ENGG 401 X2 Fundamentals of Engineering Management Spring 2008 Chapter 3 (cont): End of Period Adjustments Dave Ludwick Dept. of Mechanical Engineering University of Alberta

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Purpose of Adjusting Until now, we have largely been processing “external transactions”, which are stimulated by exchanges with another party But there are also “internal transactions” that must be entered in order to give a more complete picture of the organization’s performance during the period Adjusting takes into account 3 of the GAAP rules –Time period principle –Revenue recognition principle –Matching principle

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Time principle As time passes, economic events or business transactions can be “deemed” to occur. Consider the payment of rent. –Even though one pays rent in advance, the prepaid rent “asset” is actually “consumed” over the month or year for which it was paid The time principle becomes especially evident when you consider the rent prepaid for a whole year. –If financial statements are prepared for each quarter, then adjustments must be made to recognize the portion of the prepaid rent that has been consumed into rent expense for that time of the year

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Revenue and Expense Recognition Revenue Recognition –Revenue is recognized (counted as an increase in the economic state of the organization) when there is evidence the firm is economically better off, regardless of when cash is received Sale has been made Products have been delivered to customers who are expected to pay Sufficient time has passed to earn the revenue (rent revenues) Matching Principle –The matching principle calls for the reporting or “matching” of expenses in the same accounting period as the revenues which they helped to create –Expenses are goods and services that are consumed in the creation of revenues –Costs associated with revenues that are to be earned in the future are maintained in asset accounts (or often called “capitalized”) and drawn against over future periods

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Cash vs. Accrual Accounting Methods Accrual Method –The method where revenues and expenses are recognized (recorded in financial statements) at the time they provide the economic impact, not necessarily when cash is received or disbursed Cash Method –The method by which revenues and expenses are recorded when cash is received or disbursed The Accrual method more closely supports the qualitative standards put forward by the accounting profession. It is a more conservative and relevant method. The Accrual method supports the need for comparability The Cash method is not consistent with GAAP

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering ManagementExample Your company opens up shop on January 1, On the first day you –Take possession of a new building you contracted to have built for your purposes –You arrange for hydro, water, telephone and cable service Even though you may end up taking a mortgage to buy the building, you still do not record the complete purchase price of the new building on Jan 1. –You can’t expense a whole building in one day – it provides economic benefit (shelter in which you can earn revenue) for many years However, at the end of the first quarter, you can expense all the utilities to that date, because they have already been (they are continually) consumed

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Adjusting Accounts An Adjusting Entry is recorded/entered at the end of the accounting period to bring the asset or liability account balance to its proper amount The entry also adjusts the proper revenue or expense account The 5 main adjustments

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Adjusting Prepaid Expenses Prepaid expenses are items paid for in advance of receiving their benefits. Prepaid expenses are assets until they are consumed, which are adjusted into expenses –Remember the prepaid rent and prepaid insurance from previous examples? DateAccount Titles and explanationPRDebitCredit Jan 1Prepaid insurance3600 Cash3600 Jan 31 Insurance Expense300 Prepaid insurance300

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Amortization and Depreciation Capital assets are long-term assets such as property, plant and equipment which are used to sell products/services over a long period of time (crossing over more than one accounting period) Intangible assets are (generally long term assets) which provide some intangible benefit over a period of time (patents, trademarks, goodwill) Amortization or depreciation is the process of “writing down” or expensing these assets over the course of their useful lives The word “Depreciation” is used to refer to the write down of tangible assets and the word “Amortization” is used to refer to the write down of intangible assets

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Calculating Amortization Most common way is to use Straight Line depreciation Example: –The business buys a delivery truck for $20000 on Jan 1 –The business expects to use the truck for 10 years, at which time it expects it could dispose of the vehicle for $2000 –Annual amortization: ( )/10 = $1800 / year

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Amortization terms Cost of Asset/Purchase price: The original cash outlay required to acquire the asset Salvage Value/Disposal Value: The amount that the asset can be disposed of for Useful life: The number of accounting periods during which the asset contributes to earning revenue Book Value: The cost of the asset less the accumulated depreciation during any period Market Value: The amount the asset can actually be sold for at any given time. It is not recorded on the books unless the asset is actually sold

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Contra Accounts A contra account is an offset account in which the balance is always opposite and reported directly beneath, that of the account with which it is associated Contra accounts allow balance sheet readers to know both the costs of assets and the total amount of depreciation charged to expense to date. Sample Contra accounts –Accumulated Depreciation (Fixed Assets) –Accumulated Amortization (Intangible Assets) –Allowance for Doubtful Accounts (Accounts Receivable) –Bond Discount (Either a payable or asset, depending on the organization’s position)

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Unearned Revenues Unearned Revenues refer to cash received in advance of providing products or services. –When cash is received an obligation to provide products/services is accepted –Unearned revenues (aka deferred revenues) are liabilities until earned, when they get converted to revenues DateAccount Titles and explanationPRDebitCredit Jan 1Cash2000 Unearned revenue2000 Jan 31 Unearned revenue2000 Revenue2000

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Accrued Expenses Accrued Expenses refer to costs incurred in a period that are both unpaid and unrecorded. Accrued expenses are part of expenses and reported on the income statement Example: –Accrued interest expense –Accrued salaries expense DateAccount Titles and explanationPRDebitCredit Jan 28Accrued salary expense750 Salaries payable750 Jan 31Salaries Expense250 Salaries payable750 Cash1000

Dave Ludwick, Dept. of Mech. Eng. Depreciation and Income Statements Summer ENGG 401 X2 – Fundamentals of Engineering Management Accrued Revenues Accrued revenues are revenues earned in a period that are unrecorded and not yet received in cash Relevant in a large project organization where revenue can be recognized at completion of various project phases, even though invoicing and payment may not occur for some time I set up a separate Asset account for un-invoiced revenue, if it is not invoiced –Reserve the use of AR for invoiced but unpaid revenue DateAccount Titles and explanationPRDebitCredit Jan 28Un-invoiced revenue (not AR)750 Revenue750 Jan 31Cash750 Un-invoiced revenue750