Chapter 5 Why Is Financial Information Adjusted Prior to the Production of Financial Statements?

Accounting for the Passage of Time

Question: The first two steps of the accounting process were identified in Chapter 4 "How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?" as “analyze” and “record.” A transaction occurs and the resulting financial effects are ascertained through careful analysis. Once determined, the monetary impact on specific accounts is recorded in the form of a journal entry. Each of the debits and credits is then posted to the corresponding T-accounts located in the ledger. As needed, current balances can be determined for any of these accounts by netting the debits and credits. It is a system as old as the painting of the Mona Lisa.

The third step in this process was listed as “adjust.” Why do ledger account balances require adjustment? Why are the T-account totals found in the trial balance at the end of Chapter 4 "How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?" (Figure 4.21 "Lawndale Company Trial Balance (after all journal entries have been posted)—December 31, Year Four") not simply used by the accountant to produce Year Four financial statements for that business (Lawndale Company)?

 

Answer: Financial events take place throughout the year. As indicated, journal entries record the individual debit and credit effects that are then entered into the proper T-accounts. However, not all changes in these balances occur as the result of physical events. Some accounts increase or decrease because of the passage of time. The impact can be so gradual that producing individual journal entries is not reasonable.

For example, salary is earned by employees every day (actually every minute), but payment is not made until the end of the week or month. Many other expenses, such as utilities, rent, and interest, are incurred over time in much the same way. Accounting for supplies such as pens and envelopes is only slightly different. This asset is slowly depleted because of usage rather than time, but the impact on accounts is basically the same. As indicated in Chapter 4 "How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?", unless an accounting system is programmed to record tiny incremental changes, none of these financial effects is captured as they occur.

Following each day of work, few companies take the trouble to record the equivalent amount of salary, rent, or other expense along with the related liability. When a pad of paper is consumed within an organization, debiting supplies expense for a dollar and crediting supplies for the same amount hardly seems worth the effort.

Therefore, prior to producing financial statements, the accountant must search for any such changes that have not yet been recognized. These incremental increases or decreases must also be recorded in a debit and credit format (called adjusting entriesChanges in account balances recorded prior to preparing financial statements to update T-accounts because some amounts have increased or decreased over time but have not been recorded through a journal entry. rather than journal entries) with the impact then posted to the appropriate ledger accounts. The updating process continues until all balances are presented fairly. These adjustments are a prerequisite step in the preparation of financial statements. They are physically identical to the journal entries recorded for transactions, but they occur at a different time and for a different reason.

Examples of Adjusting Entries

Question: Adjusting entries update ledger accounts for any financial changes that occur gradually over time so that they are not recorded through a journal entry. Large companies will make hundreds, if not thousands, of adjustments at the end of each fiscal period. What kinds of adjustments are normally needed before a set of financial statements is prepared?

 

Answer: A variety of adjusting entries will be examined throughout the remainder of this textbook. One of the accountant’s primary responsibilities is the careful study of all financial information to ensure that it is presented fairly before being released. Such investigation can lead to the preparation of numerous adjusting entries. Here, in Chapter 5 "Why Is Financial Information Adjusted Prior to the Production of Financial Statements?", only the following four general types of adjustments are introduced to demonstrate the process and also reflect the importance of the revenue recognition principle and the matching principle. In later chapters, additional examples will be described and analyzed.

• Accrued expenses (also referred to as accrued liabilities)
• Prepaid expenses (including supplies)
• Accrued revenue
• Unearned revenue (also referred to as deferred revenue)

Usually, at the start of the adjustment process, the accountant prepares an updated trial balance to provide a visual, organized representation of all ledger account balances. This listing aids the accountant in spotting figures that might need adjusting in order to be fairly presented. Therefore, Figure 4.21 "Lawndale Company Trial Balance (after all journal entries have been posted)—December 31, Year Four" is replicated here in Figure 5.1 "Updated Trial Balance for the Lawndale Company" because this trial balance holds the December 31, Year Four, account balances for the Lawndale Company determined at the end of Chapter 4 "How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?". All transactions have been recorded and posted, but no adjustments have yet been made.

Adjusting Entry to Recognize an Accrued Expense

Question: The first type of adjustment listed is an accrued expenseExpenses (and related liabilities) that grow gradually over time; if not recognized automatically by the accounting system, the monetary impact is recorded prior to preparing the company’s financial statements by means of an adjusting entry.. Previously, the word “accrue” was defined as “to grow.” Thus, an accrued expense is one that increases gradually over time. As has been indicated, some companies program their accounting systems to record such expenses as incurred. This accrual process eliminates the need for subsequent adjusting entries. Other companies make few, if any, accruals and update all balances through numerous adjustments when financial statements are to be prepared.

The mechanical recording process for such expenses should be designed to meet the informational needs of company officials. Some prefer to have updated balances readily available in the ledger at all times while others are inclined to wait for periodic financial reports to be issued. What are some typical accrued expenses, and what is the appropriate adjusting entry if they are not recorded as incurred by the accounting system?

 

Answer: If a reporting company’s accounting system recognizes an expense as it grows, no adjustment is necessary. The balances are recorded properly. They are ready to be included in financial statements. Thus, when statements are prepared, the accountant only needs to search for accrued expenses that have not yet been recognized.

Numerous expenses get slightly larger each day until paid, including salary, rent, insurance, utilities, interest, advertising, income taxes, and the like. For example, on its December 31, 2010, balance sheet, The Hershey Company reported accrued liabilities of approximately $593 million. In the notes to the financial statements, this amount was explained as debts owed by the company on that day for payroll, compensation and benefits ($219 million), advertising and promotion ($211 million), and other accrued expenses ($163 million).

Assume, for illustration purposes, that the accountant reviews the trial balance presented in Figure 5.1 "Updated Trial Balance for the Lawndale Company" and realizes that utility expenses (such as electricity and water) have not been recorded since the most recent payment early in December of Year Four. Assume that Lawndale Company currently owes $900 for those utilities. The following adjustment is needed before financial statements can be created. It is an adjusting entry because no physical event took place. This liability simply grew over time and has not yet been paid.

Recording and Adjusting Prepaid Expenses

Question: The second adjustment to be considered here involves the handling of prepaid expensesA future economic benefit created when an expense is paid in advance; reported as an asset initially and then gradually reassigned to expense over time through adjusting entries.. For example, as of May 29, 2011, General Mills Inc. reported “prepaid expenses and other current assets” of $483.5 million. A decision maker studying this business needs to understand what information is conveyed by such balances.

In the transactions that were recorded in the previous chapter, Journal Entry 10 reported a $4,000 payment made by the Lawndale Company for four months of rent to use a building. An asset—prepaid rent—was recorded at that time through the normal accounting process. The resulting account is listed on the trial balance in Figure 5.1 "Updated Trial Balance for the Lawndale Company". Such costs are common and often include payments for insurance and supplies.

Assume, at the end of Year Four, the company’s accountant examines the invoice that was paid and determines that this $4,000 in rent covered the period from December 1, Year Four, until March 31, Year Five. As a result, an adjusting entry is now necessary so that all balances are presented fairly. Why is a year-end adjusting entry often needed in connection with a prepaid expense?

 

Answer: During these four months, the Lawndale Company will use the rented facility to help generate revenue. Over that time, the future economic benefit established by the payment gradually becomes a past benefit. The asset literally changes into an expense day by day. In this example, one month of the rent from this payment has now been consumed. The benefit provided by using this building during December to gain revenue no longer exists. That portion of the rent ($1,000 or $4,000/four months) reflects a past benefit and should be reported as an expense in Year Four in accordance with the matching principle. Expenses are recognized in the same period as the revenue they help to generate.

As a preliminary step in preparing financial statements, an adjusting entry is needed to reclassify $1,000 from the asset (prepaid rent) into an expense (rent expense). This adjustment leaves $3,000 in the asset (for the remaining three months of rent on the building) while $1,000 is now reported as an expense (for the previous one month of rent).

Adjusting entries are created to take whatever amounts reside in the ledger and align them with the requirements of U.S. GAAP (or IFRS, if those standards are being applied). For this illustration, the original $4,000 payment was classified as a prepaid rent and the adjustment was created in response to that initial entry. After $1,000 is moved from asset to expense, the balances are presented fairly: an asset of $3,000 for the future benefit and an expense of $1,000 for the past.

In recording transactions, some accounting systems mechanically handle events in a different manner than others. Thus, construction of each adjusting entry depends on the recording that previously took place. To illustrate, assume that when this $4,000 payment was made, the company entered the debit to rent expense rather than prepaid rent. Perhaps an error was made or, more likely, a computerized accounting system was programmed to record all money spent for rent as an expense. For convenience, many companies prefer to automate the recording process wherever possible knowing that adjusting entries can then be made to arrive at proper balances. The initial accounting has no impact on the figures to be reported but does alter the adjustment process.

If a $4,000 expense was recorded here initially rather than a prepayment, an adjusting entry is still needed. The expense appearing on the income statement should be $1,000 (for the past one month) while the appropriate asset on the balance sheet should be $3,000 (for the subsequent three months). If the entire cost of $4,000 is located in rent expense, the following alternative is necessary to arrive at proper balances. This adjustment shifts $3,000 out of the expense and into the asset.

This adjusting entry leaves the appropriate $1,000 in expense and puts $3,000 into the asset account. Those are the proper balances as of the end of the year. Regardless of the account, the accountant first determines the balance that is present in the ledger and then creates the specific adjustment needed to arrive at fairly presented figures.

Recognizing Accrued Revenue

Question: The third general type of adjustment to be covered here is accrued revenue. As the title implies, this revenue is one that grows gradually over time. If not recorded by a company’s accounting system as earned, an adjusting entry to update the balances is necessary before financial statements are prepared. This process mirrors that of accrued expenses. What adjustment is used by a reporting organization to recognize any accrued revenue that has not previously been recorded?

 

Answer: Various types of revenue are earned as time passes rather than through a physical event such as the sale of inventory. To illustrate, assume that a customer visited the Lawndale Company five days before the end of Year Four to ask for assistance. The customer must be away from his ranch for thirty days and wanted company employees to feed, water, and care for his horses during the period of absence. Everything needed for the job is available in the customer’s barn. The Lawndale Company just provides the service. The parties agreed that the company will receive $100 per day for this work with payment to be made upon the person’s return.

No asset changes hands at the start of this task. Thus, the company’s accounting system is not likely to make any entry until payment is eventually received. However, after the first five days of this work, the Lawndale Company is ready to prepare Year Four financial statements. For that reason, the company needs to recognize all revenue earned to date. Service to this customer has been carried out for five days at a rate of $100 per day. The company has performed the work to earn $500 although the money will not be received until later. Consequently, a receivable and revenue for this amount should be recognized through an adjusting entry. The earning process for the $500 occurred in Year Four and should be recorded in this year.

The $500 receivable will be removed in the subsequent period when the customer eventually pays Lawndale for the services rendered. No recognition is needed in this adjusting entry for cost of goods sold because a service, rather than inventory, is being sold.

The Earning Process

Question: As discussed in a previous chapter, the revenue realization principle (within accrual accounting) provides formal guidance for the timing of revenue reporting. It states in part that the earning process must be substantially complete before revenue is recognized. That seems reasonable. In the previous example, the work has been performed for only five days out of a total of thirty. That does not appear to qualify as substantially complete. Is accrued revenue recognized if the earning process is not substantially complete?

 

Answer: This example draws attention to one of the most challenging questions that accountants face in creating a fair portrait of a business. When should revenue be recognized? The revenue realization principle is established by U.S. GAAP, but practical issues remain. For example, when does an earning process become substantially complete? Here, the simplest way to resolve this accounting issue is to consider the nature of the task to be performed by the Lawndale Company.

Is the job of caring for the horses a single task to be carried out by the company over thirty days or is it thirty distinct tasks to be performed each day over this period of time?

If the work is viewed as one large task like painting a house, then the earning process here is only one-sixth of the way finished and not substantially complete. No revenue should be recognized until the remainder of the work has been performed. In that case, the adjusting entry is not warranted.

Conversely, if this assignment is actually thirty separate tasks, then five of them are substantially complete at the end of the year, and revenue of $500 is properly recorded by the previous adjustment. Unfortunately, the distinction is not always clear. Because accounting is conservative, revenue should never be recognized unless evidence predominates that the individual tasks are clearly separate events.

The Revenue Recognition Principle

Question: In practice, how does an accountant determine whether a specific job is substantially complete? Because of the direct impact on net income, this judgment must be critical in financial reporting.

 

Answer: Accountants spend a lot of time searching for credible evidence as to the true nature of the events they encounter and report. Their goal is to ensure that all information included in financial statements is presented fairly according to U.S. GAAP (or IFRS). The timing of revenue recognition can be a special challenge that requires analysis and expertise.

Is a job substantially complete so that revenue should be recognized or not?

That question can often be difficult to answer. Here is one technique that might be applied in analyzing this particular example. Assume that after five days, Lawndale had to quit feeding the customer’s horses for some legitimate reason. Should the company be able to demand and collect $500 for the work done to that point? If so, then those five days are distinct tasks that have been completed. However, if no money would be due based on working just five days, substantial completion has not been achieved by the services performed to date. Thus, revenue recognition would be inappropriate.

In Adjusting Entry 3 (Figure 5.5 "Adjusting Entry 3: Revenue Earned for Work Done"), the assumption is made that the daily tasks are separate and that the company could collect for the work accomplished to date. However, this type of judgment can be extremely difficult in the real world. It is often the product of much thought and discussion. The impact on the financial statements can be material, which increases pressure on the accountant. Even with standard rules, painting a fairly presented portrait is not always easy.

Students frequently enroll in a financial accounting course believing that little is required other than learning set rules and then following them mechanically. As will be demonstrated many times in this textbook, nothing ever replaces the need for experienced judgment on the part of the accountant.

Unearned Revenue

Question: The last adjusting entry to be covered at this time is unearned (or deferred) revenue. Some companies operate in industries where money is received first and then earned gradually over time. Newspaper and magazine businesses, for example, are paid in advance by their subscribers and advertisers. The earning process becomes substantially complete by the subsequent issuance of their products.

For example, the January 2, 2011, balance sheet of The Washington Post Company reported deferred revenues as a liability of over $379 million. The notes to the company’s financial statement provided clear information about the accounting process: “Amounts received from customers in advance are deferred as liabilities” or “Revenues from newspaper subscriptions and retail sales are recognized upon the later delivery or publication date.”

In Journal Entry 13 in Chapter 4 "How Does an Organization Accumulate and Organize the Information Necessary to Create Financial Statements?", the Lawndale Company reported receiving $3,000 in cash for services to be rendered at a later date. An unearned revenue account was recorded as a liability for that amount and appears in the trial balance in Figure 5.1 "Updated Trial Balance for the Lawndale Company". When is an adjusting entry needed in connection with the recognition of previously unearned revenue?

 

Answer: As indicated by The Washington Post Company, unearned revenue represents a liability recognized when money is received before work is done. After the required service is carried out so that the earning process is substantially complete, an appropriate amount is reclassified from unearned revenue on the balance sheet to revenue on the income statement. For example, in connection with the $3,000 payment collected by Lawndale, assume that all the work necessary to recognize the first $600 was performed by the end of Year Four. Prior to preparing financial statements, an adjusting entry reduces the liability and recognizes the earned revenue.

Preparing Financial Statements

Question: The accounting process is clearly a series of defined steps that take a multitude of monetary transactions and eventually turn them into fairly presented financial statements. After all adjusting entries have been recorded in the journal and posted to the appropriate T-accounts in the ledger, what happens next in the accounting process?

 

Answer: After the adjusting entries are posted, the accountant should believe that all material misstatements have been removed from the accounts. Thus, they are presented fairly according to U.S. GAAP (or IFRS) and can be used by decision makers. As one final check, an adjusted trial balance is produced for a last, careful review. Assuming that no additional concerns are uncovered, the accountant prepares an income statement, a statement of retained earnings, and a balance sheet.

The basic financial statements are then completed by the production of a statement of cash flows. In contrast to the previous three, this statement does not report ending ledger account balances but rather discloses and organizes all of the changes that took place during the period in the composition of the cash account. As indicated in Chapter 3 "How Is Financial Information Delivered to Decision Makers Such as Investors and Creditors?", cash flows are classified as resulting from operating activities, investing activities, or financing activities.

The reporting process is then finalized by the preparation of explanatory notes that accompany a set of financial statements.

The final trial balance for the Lawndale Company (including the four adjusting entries produced earlier) is presented in Figure 5.7 "Updated Trial Balance for Lawndale Company—December 31, Year Four (after posting four adjusting entries to ". The original trial balance in Figure 5.1 "Updated Trial Balance for the Lawndale Company" has been updated by the four adjusting entries that were discussed in this chapter.

 

Adjusting Entry 1

• Utilities expense increases by $900
• Utilities payable increases by $900

 

Adjusting Entry 2 (Version 1)

• Rent expense increases by $1,000
• Prepaid rent decreases by $1,000

 

Adjusting Entry 3

• Accounts receivable increases by $500
• Sales of services increases by $500

 

Adjusting Entry 4

• Unearned revenue decreases by $600
• Sales of services increases by $600

 

These changes are entered into Figure 5.1 "Updated Trial Balance for the Lawndale Company" to bring about the totals presented in Figure 5.7 "Updated Trial Balance for Lawndale Company—December 31, Year Four (after posting four adjusting entries to ".

After that, each of the final figures is appropriately placed within the first three financial statements. Revenues and expenses appear in the income statement, assets and liabilities in the balance sheet, and so on. The resulting statements for the Lawndale Company are exhibited in Figure 5.8 "Year Four Financial Statements for Lawndale Company".

To keep this initial illustration reasonably simple, no attempt has been made to record all possible accounts or adjusting entries. For example, no accrued expenses have been recognized for either income taxes or interest expense owed in connection with the notes payable. One example of an accrued expense is sufficient in this early coverage because both income taxes and interest expense will be described in depth in a later chapter. Likewise, depreciation expense of noncurrent assets with finite lives (such as the truck shown on the company’s trial balance) will be discussed subsequently. However, the creation of financial statements for the Lawndale Company should demonstrate the functioning of the accounting process as well as the basic structure of the income statement, statement of retained earnings, and balance sheet.

Several aspects of this process should be noted:

• The statements are properly identified by name of company, name of statement, and date. The balance sheet is for a particular day (December 31, Year Four) and the other statements cover a period of time (Year ending December 31, Year Four).
• Each account in the trial balance in Figure 5.7 "Updated Trial Balance for Lawndale Company—December 31, Year Four (after posting four adjusting entries to " appears within only one statement. Accounts receivable is an asset on the balance sheet. Cost of goods sold is an expense on the income statement. Dividends paid is a reduction shown on the statement of retained earnings. Each account serves one purpose and appears on only one financial statement.
• There is no T-account for net income. Net income is a composition of all revenues, gains, expenses, and losses for the year. The net income figure computed in the income statements is then used in the statement of retained earnings. In the same manner, there is no T-account for the ending retained earnings balance. Ending retained earnings is a composition of the beginning retained earnings balance, net income, and dividends paid. The ending retained earnings balance computed in the statement of retained earnings is then used in the balance sheet.
• The balance sheet does balance. The total of the assets is equal to the total of all liabilities and stockholders’ equity (capital stock and retained earnings). Assets must always have a source.

The statement of cash flows for the Lawndale Company cannot be created based solely on the limited information available in this chapter concerning the changes in the cash account. Thus, it has been omitted. Complete coverage of the preparation of a statement of cash flows will be presented in Chapter 17 "In a Set of Financial Statements, What Information Is Conveyed by the Statement of Cash Flows?".

The Purpose of Closing Entries

Question: Analyze, record, adjust, and report—the four basic steps in the accounting process. Is the work year complete for the accountant after financial statements are prepared?

 

Answer: One last mechanical process needs to be mentioned. Whether a business is as big as Microsoft or as small as the local convenience store, the final action performed each year by the accountant is the preparation of closing entriesEntries made to reduce all temporary ledger accounts (revenues, expenses, gains, losses, and dividends paid) to zero at the end of an accounting period so that a new measurement for the subsequent period can begin; the net effect of this process is transferred into the retained earnings account to update the beginning balance to the year-end figure.. Five types of accounts—revenues, expenses, gains, losses, and dividends paid—reflect the various increases and decreases that occur in a company’s net assets in the current period. These accounts are often deemed “temporary” because they only include changes for one year at a time. Consequently, the figure reported by Microsoft as its revenue for the year ended June 30, 2011, measures only sales during that year. T-accounts for rent expense, insurance expense, and the like reflect just the current decreases in net assets.

In order for the accounting system to start measuring the effects for each new year, these specific T-accounts must all be returned to a zero balance after annual financial statements are produced. Consequently, all of the revenue T-accounts maintained by Microsoft show a total at the end of its fiscal year (June 30, 2011) of $69.9 billion but contain a zero balance at the start of the very next day.

• Final credit totals existing in every revenue and gain account are closed out by recording equal and off-setting debits.
• Likewise, ending debit balances for expenses, losses, and dividends paid require a credit entry of the same amount to return each of these T-accounts to zero.

After these accounts are closed at year’s end, the resulting single figure is the equivalent of net income reported for the year (revenues and gains less expenses and losses) reduced by any dividends paid. This net effect is recorded in the retained earnings T-account. The closing process effectively moves the balance for every revenue, expense, gain, loss, and dividend paid into retained earnings. In the same manner as journal entries and adjusting entries, closing entries are recorded initially in the journal and then posted to the ledger. As a result, the beginning retained earnings balance for the year is updated to arrive at the ending total reported on the balance sheet.

Assets, liabilities, capital stock, and retained earnings all start out each year with a balance that is the same as the ending figure reported on the previous balance sheet. Those accounts are permanent; they are not designed to report an impact occurring during the current year. In contrast, revenues, expenses, gains, losses, and dividends paid all begin the first day of each year with a zero balance—ready to record the events of this new period.