The Accounting Cycle Accruals and Deferrals Chapter 4 Chapter 4: The Accounting Cycle—Accruals and Deferrals

Adjusting Entries Adjusting entries are Every adjusting needed whenever revenue or expenses affect more than one accounting period. Every adjusting entry involves a change in either a revenue or expense and an asset or liability. At the end of the period, we need to make adjusting entries to get the accounts up to date for the financial statements. The accrual basis dictates that revenues be recognized when earned and expenses be recognized when incurred. The accrual basis of accounting is considered to be in compliance with generally accepted accounting principles, GAAP. Every adjusting entry involves a revenue or expense and an asset or liability.

Types of Adjusting Entries Converting assets to expenses Converting liabilities to revenue There are two broad categories of adjustments. The first is when payments are made or cash is received before the expense or revenue is recognized. This category includes prepaid or deferred expenses (including depreciation), and unearned or deferred revenues. The second major category of adjustments is when cash is paid or received after the expense or revenue is recognized. These are very common adjustments. This category includes accrued expenses and accrued revenues. Accruing unpaid expenses Accruing uncollected revenue

Converting Assets to Expenses End of Current Period Prior Periods Current Period Future Periods Adjusting Entry Recognizes portion of asset consumed as expense, and Reduces balance of asset account. Transaction Paid cash in advance of incurring expense (creates an asset). When an adjusting entry is used to convert an asset to expense, a transaction took place in a prior period that involved the advance payment of an expense. Three common examples of adjusting entries to convert assets to expenses are the recognition of depreciation expense on plant assets, the using up of office supplies during the period, and the expiration of prepaid insurance. The adjusting entry is made at the end of the current period to recognize the converting of the prepaid asset into an expense. The asset account is reduced and the expense account is increased.

The Concept of Depreciation Depreciation is the systematic allocation of the cost of a depreciable asset to expense. Cash (credit) Fixed Asset (debit) On date when initial payment is made . . . The asset’s usefulness is partially consumed during the period. At end of period . . . Depreciation Expense (debit) Accumulated Depreciation (credit) Depreciation is the systematic and rational allocation of the cost of a depreciable asset to expense over its estimated useful life. There are many methods of depreciation; the straight-line method will be examined in this chapter. As a depreciable asset is used to produce revenue, the asset loses some of its utility and part of the asset is consumed. At the end of the accounting period, the expense relating to the consumption of the depreciable asset must be recorded.

Converting Liabilities to Revenue End of Current Period Prior Periods Current Period Future Periods Adjusting Entry Recognizes portion earned as revenue, and Reduces balance of liability account. Transaction Collect cash in advance of earning revenue (creates a liability). Now let’s look at the adjusting entry associated with converting a recorded liability to a revenue. The adjusting entry is necessary when cash has been collected in advance of earning revenue. An example is when a magazine publishing company collects cash for a one- or two-year subscription. Other examples of transactions that require an adjusting entry to convert a liability to revenue are the sales of airline tickets, or season tickets for a sports team. At the end of the accounting period, an adjusting entry will need to be recorded to recognize the revenue earned during the period and to reduce the liability account.

Accruing Unpaid Expenses End of Current Period Prior Periods Current Period Future Periods Adjusting Entry Recognizes expense incurred, and Records liability for future payment. Transaction Pay cash in settlement of liability. One of the keys to understanding the accrual of expenses is to realize that an expense has been incurred in the current accounting period but will not be paid until the following accounting period. For example, you may purchase gasoline from the local service station using a credit card. You have incurred the expense for the gasoline but have not recorded the cost. You probably will not record your expense until the following period when the credit card statement comes. Companies cannot follow this practice because expenses would be recorded in the wrong accounting period and thus violate the matching principle. The adjusting entry required is to debit, or increase, an expense account and credit, or increase, a liability account. Almost all expense accruals will require this type of entry. Some common accrued expenses include interest owed on loans, wages and salaries owed to employees, and property taxes owed to the local taxing authority.

Accruing Uncollected Revenue End of Current Period Prior Periods Current Period Future Periods Adjusting Entry Recognizes revenue earned but not yet recorded, and Records receivable. Transaction Collect cash in settlement of receivable. A revenue accrual is necessary when revenue has been earned in the current accounting period but the cash will not be collected until the next period. Examples of revenue accruals include interest earned on investments or loans made to others, and work completed but not yet billed to the customer. In the adjusting entry we will record a receivable, an asset account, and recognize the revenue earned.

Accruing Income Taxes Expense: The Final Adjusting Entry As a corporation earns taxable income, it incurs income taxes expense, and also a liability to governmental tax authorities. A corporation must pay income tax on its taxable income. Corporate taxes are due on March 15th of the year following the year in which the income was earned. The corporate income taxes for 2008 are due on March 15, 2009. It is always necessary to accrue income taxes for a corporation. The adjusting entry is just like the entry we record for any accrued expense. The adjusting entry is to debit Income Taxes Expense for the amount of the accrual and credit Income Taxes Payable for the same amount. In this case, the taxes due are $780.

Adjusting Entries and Accounting Principles Costs are matched with revenue in two ways: Direct association of costs with specific revenue transactions. Adjusting entries help us match costs with revenues either directly by associating certain costs with specific revenues, or through the allocation process. Allocation was used to record depreciation expense in this chapter. Systematic allocation of costs over the “useful life” of the expenditure.

The Concept of Materiality An item is “material” if knowledge of the item might reasonably influence the decisions of users of financial statements. Supplies Light bulbs Many companies immediately charge the cost of immaterial items to expense. Generally, accountants are most concerned about amounts that are determined to be material in nature. An amount is material if it may influence the decision of an informed user of financial information. When amounts involved are not material, many companies have established a policy of expensing the amount immediately. We know that light bulbs may last through several accounting periods. It is not cost beneficial to record the bulbs as assets and allocate a portion of their cost to each month of operation. We normally expense the cost of these and similar items as they are incurred.

Effects of the Adjusting Entries We identified four types of adjusting entries, each of which involves one income statement account and one balance sheet account. The effects of these adjustment types on the income statement and balance sheet are summarized on this slide.

Adjusted Trial Balance All balances are taken from the ledger accounts on May 31 after preparing the two depreciation adjusting entries. We have highlighted just a few of the adjusting entries prepared at the end of May 2011. Like the trial balance, the adjusted trial balance shows that the total of the debit balance accounts is equal to the total of the credit balance accounts. Our books are in balance after recording our adjusting entries.

End of Chapter 4 End of Chapter 4.