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Accounting: The Language of Business (Part 17)

“Each generation makes it’s own accounting to its children.” —Unknown

Completing the Accounting Cycle (Part A)

by

Charles Lamson 

Most of us have had to file a personal tax return. At the beginning of the year, you estimate your upcoming income and decide whether you need to increase your payroll tax withholdings or perhaps pay estimated taxes. During the year, you earn income, make investments, and enter into other tax-related transactions, such as making charitable contributions. At the end of the year, your employer sends you a tax withholding information form (W-2 form), and you collect the tax records needed for completing your yearly tax forms. If any tax is owed, you pay it; if you overpaid your taxes, you file for a refund. As the next year begins, you start the cycle all over again.

Businesses also go through a cycle of activities. At the beginning of the cycle, management plans where it wants the business to go and begins the necessary actions to achieve its operating goals. Throughout the cycle, which is normally 1 year, the accountant records the operating activities (transactions) of the business. At the end of the cycle, the accountant prepares financial statements that summarize the operating activities for the year. The accountant then prepares the accounts for recording the operating activities in the next cycle.

As we saw in part 7, the initial cycle for NetSolutions began with Chris Clark's investment in the business on November 1, 2022. The cycle continued with recording Netsolutions' transactions for November and December, as we discussed in the posts that followed. In the preceding posts, just prior to this one, the cycle continued and we recorded the adjusting entries for the two months ending December 31, 2022. In the next several posts, we discuss the flow of the adjustment data into the accounts and into the financial statements.

Accounting Cycle

The accounting process that begins with analyzing and journalizing transactions and ends with summarizing and reporting these transactions is called the accounting cycle. The most important output of this cycle is the financial statements.

In earlier posts, we described and illustrated the analysis and recording of transactions, posting to the ledger, preparing a trial balance, analyzing adjustment data, preparing adjusting entries, and preparing financial statements. In the next several posts, we complete our discussion of the accounting cycle by describing how work sheets may be used as an aid in preparing the financial statements. We also describe and illustrate how closing entries and a post-closing trial balance are used in preparing the accounting records for the next period.

Work Sheet

Accountants often use working papers for collecting and summarizing data they need for preparing various analyses and reports. Such working papers are useful tools, but they are not considered a part of the formal accounting records. This is in contrast to the chart of accounts, the journal, and the ledger, which are essential parts of the accounting system. Working papers are usually prepared by using a spreadsheet program on a computer.

The work sheet is a working paper that accountants can you use to summarize adjusting entries and the account balances for the financial statements. In small companies with few accounts and adjustments, a work sheet may not be necessary. In a computerized accounting system, a work sheet may not be necessary because the software program automatically posts entries to the accounts and prepares financial statements.

The work sheet (Exhibits 2 through 5) is a useful device for understanding the flow of the accounting data from the unadjusted trial balance to the financial statements (covered in the next post). This flow of data is the same in either a manual or a computerized accounting system.

Unadjusted Trial Balance Columns

To begin the work sheet, list at the top the name of the business, the type of working paper (work sheet), and the period of time, as shown in Exhibit 2. Next, enter the unadjusted trial balance directly on the work sheet. The work sheet in Exhibit 2 shows the unadjusted trial balance for NetSolutions at December 31, 2022.

EXHIBIT 2

Adjustments Columns

The adjustments that we explained and illustrated for NetSolutions in preceding posts are entered in the adjustments columns as shown in Exhibit 3. Cross-referencing (by letters) the debit and credit of each adjustment is useful in reviewing the worksheet. It is also helpful for identifying the adjusting entries that need to be recorded in the journal.

EXHIBIT 3

The order in which the adjustments are entered on the worksheet is not important. Most accountants enter the adjustments in the order in which the data are assembled. If the titles of some of the accounts to be adjusted do not appear in the trial balance, they should be inserted in the Account Title column, below the trial balance totals, as needed.

To review, the entries in the Adjustment columns of the worksheet are: 

1. Supplies. The supplies account has a debit balance of $2,000. The cost of the supplies on hand at the end of the period is $760. Therefore, the supplies expense for December is the difference between the two amounts, or $1,240. Enter the adjustment by writing (1) $1,240 in the Adjustments Debit column on the same line as Supplies Expense and (2) $1,240 in the Adjustments Credit column on the same line as Supplies.

2.  Prepaid Insurance. The prepaid insurance account has a debit balance of $2,400, which represents the prepayment insurance for 24 months beginning December 1. Thus, the insurance expense for December is $100 ($2,400/24). Enter the adjustment by writing (1) $100 in the Adjustments Debit column on the same line as Insurance Expense and (2) $100 in the Adjustments Credit column on the same line as Prepaid Insurance.

3. Unearned Rent. The unearned rent account has a credit balance of $360, which represents the receipt of 3 months' rent, beginning with December. Thus, the rent revenue for December is $120. Enter the adjustment by writing (1) $120 in the Adjustments Debit column on the same line as Unearned Rent and (2) $120 is in the Adjustments Credit column on the same line as Rent Revenue.

4.  Wages. Wages accrued but not paid at the end of December total $250. This amount is an increase in expenses and an increase in liabilities. Enter the adjustment by writing (1) $250 in the Adjustments Debit column on the same line as Wages Expense and (2) $250 in the Adjustments Credit column on the same line as Wages Payable.

5.  Accrued Fees. Fees accrued at the end of December but not recorded total $500. This amount is an increase in an asset and an increase in revenue. Enter the adjustment by writing (1) $500 in the Adjustments Debit column on the same line as Accounts Receivable and (2) $500 in the Adjustments Credit column on the same line as Fees Earned.

6.  Depreciation. Depreciation of the office equipment is $50 for December. enter the adjustment by writing (1) $50 in the Adjustments Debit column on the same line as Depreciation Expense and (2) $50 in the Adjustments Credit column on the same line as Accumulated Depreciation.

Total the Adjustments columns to verify the mathematical accuracy of the adjustment data. The total of the debit column must equal the total of the credit column. 

Adjusted Trial Balance Columns

The adjustment data are added to or subtracted from the amounts in the unadjusted Trial Balance columns. The adjusted amounts are then extended to (placed in) the Adjusted Trial Balance columns, as shown in Exhibit 3. For example, the cash amount of $2,065 is extended to the Adjusted Trial Balance Debit column, since no adjustments affected Cash. Accounts Receivable has an initial balance of $2,220 and a debit adjustment (increase) of $500. The amount to write in the Adjusted Trial Balance Debit column is the debit balance of $2,720. The same procedure continues until all account balances are extended to the Adjusted Trial Balance columns. Total the columns of the Adjusted Trial Balance to verify the equality of debits and credits.

Income Statement and Balance Sheet Columns

The work sheet is completed by extending the adjusted trial balance amounts to the Income Statement and Balance Sheet columns. The amounts for revenues and expenses are extended to the Income Statement columns. The amounts for assets, liabilities, owner's capital, and drawing are extended to the Balance Sheet columns.

In the NetSolutions' work sheet, the first account listed is Cash, and the balance appearing in the Adjusted Trial Balance Debit columns is $2,065. Cash is an asset, is listed on the balance sheet, and has a debit balance. Therefore, $2,065 is extended to the Balance Sheet Debit column. The Fees Earned balance of $16,840 is extended to the Income Statement Credit column. The same procedure continues until all account balances have been extended to the proper columns, as shown in Exhibit 4.

EXHIBIT 4

After all of the balances have been extended to the four statement columns, total each of these columns, as shown in Exhibit 5. The difference between the two Income Statement column totals is the amount of the net income or the net loss for the period. Likewise, the difference between the two Balance Sheet column totals is also the amount of the net income or net loss for the period.

EXHIBIT 5

If the Income Statement Credit column total (representing total revenue) is greater than the income statement debit column total (representing total expenses), the difference is the net income. If the income statement debit column total is greater than the income statement credit column total, the difference is a net loss. For NetSolutions, the computation of net income is as follows:

As shown in Exhibit 5, write the amount of the net income, $7,205, in the Income Statement Debit column and the Balance Sheet column. Write the term Net income in the account title column. If there was a net loss instead of net income, you would write the amount in the Income Statement Credit column and the Balance Sheet Debit column and the term Net loss in the Account Title column. Inserting the net income or net loss in the statement columns on the work sheet shows the effect of transferring the net balance of the revenue and expense accounts to the owner's capital account. In a later post, we explain how to journalize this transfer.

After the net income or net loss has been entered on the worksheet, again total each of the four statement columns. The totals of the two Income Statement columns must now be equal. The totals of the two Balance Sheet columns must also be equal. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 140-143*

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Accounting: The Language of Business (Part 16)

“Month end is approaching – Keep calm and carry on accounting.” —Unknown

The Matching Concept and the Adjusting Process (Part E)

by

Charles Lamson

Accrued Revenues (Accrued Assets)

During an accounting period, some revenues are recorded only when cash is received. Thus, at the end of an accounting period, there may be items of revenue that have been earned but have not been recorded. In such cases, the amount of the revenue should be recorded by debiting an asset account and crediting a revenue account.

To illustrate, assume that NetSolutions signed an agreement with Dankner Co. on December 15. The agreement provides that NetSolutions will be on call to answer computer questions and render assistance to Dankner Co. employees. The services provided will be billed to Dankner Co. On the fifteenth of each month at a rate of $20 per hour. As of December 31, NetSolutions had provided 24 hours of assistance to Dankner Co. Although, the revenue of $500 (25 hours * $20) will be billed and collected in January, NetSolutions earned the revenue in December. The adjusting journal entry and T accounts to record the claim against the customer (an account receivable) and the fees earned in December are shown below.

If the adjustment for the accrued asset ($500) is not recorded, fees earned and the net income will be understated by $500 on the income statement. On the balance sheet, Accounts Receivable and Chris Clark, Capital will be understated by $500. The effects of omitting this adjusting entry are shown below.

Fixed Assets

Physical resources that are owned and used by a business and are permanent or have a long life are called fixed assets, or plant assets. In a sense, fixed assets are a type of long-term deferred expense. However, because of their nature and long life, they are discussed separately from other deferred expenses, such as supplies and prepaid insurance.

NetSolutions fixed assets include office equipment that is used much like supplies are used to generate revenue. Unlike supplies, however, there is no visible reduction in the quantity of the equipment. Instead, as time passes, the equipment loses its ability to provide useful services. This decrease in usefulness is called depreciation.

All fixed assets, except land, lose their usefulness. Decreases in the usefulness of assets that are used in generating revenue are recorded as expenses. However, such decreases for fixed assets are difficult to measure. For this reason, a portion of the cost of a fixed asset is recorded as an expense each year of its useful life. This periodic expense is called depreciation expense. Methods of computing depreciation expense are discussed and Illustrated in a later post.

The adjusting entry to record depreciation is similar to the adjusting entry for supplies used. The account debited is a depreciation expense account. However, the asset account Office Equipment is not credited because both the original cost of a fixed asset and the amount of depreciation recorded since its purchase are normally reported on the balance sheet.

Normal titles for fixed asset accounts and their related contra asset accounts are as follows:

The adjusting entry to record depreciation for December for NetSolutions is Illustrated in the following journal entry and T accounts. The estimated amount of depreciation for the month is assumed to be $50.

The $50 increase in the accumulated depreciation account is subtracted from the $1,800, recorded in the related fixed asset account. The difference between the two balances is the $1,750 cost that has not yet been depreciated. This amount ($1,750) is called the book value of the asset (or net book value), which may be presented on the balance sheet in the following manner:

You should know that the market value of a fixed asset usually differs from its book value. This is because depreciation is an allocation method, not a valuation method. That is, depreciation allocates the cost of a fixed asset to expense over its estimated life. Depreciation does not attempt to measure changes in market values, which may vary significantly from year to year.

If the previous adjustment for depreciation ($50) is not recorded, depreciation on the income statement will be understated by $50, and the net income will be overstated by $50. On the balance sheet, the book value of Office Equipment and Chris Clark, Capital will be overstated by $50. The effects of omitting the adjustment for depreciation are shown below.

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 111-113*

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Accounting: The Language of Business (Part 15)

“Creativity is great-but not in accounting.” —Charles Scott

The Matching Concept and the Adjusting Process (Part D)

by

Charles Lamson

Deferred Revenue (Unearned Revenue)

According to NetSolutions' trial balance on December 31, the balance in the unearned rent account is $360. This balance represents the receipt of 3 months' rent on December 1 for December, January, and February. At the end of December, the unearned rent account should be decreased (debited) by $120, and the rent revenue account should be increased (credited) by $120. The $120 represents the rental revenue for one month ($360/3). The adjusting journal entry and T accounts are shown below.

After the adjustment has been recorded and posted, the unearned rent account, which is a liability, has a credit balance of $240. The amount represents a deferral that will become revenue in a future period. The rent revenue account has a balance of $120, which is revenue of the current period.

If the preceding adjustment of unearned rent and rent revenue is not recorded, the financial statements prepared on December 31 will be misstated. On the income statement, Rent Revenue and the net income will be understated by $120. On the balance sheet, Unearned Rent will be overstated by $120, and Chris Clark, Capital will be understated by $120. The effects of omitting this adjusting entry are shown below.

Accrued Expenses (Accrued Liabilities)

Some types of services, such as insurance, are normally paid for before they are used. These prepayments are deferrals. Other types of services are paid for after the service has been performed. For example, wages expense accumulates or accrues hour by hour and day by day, but payment may be made only weekly, biweekly, or monthly. The amount of such an accrued but unpaid item at the end of the accounting period is both an expense and a liability. In the case of wages expense, if the last day of a pay period is not the last day of the accounting period, the accrued wages expense and the related liability must be recorded in the accounts by an adjusting entry. This adjusting entry is necessary so that expenses are properly matched to the period in which they were incurred.

At the end of December accrued wages for NetSolutions were $250. This amount is an additional expense of December and is debited to the wages expense account. It is also a liability as of December 31 and is credited to wages payable. The adjusting journal entry and T accounts are as follows. 

After the adjustment has been recorded and posted, the debit balance of the wages expense account is $4,525, which is the wages expense for the two months, November and December. The credit balance of $250 in Wages Payable is the amount of the liability for wages owed as of December 31.

*WARREN, REEVE, FESS, 2005, ACCOUNTING, 21ST ED., PP. 108-111*

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Accounting: The Language of Business (Part 14)

“To be successful, you should concentrate on the world of companies, not arcane accounting mathematics.” —Warren Buffett

The Matching Concept and the Adjusting Process (Part C)

by

Charles Lamson

Recording Adjusting Entries

The examples of adjusting entries in the following paragraphs are based on the ledger of NetSolutions as reported in the December 31, 2022 real balance in Exhibit 2. The adjusting entries are shown in color in T accounts to separate them from other transactions. An expanded chart of accounts for NetSolutions is shown in Exhibit 3. The additional accounts that will be used in the next few posts are shown in color.

EXHIBIT 2

Deferred Expenses (Prepaid Expenses)

The concept of adjusting the accounting records was introduced in part 10 in the illustration for NetSolutions. In that illustration, supplies were purchased on November 10 (transaction c). The supplies used during November were recorded on November 31 (transaction g).

Entry C

Entry G

The balance in NetSolutions supplies account on December 31 is $2,000. Some of these supplies (paper, envelopes, etc.) were used during December, and some are still on hand (not used). If either amount is known, the other can be determined. It is normally easier to determine the cost of the supplies on hand at the end of the month than it is to keep a daily record of those used. Assuming that on December 31 the amount of supplies on hand is $760, the amount to be transferred from the asset account to the expense account is $1,240 computed as follows:

As we discussed in part 10, increases in expense accounts are recorded as debits and decreases in asset accounts are recorded as credits. Hence, at the end of December, the supplies expense account should be debited for $1,240, and the supplies account should be credited for $1,240 to record the supplies used during December. The adjusting journal entry and T accounts for supplies and supplies expense are as follows:

After the adjustment has been recorded and posted, the supplies account has a debit balance of $760. This balance represents an asset that will become an expense in a future period.

The debit balance of $2,400 in NetSolution's prepaid insurance account represents a December 1 prepayment of insurance for 24 months. At the end of December, the insurance expense account should be increased (debited), and the prepaid insurance account should be decreased (debited), and the prepaid insurance account should be decreased (credited) by $100, the insurance for one month. The adjusting journal entry and T accounts for prepaid insurance and insurance expense are as follows.

After the adjustment has been recorded and posted, the prepaid insurance account has a debit balance of $2,300. this balance represents an asset that will become an expense in future periods. The insurance expense account has a debit balance of $100, which is an expense of the current period.

What is the effect of omitting adjusting entries? If the preceding adjustments for supplies ($1,240) and insurance ($100) are not recorded, the financial statements prepared as of December 31 will be misstated. On the income statement, Supplies Expense and Insurance Expense will be understated by a total of $1,340, and net income will be overstated by $1,340. On the balance sheet, Supplies and Prepaid Insurance will be overstated by a total of $1,340. Since net income increases owner's equity, Chris Clark, Capital will also be overstated by $1,340 on the balance sheet. The effects of omitting these adjusting entries on the income statement and balance sheet are shown below.

Arrow (1) indicates the effect of the understated expenses on assets. Arrow (2) indicates the effect of the overstated net income on owner's equity.

Prepayments of expenses are sometimes made at the beginning of the period in which they will be entirely consumed. On December 1, for example, NetSolutions paid rent of $800 for the month. On December 1, the rent payment represents the asset prepaid rent. The prepaid rent expires daily, and at the end of December, the entire amount has become an expense (rent expense). In cases such as this, the initial payment is recorded as an expense rather than as an asset. Thus, if the payment is recorded as a debit to rent expense, no adjusting entry is needed at the end of the period. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21 ED., PP. 104-107*

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