview Read Text and Answer Do it! p. 175 p. 180 p. 185 study objectives After studying this chapter, you should be able to: p. 189 Work Using the Decision Toolkit Review Summary of Study Objectives Work Comprehensive Do it! p. 197 Answer Self-Test Questions Complete Assignments Go to WileyPLUS for practice and tutorials 162 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. c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 163 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 flowbut 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 c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 164 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. c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 165 Timing Issues June July Accounts Receivable Service Revenue xxx Cash Accounts Receivable 165 xxx 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) c04AccrualAccountingConcepts.qxd 166 8/3/10 1:50 PM Page 166 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\" revenuesthat 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 salesthat 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. c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 167 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 balancethe first pulling together of the transaction datamay 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. c04AccrualAccountingConcepts.qxd 168 8/3/10 1:50 PM Page 168 chapter 4 Accrual Accounting Concepts 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. c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 169 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 c04AccrualAccountingConcepts.qxd 170 8/3/10 1:50 PM Page 170 chapter 4 Accrual Accounting Concepts $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, c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 171 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 DepreciationEquipment. Accumulated Depreciation is called a contra asset account. Such an account is offset against an asset account on the balance sheet. Thus, the Accumulated DepreciationEquipment 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 DepreciationEquipment 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 c04AccrualAccountingConcepts.qxd 172 8/3/10 1:50 PM Page 172 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 DepreciationEquipment is increased $40. Assets Accumulated DepreciationEquipment Equation Analysis $40 = Liabilities + Stockholders' Equity Depreciation Expense $40 = Debits increase expenses: debit Depreciation Expense $40. Credits increase contra assets: credit Accumulated DepreciationEquipment $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 DepreciationEquipment 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 DepreciationEquipment from the related asset account, as shown in Illustration 4-9. Equipment Less: Accumulated depreciationequipment $ 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, c04AccrualAccountingConcepts.qxd 8/4/10 12:09 PM Page 173 The Basics of Adjusting Entries ACCOUNTING FOR PREPAID EXPENSES Reason for Adjustment Examples Insurance, supplies, advertising, rent, depreciation Accounts Before Adjustment Adjusting Entry Prepaid expenses recorded in asset accounts have been used. Assets overstated. Expenses understated. Illustration 4-10 Accounting for prepaid expenses 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 Unadjusted Balance 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 Debit Adjusting Entry (-) 173 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. c04AccrualAccountingConcepts.qxd 174 8/3/10 1:50 PM Page 174 chapter 4 Accrual Accounting Concepts 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.) c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 175 The Basics of Adjusting Entries 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 DepreciationEquipment 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 DepreciationEquipment (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 c04AccrualAccountingConcepts.qxd 176 8/3/10 1:50 PM Page 176 chapter 4 Accrual Accounting Concepts 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 salesthat 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 c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 177 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 Reason for Adjustment Examples Interest, rent, services performed but not collected Accounts Before Adjustment Adjusting Entry Revenues have been earned but not yet received in cash or recorded. Assets understated. Revenues understated. Illustration 4-16 Accounting for accrued revenues 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. Illustration 4-17 Adjusting entries for accrued expenses Accrued Expenses Expense 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. 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 Annual Interest Rate $5,000 12% Time in Terms of One Year Interest 1 12 $50 Illustration 4-18 Formula for computing interest c04AccrualAccountingConcepts.qxd 178 8/3/10 1:50 PM Page 178 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 obligationsinterest 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.) c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 179 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 Oct. 31 Salaries Expense Salaries Payable (To record accrued salaries) Oct. 26 31 Salaries Expense 4,000 Adj. 1,200 Oct. 31 Posting Illustration 4-21 Adjustment for accrued salaries 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 c04AccrualAccountingConcepts.qxd 180 8/3/10 1:50 PM Page 180 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 c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 181 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 Illustration 4-23 Summary of adjusting entries Dr. Expenses Cr. Liabilities 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 DepreciationEquipment (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 c04AccrualAccountingConcepts.qxd 182 8/3/10 1:50 PM Page 182 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 Oct. 20 500 Oct. 31 200 Oct. 31 Bal. 500 Bal. 200 Service Revenue Supplies Oct. 5 2,500 Oct. 31 Oct. 31 Oct. 3 31 31 Bal. 1,000 1,500 600 Oct. 31 Bal. 550 Oct. 31 Oct. 26 31 4,000 1,200 Oct. 31 Bal. 5,200 5,000 Oct. 31 Salaries Expense 50 Equipment Oct. 2 Bal. 5,000 Supplies Expense Oct. 31 Accumulated Depreciation Equipment 1,500 Oct. 31 Bal. 1,500 Oct. 31 Bal. 40 Rent Expense 40 Oct. 31 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 Oct. 31 400 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 c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 183 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 DepreciationEquipment 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 c04AccrualAccountingConcepts.qxd 184 8/3/10 1:50 PM Page 184 chapter 4 Accrual Accounting Concepts 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 Credit $15,200 200 1,000 550 5,000 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 c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 185 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 depreciationequipment 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 DepreciationEquipment $ 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 c04AccrualAccountingConcepts.qxd 186 8/3/10 1:50 PM Page 186 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 accountRetained Earnings through the preparation of closing entries. Closing entries transfer net income c04AccrualAccountingConcepts.qxd 8/3/10 1:50 PM Page 187 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 c04AccrualAccountingConcepts.qxd 188 8/3/10 1:50 PM Page 188 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