Timing Issues

We would need no adjustments if we could wait to prepare financial statements until a company ended its operations. At that point, we could easily determine its final statement of financial position and the amount of lifetime income it earned.

However, most companies need immediate feedback about how well they are doing. For example, management usually wants monthly financial statements, and taxing agencies require all businesses to file annual tax returns. Therefore, accountants divide the economic life of a business into artificial time periods. This convenient assumption is referred to as the time period assumption.

Many business transactions affect more than one of these arbitrary time periods. For example, the airplanes purchased by Cathay Pacific (HKG) five years ago are still in use today. We must determine the relevance of each business transaction to specific accounting periods. (How much of an airplane's original cost contributed to this period's operations?)

Fiscal and Calendar Years

Both small and large companies prepare financial statements periodically in order to assess their financial condition and results of operations. Accounting time periods are generally a month, a quarter, or a year. Monthly and quarterly time periods are called interim periods. Most large companies must prepare both quarterly and annual financial statements.

An accounting time period that is one year in length is a fiscal year. A fiscal year usually begins with the first day of a month and ends 12 months later on the last day of a month. Most businesses use the calendar year (January 1 to December 31) as their accounting period. Some do not. Companies whose fiscal year differs from the calendar year include Vodafone Group (GBR), March 31, and Walt Disney Productions (USA), September 30. Sometimes a company's year-end will vary from year to year. For example, JJB Sports' (GBR) fiscal year ends on the Sunday that falls closest before January 31, resulting in accounting periods of either 52 or 53 weeks.

Accrual- versus Cash-Basis Accounting

What you will learn in this chapter is accrual-basis accounting. Under the accrual basis, companies record transactions that change a company's financial statements in the periods in which the events occur. For example, using the accrual basis to determine net income means companies recognize revenues when they actually perform the services (rather than when they receive cash). It also means recognizing expenses when incurred (rather than when paid).

An alternative to the accrual basis is the cash basis. Under cash-basis accounting, companies record revenue when they receive cash. They record an expense when they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading financial statements. It fails to record revenue for a company that has provided services but for which it has not received the cash. As a result, it does not match expenses with revenues. Cash-basis accounting is not in accordance with International Financial Reporting Standards (IFRS).

Individuals and some small companies do use cash-basis accounting. The cash basis is justified for small businesses because they often have few receivables and payables. Medium and large companies use accrual-basis accounting.

Recognizing Revenues and Expenses

It can be difficult to determine when to report revenues and expenses. The revenue recognition principle and the expense recognition principle help in this task.

REVENUE RECOGNITION PRINCIPLE

When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. When the company meets this performance obligation, it recognizes revenue. The revenue recognition principle therefore requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied.¹ To illustrate, assume that Dave's Dry Cleaning cleans clothing on June 30, but customers do not claim and pay for their clothes until the first week of July. Dave's should record revenue in June when it performed the service (satisfies the performance obligation) rather than in July when it received the cash. At June 30, Dave's would report a receivable on its statement of financial position and revenue in its income statement for the service performed.

EXPENSE RECOGNITION PRINCIPLE

Accountants follow a simple rule in recognizing expenses: “Let the expenses follow the revenues.” Thus, expense recognition is tied to revenue recognition. In the dry cleaning example, this means that Dave's should report the salary expense incurred in performing the June 30 cleaning service in the same period in which it recognizes the service revenue. The critical issue in expense recognition is when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Dave's does not pay the salary incurred on June 30 until July, it would report salaries payable on its June 30 statement of financial position.

This practice of expense recognition is referred to as the expense recognition principle (often referred to as the matching principle). It dictates that efforts (expenses) be matched with results (revenues). Illustration 3-1 summarizes the revenue and expense recognition principles.

Illustration 3-1 IFRS relationships in revenue and expense recognition

The Basics of Adjusting Entries

In order for revenues to be recorded in the period in which services are performed, 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 expense recognition 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 statement of financial position account.

Types of Adjusting Entries

Adjusting entries are classified as either deferrals or accruals. As Illustration 3-2 shows, each of these classes has two subcategories.

Illustration 3-2 Categories of adjusting entries

Subsequent sections give examples of each type of adjustment. Each example is based on the October 31 trial balance of Pioneer Advertising Agency Inc. from Chapter 2, reproduced in Illustration 3-3.

Illustration 3-3 Trial balance

We assume that Pioneer Advertising 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 recognized as revenue during the current accounting period. The two types of deferrals are prepaid expenses and unearned revenues.

PREPAID EXPENSES

When companies record payments of expenses that will benefit more than one accounting period, they record an asset 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 3-4, 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.

Illustration 3-4 Adjusting entries for prepaid expenses

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 (page 103).

Recall from Chapter 2 that Pioneer Advertising Agency Inc. purchased supplies costing 2,500 on October 5. Pioneer recorded the purchase by increasing (debiting) the asset 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, Supplies. It also decreases equity by increasing an expense account, Supplies Expense. This is shown in Illustration 3-5.

Illustration 3-5 Adjustment for supplies

After adjustment, the asset account Supplies shows a balance of 1,000, which is equal to the cost of supplies on hand at the statement date. In addition, Supplies Expense shows a balance of 1,500, which equals the cost of supplies used in October. If Pioneer does not make the adjusting entry, October expenses will be understated and net income overstated by 1,500. Moreover, both assets and equity will be overstated by 1,500 on the October 31 statement of financial position.

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, Pioneer Advertising paid 600 for a one-year fire insurance policy. Coverage began on October 1. Pioneer 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 equity by increasing an expense account, Insurance Expense.

As shown in Illustration 3-6 (page 104), the asset Prepaid Insurance shows a balance of 550, which represents the unexpired cost for the remaining 11 months of coverage. At the same time, the balance in Insurance Expense equals the insurance cost that expired in October. If Pioneer does not make this adjustment, October expenses are understated by 50 and net income is overstated by 50. Moreover, as the accounting equation shows, both assets and equity will be overstated by 50 on the October 31 statement of financial position.

Illustration 3-6 Adjustment for insurance

DEPRECIATION A company typically owns a variety of assets that have long lives, such as buildings, equipment, and motor vehicles. The period of service is referred to as the useful life of the asset. Because a building is expected to provide service for many years, it is recorded as an asset, rather than an expense, on the date it is acquired. As explained in Chapter 1, companies record such assets at cost, as required by the historical cost principle. To follow the expense recognition principle, companies allocate a portion of this cost as an expense during each period of the asset's useful life. Depreciation is the process of allocating the cost of an asset to expense over its useful life.

Need for Adjustment. The acquisition of long-lived assets is essentially a long-term prepayment for the use of an asset. An adjusting entry for depreciation is needed to recognize the cost that has been used (an expense) during the period and to report the unused cost (an asset) at the end of the period. One very important point to understand: Depreciation is an allocation concept, not a valuation concept. That is, depreciation allocates an asset's cost to the periods in which it is used. Depreciation does not attempt to report the actual change in the value of the asset.

For Pioneer Advertising, assume that depreciation on the equipment is 480 a year, or 40 per month. As shown in Illustration 3-7 on the next page, rather than decrease (credit) the asset account directly, Pioneer instead credits Accumulated Depreciation—Equipment. Accumulated Depreciation is called a contra asset account. Such an account is offset against an asset account on the statement of financial position. Thus, the Accumulated Depreciation—Equipment account offsets the asset Equipment. This account keeps track of the total amount of depreciation expense taken over the life of the asset. To keep the accounting equation in balance, Pioneer decreases equity by increasing an expense account, Depreciation Expense.

Illustration 3-7 Adjustment for depreciation

The balance in the Accumulated Depreciation—Equipment account will increase 40 each month, and the balance in Equipment remains 5,000.

Statement Presentation. As indicated, Accumulated Depreciation—Equipment is a contra asset account. It is offset against Equipment on the statement of financial position. The normal balance of a contra asset account is a credit. A theoretical alternative to using a contra asset account would be to decrease (credit) the asset account by the amount of depreciation each period. But using the contra account is preferable for a simple reason: It discloses both the original cost of the equipment and the total cost that has expired to date. Thus, in the statement of financial position, Pioneer deducts Accumulated Depreciation—Equipment from the related asset account, as shown in Illustration 3-8.

Illustration 3-8 Statement of financial position presentation of accumulated depreciation

Book value is the difference between the cost of any depreciable asset and its related accumulated depreciation. In Illustration 3-8, the book value of the equipment at the statement of financial position date is 4,960. The book value and the fair value of the asset are generally two different values. As noted earlier, the purpose of depreciation is not valuation but a means of cost allocation.

Depreciation expense identifies the portion of an asset's cost that expired during the period (in this case, in October). The accounting equation shows that without this adjusting entry, assets, equity, and net income are overstated by 40 and depreciation expense is understated by 40.

Illustration 3-9 summarizes the accounting for prepaid expenses.

Illustration 3-9 Accounting for prepaid expenses

UNEARNED REVENUES

When companies receive cash before services are performed, they record a liability called unearned revenue. In other words, a company now has a performance obligation (liability) to transfer a service to one of its customers. Items like rent, magazine subscriptions, and customer deposits for future service may result in unearned revenues. Airlines such as Ryanair (IRL), Qatar Airways (QAT), and Delta Airlines (USA), for instance, treat receipts from the sale of tickets as unearned revenue until the flight service is provided.

Unearned revenues are the opposite of prepaid expenses. Indeed, unearned revenue on the books of one company is likely to be a prepaid expense on the books of the company that has made the advance payment. For example, if identical accounting periods are assumed, a landlord will have unearned rent revenue when a tenant has prepaid rent.

When a company receives payment for services to be performed in a future accounting period, it increases (credits) an unearned revenue (a liability) account to recognize the liability that exists. The company subsequently recognizes revenues when it performs the service. During the accounting period, it is not practical to make daily entries as the company provides services. Instead, the company delays recognition of revenue until the adjustment process. Then, the company makes an adjusting entry to record the revenue for services performed during the period and to show the liability that remains at the end of the accounting period. Typically, prior to adjustment, liabilities are overstated and revenues are understated. Therefore, as shown in Illustration 3-10, the adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.

Illustration 3-10 Adjusting entries for unearned revenues

Pioneer Advertising received 1,200 on October 2 from R. Knox for advertising services expected to be completed by December 31. Pioneer credited the payment to Unearned Service Revenue, and this liability account shows a balance of 1,200 in the October 31 trial balance. From an evaluation of the service Pioneer performed for Knox during October, the company determines that it should recognize 400 of revenue in October. The liability (Unearned Service Revenue) is therefore decreased, and equity (Service Revenue) is increased.

As shown in Illustration 3-11, the liability Unearned Service Revenue now shows a balance of 800. That amount represents the remaining advertising services expected to be performed in the future. At the same time, Service Revenue shows total revenue recognized in October of 10,400. Without this adjustment, revenues and net income are understated by 400 in the income statement. Moreover, liabilities are overstated and equity is understated by 400 on the October 31 statement of financial position.

Illustration 3-11 Service revenue accounts after adjustment

Illustration 3-12 summarizes the accounting for unearned revenues.

Illustration 3-12 Accounting for unearned revenues

Adjusting Entries for Accruals

The second category of adjusting entries is accruals. Prior to an accrual adjustment, the revenue account (and the related asset account) or the expense account (and the related liability account) are understated. Thus, the adjusting entry for accruals will increase both a statement of financial position and an income statement account.

ACCRUED REVENUES

Revenues for services performed but not yet recorded at the statement date are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in the case of interest revenue. These are unrecorded because the earning of interest does not involve daily transactions. Companies do not record interest revenue on a daily basis because it is often impractical to do so. Accrued revenues also may result from services that have been performed but not yet billed or collected, as in the case of commissions and fees. These may be unrecorded because only a portion of the total service has been provided and the clients won't be billed until the service has been completed.

An adjusting entry records the receivable that exists at the statement of financial position date and the revenue for the services performed during the period. Prior to adjustment, both assets and revenues are understated. As shown in Illustration 3-13, an adjusting entry for accrued revenues results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account.

Illustration 3-13 Adjusting entries for accrued revenues

In October, Pioneer Advertising Agency Inc. recognized 200 for advertising services performed that were not billed to clients on or before October 31. Because these services are not billed, they are not recorded. The accrual of unrecorded service revenue increases an asset account, Accounts Receivable. It also increases equity by increasing a revenue account, Service Revenue, as shown in Illustration 3-14.

Illustration 3-14 Adjustment for accrued revenue

Equation analyses summarize the effects of transactions on the three elements of the accounting equation, as well as the effect on cash flows.

The asset Accounts Receivable shows that clients owe Pioneer 200 at the statement of financial position date. The balance of 10,600 in Service Revenue represents the total revenue for services performed by Pioneer during the month (10,000 + 400 + 200). Without the adjusting entry, assets and equity on the statement of financial position and revenues and net income on the income statement are understated.

On November 10, Pioneer receives cash of 200 for the services performed in October and makes the following entry.

The company records the collection of the receivables by a debit (increase) to Cash and a credit (decrease) to Accounts Receivable.

Illustration 3-15 summarizes the accounting for accrued revenues.

Illustration 3-15 Accounting for accrued revenues

ACCRUED EXPENSES

Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses. Interest, taxes, and salaries are common examples of accrued expenses.

Companies make adjustments for accrued expenses to record the obligations that exist at the statement of financial position date and to recognize the expenses that apply to the current accounting period. Prior to adjustment, both liabilities and expenses are understated. Therefore, as Illustration 3-16 shows, an adjusting entry for accrued expenses results in an increase (a debit) to an expense account and an increase (a credit) to a liability account.

Illustration 3-16 Adjusting entries for accrued expenses

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

ACCRUED INTEREST Pioneer Advertising signed a three-month note payable in the amount of 5,000 on October 1. The note requires Pioneer to pay interest at an annual rate of 12%.

The amount of the interest recorded is determined by three factors: (1) the face value of the note; (2) the interest rate, which is always expressed as an annual rate; and (3) the length of time the note is outstanding. For Pioneer, the total interest due on the 5,000 note at its maturity date three months in the future is 150 (), or 50 for one month. Illustration 3-17 shows the formula for computing interest and its application to Pioneer for the month of October.

Illustration 3-17 Formula for computing interest

As Illustration 3-18 (page 112) shows, the accrual of interest at October 31 increases a liability account, Interest Payable. It also decreases equity by increasing an expense account, Interest Expense.

Interest Expense shows the interest charges for the month of October. Interest Payable shows the amount of interest the company owes at the statement date. Pioneer will not pay the interest until the note comes due at the end of three months. Companies use the Interest Payable account, instead of crediting Notes Payable, to disclose the two different types of obligations—interest and principal—in the accounts and statements. Without this adjusting entry, liabilities and interest expense are understated, and net income and equity are overstated.

Illustration 3-18 Adjustment for accrued interest

ACCRUED SALARIES AND WAGES Companies pay for some types of expenses, such as employee salaries and wages, after the services have been performed. Pioneer paid salaries and wages on October 26 for its employees' first two weeks of work; the next payment of salaries will not occur until November 9. As Illustration 3-19 shows, three working days remain in October (October 29–31).

Illustration 3-19 Calendar showing Pioneer's pay periods

At October 31, the salaries and wages for these three days represent an accrued expense and a related liability to Pioneer. The employees receive total salaries and wages of 2,000 for a five-day work week, or 400 per day. Thus, accrued salaries and wages at October 31 are 1,200 (400 × 3). This accrual increases a liability, Salaries and Wages Payable. It also decreases equity by increasing an expense account, Salaries and Wages Expense, as shown in Illustration 3-20.

After this adjustment, the balance in Salaries and Wages Expense of 5,200 (13 days × 400) is the actual salary and wages expense for October. The balance in Salaries and Wages Payable of 1,200 is the amount of the liability for salaries and wages Pioneer owes as of October 31. Without the 1,200 adjustment for salaries and wages, Pioneer's expenses are understated 1,200 and its liabilities are understated 1,200.

Illustration 3-20 Adjustment for accrued salaries and wages

Pioneer Advertising pays salaries and wages every two weeks. Consequently, the next payday is November 9, when the company will again pay total salaries and wages of 4,000. The payment consists of 1,200 of salaries and wages payable at October 31 plus 2,800 of salaries and wages expense for November (7 working days, as shown in the November calendar × 400). Therefore, Pioneer makes the following entry on November 9.

This entry eliminates the liability for Salaries and Wages Payable that Pioneer recorded in the October 31 adjusting entry, and it records the proper amount of Salaries and Wages Expense for the period between November 1 and November 9.

Illustration 3-21 summarizes the accounting for accrued expenses.

Illustration 3-21 Accounting for accrued expenses

Summary of Basic Relationships

Illustration 3-22 summarizes the four basic types of adjusting entries. Take some time to study and analyze the adjusting entries. Be sure to note that each adjusting entry affects one statement of financial position account and one income statement account.

Illustration 3-22 Summary of adjusting entries

Illustrations 3-23 (below) and 3-24 (on page 116) show the journalizing and posting of adjusting entries for Pioneer Advertising Agency Inc. on October 31. The ledger identifies all adjustments by the reference J2 because they have been recorded on page 2 of the general journal. The company may insert a center caption “Adjusting Entries” between the last transaction entry and the first adjusting entry in the journal. When you review the general ledger in Illustration 3-24, note that the entries highlighted in color are the adjustments.

Illustration 3-23 General journal showing adjusting entries

Illustration 3-24 General ledger after adjustment

The Adjusted Trial Balance and Financial Statements

After a company has journalized and posted all adjusting entries, it prepares another trial balance from the ledger accounts. This trial balance is called an adjusted trial balance. It shows the balances of all accounts, including those adjusted, at the end of the accounting period. The purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments. Because the accounts contain all data needed for financial statements, the adjusted trial balance is the primary basis for the preparation of financial statements.

Preparing the Adjusted Trial Balance

Illustration 3-25 presents the adjusted trial balance for Pioneer Advertising Agency Inc. prepared from the ledger accounts in Illustration 3-24. The amounts affected by the adjusting entries are highlighted in color. Compare these amounts to those in the unadjusted trial balance in Illustration 3-3 on page 101. In this comparison, you will see that there are more accounts in the adjusted trial balance as a result of the adjusting entries made at the end of the month.

Illustration 3-25 Adjusted trial balance

Preparing Financial Statements

Companies can prepare financial statements directly from the adjusted trial balance. Illustrations 3-26 and 3-27 present the interrelationships of data in the adjusted trial balance and the financial statements.

As Illustration 3-26 shows, companies prepare the income statement from the revenue and expense accounts. Next, they use the Retained Earnings and Dividends accounts and the net income (or net loss) from the income statement to prepare the retained earnings statement. As Illustration 3-27 shows, companies then prepare the statement of financial position from the asset and liability accounts and the ending retained earnings balance as reported in the retained earnings statement.

Illustration 3-26 Preparation of the income statement and retained earnings statement from the adjusted trial balance

Illustration 3-27 Preparation of the statement of financial position from the adjusted trial balance

SUMMARY OF LEARNING OBJECTIVES

1 Explain the time period assumption. The time period assumption assumes that the economic life of a business is divided into artificial time periods.

2 Explain the accrual basis of accounting. Accrual-basis accounting means that companies record events that change a company's financial statements in the periods in which those events occur, rather than in the periods in which the company receives or pays cash.

3 Explain the reasons for adjusting entries. Companies make adjusting entries at the end of an accounting period. Such entries ensure that companies recognize revenues in the period in which the performance obligation is satisfied and recognize expenses in the period in which they are incurred.

4 Identify the major types of adjusting entries. The major types of adjusting entries are deferrals (prepaid expenses and unearned revenues) and accruals (accrued revenues and accrued expenses).

5 Prepare adjusting entries for deferrals. Deferrals are either prepaid expenses or unearned revenues. Companies make adjusting entries for deferrals to record the portion of the prepayment that represents the expense incurred or the revenue for services performed in the current accounting period.

6 Prepare adjusting entries for accruals. Accruals are either accrued revenues or accrued expenses. Companies make adjusting entries for accruals to record revenues for services performed and expenses incurred in the current accounting period that have not been recognized through daily entries.

7 Describe the nature and purpose of an adjusted trial balance. An adjusted trial balance shows the balances of all accounts, including those that have been adjusted, at the end of an accounting period. Its purpose is to prove the equality of the total debit balances and total credit balances in the ledger after all adjustments.

GLOSSARY

Accrual-basis accounting Accounting basis in which companies record transactions that change a company's financial statements in the periods in which the events occur. (p. 98).

Accruals Adjusting entries for either accrued revenues or accrued expenses. (p. 101).

Accrued expenses Expenses incurred but not yet paid in cash or recorded. (p. 110).

Accrued revenues Revenues for services performed but not yet received in cash or recorded. (p. 109).

Adjusted trial balance A list of accounts and their balances after the company has made all adjustments. (p. 117).

Adjusting entries Entries made at the end of an accounting period to ensure that companies follow the revenue and expense recognition principles. (p. 100).

Book value The difference between the cost of a depreciable asset and its related accumulated depreciation. (p. 105).

Calendar year An accounting period that extends from January 1 to December 31. (p. 98).

Cash-basis accounting Accounting basis in which companies record revenue when they receive cash and an expense when they pay cash. (p. 98).

Contra asset account An account offset against an asset account on the statement of financial position. (p. 104).

Deferrals Adjusting entries for either prepaid expenses or unearned revenues. (p. 101).

Depreciation The allocation of the cost of an asset to expense over its useful life in a rational and systematic manner. (p. 104).

Expense recognition (matching) principle The principle that companies match efforts (expenses) with accomplishments (revenues). (p. 99).

Fiscal year An accounting period that is one year in length. (p. 98).

Interim periods Monthly or quarterly accounting time periods. (p. 98).

Prepaid expenses (prepayments) Expenses paid in cash before they are used or consumed. (p. 102).

Revenue recognition principle The principle that companies recognize revenue in the accounting period in which the performance obligation is satisfied. (p. 99).

Time period assumption An assumption that accountants can divide the economic life of a business into artificial time periods. (p. 98).

Unearned revenue Cash received and recorded as a liability before services are performed. (p. 106).

Useful life The length of service of a long-lived asset. (p. 104).

APPENDIX 3A ALTERNATIVE TREATMENT OF PREPAID EXPENSES AND UNEARNED REVENUES

In discussing adjusting entries for prepaid expenses and unearned revenues, we illustrated transactions for which companies made the initial entries to statement of financial position accounts. In the case of prepaid expenses, the company debited the prepayment to an asset account. In the case of unearned revenue, the company credited a liability account to record the cash received.

Some companies use an alternative treatment: (1) When a company prepays an expense, it debits that amount to an expense account. (2) When it receives payment for future services, it credits the amount to a revenue account. In this appendix, we describe the circumstances that justify such entries and the different adjusting entries that may be required. This alternative treatment of prepaid expenses and unearned revenues has the same effect on the financial statements as the procedures described in the chapter.

Prepaid Expenses

Prepaid expenses become expired costs either through the passage of time (e.g., insurance) or through consumption (e.g., advertising supplies). If, at the time of purchase, the company expects to consume the supplies before the next financial statement date, it may choose to debit (increase) an expense account rather than an asset account. This alternative treatment is simply more convenient.

Assume that Pioneer Advertising Agency Inc. expects that it will use before the end of the month all of the supplies purchased on October 5. A debit of 2,500 to Supplies Expense (rather than to the asset account Supplies) on October 5 will eliminate the need for an adjusting entry on October 31. At October 31, the Supplies Expense account will show a balance of 2,500, which is the cost of supplies used between October 5 and October 31.

But what if the company does not use all the supplies? For example, what if an inventory of 1,000 of advertising supplies remains on October 31? Obviously, the company would need to make an adjusting entry. Prior to adjustment, the expense account Supplies Expense is overstated 1,000, and the asset account Supplies is understated 1,000. Thus, Pioneer makes the following adjusting entry.

After the company posts the adjusting entry, the accounts show:

Illustration 3A-1 Prepaid expenses accounts after adjustment

After adjustment, the asset account Supplies shows a balance of 1,000, which is equal to the cost of supplies on hand at October 31. In addition, Supplies Expense shows a balance of 1,500. This is equal to the cost of supplies used between October 5 and October 31. Without the adjusting entry expenses are overstated and net income is understated by 1,000 in the October income statement. Also, both assets and equity are understated by 1,000 on the October 31 statement of financial position.

Illustration 3A-2 compares the entries and accounts for advertising supplies in the two adjustment approaches.

Illustration 3A-2 Adjustment approaches—a comparison

After Pioneer posts the entries, the accounts appear as follows.

Illustration 3A-3 Comparison of accounts

Note that the account balances under each alternative are the same at October 31: Supplies 1,000 and Supplies Expense 1,500.

Unearned Revenues

Unearned revenues are recognized as revenue at the time services are performed. Similar to the case for prepaid expenses, companies may credit (increase) a revenue account when they receive cash for future services.

To illustrate, assume that Pioneer Advertising Agency Inc. received 1,200 for future services on October 2. Pioneer expects to perform the services before October 31.² In such a case, the company credits Service Revenue. If Pioneer in fact performs the service before October 31, no adjustment is needed.

However, if at the statement date Pioneer has not performed 800 of the services, it would make an adjusting entry. Without the entry, the revenue account Service Revenue is overstated 800, and the liability account Unearned Service Revenue is understated 800. Thus, Pioneer makes the following adjusting entry.

After Pioneer posts the adjusting entry, the accounts show:

Illustration 3A-4 Unearned service revenue accounts after adjustment

The liability account Unearned Service Revenue shows a balance of 800. This equals the services that will be performed in the future. In addition, the balance in Service Revenue equals the services performed in October. Without the adjusting entry, both revenues and net income are overstated by 800 in the October income statement. Also, liabilities are understated by 800, and equity is overstated by 800 on the October 31 statement of financial position.

Illustration 3A-5 compares the entries and accounts for initially recording unearned service revenue in (1) a liability account or (2) a revenue account.

Illustration 3A-5 Adjustment approaches—a comparison

After Pioneer posts the entries, the accounts appear as follows.

Illustration 3A-6 Comparison of accounts

Note that the balances in the accounts are the same under the two alternatives: Unearned Service Revenue 800 and Service Revenue 400.

Summary of Additional Adjustment Relationships

Illustration 3A-7 provides a summary of basic relationships for deferrals.

Illustration 3A-7 Summary of basic relationships for deferrals.

Alternative adjusting entries do not apply to accrued revenues and accrued expenses because no entries occur before companies make these types of adjusting entries.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 3A

8 Prepare adjusting entries for the alternative treatment of deferrals. Companies may initially debit prepayments to an expense account. Likewise, they may credit unearned revenues to a revenue account. At the end of the period, these accounts may be overstated. The adjusting entries for prepaid expenses include a debit to an asset account and a credit to an expense account. Adjusting entries for unearned revenues include a debit to a revenue account and a credit to a liability account.

APPENDIX 3B CONCEPTS IN ACTION

This appendix provides a summary of the concepts in action used in this textbook. In addition, it provides other useful concepts which accountants use as a basis for recording and reporting financial information.

Qualities of Useful Information

Recently, the IASB and FASB completed the first phase of a joint project in which they developed a conceptual framework to serve as the basis for future accounting standards. The framework begins by stating that the primary objective of financial reporting is to provide financial information that is useful to investors and creditors for making decisions about providing capital. According to the IASB, useful information should possess two fundamental qualities, relevance and faithful representation, as shown in Illustration 3B-1.

Illustration 3B-1 Fundamental qualities of useful information

ENHANCING QUALITIES

In addition to the two fundamental qualities, the IASB and FASB also describe a number of enhancing qualities of useful information. These include comparability, consistency, verifiability, timeliness, and understandability. In accounting, comparability results when different companies use the same accounting principles. Another characteristic that enhances comparability is consistency. Consistency means that a company uses the same accounting principles and methods from year to year. Information is verifiable if independent measures, using the same methods, obtain similar results. For accounting information to have relevance, it must be timely. That is, it must be available to decision-makers before it loses its capacity to influence decisions. For example, public companies like Google (USA) or Best Buy (USA) must provide their annual reports to investors within 60 days of their year-end. Information has the quality of understandability if it is presented in a clear and concise fashion, so that reasonably informed users of that information can interpret it and comprehend its meaning.

Assumptions in Financial Reporting

To develop accounting standards, the IASB relies on some key assumptions, as shown in Illustration 3B-2. These include assumptions about the monetary unit, economic entity, time period, and going concern.

Illustration 3B-2 Key assumptions in financial reporting

Principles in Financial Reporting

MEASUREMENT PRINCIPLES

IFRS generally uses one of two measurement principles, the historical cost principle or the fair value principle. Selection of which principle to follow generally relates to trade-offs between relevance and faithful representation.

HISTORICAL COST PRINCIPLE The historical cost principle (or cost principle, discussed in Chapter 1) dictates that companies record assets at their cost. This is true not only at the time the asset is purchased but also over the time the asset is held. For example, if land that was purchased for $30,000 increases in value to $40,000, it continues to be reported at $30,000.

FAIR VALUE PRINCIPLE The fair value principle (discussed in Chapter 1) indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain types of assets and liabilities. For example, certain investment securities are reported at fair value because market price information is often readily available for these types of assets. In choosing between cost and fair value, two qualities that make accounting information useful for decision-making are used—relevance and faithful representation. In determining which measurement principle to use, the factual nature of cost figures are weighed versus the relevance of fair value. In general, most assets follow the historical cost principle because market values are representationally faithful. Only in situations where assets are actively traded, such as investment securities, is the fair value principle applied.

REVENUE RECOGNITION PRINCIPLE

The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. As discussed in Chapter 3, in a service company, revenue is recognized at the time the service is performed. In a merchandising company, the performance obligation is generally satisfied when the goods transfer from the seller to the buyer (discussed in Chapter 4). At this point, the sales transaction is complete and the sales price established.

EXPENSE RECOGNITION PRINCIPLE

The expense recognition principle (often referred to as the matching principle, discussed in Chapter 3) dictates that efforts (expenses) be matched with results (revenues). Thus, expenses follow revenues.

FULL DISCLOSURE PRINCIPLE

The full disclosure principle (discussed in Chapter 11) requires that companies disclose all circumstances and events that would make a difference to financial statement users. If an important item cannot reasonably be reported directly in one of the four types of financial statements, then it should be discussed in notes that accompany the statements.

Cost Constraint

The cost constraint relates to the fact that providing information is costly. In deciding whether companies should be required to provide a certain type of information, accounting standard-setters weigh the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 3B

9 Discuss financial reporting concepts. To be judged useful, information should have the primary characteristics of relevance and faithful representation. In addition, it should be comparable, consistent, verifiable, timely, and understandable.

The monetary unit assumption requires that companies include in the accounting records only transaction data that can be expressed in terms of money. The economic entity assumption states that economic events can be identified with a particular unit of accountability. The time period assumption states that the economic life of a business can be divided into artificial time periods and that meaningful accounting reports can be prepared for each period. The going concern assumption states that the company will continue in operation long enough to carry out its existing objectives and commitments.

The historical cost principle states that companies should record assets at their cost. The fair value principle indicates that assets and liabilities should be reported at fair value. The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. The expense recognition principle dictates that efforts (expenses) be matched with results (revenues). The full disclosure principle requires that companies disclose circumstances and events that matter to financial statement users.

The cost constraint weighs the cost that companies incur to provide a type of information against its benefits to financial statement users.

GLOSSARY FOR APPENDIX 3B

Comparability Ability to compare the accounting information of different companies because they use the same accounting principles. (p. 126).

Consistency Use of the same accounting principles and methods from year to year within a company. (p. 126).

Cost constraint Constraint of determining whether the cost that companies will incur to provide the information will outweigh the benefit that financial statement users will gain from having the information available. (p. 128).

Economic entity assumption An assumption that every economic entity can be separately identified and accounted for. (p. 127).

Expense recognition principle Efforts (expenses) should be matched with results (revenues). (p. 128).

Fair value principle Assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability). (p. 128).

Faithful representation Information that accurately depicts what really happened. (p. 126).

Full disclosure principle Accounting principle that dictates that companies disclose circumstances and events that make a difference to financial statement users. (p. 128).

Going concern assumption The assumption that the company will continue in operation for the foreseeable future. (p. 127).

Historical cost principle An accounting principle that states that companies should record assets at their cost. (p. 127).

Materiality A company-specific aspect of relevance. An item is material when its size makes it likely to influence the decision of an investor or creditor. (p. 127).

Monetary unit assumption An assumption that requires that only those things that can be expressed in money are included in the accounting records. (p. 127).

Relevance The quality of information that indicates the information makes a difference in a decision. (p. 126).

Revenue recognition principle Companies recognize revenue in the accounting period in which the performance obligation is satisfied. (p. 128).

Timely Information that is available to decision-makers before it loses its capacity to influence decisions. (p. 126).

Time period assumption An assumption that the life of a business can be divided into artificial time periods and that useful reports covering those periods can be prepared for the business. (p. 127).

Understandability Information presented in a clear and concise fashion so that users can interpret it and comprehend its meaning. (p. 126).

Verifiable The quality of information that occurs when independent measures, using the same methods, obtain similar results. (p. 126).