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study objectives

After studying this chapter, you should be able to:

1 Explain the revenue recognition principle and the matching principle.

2 Differentiate between the cash basis and the accrual basis of accounting.

3 Explain why adjusting entries are needed, and identify the major types of adjusting entries.

4 Prepare adjusting entries for deferrals.

5 Prepare adjusting entries for accruals.

6 Describe the nature and purpose of the adjusted trial balance.

7 Explain the purpose of closing entries.

8 Describe the required steps in the accounting cycle.

9 Understand the causes of differences between net income and cash provided by operating activities.

feature story

What Was Your Profit?

The accuracy of the financial reporting system depends on answers to a few fundamental questions. At what point has revenue been earned? At what point is the earnings process complete? When have expenses really been incurred?

During the 1990s the stock prices of dot-com companies boomed. Many dot-com companies earned most of their revenue from selling advertising space on their Web sites. To boost reported revenue, some dot-coms began swapping website ad space. Company A would put an ad for its website on company B's website, and company B would put an ad for its website on company A's website. No money ever changed hands, but each company recorded revenue (for the value of the space that it gave up on its site). This practice did little to boost net income and resulted in no additional cash flow-but it did boost reported revenue. Regulators eventually put an end to the practice.

Another type of transgression results from companies recording revenue or expenses in the wrong year. In fact, shifting revenues and expenses is one of the most common abuses of financial accounting. Xerox recently admitted reporting billions of dollars of lease revenue in periods earlier than it should have been reported. And WorldCom stunned the financial markets with its admission that it had boosted net income by billions of dollars by delaying the recognition of expenses until later years.

Unfortunately, revelations such as these have become all too common in the corporate world. It is no wonder that recently the U.S. Trust Survey of affluent Americans reported that 85 percent of its respondents believed that there should be tighter regulation of financial disclosures, and 66 percent said they did not trust the management of publicly traded companies.

Why did so many companies violate basic financial reporting rules and sound ethics? Many speculate that as stock prices climbed, executives were under increasing pressure to meet higher and higher earnings expectations. If actual results weren't as good as hoped for, some gave in to temptation and "adjusted" their numbers to meet market expectations.

On the World Wide Web Xerox: www.xerox.com

Preview of Chapter 4

As indicated in the Feature Story, making adjustments is necessary to avoid misstatement of revenues and expenses such as those at Xerox and WorldCom. In this chapter we introduce you to the accrual accounting concepts that make such adjustments possible.

The organization and content of the chapter are as follows.

[ILLUSTRATION OMITTED]

Timing Issues

Most businesses need immediate feedback about how well they are doing. For example, management usually wants monthly reports on financial results, most large corporations are required to present quarterly and annual financial statements to stockholders, and the Internal Revenue Service requires all businesses to file annual tax returns. Accounting divides the economic life of a business into artificial time periods. As indicated in Chapter 2, this is the time period assumption. Accounting time periods are generally a month, a quarter, or a year.

Many business transactions affect more than one of these arbitrary time periods. For example, a new building purchased by Citigroup or a new airplane purchased by Delta Air Lines will be used for many years. It doesn't make sense to expense the full cost of the building or the airplane at the time of purchase because each will be used for many subsequent periods. Instead, we determine the impact of each transaction on specific accounting periods.

Determining the amount of revenues and expenses to report in a given accounting period can be difficult. Proper reporting requires an understanding of the nature of the company's business. Two principles are used as guidelines: the revenue recognition principle and the matching principle.

THE REVENUE RECOGNITION PRINCIPLE

The revenue recognition principle requires that companies recognize revenue in the accounting period in which it is earned. In a service company, revenue is considered to be earned at the time the service is performed. To illustrate, assume Conrad Dry Cleaners cleans clothing on June 30, but customers do not claim and pay for their clothes until the first week of July. Under the revenue recognition principle, Conrad earns revenue in June when it performs the service, not in July when it receives the cash. At June 30 Conrad would report a receivable on its balance sheet and revenue in its income statement for the service performed. The journal entries for June and July would be as follows.

THE MATCHING PRINCIPLE

In recognizing expenses, a simple rule is followed: "Let the expenses follow the revenues." Thus, expense recognition is tied to revenue recognition. Applied to the preceding example, this means that the salary expense Conrad incurred in performing the cleaning service on June 30 should be reported in the same period in which it recognizes the service revenue. The critical issue in expense recognition is determining when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Conrad does not pay the salary incurred on June 30 until July, it would report salaries payable on its June 30 balance sheet.

The practice of expense recognition is referred to as the matching principle because it dictates that efforts (expenses) be matched with accomplishments (revenues). Illustration 4-1 shows these relationships.

ACCRUAL VERSUS CASH BASIS OF ACCOUNTING

Accrual-basis accounting means that transactions that change a company's financial statements are recorded in the periods in which the events occur, even if cash was not exchanged. For example, using the accrual basis means that companies recognize revenues when earned (the revenue recognition principle), even if cash was not received. Likewise, under the accrual basis, companies recognize expenses when incurred (the matching principle), even if cash was not paid.

An alternative to the accrual basis is the cash basis. Under cash-basis accounting, companies record revenue only when cash is received. They record expense only when cash is paid. The cash basis of accounting is prohibited under generally accepted accounting principles. Why? Because it does not record revenue when earned, thus violating the revenue recognition principle. Similarly, it does not record expenses when incurred, which violates the matching principle.

Illustration 4-2 compares accrual-based numbers and cash-based numbers. Suppose that Fresh Colors paints a large building in 2009. In 2009 it incurs and pays total expenses (salaries and paint costs) of $50,000. It bills the customer $80,000, but does not receive payment until 2010. On an accrual basis, Fresh Colors reports $80,000 of revenue during 2009 because that is when it is earned. The company matches expenses of $50,000 to the $80,000 of revenue. Thus, 2009 net income is $30,000 ($80,000 - $50,000). The $30,000 of net income reported for 2009 indicates the profitability of Fresh Colors' efforts during that period.

If, instead, Fresh Paint were to use cash-basis accounting, it would report $50,000 of expenses in 2009 and $80,000 of revenues during 2010. As shown in Illustration 4-2, it would report a loss of $50,000 in 2009 and would report net income of $80,000 in 2010. Clearly, the cash-basis measures are misleading because the financial performance of the company would be misstated for both 2009 and 2010.

The Basics of Adjusting Entries

In order for revenues to be recorded in the period in which they are earned, and for expenses to be recognized in the period in which they are incurred, companies make adjusting entries. Adjusting entries ensure that the revenue recognition and matching principles are followed.

Adjusting entries are necessary because the trial balance-the first pulling together of the transaction data-may not contain up-to-date and complete data. This is true for several reasons:

1. Some events are not recorded daily because it is not efficient to do so. Examples are the use of supplies and the earning of wages by employees.

2. Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions. Examples are charges related to the use of buildings and equipment, rent, and insurance. 3. Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period.

Adjusting entries are required every time a company prepares financial statements. The company analyzes each account in the trial balance to determine whether it is complete and up to date for financial statement purposes. Every adjusting entry will include one income statement account and one balance sheet account.

TYPES OF ADJUSTING ENTRIES

Adjusting entries are classified as either deferrals or accruals. As Illustration 4-3 (next page) shows, each of these classes has two subcategories.

Subsequent sections give examples of each type of adjustment. Each example is based on the October 31 trial balance of Sierra Corporation, from Chapter 3, reproduced in Illustration 4-4. Note that Retained Earnings, with a zero balance, has been added to this trial balance. We will explain its use later.

We assume that Sierra Corporation uses an accounting period of one month. Thus, monthly adjusting entries are made. The entries are dated October 31.

ADJUSTING ENTRIES FOR DEFERRALS

To defer means to postpone or delay. Deferrals are costs or revenues that are recognized at a date later than the point when cash was originally exchanged. Companies make adjusting entries for deferrals to record the portion of the deferred item that was incurred as an expense or earned as revenue during the current accounting period. The two types of deferrals are prepaid expenses and unearned revenues.

Prepaid Expenses

Companies record payments of expenses that will benefit more than one accounting period as assets called prepaid expenses or prepayments. When expenses are prepaid, an asset account is increased (debited) to show the service or benefit that the company will receive in the future. Examples of common prepayments are insurance, supplies, advertising, and rent. In addition, companies make prepayments when they purchase buildings and equipment.

Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use (e.g., supplies). The expiration of these costs does not require daily entries, which would be impractical and unnecessary. Accordingly, companies postpone the recognition of such cost expirations until they prepare financial statements. At each statement date, they make adjusting entries to record the expenses applicable to the current accounting period and to show the remaining amounts in the asset accounts.

Prior to adjustment, assets are overstated and expenses are understated. Therefore, as shown in Illustration 4-5, an adjusting entry for prepaid expenses results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account.

Let's look in more detail at some specific types of prepaid expenses, beginning with supplies.

SUPPLIES. The purchase of supplies, such as paper and envelopes, results in an increase (a debit) to an asset account. During the accounting period, the company uses supplies. Rather than record supplies expense as the supplies are used, companies recognize supplies expense at the end of the accounting period. At the end of the accounting period the company counts the remaining supplies. The difference between the unadjusted balance in the Supplies (asset) account and the actual cost of supplies on hand represents the supplies used (an expense) for that period.

Recall from Chapter 3 that Sierra Corporation purchased advertising supplies costing $2,500 on October 5. Sierra recorded the payment by increasing (debiting) the asset Advertising Supplies. This account shows a balance of $2,500 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still on hand. Thus, the cost of supplies used is $1,500 ($2,500 - $1,000). This use of supplies decreases an asset, Advertising Supplies. It also decreases stockholders' equity by increasing an expense account, Advertising Supplies Expense. The use of supplies affects the accounting equation in the following way.

Assets/-$1,500 = Liabilities + Stockholders' Equity/-$1,500

Thus, Sierra makes the following adjusting entry:

Oct. 31 Advertising Supplies Expense 1,500 Advertising Supplies 1,500 (To record supplies used)

After the adjusting entry is posted, the accounts, in T account form, appear as in Illustration 4-6.

The asset account Advertising Supplies now shows a balance of $1,000, which is equal to the cost of supplies on hand at the statement date. In addition, Advertising Supplies Expense shows a balance of $1,500, which equals the cost of supplies used in October. If Sierra does not make the adjusting entry, October expenses will be understated and net income overstated by $1,500. Moreover, both assets and stockholders' equity will be overstated by $1,500 on the October 31 balance sheet.

INSURANCE. Companies purchase insurance to protect themselves from losses due to fire, theft, and unforeseen events. Insurance must be paid in advance, often for more than one year. The cost of insurance (premiums) paid in advance is recorded as an increase (debit) in the asset account Prepaid Insurance. At the financial statement date companies increase (debit) Insurance Expense and decrease (credit) Prepaid Insurance for the cost of insurance that has expired during the period.

On October 4 Sierra Corporation paid $600 for a one-year fire insurance policy. Coverage began on October 1. Sierra recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in the October 31 trial balance. Insurance of $50 ($600 / 12) expires each month. The expiration of Prepaid Insurance decreases an asset, Prepaid Insurance. It also decreases stockholders' equity by increasing an expense account, Insurance Expense. The expiration of Prepaid Insurance affects the accounting equation in October (and in each of the next 11 months) in the following way.

(Continues...)

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Excerpted from Financial Accounting by Paul D. Kimmel Jerry J. Weygandt Donald E. Kieso Copyright © 2008 by Paul D. Kimmel. Excerpted by permission.
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