The Adjusting Process

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C H A P T E R

M A R V E L E N T E R T A I N M E N T, I N C .

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The Adjusting Process

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o you subscribe to any magazines? Most of us subscribe to one or more magazines such as Cosmopolitan, Sports Illustrated, Golf Digest, Newsweek, or Rolling Stone. Magazines usually require you to prepay the yearly subscription price before you receive any issues. When should the magazine company record revenue from the subscriptions?

As we discussed in Chapter 2, sometimes revenues are earned and expenses are incurred at the point cash is re- ceived or paid. For transactions such as magazine sub- scriptions, the revenue is earned when the magazine is delivered, not when the cash is received. Most companies are required to account for revenues and expenses when the benefit is substantially provided or consumed, which may not be when cash is received or paid.

One company that records revenue from subscriptions is Marvel Entertainment, Inc.Marvel began in 1939 as a

comic book publishing company, establishing such popular comic book characters as Spider-Man®, X-Men®, Fantastic Four®, and the Avengers®. From these humble beginnings, Marvel has grown into a full-line, multi-billion-dollar enter- tainment company. Marvel not only publishes comic books, but it has also added feature films, such as the Spider-Man movies, video games, and toys to its

product offerings.

Most companies, like Marvel Entertainment, are required to update their accounting records for items such as revenues earned from magazine subscriptions before preparing their fi- nancial statements. In this chapter, we describe and illustrate this updating process.

© AP Photo/Jeff Kravitz

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100 Chapter 3 The Adjusting Process

Nature of the Adjusting Process

When preparing financial statements, the economic life of the business is divided into time periods. This accounting period concept requires that revenues and expenses be reported in the proper period. To determine the proper period, accountants use gen- erally accepted accounting principles (GAAP). The use of the accrual basis of account- ing is required by GAAP.

Under the accrual basis of accounting, revenues are reported in the income state- ment in the period in which they are earned. For example, revenue is reported when the services are provided to customers. Cash may or may not be received from customers during this period. The accounting concept supporting this reporting of revenues is called the revenue recognition concept.

Under the accrual basis, expenses are reported in the same period as the revenues to which they relate. For example, utility expenses incurred in December are reported as an expense and matched against December’s revenues even though the utility bill may not be paid until January. The accounting concept supporting reporting revenues and related expenses in the same period is called the matching concept, or matching principle. By matching revenues and expenses, net income or loss for the period is properly reported on the income statement.

Although GAAP requires the accrual basis of accounting, some businesses use the cash basis of accounting. Under the cash basis of accounting, revenues and expenses are

Describe the nature of the adjusting process.

Journalize entries for accounts requiring adjustment.

Summarize the

adjustment process. Prepare an adjusted trial balance.

After studying this chapter, you should be able to:

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At a Glance Menu Turn to pg 121

2 3 4

Nature of the Adjusting Process

The Adjusting Process

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3-1(page 101) Types of Accounts Requiring Adjustment

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3-2(page 104)

Prepaid Expenses Recording Adjusting Entries

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3-3(page 107) Unearned Revenues

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3-4(page 108) Accrued Revenues

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3-5(page 109) Accrued Expenses

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(page 111)3-6 Depreciation Expense

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(page 113)3-7

Summary of Adjustment Process

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3-8(page 113)

Adjusted Trial Balance

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3-9(page 119)

Describe the nature of the adjusting process.

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American Airlinesuses the accrual basis of accounting.

Revenues are recognized when passengers take flights, not when the pas- senger makes the reserva- tion or pays for the ticket.

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reported in the income statement in the period in which cash is received or paid. For ex- ample, fees are recorded when cash is received from clients; likewise, wages are recorded when cash is paid to employees. The net income (or net loss) is the difference between the cash receipts (revenues) and the cash payments (expenses).

Small service businesses may use the cash basis, because they have few receivables and payables. For example, attorneys, physicians, and real estate agents often use the cash basis. For them, the cash basis provides financial statements similar to those of the accrual basis. For most large businesses, however, the cash basis will not provide accurate financial statements for user needs. For this reason, we use the accrual basis in this text.

The Adjusting Process

At the end of the accounting period, many of the account balances in the ledger can be reported in the financial statements without change. For example, the balances of the cash and land accounts are normally the amount reported on the balance sheet.

Under the accrual basis, however, some accounts in the ledger require updating.1 This updating is required for the following reasons:

1. Some expenses are not recorded daily. For example, the daily use of supplies would require many entries with small amounts. Also, managers usually do not need to know the amount of supplies on hand on a day-to-day basis.

2. Some revenues and expenses are incurred as time passes rather than as separate trans- actions. For example, rent received in advance (unearned rent) expires and becomes revenue with the passage of time. Likewise, prepaid insurance expires and becomes an expense with the passage of time.

3. Some revenues and expenses may be unrecorded. For example, a company may have provided services to customers that it has not billed or recorded at the end of the accounting period. Likewise, a company may not pay its employees until the next accounting period even though the employees have earned their wages in the current period.

The analysis and updating of accounts at the end of the pe- riod before the financial statements are prepared is called the adjusting process. The journal entries that bring the accounts up to date at the end of the accounting period are called ad- justing entries. All adjusting entries affect at least one income statement account and one balance sheet account. Thus, an ad- justing entry will always involve a revenue or an expense ac- count and an asset or a liability account.

1 Under the cash basis of accounting, accounts do not require adjusting. This is because transactions are recorded only when cash is received or paid. Thus, the matching concept is not used under the cash basis.

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Example Exercise 3-1 Accounts Requiring Adjustment

Indicate with a Yes or No whether or not each of the following accounts normally requires an adjusting entry.

a. Cash c. Wages Expense e. Accounts Receivable

b. Prepaid Rent d. Office Equipment f. Unearned Rent

Follow My Example 3-1

a. No c. Yes e. Yes

b. Yes d. No f. Yes

For Practice: PE 3-1A, PE 3-1B The matching concept supports

reporting revenues and related expenses in the same period.

All adjusting entries affect at least one income statement account and one balance sheet account.

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102 Chapter 3 The Adjusting Process

Types of Accounts Requiring Adjustment

Four basic types of accounts require adjusting entries as shown below.

1. Prepaid expenses 3. Accrued revenues 2. Unearned revenues 4. Accrued expenses

Prepaid expenses are the advance payment of future expenses and are recorded as assets when cash is paid. Prepaid expenses become expenses over time or during normal operations. To illustrate, the following transaction of NetSolutions from Chapter 2 is used.

The tuition you pay at the beginning of each term is an example of a prepaid ex- pense to you, as a student.

Exhibit 1

Type of Adjustments: Prepaid Expenses and Unearned Revenues

Dec. 1 NetSolutions received $360from a local retailer to rent land for three months.

Dec. 1 NetSolutions paid $2,400 as a premium on a one-year insurance policy.

On December 1, the cash receipt of $360 was recorded as a debit to Cash and a credit to Unearned Rent for $360. At the end of December, $120 ($360 divided by 3 months) of the unearned rent has been earned. The remain- ing $240 will become rent revenue in future months. Thus, the $120 is rent revenue of December and should be recorded with an adjusting entry.

Other examples of unearned revenues include tuition received in advance by a school, an annual retainer fee received by an attorney, premiums received in advance by an in- surance company, and magazine subscriptions received in advance by a publisher.

Exhibit 1 illustrates the nature of prepaid expenses and unearned revenues.

On December 1, the cash payment of $2,400 was recorded as a debit to Prepaid Insurance and credit to Cash for $2,400. At the end of December, only $200 ($2,400 divided by 12 months) of the insurance premium is ex- pired and has become an expense. The remaining $2,200 of prepaid insur- ance will become an expense in future months. Thus, the $200 is insurance expense of December and should be recorded with an adjusting entry.

Other examples of prepaid expenses include supplies, prepaid advertising, and prepaid interest.

Unearned revenues are the advance receipt of future revenues and are recorded as liabilities when cash is received. Unearned revenues become earned revenues over time or during normal operations. To illustrate, we use the following December 1 transac- tion of NetSolutions.

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Exhibit 2

Type of Adjustments: Accrued Revenues and Expenses

Dec. 31 NetSolutions owes its employees wages of $250 for Monday and Tuesday, December 30 and 31.

Dec. 15 NetSolutions signed an agreement with Dankner Co. on December 15 under which NetSolutions will bill Dankner Co. on the fifteenth of each month for services rendered at the rate of $20 per hour.

From December 16–31, NetSolutions provided 25 hours of service to Dankner Co. Although the revenue of $500 (25 hours  $20) has been earned, it will not be billed until January 15. Likewise, cash of $500 will not be received un- til Dankner pays its bill. Thus, the $500 of accrued revenue and the $500 of fees earned should be recorded with an adjusting entry on December 31.

Other examples of accrued revenues include accrued interest on notes receivable and accrued rent on property rented to others.

Accrued expenses are unrecorded expenses that have been incurred and for which cash has yet to be paid. Wages owed to employees at the end of a period but not yet paid is an accrued expense. To illustrate, the following example involving NetSolutions and its employees is used:

NetSolutions paid wages of $950 on December 13 and $1,200 on December 27, 2009. These payments covered the biweekly pay periods that ended on those days. As of December 31, 2009, NetSolutions owes its employees wages of $250 for Monday and Tuesday, December 30 and 31. The wages of $250 will be paid on January 10, 2010, however, they are an expense of December. Thus, $250 of accrued wages should be recorded with an adjusting entry on December 31.

Other examples of accrued expenses include accrued interest on notes payable and accrued taxes.

As illustrated above, accrued revenues are earned revenues that are unrecorded.

The cash receipts for accrued revenues are normally received in the next accounting period. Accrued expenses are expenses that have been incurred, but are unrecorded.

The cash payments for accrued expenses are normally paid in the next accounting pe- riod. Exhibit 2 illustrates the nature of accrued revenues and accrued expenses.

Accrued revenues are unrecorded revenues that have been earned and for which cash has yet to be received. Fees for services that an attorney or a doctor has provided but not yet billed are accrued revenues. To illustrate, we use the following example in- volving NetSolutions and one of its customers.

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104 Chapter 3 The Adjusting Process

Recording Adjusting Entries

To illustrate adjusting entries, we use the December 31, 2009, unadjusted trial balance of NetSolutions shown in Exhibit 3. An expanded chart of accounts for NetSolutions is shown in Exhibit 4. The additional accounts used in this chapter are shown in color. The rules of debit and credit shown in Exhibit 3 of Chapter 2 are used to record the adjusting entries.

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Example Exercise 3-2 Type of Adjustment 1

Classify the following items as (1) prepaid expense, (2) unearned revenue, (3) accrued expense, or (4) accrued revenue.

a. Wages owed but not yet paid. c. Fees received but not yet earned.

b. Supplies on hand. d. Fees earned but not yet received.

Follow My Example 3-2

a. Accrued expense c. Unearned revenue

b. Prepaid expense d. Accrued revenue

For Practice: PE 3-2A, PE 3-2B

Cash

Accounts Receivable Supplies

Prepaid Insurance Land

Office Equipment Accounts Payable Unearned Rent Chris Clark, Capital Chris Clark, Drawing Fees Earned Wages Expense Rent Expense Utilities Expense Supplies Expense Miscellaneous Expense

2,065 2,220 2,000 2,400 20,000 1,800

4,000

4,275 1,600 985 800 455 42,600

900 360 25,000

16,340

42,600 NetSolutions

Unadjusted Trial Balance December 31, 2009

Debit Balances

Credit Balances

Exhibit 3 Unadjusted Trial Balance for NetSolutions

Journalize entries for accounts requiring adjustment.

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Prepaid expenses and unearned revenues are sometimes referred to as deferrals. This is because the recording of the related expense or revenue is deferred to a future period.

Accrued revenues and accrued expenses are sometimes referred to as accruals. This is be- cause the related revenue or expense should be recorded or accrued in the current period.

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Prepaid Expenses

The balance in NetSolutions’ supplies account on December 31 is $2,000. Some of these supplies (CDs, paper, envelopes, etc.) were used during December, and some are still on hand (not used). If either amount is known, the other can be determined. It is nor- mally easier to determine the cost of the supplies on hand at the end of the month than to record daily supplies used. Assuming that on December 31 the amount of supplies on hand is $760, the amount to be transferred from the asset account to the expense account is $1,240, computed as follows:

Supplies available during December (balance of account) $2,000

Supplies on hand, December 31 ______760

Supplies used (amount of adjustment) ____________$1,240

At the end of December, the supplies expense account should be increased (deb- ited) for $1,240, and the supplies account should be decreased (credited) for $1,240 to record the supplies used during December. The adjusting journal entry and T accounts for Supplies and Supplies Expense are as follows:

Balance Sheet Accounts Income Statement Accounts

1. Assets 4. Revenue

11 Cash 41 Fees Earned

12 Accounts Receivable 42 Rent Revenue

14 Supplies 5. Expenses

15 Prepaid Insurance 51 Wages Expense

17 Land 52 Rent Expense

18 Office Equipment 53 Depreciation Expense

19 Accumulated Depreciation—Office Equipment 54 Utilities Expense

2. Liabilities 55 Supplies Expense

21 Accounts Payable 56 Insurance Expense

22 Wages Payable 59 Miscellaneous Expense

23 Unearned Rent 3. Owner’s Equity 31 Chris Clark, Capital 32 Chris Clark, Drawing

Exhibit 4 Expanded Chart of Accounts for NetSolutions

1,240 31 Supplies Expense

1,240 Dec.

2009

55 14 Supplies

Supplies used ($2,000  $760).

Journal Page 5

Date Description

Post.

Ref. Debit Credit

Supplies Supplies Expense

Bal. 2,000 Dec. 31 1,240 Bal. 800

Adj. Bal. 760 Dec. 31 _____1,240

Adj. Bal. 2,040

The adjusting entry is shown in color in the T accounts to separate it from other trans- actions. After the adjusting entry is recorded and posted, the supplies account has a debit balance of $760. This balance is an asset that will become an expense in a future period.

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106 Chapter 3 The Adjusting Process

The debit balance of $2,400 in NetSolutions’ prepaid insurance account represents a December 1 prepayment of insurance for 12 months. At the end of December, the insurance expense account should be increased (debited), and the prepaid insurance account should be decreased (credited) by $200, the insurance for one month. The adjusting journal entry and T accounts for Prepaid Insurance and Insurance Expense are as follows:

200

31 56

15 Insurance Expense

Prepaid Insurance

Insurance expired ($2,400/12).

200

Prepaid Insurance Insurance Expense

Bal. 2,400_____ Dec. 31 200 Dec. 31 200

Adj. Bal. 2,200

After the adjusting entry is recorded and posted, the prepaid insurance account has a debit balance of $2,200. This balance is an asset that will become an expense in future periods. The insurance expense account has a debit balance of $200, which is an

expense of the current period.

What is the effect of omitting adjusting entries? If the pre- ceding adjustments for supplies ($1,240) and insurance ($200) are not recorded, the financial statements prepared as of December 31 will be misstated. On the income statement, Supplies Expense and Insurance Expense will be understated by a total of $1,440 ($1,240 + $200), and net income will be overstated by $1,440. On the balance sheet, Supplies and Prepaid Insurance will be overstated by a total of $1,440.

Since net income increases owner’s equity, Chris Clark, Capital will also be overstated by $1,440 on the balance sheet. The effects of omitting these adjusting entries on the in- come statement and balance sheet are as follows:

Amount of Misstatement Income Statement

Revenues correctly stated $ XXX

Expensesunderstated by ______(1,440) Net incomeoverstated by (1) $ 1,440____________

Balance Sheet

Assetsoverstated by $ 1,440____________

Liabilities correctly stated $ XXX Owner’s equityoverstated by ______1,440 Total liabilities and

owner’s equity overstated by $ 1,440____________

Arrow (1) indicates the effect of the understated expenses on assets. Arrow (2) indicates the effect of the overstated net income on owner’s equity.

FREE ISSUE

Office supplies are often available to employees on a

“free issue” basis. This means that employees do not have to “sign” for the release of office supplies but merely obtain the necessary supplies from a local storage area

as needed. Just because supplies are easily available, however, doesn’t mean they can be taken for personal use. There are many instances where employees have been terminated for taking supplies home for personal use.

(2) The adjusted balance of a prepaid

expense is an asset that will be- come an expense in a future period.

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Payments for prepaid expenses are sometimes made at the beginning of the period in which they will be entirely used or consumed. To illustrate, we use the following December 1 transaction of NetSolutions:

2 An alternative treatment of recording the cost of supplies, rent, and other prepayments of expenses is discussed in an appendix that can be downloaded from the book’s companion Web site (academic.cengage.com/accounting/warren) 3 An alternative treatment of recording revenues received in advance of their being earned is discussed in an appendix that can be downloaded from the book’s companion Web site (academic.cengage.com/accounting/warren).

Example Exercise 3-3 Adjustment for Prepaid Expense

The prepaid insurance account had a beginning balance of $6,400 and was debited for $3,600 of premiums paid during the year. Journalize the adjusting entry required at the end of the year assuming the amount of unexpired insurance related to future periods is $3,250.

Follow My Example 3-3

Insurance Expense . . . 6,750

Prepaid Insurance . . . . 6,750 Insurance expired ($6,400  $3,600  $3,250).

For Practice: PE 3-3A, PE 3-3B

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Unearned Revenues

The December 31 unadjusted trial balance of NetSolutions indicates a balance in the unearned rent account of $360. This balance represents the receipt of three months rent on December 1 for December, January, and February. At the end of December, one month’s rent has been earned. Thus, the unearned rent account should be decreased (debited) by $120, and the rent revenue account should be increased (credited) by $120.

The $120 represents the rental revenue for one month ($360/3). The adjusting journal entry and T accounts are shown below.

120

31 23

42 Unearned Rent

Rent Revenue

Rent earned ($360/3 months).

120

Unearned Rent Rent Revenue

Dec. 31 120 Bal. ____360 Dec. 31 120

Adj. Bal. 240

After the adjusting entry is recorded and posted, the unearned rent account has a credit balance of $240. This balance is a liability that will become revenue in a future period. Rent Revenue has a balance of $120, which is revenue of the current period.3

If the preceding adjustment of unearned rent and rent revenue is not recorded, the fi- nancial statements prepared on December 31 will be misstated. On the income statement, Rent Revenue and the net income will be understated by $120. On the balance sheet, Unearned Rent will be overstated by $120, and Chris Clark, Capital will be understated by $120. The effects of omitting this adjusting entry are shown at the top of the next page.

Best Buysells extended warranty contracts with terms between 12 and 36 months. The receipts from sales of these contracts are reported as unearned reve- nue on Best Buy’s balance sheet. Revenue is recorded as the contracts expire.

Dec. 1 NetSolutions paid rent of $800 for the month.

On December 1, the rent payment of $800 represents Prepaid Rent. However, the Prepaid Rent expires daily, and at the end of December there will be no asset left. In such cases, the payment of $800 is recorded as Rent Expense rather than as Prepaid Rent. In this way, no adjusting entry is needed at the end of the period.2

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108 Chapter 3 The Adjusting Process

Amount of Misstatement Income Statement

Revenuesunderstated by $(120) Expenses correctly stated _____XXX Net incomeunderstated by $(120)____________

Balance Sheet

Assets correctly stated $XXX___________

Liabilitiesoverstated by $ 120 Owner’s equityunderstated by ______(120) Total liabilities and

owner’s equity correctly stated $XXX___________

Example Exercise 3-4 Adjustment for Unearned Revenue

The balance in the unearned fees account, before adjustment at the end of the year, is $44,900.

Journalize the adjusting entry required if the amount of unearned fees at the end of the year is $22,300.

Follow My Example 3-4

Unearned Fees . . . 22,600

Fees Earned . . . . 22,600 Fees earned ($44,900  $22,300).

For Practice: PE 3-4A, PE 3-4B

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Accrued Revenues

During an accounting period, some revenues are recorded only when cash is received.

Thus, at the end of an accounting period, there may be revenue that has been earned but has not been recorded. In such cases, the revenue should be recorded by increasing (debiting) an asset account and increasing (crediting) a revenue account.

To illustrate, assume that NetSolutions signed an agreement with Dankner Co. on December 15. The agreement provides that NetSolutions will answer computer ques- tions and render assistance to Dankner Co.’s employees. The services will be billed to Dankner Co. on the fifteenth of each month at a rate of $20 per hour. As of December 31, NetSolutions had provided 25 hours of assistance to Dankner Co. The revenue of $500 (25 hours  $20) will be billed on January 15. However, NetSolutions earned the revenue in December.

The claim against the customer for payment of the $500 is an account receivable (an asset). Thus, the accounts receivable account should be increased (debited) by $500 and the fees earned account should be increased (credited) by $500. The adjusting jour- nal entry and T accounts are shown below.

Accounts Receivable Fees Earned

Bal. 2,220 Bal. 16,340

Dec. 31 _____500 Dec. 31 ______500

Adj. Bal. 2,720 Adj. Bal. 16,840

500

31 12

41 Accounts Receivable

Fees Earned

Accrued fees (25 hrs.  $20).

500 RadioShack Corporationis

engaged in consumer elec- tronics retailing. RadioShack accrues revenue for finance charges, late charges, and returned check fees related

to its credit operations.

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If the adjustment for the accrued revenue ($500) is not recorded, Fees Earned and the net income will be understated by $500 on the income statement. On the balance sheet, Accounts Receivable and Chris Clark, Capital will be understated by $500. The effects of omitting this adjusting entry are shown below.

Amount of Misstatement Income Statement

Revenuesunderstated by $ (500) Expenses correctly stated ______XXX Net incomeunderstated by $ (500)____________

Balance Sheet

Assetsunderstated by $ (500)____________

Liabilities correctly stated $ XXX Owner’s equityunderstated by ______(500) Total liabilities and

owner’s equity understated by $ (500)____________

Example Exercise 3-5 Adjustment for Accrued Revenues

At the end of the current year, $13,680 of fees have been earned but have not been billed to clients.

Journalize the adjusting entry to record the accrued fees.

Follow My Example 3-5

Accounts Receivable . . . 13,680

Fees Earned . . . . 13,680 Accrued fees.

For Practice: PE 3-5A, PE 3-5B

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Accrued Expenses

Some types of services used in earning revenues are paid for after the service has been performed. For example, wages expense is used hour by hour, but is paid only daily, weekly, biweekly, or monthly. At the end of the accounting period, the amount of such accrued but unpaid items is an expense and a liability.

For example, if the last day of the employees’ pay period is not the last day of the accounting period, an accrued expense (wages expense) and the related liability (wages payable) must be recorded by an adjusting entry. This adjusting entry is necessary so that expenses are properly matched to the period in which they were incurred in earn- ing revenue.

To illustrate, NetSolutions pays its employees biweekly. During December, NetSolutions paid wages of $950 on December 13 and $1, 200 on December 27. These payments covered pay periods ending on those days as shown in Exhibit 5. As of December 31, NetSolutions owes $250 of wages to employees for Monday and Tuesday, December 30 and 31. Thus, the wages expense account should be increased (debited) by $250 and the wages payable account should be increased (credited) by $250. The ad- justing journal entry and T accounts are shown below.

250

31 51

22 Wages Expense

Wages Payable Accrued wages.

250

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110 Chapter 3 The Adjusting Process

Wages Expense Wages Payable

Bal. 4,275 Dec. 31 250

Dec. 31 _____250 Adj. Bal. 4,525

After the adjusting entry is recorded and posted, the debit balance of the wages expense account is $4,525. This balance of $4,525 is the wages expense for two months, November and December. The credit balance of $250 in Wages Payable is the liability for wages owed on December 31.

As shown in Exhibit 5, NetSolutions paid wages of $1,275 on January 10. This pay- ment includes the $250 of accrued wages recorded on December 31. Thus, on January 10, the wages payable account should be decreased (debited) by $250. Also, the wages expense account should be increased (debited) by $1,025 ($1,275  $250), which is the wages expense for January 1–10. Finally, the cash account is decreased (credited) by

$1,275. The journal entry for the payment of wages on January 10 is shown below.4

What would be the effect on the financial statements if the adjustment for wages ($250) is not recorded? On the income statement, Wages Expense will be understated by $250, and the net income will be overstated by $250. On the balance sheet, Wages

1,025 10

Jan. Wages Expense

Wages Payable

Cash 1,275

250 51

22 11 Callaway Golf Company,a

manufacturer of such inno- vative golf clubs as the “Big Bertha” driver, reports ac- crued warranty expense on its balance sheet.

4 To simplify the subsequent recording of the following period’s transactions, some accountants use what is known as reversing entries for certain types of adjustments. Reversing entries are discussed and illustrated in Appendix B at the end of the textbook.

December

S M T W T F S 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31

January

1 2 3 4 5 6 7 8 9 10 11 Wages paid,

$1,275

Wages expense (Jan.1–10), $1,025 Wages expense

(accrued), $250

Wages expense (paid), $1,200 Wages expense (paid), $950 1.

2.

3.

Wages are paid on the second and fourth Fridays for the two-week periods ending on those Fridays. The payments were $950 on December 13 and $1,200 on December 27.

The wages accrued for Monday and Tuesday, December 30 and 31, are $250.

4. Wages expense, January 1–10, $1,025.

Wages paid on Friday, January 10, total $1,275.

Exhibit 5 Accrued Wages

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Payable will be understated by $250, and Chris Clark, Capital will be overstated by

$250. The effects of omitting this adjusting entry are shown as follows:

Amount of Misstatement Income Statement

Revenues correctly stated $XXX

Expensesunderstated by ______(250) Net incomeoverstated by $ 250____________

Balance Sheet

Assets correctly stated $XXX____________

Liabilitiesunderstated by $ (250) Owner’s equityoverstated by 250 Total liabilities and owner’s ______

equity correctly stated $XXX____________

Example Exercise 3-6 Adjustment for Accrued Expense

Sanregret Realty Co. pays weekly salaries of $12,500 on Friday for a five-day week ending on that day.

Journalize the necessary adjusting entry at the end of the accounting period, assuming that the period ends on Thursday.

Follow My Example 3-6

Salaries Expense . . . 10,000

Salaries Payable . . . . 10,000 Accrued salaries [($12,500/5 days)  4 days].

For Practice: PE 3-6A, PE 3-6B

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Depreciation Expense

Fixed assets, or plant assets, are physical resources that are owned and used by a busi- ness and are permanent or have a long life. Examples of fixed assets include land, build- ings, and equipment. In a sense, fixed assets are a type of long-term prepaid expense.

Because of their unique nature and long life, they are discussed separately from other prepaid expenses, such as supplies and prepaid insurance.

Fixed assets such as office equipment are used to generate revenue much like sup- plies are used to generate revenue. Unlike supplies, however, there is no visible re- duction in the quantity of the equipment. Instead, as time passes, the equipment loses its ability to provide useful services. This decrease in usefulness is called depreciation.

All fixed assets, except land, lose their usefulness and, thus, are said to depreciate.

As a fixed asset depreciates while being used to generate revenue, a portion of its cost should be recorded as an expense. This periodic expense is called depreciation expense.

The adjusting entry to record depreciation expense is similar to the adjusting en- try for supplies used. The depreciation expense account is increased (debited) for the amount of depreciation. However, the fixed asset account is not decreased (credited).

This is because both the original cost of a fixed asset and the depreciation recorded since its purchase are normally reported on the balance sheet. Instead, an account en- titled Accumulated Depreciation is increased (credited).

Accumulated depreciation accounts are called contra accounts, or contra asset ac- counts. This is because accumulated depreciation accounts are deducted from their re- lated fixed asset accounts on the balance sheet. The normal balance of a contra account is opposite to the account from which it is deducted. Since the normal balance of a fixed asset account is a debit, the normal balance of an accumulated depreciation account is a credit.

Lowe’s Companies, Inc., reported land, buildings, and store equipment at a cost of over $18 billion and accu- mulated depreciation of over $4.1 billion.

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112 Chapter 3 The Adjusting Process

The normal titles for fixed asset accounts and their related contra asset accounts are as follows:

Fixed Asset Account Contra Asset Account

Land None—Land is not depreciated.

Buildings Accumulated Depreciation—Buildings Store Equipment Accumulated Depreciation—Store Equipment Office Equipment Accumulated Depreciation—Office Equipment

The December 31,2009, unadjusted trial balance of NetSolutions (Exhibit 3) indicates that NetSolutions owns two fixed assets: land and office equipment. Land does not de- preciate; however, an adjusting entry should be recorded for the depreciation of the office equipment for December. We assume that the office equipment has depreciated $50 dur- ing December.5Thus, the depreciation expense account should be increased (debited) by

$50 and the accumulated depreciation—office equipment account should be increased (credited) by $50. The adjusting journal entry and T accounts are shown below.

Office Equipment Accumulated Depr.—Office Equip.

Bal. 1,800 Dec. 31 50

Depreciation Expense

Dec. 31 50

After the adjusting journal entry is recorded and posted, the office equipment ac- count still has a debit balance of $1,800. This is the original cost of the office equipment that was purchased on December 4. The accumulated depreciation—office equipment account has a credit balance of $50. The difference between these two balances of $1,750 ($1,800 $50) is the cost of the office equipment that has not yet been depreciated. This amount of $1,750 is called the book value of the asset (or net book value).

The office equipment and its related accumulated depreciation are reported on the December 31, 2009 balance sheet as follows:

Office equipment $1,800

Less accumulated depreciation _____50 $1,750

The market value of a fixed asset usually differs from its book value. This is be- cause depreciation is an allocation method, not a valuation method. That is, depreciation allocates the cost of a fixed asset to expense over its estimated life. Depreciation does not measure changes in market values, which vary from year to year. Thus, on December 31, 2009, the market value of NetSolutions’ office equipment could be more or less than

$1, 750.

If the adjustment for depreciation ($50) is not recorded, Depreciation Expense on the income statement will be understated by $50, and the net income will be overstated by $50. On the balance sheet, the book value of Office Equipment and Chris Clark, Capital will be overstated by $50. The effects of omitting the adjustment for deprecia- tion are shown at the top of the next page.

50

31 53

19 Depreciation Expense

Accumulated Depreciation––Office Equip.

Depreciation on office equipment.

50

5 We describe and illustrate methods of computing depreciation expense in Chapter 10.

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Amount of Misstatement Income Statement

Revenues correctly stated $XX

Expensesunderstated by ____(50) Net incomeoverstated by $ 50________

Balance Sheet

Assetsoverstated by $ 50________

Liabilities correctly stated $XX Owner’s equityoverstated by ____50 Total liabilities and owner’s

equity overstated by $ 50________

Example Exercise 3-7 Adjustment for Depreciation

The estimated amount of depreciation on equipment for the current year is $4,250. Journalize the adjusting entry to record the depreciation.

Follow My Example 3-7

Depreciation Expense . . . . 4,250

Accumulated Depreciation—Equipment . . . . 4,250 Depreciation on equipment.

For Practice: PE 3-7A, PE 3-7B

2

Summary of Adjustment Process

3 objective

Example Exercise 3-8 Effect of Omitting Adjustments

For the year ending December 31, 2010, Mann Medical Co. mistakenly omitted adjusting entries for (1) $8,600 of unearned revenue that was earned, (2) earned revenue that was not billed of $12,500, and (3) accrued wages of $2,900. Indicate the combined effect of the errors on (a) revenues, (b) expenses, and (c) net income for the year ended December 31, 2010.

Follow My Example 3-8

a. Revenues were understated by $21,100 ($8,600  $12,500).

b. Expenses were understated by $2,900.

c. Net income was understated by $18,200 ($8,600  $12,500  $2,900).

For Practice: PE 3-8A, PE 3-8B

3

Summarize the adjust- ment process.

3

We have described and illustrated the basic types of adjusting entries. A summary of these basic adjustments is shown in Exhibit 6 on pages 114–115.

The adjusting entries for NetSolutions are shown in Exhibit 7 on page 116. The ad- justing entries are dated as of the last day of the period. However, because collecting the adjustment data requires time, the entries are usually recorded at a later date. An explanation is included with each adjusting entry.

NetSolutions’ adjusting entries have been posted to the ledger shown in Exhibit 8 on pages 117–118. The adjustments are shown in color in Exhibit 8 to distinguish them from

other transactions.

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PREPAID EXPENSES Financial Statement Impact if ExamplesReason for AdjustmentAdjusting EntryExamples from NetSolutionsAdjusting Entry Is Omitted

Exhibit 6 Summary of Adjustments Supplies, Prepaid Prepaid expenses ExpenseDr.Supplies Expense1,240Income Statement: Insurance(assets) have been Asset Cr.Supplies1,240Revenues No effect used or consumed in Expenses Understated the business operations.Insurance Expense 200Net income Overstated Prepaid Insurance200Balance Sheet: Assets Overstated Liabilities No effect Owner’s Equity Overstated (Capital) UNEARNED REVENUES Unearned rent, Cash received before the LiabilityDr.Unearned Rent120Income Statement: magazine services have been RevenueCr.Rent Revenue120RevenuesUnderstated subscriptions provided is recorded as ExpensesNo effect received in a liability. Some servicesNet incomeUnderstated advance, fees have been provided to Balance Sheet: received in customer before the end AssetsNo effect advance of of the accounting period.LiabilitiesOverstated servicesOwner’s Equity Understated (Capital) ACCRUED REVENUES Services Services have been AssetDr.Accounts Receivable500Income Statement: performed but provided to the Revenue Cr.Fees Earned500RevenuesUnderstated not billed, interest customer, but have not ExpensesNo effect to be receivedbeen billed or recorded.Net incomeUnderstated Interest has been Balance Sheet: earned, but has not AssetsUnderstated been received or LiabilitiesNo effect recorded.Owner’s Equity Understated (Capital)

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Wages or salariesExpenses have been ExpenseDr.Wages Expense250Income Statement: incurred but not incurred, but have not Liability Cr.Wages Payable250RevenuesNo effect paid, interest been paid or recorded.ExpensesUnderstated incurred but not Net incomeOverstated paidBalance Sheet: AssetsNo effect LiabilitiesUnderstated Owner’s Equity Overstated (Capital) DEPRECIATION Depreciation of Fixed assets depreciate ExpenseDr.Depreciation Expense—Income Statement: equipment and as they are used or Contra Asset Cr.Office Equipment50RevenuesNo effect buildingsconsumed in the Accumulated Depr.—ExpensesUnderstated business operations.Office Equipment50Net incomeOverstated Balance Sheet: AssetsOverstated LiabilitiesNo effect Owner’s EquityOverstated (Capital) ACCRUED EXPENSES Financial Statement Impact if ExamplesReason for AdjustmentAdjusting EntryExamples from NetSolutionsAdjusting Entry Is Omitted

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116 Chapter 3 The Adjusting Process

1,240

200

120

500

250

50 1,240

200

120

500

250

50 Supplies Expense

Supplies

Insurance Expense Prepaid Insurance

Unearned Rent Rent Revenue

Accounts Receivable Fees Earned

Wages Expense Wages Payable

Depreciation Expense

Accum. Depreciation—Office Equipment Supplies used ($2,000  $760).

Insurance expired ($2,400/12 months).

Rent earned ($360/3 months).

Accrued fees (25 hrs.  $20).

Accrued wages.

Depreciation on office equipment.

Journal Page 5

Date Description

Post.

Ref. Debit Credit

2009

31

31

31

31

31

31

55 14

56 15

23 42

12 41

51 22

53 19 Adjusting Entries

Dec.

One way for an accountant to check whether all adjust- ments have been made is to compare the current period’s adjustments with those of the prior period.

MICROSOFT CORPORATION

Microsoft Corporationdevelops, manufactures, licenses, and supports a wide range of computer software prod- ucts, including Windows Vista, Windows XP, Word, Excel, and the Xbox® gaming system. When Microsoft sells its products, it incurs an obligation to support its software with technical support and periodic updates. As a result,

During the year ending June 30, 2008, Microsoft expects to record over $10,779 million of unearned revenue as revenue.

At the same time, Microsoft will record additional unearned revenue from current period sales.

not all the revenue is earned on the date of sale; some of the revenue on the date of sale is unearned. The portion of revenue related to support services, such as updates and technical support, is earned as time passes and sup- port is provided to customers. Thus, each year Microsoft makes adjusting entries transferring some of its unearned revenue to revenue. The following excerpts were taken from Microsoft’s 2007 financial statements:

The percentage of revenue recorded as unearned . . . ranges from approximately 15%

to 25% of the sales price for Windows XP Home, approximately 5% to 15% of the sales price for Windows XP Professional,. . .

Unearned Revenue:

June 30, 2007 June 30, 2006

Unearned revenue (in millions) $12,646 $10,902

Source: Taken from Microsoft’s June 30, 2007, annual report.

Exhibit 7 Adjusting Entries—

NetSolutions

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1 1 1 1 1 2 2 2 2 2 2 3 3 3 3 3 3 3 4 4 4

25,000 7,500

360

3,100 650

2,870

Account Cash Account No. 11

Date Item

Post.

Ref. Debit Credit

Nov. 1 5 18 30 30 30 Dec. 1 1 1 6 11 13 16 20 21 23 27 31 31 31 31

2009

20,000

3,650 950 2,000 2,400 800

180 400 950 900

1,450 1,200 310 225 2,000

25,000 5,000 12,500 8,850 7,900 5,900 3,500 2,700 3,060 2,880 2,480 1,530 4,630 3,730 4,380 2,930 1,730 1,420 1,195 4,065 2,065 Debit Credit

Balance

3 3 4 5

1,750

1,120 500

Account Accounts Receivable Account No. 12

Date Item

Post.

Ref. Debit Credit

Dec. 16 21 31 31

2009

650 1,750 1,100 2,220 2,720 Debit Credit

Balance

Adjusting

1 1 3 5

1,350 1,450

Account Supplies Account No. 14

Date Item

Post.

Ref. Debit Credit

Nov. 10 30 Dec. 23 31

2009

800 1,240

1,350 550 2,000 760 Debit Credit

Balance

Adjusting

2 5

2,400

Account Prepaid Insurance Account No. 15

Date Item

Post.

Ref. Debit Credit

Dec. 1 31

2009

200 2,400 2,200 Debit Credit

Balance

Adjusting

1 20,000

Account Land Account No. 17

Date Item

Post.

Ref. Debit Credit

Nov. 5

2009

20,000 Debit Credit

Balance

2 1,800

Account Office Equipment Account No. 18

Date Item

Post.

Ref. Debit Credit

Dec. 4

2009

1,800 Debit Credit

Balance

1 1 2 2 3

950

400 900

Account Accounts Payable Account No. 21

Date Item

Post.

Ref. Debit Credit

Nov. 10 30 Dec. 4 11 20

2009

1,350 1,800

Debit Credit Balance

1,350 400 2,200 1,800 900

5 250

Account Wages Payable Account No. 22

Date Item

Post.

Ref. Debit Credit

Dec. 31

2009

250 Debit Credit

Balance

Adjusting

5 50

Account Acc. Depr.—Office Equip. Account No. 19

Date Item

Post.

Ref. Debit Credit

Dec. 31

2009

50 Debit Credit

Balance

Adjusting

2 5

360

Account Unearned Rent Account No. 23

Date Item

Post.

Ref. Debit Credit

Dec. 1 31

2009

360 240 Debit Credit

Balance

Adjusting 120

1 25,000

Account Chris Clark, Capital Account No. 31

Date Item

Post.

Ref. Debit Credit

Nov. 1

2009

25,000 Debit Credit

Balance

Exhibit 8

Ledger with Adjusting Entries—NetSolutions

(continued)

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Figure

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References

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