Accounting: The Language of Business - Vol. 2 (Intermediate: Part 29)

The great myth is the manager as orchestra conductor. It's this idea of standing on a pedestal and you wave your baton and accounting comes in, and you wave it somewhere else and marketing chimes in with accounting, and they all sound very glorious. But management is more like orchestra conducting during rehearsals, when everything is going wrong.

Henry Mintzberg

Review of the Accounting Cycle (Part F)

by

Charles Lamson

Step 5: Prepare Adjusting Journal Entries

The unadjusted trial balance (from part 28) may not reflect all of a company's events and transactions because the adjusting journal entries have not been made. Adjusting journal entries are entries made to ensure that all revenues are recognized in the period when control of a good or service has passed to the customer, and all expenses are recognized in the period incurred. Adjusting journal entries are necessary because generally accepted accounting principles (GAAP or U.S. GAAP) require that financial information be reported using the accrual basis of accounting. The company prepares the adjusted trial balance after making all adjusting journal entries and posting these entries to the ledger accounts at the end of the reporting period. The adjusted trial balance is the listing of all accounts and their ending debit or credit balances after making the adjusting journal entries.

Cash versus Accrual Bases of Accounting

The cash basis of accounting is not acceptable for financial reporting under U.S. GAAP. Under the cash basis, companies recognize revenues only when cash is received and expenses only when cash is paid. This approach of revenue and expense recognition measures only cash receipts and disbursements but does not accurately measure the economic activity underlying cash receipts and payments.

Under the accrual basis, companies recognize revenues when control of a good or service has passed to the customer, regardless of when cash is received. Expenses are recognized when incurred, regardless of when cash is paid. Because U.S. GAAP requires the preparation of financial statements under the accrual basis and companies present these financial statements throughout the life of the firm, adjusting journal entries are needed at the end of each reporting period. Companies record adjusting journal entries (AJEs) to ensure that all economic events are properly reflected in the financial statements. Every AJE will impact one balance sheet account and one income statement account.

Adjusting journal entries involve accounting for both deferrals and accruals.

Deferrals

Deferrals occur when a company receives or pays cash before recognizing the revenue or expense in the financial statements. AJEs are required for both deferred expenses and deferred revenues.

Deferred Expenses. A differed expense occurs when a company makes a cash payment before incurring an expense under accrual basis accounting. For example, paying rent on the first of the year for occupancy of a building during that year creates a deferred expense. The cash payment occurs on the first day of the year, but the expense is incurred ratably over the year. Thus, the company should not record the full amount of the expense until the end of the year. Deferred expenses are also referred to as prepaid expenses.

Companies record deferred expenses as assets until they are used or consumed in operations. Therefore, an adjusting journal entry for deferred expenses will cause a change in both an asset and an expense account as the asset is derecognized and the expense is recognized. Examples of deferred expenses include prepaid rent, prepaid insurance, supplies, and depreciation. Exhibit 4.10 illustrates this asset expense relationship.

EXHIBIT 4.10 Deferred Expenses

If the company does not adjust the prepaid expense, it will overstate assets and understate expenses. The adjusting journal entry results in a debit to an expense account and a credit to an asset account. It may be the case that the company initially records the cash payment as an expense, a scenario we will discuss in an upcoming post.

Depreciation and amortization are other types of deferred expenses. Depreciation is the systematic and rational allocation of the cost of a long-term operating asset to expense over the asset's expected useful life. Amortization is the systematic and rational allocation of the cost of an intangible asset to expense over the asset's expected useful life.

When a company purchases a long-term operating asset, it records the asset with a debit. As the company uses the asset over time, the company reports an expense on the income statement, debiting expense. It also reduces the carrying value (the cost of an asset less accumulated depreciation) of the asset by the same amount. In the case of depreciation, the credit to reduce the value of the asset is to an account referred to as accumulated depreciation. Accumulated depreciation is a contra-asset account, which is an asset account that has a normal credit balance. The contra-asset accumulated depreciation directly offsets the asset account, and the net value of the two accounts is the asset's net carrying value. In the case of amortization the company may credit an accumulated amortization account or the intangible asset account directly. We will discuss depreciation and amortization in more depth in a later post.

Example 4.5 Deferred Expenses

PROBLEM: Plush Service Corporation paid $72,000 for a three year insurance policy on July 10 with coverage beginning on August 1. As we saw in Example 4.2 from part 26, on the date it purchased the insurance. Plush made the following journal entry:

Before we discuss what adjusting journal entry is needed on December 31, recall from part 27 that typically, the formal general ledger accounts are not used when presenting illustrations in this volume. Rather, a simplified version of the ledger accounts is used, known as T-accounts with three major parts:

1. The account title,

2. A left (debit) side, and

3. A right (credit) side.

Exhibit 4.9 (from part 27 and reintroduced below) presents a sample t-account.

We will use the t-account rather than formal general ledger accounts for the next several posts.

EXHIBIT 4.9 T-Account 

So, bearing all that in mind, what adjusting journal entry is needed on December 31? Prepare the t-accounts for prepaid insurance and insurance expense both before and after the adjusting journal entry.

SOLUTION: The t-accounts for the prepaid insurance and insurance expense accounts would appear as follows on December 31 before Plush records the adjusting journal entry and posts to the t-accounts.

On December 31, insurance expense is understated because Plush has received five months' insurance coverage and that portion of the coverage has expired. Prepaid insurance is overstated because there are only 31 of the 36 months of prepaid Insurance remaining. In order to add just the prepaid Insurance account, Plush must prepare the following adjusting journal entry:

After Plush posts the adjusting journal entry, the t-accounts will reflect the correct balances of the asset and the expense:

Example 4.6 illustrates recording depreciation expense.

SAMPLE 4.6 Depreciation Expense

PROBLEM: Plush Service Corporation depreciates its store equipment at a rate of $8,000 per year. Provide the adjusting journal entry to record depreciation for the current year.

SOLUTION: Plush debits an expense account and credits accumulated depreciation for $8,000.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 106-108*

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