Adjust Accounts

Companies often record transactions when it is most convenient. The most convenient time to record transactions is when something of value is exchanged. For instance cash for product or accounts payable for inventory.

Sometimes there is no obvious direct connection between expenses and revenue. Accountants must exercise judgment to select the accounting period in which to recognize revenues and expenses.

Moreover, a single business transaction could pertain to more than one accounting period. To provide accurate financial reports businesses need to recognize expenses that affect the current accounting period but has not yet been entered in the books. For example, your next pay period might span 2 accounting periods, so the pay due in the current accounting period  needs to be recognized before the preparation of the year end financial statement.

There are 4 adjusting entries discussed in this unit namely:

1. Adjusting for supplies expense
2. Adjusting for rent expense
3. Recognizing revenue earned
4. Accruing salaries expense

Adjusting Entry 1: Adjusting for supplies purchase

 Adj Event 1-1: Cato purchased $800 of supplies on account.

The purchase of supplies on hand is an asset source transaction. When supplies are purchased in bulk, they are recognized as assets as they still have future value at the time of purchase. However, at the end of the year, supplies that has been used up has to be recognized as an expense.

Just like we discussed earlier, accrual accounting defers between cost and expense. A cost might be an asset or expense. If a business has already consumed a purchased resource in the process of earning revenue, the cost of the resource is an expense. Supplies are not consumed as soon as they are purchased but slowly over time. At the end of the year, the company has to recognize the supplies that has been used up.

When Cato purchases the supplies, supplies increases and accounts payable increases (he bought the supplies on account). Also note the effect on the profit and loss and cash flow statement.

Cato purchased $800 of supplies on account		Effect on accounting equation
Assets	=	Liab.	+	Stockholders’ Equity
Supplies	=	Accounts Payable	+	Common Stock	+	Retained Earnings
800	=	800	+	n/a	+	n/a
		Effect on profit and loss statement
Revenue	–	Expenses	=	Net Income
n/a	–	n/a	=	n/a
		Effect on cash flow statement
Cash Flow
n/a		Cash from operations is affected at the time of payment

 

Recognize expired supplies

Adj Event 1-2:After determining through a physical count that it had $150 of unused supplies on hand as of December 31, Cato recognized supplies expense.

At the end of the year, just before a business closes its book, inventory will be taken to determine how much supplies is left. The supplies that is left is called the supplies on hand and will be the ending balance on the balance sheet. The supplies that is used up is computed as follows:

Beginning supplies balance + supplies purchased  = supplies available for use

Supplies available for use – ending supplies balance = supplies used

Beginning supplies balance$0

+

Supplies purchased$800

=

Supplies available for use$800

–

Ending supplies balance$150

=

Supplies used$650

The effect of purchasing supplies on the accounting equation (balance sheet statement), the profit and loss statement and cash flow statement is as follows:

		Effect of recognizing supplies expense on accounting equation
Assets	=	Liab.	+	Stockholders’ Equity
Supplies	=	Accounts Payable	+	Common Stock	+	Retained Earnings
-650	=	n/a	+	n/a	+	-650
		Effect on profit and loss statement
Revenue	–	Expenses	=	Net Income
n/a	–	-650	=	-650
		Effect on cash flow statement
Cash Flow
n/a

Adjusting entry 2- Adjusting for rent expense

Adj Event 2-1 :  On March 1, 2014, Cato signed a one-year lease agreement  and paid $12,000 cash in advance to rent office space. The one-year lease term begins March 1.

A prepaid expense is an expense paid in advance. Just like the supplies example, prepaid expenses have future value and are classified as assets.

Prepaid expense is an asset exchange transaction because cash is reduced and another asset prepaid expense is increased.

The effect of prepaid rent on the accounting equation (the balance sheet statement), the profit and loss statement and cash flow statement is as follows:

			Adjusting entry 2- Adjusting for rent expense
				Effect on accounting equation
Assets			=	Liab.	+	Stockholders’ Equity
Cash	+	Prepaid Rent	=		+	Common Stock	+
-12000		12000	=	n/a	+	n/a	+
Effect on profit and loss statement
Revenue	–	Expenses	=	Net Income
n/a	–	n/a	=	n/a
Effect on cash flow statement
Cash Flow
-12,000	OA	Even though no expenses were recognized on the profit and loss statement, cash still went out for the operations of the business

Recognize expired prepaid item

Adj Event 2-2: Cato recognized rent expense for the office space used during the accounting period.

Cato paid $12,000 on March 1, 2014, to rent office space for one year (Event 3)

The amount Cato uses up or expenses each  month is $12,000/12 = $1,000

At the end of the accounting period, 10 months had elapsed so he had to recognize 10 months of expenses – $1000 * 10 months used = $10,000 Rent expense

• Decrease assets (prepaid rent).
• Increase  expense and decrease retained earnings(equity).

This is an asset use transaction

The effect of  recognizing rent expense on the accounting equation (the balance sheet statement), the profit and loss statement and cash flow statement is as follows:

Recognize expired rent
				Effect of recognizing rent expense on accounting equation
Assets	=	Liab.	+	Stockholders’ Equity
Prepaid rent	=	Accounts Payable	+	Common Stock	+	Retained Earnings
-10,000	=	n/a	+	n/a	+	-10,000
Effect on profit and loss statement
Revenue	–	Expenses	=	Net Income
n/a	–	-10,000	=	-10,000
Effect on cash flow statement
Cash Flow
n/a		The expense was recognized on the profit and loss statement but no cash went out

 

Adjusting entry 3 – Unearned revenue

Adj event 3-1:  Cato received $18,000 cash in advance from Westberry Company for consulting services to be performed over a one-year period beginning June 1, 2014.

When payment is received in advance for a product or service it is called “unearned revenue”. Cato is still obligated to perform the services in the future. Unearned revenue is an asset source transaction. Unearned revenue is a liability till Cato performs the service. The effect of unearned revenue on the accounting equation is as follows:

• Increase assets (cash).
• Increase liabilities (unearned revenue).

			Adjusting entry 3- Unearned revenue
				Effect on accounting equation
Assets	=	Liab.	+	Stockholders’ Equity
Cash	+	Unearned Rev	=		+	Common Stock	+	Retained Earnings
18,000		18,000	=	n/a	+	n/a	+	n/a
Effect on profit and loss statement
Revenue	–	Expenses	=	Net Income
n/a	–	n/a	=	n/a
Effect on cash flow statement
Cash Flow
18,000	OA	Even though no revenue was recognized on the profit and loss statement, cash still came in for the operations of the business

 

Unearned revenue – Recognize revenue earned

Adj event 3-2: Cato recognized the portion of the unearned revenue it earned during the accounting period.

In adj event 3-1, we see that Cato performed the service over a one year period. It is safe to assume that Cato performed a portion of the service each month so a portion of the revenue should be recognized for each month that has elapsed.

Cato can choose to wait till the end of the accounting period to recognize all revenue (service that has been performed).

To recognize the revenue whose services has been performed, divide the amount paid over the time period paid. In this case Cato was paid for 12 months.

$18,000 / 12 = $1,500 revenue earned per month

$1,500 per month  * 7 months =$10,500 revenue to be recognized in 2014

• Decrease liabilities (unearned revenue).
• Increase revenue  which increases retained earnings( equity).

This is a claims exchange transaction ( exchange equity for liabilities)

				Effect of recognizing rent expense on accounting equation
Assets	=	Liab.	+	Stockholders’ Equity
	=	Unearned Rev	+	Common Stock	+	Retained Earnings
n/a	=	-10,500	+	n/a	+	10,500
Effect on profit and loss statement
Revenue	–	Expenses	=	Net Income
10,500	–	n/a	=	10,500
Effect on cash flow statement
Cash Flow
n/a		The revenue was recognized on the profit and loss statement but no cash came in

 

Adjusting entry 4 – Accruing salaries expense

Adj event 4-1: Cato paid $32,000 cash for salary expense.

This transaction decreases the cash asset account and increases expenses which decreases the retained earnings (equity) account.  The salaries expense reduces net income, and the statement of cash flows reports an outflow for operating activities.  This is classified as an asset use transaction.

• Decrease cash (assets).
• Decrease stockholders’ equity (retained earnings).

 

		Cato paid $32,000 cash for salaries expense
		Adjusting entry 3- Unearned revenue
			Effect on accounting equation
Assets	=	Liab.	+	Stockholders’ Equity
Cash	=	Salaries Payable	+	Common Stock	+	Retained Earnings
-32,000	=	n/a	+	n/a	+	-32,000
Effect on profit and loss statement
Revenue	–	Expenses	=	Net Income
n/a	–	-32,000	=	-32,000
Effect on cash flow statement
Cash Flow
-32,000	OA	Revenue recognition and cash out flow occurred the same time

Accrued salaries

Adj event 4-2: Cato recognized $4,000 of accrued salary expense.

Accrual accounting requires companies to recognize expenses when they are incurred, regardless of when they are paid.  Cato must recognize salary expense in the year that the instructors perform the work, even though the payment will not be made until 2014.  The adjusting entry affects the balance sheet by increasing the salaries payable liability account and decreasing the retained earnings equity account (an increase in salaries expense causes a reduction in retained earnings).  It is a claims exchange transaction.  The salary expense will decrease net income (increases salaries expense).

• Increase liabilities (salaries payable).
• Decrease stockholders’ equity (retained earnings).

		Effect of recognizing salaries expense
			Effect on accounting equation
Assets	=	Liab.	+	Stockholders’ Equity
	=	Salaries Payable	+	Common Stock	+	Retained Earnings
n/a	=	4,000	+	n/a	+	-4,000
Effect on profit and loss statement
Revenue	–	Expenses	=	Net Income
n/a	–	4,000	=	-4,000
Effect on cash flow statement
Cash Flow
n/a		No cash has exchanged hands yet