CHAPTER THREE

CHAPTER THREE

MEASURING BUSINESS INCOME: THE ADJUSTING PROCESS

ACCRUAL BASIS ACCOUNTINGAKA ACCRUAL ACCOUNTING

• Required by GAAP for income tax reporting for most businesses

• Uses revenue principle, matching principle and time-period concept

REVENUE PRINCIPLE

• Revenue is recorded in the accounting period earned, e.g. when service is performed or goods are sold, REGARDLESS OF WHEN THE CUSTOMER PAID FOR IT

• In other words, the receipt of the cash is secondary

MATCHING PRINCIPLEMATCHING PRINCIPLE

• All expenses incurred to earn the revenue recorded must be recorded in the same period, REGARDLESS OF WHEN THE CASH IS PAID OUT

• In other words, the payment of the cash is secondary

TIME PERIOD CONCEPT

• For accounting purposes, we must divide the economic life of a business into relatively short, artificial periods

• Changes are to be measured and reported over these periods

• Time period concept ensures that accounting info is reported at regular intervals (from one month to one year)

• FISCAL or ACCOUNTING YEAR does not have to be the calendar year

• Most businesses use their NATURAL BUSINESS YEAR, i.e. the year end is set for when business activity is at its lowest, e.g. most retail stores use January or February; ski resort would use June or July

• F/S must be prepared at the end of the fiscal year• INTERIM STATEMENTS are F/S prepared during the

fiscal yea• These three principles form the basis of the accrual

basis of accounting, and ensure that the correct amount of revenue and expense are reported in the correct time period so we can compare NI from period to period

ADJUSTING JOURNAL ENTRIES (AJEs)

• When F/S are to be prepared, AJEs are required at the end of the accounting period to bring assets and liabilities up to date

• Also, revenues and expenses will be updated as well

• This is because there will be internal events/transactions that may not have been recorded yet; and may be some external transactions also not yet recorded

• We will analyze each account as necessary to determine any AJEs required

• In effect, we say “Is there anything here that needs to be fixed?”

• Revenue and matching principles apply (!)

FEATURES OF (TRUE) ADJUSTING JOURNAL ENTRIES

• ALWAYS DATED AT THE END OF THE PERIOD, i.e. B/S date

• ALWAYS AFFECT A B/S ACCOUNT (asset or liability) AND AN I/S ACCOUNT (revenue or expense)

• NEVER AFFECT THE CASH ACCOUNT, i.e. NO debit or credits to Cash

• PREPARED TO CONFORM TO THE REVENUE AND MATCHING PRINCIPLES

• REQUIRED FOR TRANSACTIONS THAT AFFECT MORE THAN ONE ACCOUNTING PERIOD

• USUALLY SIMPLE ENTRIES (but not necessarily)

ACCRUED REVENUE• This is revenue earned but not yet recorded

or paid, therefore is receivable• May be revenue that the bookkeeper forgot

to record (!) Or could be revenue earned but not yet due for payment (e.g. service revenue only billed every two months)

• Unless an AJE is prepared, both-----and -----will be understated (too low)

EXAMPLE #1

• Aye Company, a small accounting firm owned by Mr Aye, is preparing AJEs at the end of its fiscal year, December 31, 2005. The company rents part of its space to Mr Bee for $500 a month. Mr Bee has not yet paid the December rent, but has promised to pay both December and January rent by January 5, 2006. AJE

• 2005 Dec 31• Rent receivable 500• Rent revenue 500

EXAMPLE #2

• One of their clients, Ms Cee, pays $400 per month for accounting services, but is billed only every two months, at the end of each odd-numbered month. The last billing, invoice #3287, dated November 30, 2005, was for $800.

• AJE• 2005 Dec 31• Accounts receivable 400• Service revenue 400

UNEARNED REVENUE

• This represents money received in advance • At the time of receipt the business had not y

et earned the revenue, therefore was recorded as a liability

• At period-end, we must record any earned portion as revenue

• Unless an AJE is prepared, -----will be overstated (too high) and -------will be understated (too low)

EXAMPLE• On Nov 27, 2005, Dee Company had paid

Aye Company $1,200 in advance for accounting services to be performed in December and January. “Regular” journal entry recorded and posted at this date was:

• Cash 1,200• Unearned Revenue 1,200• To record advance payment from Dee Co

mpany

• At Dec 31, 2005, Mr Aye estimates 40% of this deposit had been earned,

• i.e. $1,200 X 40% =480• 2005 Dec 31• Unearned Revenue 480• Service Revenue 480

ACCRUED EXPENSES

• These are expenses that have been incurred but not yet recorded as payable

• Either they were missed or they are not yet due for payment

• Unless an AJE is prepared, both---- and -----will be understated (too low)

EXAMPLE #1EXAMPLE #1

• An invoice from Aye Company’s lawyer for $500 (for legal services performed in December 2005) was not received until January 4, 2006, and has not yet been recorded.

• AJE REQUIRED:• 2005 Dec 31• Legal expense 500• Accounts payable 500


• Aye Company pays its employees every two weeks. The next payday is Monday, Jan 9, 2006, and will cover the period Monday, Dec 26, 2005 to Friday, Jan 6, 2006. All employees work Monday to Friday and the total weekly payroll is $3,500, or $700 a day.

• AJE REQUIRED• 2005 Dec 31• Wages expense 3500• Wages payable 3500


• Aye Company borrowed $ 50,000 from their bank on Dec 9, 2005, by signing a note payable, which is due to be repaid, PLUS 7% interest, on Feb 9, 2006“Regular” journal entry recorded and posted on Dec 9 was:

• Cash 50,000• Note Payable 50,000• To record note payable due Feb 9, 2006

• Even though this note is not due to be paid until February, the cost of borrowing money, i.e. the interest which has accrued to Dec 31, must be recorded.

• USE THE “PRT” FORMULA, with EXACT days. I = P X R X T

• I=50000 X 7% X ( 31-9 ) =210.96• 2005 Dec 31• Interest expense 210.96• Interest payable 210.96

“USED UP” OR EXPIRED ITEMS• These are items that have been paid for in a

dvance and originally recorded as an asset, e.g. prepaid insurance, prepaid rent, shop or office supplies

• As time goes by, these items are “used up” - and since the “used” portion is of no economic value to us any more, we expense it

• Unless an AJE is prepared,------ will be overstated and----- will be understated


• On August 1, 2005, Aye Company renewed this insurance policy for another year, at a cost of $1,500. Coverage was for Aug 1, 2005 to July 31,2006.

• “Regular” journal entry recorded and posted on Aug 1, 2005 was:

• Prepaid Insurance 1,500• Cash 1,500• To record cost of one year insurance policy

(expires July 31, 2006)

• at Dec 31, 2005, part of the Aug 1 prepayment has been “used up,” and part is still prepaid, i.e. an asset.

• Portion that has been used up (expense) is: 1500 X 5/12 =625

• 2005 Dec 31 • Insurance expense 625• Prepaid insurance 625

AMORTIZATION• A capital asset represents a asset that we will be able t

o use for an estimated number of years, e.g. machine that will manufacture DVDs for 10 years, delivery truck that can be used for 5 years

• SERVICE or USEFUL LIFE - number of years we expect to use

• Note that the “useful life” is not necessarily the actual physical life of the asset, but the length of time we expect to use it , or its economic life for us

• ALL ASSETS EXCEPT LAND HAVE A FINITE (LIMITED) LIFE, or specific period of usefulness to the owner

• As time goes by, the asset’s “usefulness” is used up (or expires, like prepaid insurance)

• The “accounting speak” for this is AMORTIZATION

• FOR ACCOUNTING PURPOSES, amortization is the expense arising from the process of allocating a capital asset's cost over its useful life, i.e. the accounting periods that benefit from the asset's service

• NOTE this has nothing to do with market value!

• RESIDUAL or SALVAGE VALUE - is the estimated amount to be recovered (if any) at the end of asset's service life, e.g. from sale or trade-in. Represents partial recovery of original cost


• On July 3, 2005, Aye Company purchased new computer equipment at a cost of $10,000. This equipment was expected to last four years, with a residual value of $1,000. “Regular” journal entry recorded and posted on July 3 was:

• Computer Equipment 10,000• Cash 10,000• To record purchase of new computer equip

ment from Supplier Y

• At Dec 31, 2005 part of the “usefulness” of this asset has been used up or has “expired.”

• “FORMULA” FOR ANNUAL AMORTIZATION EXPENSE IS

COST MINUS RESIDUAL VALUE SERVICE LIFE• AND AMORTIZATION EXPENSE FOR 2005 IS:• (10000-1000) /4 = 2250• 2250 X6/12 =1125

• Amortization Expense 1125• Accumulated Amortization, Comp

uter 1125• To record 2005 amortization expense

for computer equipment

AMORTIZATION - POINTS TO NOTE

• Amortization is an ESTIMATE only - may be changed if circumstances warrant it

• Accumulated Amortization account is a CONTRA-ASSET account used to keep track of total amortization expense over the asset’s useful life

• A contra-asset account always directly follows its related asset account in the G/L; NORMAL BALANCE IS ALWAYS CR

• On the B/S, the asset cost & accumulated amortization are shown on separate lines, with the “net” shown as well

• e.g. Computer Equipment . . . . . . . . . $ 10,000

• Less Accumulated • Amortization . . (1,125)• Carrying Value OR Net Book Value . . . .

. . . . . $

Documents

CHAPTER THREE