Chapter 6: Adjusting The Accounts - Incomplete

Question 1

Timing issues.

Answer 1

No adjustments would be necessary if we could wait to prepare financial statements only when a business ended its operations.

At that point, we could easily determine its final statement of financial position and the amount of lifetime profit it generated.

Question 2

What is the time period assumption?

Answer 2

All entities find it desirable and necessary to report the results of their activities more frequently. Eg. management usually wants monthly financial statements, and the taxation authorities require all companies 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.

Question 3

How do many business transactions affect more than one arbitrary time period?

Answer 3

Many business transactions affect more than one of these arbitrary time periods because they often still in use a while after they are first purchased.

Eg. the refrigerators bought by the delicatessen owner in 2006 and the aeroplanes purchased by Qantas a number of years ago are still in use today.

Therefore, we must determine the relevance of each business transaction to specific accounting periods. Doing so may involve judgements and estimates.

Question 4

What are interim periods?

Answer 4

Both small and large entities prepare financial statements periodically in order to assess their financial condition and results of operations.

Accounting time periods are generally a month, a quarter, semi-annual or a year. Monthly and quarterly time periods are called interim periods.

Most large companies are required to prepare either quarterly or semi-annual financial statements in addition to annual financial statements.

Question 5

What does the annual reporting period usually coincide with?

Answer 5

The financial year (1 July to 30 June) or the calendar year (1 January to 31 December).

Question 6

What are the two principles accountants have developed to help determine revenue and expenses?

Answer 6

The revenue and expense recognition principles.

Question 7

Explain the revenue recognition principle.

Answer 7

The revenue recognition principle dictates that revenue be recognised in the accounting period when an increase in future economic benefits has occurred (e.g. the revenue is earned).

In a service entity, revenue is considered to be earned at the time the service is performed.

Accountants have traditionally followed the approach of ‘let expenses follow revenue’. That is, expense recognition is tied to revenue recognition.

This approach means that, for example, any salary expense incurred in performing a cleaning service on 30 June should be reported in the statement of profit or loss for the same period in which the service revenue is recognised.

Question 8

Explain the expense recognition principle.

Answer 8

The expense recognition principle dictates that expenses be recognised in the accounting period when a decrease in a future economic benefit has accrued (i.e. the expense is incurred).

This may or may not be the same period in which the expense is paid. If the salary incurred on 30 June is not paid until July, the dry cleaner would report salaries payable on its 30 June statement of financial position.

Once the economic life of a business has been divided into artificial time periods, the revenue and expense recognition principles can be applied. These assumptions and principles provide guidelines as to when revenue and expenses should be reported.

Question 9

Explain the relationship between revenue and expense recognition.

Answer 9

Time period assumption (Economic life of business can be divided into artificial time periods). ⬇️
⬇️ ⬇️
Revenue recognition principle ⬇️
(Revenue recognised in the ⬇️
accounting period in which it ⬇️
is earned). ⬇️
⬆️ ⬇️️
Expense recognition principle (Expenses recognised in the accounting period when incurred).

Question 10

Why are adjusting entries needed?

Answer 10

In order for revenue to be recorded in the period in which it is earned, and for expenses to be recognised in the period in which they are incurred, adjusting entries are made at the end of the accounting period.

In short, adjusting entries are needed to ensure that the revenue and expense recognition principles are followed.

Adjusting entries make it possible to report on the statement of financial position the appropriate assets, liabilities and owner’s equity at the statement date and to report on the statement of profit or loss the profit (or loss) for the period.

Adjusting entries are required every time financial statements are prepared.

Question 11

What happens if adjusting entries are not made?

Answer 11

If adjusting entries are not made, the profit for the period will be incorrectly reported, as will the assets and liabilities on the statement of financial position. Failing to make adjusting entries will over or underestimate the elements in the financial statements. The trial balance — the first pulling together of the transaction data — may not contain up-to- date and complete data.

Question 12

Reasons for the faults caused by failing to make adjusting entires.

Answer 12

1. Some events are not journalised daily because it is too time consuming. Examples are the consumption of supplies and the earning of wages by employees.
2. Some costs are not journalised during the accounting period because they expire with the passage of time rather than through recurring daily transactions. Examples are equipment deterioration, and rent and insurance.
3. Some items may be unrecorded. An example is a utility service bill (e.g. telephone, gas, electricity) that will not be received and therefore paid until the next accounting period.

Question 13

What is the starting point of adjusting entries?

Answer 13

The starting point is an analysis of each account in the trial balance to determine whether it is complete and up-to-date.

The analysis requires a thorough understanding of the business’s operations and the interrelationship of accounts. Preparing adjusting entries is often an involved process.

The business may need to make inventory counts of supplies and repair parts. It may need to prepare supporting schedules of insurance policies, rental agreements and other contractual commitments.

Adjustments are often prepared after the reporting date. However, the adjusting entries are dated as of the reporting date.

Question 14

What are the types of adjusting entries?

Answer 14

Adjusting entries can be classified as either prepayments or accruals. Each have two subcategories.

Question 15

Explain the following adjusting entry: prepayments.

Answer 15

It’s two subcategories are prepaid expenses and unearned revenue.

1. Prepaid expenses. Expenses paid in cash and recorded as assets before they are used or consumed. They are recorded as assets as they will provide future economic benefits to the business as well as satisfy all the other asset definition criteria.
2. Unearned revenue. Cash received and recorded as liabilities before revenue is earned. It is recorded as liabilities because it will involve the business sacrificing future economic benefits in order to earn the revenue and because it satisfies all the other liability definition criteria.

Question 16

Explain the following adjusting entry: accruals.

Answer 16

It’s two subcategories are accrued revenue and accrued expenses.

1. Accrued revenue. Revenue earned but not yet received in cash or recorded. It is recorded as assets because it will provide future economic benefits to the business and satisfy all the other asset definition criteria.
2. Accrued expenses. Expenses incurred but not yet paid in cash or recorded. They are recorded as liabilities because they will involve the business sacrificing future economic benefits and because they satisfy all the other liability definition criteria.

Question 17

Adjusting entries for prepayments.

Answer 17

As indicated earlier, prepayments are either prepaid expenses or unearned revenue.

Adjusting entries for prepayments are required to record the portion of the prepayment that represents the expense incurred or the revenue earned in the current accounting period.

If an adjustment is needed for prepayments, the asset and liability are overstated and the related expense and revenue are understated before the adjustment.

Question 18

What are prepaid expenses?

Answer 18

Expenses paid in cash and recorded as assets before they are used or consumed are called prepaid expenses or prepayments.

That is, when the business pays insurance 12 months in advance, the accounting entry is debit (increase) Prepaid Insurance and credit Bank.

When a cost is prepaid, an asset account is debited (increased) to show the service or benefit that will be received in the future.

Question 19

When do prepayments often occur?

Answer 19

Prepayments often occur in regard to insurance, supplies, advertising and rent. It can be argued that another form of prepayment is made when buildings and equipment are purchased.

Question 20

What is important to remember about debits and credits?

Answer 20

Remember that credits decrease assets and increase revenue.

Debits increase expenses and decrease liabilities.

Question 21

When do prepaid expenses expire?

Answer 21

Prepaid expenses expire either with the passage of time (e.g. rent and insurance) or through use and consumption (e.g. supplies).

The expiration of these costs does not require daily journal entries, which would be unnecessary and impractical. Instead, it is customary to postpone recognising cost expirations until financial statements are prepared.

At each statement date, adjusting entries are made for two purposes.

Question 22

At each statement date, what are the two purposes for adjusting entries?

Answer 22

(1) to record the expenses that apply to the current accounting period and
(2) to show the unexpired costs in the asset accounts.

Prior to adjustment, assets are overstated and expenses are understated. Therefore, an adjusting entry for prepaid expense results in an increase (debit) to an expense account and a decrease (credit) to an asset account.

Question 23

Adjusting entries for prepayments: insurance.

Answer 23

Most businesses have fire and theft insurance on inventory and equipment, personal liability insurance for accidents suffered by customers and car insurance on cars and trucks owned by the business.

The cost of insurance protection is determined by the payment of insurance premiums. The minimum term of coverage is usually 1 year, but 3- to 5-year terms are available and offer lower annual premiums.

Question 24

Where are insurance premiums usually charged?

Answer 24

Insurance premiums normally are charged to the asset account Prepaid Insurance when paid. At the financial statement date it is necessary to debit (increase) Insurance Expense and credit (decrease) Prepaid Insurance for the cost that has expired during the period.

Question 25

Insurance: What would the accounting entry be if on 4 October, Karima’s Beauty Business paid $600 for a 1-year fire insurance policy?

Answer 25

. Prepaid insurance = increased assets (debit)
. Decreased cash = decreased assets (credit)

Entry: Oct 4 on far left column
Prepaid insurance (Dr) 600
Cash (Cr) 600
(To record prepaid insurance)

Question 26

Insurance: The effective commencement date of coverage was 1 October. The premium was charged to Prepaid Insurance when it was paid, and this account shows a balance of $600 in the 31 October trial balance. Analysis reveals that $50 ($600 ➗ 12) of insurance expires each month. What is the adjusting entry made?

Answer 26

Insurance expense (Dr) 600
   Prepaid expense (Cr) 6000
      (To record insurance expired)

After the adjusting entry is posted, the accounts show:

       Prepaid insurance  4/10               600 |31/10 Adj.      50| ————————|——————— 31/10 Bal.     550  |                          |

     Insurance expense  31/10 Adj.      50   |                          |

Question 27

Adjusting entries for prepayments: supplies.

Answer 27

Businesses use various types of supplies.

Eg. An accounting firm will have office supplies such as stationery, envelopes and accounting paper. An advertising firm will have advertising supplies such as graph paper, video film and poster paper.

Supplies can be debited to an asset account when they are acquired. In the course of operations, supplies are depleted, but recognition of supplies used is deferred until the adjustment process.

At that point, a physical inventory (count) of supplies is taken. The difference between the balance in the Supplies (asset) account and the cost of supplies on hand represents the supplies used (expense) for the period.

Question 28

Supplies: Assume that Karima’s Beauty Business purchased stationery supplies costing $500 on 5 October on credit. In order to recognise the asset Stationary Supplies, what accounting entry is made?

Answer 28

. Increased stationary supplies = increased assets (debit)
. Increased accounts payable = increase liability (credit)

Oct. 5 (left column)
Stationary supplies (Dr) 500
Accounts payable (Cr) 500
(Purchase supplies on credit)

Question 29

Supplies: The account shows a balance of $500 in the 31 October trial balance. An inventory count at the close of business on 31 October reveals that $200 of supplies are still on hand. Thus, the cost of supplies used is $300 ($500 - $200), what adjustments are made?

Answer 29

. Stationary supplies expense = decreased OE (debit)
. Stationary supplies = decreased assets (credit)

Oct. 31
Stationary supplies expense (Dr) 300
Stationary supplies (Cr) 300
(To record supplies used)

Question 30

Adjusting entries for prepayments: depreciation.

Answer 30

A business typically owns productive facilities such as buildings, plant and equipment and vehicles. Because these assets provide service for a number of years, each is recorded as an asset, rather than an expense, in the year it is acquired.

Such assets are recorded at cost, as required by the cost principle. The term of service is referred to as the useful life of the asset to the entity.

Question 31

What is depreciation?

Answer 31

Given that the economic benefits associated with long-lived assets are consumed over their useful lives, a portion of the cost of a long-lived asset should be reported as an expense during each period of the asset’s useful life.

Depreciation is the allocation of the cost of an asset to expense over its useful life in a rational and systematic manner.

Question 32

Need for depreciation adjustment.

Answer 32

From an accounting stand point, acquiring productive facilities is viewed essentially as a long-term prepayment for services.

The need for periodic adjusting entries for depreciation is, therefore, the same as that for other prepaid expenses: to recognise the cost that has expired (expense) during the period and to report the unexpired cost (asset) at the end of the period.

At the time an asset is acquired, its useful life cannot be known with certainty. Thus, you should recognise that depreciation is an estimate rather than a factual measurement of the cost that has expired.

Question 33

Why can the useful life of an asset not be known with certainty?

Answer 33

At the time an asset is acquired, its useful life cannot be known with certainty. This is because an asset may be useful for a longer or shorter time than expected, depending on such factors as actual use, deterioration due to the elements or obsolescence.

Question 34

What do the charging amounts of depreciation involve?

Answer 34

The charging of amounts for depreciation involves some type of reliable estimation. This estimation is provided by professional accountants.

It is one way that indicates that the role of the accountant is much more than a bookkeeper. Estimations should be based on some prior data that the accountant would use to make their professional judgement.

A common procedure in calculating depreciation expense is to divide the cost of the asset by its useful life. For example, if cost is $10 000 and useful life is expected to be 10 years, annual depreciation is $1000.

Question 35

Depreciation: For Karima’s Beauty Business, assume the office equipment was purchased on 2 October at a price of $5800. What is the accounting entry?

Answer 35

. Office equipment = increase in assets (debit)
. Decrease in cash = decrease in assets (credit)

Entry:
Oct. 2
Office equipment (Dr) 5800
    Cash (Cr) 5800
        (To record the purchase of office equipment)

Question 36

Depreciation: The useful life of the office equipment (bought for $5800) was estimated to be 10 years, at which time the residual value would be an estimated $1000. What would the formula for the annual depreciation charged look like?

Answer 36

(Cost - Residual Value) ➗ Useful Life = Annual Depreciation

($5800 - $1000) ➗ 10 = $480 per year

$480 ➗ 12 = $40 per month

Question 37

What is straight-line depreciation?

Answer 37

This is common procedure in calculating depreciation expense which involves dividing the cost of the asset by its useful life.

This method of calculating depreciation expense is called straight-line, because the same amount is depreciated every year (or part thereof).

(Cost - Residual Value) ➗ Useful Life = Annual Depreciation

Question 38

Adjusting entries for prepayments: statement presentation.

Answer 38

Accumulated Depreciation — Office Equipment is a contra asset account.

A contra asset account is one that is offset against an asset account on the statement of financial position. This accumulated depreciation account appears just after Office Equipment on the statement of financial position. Its normal balance is a credit. An alternative would be to credit (decrease) Office Equipment directly for the depreciation each month. But use of the contra account provides disclosure of both the original cost of the equipment and the total cost that has expired to date. In the statement of financial position, Accumulated Deprecia- tion — Office Equipment is deducted from the related asset account as follows