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*

end