Adjustments for Financial Reporting

This chapter dives deeper into the importance of making proper adjustments so that the financial statements reflect the current condition of the organization. One of the main principles of accounting is accurate and honest presentation of the financial condition of an organization. Without the proper posting of adjustments and correcting entries, the financial statements will be incorrect. Accounting is typically done within a specified period so that end users can assess the performance of a business entity. This section also discusses accounting periods, fiscal years, calendar years, adjusting entries, the matching principle, and the two classes and four types of adjusting entries.

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:

2010
Dec.
31 Interest Receivable 600 Adjustment
Interest Revenue 600 6 – Interest
To record one month's interest revenue. revenue accrued

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

(Dr.) Interest Receivable (Cr.)
2010
Dec. 31 Adjustment 6
600

(Dr.) Interest Revenue (Cr.)



2010
Dec. 31 Adjustment 6
600.
Increased by $600

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:

2010
Dec.
31 Accounts Receivable (or Service Fees Receivable) 1,000 Adjustment 7 – Unbilled
Service Revenue 1,000
To record unbilled training services performed in December.

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

(Dr.) Accounts Receivable (Cr.)
2010


Previous bal. 5,200*
Dec. 31 Adjustment 7 1,000*_
Bal. after adjustment 6,200

(Dr.) Service Revenue (Cr.)


2010



Bal. before adjustment
10,700


Dec. 31 Adjustment



5 – previously



unearned



revenue.
1,500


Dec. 31 Adjustment 7
1,000


Bal. after both adjustments
13,200

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:

2010
Dec.
28 Salaries Expense 3,600
Cash 3,600
Paid training employee salaries for the first four weeks of December.

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:

(Dr.) Salaries Expense (Cr) (Dr.) Salaries Payable (Cr)
2010 Dec. 28 3,600 2010 Dec. 28 Bal.
-0-

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:

2010
Dec.
31 Salaries Expense 180
Salaries Payable 180
To accrue one day's salaries that were earned but not paid.

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

(Dr.) Salaries Expense (Cr)
2010

Dec. 28 Bal.
3,600

Dec. 31 Adjustment 8
180

Bal. after adjustment
3,780

(Dr.) Salaries Payable (Cr)
2010
Dec. 31 Adjustment 8
180
Increased by $180

Failure to Recognize Effect on Net Income Effect on Balance Sheet Items
1. Consumption of the benefits of an asset (prepaid expense) Overstates net income
Overstates assets Overstates retained earnings
2. Earning of previously unearned revenues Understates net income Overstates liabilities Understates retained earnings
3. Accrual of assets
Understates net income Understates assets Understates retained earnings
4. Accrual of liabilities Overstates net income Understates liabilities Overstates retained earnings

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.