Adjustments for Financial Reporting

Learning objectives

• Describe the basic characteristics of the cash basis and the accrual basis of accounting.
• Identify the reasons why adjusting entries must be made.
  
• Identify the classes and types of adjusting entries.
  
• Prepare adjusting entries.
  
• Determine the effects of failing to prepare adjusting entries.
  
• Analyze and use the financial results and trend percentages.
  

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A career as a tax specialist

While most students are aware that accountants frequently assist their clients with tax returns and other tax issues, few are aware of the large number of diverse and challenging careers available in the field of taxation. Nearly all public accounting firms, ranging from the "Big 4" international firms to the sole practitioner, generate a significant portion of their fees through tax compliance, planning and consulting. With over 155 million individual tax returns filed in the US every year, it is not surprising that many individuals and most businesses need assistance in dealing with the incredibly complex US and international tax laws. This complexity also provides tremendous tax planning opportunities. As a tax specialist, you will show individual clients how to reduce their taxes while simultaneously helping them make decisions about investing, buying a house, funding their children's education, and planning their retirement. For your business clients, careful planning and structuring of business investments and transactions can save millions of dollars in taxes. In fact, it is safe to say that very few significant business transactions take place without the careful guidance of a tax specialist.

A career in taxation is by no means limited to public accounting. Because there are so many types of taxes impacting so many aspects of our lives, tax specialists act as consultants in a large number of fields. For example, many companies offer deferred compensation or stock bonus plans to their executives. Nearly all companies provide some sort of pension or other retirement plan for their employees, as well as health care benefits. Significant tax savings can be generated for both the company and their employees if these benefits are structured correctly. In response to the amazing complexity of our tax laws, many schools offer masters degrees specializing in tax. Such a degree is not required to specialize in tax, but does offer students a significant advantage if they want to pursue a career in taxation. In a recent survey of 1,400 chief financial officers, the top two responses to the question "which one of the following areas of specialization would you recommend to someone just beginning his or her career in accounting?" were personal financial planning and tax accounting. These responses reflect the indisputable fact that as the US demographic includes more wealthy, and older, Americans than ever before, professional tax guidance will be in ever-increasing demand.

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Chapters 1 and 2 introduced the accounting process of analyzing, classifying, and summarizing business transactions into accounts. You learned how these transactions are entered into the journal and posted to the ledger accounts. You also know how to use the trial balance to test the equality of debits and credits in the journalizing and posting process. The purpose of the accounting process is to produce accurate financial statements so they may be used for making sound business decisions. At this point in your study of accounting, you are concentrating on three financial statements – the income statement, the statement of retained earnings, and the balance sheet. Detailed coverage of the statement of cash flows appears in Chapter 16.

When you began to analyze business transactions in Chapter 1, you saw that the evidence of the transaction is usually a source document. It is any written or printed evidence that describes the essential facts of a business transaction. Examples are receipts for cash paid or received, checks written or received, bills sent to customers, or bills received from suppliers. The giving, receiving, or creating of source documents triggered the journal entries made in Chapter 2.

The journal entries we discuss in this chapter are adjusting entries. The arrival of the end of the accounting period triggers adjusting entries. Accountants use adjusting entries to bring accounts to their proper balances before preparing financial statements. In this chapter, you learn the difference between the cash basis and accrual basis of accounting. Then you learn about the classes and types of adjusting entries and how to prepare them.

Cash versus accrual basis accounting

Professionals such as physicians and lawyers and some relatively small businesses may account for their revenues and expenses on a cash basis. The cash basis of accounting recognizes revenues when cash is received and recognizes expenses when cash is paid out. For example, under the cash basis, a company would treat services rendered to clients in 2010 for which the company collected cash in 2011 as 2011 revenues. Similarly, under the cash basis, a company would treat expenses incurred in 2010 for which the company disbursed cash in 2011 as 2011 expenses. Under the “pure” cash basis, even the purchase of a building would be debited to an expense. However, under the “modified” cash basis, the purchase of long-lived assets (such as a building) would be debited to an asset and depreciated (gradually charged to expense) over its useful life. Normally the “modified” cash basis is used by those few individuals and small businesses that use the cash basis.

Exhibit 14: Cash basis and accrual basis of accounting compared

Because the cash basis of accounting does not match expenses incurred and revenues earned, it is generally considered theoretically unacceptable. The cash basis is acceptable in practice only under those circumstances when it approximates the results that a company could obtain under the accrual basis of accounting. Companies using the cash basis do not have to prepare any adjusting entries unless they discover they have made a mistake in preparing an entry during the accounting period. Under certain circumstances, companies may use the cash basis for income tax purposes.

Throughout the text we use the accrual basis of accounting, which matches expenses incurred and revenues earned, because most companies use the accrual basis. The accrual basis of accounting recognizes revenues when sales are made or services are performed, regardless of when cash is received. Expenses are recognized as incurred, whether or not cash has been paid out. For instance, assume a company performs services for a customer on account. Although the company has received no cash, the revenue is recorded at the time the company performs the service. Later, when the company receives the cash, no revenue is recorded because the company has already recorded the revenue. Under the accrual basis, adjusting entries are needed to bring the accounts up to date for unrecorded economic activity that has taken place. In Exhibit 14, shown below, we show when revenues and expenses are recognized under the cash basis and under the accrual basis.

The need for adjusting entries

The income statement of a business reports all revenues earned and all expenses incurred to generate those revenues during a given period. An income statement that does not report all revenues and expenses is incomplete, inaccurate, and possibly misleading. Similarly, a balance sheet that does not report all of an entity's assets, liabilities, and stockholders' equity at a specific time may be misleading. Each adjusting entry has a dual purpose: (1) to make the income statement report the proper revenue or expense and (2) to make the balance sheet report the proper asset or liability. Thus, every adjusting entry affects at least one income statement account and one balance sheet account.

Exhibit 15: Summary-fiscal year ending by month

Since those interested in the activities of a business need timely information, companies must prepare financial statements periodically. To prepare such statements, the accountant divides an entity's life into time periods. These time periods are usually equal in length and are called accounting periods. An accounting period may be one month, one quarter, or one year. An accounting year, or fiscal year, is an accounting period of one year. A fiscal year is any 12 consecutive months. The fiscal year may or may not coincide with the calendar year, which ends on December 31. As we show in Exhibit 15, 63 per cent of the companies surveyed in 2004 had fiscal years that coincide with the calendar year. In 2008, the comparable figure for publicly-traded companies in the US was 65 per cent. Companies in certain industries often have a fiscal year that differs from the calendar year. For instance many retail stores end their fiscal year on January 31 to avoid closing their books during their peak sales period. Other companies select a fiscal year ending at a time when inventories and business activity are lowest.

Periodic reporting and the matching principle necessitate the preparation of adjusting entries. Adjusting entries are journal entries made at the end of an accounting period or at any time financial statements are to be prepared to bring about a proper matching of revenues and expenses. The matching principle requires that expenses incurred in producing revenues be deducted from the revenues they generated during the accounting period. The matching principle is one of the underlying principles of accounting. This matching of expenses and revenues is necessary for the income statement to present an accurate picture of the profitability of a business. Adjusting entries reflect unrecorded economic activity that has taken place but has not yet been recorded. Why has the company not recorded this activity by the end of the period? One reason is that it is more convenient and economical to wait until the end of the period to record the activity. A second reason is that no source document concerning that activity has yet come to the accountant's attention.

Adjusting entries bring the amounts in the general ledger accounts to their proper balances before the company prepares its financial statements. That is, adjusting entries convert the amounts that are actually in the general ledger accounts to the amounts that should be in the general ledger accounts for proper financial reporting. To make this conversion, the accountants analyze the accounts to determine which need adjustment. For example, assume a company purchased a three-year insurance policy costing USD 600 at the beginning of the year and debited USD 600 to Prepaid Insurance. At year-end, the company should remove USD 200 of the cost from the asset and record it as an expense. Failure to do so misstates assets and net income on the financial statements.

Exhibit 16: Two classes and four types of adjusting entries

Companies continuously receive benefits from many assets such as prepaid expenses (e.g. prepaid insurance and prepaid rent). Thus, an entry could be made daily to record the expense incurred. Typically, firms do not make the entry until financial statements are to be prepared. Therefore, if monthly financial statements are prepared, monthly adjusting entries are required. By custom, and in some instances by law, businesses report to their owners at least annually. Accordingly, adjusting entries are required at least once a year. Remember, however, that the entry transferring an amount from an asset account to an expense account should transfer only the asset cost that has expired.

Classes and types of adjusting entries

Adjusting entries fall into two broad classes: deferred (meaning to postpone or delay) items and accrued (meaning to grow or accumulate) items. Deferred items consist of adjusting entries involving data previously recorded in accounts. These entries involve the transfer of data already recorded in asset and liability accounts to expense and revenue accounts, respectively. Accrued items consist of adjusting entries relating to activity on which no data have been previously recorded in the accounts. These entries involve the initial, or first, recording of assets and liabilities and the related revenues and expenses (see Exhibit 16).

Deferred items consist of two types of adjusting entries: asset/expense adjustments and liability/revenue adjustments. For example, prepaid insurance and prepaid rent are assets until they are used up; then they become expenses. Also, unearned revenue is a liability until the company renders the service; then the unearned revenue becomes earned revenue.

Accrued items consist of two types of adjusting entries: asset/revenue adjustments and liability/expense adjustments. For example, assume a company performs a service for a customer but has not yet billed the customer. The accountant records this transaction as an asset in the form of a receivable and as revenue because the company has earned a revenue. Also, assume a company owes its employees salaries not yet paid. The accountant records this transaction as a liability and an expense because the company has incurred an expense.

MICROTRAIN COMPANY Trial Balance 2010 December 31

Exhibit 17: Trial balance

In this chapter, we illustrate each of the four types of adjusting entries: asset/expense, liability/revenue, asset/revenue, and liability/expense. Look at Exhibit 17, the trial balance of the MicroTrain Company at 2010 December 31. As you can see, MicroTrain must adjust several accounts before it can prepare accurate financial statements. The adjustments for these accounts involve data already recorded in the company’s accounts.

In making adjustments for MicroTrain Company, we must add several accounts to the company’s chart of accounts shown in Chapter 2. These new accounts are:

Now you are ready to follow as MicroTrain Company makes its adjustments for deferred items. If you find the process confusing, review the beginning of this chapter so you clearly understand the purpose of adjusting entries.

Adjustments for deferred items

Adjustments for accrued items

Accrued items require two types of adjusting entries: asset/revenue adjustments and liability/expense adjustments. The first group – asset/revenue adjustments – involves accrued assets; the second group – liability/expense adjustments – involves accrued liabilities.

Accrued assets are assets, such as interest receivable or accounts receivable, that have not been recorded by the end of an accounting period. These assets represent rights to receive future payments that are not due at the balance sheet date. To present an accurate picture of the affairs of the business on the balance sheet, firms recognize these rights at the end of an accounting period by preparing an adjusting entry to correct the account balances. To indicate the dual nature of these adjustments, they record a related revenue in addition to the asset. We also call these adjustments accrued revenues because the revenues must be recorded.

Interest revenue Savings accounts literally earn interest moment by moment. Rarely is payment of the interest made on the last day of the accounting period. Thus, the accounting records normally do not show the interest revenue earned (but not yet received), which affects the total assets owned by the investor, unless the company makes an adjusting entry. The adjusting entry at the end of the accounting period debits a receivable account (an asset) and credits a revenue account to record the interest earned and the asset owned.

For example, assume MicroTrain Company has some money in a savings account. On 2010 December 31, the money on deposit has earned one month's interest of USD 600, althoug h the company has not received the interest. An entry must show the amount of interest earned by 2010 December 31, as well as the amount of the asset, interest receivable (the right to receive this interest). The entry to record the accrual of revenue is:

The T-accounts relating to interest would appear as follows:

MicroTrain reports the USD 600 debit balance in Interest Receivable as an asset in the 2010 December 31, balance sheet. This asset accumulates gradually with the passage of time. The USD 600 credit balance in Interest Revenue is the interest earned during the month. Recall that in recording revenue under accrual basis accounting, it does not matter whether the company collects the actual cash during the year or not. It reports the interest revenue earned during the accounting period in the income statement.

Unbilled training fees A company may perform services for customers in one accounting period while it bills for the services in a different accounting period.

MicroTrain Company performed USD 1,000 of training services on account for a client at the end of December. Since it takes time to do the paper work, MicroTrain will bill the client for the services in January. The necessary adjusting journal entry at 2010 December 31, is:

After posting the adjusting entry, the T-accounts appear as follows:

The service revenue appears in the income statement; the asset, accounts receivable, appears in the balance sheet.

Accrued liabilities are liabilities not yet recorded at the end of an accounting period. They represent obligations to make payments not legally due at the balance sheet date, such as employee salaries. At the end of the accounting period, the company recognizes these obligations by preparing an adjusting entry including both a liability and an expense. For this reason, we also call these obligations accrued expenses.

Salaries The recording of the payment of employee salaries usually involves a debit to an expense account and a credit to Cash. Unless a company pays salaries on the last day of the accounting period for a pay period ending on that date, it must make an adjusting entry to record any salaries incurred but not yet paid.

MicroTrain Company paid USD 3,600 of salaries on Friday, 2010 December 28, to cover the first four weeks of December. The entry made at that time was:

Assuming that the last day of December 2010 falls on a Monday, this expense account does not show salaries earned by employees for the last day of the month. Nor does any account show the employer's obligation to pay these salaries. The T-accounts pertaining to salaries appear as follows before adjustment:

If salaries are USD 3,600 for four weeks, they are USD 900 per week. For a five-day workweek, daily salaries are USD 180. MicroTrain makes the following adjusting entry on December 31 to accrue salaries for one day:

After adjustment, the two T-accounts involved appear as follows:

Exhibit 18: Effects of failure to recognize adjustments

The debit in the adjusting journal entry brings the month's salaries expense up to its correct USD 3,780 amount for income statement purposes. The credit to Salaries Payable records the USD 180 salary liability to employees. The balance sheet shows salaries payable as a liability.

Another example of a liability/expense adjustment is when a company incurs interest on a note payable. The debit would be to Interest Expense, and the credit would be to Interest Payable. We discuss this adjustment in Chapter 9.

Effects of failing to prepare adjusting entries

Failure to prepare proper adjusting entries causes net income and the balance sheet to be in error. You can see the effect of failing to record each of the major types of adjusting entries on net income and balance sheet items in Exhibit 18.

Using MicroTrain Company as an example, this chapter has discussed and illustrated many of the typical entries that companies must make at the end of an accounting period. Later chapters explain other examples of adjusting entries.

Analyzing and using the financial results – trend percentages

Understanding the learning objectives

• The cash basis of accounting recognizes revenues when cash is received and recognizes expenses when cash is paid out.
• The accrual basis of accounting recognizes revenues when sales are made or services are performed, regardless of when cash is received; expenses are recognized as incurred, whether or not cash has been paid out.
• The accrual basis is more generally accepted than the cash basis because it provides a better
• matching of revenues and expenses.
• Adjusting entries convert the amounts that are actually in the accounts to the amounts that should be in the accounts for proper periodic financial reporting.
• Adjusting entries reflect unrecorded economic activity that has taken place but has not yet been recorded.
• Deferred items consist of adjusting entries involving data previously recorded in accounts. Adjusting entries in this class normally involve moving data from asset and liability accounts to expense and revenue accounts. The two types of adjustments within this deferred items class are asset/expense adjustments and liability/revenue adjustments.
• Accrued items consist of adjusting entries relating to activity on which no data have been previously recorded in the accounts. These entries involve the initial recording of assets and liabilities and the related revenues and expenses. The two types of adjustments within this accrued items class are asset/revenue adjustments and liability/expense adjustments.
• This chapter illustrates entries for deferred items and accrued items.
• Failure to prepare adjusting entries causes net income and the balance sheet to be in error.
• For a particular item such as sales or net income, select a base year and express all dollar amounts in other years as a percentage of the base year dollar amount.