CHAPTER THREE MEASURING BUSINESS INCOME: THE ADJUSTING PROCESS

ACCRUAL BASIS ACCOUNTING AKA ACCRUAL ACCOUNTING Required by GAAP for income tax reporting for most businesses Uses revenue principle, matching principle and time-period concept

REVENUE PRINCIPLE Revenue is recorded in the accounting period earned, e.g. when service is performed or goods are sold, REGARDLESS OF WHEN THE CUSTOMER PAID FOR IT In other words, the receipt of the cash is secondary

MATCHING PRINCIPLE All expenses incurred to earn the revenue recorded must be recorded in the same period, REGARDLESS OF WHEN THE CASH IS PAID OUT In other words, the payment of the cash is secondary

TIME PERIOD CONCEPT For accounting purposes, we must divide the economic life of a business into relatively short, artificial periods Changes are to be measured and reported over these periods Time period concept ensures that accounting info is reported at regular intervals (from one month to one year)

FISCAL or ACCOUNTING YEAR does not have to be the calendar year Most businesses use their NATURAL BUSINESS YEAR, i.e. the year end is set for when business activity is at its lowest, e.g. most retail stores use January or February; ski resort would use June or July F/S must be prepared at the end of the fiscal year INTERIM STATEMENTS are F/S prepared during the fiscal yea These three principles form the basis of the accrual basis of accounting, and ensure that the correct amount of revenue and expense are reported in the correct time period so we can compare NI from period to period

ADJUSTING JOURNAL ENTRIES (AJEs) When F/S are to be prepared, AJEs are required at the end of the accounting period to bring assets and liabilities up to date Also, revenues and expenses will be updated as well This is because there will be internal events/transactions that may not have been recorded yet; and may be some external transactions also not yet recorded We will analyze each account as necessary to determine any AJEs required In effect, we say “ Is there anything here that needs to be fixed? ” Revenue and matching principles apply (!)

FEATURES OF (TRUE) ADJUSTING JOURNAL ENTRIES ALWAYS DATED AT THE END OF THE PERIOD, i.e. B/S date ALWAYS AFFECT A B/S ACCOUNT (asset or liability) AND AN I/S ACCOUNT (revenue or expense) NEVER AFFECT THE CASH ACCOUNT, i.e. NO debit or credits to Cash PREPARED TO CONFORM TO THE REVENUE AND MATCHING PRINCIPLES REQUIRED FOR TRANSACTIONS THAT AFFECT MORE THAN ONE ACCOUNTING PERIOD USUALLY SIMPLE ENTRIES (but not necessarily)

ACCRUED REVENUE This is revenue earned but not yet recorded or paid, therefore is receivable May be revenue that the bookkeeper forgot to record (!) Or could be revenue earned but not yet due for payment (e.g. service revenue only billed every two months) Unless an AJE is prepared, both----- and -----will be understated (too low)

EXAMPLE #1 Aye Company, a small accounting firm owned by Mr Aye, is preparing AJEs at the end of its fiscal year, December 31, The company rents part of its space to Mr Bee for $500 a month. Mr Bee has not yet paid the December rent, but has promised to pay both December and January rent by January 5, AJE

2005 Dec 31 Rent receivable 500 Rent revenue 500

EXAMPLE #2 One of their clients, Ms Cee, pays $400 per month for accounting services, but is billed only every two months, at the end of each odd-numbered month. The last billing, invoice #3287, dated November 30, 2005, was for $800. AJE 2005 Dec 31 Accounts receivable 400 Service revenue 400

UNEARNED REVENUE This represents money received in advance At the time of receipt the business had not yet earned the revenue, therefore was recorded as a liability At period-end, we must record any earned portion as revenue Unless an AJE is prepared, -----will be overstated (too high) and will be understated (too low)

EXAMPLE On Nov 27, 2005, Dee Company had paid Aye Company $1,200 in advance for accounting services to be performed in December and January. “ Regular ” journal entry recorded and posted at this date was: Cash 1,200 Unearned Revenue 1,200 To record advance payment from Dee Company

At Dec 31, 2005, Mr Aye estimates 40% of this deposit had been earned, i.e. $1,200 X 40% = Dec 31 Unearned Revenue 480 Service Revenue 480

ACCRUED EXPENSES These are expenses that have been incurred but not yet recorded as payable Either they were missed or they are not yet due for payment Unless an AJE is prepared, both-- -- and -----will be understated (too low)

EXAMPLE #1 An invoice from Aye Company ’ s lawyer for $500 (for legal services performed in December 2005) was not received until January 4, 2006, and has not yet been recorded. AJE REQUIRED: 2005 Dec 31 Legal expense 500 Accounts payable 500

EXAMPLE #2 Aye Company pays its employees every two weeks. The next payday is Monday, Jan 9, 2006, and will cover the period Monday, Dec 26, 2005 to Friday, Jan 6, All employees work Monday to Friday and the total weekly payroll is $3,500, or $700 a day. AJE REQUIRED 2005 Dec 31 Wages expense 3500 Wages payable 3500

EXAMPLE #3 Aye Company borrowed $ 50,000 from their bank on Dec 9, 2005, by signing a note payable, which is due to be repaid, PLUS 7% interest, on Feb 9, 2006 “ Regular ” journal entry recorded and posted on Dec 9 was: Cash 50,000 Note Payable 50,000 To record note payable due Feb 9, 2006

Even though this note is not due to be paid until February, the cost of borrowing money, i.e. the interest which has accrued to Dec 31, must be recorded. USE THE “ PRT ” FORMULA, with EXACT days. I = P X R X T I=50000 X 7% X ( 31-9 ) = Dec 31 Interest expense Interest payable

“ USED UP ” OR EXPIRED ITEMS These are items that have been paid for in advance and originally recorded as an asset, e.g. prepaid insurance, prepaid rent, shop or office supplies As time goes by, these items are “ used up ” - and since the “ used ” portion is of no economic value to us any more, we expense it Unless an AJE is prepared, will be overstated and----- will be understated

EXAMPLE #4 On August 1, 2005, Aye Company renewed this insurance policy for another year, at a cost of $1,500. Coverage was for Aug 1, 2005 to July 31,2006. “ Regular ” journal entry recorded and posted on Aug 1, 2005 was: Prepaid Insurance 1,500 Cash 1,500 To record cost of one year insurance policy (expires July 31, 2006)

at Dec 31, 2005, part of the Aug 1 prepayment has been “ used up, ” and part is still prepaid, i.e. an asset. Portion that has been used up (expense) is: 1500 X 5/12 = Dec 31 Insurance expense 625 Prepaid insurance 625

AMORTIZATION A capital asset represents a asset that we will be able to use for an estimated number of years, e.g. machine that will manufacture DVDs for 10 years, delivery truck that can be used for 5 years SERVICE or USEFUL LIFE - number of years we expect to use Note that the “ useful life ” is not necessarily the actual physical life of the asset, but the length of time we expect to use it, or its economic life for us ALL ASSETS EXCEPT LAND HAVE A FINITE (LIMITED) LIFE, or specific period of usefulness to the owner As time goes by, the asset ’ s “ usefulness ” is used up (or expires, like prepaid insurance)

The “ accounting speak ” for this is AMORTIZATION FOR ACCOUNTING PURPOSES, amortization is the expense arising from the process of allocating a capital asset's cost over its useful life, i.e. the accounting periods that benefit from the asset's service NOTE this has nothing to do with market value! RESIDUAL or SALVAGE VALUE - is the estimated amount to be recovered (if any) at the end of asset's service life, e.g. from sale or trade-in. Represents partial recovery of original cost

EXAMPLE #6 On July 3, 2005, Aye Company purchased new computer equipment at a cost of $10,000. This equipment was expected to last four years, with a residual value of $1,000. “ Regular ” journal entry recorded and posted on July 3 was: Computer Equipment 10,000 Cash 10,000 To record purchase of new computer equipment from Supplier Y

At Dec 31, 2005 part of the “ usefulness ” of this asset has been used up or has “ expired. ” “ FORMULA ” FOR ANNUAL AMORTIZATION EXPENSE IS COST MINUS RESIDUAL VALUE SERVICE LIFE AND AMORTIZATION EXPENSE FOR 2005 IS: ( ) /4 = X6/12 =1125

Amortization Expense 1125 Accumulated Amortization, Computer 1125 To record 2005 amortization expense for computer equipment

AMORTIZATION - POINTS TO NOTE Amortization is an ESTIMATE only - may be changed if circumstances warrant it Accumulated Amortization account is a CONTRA-ASSET account used to keep track of total amortization expense over the asset ’ s useful life A contra-asset account always directly follows its related asset account in the G/L; NORMAL BALANCE IS ALWAYS CR

On the B/S, the asset cost & accumulated amortization are shown on separate lines, with the “ net ” shown as well e.g. Computer Equipment $ 10,000 Less Accumulated Amortization.. (1,125) Carrying Value OR Net Book Value $