worksheet
Set up a tool to organize information for fi nancial statements
Use the completed worksheet to compute your business’s bottom line 6.2 How and why to make
adjusting journal entries
Record expenses that are not cash outlays
6.3 How to determine net income or loss
Balancing your books at the end of the ac- counting period means you fi nally get to show what your company has accomplished fi nan- cially. Before you can develop reports to pres- ent to others, you need to adjust the balances of
certain accounts. These adjustments usually re- sult from the passage of time or change in cir- cumstances, not from any specifi c transactions with outside parties.
INTRODUCTION
After you produce a successful trial balance, you are closer to preparing the fi nancial statements. You will use a worksheet, which is Step 5 of the accounting cycle. A worksheet is an optional form used to gather the necessary information for the balance sheet and income statement. It is an internal document and not part of the formal fi nancial statements.
The worksheet has six sections: • Account.
• Trial Balance. • Adjustments.
• Adjusted Trial Balance. • Income Statement. • Balance Sheet.
The fi ve dollar-amount sections each have two columns: one for debit amounts and one for credit amounts.
The fi rst task in preparing a worksheet is transferring information from the trial balance to the worksheet:
• Transfer account names (and account numbers, if you use them) to the worksheet’s Account section.
• Transfer debit balances to the worksheet’s Trial Balance Debit column. • Transfer credit balances to the worksheet’s Trial Balance Credit column. Figure 6-1 shows the worksheet for Andrea’s Artistic Visions for the month ended January 31.
Worksheet:
An optional form used to gather the necessary information for the balance sheet and income statement.
Worksheet:
An optional form used to gather the necessary information for the balance sheet and income statement.
6.1 SETTING UP THE WORKSHEET
Small Business Accounting in Action
Set up a tool to organize information for fi nancial statements.
FOR EXAMPLE
See Figure 6-1 for an ex- ample of how information is transferred from a trial balance to a worksheet.
Figure 6-1
Information is transferred from the trial balance to the worksheet.
Account Debit Credit Debit Credit Debit Credit Debit Credit Debit
Trial Balance Adjustments
Adjusted Trial Balance
Income
Statement Balance Sheet
Credit 1010 Cash in Checking 2,100 1020 Cash in Savings 3,500 1030 Petty Cash 100 1100 Accounts Receivable 850 1200 Prepaid Insurance 1,200 1510 Equipment 3,000 1515 Accumulated Depreciation--Equipment 1520 Car 15,000 1525 Accumulated Depreciaiton--Car 2010 Accounts Payable 2,500 2520 Loan Payable--Car 8,000
3010 Andrea Williams, Capital 18,000
3020 Andrea Williams, Withdrawals 8,500
4010 Art Fees 8,000 6010 Advertising 500 6015 Bad Debt 6020 Insurance 6030 Supplies--Art 900 6040 Supplies--Office 850 6510 Depreciation--Equipment 6520 Depreciation--Car 36,500 36,500
Andrea's Artistic Visions Worksheet
For the Month Ended January 31, 200X
It’s the end of the month and you have already posted your daily transactions. What are the next three things you would do as you prepare a worksheet?
SELF-CHECK 1. What is a worksheet?
2. What information is found in the three-line heading of a worksheet? 3. How many columns are in a worksheet? List the columns.
4. Where do you fi nd the information for the fi rst three columns?
Apply Your Knowledge
During an accounting period, your bookkeeping duties focus on the busi- ness’s day-to-day transactions. When it comes time to report those transac- tions in fi nancial statements, you must make some adjustments to your books. Your fi nancial statements are supposed to show your company’s fi - nancial performance and status, so your books must refl ect any signifi cant change in the value of your assets, even if that change doesn’t involve the exchange of cash.
Besides gathering the information for fi nancial statements, the work- sheet also helps you with Step 6, which is recording and posting the adjust- ing journal entries. An adjusting journal entry (also called an adjustment)
is a journal entry that brings account balances up to date at the end of the accounting period.
Why do you need to bring the balances up to date? Doesn’t the posting process already do that? The transactions posted in Chapter 5 are based on economic events involving parties outside the business. Some economic events occur within the business. For example, the following “non-cash transactions” decrease the value of certain assets:
• Your equipment ages and has wear-and-tear over time.
• You use up something that was paid for in advance, such as rent or insurance coverage.
• You discover and accept that a customer will not pay an amount due you. If you use cash-basis accounting, these adjustments aren’t necessary because you only record transactions when cash changes hands. This book uses accrual accounting, a system in which you record a transaction when it’s completed, even if cash doesn’t change hands. Chapter 1 goes into more detail about cash-basis accounting and accrual accounting.
Adjusting journal entry:
A journal entry that brings account balances up to date at the end of the accounting period. Also called an
adjustment.
Adjusting journal entry:
A journal entry that brings account balances up to date at the end of the accounting period. Also called an
adjustment.
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Accrual accounting is based on the matching principle, the concept
that revenue earned in an accounting period is matched with expenses incurred in order to earn the revenue. Timing is an important factor in matching expenses with revenue. Using adjustments, you can apply the appropriate expenses to revenue earned in a specifi c accounting period.
Applying the matching principle can be diffi cult, and often requires estimates—for example pensions, warranties, and bad debts. Also, when applying the matching principle, keep in mind that you are trying to measure the activities of the business and ignore cash fl ows.
This chapter illustrates three adjustments: • Prepaid expenses.
• Assets depreciation. • Bad debts.
In each of these adjustments, an expense is increased and an asset is decreased. In another type of adjustment, the increase in expenses could increase liabilities. Other types of adjustments are covered in Chapter 14.
6.2.1 Prepaid Expenses
Most businesses have to pay certain expenses at the beginning of the year even though they will benefi t from those expenses throughout the year. Insurance is a prime example of this type of expense. Most insurance companies require you to pay the premium annually at the start of the year even though the value of that insurance protects the company throughout the year. The benefi t should be apportioned out against ex- penses for each month.
For example, suppose that Andrea’s Artistic Visions paid an annual insurance premium of $1,200 at the beginning of the year. The premium paid in January maintains insurance coverage throughout the year. Showing the full cash expense of the insurance in the January fi nancial statements would greatly reduce any profi t that month and make the fi nancial results look worse than they actually are.
Instead, a large expense such as insurance or prepaid rent is re- corded in the assets category called prepaid expenses. A prepaid ex- pense is an asset that is paid up front and then allocated each month
using an adjusting entry. It is often said that assets are expenses waiting to happen. You adjust the value of the asset to refl ect that it’s being ex- pired, or used up.
The $1,200 annual insurance premium is actually valuable to the company for 12 months, so it is recorded in the assets account Prepaid Insurance. You calculate the actual expense for insurance by dividing $1,200 by 12 months, giving you $100 per month. At the end of each Matching principle:
The concept that revenue earned in an accounting period is matched with expenses incurred in order to earn the revenue.
Matching principle:
The concept that revenue earned in an accounting period is matched with expenses incurred in order to earn the revenue.
Prepaid expense:
An asset that is paid up front and then allocated each month using an adjusting entry.
Prepaid expense:
An asset that is paid up front and then allocated each month using an adjusting entry.
month, you record the use of that asset by preparing an adjusting entry that looks like this:
This entry increases insurance expenses on the income statement and decreases the assets Prepaid Insurance on the balance sheet. No cash changes hands in this entry because cash was laid out when the insurance bill was paid, and the assets account Prepaid Insurance was increased in value at the time the cash was paid.
6.2.2 Depreciation
The largest non-cash expense for most businesses is depreciation of fi xed assets. The term fi xed assets refers to property used to generate revenue;
these assets will be useful to a business for more than one year. Examples are buildings, factories, vehicles, equipment, and furniture.
You are probably familiar with the concept of depreciation as it relates to personal vehicles. You might have heard that a new car “depreciates as soon as you drive it off the lot.” In accounting, depreciation is the systematic allocation—not valuation—of the cost of an asset to expense over the asset’s useful life. It is important to note that depreciation is an estimate; in fact, the two critical items used to calculate depreciation—estimated useful life and estimated salvage value—are both estimates.
What is the difference between cost and expense? Cost is the total amount paid or charged for something. Expense is the portion of cost that is associated with revenue earned in an accounting period. The cost of an asset is spread out over its useful life.
Depreciation refl ects the use and aging of assets. Older assets need more maintenance and repair and also need to be replaced eventually. As the depreciation of an asset increases and the value of the asset dwindles, the need for more maintenance or replacement becomes apparent. For example, if you own a car, you know that each year you use the car its value is reduced (unless you own one of those classic cars that go up in value). Every fi xed asset a business owns will age and eventually need replacement.