Chapter 5 Accrual Adjustments and Financial Statement ... · 1 Chapter 5 Accrual Adjustments and...
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Transcript of Chapter 5 Accrual Adjustments and Financial Statement ... · 1 Chapter 5 Accrual Adjustments and...
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Chapter 5 Accrual Adjustments and Financial Statement Preparation
Revenue recognitionMatching expenses to revenues
Expenses related to periods
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The Measurement of Income
major function of accounting to monitor business performanceone important way of doing it – measuring and reporting a company‘s net income
Net income = revenues – expensesRevenues: Value retrieved in exchange for goods sold orservices rendered to customersExpenses: cost of goods and services used in the processof obtaining revenues
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Impact of Basic Accounting Principles on Income Measurement
Periodicity assumptionBusinesses need regular progress reports, so accountants prepare financial statements for specific periods and at regular intervals. • yearly - twelve-month accounting period is called a fiscal year• quarterly / monthly - reporting is called interim reporting
Going-concern assumptionallows cost allocation over several periods
Revenue Recognition and Matching PrincipleRecognize revenues when earned and let cost follow therevenues
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Realization Principle
Revenues of a transaction are realized when each of the following conditions hold:1. the company is expected to receive economic benefits from the
transaction2. the benefits and the costs from the transaction can reliably be
measuredIn the case of sales of goods: economic ownership of the object has been transferred to the customer• „economic ownership“ means that the customer has acquired all
the property rights that have to be transferred according to thecontract and has taken over all the respective risks
Revenue realization usually is documented by sending an invoice to the customer
when the customer remains silent after a due time, (s)he has accepted that (s)he is in charge of the return; that‘s when the revenue is realized
Long-term contracts: percentage of completion method: realisation is assumed pro rata based on conditions 1. and 2.
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Recognition of expenses
Production costs are attributed to revenuethey are matched with the revenue they were sacrificed for
Nonproduction costs are to be matched to an indefinite set of future revenues
they are recognized in the period in which they occurredModifying principle: Prudence (Conservatism)
expected losses are anticipated; they are recognized in the period in which they come to be knownexample: a construction company has to deliver a project at a fixed price, but it turns out that the costs will exceed the price because of unexpected difficulties with the underground; then the uncovered part of cost is expensed as soon as possible: it is considered as a loss actually obtained when the contract was signed
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Accrual basis versus cash basis
Instead of accrual basis accounting cash basis could be used
i.e. Revenues and Expenses are recognized when the corresponding cash flows occur
Cash basis Accounting is less informative as a basis for assessing regular performance and may be outright misleading
cash flows occur far from the basic economic processes e.g.• purchasing durable equipment• provisions of pension liabilities• provisions for closing down a nuclear power plant• revenues from long-term contracts
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Trial Balance as the Starting Point of theAdjustment Process
Trial Balance ZiscoSys Magdeburg Trial Balance September 30, 2003
Cash 6.500Accounts Receivable 2.000Equipment 4.000Supplies 500Prepaid Insurance 1.200Accounts Payable 300Unearned Revenue 2.400Owner's Investment 8.000Owner's Withdrawal 800 Revenues 5000Rent Expense 500Utility Expense 200
15.700 15.700
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The Adjustment Process
adjusting entries to apply accrual accounting to transactions that span more than one accounting periodadjusting entries required whenever financial statements are prepared
Deferral: postponement of the recognition of an expense already paid for or of a revenue already received
examples: prepaid expenses, unearned revenues
Accrual: recognition of an expense or revenue that has arisen but has not yet caused an expenditure (or receipt, respectively)
examples: accrued expenses, accrued revenues
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Adjusting entries accomplish four things:
DeferralsApportion recorded costs among two or more accounting periods • prepaid expenses – e.g. cost of machinery, prepaid rent
Apportion recorded revenues among two or more accounting periods • unearned revenues – e.g. sale of a one-year contract for
wireless phone service
AccrualsRecord unrecorded expenses• accrued expenses – e.g. interest payable on a loan
Record unrecorded revenues• accrued revenues – e.g. fees earned but not yet billed to
customers
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How do we make the adjustment(s)?
(1) record the transaction in the journal journalizing(2) transfer the journal entry to the ledger account
posting
... we basically run through the accounting cycle again!
... that‘s why we need a „new“ trial balance, the adjusted trial balance!
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Adjusting Entries for Deferrals
deferral – expiry-of-asset / liability adjustmentrequired to record the portion of the prepayment (deferral) that represents the expense incurred or the revenue earned in the current accounting perioddecrease a balance sheet accountincrease an income statement account
Prepaid expenses: adjusting entry increase an expense account, decrease an asset accountUnearned revenues: adjusting entry increase a revenue account, decrease a liability account
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Prepaid Expense
... refers to expenses paid in cash and recorded as assets before they are used or consumed
initial account entry: debit an asset accountprepaid expenses expire in two ways:
with passage of time (e.g. prepaid rent and insurance)through use or consumption (e.g. equipment, supplies)
if used or expired record the expenses that apply to the current period & prepare adjusting entry
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Asset Account Expense Account
Unadjusted Adjusting AdjustingBalance Entry Entry
Credit Debit
Amount equals cost of goodsor services used up or expired
Note: asset expense relation
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Adjustments for Supplies Used Up
supplies used – difference between balance in the supplies account and cost of supplies still in store
ZiscoSys had bought supplies for € 500 at the beginning of September. At the end of September, supplies still on hand are counted and valued at historical cost. Amount: € 300. Hence, € 200 must be recorded as an expense.
Journal entry
Sept. 30 Supplies expense 200 Supplies 200
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now we can transfer the journal entry to the ledger
without adjusting entries: (1) September expenses will be under-and net income overstated by € 200
(2) both assets and owner‘s equity will be overstated by € 200.
Supplies Supplies Expense
Sept. 8 500 Sept. 30 Adj. 200 Sept. 30 Adj. 200
Sept. 30 Bal. 300
adjustment
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Adjustment for Insurance Expired
insurance expired – equal to the insurance premium times the length of the accounting period over the entire term of coverage
ZiscoSys bought a one-year insurance policy. At the end of September € 100 have expired (€ 1.200 * 1 month / 12 months).
Journal entry
Sept. 30 Insurance expense 100Prepaid insurance 100
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without adjusting entries:(1) September expenses will be under- and net income
overstated by € 100(2) both assets and owner‘s equity will be overstated by € 100
Prepaid Insurance Insurance Expense
Sept. 2 1.200 Sept. 30 Adj. 100 Sept. 30 Adj. 100
Sept. 30 Bal. 1.100
adjustment
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Adjustment for Depreciation
depreciation – allocation of the cost of an asset to expense over its useful life in a rational and systematic manneramount of depreciation is an estimate and not a factual measurement
ZiscoSys invested € 4.000 in office equipment which will provide service for four years, that means monthly depreciation will be appr. € 84. (€ 4.000 / 48 months = € 84 per month)
Office Equipment
Sept. 2 4.000
Accumulated Depreciation - Office Equipment Depreciation Expense
Sept. 30 Adj. 84 Sept. 30 Adj. 84
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contra accounts
„accumulated depreciation – office equipment“ is a contra-asset account
a valuation account that is paired with and deducted from a related account in the financial statements
Why not credit the asset account directly?Because ...... depreciation is an estimate, and... to preserve original cost of the asset
separate „Accumulated depreciation“ accounts for each long-lived assetdifference between cost of asset and accumulated depreciation is called carrying value or book value
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Balance sheet presentation of accumulateddepreciation
the entries show:original cost of € 4.000,cost that have expired to date (€ 84), andthe balance left to be depreciated (€ 3.916)
Plant and Equipment Office Equipment € 4.000 Less Accumulated Depreciation 84 Total Plant and Equipment € 3.916
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Unearned Revenue
... is an obligation arising from receiving cash before providing a service
initial account entry: credit a liability accountif a fraction of the service is rendered or goods are delivered, the adjusting entry recognizes this revenue
Note: liability revenue relation
Liability Account Revenue Account
Adjusting Unadjusted AdjustingEntry Balance EntryDebit Credit
Amount equals price of servicesperformed or goods delivered
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ZiscoSys received € 2.400 for maintenance work that should be performed over the course of a year. At month-end of September, € 200 were earned.
without adjusting entries:(1) September revenues and net income would be understated
by € 200 in the income statement(2) liabilities would be over- and owner‘s equity will be
understated by € 200 on the balance sheet.
Unearned Revenue Service Revenue
Sept. 30 Adj. 200 Sept. 4 2.400 Sept. 10 5.000 Sept. 30 Adj. 200
Sept. 30 Bal. 2.200
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Adjusting Entries for Accruals
accrual – passage of time adjustmentrequired to record revenues earned and expenses incurred in the current period that have not been recognized or recordedadjusting entry for accruals will increase both a balance sheet and an income statement account.
accrued revenues: adjusting entry increase an asset account, -increase a revenue account
accrued expenses: adjusting entry increase an expense account, increase a liability account
Note: The following examples do not pertain to the ZiscoSysexample and, thus, will not affect the adjusted trial balance.
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Accrued Revenues
revenues for which services have been performed or goods delivered but are unrecorded so far
may accumulate with passing of time (interest, rent etc.) or from services that are neither billed nor collected
Asset Receivable Account Revenue Account
Adjusting AdjustingEntry EntryDebit Credit
Amount equals price of services performed
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Let‘s assume a company has provided a service worth € 750 to a client that hasn‘t been billed to him/her. The following adjusting entry would be made at month-end
without adjustment assets, owner‘s equity, revenues and net income would all be understated
Accounts Receivable Service Revenue
10/31 Adj. 750 10/31 5.000 31 400
31 750 10/31 6.150
Adj.Bal.
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Accrued Expenses
expenses that have been incurred but notyet recorded in the accounts
accrue from the same sources as accrued revenues
Expense Account Liability Account
Adjusting AdjustingEntry EntryDebit Credit
Amount equals cost of expense incurred
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let‘s assume we have borrowed money for which€ 100 interest accrues every month
without adjusting entries:(1) expenses and liabilities will be understated by
€ 100(2) net income and owner‘s equity will be
overstated by € 100
Interest Expense Interest Payable
10/31 Adj. 100 10/31 Adj. 100
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Summary of the adjusting entries
Type of Reason for Accounts before AdjustingAdjustment Adjustment Adjustment Entry
1. Prepaid expenses Prepaid expenses originally recorded in Assets overstated Dr. Expensesasset accounts have been used Expenses understated Cr. Assets
2. Unearned revenues Unearned revenues initially recorded in Liabilities overstated Dr. Liabilities liability accounts have been earned Revenues understated Cr. Revenues
3. Accrued revenues Revenues have been earned but not yet Assets understated Dr. Assetsreceived in cash or recorded Revenues understated Cr. Revenues
4. Accrued expenses Expenses have been incurred but not Expenses understated Dr. Expensesyet paid in cash or recorded Liabilities understated Cr. Liabilities
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General Journal J2
Date Account Titles and Explanation Ref. Debit Credit
2003 Adjusting Entries
Sept. 30 Supplies Expense 200 Supplies 200 (to record supplies used)
30 Insurance Expense 100 Prepaid Insurance 100 (to record insurance expired)
30 Depreciation Expense 84 Accumulated Depreciation - Office Equipment 84 (to record monthly depreciation)
30 Unearned Revenue 200 Service Revenue 200 (to record revenue for service provided)
account
numbers
Summary of Adjusting Entries for ZiscoSys
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The Adjusted Trial BalanceAdjusted Trial Balance ZiscoSys Magdeburg Adjusted Trial Balance September 30, 2003
Cash 6.500Accounts Receivable 2.000Equipment 4.000Supplies 300Prepaid Insurance 1.100Accumulated Depreciation - Office Equipement 84Accounts Payable 300Unearned Revenue 2.200Owner's Investment 8.000Owner's Withdrawal 800Revenues 5.200Supplies Expense 200Rent Expense 500Utility Expense 200Insurance Expense 100Depreciation Expense 84
15.784 15.784
Entries affectedby adjustmentsare in boldnumbers.
The financialstatements canbe prepareddirectly from theadjusted trialbalance.
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ZiscoSys MagdeburgIncome Statement
For the Month Ended September 2003
Revenues Service Revenues 5.200
Expenses Rental Expense 500 Utility Expense 200 Supplies Expense 200 Insurance Expense 100 Depreciation Expense 84 Total Expenses 1.084
Net Income 4.116€
ZiscoSys MagdeburgStatement of Owner's Equity
For the Month Ended September 2003
ZiscoSys Capital, September 1, 2003 0Add: Owner's Investment 8.000 Net Income for the Month 4.116 12.116Subtotal 12.116Less: Withdrawal 800ZiscoSys Capital, September 30, 2003 11.316€
Income Statement and Owner‘s Equity Statement
Recall the „unadjusted“numbers:
Net income: € 4.300
ZiscoSys Capital: €11.500
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The Balance SheetZiscoSys MagdeburgBalance Sheet
September 30, 2003
Assets Liabilities
Cash 6.500 Accounts Payable 300Accounts Receivable 2.000 Unearned Revenue 2.200Supplies 300 Prepaid Insurance 1.100 Owner's EquityEquipment 4.000 ZiscoSys, Capital 11.316 Less: Accumulated Depreciation 84 3.916
Total Liabilities andTotal Assets 13.816 Owner's Equity 13.816
€ €
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Alternative Treatment of Deferrals
Prepaid expenses, usual treatment: debit an asset account (initially)alternative treatment: debit an expense account (initially)Why? Because we expect to use up, say, the supplies completely before the next financial statement date.
Advantage: We do not need to make adjusting entries (provided that we in fact use up the supplies completely)!
If, however, we do not completely use up the supplies, we make the following adjustments (numbers taken from our example):
Supplies Supplies Expense
Sept. 30 Adj. 300 Sept. 8 500 Sept. 30 Adj. 300
Sept. 30 Bal. 200
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Alternative treatment of Unearned Revenues
Instead of crediting a liability account, we can alternatively credit a revenue account.
Why? Because we expect to earn the revenue, e.g. performthe service, until the next financial statement date.
Advantage: If we do earn the revenue until the next financialstatement date, no adjusting entry is needed.
If, however, we do not fully earn the revenue until the next financial statement day, we make the following adjustment (numbers taken from our example):
Unearned Revenue Service Revenue
Sept. 30 Adj. 2.200 Sept. 30 Adj. 2.200 Sept. 4 2.400
Sept. 30 Bal. 200