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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 or services rendered to customersExpenses: 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 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 the revenues

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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 the contract 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 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 the Adjustment Process

6.5002.0004.000500

1.200300

2.4008.000

8005.000

500200

15.700 15.700

Revenues

Trial Balance

ZiscoSys MagdeburgTrial Balance

September 30, 2011CashAccounts ReceivableEquipmentSuppliesPrepaid InsuranceAccounts PayableUnearned RevenueOwner´s InvestmentOwner´s Withdrawal

Rent ExpensesUtility Expense

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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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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.

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 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)

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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 accumulated depreciation

the entries show:original cost of € 4.000,cost that have expired to date (€ 84), andthe 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 accountif 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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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 ZiscoSys example 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

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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

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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

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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

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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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Summary of Adjusting Entries for ZiscoSys

Date Account Titles and Explanation Ref. Debit Credit

2011 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, 2011

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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 2011

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 2011Recall 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, 2011

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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. 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):