Bob's Notes ... Read these first!

Chapters 1, 2, 3 and 4 are laying the foundation for ALL other chapters of this course (as well as all other accounting courses in your future).

As usual check over your chapter 3 "Tips & Hints" AND the "Chapter Outline".   Again pay attention to the terms and definitions at the end of the chapter since this can be a "challenging" chapter.   Introduced in this chapter is the difference between the Cash Basis of accounting and the Accrual Basis of accounting.  

Just in case your short term memory has atrophied due to hard-core partying or having children of your own we are doing the ACCRUAL BASIS of accounting and NOT the Cash Basis.   The ACCRUAL BASIS is based on THREE major accounting precepts.   These are:

The Revenue Principle:
Revenues are recorded when earned, and the amount of revenue recorded equals the cash value of the goods or services transferred to the customer.

The Matching Principle:
Expenses should be deducted from (matched against) the revenues earned in the same period.

The Time-Period Concept:
Requires that accounting information be reported at regular intervals and that income be measured accurately each period.   To measure income accurately, companies update their accounts at the end of each period.   This process also helps to properly match revenues and expenses.   In order to completely measure income, journal entries called adjusting entries must be prepared at period end to ensure that all revenues and expenses have been recorded properly.


The bulk of chapter 3 deals with the adjusting process.   Adjusting entries are usually made at the end of an accounting period to allocate income and expenses to the period in which they actually occurred.   Adjusting entries can be categorized as either ACCRUALS or DEFERRALS.


Accrual-type adjusting entries result from this scenario:
Nothing has been entered in the accounting records for certain expenses and/or revenues ... but those expenses and/or revenues did occur and must be included in the current period's income statement and balance sheet.   Accruals can pertain to either revenues or expenses.   (The only way to include or exclude anything in the financial statements is by making and posting a journal entry).


Accrual of Expenses
An accountant might say, "We need to accrue the interest expense on the bank loan."  (Accrue means to "periodically accumulate over time")  

Assume that on JAN 1 your company borrowed $1,000,000 at 6% interest for 2 years.   Each month your company incurs (Calculation = $5,000 per month interest ($1,000,000 x 6% = $60,000 per year divided by 12 months = $5,000 per month).   The interest expense is not due to be paid until the loan itself is to be repaid.   An adjusting entry is needed because nothing had been recorded in the accounts for interest expense, but the company did incur  (means to "become liable for")  interest expense during the accounting period.   Further, the company has a liability or obligation for the unpaid interest up to the end of the accounting period.   What the accountant is saying is that an accrual-type adjusting journal entry needs to be recorded.

The adjusting entry to ACCRUE the Interest Expense is:
JAN
31
Interest Expense $ 5,000  
       Interest Payable   $ 5,000
This entry would be made each month until the loan is repaid (24 months total). When the interest expense is actually paid to the lender, Interest Payable will be debited (decreased because you are paying it) while Cash will be credited (decreased due to payment).
The effect of the adjusting entry on the financial statements is:
Income Statement ... $5,000 in Interest Expense will reduce JAN revenues.
Balance Sheet ... $5,000 in Interest Payable (a liability) will be shown.



Another situation requiring an adjusting entry is when a payroll period falls between 2 accounting periods.   For example assume you are paid every two weeks.   You earn $500 per week ($1,000 per two week payroll-payday).   Assume that one of the weeks was in JAN while the second week is in FEB.   The accountant might also say, "We need to accrue for the wages earned by the employees on Mon JAN26 thru Fri JAN30."   The adjusting entry would be ... DEBIT Salary Expense, $500  and  CREDIT Salary Payable, $500.   (When the salary is actually paid to employees in FEB, Salary Payable will be debited (decreased) and Cash will be credited (also decreased). The salary expense for JAN will be subtracted from JAN revenues to determine Net Income (Profit or Loss).


Accrual of Revenue
Accountants might also state that they must "accrue" revenues that have been earned but not yet received.   For example, assume that your company has provided services to customer SmithCorp in FEB.   On FEB 28 you send a bill to SmithCorp requesting payment.   SmithCorp will send the payment within 30 days which is typical for an Account Receivable.

The adjusting entry to ACCRUE the Revenue you've earned is:
FEB
28
Accounts Receivable   (SmithCorp) $ 7,500  
       Revenue   $ 7,500
When payment is received from SmithCorp the asset "Cash" will be debited (increased) while the asset "Accounts Receivable" (SmithCorp) will be credited (decreased, as in eliminated).   Many companies have an "end of the month crunch time" when they try to ship merchandise or complete work so they can BILL customers and show the Revenue on that periods income statement.
The effect of the adjusting entry on the financial statements is:
Income Statement ... $7,500 in Revenue will show on the FEB statement.
Balance Sheet ... $7,500 in Accounts Receivable (an asset) will be shown.



In another situation, on MAR 01, your company invested $60,000 in a one-year CD (Certificate of Deposit at a bank) which pays you 10% annual interest.   On MAR 31, you need to ACCRUE the interest you've earned, but not yet received.   The adjusting entry will be ... DEBIT: Interest Receivable, $500  and  CREDIT: Interest Revenue, $500 .   (Calculation is $60,000 x 10% = $6,000 for one year, divided by 12 = $500 p[er month).   This entry would be made each month until the Cash payment for the interest is received from the bank CD. Then you would debit "Cash" and credit "Interest Receivable".





Deferral-type adjusting entries result from this scenario:
Something has already been entered in the accounting records, but the amount needs to be divided up between two or more accounting periods.   Deferral can pertain to either revenues or expenses.   (The only way to allocate anything between accounting periods is by making and posting a journal entry).


Deferral of Expenses
Assume that, On Jan 01 you paid GEICO insurance (the annoying little lizard SOB on TV) $1,800 to provide insurance for your company for the following six months (Jan, Feb, Mar, Apr, May, June) at a rate of $300 per month.

The entry for this payment is:
JAN
01
Prepaid Insurance $ 1,800  
       Cash   $ 1,800
This is NOT the adjusting entry, it is because of this transaction that an adjusting entry will be needed ... see below. By "prepaying" GEICO my company owns the right to be insured by them for the next six months.   This "right" (that I OWN) is an asset called PREPAID INSURANCE.

At the end of JAN, you have "Used Up or Consumed" one month of the GEICO insurance coverage.   An adjusting entry is needed to allocate an Insurance Expense (using-up) to JAN and reflect that your asset PREPAID INSURANCE has been reduced by 1/6 (one of the six months of insurance coverage).

The adjusting entry is:
JAN
31
Insurance Expense $ 300  
       Prepaid Insurance   $ 300
This is the adjusting entry.   It increases (debits) an expense and decreases (credits) an asset.
The effect of the adjusting entry on the financial statements is:
Income Statement ... $300 in Insurance Expense will reduce JAN revenues.
Balance Sheet ... Prepaid Insurance (asset) will be reduced by $300 resulting in a balance of $1,500 ($1800-$300) showing on the JAN balance sheet.




Another related situation relates to buying supplies to be used in your business operation (office supplies, copy papers etc).   Assume that, on MAR 01 you bought 10 cases of copy paper paying, in cash, $100 per case.   The entry would be ... DEBIT Supplies, $1,000  and  CREDIT Cash, $1,000.   At the end of MAR you determine that you only have 4 cases of copy paper remaining.   Therefore, during MAR you must have "used-up" the other 6 cases (in the amount of 6 cases x $100 per case).

The adjusting entry is:
MAR
31
Supply Expense $ 600  
       Supplies   $ 600
The entry decreases the asset "Supplies" and increases the expense "Supply Expense".
The effect of the adjusting entry on the financial statements is:
Income Statement ... $600 in Supply Expense will reduce JAN revenues.
Balance Sheet ... the asset Supplies (NOT "prepaid" supplies) will be reduced by $600 - a more accurate amount - resulting in a balance of $400 in the Supplies account on the balance sheet (original purchase of $1,000 - $600 used-up = $400 remaining).





Deferral of Revenues
Deferrals can also involve revenues.   Assume that you are the owner of the infamous magazine BOB (as in "hunka-hunka" ... but I digress).   A subscriber pays (obviously a highly intelligent, damn near-perfect individual - but I digress again), IN ADVANCE, for a one-year subscription (12 monthly issues) to  BOB magazine.   The cost for the one-year subscription is $600 (and worth every cent).   You  (BOB magazine)  receives the $600 on JUNE 01 2008 in payment through MAY 31, 2009.

The entry to record the receipt of this subscription PRE-PAYMENT is:
JUNE
01
Cash $ 600  
       UNearned Revenue   $ 600
This is NOT the adjusting entry, it is because of this transaction that an adjusting entry will be needed ... see below. Since you  (BOB magazine)  accepted the $600 BEFORE you did anything to EARN IT you OWE something (as in a liability).   You owe EITHER the delivery of the magazine each month for one-year OR you owe the money back to the customer.

At the end of JUNE, you (BOB magazine) send the June issue to your subscriber (did I mention that he or she has exceptional taste).   In effect you have reduced your liability to deliver 12 issues by 1/12 (the issue you just sent).   An adjusting entry is needed to reflect your "earning" of one months worth (1/12th) of the original $600 (one-year) payment.

The adjusting entry is:
JAN
31
Unearned Revenue $ 50  
       Revenue   $ 50
This is the adjusting entry.   It decreases (debits) a liability and increases (credits) revenue.
The effect of the adjusting entry on the financial statements is:
Income Statement ... $50 in revenue will appear on the JAN income statement.
Balance Sheet ... Unearned Revenue (a liability) is reduced by $50 and will now show a balance of $550 ($600 - $50).

This situation (above) routinely occurs in the construction industry.   For example, when a swimming pool builder receives 100% of the Cash payment before the pool is built, the pool builder has both an Asset (debit (increase) CASH) ... AND ... a LIABILITY (credit (increase) UNEARNED REVENUE) ... THE pool builder OWES the customer either the a swimming pool OR the Cash back.   When the swimming pool is 18% completed (or 6% or 72%), the pool builder has earned the right to keep 18% of Cash and owes 18% less that he did.


In summary, each adjusting entry affects an income statement account - (either a revenue or an expense) ... AND ... it also adjusts a balance sheet account (either an asset or a liability).   Look over the "Summary Problem" at the end of the chapter to tie it all together.




Links to Online Resources   →   USE them!
Accrued Revenues Accrued Expenses Unearned Revenues
Prepaid Expenses Depreciation Adjustment Process Illustrated


Homework Assignment   ...   (from the textbook - at the end of the chapter)
  Use the "Working Papers" (link below) to complete this assignment.   Type in, and save, your
  answers.   Submit it  (upload by the due date)  ...  using the ANGEL "Assignment Drop Box".   
S3 - 3   (pg 155) S3 - 4   (pg 155) S3 - 8   (pg 156)
S3 - 9   (pg 156) S3 - 10   (pg 156) E3 - 14   (pg 157)
E3 - 17   (pg 158) E3 - 18   (pg 158) E3 - 24   (pg 160)
P3 - 32 A   (pg 163) P3 - 34 A   (pg 165) P3 - 35 A   (pg 163)

  Link To the "Working Papers" - use these for homework !  
Do the homework.   Use these answers to help you over any "bumps" ...   they'll save you time and reduce frustrations (a little).   Check your work and fix the mistakes - it's not cheating - it's learning - remember I don't "grade" these ... but I do deduct (a lot) for incomplete assignments.
  Link To The Answers For The Assignment Above ... Click Here !