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Chapter 4: Accrual Adjustments and Financial Statement Preparation

The measurement of Income:

• major function of accounting to monitor business performance• one important way of doing it – measuring and reporting a

company‘s net income

• Net income = revenues – expenses– Revenues: Value retrieved in exchange for goods sold or services

rendered to customers– Expenses: cost of goods and services used in the process of obtaining

revenues

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Impact of Basic Accounting Principles on Income Measurement

• Periodicity assumption– 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 is called interim reporting

• Going-concern assumption– allows cost allocation over several periods

• Revenue Recognition and Matching Principle– Recognize revenues when earned and let cost follow the revenues

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Revenue Recognition

• Revenues are recognized if– A contract is present that has been approved by contracting parties

and identifies obligations and payment terms– The entity has satisfied the performance obligation by transferring an

asset as agreed upon in the contract • The asset has been transferred when the customer obtains control

of the asset• Control refers to the ability to direct the use of, and obtain

substantially all of the remaining benefits from, the asset.(IFRS 15.33)

• Practically revenue is typically recognized along with 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

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Recognition of expenses

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

• Nonproduction costs are to be matched to an indefinite set of revenues– they are recognized in the period in which they occurred

• Modifying principle: Prudence (Conservatism)– expected losses are anticipated; they are recognized in the period in

which they come to be known– example: 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 the Adjustment Process

6.5002.0004.000500

1.200300

2.4008.000

8005.000

500200

15.700 15.700

Rent ExpensesUtility Expense

Revenues

Trial Balance

ZiscoSys MagdeburgTrial Balance

September 30, 2013CashAccounts ReceivableEquipmentSuppliesPrepaid InsuranceAccounts PayableUnearned RevenueOwner´s InvestmentOwner´s Withdrawal

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The Adjustment Process

• adjusting entries to apply accrual accounting to transactions that span more than one accounting period

• adjusting 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:

• Deferrals– Apportion recorded expenses 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

• Accruals– Record 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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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.

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

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 manner

• amount 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)

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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 asset

• difference between cost of asset and accumulated depreciation is called carrying value or book value

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Balance sheet presentation of accumulated depreciation

• the entries show:– original cost of € 4.000,– cost that have expired to date (€ 84), and– the balance left to be depreciated (€ 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 account– if a fraction of the service is rendered or goods are delivered, the

adjusting entry recognizes this revenue

Note: liability revenue relation

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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.

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Summary of Adjusting Entries for ZiscoSys

Date Account Titles and Explanation Ref. Debit Credit

2013 Adjusting Entries ac

Sep 30 Supplies Expense c 200Supplies o 200

(to record supplies used) un

30 Insurance Expense t 100Prepaid Insurance 100

(to record insurance expired) nu

30 Depreciation Expense m 84Accumulated Depreciation ‐ Office Equipment b 84

(to record monthly dpreciation) er

30 Unearned Revenue s 200Service Revenue 200

(to record revenue for service provided)

                                                                                  General Journal                                                                        J2

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• The Adjusted Trial Balance

Entries affected by adjustments are in bold numbers.

The financial statements can be prepared directly from the adjusted trial balance.

Cash 6.500Accounts Receivable 2.000Equipment 4.000Supplies 300Prepaid Insurance 1.100Accumulated Depreciation ‐ Office Equipment 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

Adjusted Trial Balance

ZiscoSys MagdeburgAdjusted Trial BalanceSeptember 30, 2013

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Income Statement and Owner‘s Equity Statement

RevenuesService Revenues 5.200

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

Net Income €4.116

ZiscoSys MagdeburgIncome Statement

For the Month Ended September 2013

ZyscoSys Capital, Septmeber 1, 2003 0Add: Owner´s Investment 8.000

  Net Income for the Month 4.116 12.116Subtotal 12.116Less Withdrawal 800ZyscosSys Capital, September 30, 2003 €11.316

ZiscoSys MagdeburgStatement of Owner´s Equity

For the Month Ended September 2013Recall the „unadjusted“ numbers:

Net income: € 4.300

ZiscoSys Capital: €11.500

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• The Balance Sheet

Assets LiabilitiesCash 6.500 Accounts Payable 300Accounts Receivable 2.000 Unearned Revenue 2.200Supplies 300Prepaid Insurance 1.100 Owner´s EquityEquipment 4.000 ZyscoSys, Capital 11.316

Less: Accumulated Depreciation 84 3.916Total Liabilities and

Total Assets €13.816 Owner´s Equity €13.816

ZiscoSys MagdeburgBalance Sheet

September 30, 2013

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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):

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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. perform

the service, until the next financial statement date.– Advantage: If we do earn the revenue until the next financial

statement 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):