Closing entries wileyplus

study objectives

After studying this chapter, you should be able to:

1 Explain the revenue recognition principle and the expense recognition principle.

2 Differentiate between the cash basis and the accrual basis of accounting.

3 Explain why adjusting entries are needed, and identify the major types of adjusting entries.

4 Prepare adjusting entries for deferrals.

5 Prepare adjusting entries for accruals.

6 Describe the nature and purpose of the adjusted trial balance.

7 Explain the purpose of closing entries.

8 Describe the required steps in the accounting cycle.

9 Understand the causes of differences between net income and cash provided by operating activities.

chapter

ACCRUAL ACCOUNTING CONCEPTS

4

● Scan Study Objectives

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● Read Text and Answer p. 175 p. 180 p. 185 p. 189

● Work Using the Decision Toolkit

● Review Summary of Study Objectives

● Work Comprehensive p. 197

● Answer Self-Test Questions

● Complete Assignments

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162

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feature story

163

The accuracy of the financial reporting system de-

pends on answers to a few fundamental questions. At

what point has revenue been earned? At what point

is the earnings process complete? When have ex-

penses really been incurred?

During the 1990s, the stock prices of dot-com com-

panies boomed. Many dot-com companies earned most

of their revenue from selling advertising

space on their websites. To boost re-

ported revenue, some dot-coms began

swapping website ad space. Company

A would put an ad for its website on company B’s web-

site, and company B would put an ad for its website on

company A’s website. No money ever changed hands,

but each company recorded revenue (for the value of

the space that it gave up on its site). This practice did

little to boost net income and resulted in no additional

cash flow—but it did boost reported revenue. Regula-

tors eventually put an end to the practice.

Another type of transgression results from compa-

nies recording revenue or expenses in the wrong year.

In fact, shifting revenues and expenses is one of the

most common abuses of financial accounting. Xerox

admitted reporting billions of dollars of lease revenue

in periods earlier than it should have been reported.

And WorldCom stunned the financial markets with its

admission that it had boosted net income by billions

of dollars by delaying the recognition of expenses un-

til later years.

Unfortunately, revelations such as

these have become all too common in

the corporate world. It is no wonder that

the U.S. Trust Survey of affluent Ameri-

cans reported that 85 percent of its respondents be-

lieved that there should be tighter regulation of finan-

cial disclosures, and 66 percent said they did not trust

the management of publicly traded companies.

Why did so many companies violate basic financial

reporting rules and sound ethics? Many speculate that

as stock prices climbed, executives were under increas-

ing pressure to meet higher and higher earnings expec-

tations. If actual results weren’t as good as hoped for,

some gave in to temptation and “adjusted” their num-

bers to meet market expectations.

● Cooking the Books? (p. 166) ● Reporting Revenue Accurately (p. 167) ● Turning Gift Cards into Revenue (p. 174) ● Cashing In on Accrual Accounting (p. 178)

INSIDE CHAPTER 4 . . .

W HAT WAS YOU R P RO F IT?

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Accrual Accounting Concepts

As indicated in the Feature Story, making adjustments is necessary to avoid misstatement of revenues and expenses such as those at Xerox and WorldCom. In this chapter, we introduce you to the accrual accounting concepts that make such adjustments possible.

The organization and content of the chapter are as follows.

Timing Issues Most businesses need immediate feedback about how well they are doing. For example, management usually wants monthly reports on financial results, most large corporations are required to present quarterly and annual financial state- ments to stockholders, and the Internal Revenue Service requires all businesses to file annual tax returns. Accounting divides the economic life of a business into artificial time periods. As indicated in Chapter 2, this is the periodicity assumption. Accounting time periods are generally a month, a quarter, or a year.

Many business transactions affect more than one of these arbitrary time pe- riods. For example, a new building purchased by Citigroup or a new airplane purchased by Delta Air Lines will be used for many years. It doesn’t make sense to expense the full cost of the building or the airplane at the time of purchase because each will be used for many subsequent periods. Instead, we determine the impact of each transaction on specific accounting periods.

Determining the amount of revenues and expenses to report in a given ac- counting period can be difficult. Proper reporting requires an understanding of the nature of the company’s business. Two principles are used as guidelines: the revenue recognition principle and the expense recognition principle.

THE REVENUE RECOGNITION PRINCIPLE

The revenue recognition principle requires that companies recognize revenue in the accounting period in which it is earned. In a service company, revenue is considered to be earned at the time the service is performed. To illustrate, as- sume Conrad Dry Cleaners cleans clothing on June 30, but customers do not claim and pay for their clothes until the first week of July. Under the revenue recognition principle, Conrad earns revenue in June when it performs the ser- vice, not in July when it receives the cash. At June 30, Conrad would report a receivable on its balance sheet and revenue in its income statement for the ser- vice performed. The journal entries for June and July would be as follows.

preview of chapter 4

• Revenue recognition principle

• Expense recognition principle

• Accrual versus cash basis of accounting

Timing Issues

• Types of adjusting entries

• Adjusting entries for deferrals

• Adjusting entries for accruals

• Summary of basic relationships

The Basics of Adjusting Entries

• Preparing the adjusted trial balance

• Preparing financial statements

The Adjusted Trial Balance and Financial

Statements

• Preparing closing entries

• Preparing a post- closing trial balance

• Summary of the accounting cycle

Closing the Books

• Earnings management • Sarbanes-Oxley

Quality of Earnings

164

1 Explain the revenue recognition principle and the expense recognition principle.

Helpful Hint An accounting time period that is one year long is called a fiscal year.

Revenue should be recog- nized in the accounting

period in which it is earned (generally when service is

performed).

Revenue Recognition

Customer requests service

Service performed

Cash received

study objective

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June Accounts Receivable xxx Service Revenue xxx

July Cash xxx Accounts Receivable xxx

THE EXPENSE RECOGNITION PRINCIPLE

In recognizing expenses, a simple rule is followed: “Let the expenses follow the revenues.” Thus, expense recognition is tied to revenue recognition. Applied to the preceding example, this means that the salary expense Conrad incurred in performing the cleaning service on June 30 should be reported in the same pe- riod in which it recognizes the service revenue. The critical issue in expense recognition is determining when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Con- rad does not pay the salary incurred on June 30 until July, it would report salaries payable on its June 30 balance sheet.

The practice of expense recognition is referred to as the expense recogni- tion principle (often referred to as the matching principle). It dictates that efforts (expenses) be matched with results (revenues). Illustration 4-1 shows these relationships.

Timing Issues 165

DECISION TOOLKIT DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

At what point should the company record revenue?

Need to understand the nature of the company’s business

Record revenue when earned. A service business earns revenue when it performs a service.

Recognizing revenue too early overstates current period revenue; recognizing it too late understates current period revenue.

INFO NEEDED FOR DECISION

Revenue and Expense Recognition

In accordance with generally accepted accounting principles

(GAAP)

Expense Recognition Principle

Expenses matched with revenues in the period when efforts are

expended to generate revenues

Periodicity Assumption

Economic life of business can be divided into

artificial time periods

Revenue Recognition Principle

Revenue recognized in the accounting period in

which it is earned

Illustration 4-1 GAAP relationships in revenue and expense recognition

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166 chapter 4 Accrual Accounting Concepts

ACCRUAL VERSUS CASH BASIS OF ACCOUNTING

Accrual-basis accounting means that transactions that change a company’s fi- nancial statements are recorded in the periods in which the events occur, even if cash was not exchanged. For example, using the accrual basis means that companies recognize revenues when earned (the revenue recognition princi- ple), even if cash was not received. Likewise, under the accrual basis, com- panies recognize expenses when incurred (the expense recognition principle), even if cash was not paid.

An alternative to the accrual basis is the cash basis. Under cash-basis accounting, companies record revenue only when cash is received. They record expense only when cash is paid. The cash basis of accounting is pro- hibited under generally accepted accounting principles. Why? Because it does not record revenue when earned, thus violating the revenue recognition principle. Similarly, it does not record expenses when incurred, which violates the expense recognition principle.

Illustration 4-2 compares accrual-based numbers and cash-based numbers. Suppose that Fresh Colors paints a large building in 2011. In 2011, it incurs and pays total expenses (salaries and paint costs) of $50,000. It bills the customer $80,000, but does not receive payment until 2012. On an accrual basis, Fresh Col- ors reports $80,000 of revenue during 2011 because that is when it is earned. The company matches expenses of $50,000 to the $80,000 of revenue. Thus, 2011 net income is $30,000 ($80,000 � $50,000). The $30,000 of net income reported for 2011 indicates the profitability of Fresh Colors’ efforts during that period.

If, instead, Fresh Colors were to use cash-basis accounting, it would report $50,000 of expenses in 2011 and $80,000 of revenues during 2012. As shown in Illustration 4-2, it would report a loss of $50,000 in 2011 and would report net income of $80,000 in 2012. Clearly, the cash-basis measures are misleading be- cause the financial performance of the company would be misstated for both 2011 and 2012.

DECISION TOOLKIT DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

At what point should the company record expenses?

Need to understand the nature of the company’s business

Expenses should “follow” revenues—that is, match the effort (expense) with the result (revenue).

Recognizing expenses too early overstates current period expense; recognizing them too late understates current period expense.

INFO NEEDED FOR DECISION

What motivates sales executives and finance and accounting executives to participate in activities that result in inaccurate reporting of revenues? (See page 223.)

Cooking the Books?

Allegations of abuse of the revenue recognition principle have become all too common in recent years. For example, it was alleged that Krispy Kreme sometimes dou- bled the number of doughnuts shipped to wholesale customers at the end of a quarter to boost quarterly results. The customers shipped the unsold doughnuts back after the beginning of the next quarter for a refund. Conversely, Computer Associates International was accused of backdating sales—that is, saying that a sale that occurred at the begin- ning of one quarter occurred at the end of the previous quarter in order to achieve the previous quarter’s sales targets.

Ethics Insight

?

International Note Although different accounting standards are often used by companies in other countries, the accrual basis of accounting is central to all of these standards.

2 Differentiate between the cash basis and the accrual basis of accounting.

study objective

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The Basics of Adjusting Entries In order for revenues to be recorded in the period in which they are earned, and for expenses to be recognized in the period in which they are incurred, compa- nies make adjusting entries. Adjusting entries ensure that the revenue recog- nition and expense recognition principles are followed.

Adjusting entries are necessary because the trial balance—the first pulling together of the transaction data—may not contain up-to-date and complete data. This is true for several reasons:

1. Some events are not recorded daily because it is not efficient to do so. Exam- ples are the use of supplies and the earning of wages by employees.

The Basics of Adjusting Entries 167

( )

$ 0 0

$ 0

Revenue Expense Net loss

$80,000 0

$80,000

Revenue Expense Net income

Cash basis

$80,000 50,000

$30,000

Revenue Expense Net income

Revenue Expense Net income

Accrual basis

Purchased paint, painted building, paid employees

2011

Received payment for work done in 2011

Activity

2012

PAINT

Fresh Colors

PAINT

PAINT

Bob's Bait Ba rnBob's Bait Barn

$ 0 50,000

$ 50,000

$

$

Bob's Bait Barn

Illustration 4-2 Accrual- versus cash-basis accounting

Reporting Revenue Accurately

Until recently, electronics manufacturer Apple was required to spread the revenues earned from iPhone sales over the two-year period following the sale of the phone. Accounting standards required this because it was argued that Apple was ob- ligated to provide software updates after the phone was sold. Therefore, since Apple had service obligations after the initial date of sale, it was forced to spread the revenue over a two-year period. However, since the company received full payment upfront, the cash flows from iPhones significantly exceeded the revenue reported from iPhone sales in each accounting period. It also meant that the rapid growth of iPhone sales was not fully reflected in the revenue amounts reported in Apple’s income statement. A new ac- counting standard now enables Apple to report nearly all of its iPhone revenue at the point of sale. It was estimated that 2009 revenues would have been about 17% higher, and earnings per share would have been almost 50% higher, under the new rule.

Investor Insight

? In the past, why was it argued that Apple should spread the recognition of iPhonerevenue over a two-year period, rather than recording it upfront? (See page 223.)

3study objective Explain why adjusting entries are needed, and identify the major types of adjusting entries.

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168 chapter 4 Accrual Accounting Concepts

2. Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions. Examples are charges related to the use of buildings and equipment, rent, and insurance.

3. Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period.

Adjusting entries are required every time a company prepares financial statements. The company analyzes each account in the trial balance to deter- mine whether it is complete and up to date for financial statement purposes. Every adjusting entry will include one income statement account and one balance sheet account.

TYPES OF ADJUSTING ENTRIES

Adjusting entries are classified as either deferrals or accruals. As Illustration 4-3 shows, each of these classes has two subcategories.

International Note Internal controls are a system of checks and balances designed to detect and prevent fraud and errors. The Sarbanes-Oxley Act requires U.S. companies to enhance their systems of internal control. However, many foreign companies do not have to meet strict internal control requirements. Some U.S. companies believe that this gives foreign firms an unfair advantage because developing and maintaining internal controls can be very expensive.

Deferrals:

1. Prepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed.

2. Unearned revenues: Cash received and recorded as liabilities before revenue is earned.

Accruals:

1. Accrued revenues: Revenues earned but not yet received in cash or recorded.

2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.

SIERRA CORPORATION Trial Balance

October 31, 2012

Debit Credit

Cash $15,200 Supplies 2,500 Prepaid Insurance 600 Equipment 5,000 Notes Payable $ 5,000 Accounts Payable 2,500 Unearned Service Revenue 1,200 Common Stock 10,000 Retained Earnings 0 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900

$28,700 $28,700

Subsequent sections give examples of each type of adjustment. Each example is based on the October 31 trial balance of Sierra Corporation, from Chapter 3, reproduced in Illustration 4-4. Note that Retained Earnings, with a zero balance, has been added to this trial balance. We will explain its use later.

We assume that Sierra Corporation uses an accounting period of one month. Thus, monthly adjusting entries are made. The entries are dated October 31.

Illustration 4-3 Categories of adjusting entries

Illustration 4-4 Trial balance

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ADJUSTING ENTRIES FOR DEFERRALS

To defer means to postpone or delay. Deferrals are costs or revenues that are recognized at a date later than the point when cash was originally exchanged. Companies make adjusting entries for deferrals to record the portion of the de- ferred item that was incurred as an expense or earned as revenue during the current accounting period. The two types of deferrals are prepaid expenses and unearned revenues.

Prepaid Expenses Companies record payments of expenses that will benefit more than one ac- counting period as assets called prepaid expenses or prepayments. When ex- penses are prepaid, an asset account is increased (debited) to show the service or benefit that the company will receive in the future. Examples of common pre- payments are insurance, supplies, advertising, and rent. In addition, companies make prepayments when they purchase buildings and equipment.

Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use (e.g., supplies). The expiration of these costs does not require daily entries, which would be impractical and unneces- sary. Accordingly, companies postpone the recognition of such cost expirations until they prepare financial statements. At each statement date, they make ad- justing entries to record the expenses applicable to the current accounting pe- riod and to show the remaining amounts in the asset accounts.

Prior to adjustment, assets are overstated and expenses are understated. Therefore, as shown in Illustration 4-5, an adjusting entry for prepaid expenses results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account.

The Basics of Adjusting Entries 169

4 Prepare adjusting entries for deferrals.

Prepaid Expenses

Asset

Credit Adjusting Entry (–)

Unadjusted Balance

Expense

Debit Adjusting Entry (+)

Let’s look in more detail at some specific types of prepaid expenses, begin- ning with supplies.

SUPPLIES. The purchase of supplies, such as paper and envelopes, results in an increase (a debit) to an asset account. During the accounting period, the com- pany uses supplies. Rather than record supplies expense as the supplies are used, companies recognize supplies expense at the end of the accounting period. At the end of the accounting period, the company counts the remaining supplies. The difference between the unadjusted balance in the Supplies (asset) account and the actual cost of supplies on hand represents the supplies used (an expense) for that period.

Recall from Chapter 3 that Sierra Corporation purchased supplies cost- ing $2,500 on October 5. Sierra recorded the purchase by increasing (debiting) the asset Supplies. This account shows a balance of $2,500 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still on hand. Thus, the cost of supplies used is

Illustration 4-5 Adjusting entries for prepaid expenses

Supplies used; record supplies expense

Supplies purchased; record asset

Oct. 31

Oct. 5

Supplies

study objective

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170 chapter 4 Accrual Accounting Concepts

$1,500 ($2,500 � $1,000). This use of supplies decreases an asset, Supplies. It also decreases stockholders’ equity by increasing an expense account, Sup- plies Expense. This is shown in Illustration 4-6.

After adjustment, the asset account Supplies shows a balance of $1,000, which is equal to the cost of supplies on hand at the statement date. In addi- tion, Supplies Expense shows a balance of $1,500, which equals the cost of sup- plies used in October. If Sierra does not make the adjusting entry, October expenses will be understated and net income overstated by $1,500. More- over, both assets and stockholders’ equity will be overstated by $1,500 on the October 31 balance sheet.

INSURANCE. Companies purchase insurance to protect themselves from losses due to fire, theft, and unforeseen events. Insurance must be paid in advance, often for more than one year. The cost of insurance (premiums) paid in advance is recorded as an increase (debit) in the asset account Prepaid Insurance. At the financial statement date, companies increase (debit) Insurance Expense and decrease (credit) Prepaid Insurance for the cost of insurance that has expired during the period.

On October 4, Sierra Corporation paid $600 for a one-year fire insurance pol- icy. Coverage began on October 1. Sierra recorded the payment by increasing (deb- iting) Prepaid Insurance. This account shows a balance of $600 in the October 31 trial balance. Insurance of $50 ($600 � 12) expires each month. The expiration of prepaid insurance decreases an asset, Prepaid Insurance. It also decreases stock- holders’ equity by increasing an expense account, Insurance Expense.

As shown in Illustration 4-7, the asset Prepaid Insurance shows a balance of $550, which represents the unexpired cost for the remaining 11 months of cov- erage. At the same time, the balance in Insurance Expense equals the insurance cost that expired in October. If Sierra does not make this adjustment, October expenses are understated by $50 and net income is overstated by $50. Moreover,

Debit–Credit Analysis

Journal Entry

Posting

Basic Analysis

Equation Analysis

Oct. 5 2,500

Oct. 31 Bal. 1,000

Oct. 31 Adj. 1,500

Supplies

Oct. 31 Adj. 1,500

Oct. 31 Bal. 1,500

Supplies Expense

Debits increase expenses: debit Supplies Expense $1,500. Credits decrease assets: credit Supplies $1,500.

Oct. 31 Supplies Expense Supplies (To record supplies used)

1,500 1,500

The expense Supplies Expense is increased $1,500, and the asset Supplies is decreased $1,500.

Assets Supplies

–$1,500

=

=

+Liabilities Stockholders’ Equity Supplies Expense

–$1,500

(1)

Illustration 4-6 Adjustment for supplies

Insurance expired; record insurance expense

Insurance purchased; record asset

Oct. 4

Oct. 31

Insurance

Insurance Policy Nov $50

Dec $50

Jan $50

Feb $50

March $50

April $50

May $50

June $50

July $50

Aug $50

Sept $50

1 YEAR $600

Oct $50

1 year insurance policy$600

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DEPRECIATION. A company typically owns a variety of assets that have long lives, such as buildings, equipment, and motor vehicles. The period of service is re- ferred to as the useful life of the asset. Because a building is expected to pro- vide service for many years, it is recorded as an asset, rather than an expense, on the date it is acquired. As explained in chapter 2, companies record such as- sets at cost, as required by the cost principle. To follow the expense recognition principle, companies allocate a portion of this cost as an expense during each period of the asset’s useful life. Depreciation is the process of allocating the cost of an asset to expense over its useful life.

Need for adjustment. The acquisition of long-lived assets is essentially a long-term prepayment for the use of an asset. An adjusting entry for depreciation is needed to recognize the cost that has been used (an expense) during the period and to report the unused cost (an asset) at the end of the period. One very important point to understand: Depreciation is an allocation concept, not a valuation concept. That is, depreciation allocates an asset’s cost to the periods in which it is used. Depreciation does not attempt to report the actual change in the value of the asset.

For Sierra Corporation, assume that depreciation on the equipment is $480 a year, or $40 per month. As shown in Illustration 4-8 (page 172), rather than de- crease (credit) the asset account directly, Sierra instead credits Accumulated De- preciation—Equipment. Accumulated Depreciation is called a contra asset account. Such an account is offset against an asset account on the balance sheet. Thus, the Accumulated Depreciation—Equipment account offsets the asset Equipment. This account keeps track of the total amount of depreciation expense taken over the life of the asset. To keep the accounting equation in balance, Sierra decreases stockhold- ers’ equity by increasing an expense account, Depreciation Expense.

The balance in the Accumulated Depreciation—Equipment account will in- crease $40 each month, and the balance in Equipment remains $5,000.