1. Chapter 3 The Adjusting Process
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2. What is the Difference Between Cash Basis Accounting and Accrual Basis Accounting?
Revenue is recorded when cash is received.
Expenses are recorded when cash is paid.
Not allowed under GAAP.
Accrual basis accounting
Revenue is recorded when earned.
Expenses are recorded when incurred.
Used by most businesses.
There are two ways to record transactions: cash basis accounting and accrual basis accounting. Cash basis records transactions based upon the receipt or payment of cash. Under cash basis, revenues are recorded only when cash is received, and expenses are recorded only when cash payments are made.
Accrual basis records the effect of each transaction as it occurs—revenues are recorded when earned and expenses are recorded when incurred. Most businesses use the accrual basis. The accrual basis of accounting provides a better picture of a business’s revenues and expenses. It records revenue only when it has been earned and expenses only when they have been incurred. Under accrual basis accounting, it is irrelevant when cash is received or paid.
Accrual basis accounting is required by Generally Accepted Accounting Principles (GAAP). Cash Basis accounting is not allowed under GAAP.
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3. The Time Period Concept
Business activities are sliced into small time segments.
Financial statements can be prepared monthly, quarterly, or annually.
Fiscal year
Any 12-month accounting period.
Often coincides with a calendar year.
The time period concept simply states that a business’s activities can be sliced into small time segments, such as months, quarters, or years. The basic accounting period is one year, and most businesses prepare annual financial statements. The 12-month accounting period used for the annual financial statements is called a fiscal year. For most companies, the annual accounting period is the calendar year, from January 1 through December 31. The year-end date is usually the low point in business activity for the year.
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4. The Revenue Recognition Principle
The revenue recognition principle dictates when to record revenue and the amount of revenue to record.
Record revenue when earned.
May be different from cash collections.
Revenue is based on the actual selling price of the item or service.
The revenue recognition principle dictates when a journal entry is required to record revenue and the amount of revenue to record. The revenue recognition principle requires companies to record revenue when it has been earned – but not before. Revenue has been earned when the business has delivered a good or service to the customer, not necessarily when the business receives the cash from the customer. The earnings process is complete when the company has done everything required by the sales agreement regardless of whether cash is received.
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5. The Revenue Recognition Principle
Revenue should be recorded when it is EARNED.
A good has been delivered or a service has been performed.
The earnings process is complete.
The revenue recognition principle guides when to record revenue and the amount that must be recognized. Under accrual basis accounting, revenue is recognized when it is earned. The earnings process is deemed complete when the seller has either delivered a product or performed a service.
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6. The Matching Principle
The matching principle guides accounting for expenses.
Expenses are recorded when they are incurred during the period.
Expenses are matched against the revenue of the period.
For example, record rent expense for January against January revenues, even if the rent was paid in December.
The matching principle guides accounting for expenses and states that all expenses are recorded when they are incurred during the period and expenses are matched against the revenues of the period. To match expenses against revenues means to subtract expenses incurred during one month from revenue earned during the same month. The goal is to compute an accurate net income or net loss for the time period.
There is a natural link between some expenses and revenues. For example, Smart Touch Learning pays a commission to the employee who sells the e-learning company’s services. The commission expense is directly related to the e-learning company’s revenue earned.
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Deferred Expenses
Deferred expenses are:
Advance payments of future expenses
Treated as assets until used
Recognized as an expense by an adjusting journal entry when the prepayment is used
Types of deferred expenses:
Prepaid rent
Office supplies
Depreciation
Deferred expenses, also called prepaid expenses, are advance payments of future expenses. They are deferrals because the expense is not recognized at the time of payment but deferred until they are used up. Such payments are considered assets rather than expenses until they are used up. When the prepayment is used up, the used portion of the asset becomes an expense via an adjusting entry.
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Prepaid Rent
Paying $3,000 for rent in advance gives us the right to use the property for three months.
In Transaction 10 in Chapter 2, Smart Touch Learning prepaid three months of the office rent of $3,000 ($1,000 per month x 3 months). The initial entry required a debit to the Prepaid Rent current asset account and a credit to Cash for $3,000. This represents that Smart Touch Learning has the right to use the property for the next three months and, as such, records an asset on the balance sheet. Each month Smart Touch Learning will adjust the Prepaid Rent account for the use of the facilities.
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Prepaid Rent
To adjust the Prepaid Rent account on Dec. 31 , we need to reduce it by 1/3 since the company has used the space for one month.
By the end of December, Smart Touch Learning has used one full month of the rent previously paid. The allocation for the one month is $1,000 (remember: $3,000/3 months). Recall that an asset that has expired is an expense.
At the end of the December, the remaining balance in the Prepaid Rent asset account is $2,000, which is found by taking the original prepayment of $3,000 less the one month usage of $1,000, which equals $2,000. At the end of January the same adjustment will be posted to show another month of rent has been used.
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Office Supplies
On November 3, Smart Touch Learning purchased $500 of supplies on account. As of December 31, only $100 of supplies remain on hand.
The December 31 unadjusted trial balance for Smart Touch Learning shows a balance in Office Supplies of $500. This represents the amount of office supplies that were purchased earlier in the period. Assume the ending balance of supplies is $100, which was found by counting the office supplies on hand at the end of the month. Since there are only $100 of supplies left on hand, the company has used $400 worth of supplies (found by taking $500 beginning balance ‒ $100 ending balance).
During November and December, the e-learning company used office supplies to conduct business. The cost of supplies used becomes Supplies Expense.
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Depreciation
Plant assets:
Long-lived, tangible assets
Used in the operations of the business
Value and usefulness decline as the assets are used
Similar to deferred expenses:
Paid for when acquired
Used up over time
Usage is recorded as Depreciation Expense
Plant assets are long-lived, tangible assets used in the operations of a business. Examples include land, buildings, equipment, furniture, and automobiles. As a business uses these assets they become an expense, and accountants systematically spread the asset’s cost over its useful life. They act much like other prepaid assets, except adjustments will be made to the plant assets over a number of years instead of one or two years through Depreciation Expense.
Depreciation is the process by which businesses spread the allocation of a plant asset’s cost over its useful life. Plant assets are recorded in full at the time of purchase; therefore, an adjustment is recorded to reduce the value of the asset over its useful life.
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Depreciation
On December 2, Smart Touch Learning received a contribution of furniture with a market value of $18,000 from a Sheena Bright, the owner.
In Chapter 2 on December 2, Smart Touch Learning received a contribution of furniture having a market value of $18,000 from a Sheena Bright, the owner. The original entry included a debit to the Furniture account on the balance sheet and a credit to the Bright, Capital account. Assume that the furniture has a five-year useful life.
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Depreciation
Depreciation is the allocation of a plant asset’s cost over its useful life.
All plant assets are depreciated, with the exception of land.
Residual value is the expected value of a depreciable asset at the end of its useful life.
The straight-line method allocates an equal amount of depreciation each year.
Depreciation is usually defined as the periodic, systematic allocation of the cost of a long-lived tangible asset to expense over its estimated useful life. When recording depreciation, a debit is made to an expense account, called Depreciation Expense.
Under Generally Accepted Accounting Principles, land is never depreciated.
Residual value is the expected value of a depreciable asset at the end of its useful life. The residual value is used in the numerator of the straight-line method. The straight-line depreciation method is a depreciation method used to allocate an equal amount of depreciation each year. The formula is (Cost – Residual value) / Useful life.
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Depreciation
Using the straight-line method, Smart Touch Learning calculates $300 of depreciation for December. Assume the residual value of the asset is zero and the useful life is 5 years.
For this example, we will use the straight-line method of computing depreciation. Using this method, the cost of the asset, after adjusting for residual value, is allocated evenly over the estimated useful life of the asset. In this case, we will divide the cost of the furniture of $18,000 by the estimated useful life of 5 years to arrive at an annual depreciation expense of $3,600 per year. Note: The residual value was zero, so there is no adjustment to cost in the numerator. We only want to depreciate this asset for one month, December, instead of a full year; therefore, we divide the annual depreciation expense amount by 12 months, so $3,600 / 12 months = $300 per month.
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Depreciation
Recording the entry requires the use of two accounts: Depreciation Expense and Accumulated Depreciation.
The adjusting journal entry records a debit to Depreciation Expense of $300 for the one month the furniture has been used. The corresponding credit for the depreciation adjusting entry is Accumulated Depreciation for the same $300.
Every plant asset account will have its own corresponding Accumulated Depreciation account.
The book value for the furniture as of December 31 would be $17,700, which is the original cost of $18,000 less the $300 accumulated depreciation for the month.
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Depreciation
The Accumulated Depreciation account is the sum of all depreciation expense recorded for the depreciable asset to date.
Accumulated Depreciation is a contra account; therefore, the account balance is the opposite of the normal balance of the related asset account.
The cost minus accumulated depreciation of a plant asset is called its book value.
The Accumulated Depreciation account is the sum of all depreciation expense recorded for the depreciable asset to date. Adjustments to the value of the plant assets are not made directly to the original asset account so that we do not violate the cost principle. Instead, the adjustment is made to a contra account called Accumulated Depreciation. A contra account has an account balance that is the opposite of the normal balance of the related asset account.
The net result of the cost of the plant asset less Accumulated Depreciation is called book value. The book value is the amount reported in the assets section of the balance sheet.
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Depreciation
The cost principle requires the plant asset account to maintain the cost value in the asset account. However, the corresponding contra account is reported in the assets section of the balance sheet. The plant asset and corresponding accumulated depreciation accounts are netted so that the depreciated value (i.e., book value) of the asset is reported properly in the assets section of the balance sheet. After recording the adjusting entries, plant assets are reported at the correct net amount, as shown on the December 31 partial balance sheet in Exhibit 3-2.
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Deferred Revenue
Deferred revenue:
Occurs when a company receives cash before it does the work or delivers a product
Is a liability because the business owes the customer the product, the service, or a refund
Upon performance or delivery, deferred revenue is converted to earned revenue.
Deferred revenues occur when a company receives cash before it does the work or delivers a product to earn that cash. The company owes a product or a service to the customer, or it owes the customer his or her money back. Only after completing the job or delivering the product does the company earn the revenue. Because of this delay, unearned revenue is a liability and is also called deferred revenue. The revenue associated with the work or product is not recognized when the cash is received but is instead deferred until it is earned.
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Deferred Revenue
On December 21, a law firm engages Smart Touch Learning to provide e-learning services for the next 30 days, paying $600 in advance.
Suppose, for example, a law firm engages Smart Touch Learning to provide e-learning services for the next 30 days, agreeing to pay $600 in advance. Smart Touch Learning records the receipt of $600 Cash and Unearned Revenue of $600. The liability account, Unearned Revenue, shows that Smart Touch Learning owes $600 in services.
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Deferred Revenue
During the last 10 days of the month, Smart Touch Learning performs 1/3 of the services.
In our example, Smart Touch Learning initially recorded a liability of $600 for Unearned Revenue. During the last 10 days of the month – December 22 through December 31 – Smart Touch Learning will earn approximately one-third (10 days divided by 30 days) of the $600, or $200. Therefore, Smart Touch Learning will record an adjustment to Unearned Revenue for $200 and recognize the earned Service Revenue of $200.
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Accrued Expenses
Accrued expenses are expenses a business has incurred but has not yet paid.
Examples of accrued expenses:
Salaries
Interest
Utilities
Businesses often incur expenses prior to paying for them. An accrued expense hasn’t been paid for yet. Salaries Expense grows as the employee works, so the expense is said to accrue. Companies do not make daily or weekly journal entries to accrue expenses. Instead, they wait until the end of the accounting period. They make an adjusting entry to bring each expense (and the related liability) up to date for the financial statements.
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22. Accrued Salaries Expense
Smart Touch Learning pays its employee a monthly salary of $2,400, half on the 15th and half on the first day of the next month.
Assume that Smart Touch Learning normally pays its employee a monthly salary of $2,400. Smart Touch Learning typically pays half the salary on the 15th of the month and the remainder on the first day of the next month. If we look at a calendar for December 2016, we see that December 31, 2016, falls on a Saturday. On December 31, Smart Touch Learning will need to recognize that it owes its employee for one-half month of salary, or $1,200.
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23. Accrued Salaries Expense
On December 31, Smart Touch Learning owes its employee $1,200, which won’t be paid until January 1. Accrue salaries for December.
The adjusting entry to record salaries accrued during the month of December is a debit to Salaries Expense and a credit to Salaries Payable of $1,200 (found by taking the monthly salary of $2,400 / 2 pay periods). The accrual is necessary because the company has incurred the expense since the employee has performed the work. When the payment is made on January 1, the Salaries Payable account will be debited, effectively eliminating the liability, and Cash will be credited.
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24. Accrued Interest Expense
Smart Touch Learning borrows $60,000 on December 1 to purchase a building. As of December 31, Smart Touch Learning incurs $100 of interest on the note.
Companies often borrow money for purchase of equipment or buildings. Interest on the note is payable one year later, on December 1, Although the company won’t make the interest payment for a year, the company must record the amount of interest expense that has been incurred by December 31, The company will make an adjusting entry to record interest expense for one month (December 1 – December 31). Assume one month’s interest expense on this note is $100. The entry to record accrued interest is a debit to Interest Expense and a credit to Interest Payable. When the interest is paid, Interest Payable will be debited, and Cash will be credited.
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