GLENCOE / McGraw-Hill

Accruals, Deferrals, and the Worksheet

1.Determine the adjustment for merchandise inventory, and enter the adjustment on the worksheet. 2.Compute adjustments for accrued and prepaid expense items, and enter the adjustments on the worksheet. 3.Compute adjustments for accrued and deferred income items, and enter the adjustments on the worksheet. Calculating and Recording Adjustments Section Objectives

Page 430 The Accrual Basis of Accounting

The accrual basis is a system of accounting by which all revenues and expenses are matched and reported on financial statements for the applicable period. ANSWER: QUESTION: What is the accrual basis? Page 430

Financial statements usually are prepared using the accrual basis of accounting because it most nearly attains the goal of matching expenses and revenue in an accounting period. Page 430

Revenue is recognized when earned, not necessarily when the cash is received. Page 430 Revenue is recognized when the sale is complete. A sale is complete when title to the goods passes to the customer or when the service is provided. For sales on account, revenue is recognized when the sale occurs even though the cash is not collected immediately.

Page 430 Expenses are recognized when incurred or used, not necessarily when cash is paid. Each expense is assigned to the accounting period in which it helped to earn revenue for the business, even if cash is not paid at that time. This is often referred to as matching revenues and expenses.

Adjustment for Merchandise Inventory Page 431

Objective 1 Determine the adjustment for merchandise inventory, and enter the adjustment on the worksheet. Page 431

An asset account for merchandise inventory is maintained in the general ledger. Inventory All purchases of merchandise are debited to the Purchases account. All sales of merchandise are credited to the revenue account Sales. Purchases Sales Page 431

Notice that no entries are made directly to the Merchandise Inventory account during the accounting period. Consequently, when the trial balance is prepared at the end of the period, the Merchandise Inventory account still shows the beginning inventory for the period. Merchandise Inventory Purchases Sales Page 431

Adjustment for Merchandise Inventory At the end of each period a business determines the ending balance of the Merchandise Inventory account. The first step in determining the ending inventory is to count the number of units of each type of item on hand. As the merchandise is counted, the quantity on hand is entered on an inventory sheet. Page 431

An inventory sheet is a form used to list the quantity and type of goods a firm has in stock. ANSWER: QUESTION: What is an inventory sheet? Page 431

Modern Casuals needs to adjust the Merchandise Inventory account to reflect the balance at the end of the year. The adjustment is made in two steps. Each step needs two general ledger accounts: Based on a count taken on December 31, merchandise inventory for Modern Casuals totaled $46,000. Merchandise Inventory Income Summary Page 431

Page 431 The first step is to remove beginning inventory from the books. Modern Casuals began the year with $51,500 in inventory. QUESTION: What is the amount of the first inventory adjustment? ANSWER: Beginning Inventory $51,500

Which account is credited? For what amount? Which account is debited? For what amount? Adjustment for Beginning Inventory Page 431

Page 431 Income Summary 51,500 Merchandise Inventory Bal. 51,500 Adjustment for Beginning Inventory 51,500

Page 431 The next step is to place ending inventory on the books. Modern Casuals ended the year with $46,000 in inventory. QUESTION: What is the amount of the next inventory adjustment? ANSWER: Ending Inventory $46,000

Which account is credited? For what amount? Which account is debited? For what amount? Adjustment for Ending Inventory Page 431

Page 431 Merchandise Inventory 46,000 Income Summary Adjustment for Ending Inventory 46,000

Objective 2 Compute adjustments for accrued and prepaid expense items, and enter the adjustments on the worksheet. Page 433

Adjustment for Loss from Uncollectible Accounts Page 433

Credit sales are made with the expectation that the customers will pay the amount due later. Page 433 Sometimes the account receivable is never collected. Losses from uncollectible accounts are classified as operating expenses.

Under accrual accounting, the expense for uncollectible accounts is recorded in the same period as the related sale. Page 433 The expense is estimated because the actual amount of uncollectible accounts is not known until later periods. The estimated expense is debited to an account named Uncollectible Accounts Expense.

Several methods exist for estimating the expense for uncollectible accounts. Page 433 Modern Casuals uses the percentage of net credit sales method. The rate used is based on the company's past experience with uncollectible accounts and management's assessment of current business conditions.

Modern Casuals estimates that 0.75 percent of net credit sales will be uncollectible. Page 433 Net credit sales for the year were $100,000. The estimated expense for uncollectible accounts is $750 ($100,000 x ).

Page 433 Accounts Receivable $32,000 Allowance for Doubtful Accounts (750) The entry to record the expense for uncollectible accounts includes a credit to a contra asset account, Allowance for Doubtful Accounts. This account appears on the balance sheet as follows. Net Accounts Receivable $31,250

Which account is credited? For what amount? Which account is debited? For what amount? Adjustment for Uncollectible Accounts Page 431

Page 431 Adjustment for Uncollectible Accounts Uncollectible Accounts Expense 750 Allowance for Doubtful Accounts 750

Page 434 Why doesn’t Uncollectible Accounts Expense increase when a customer’s account is written off? QUESTION: The expense was already recorded based on the estimate. ANSWER:

Adjustments for Depreciation Page 434

Property, plant, and equipment are long-term assets that are used in the operation of a business and that are subject to depreciation. ANSWER: QUESTION: What is property, plant, and equipment? Page 434

EXCEPTION: Land is not depreciated. Page 434

Adjustments for Accrued Expenses Page 435

Accrued expenses are expense items that relate to the current period but have not yet been paid and do not yet appear in the accounting records. ANSWER: QUESTION: What are accrued expenses? Page 435

Page 435 Modern Casuals makes adjustments for three types of accrued expenses: Because accrued expenses involve amounts that must be paid in the future, the adjustment for each item is a debit to an expense account and a credit to a liability account. Accrued salaries Accrued payroll taxes Accrued interest on notes payable

Page 435 From December 28 to January 3, the firm hired several part-time clerks for the year-end sale. The part-time salaries expense has not been recorded because the employees will not be paid until January 3, Adjustment for Accrued Salaries Through December 31, 2004, these employees earned $1,500.

Page 435 Which account is credited? For what amount? Which account is debited? For what amount? Adjustment for Accrued Salaries

Page 436 Salaries Expense – Sales 1,500 Salaries Payable 1,500 Adjustment for Accrued Salaries

Accrued Payroll Taxes Page 436 Payroll taxes are not legally owed until the salaries are paid. Businesses that want to match revenue and expenses in the appropriate period make adjustments to accrue the employer's payroll taxes even though the taxes are technically not yet due.

Accrued Payroll Taxes Page 436 None of the part-time clerks employed by Modern Casuals have reached the social security wage base limit. The entire $1,500 of accrued salaries is subject to the employer's share of social security and Medicare taxes.

Social security tax $1,500 x = $ Medicare tax 1,500 x = Total accrued payroll taxes $ The accrued employer's payroll taxes are: Page 436

Which accounts are credited? For what amounts? Which account is debited? For what amount? Adjustment for Accrued Payroll Taxes Page 436

93.00 Page 436 Adjustment for Accrued Payroll Taxes Payroll Taxes Expense Medicare Tax Payable Social Security Tax Payable 21.75

Page 436 Federal unemployment tax $1,500 x = $ State unemployment tax $1,500 x = Total accrued taxes $ The accrued unemployment taxes are: The entire $1,500 is also subject to unemployment taxes.

Which accounts are credited? For what amounts? Which account is debited? For what amount? Page 436 Adjustment for Accrued Payroll Taxes

12.00 Page 436 Payroll Taxes Expense State Unemp. Tax Payable Federal Unemp. Tax Payable Adjustment for Accrued Payroll Taxes

Page 437 Accrued Interest on Notes Payable On December 1, 2004, Modern Casuals issued a two- month note for $2,000, with annual interest of 12 percent. Modern Casuals will pay the interest when the note matures on February 1, However, the interest expense is incurred day by day and should be allocated to each fiscal period involved in order to obtain a complete and accurate picture of expenses.

Page 437 Principal x Rate x Time $2,000 x 0.12 x 1/12 = $20 The fraction 1/12 represents one month, which is 1/12 of a year. The accrued interest expense amount is determined by using the interest formula: Date of note: December 1, 2004 Expense for 2004 = 1 month (Dec )

Page 437 Which account is credited? For what amount? Which account is debited? For what amount? Adjustment for Accrued Interest on Notes Payable

Interest Expense 20 Interest Payable 20 Page 437 Adjustment for Accrued Interest on Notes Payable

Adjustments for Prepaid Expenses Page 437

Prepaid expenses (also called deferred expenses) are expenses that are paid for and recorded before they are used, such as rent or insurance. ANSWER: QUESTION: What are prepaid expenses? Page 437

Page 437 Modern Casuals makes adjustments for three types of prepaid expenses: Prepaid supplies Prepaid insurance Prepaid interest on notes payable

Page 438 On November 1, 2004, Modern Casuals borrowed $9,000 from its bank and signed a three-month note at an annual interest rate of 10 percent. The bank deducted the entire amount of interest in advance. Adjustment for Prepaid Interest on Notes Payable

Page 438 QUESTION: What is the amount of interest prepaid for three months? ANSWER: = $225 $9,000 x 0.10 x 3/12 Principal x Rate x Time Adjustment for Prepaid Interest on Notes Payable

The interest expense for 1 month is $75: $225  3 months = $75 OR $9,000 x 10% x 1/12 = $75 QUESTION: What is the interest expense for 2004? ANSWER: $ 75 X 2 $150 Page months (November and December)

Page 438 Adjustment for Prepaid Interest on Notes Payable Which account is debited? For what amount? Which account is credited? For what amount?

Interest Expense 150 Prepaid Insurance 150 Bal. 225 Page 438 Adjustment for Prepaid Interest on Notes Payable

Adjustments for Accrued Income Page 439

Objective 3 Compute adjustments for accrued and deferred income items, and enter the adjustments on the worksheet. Page 439

Accrued income is income that has been earned but not yet received and recorded. ANSWER: QUESTION: What is accrued income? Page 439

Page 439 On December 31, 2004, Modern Casuals had two types of accrued income: Accrued interest on notes receivable Accrued commission on sales tax

Page 440 On November 1, 2004, Modern Casuals accepted from a customer a four-month, 12 percent note for $1,200. The interest income is recorded when it is received, which is normally when the note matures. However, interest income is earned day by day. At the end of the period, an adjustment is made to recognize interest income earned but not yet received or recorded. Accrued Interest on Notes Receivable

Page 440 The amount of earned interest income is determined by using the interest formula: Date of note: November 1, 2004 Income for 2004 = 2 months (Nov.1 – Dec. 31) Principal x Rate x Time $1,200 x 0.12 x 2/12 = $24 The fraction 1/12 represents one month, which is 1/12 of a year.

Page 440 Adjustment for Accrued Interest on Notes Receivable Which account is debited? For what amount? Which account is credited? For what amount?

Interest Receivable 24 Interest Income 24 Bal. 136 Page 440 Adjustment for Accrued Interest on Notes Receivable

Adjustments for Unearned Income Page 440

Unearned income (also called deferred income) is income received before it is earned. ANSWER: QUESTION: What is unearned income? Page 440

Page 440 Under the accrual basis of accounting, only income that has been earned appears on the income statement. Modern Casuals has no unearned income.

Unearned Income Items include: Page 441 Subscription income Management fees Rental income Legal fees Architectural fees Construction fees Advertising income

REVIEWREVIEW Financial statements are usually prepared using the ____________ of accounting because it most nearly attains the goal of matching expenses and revenue in an accounting period. An ______________ lists the quantity of each type of goods a firm has in stock. The one item classified as property, plant, and equipment that is not subject to depreciation is ____. land inventory sheet accrual basis Complete the following sentences:

REVIEWREVIEW ________________ are expense items that relate to the current period but have not yet been paid and do not yet appear in the accounting records. _______________ is the income that has been earned but not yet received. ________________ is the income received before it is earned. Accrued income Complete the following sentences: Accrued expenses Unearned income

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