Adjusting the Accounts \Who doesn't like buying things ata discount? That's why its not surprising that three years after it started as a company, Groupon was estimated to be worth $16 billion. This translates nto an average increase in value of almost $15 million per day. ‘Now consider that Groupon had previously been estimated to be worth even more than that. What happened? Well, ‘accounting regulators and investors began to question the way that Groupon had accounted for some ofits transactions. But if .Groupon sells oly coupons (“groupons"), how hard can it be to accurately account for that? It turns out that accounting for caupons is not as easy as you might think. First consider what happens when Groupon makes a sale. Suppose it sells a qroupon for $30 for Highrise Hamburgers. When it receives the $30 from the customer, record revenue forthe full §30 or just §15? Until recently, Groupon recorded the full $30. But, in response to an SEC ruling on he issue, Groupon now records revenue of $15 instead, ‘must turn over half of that amount (15) to Highrise Hamburgers. So should Groupon ‘A second issue is a matter of timing. When should Groupon record this $15 revenue? Should it record the revenue when it slls the groupon, or must it wait until the customer uses the groupon at Highrise Hamburgers? You can find the answer to this question in the notes to Groupon's financial statements, It recognizes the revenue once “the number of customers who purchase the daly deal exceeds the predetermined threshold, the Groupon has been electronically delivered to the purchaser and a listing af Groupons sald has been made available to the merchant The accounting becomes even more complicated when you consider the company's loylly programs. Groupon offers free or discounted groupons to its subscribers for doin: hings such as referring new customers or participating in promotions, These groupons are t used for future purchases, yet the company must record the expense at the time the customer receives the groupon. The cost of these programs is huge for Groupon, so the timing of this expense can definitely affect its reported income The final kicker is that Groupon, lke all other companies, must rely on many estimates in its financial reporting. For example, Groupon reports that “estimates are utilized for, but not limited to, stock-based compensation, income taxes, valuation of ‘acquired goodwill and intangible assets, customer refunds, contingent labilties and the depreciable wes of fixed assets." concludes by saying that “actual results could differ materially from those estimates.” So, next time you use a coupon, think ‘about what that means for the company’s accountants! LEARNING OBJECTIVES © Hipiain the accra bass of accounting and the reasons for Prepare adjusting entries for accruals. adjusting entries. @ Describe the nature and purpose of an adjusted trial © Prepare ajustng entries or deferral. balance.72 B Adjusting the Accounts LEARNING OBJECTIVE adjusting entries. Terminology “The time period assumption Isalso called the periodicity assumption, Ceca hace eaekas If we could wait to prepare financial statements until a company ended its oper- ations, no adjustments would be needed. At that point, we could easily determine its final balance sheet and the amount of lifetime income it earned. However, most companies need immediate feedback about how well they are doing. For example, management usually wants monthly financial statements. The Internal Revenue Service requires all businesses to file annual tax returns. Therefore, accountants divide the economic life of a business into artificial time periods, ‘This convenient assumption is referred to as the time period assumption. Many business transactions affect more than one of these arbitrary time periods. For example, the airplanes purchased by Southwest Airlines five years ago are still in usc today. We must determine the relevance of each business transaction to specific accounting periods. (How much of the cost of an airplane contributed to operations this year?) Fiscal and Calendar Years Both small and large companies prepare financial statements periodically in order to assess their financial condition and results of operations. Accounting, time periods are generally a month, a quarter, or a year. Monthly and quar- terly time periods are called interim periods. Most large companies must pre- pare both quarterly and annual financial statements. ‘An accounting time period that is one year in length is a fiscal year. A fiscal ‘year usually begins with the first day of a month and ends 12 months later on the last day ofa month. Many businesses use the calendar year (January | to Decem- ber 31) as their accounting period. Some do not. Companies whose fiscal year differs from the calendar year include Delta Air Lines, June 30, and The Walt Disney Company, September 30. Sometimes a company’s yearend will vary from year to year. For example, PepsiCo's fiscal vear ends on the Friday closest to December 31, which was December 29 in 2012 and December 28 in 2013, Accrual- versus Cash-Basis Accounting What you will lean in this chapter is accrual-basis accounting. Under the accrual basis, companies record transactions that change a company's financial statements in the periods in which the events occur. For example, using the accrual basis to determine net income means companies recognize revenues when they perform services (rather than when they receive cash). It also means recognizing expenses when incurred (rather than when paid). An alternative to the accrual basis is the cash basis. Under eash-basis account- ing, companies record revenue when they receive cash. They record an expense when they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading financial statements. It fails to record revenue for a ‘company that has performed services but for which the company has not received the cash, As a result, the cash basis does not match expenses with revenues. Accrual-basis accounting is therefore in accordance with generally accepted accounting principles (GAAP). Individuals and some small compa- nies, however, do use cash-basis accounting. The cash basis is justified for small businesses because they often have few receivables and payables. Medium and large companies use accrual-basis accounting. Recognizing Revenues and Expenses It can be difficult to determine when to report revenues and expenses. The reve- nue recognition principle and the expense recognition principle help in this task,‘Accrual-Basis Accounting and Adjusting Entries 73, REVENUE RECOGNITION PRINCIPLE When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. When the company meets this performance obligation, it recognizes revenue. The revenue recognition principle there- fore requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied, To illustrate, assume that Dave's Dry Cleaning cleans clothing on June 30 but customers do not claim and pay for their clothes until the first week of July. Dave's should record revenue in June when it performed the service (satisfied the performance obligation) rather than in July when it received the cash. At June 30, Dave's would report a receiv able on its balance sheet and revenue in its income statement for the service performed. EXPENSE RECOGNITION PRINCIPLE Accountants follow a simple rule in recognizing expenses: “Let the expenses fol- low the revenues.” Thus, expense recognition is tied to revenue recognition. In the dry cleaning example, this means that Dave's should report the salary expense incurred in performing the June 30 cleaning service in the same period in which it recognizes the service revenue. The critical issue in expense recognition is ‘when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Dave's does not pay the salary incurred on June 30 until July, it would report salaries payable on its June 30 balance sheet. This 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 3-1 summarizes the revenue and expense recognition principles, The Need for Adjusting Entries In order for revenues to be recorded in the period in which services are per formed 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. Revenue Recognition ‘Saesfed | formance * blation Ss Customer ‘Cash requests received Revenue i recog: | nized when performance | biptionis said | Expense Recognition Matching | Iustration 3-1 GAAP relationships in revenue and expense recognition74. B Adjusting the Accounts International Note Internal controls are a system of checks and balances designed ‘to detect and prevent fraud and errors. The Sarbanes-Onley Act requires U.S. companies to lenhance their systems of internal control. However, many foreign companies do not have to meet strict internal control require- ‘ments. Some U.S. companies believe that this gives foreign ‘irs an unfair advantage because developing and main- ‘taining internal controls can be very expensive. Adjusting entries are necessary because the trial balance—the first pulling together of the transaction data—may 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. 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 fied as either deferrals or accruals. As [llustration 3-2, s has two subcategories. Adjusting entries are cla shows, each of these clas: Ilustration 3-2 Categories of adjusting enties Deferral: 1, Prepaid expenses: Expenses paid in cash before they are used or consumed. 2. Unearned revenues: Cash received before services are performed, Accruals: 1, Accrued revenues: Revenues for services performed but not yet received in cash or recorded 2. Acerued 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 Pioneer Advertising from Chapter 2, reproduced in Illustration 3-3, Suustration 3 Eros ‘Malbec Desens Cree Debit Credit Cash. $15,200 Supplies 2,500 Prepaid Insurance ‘500 Equipment 5,000 Notes Payable $5,000 Accounts Payable 2,500 \ Unearned Service Revenue 1,200 Owner's Capital 10,000 Owner's Drawings 500 Service Revenue 10,000 i Salaries and Wages Expense Rent ExpenseAdjusting Entries for Deferrals. 75 We assume that Pioneer uses an accounting period of one month. Thus, monthly adjusting entries are made. The entries are dated October 31 cone @ ‘To defer means to postpone or delay. Deferrals are expenses or revenues that are recognized at a date later than the point when cash was originally exchanged. The two types of deferrals are prepaid expenses and unearned revenues. Teun eae eae Prepaid Expenses When companies record payments of expenses that will benefit more than one accounting period, they record an asset called prepaid expenses or prepay- ments. When expenses are prepaid, an asset account is increased (debited) to show the service or benefit that the company will receive in the future, Exam- ples 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 (eg. rent and insurance) or through use (¢.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 3-4, 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. i - ———— >) itustration 3-4 | Prepaid Expenses Adjusting entries fr prepaid KZ expenses | Capeeneee se Balance Adjusting Adjusting Ener) Entry (+) = - ~ | ‘Supplies Lets Look in more detail at some specific types of prepaid expenses, beginning °° with supplies. LY SUPPLIES —— | suppties purchased: ‘The purchase of supplies, such as paper and envelopes, results in an increase (a Teodaset | debit) to an asset account, During the accounting period, the company uses sup- | plies. 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. As shown in Ilustration 3-5, the difference between the unadjusted balance in the Supplies (asset) account and the actual cost of supplies on hand represents the supplies | oc. 31 used (an expense) for that period. ‘Supplies used: Recall from Chapter 2 that Pioneer Advertising purchased supplies costing | record Supls expense $2,500 on October 5. Pioneer recorded the purchase by increasing (debiting) the76 3 Adjusting the Accounts 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 $1,500 ($2,500 ~ $1,000). This use of supplies decreases an asset, Supplies. Tt also decreases owner's equity by increasing an expense account, Supplies Expense. This is shown in Ilustration 3-5. ‘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 Pioneer does not make the adjusting entry, October expenses are understated and net income is overstated by $1,500. More- over, both assets and owner's equity will be overstated by $1,500 on the October 31 balance sheet, Ilystration 3-5 ‘Adjustment for supplies ae “The expense Supplies Expense is increased $1,500; the asset Analysis - Supplies is decreased $1,500. (y Rss = ties + owner’ eauty_ Ea Seer Tapes est 51500 00 Debra STs aae ese ae Spee ED ‘Analysis (Credits dacresse set: credit Supplies $1 500. (Ocx 31] Spas Expense ‘Steps ‘To record suples used) 1500 sap 126, Suppies Expense 631 Gas 2500[Oe st Aap 1500 “cesT Adj. 1.500 Ocest Bl 1.600 (Gee 31a | INSURANCE Companies purchase insurance to protect themselves from losses due to fire, 4 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. j On October 4, Pioneer Advertising paid $600 for a one-year fire insurance Insurance purchased, | policy. Coverage began on October I. Pioneer recorded the payment by increas- record asset ing (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 Fe] expiration of prepaid insurance decreases an asset, Prepaid Insurance. It also $8 #2 | decreases owner’s equity by increasing an expense account, Insurance Expense. a te || “As shown in illustration 3-6, the asset Prepaid Insurance shows a balance Tene Sipe] | of $550, which represents the unexpired cost for the remaining 11 months of $80 80) coverage. At the same time, the balance in Insurance Experise equals the insur YEAR $600 ance cost that expired in October. If Pioneer does not make this adjustment, Oct | October expenses are understated by $50 and net income is overstated by Insurance expredi | $50, Moreover, both assets and owner's equity will be overstated by $50 on record insurance exPens® | the October 31 balance sheet.Adjusting Entries for Deferrals 77 Mlusteation 3-6 z 7 Agjstment for insurance = Liabitiies + __ Owner's Equiey Turance pense 50 DEPRECIATION A company typically owns a variety of assets that have long lives, such as build- ings, equipment, and motor vehicles. The period of service is referred to as the useful life of the asset. Because a building is expected to be of service for many ‘years, it is recorded as an asset, rather than an expense, on the date it is acquired. As explained in Chapter 1, companies record such assets at cost, as required by the historical cost principle. To follow the expense recognition principle, compa- nies 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 | Depreciation recognize: value of the asset. record depreciation expense For Pioneer Advertising, assume that depreciation on the equipment is $480 a ‘year, or $40 per month. As shown in Illustration 3-7, rather than decrease (credit) the asset account directly, Pioneer instead credits Accumulated Depreciation— Equipment. Accumulated Depreciation is called a contra asset account. Such ‘an account Is offset against an asset account on the balance sheet. Thus, the Accumulated Depreciation—Equipment 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, Pioncer decreases owner's equity by increasing an expense account, Deprecia- tion Expense. The balance in the Accumulated Depreciation—Equipment account will increase $40 each month, and the balance in Equipment remains $5,000. STATEMENT PRESENTATION As indicated, Accumulated Depreciation—Equipment isa contra asset account. Its 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78 3 Adjusting the Accounts Illustration 3-7 ‘Adjustment fr depreciation Ilustration 3-8 Balance sheet presentation of accumulated deprecation Terminology Book value is also referred to as carrying value. Ilustration 3-9 ‘Accounting for prepaid expenses Basic ‘The expanse Depreciation Expense is increased $40; the contra asset ae aS ee pene gil aise ote pein = F ReRRI RE EEAEe. en Orpecre [ise bern cba tae ee Acoma eee es ceo . rnd ae (ee | en 17 eT aaa a aa ca eae pee poo be Saganiel Salman the amount of depreciation each period. But using the contra account is prefera- ble for a simple reason: It discloses both the original cost of the equipment and the total cost that has been expensed to date. Thus, in the balance sheet, Pioneer deducts Accumulated Depreciation—Equipment from the related asset account, as shown in Illustration 3-8, Equipment Less: Accumulated depreciation—equipment Book value is the difference between the cost of any depreciable asset and its related accumulated depreciation. In Illustration 3-8, the book value of the equip- ment 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 depre- ciation is not valuation but a means of cost allocatioy 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 owner's equity, and net income are overstated by $40 and depreciation expense is understated by $40. lustration 3-9 summarizes the accounting for prepaid expenses. eee eka eed Reason for Accounts Before Adjusting. Examples Adjustment Adjustment Entry Insurance, supplies, Prepaid expenses. Assets overstated. Drs Expenses advertising, rent, recorded in asset Expenses x Assets depreciation accounts have understated. or Contra ‘been used AssetsAdjusting Entries for Deferrals. 79. Unearned Revenues When companies receive cash before services are performed, they record a liability by increasing (crediting) a liability account called unearned revenues, In other words, 2 company now has a performance obligation (lia- bility) to transfer a service to one of its customers. Items like rent, magazine subscriptions, and customer deposits for future service may result in unearned revenues. Airlines such as United, Southwest, 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 iden- tical 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 performed in a future accounting period, it increases (credits) an unearned revenue (a liability) account _|Cashis received inadvance: to recognize the liability that exists. The company subsequently recognizes reve- | _labiltyis recorded rues when it performs the service. During the accounting period, it is not practi- cal to make daily entries as the company performs services. Instead, the company delays recognition of revenue until the adjustment process. Then, the company makes an adjusting entry to record the revenue for services performed 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 under | Oct. 31 stated, Therefore, as shown in Illustration 3-10, the adjusting entry forunearned | Some service has been revenues results in a decrease (a debit) to a liability account and an increase __ Petformedi some revenue (a credit) to a revenue account. recorded | Unearned Revenues | Ly | a | tustration 3-10 | | Adjusting entries for unearned Pioneer Advertising received $1,200 on October 2 from R. Knox for adver tising services expected to be completed by December 31. Pioneer credited the payment to Unearned Service Revenue. This liability account shows a balance of $1,200 in the October 31 trial balance, From an evaluation of the services Pioneer performed for Knox during October, the company determines that it should recognize $400 of revenue in October. The liability (Unearned Service Revenue) is therefore decreased, and owner's equity (Service Revenue) is increased. ‘As shown in Illustration 3-11, the liability Unearned Service Revenue now shows a balance of $800. That amount represents the remaining advertising services expected to be performed in the future. At the same time, Service Revenue shows total revenue recognized in October of $10,400. Without this adjustment,80 3 Adjusting the Accounts eee — ae ee eee sles «| runaaer = seal Ss eee os = Pees Sia REE ee (ee Service Revene ‘00 “Tho record revenue for services performed) Unearned Service Revenue 209) Service Revenue 400, | : Ox3) 400]Ox. 2 1200, fox 310000 Posting A 31_Adj. 400 Oa si Bal 800 (Oc 31 ex, 10400 Ilustration 3-11 Service revenue accounts after adjustment revenues and net income are understated by $400 in the income state- ment. Moreover, liabilities will be overstated and owner's equity will be understated by $400 on the October 31 balance sheet. Illustration 3-12 summarizes the accounting for unearned revenues, Ilustration 3-42 paca said Eo aes revenues Reason for Accounts Before Adjusting Examples Adjustment Adjustment Eniry Rent, magazine _Unearned revenues Dr Liabilities subscriptions, recorded in liability overstated. Cx Revenues customer deposits accounts arenow Revenues forfuture service recognized as understated. revenue for services performed LEARNING Baee 8 ee ett Recon ast re The second category of adjusting entries is accruals. Prior to an accrual adjust- ‘ment, 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 for services performed but not yet recorded at the statement date are acerued revenues. Accrued revenues may accumulate (accrue) with theAdjusting Entries for Accruals 81 passing of time, as in the case of interest revenue. These are unrecorded because the earning of interest does not involve daily transactions. Compa- nies do not record interest revenue on a daily basis because it is often imprac- tical 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 performed and the clients will not be billed until the service has been completed. ‘An adjusting entry records the receivable that exists at the balance sheet date ‘and the revenue for the services performed during the period. Prior to adjust- ‘ment, both assets and revenues are understated. As shown in Illustration 3-13, 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. Sree eeegeecarraece re raceas rao uaa 3 ‘Adjusting ents for accrued Accrued Revenues revenues | In October, Pioneer Advertising performed services worth $200 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 owner's equity by increasing a revenue account, Service Revenue, as shown in Illustration 3-14. Mlustration 3-14 Ajstment for accrued revenue82.3 Adjusting the Accounts The asset Accounts Receivable shows that clients owe Pioneer $200 at the balance sheet date. The balance of $10,600 in Service Revenue represents the total revenue for services performed by Pioneer during the month ($10,000 + $400 + $200), Without the adjusting entry, assets and owner's equity on the balance sheet and revenues and net income on the income statement are understated, ‘On November 10, Pioneer receives cash of $200 for the services performed in October and makes the following entry. -n- +200 Now 10 | Cash 200 200 ‘Accounts Receivable 200 ‘cash rome (To record cash collected on account) $200 ‘The company records the collection of the receivables by a debit (increase) to Cash and a credit (decrease) to Accounts Receivable. ipenatlonuediees Tlustration 3-15 summarizes the accounting for accrued revenues. summarize the effects of transactions om the three elements of the accounting eg aE ir 2 ee Ee Interest, rent, Services performed Assets Dr. Assets = eS er ane maton 8 oes : = 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, as Ilustration 3-16 shows, 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. Accrued Expenses Debi Adjusting Entry (+) ustation246 Histagenetrvened | expenses Let's look in more detail at some specific types of accrued expenses, begin- ning with accrued interest‘ACCRUED INTEREST Pioneer Advertising signed a three-month note payable in the amount of $5,000 ‘on October 1. The note requires Pioneer 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 Pioneer, the {otal interest due on the $5,000 note at its maturity date three months in the future is $150 ($5,000 x 12% x 3), or $50 for one month. Mlustration 3-17 shows the formula for computing interest and its application to Pioneer for the month of October. oe) Tiasin Facewe mest x Tat = nt tate Oneer $5,000 As Illustration 3-18 shows, the accrual of interest at October 31 increases a liability account, Interest Payable, It also decreases owner's equity by increasing an expense account, Interest Expense. Interest Expense shows the interest charges for the month of October: Inter est Payable shows the amount of interest the company owes at the statement date. Pioncer 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 obligations—interest and principal— in the accounts and statements. Without this adjusting entry, liabilities and interest expense are understated, and net income and owner's equity are overstated. ACCRUED SALARIES AND WAGES ‘Companies pay for some types of expenses, such as employee salaries and wages, after the services have been performed. Pioneer Advertising paid salaries and ‘wages on October 26 for its employees’ first two weeks of work, The next payment Adjusting Entries for Accruals Mlustration 3-17 Formule for computing interest Ilustration 3-18 Adjustment for accrued interest (Oct 31) terest Gxpense Incerest Payable (To record ierest on notas ayia) 8384-3 Acjusting the Accounts of salaries will not occur until November 9. As Illustration 3-19 shows, three working days remain in October (October 29-31). IMlustration 3-18 Calendar showing Pioneer's ay periods Adjustment period Payday At October 31, the salaries and wages for these three days represent an accrued expense and a related liability to Pioneer. The employees receive total salaries and ‘wages of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries and ‘wages at October 31 are $1,200 ($400 x 3). This accrual increases a liability, Salaries and Wages Payable. It also decreases owner's equity by increasing an expense account, Salaries and Wages Expense, as shown in Iilustration 3-20. Anes = ___Unbites + __Ownors Equity | Sieerard Wages Peake Ger and Wages Beate 7 S00 ‘Oct 31] Saari and Wages Expense Salaries and Wages Payable (To record accrued tres and wages) Illustration 3-20 Adjustment for accrued | salaries and wages After this adjustment, the balance in Salaries and Wages Expense of $5,200 (13 days x $400) is the actual salary and wages expense for October. The balance in Salaries and Wages Payable of $1,200 is the amount of the liability for salaries and wages Pioneer owes as of October 31. Without the $1,200 adjustment for salaries and wages, Pioneer's expenses are understated $1,200 and its liabil- ities are understated $1,200. Pioneer pays salaries and wages every two weeks. Consequently, the next payday is November 9, when the company will again pay total salaries and ‘wages of $4,000. The payment consists of $1,200 of salaries and wages payable atAdjusting Entries for Accruals 85 October 31 plus $2,800 of salaries and wages expense for November (7 working, days, as shown in the November calendar X $400). Therefore, Pioneer makes the following entry on November 9. Nov.9 | Salaries and Wages Payable 1,200 Salaries and Wages Expense 2,800 Cash 4,000 (To record November 9 payroll) This entry climinates the liability for Salaries and Wages Payable that Pioneer recorded in the October 31 adjusting entry, and it records the proper amount of Salaries and Wages Expense for the period between November I and November 9. Illustration 3-21 summarizes the accounting for accrued expenses. Pesan seesaaacd Reason for Accounts Before Adjusting Examples Adjustment Adjustment Entry Interest, rent, Expenses have Expenses understated. Dr Expenses salaries been incurred but Liabilities understated. Cr: Liabilities not yet paid in ceash or recorded. Summary of Basic Relationships Illustration 3-22 summarizes the four basic types of adjusting entries. Take some time to study and analyze the adjusting entries. Be sure to note that each adjust- ing entry affects one balance sheet account and one income statement account. ‘Type of Adjustment Accounts Before Adjustment Adjusting Entry Prepaid expenses ‘Assets overstated. Dr. Expenses. Expenses understated, Cr: Asets or Contra Assets Unearned revenues Liabilities overstated, Dr, Liabilities Revenues understated. Cr Revenues, Accrued revenues Assets understated Dr. Assets Revenues understated. ‘Cx: Revenues Acerued expenses Expenses understated. Dr. Expenses. Liabilities understated. Cr Liabilities Illustrations 3-23 (on page 86) and 3-24 (on page 87) show the journalizing and posting of adjusting entries for Pioneer Advertising on October 31. The ledger identifies all adjustments by the reference J2 because they have been recorded on page 2 of the general journal. The company may insert a center cap- tion “Adjusting Entries” between the last transaction entry and the first adjusting. entry in the journal. When you review the general ledger in Ilustration 3-24, note that the entries highlighted in color are the adjustments. Zn-os- o ~1,200 2800 Cash ows “eo” llustration 3-21, ‘Accounting for accrued expenses Ilustration 3-22 ‘Summary of adjusting entries86 3 Acjusting the Accounts estat 323 GENERAL JOURNAL EB adjusting ens ‘Account Titles and Explan | Ret, | Debit _| Adjusting Entries ‘Supplies Expense ‘Supplies (To record supplies used) Insurance Expense Propaid Insurance (To record insurance expired) Depreciation Expense ‘Accumulated Depreciation—Equipment (fo record monthly depreciation) Uncarned Service Revenue ‘Service Revenue (To record revenue for services performed) Accounts Receivable ‘Service Revenue (To record revenue for services performed) Interest Expense Interest Payable (fo record interest on notes payable) Salaries and Wages Expense Salaries and Wages Payable (To record accrued salaries ‘and wages) 1,500 50 40 400 200,Imustration 3-24 Genel ledge after adjustment Eoramiast Cash No. 101 Interest Payable No. 230 Daie | Explanation [Ret.| Debie | Credit | Balance Date | Explanation | Ref.| Debit | Credit | Balance 2017 2017 et. 1 11 | 10,000 10,000 Gct.31 |Adj-entey | 32 sol so 2 ai | 1.200 11,200 3 n 900 | 10;300 Owner's Capital No. 301 4 hn 600 | 9700 Date [Explanation [Ref.| Debit | Credit | Balance 20 hi 500 | 9,200. >917 26 a Aon, 5.200 oct. 1 n 10,000 | 10,000 31 11 | 10,000 15200 Owner's Drawings No. 306 Accounts Receivable No. 112 Date | Explanation | Ref.| Debit | Credit | Balance Date Explanation |Ref.| Debit | Credit | Balance 2917 2017 Oct. 20 a] 500 500 ct.31 ladj.ennry | 32! 200 200 ae eee iSuppiies! No.126 Date [Explanation | Ref.| Debit | Credit | Balance Date | Explanation | Rof.| Debit | Credit | Balance 39)7 2017 ct. 31 n 10,000 | 10,000 oct. 5 a | 2,500 2500 31 |Adjentry | 32 ‘400 | 10,400 31 | Adj. entry R 1,500 1,000 31 | Adj. entry 2 200 | 10,600 Prepaid Insurance No.130 Ee eneereee No.631 Date _| Explanation [Ref.[ Debit | Credit | Balance pate | Explanation | Ref. Credit | Balance 2017 2017 Oct. 4 J | 600 600 Get. at |Adj.entey | 42 | 1,500 1,500 31 ladjentry | 32 so! 550 3 ee Depreciation Expense __No. 711 opel - Date | Explanation | Ref.| Debit | Credit | Balance Date [Explanation [Ref.[ Debit [ Credit | Balance $5 " ett Oct. 31 |Adj. entry ard 40 40 ct 1 a1 | 5,000 5,000 Accumulated Depreciati juipment Now188 57 SS aoe Date | Esplaation [Ret| Dobe | crt [eslnce Date [Explanation [Ret | psbi [Cred [Balnes 2017 a ae Peretti cee, go! 49 Oct 311Adj entry 12] 50 50 Nsla Payable mee Salaries and Wages Es No. 726 Dae] Riplanation [Ref | Debit [Creda [Balance Date [ Explanation [Ref.[ Debit [ Credit [ Balance 2017 eu Oct. 26 31 | 4000 4,000 oe x po se 31 | Adj. entry J2 | 1,200 5,200 Accounts Payable No. 201 fe ae Date Explanation | Ref.| Debit | Credit_| Balance aon ae Sar Date [Explanation [ Ref.| Debit | Gredit | Balance Oct. 5 a 2,500 2,500 2017 Oct. 3 si} 900 900 Unearned Service Revenue _No. 209 Date Explanation | Ref.| Debit | Credit | Balance Interest Expense No. 905, 3017 Date Explanation | Ref.| Debit | Gredit | Balance Oct. 2 n 1,200 | 1,200 2017 at lAdjenty | 32] 400 800 Oct.31|Adj entry | s2| 50 50 Salaries and Wages Payable No. 212 Date | Explanation | Ref.| Debit | Credit | Balance 2017 Oct, 31 |adj.entry | 32 1,200 | 1,20088 3B Adjusting the Accounts Learns g Lanes. 8 Describe the nature and purpose of an adjusted trial balance. 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. Preparing the Adjusted Trial Balance Ilustration 3-25 presents the adjusted trial balance for Pioneer Advertising pre- pared from the ledger accounts in Illustration 3-24. The amounts affected by the adjusting entries are highlighted in color. Compare these amounts to those in the ‘unadjusted trial balance in Illustration 3-3 (page 74). In this comparison, you will ‘see that there are more accounts in the adjusted trial balance as a result of the adjusting entries made at the end of the month. tasraton323 Priel oom PIONEER ADVERTSINS Debit Sele cash Sts200 lamar a0 So 10 Anas 80 Dita sioe Bet preter +» Nou Pua si00 Maree 20 ee 2 : Miata or rere 200 ee oer 0 Court apa shoe frets so as 10600 Saco 520 See ee Insurance Expense Interest Expense Depreciation Expense $30,190 Preparing Financial Statements Companies can prepare financial statements directly from the adjusted trial balance. Illustrations 3-26 (page 89) and 3-27 (page 90) present the interre- lationships of data in the adjusted trial balance and the financial statements. 'As Illustration 3-26 shows, companies prepare the income statement from the revenue and expense accounts. Next, they use the owner's capital and drawingsAdjusted Trial Balance and Financial Statements 89 P| PIONEER ADVERTISING Gy) Adjusted Trial Balance GES October 31,2017 Account Cast ‘Accounts Reesivable Supplies ropa Insurance ‘Accumulated Depreciation — "Equipment Notes Payable ‘Account Payable UUnearned Service Revenue Solaris and Wages Payable Interest Payable Owners Capital Owner's Dravsings Service Revenue Salaries and Wages Expense Supplies Expense Rent Expense Insurance Expense InerestPxpense Depreciation Expense Illustration 3-26 Preparation of the income accounts and the net income (or net loss) from the income statement to prepare statement and owners equity the owner's equity statement. Statement fom the adjusted As Illustration 3-27 (page 90) shows, companies then prepare the balance 2! balance - sheet from the asset and liability accounts and the ending owner's capital balance as reported in the owner's equity statement.90 3 Adjusting the Accounts py | PIONEER ADVERTISING AWA) Acjusted Trial Balance Ni ‘October 31,2017 Account Debit Credit 7 15.200 ‘Accounts Receivable 200 ‘Supplies 14000 Prepaid Insurance 550 Equipment 5,000 Accumelated Depreciation — Equipment Notes Payable “Accounts Payable Uncarned Service Revenue ‘Owner's Capital Oumer’s Drawings Service Revenue Salaries and Wages Expense Supplies Expense Rent Expense Insurance Expense Inteost Expense Depreciation Expense ‘opt bape ae On ‘romowners equ, sacemane in lestion 3.26 | | | Ilustration 3-27 Preparation ofthe balance sheet from the adjusted tral balance LEARNING “| Ea ee Ce cu neem er ‘OBJECTIVE treatment of deferrals. In discussing adjusting entries for prepaid expenses and unearned revenues, we illustrated transactions for which companies made the initial entries to balance sheet accounts. In the case of prepaid expenses, the company debited the prepay- ‘ment to an asset account. In the case of unearned revenue, the company credited a liability account to record the cash received. ‘Some companies use an alternative treatment. (1) When a company prepays fan expense, it debits that amount to an expense account. (2) When it receives payment for future services, it credits the amount to a revenue account. In this appendix, we describe the circumstances that justify such entries and the differ- ent adjusting entries that may be required. This alternative treatment of prepaid expenses and unearned revenues has the same effect on the financial statements as the procedures described in the chapter. Prepaid Expenses Prepaid expenses become expired costs either through the passage of time (e.g., insurance) or through consumption (e.g., advertising supplies). [fat the time of purchase the company expects to consume the supplies before the next finan- cial statement date, it may choose to debit (increase) an expense accountAppendix 3A; Adjusting Entries for the Alternative Treatment of Deferrals 91 rather than an asset account. This alternative treatment is simply more convenient. ‘Assume that Pioneer Advertising expects that it will use before the end of the ‘month all of the supplies purchased on October 5. A debit of $2,500 to Supplies ‘Expense (rather than to the asset account Supplies) on October 5 will eliminate the need for an adjusting entry on October 31. At October 31, the Supplies Expense account will show a balance of $2,500, which is the cost of supplies used petween October 5 and October 31 ‘But what if the company does not use all the supplies? For example, what if an inventory of $1,000 of advertising supplies remains on October 31? Obviously, the company would need to make an adjusting entry. Prior to adjustment, the expense account Supplies Expense is overstated $1,000, and the asset account Supplies is understated $1,000. Thus, Pioneer makes the following adjusting entry. = Oct. 31 | Supplies 3,000 +1000 Supplies Expense 1,000 $1,000 Exp (To record supplies inventory) cea noctfect After the company posts the adjusting entry, the accounts show the following. lustration 34-1 snp Eons Prepaid expenses accounts 10/31 Adj. 1,000 afteradjustment After adjustment, the asset account Supplies shows a balance of $1,000, ‘which is equal (o the cost of supplies on hand at October 31. In addition, Sup- plies Expense shows a balance of $1,500. This is equal to the cost of supplies used between October 5 and October 31. Without the adjusting entry, expenses are overstated and net income is understated by $1,000 in the October income statement. Also, both assets and owner's equity are understated by $1,000 on the October 31 balance sheet Illustration 3A-2 compares the entries and accounts for advertising supplies in the two adjustment approaches. oy IMlustration 34-2 ‘Prepayment Initially Prepayment Initially ‘Adjustment approaches— Debited to Asset Account Debited to Expense Account seaguat (per chapter) (per appendix) Oc.5 Supplies 2,500 Oct. 5 Supplies Expense 2,500 Accounts Payable 2,500 Accounts Payable 2,500 ‘Oct. 31 Supplies Expense 1,500 Oct. 31 Supplies 1,000 Supplies 1,500 ‘Supplies Expense 1,000 After Pioneer posts the entries, the accounts appear as follows. Ilustration 38-3 (per chapter) (per appendix) ‘Comparison of accounts ‘Supplies ‘Supplies 1085 2,500] 101 Adj. 1,500 10/31 Adj. 1,000 1031 Bal. 1,000 ‘Supplies Expense ‘Supplies Expense 1031 Adj. 1,500 10/5 2,500 | 10/31 Adj. 1,000 10/31 Bal. 1,500923 Adjusting the Accounts Note that the account balances under each alternative are the same at October 31: Supplies $1,000 and Supplies Expense $1,500, Unearned Revenues Unearned revenues are recognized as revenue at the time services are performed. Similar to the case for prepaid expenses, companies may credit (increase) a rev- enue account when they receive cash for future services. ‘To illustrate, assume that Pioneer Advertising received $1,200 for future ser vices on October 2. Pioneer expects to perform the services before October 31.! In such a case, the company credits Service Revenue. If Pioneer in fact performs the service before October 31, no adjustment is needed. However, if at the statement date Pioneer has not performed $800 of the services, it would make an adjusting entry. Without the entry, the revenue account Service Revenue is overstated $800, and the liability account Unearned, Service Revenue is understated $800. Thus, Pioneer makes the following adjusting, entry. BODRev Oct. 31 | Service Revenue 800 800 Unearned Service Revenue 800 eenaaa (To record unearned service revenue) no effect, After Pioncer posts the adjusting entry, the accounts show the following. Illustration 34-4 r iinecrled eee teria Unearned Service Revenue Service Revenue ‘accounts after agjustment 1031 Adj. 800 10/31 Adj. 800] 1072 200 1031 Bal. 400 The liability account Unearned Service Revenue shows a balance of $800. This equals the services that will be performed in the future. In addition, the balance in Service Revenue equals the services performed in October. Without the adjust- ing entry, both revenues and net income are overstated by $800 in the October income statement. Also, liabilities are understated by $800 and owner's equity is overstated by $800 on the October 31 balance sheet. Ilustration 3A-5 compares the entries and accounts for initially recording unearned service revenue in (1) a liability account or (2) a revenue account, Ilustration 34-5 ‘Unearned Service Revenue reese adosmererotee— Tnitlly Credited Trill Credited oes to Liability Account to Revenue Account ____ (er chapter) (per appendix) On? Cah 1300 *[ oun? Gah 200 Uneared Service ServiceRevense 1,200 Enaone 1.200 oci.3t marnebserice (ct. 31 Service Revenue 800 event 4oo Theaonel Semon Service Revenue 400 Revenue 00 "This example focuses only on the alterna fe treatment of unearned revenues. For simplicity; we have ignored the entries to Service Revenue pertaining tothe Immediate recognition of revenue ($10,000) andthe adjusting entry for acerted revenue ($200),After Pioneer posts the entries, the accounts appear as follows. Appendix 38: Financial Reporting Concepts 93 ih i (per chapter) (per appendix) Pesce at Uneamed Service Revenue Unearned Service Revenue asi Adj. 400 [102 1200 1031 Adj. 800 ead 1031 Bal. 800 Service Revenue Service Revenue 10/31 Adj. 400 10/31 Adj. 10/2, 1,200, 1031 Bal. 400 Note that the balances in the accounts are the same under the two alternatives: Unearned Service Revenue $800 and Service Revenue $400. Summary of Additional Adjustment Relationships stration 38-7 Illustration 34-7 provides a summary of basic relationships for deferrals. ‘Summary of basic relationships for deters ‘Type of Reason for Account Balances Adjusting Adjustment Adjustment, Before Adjustment Entry, T,Prepeld expenses (@) Prepaid expenses intially recorded ‘Aasets overstated De Expentes in asset accounts have been used. Expenses understated. Cr Assets, (b) Prepaid expenses initially recorded Assets understated. Dr. Assets in expense accounts have not Expenses overstated, Cr Expenses 2. Unearned revenues been used. (a) Unearned revenues initially recorded in liability accounts are now recognized as revenue. (b) Unearned revenues initially recorded in revenue accounts are stil Liabilities overstated. Revenues understated. Liabilities understated. Revenues overstated. Dr. Liabilities Cx Revenues unearned, Alternative adjusting entries do not apply to accrued revenues and accrued expenses because no entries occur before companies make these types of adjusting entries. e APPENDIX 3B: Discuss financial reporting concepts. This appendix provides a summary of the concepts in action used in this text- book, In addition, it provides other useful concepts which accountants use as & basis for recording and reporting financial information, LEARNING OBJECTIVE Qualities of Useful Information Recently, the FASB completed the first phase of a project in which it developed a conceptual framework to serve as the basis for future accounting standards, ‘The framework begins by stating that the primary objective of financial report- ing is to provide financial information that is useful to investors and creditors for making decisions about providing capital. Useful information should possess two fundamental qualities, relevance and faithful representation, as shown in Mlustration 3B-194 3 Adjusting the Accounts Ilustration 38-1 Fundamental qualities of useful information Relevance Accounting information has relevance if it would make a difference in a business decision. Information is considered relevant if it provides information that has predictive value, that is, helps provide accurate expectations about the future, and has confirmatory value, that is, confirms or corrects prior expectations. Materiality is a company-specfic aspect of relevance. An item is material when its size makes it, likely to influence the decision of an investor ar creditor. Faitfl Representation Faithful representation means thatinfarmton scartey copes at ely happened Toprovides fatal epresnaton formation mest be onplet (ething tnprtan hos ben ores), neta (is not biased toward one position or another), and free | Somer. ENHANCING QUALITIES In addition to the two fundamental qualities, the FASB also describes a number of enhancing qualities of useful information. These include comparability, consistency, verifiability, timeliness, and understandability. In accounting, comparability results when different companies use the same accounting prin- ciples. Another characteristic that enhances comparability is consistency. Con- sistency means that a company uses the same accounting principles and methods from year to year. Information is verifiable if independent observers, using the same methods, obtain similar results. For accounting information to have rele- vance, it must be timely. That is, it must be available to decision-makers before it loses its capacity to influence decisions. For example, public companies like Google or Best Buy provide their annual reports to investors within 60 days of their year-end, Information has the quality of understandability if itis presented ina clear and concise fashion, so that reasonably informed users of that informa- tion can interpret it and comprehend its meaning. Assumptions in Financial Reporting To develop accounting standards, the FASB relies on some key assumptions, as shown in Illustration 3B-2 (page 95). These include assumptions about the monetary unit, economic entity, time period, and going concern. Principles in Financial Reporting MEASUREMENT PRINCIPLES GAAP generally uses one of two measurement principles, the historical cost prin- ciple or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation. HISTORICAL COST PRINCIPLE The historical cost prineiple (or cost principle, dis- cussed in Chapter 1) dictates that companies record assets at their cost. This is ‘true not only at the time the asset is purchased but also over the tite the asset is, held. For example, if land that was purchased for $30,000 increases in value to $40,000, it continues to be reported at $30,000. FAIR VALUE PRINCIPLE TI: cates that assets and liabi fair value principle (discussed in Chapter 1) indi ss should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market price information is often readily available for these types of assets. In choosing between cost and