On pages 140 and 141, we identified four types of adjusting entries, each of which involve one income statement account and one balance sheet account. The effects of these adjustment types on the income statement and balance sheet are summarized in Exhibit 4–8 .
would consider amounts of less than 2 percent or 3 percent of net income to be immate- rial, unless there were other factors to consider. One such other factor is the cumulative effect of numerous immaterial events. Each of a dozen items may be immaterial when considered by itself. When viewed together, however, the combined effect of all 12 items may be material.
Finally, materiality depends on the nature of the item, as well as its dollar amount. Assume, for example, that several managers systematically have been stealing money from the com- pany that they manage. Stockholders probably would consider this fact important even if the dollar amounts were small in relation to the company’s total resources.
Income Statement Balance Sheet
Net Owners’
Adjustment Revenue Expenses Income Assets Liabilities Equity Type I
Converting Assets to Expenses No effect Increase Decrease Decrease No effect Decrease
Type II
Converting Liabilities to Revenue Increase No effect Increase No effect Decrease Increase
Type III
Accruing Unpaid Expenses No effect Increase Decrease No effect Increase Decrease
Type IV
Accruing Uncollected Revenue Increase No effect Increase Increase No effect Increase
Exhibit 4–8 THE EFFECTS OF ADJUSTING ENTRIES ON THE FINANCIAL STATEMENTS
The four adjustment types were illustrated and discussed in nine separate adjusting entries made by Overnight on December 31. These adjustments appear in the format of general jour- nal entries in Exhibit 4–9 . (Overnight also recorded many transactions throughout the month of December. These transactions are not illustrated here but were accounted for in the manner described in Chapter 3.)
You just found out that Betty, one of the best mechanics that you supervise for Overnight Auto, has taken home small items from the company’s supplies, such as a screwdriver and a couple of cans of oil. When you talk to Betty, she suggests that these items are immaterial to Overnight Auto because they are not recorded in the inventory and they are expensed when they are purchased. How should you respond to Betty?
(See our comments on the Online Learning Center Web site.)
Y O U R T U R N You as Overnight Auto’s Service Department Manager
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Adjusting Entries and Accounting Principles 157
After these adjustments are posted to the ledger, Overnight’s ledger accounts will be up- to-date (except for the balance in the Retained Earnings account). 9 The company’s adjusted trial balance at December 31, 2011, appears in Exhibit 4–10 . (For emphasis, those accounts affected by the month-end adjusting entries are shown in red.)
Overnight’s financial statements are prepared directly from the adjusted trial balance. Note the order of the accounts: All balance sheet accounts are followed by the statement of retained earnings accounts and then the income statement accounts. In Chapter 5, we illustrate exactly how these three financial statements are prepared.
Prepare an adjusted trial balance and describe its purpose.
L e a r n i n g O b j e c t i v ee
LO9 OVERNIGHT AUTO SERVICE
GENERAL JOURNAL DECEMBER 31, 2011
Date Account Titles and Explanation Debit Credit 2011
Dec. 31 Supplies Expense . . . 600
Shop Supplies . . . 600 December shop supplies adjustment.
31 Insurance Expense . . . 1,500
Unexpired Insurance . . . 1,500 December Insurance adjustment.
31 Depreciation Expense: Building . . . 150
Accumulated Depreciation: Building . . . 150 December depreciation adjustment on buildings
($36,000 ⫼ 240 mo.).
31 Depreciation Expense: Tools and Equipment . . . 200
Accumulated Depreciation: Tools and Equipment . . . 200 December depreciation adjustment on tools and
equipment ($12,000 ⫼ 60 mo.).
31 Unearned Rent Revenue . . . 3,000
Rent Revenue Earned . . . 3,000 December unearned revenue adjustment
($9,000 ⫼ 3 mo.).
31 Wages Expense . . . 1,950
Wages Payable . . . 1,950 December adjustment to accrue wages payable.
31 Interest Expense . . . 30
Interest Payable . . . 30 December adjustment to accrue interest payable
($4,000 ⫻ .09 ⫻ 1Ⲑ12).
31 Accounts Receivable. . . 750
Repair Service Revenue . . . 750 December adjustment to accrue repair service revenue.
31 Income Taxes Expense. . . 4,020
Income Taxes Payable. . . 4,020 December adjustment to accrue income taxes payable.
Exhibit 4–9
ADJUSTING ENTRIES
Adjusting entries are recorded only at the end of the period
9 The balance in the Retained Earnings account will be brought up-to-date during the closing process, discussed in Chapter 5.
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OVERNIGHT AUTO SERVICE ADJUSTED TRIAL BALANCE
DECEMBER 31, 2011
Cash . . . $ 18,592 Accounts receivable . . . 7,250 Shop supplies . . . 1,200 Unexpired insurance. . . 3,000 Land . . . 52,000 Building. . . 36,000
Accumulated depreciation: building . . . $ 1,650 Tools and equipment . . . 12,000
Accumulated depreciation: tools and equipment . . . 2,200 Notes payable. . . 4,000 Accounts payable . . . 2,690 Wages payable. . . 1,950 Income taxes payable. . . 5,580 Interest payable . . . 30 Unearned rent revenue. . . 6,000 Capital stock . . . 80,000 Retained earnings (Note: still must be
updated for transactions recorded in the accounts
listed below. Closing entries serve this purpose.). . . 0 Dividends . . . 14,000
Repair service revenue. . . 172,000 Rent revenue earned . . . 3,000 Advertising expense . . . 3,900
Wages expense . . . 58,750 Supplies expense . . . 7,500 Depreciation expense: building . . . 1,650 Depreciation expense: tools and equipment . . . 2,200 Utilities expense . . . 19,400 Insurance expense . . . 15,000 Interest expense . . . 30 Income taxes expense . . . 26,628
$279,100 $279,100
Balance sheet accounts
Income statement accounts Statement of retained earnings accounts
h
h
d
Exhibit 4–10
ADJUSTED TRIAL BALANCE
Concluding Remarks
Throughout this chapter, we illustrated end-of-period adjusting entries arising from timing differences between cash flows and revenue or expense recognition. In short, the adjusting process helps to ensure that appropriate amounts of revenue and expense are measured and reported in a company’s income statement.
In Chapter 5, we continue with our illustration of Overnight Auto Service and demonstrate how adjusting entries are reflected throughout a company’s financial statements.
Later chapters explain why accurate income measurement is of critical importance to inves- tors and creditors in estimating the timing and amounts of a company’s future cash flows. We also illustrate how understanding certain timing differences enables managers to budget and to plan for future operations.
Concluding Remarks
Th h hi h ill d d f i d dj i i i i f i i
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Concluding Remarks 159
Ethics, Fraud & Corporate Governance
Improper accounting for operating costs has often resulted in the SEC bringing action against companies for fraudulent financial reporting. Expenditures that are expected only to benefit the year in which they are made should be expensed (deducted from revenue in the determination of net income for the current period). Companies that engage in fraud will often defer these expenditures by capitalizing them (they debit an asset account reported in the balance sheet instead of an expense account reported in the income statement).
Prior to Enron and WorldCom, one of the largest financial scandals in U.S. history occurred at Waste Management.
Waste Management was the world’s largest waste services company. The improper accounting at Waste Management lasted for approximately five years and resulted in an over- statement of earnings during this time period of $1.7 billion.
Investors lost over $6 billion when Waste Management’s improper accounting was revealed.
Waste Management’s scheme for overstating earnings was simple. The company deferred recognizing normal operating expenditures as expenses until future periods.
These improper deferrals were accomplished in a number of different ways, many of which involved improper accounting for long-term assets. For example, Waste Management incurred costs in buying and developing land to be used as landfills (i.e., garbage dumps). Capitalizing these costs—
treating them as long-term assets—was proper accounting.
However, in certain cases, the company was not able to secure the necessary governmental permits and approvals to use the purchased land as intended. In these cases, the costs that had been capitalized and reported as landfills in the balance sheet should have been expensed immediately, thereby reducing net income for the year in which the company’s failure to obtain government permits and approvals occurred.
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END-OF-CHAPTER REVIEW
S U M M A R Y O F L E A R N I N G O B J E C T I V E S
Explain the purpose of adjusting entries. The purpose of adjusting entries is to allocate revenue and expenses among accounting periods in accordance with the realization and matching principles. These end-of-period entries are necessary because revenue may be earned and expenses may be incurred in periods other than the period in which related cash flows are recorded.
Describe and prepare the four basic types of adjusting entries. The four basic types of adjusting entries are made to (1) convert assets to expenses, (2) convert liabilities to revenue, (3) accrue unpaid expenses, and (4) accrue uncollected revenue. Often a transaction affects the revenue or expenses of two or more accounting periods. The related cash inflow or outflow does not always coincide with the period in which these revenue or expense items are recorded.
Thus, the need for adjusting entries results from timing differences between the receipt or disbursement of cash and the recording of revenue or expenses.
Prepare adjusting entries to convert assets to expenses. When an expenditure is made that will benefit more than one accounting period, an asset account is debited and cash is credited. The asset account is used to defer (or postpone) expense recognition until a later date. At the end of each period benefiting from this expenditure, an adjusting entry is made to transfer an appropriate amount from the asset account to an expense account. This adjustment reflects the fact that part of the asset’s cost has been matched against revenue in the measurement of income for the current period.
Prepare adjusting entries to convert liabilities to revenue. Customers sometimes pay in advance for services to be rendered in later accounting periods. For accounting purposes, the cash received does not represent revenue until it has been earned. Thus, the recognition of revenue must be deferred until it is earned. Advance collections from customers are recorded by debiting Cash and by crediting a liability account for unearned revenue. This liability is sometimes called Customer Deposits, Advance Sales, or Deferred Revenue.
As unearned revenue becomes earned, an adjusting entry is made at the end of each period to transfer an appropriate amount from the liability account to a revenue account. This adjustment reflects the fact that all or part of the company’s obligation to its customers has been fulfilled and that revenue has been realized.
Prepare adjusting entries to accrue unpaid expenses. Some expenses accumulate (or accrue ) in the current period but are not paid until a future period.
These accrued expenses are recorded as part of the adjusting E
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process at the end of each period by debiting the appropriate expense (e.g., Salary Expense, Interest Expense, or Income Taxes Expense), and by crediting a liability account (e.g., Salaries Payable, Interest Payable, or Income Taxes Payable).
In future periods, as cash is disbursed in settlement of these liabilities, the appropriate liability account is debited and Cash is credited. Note: Recording the accrued expense in the current period is the adjusting entry. Recording the disbursement of cash in a future period is not considered an adjusting entry.
Prepare adjusting entries to accrue uncollected revenue. Some revenues are earned (or accrued ) in the current period but are not collected until a future period.
These revenues are normally recorded as part of the adjusting process at the end of each period by debiting an asset account called Accounts Receivable, and by crediting the appropriate revenue account. In future periods, as cash is collected in settlement of outstanding receivables, Cash is debited and Accounts Receivable is credited. Note: Recording the accrued revenue in the current period is the adjusting entry. Recording the receipt of cash in a future period is not considered an adjusting entry.
Explain how the principles of realization and matching relate to adjusting entries. Adjusting entries are the tools by which accountants apply the realization and matching principles. Through these entries, revenues are recognized as they are earned, and expenses are recognized as resources are used or consumed in producing the related revenue.
Explain the concept of materiality. The concept of materiality allows accountants to use estimated amounts and to ignore certain accounting principles if these actions will not have a material effect on the financial statements. A material effect is one that might reasonably be expected to influence the decisions made by the users of financial statements. Thus, accountants may account for immaterial items and events in the easiest and most convenient manner.
Prepare an adjusted trial balance and describe its purpose. The adjusted trial balance reports all of the balances in the general ledger after the end-of- period adjusting entries have been made and posted. Generally, all of a company’s balance sheet accounts are listed, followed by the statement of retained earnings accounts and, finally, the income statement accounts. The amounts shown in the adjusted trial balance are carried forward directly to the financial statements. The adjusted trial balance is not considered one of the four general-purpose financial statements introduced in Chapter 2. Rather, it is simply a schedule (or worksheet) used in preparing the financial statements.
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Demonstration Problem 161
Demonstration Problem
Internet Consulting Service, Inc., adjusts its accounts every month. On the following page is the company’s year-end unadjusted trial balance dated December 31, 2011. (Bear in mind that adjust- ing entries already have been made for the first 11 months of 2011, but have not been made for December.)
Other Data
1. On December 1, the company signed a new rental agreement and paid three months’ rent in advance at a rate of $2,100 per month. This advance payment was debited to the Prepaid Office Rent account.
2. Dues and subscriptions expiring during December amounted to $50.
3. An estimate of supplies on hand was made at December 31; the estimated cost of the unused supplies was $450.
4. The useful life of the equipment has been estimated at five years (60 months) from date of acquisition.
5. Accrued interest on notes payable amounted to $100 at year-end. (Set up accounts for Interest Expense and for Interest Payable.)
6. Consulting services valued at $2,850 were rendered during December to clients who had made payment in advance.
Demonstration Problem
Key Terms Introduced or Emphasized in Chapter 4
accrue (p. 150) To grow or accumulate over time; for exam- ple, interest expense.
accumulated depreciation (p. 148) A contra-asset account shown as a deduction from the related asset account in the bal- ance sheet. Depreciation taken throughout the useful life of an asset is accumulated in this account.
adjusted trial balance (p. 157) A schedule indicating the bal- ances in ledger accounts after end-of-period adjusting entries have been posted. The amounts shown in the adjusted trial bal- ance are carried directly into financial statements.
adjusting entries (p. 140) Entries made at the end of the accounting period for the purpose of recognizing revenue and expenses that are not properly measured as a result of journal- izing transactions as they occur.
book value (p. 148) The net amount at which an asset appears in financial statements. For depreciable assets, book value repre- sents cost minus accumulated depreciation. Also called carrying value.
contra-asset account (p. 148) An account with a credit bal- ance that is offset against or deducted from an asset account to produce the proper balance sheet amount for the asset.
depreciable assets (p. 146) Physical objects with a limited life. The cost of these assets is gradually recognized as deprecia- tion expense.
depreciation (p. 146) The systematic allocation of the cost of an asset to expense during the periods of its useful life.
immaterial (p. 155) Something of little or no consequence.
Immaterial items may be accounted for in the most convenient manner, without regard to other theoretical concepts.
matching (principle) (p. 154) The accounting principle of offsetting revenue with the expenses incurred in producing that revenue. Requires recognition of expenses in the periods that the goods and services are used in the effort to produce revenue.
materiality (p. 155) The relative importance of an item or amount. Items significant enough to influence decisions are said to be material. Items lacking this importance are considered immaterial. The accounting treatment accorded to immaterial items may be guided by convenience rather than by theoretical principles.
prepaid expenses (p. 144) Assets representing advance pay- ment of the expenses of future accounting periods. As time passes, adjusting entries are made to transfer the related costs from the asset account to an expense account.
realization (principle) (p. 154) The accounting principle that governs the timing of revenue recognition. Basically, the prin- ciple indicates that revenue should be recognized in the period in which it is earned.
straight-line method of depreciation (p. 147) The widely used approach of recognizing an equal amount of depreciation expense in each period of a depreciable asset’s useful life.
unearned revenue (p. 149) An obligation to deliver goods or render services in the future, stemming from the receipt of advance payment.
useful life (p. 146) The period of time that a depreciable asset is expected to be useful to the business. This is the period over which the cost of the asset is allocated to depreciation expense.
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7. It is the custom of the firm to bill clients only when consulting work is completed or, in the case of prolonged engagements, at monthly intervals. At December 31, consulting services valued at $11,000 had been rendered to clients but not yet billed. No advance payments had been received from these clients.
8. Salaries earned by employees but not paid as of December 31 amount to $1,700.
9. Income taxes expense for the year is estimated at $56,000. Of this amount, $51,000 has been recognized as expense in prior months, and $39,000 has been paid to tax authorities. The com- pany plans to pay the $17,000 remainder of its income tax liability on January 15.
Instructions
a. Prepare the necessary adjusting journal entries on December 31, 2011.
b. Determine the amounts to be reported in the company’s year-end adjusted trial balance for each of the following accounts:
Consulting Fees Earned Dues and Subscriptions Expense Salaries Expense Depreciation Expense: Equipment Telephone Expense Miscellaneous Expenses
Rent Expense Interest Expense
Supplies Expense Income Taxes Expense
c. Determine the company’s net income for the year ended December 31, 2011. (Hint: Use the amounts determined in part b above.)
INTERNET CONSULTING SERVICE, INC.
UNADJUSTED TRIAL BALANCE DECEMBER 31, 2011
Cash . . . $ 49,100 Consulting fees receivable . . . 23,400 Prepaid office rent . . . 6,300 Prepaid dues and subscriptions . . . 300 Supplies . . . 600 Equipment . . . 36,000
Accumulated depreciation: equipment . . . $ 10,200 Notes payable. . . 5,000 Income taxes payable. . . 12,000 Unearned consulting fees . . . 5,950 Capital stock . . . 30,000 Retained earnings. . . 32,700 Dividends . . . 60,000
Consulting fees earned. . . 257,180 Salaries expense . . . 88,820
Telephone expense . . . 2,550 Rent expense . . . 22,000 Income taxes expense . . . 51,000 Dues and subscriptions expense . . . 560 Supplies expense . . . 1,600 Depreciation expense: equipment . . . 6,600 Miscellaneous expenses . . . 4,200
$353,030 $353,030
Confirming Pages
Demonstration Problem 163
Solution to the Demonstration Problem a.
INTERNET CONSULTING SERVICE, INC.
GENERAL JOURNAL DECEMBER 31, 2011
Date Account Titles and Explanation Debit Credit Dec. 31
2011
1. Rent Expense . . . 2,100
Prepaid Office Rent . . . 2,100 December rent adjustment.
2. Dues and Subscriptions Expense . . . 50
Prepaid Dues and Subscriptions . . . 50 December dues and subscriptions adjustment.
3. Supplies Expense . . . 150
Supplies . . . 150 December supplies adjustment.
4. Depreciation Expense: Equipment . . . 600
Accumulated Depreciation: Equipment . . . 600 December depreciation adjustment ($36,000 ⫼ 60 mos.).
5. Interest Expense . . . 100
Interest Payable . . . 100 December interest adjustment.
6. Unearned Consulting Fees . . . 2,850
Consulting Fees Earned. . . 2,850 December unearned revenue adjustment.
7. Consulting Fees Receivable . . . 11,000
Consulting Fees Earned. . . 11,000 December accrued revenue adjustment.
8. Salaries Expense . . . 1,700
Salaries Payable . . . 1,700 December salaries adjustment.
9. Income Taxes Expense . . . 5,000
Income Taxes Payable. . . 5,000 December income tax expense adjustment.
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