Chapter 3 Textbook - Accrual vs. Cash Accounting PDF

3.1 Accrual versus cash-basis accounting LO 3.1 Differentiate between accrual and cash-basis accounting There are two ways to do accounting: Accrual (or accrual-basis) accounting records the effect of each transaction as it occurs. Most businesses use the accrual basis as covered in thi...

3.1 Accrual versus cash-basis accounting LO 3.1 Differentiate between accrual and cash-basis accounting There are two ways to do accounting: Accrual (or accrual-basis) accounting records the effect of each transaction as it occurs. Most businesses use the accrual basis as covered in this book. Cash-basis accounting records only cash receipts and cash payments. It ignores receivables, payables and other items. Only very small businesses use the cash basis of accounting. Suppose that Smart Touch purchased $200 of office supplies on credit. On the accrual basis, Smart Touch records Office supplies and Accounts payable as follows: Jun 15 Office supplies (A+) 200 Accounts payable (L+) 200 Purchased supplies on credit. N OT DISTR O I B Jul 3 Accounts payable (L–)D 200 UT - Cash (A–) 200 © P E A RS O N E Paid on account. In contrast, cash-basis accounting ignores this transaction because Smart Touch paid no cash. The cash basis ENT.... records only cash receipts and cash payments. In the cash basis: Cash receipts are treated as revenues. Cash payments are treated as expenses. TUD Under the cash basis, when the account was paid Smart Touch would record the cash payment as an expense S and not as an asset. Under the accrual basis, at the time of the purchase Smart Touch acquired an asset FO 7@ because the supplies provide future benefit to the business until such time as they are used up. R H 58 1 T E Pbasis and the cash basis account Now let’s see how differently the accrual 94 for revenues. Suppose that Smart R Touch performs services and earns revenue ofIV 2 0 USE OF $1 A000 on 20 June 2021 but collects no cash. Under the accrual T follows: basis, Smart Touch records the revenue on credit as E Jun 20 Accounts receivable (A+) 1 000 Service revenue (R+) 1 000 Earned revenue on credit. Jul 5 Cash (A+) 1 000 Accounts receivable (A–) 1 000 Received cash on account. Under the cash basis, Smart Touch won’t record revenue earned on credit because there is no cash receipt. Instead, Smart Touch will wait until it receives the cash to record it as revenue. As a result, cash-basis accounting never reports accounts receivable from customers and may show the revenue in an entirely different accounting period from that in which it would appear under accrual accounting. In accrual accounting, revenues are recorded when earned, which isn’t necessarily in the same accounting period as when the corresponding cash is received. Exhibit 3-1 illustrates the difference between the accrual basis and the cash basis for a florist. Keep in mind that the accrual basis is the normal way to do accounting—and it’s required by Australian and New Zealand accounting standards. Exhibit 3-1 Accrual-basis versus cash-basis accounting N OT DISTR O I B D UT - © P E A RS O N E Cartoon for accrual basis and cash basis accounting, on left and right, respectively, is labelled revenue and two scenarios are depicted in it. ENT.... On the left, a man is seen delivering flowers at a doorstep and this image is captioned: Delivered flowers. Text above reads: Records a revenue when it is earned. TUD On the right, a man is seen depositing cash collected at the florist and this image is captioned: Received cash. Text above reads: Records only cash receipts as revenue. S FO 7@ Cartoon for accrual basis and cash basis accounting, on left and right, respectively, is labelled expense and R HE 58 two scenarios are depicted in it. 1 T PR 2 094 On the left, a woman is seen making a Ibouquet VATEof flowers E OFand this image is captioned: Must pay U S expense. Text above reads: Records an expense when it’s incurred. On the right, a man is seen receiving cash at the florist and this image is captioned: Paid cash. Text above reads: records only cash payments as expenses. Try it! 3.1 Most of us think, in everyday life, in terms of cash. Did our bank balance go up or down? This is in essence what the cash basis measures—changes in the cash balance. But consider your job. When do you actually earn your salary—when you go to work or when you get paid? When you go to work, you earn. That is when you record revenue under the accrual basis—not when you get paid by your employer. If revenue is $100 and cash of $50 is received, is the $50 owing a receivable or a payable? Accrual-basis accounting provides more-complete information than a cash-basis accounting system. This difference is important because the more complete the data, the better-equipped decision makers are to reach conclusions about a firm’s financial health and future prospects. Sustainability in action How sustainability can increase your profits ‘We help companies integrate sustainability into their core business and make money in the process. We help businesses address sustainability issues in their operations and supply chains, which results in higher profits and lower risk,’ says Ajay Varadharajan, CEO of Green Insights, an innovative sustainability consulting company based in Amsterdam.’ Being sustainable is not just about altruism or doing the right thing—it is simply better for your business. ‘However, not every issue is relevant to every business, especially in agriculture. We help farmers and co-ops by identifying key priority issues that their stakeholders and customers care about. We then try to see where there is an intersection with internal strategic goals,’ Ajay explains. ‘Once the farmers and co-ops understand the impact of these issues on their business, we quantify their impact. This is the very first step toward helping them lower their negative impact. We then come up with recommendations and strategies that lower their negative impact while improving sales and reducing costs. In doing so we generate business value. That is the core of our company.’ Ajay says that while big companies have already started measuring and managing their impact, most other companies in the world have not done so yet. ‘We do this for them. As a business, just like you measure and improve your finances, you want to track, measure, and reduce your negative impact. We help companies do OT DISTR this through a variety of strategies—changing business models, using new technology and most importantly, improving your supply chain processes,’ says Ajay.* O N I D B Questions to think about UT - © P E A RS O N E Many people assume that making activities sustainable and environmentally friendly adds to business costs. Does the example in this box support that belief? Can you think of other examples that support and oppose this assumption? ENT.... STUD FO 7@ R HE 58 1 T PR 2 094 IVAT E USE OF 3.2 Why we adjust the accounts LO 3.2 Explain why adjusting entries are needed At the end of the period, the accountant prepares the financial statements. The end-of-period process begins with the trial balance, which you learned how to prepare in the previous chapter. Exhibit 3-2 is the trial balance of Smart Touch as at 30 June 2021. Exhibit 3-2 Unadjusted trial balance SMART TOUCH LEARNING Unadjusted trial balance N as T O DIST2021 at 30 June RI D O B $ $ UT - Balance ©PEARSON E Account Debit Credit Cash 4 800 ENT.... Accounts receivable 2 200 Supplies 700 Prepaid rent 3 000 TU D Furniture 18 000 Building 48 000 S FO 7@ Accounts payable 18 200 R HE revenue 58 41 T Unearned service 600 PR 2 09 Loans payable IVAT OF 20 000 E USE Sheena Bright, beginning capital 33 200 Sheena Bright, drawings 1 000 Service revenue 7 000 Salary expense 900 Electricity and gas expense 400 Total 79 000 79 000 This unadjusted trial balance lists the revenues and expenses of the e-learning agency. But these amounts are incomplete because they omit various transactions. That is why the trial balance is unadjusted. Usually, however, we refer to it simply as the trial balance, without the label ‘unadjusted’. Accrual accounting requires adjusting entries at the end of the period. We must have correct balances for the financial statements. To see why, consider the Supplies account in Exhibit 3-2. Smart Touch uses supplies during the month. This reduces the supplies on hand (an asset) and creates an expense (supplies expense). It is a waste of time to record supplies expense every time supplies are used. But by the end of the month, enough of the $700 of supplies on the unadjusted trial balance (Exhibit 3-2) have probably been used that we need to adjust the Supplies account. This is an example of why we need to adjust some accounts at the end of the period. Adjusting entries assign revenues to the period when they are earned and expenses to the period when they are incurred. Adjusting entries also update the assets and liability accounts. Adjustments are needed to properly measure two things: 1. profit (loss) in the income statement, and 2. assets and liabilities in the balance sheet. This end-of-period process is called making the adjustments, adjusting the books or balance day adjustments. Remember the following three facts about adjusting entries: 1. Adjusting entries never involve the Cash account. 2. Adjusting entries either: 1. increase revenue earned (Revenue credit), or 2. increase an expense (Expense debit). 3. When information is provided about an adjustment to an account and the information is worded as ‘accrued’ or ‘prepaid’ an amount for a particular account, you journalise the stated amount to the stated OT DISTR account in your adjusting entry. (This will be explained further in an example later in the chapter.) N O I B D UT - ©PEARSON E ENT.... STU D FO 7@ R HE 58 41 T PR 2 09 IVAT E USE OF 3.3 Two categories of adjusting entry LO 3.3 Journalise and post adjusting entries The two basic categories of adjusting entry are prepayments and accruals. In a prepaid adjustment, the cash payment occurs before an expense is recorded or the cash receipt occurs before the revenue is earned. Prepayments are also called deferrals because the recognition of revenue or expense is deferred to a date after the cash is received or paid. Accrual adjustments are the opposite. An accrual records an expense before the cash payment or records the revenue before the cash is received. Adjusting entries fall into five types: 1. Prepaid expenses 2. Depreciation of non-current assets 3. Accrued expenses 4. Accrued revenues 5. Unearned revenues N OT DISTR O I The focus of this chapter is on learning how to account for these five types of adjusting entry. B D UT - © P E A RS O N E ENT.... S TUD FO 7@ R HE 58 1 T PR 2 094 IVAT E USE OF Prepaid expenses Prepaid expenses are advance payments of expenses. JB Hi-Fi and Qantas make prepayments for rent, insurance and supplies. Prepaid expenses are considered assets rather than expenses. When the prepayment is used up, the used portion of the asset becomes an expense via an adjusting journal entry. Prepaid rent Some landlords require tenants to pay rent in advance. This prepayment creates an asset for the renter. Suppose that Smart Touch prepays three months’ office rent of $ 3 000 ( $ 1 000 per month × 3 month on 1 June 2021. The entry to record the payment is as follows: Jun 1 Prepaid rent ($1 000 × 3) (A+) 3 000 Cash (A–) 3 000 Paid rent in advance. N OT DISTR O I B D After posting, Prepaid rent has a $3 000 debit balance. UT - © P E A RS O N E Assets Prepaid rent ENT.... Jun 1 3 000 TUD 1. The trial balance at 30 June 2021 lists Prepaid rent with a debit balance of $3 000 (Exhibit 3-2). Throughout June, Prepaid rent maintains this balance. But $3 000 is not the amount of Prepaid rent for the S FO balance sheet at 30 June. Why? 7@ R HE 58 1 T PR 2 0 94 IVAT E USE OF At 30 June, Prepaid rent should be decreased for the amount that has been used up. The used-up portion is one month of the three months prepaid, or one-third of the prepayment. Recall that an asset that has expired is an expense. The adjusting entry transfers $ 1 000 ( $ 3 000 × 1 / 3 ) from Prepaid rent to Rent expense. The adjusting entry is as follows: (a) Jun 30 Rent expense ($3 000 × 1/3) (E+) 1 000 Prepaid rent (A–) 1 000 To record rent expense. After posting, Prepaid rent and Rent expense show correct ending balances:  Assets Expenses Prepaid rent Rent expense Jun 1 3 000 Jun 30 1 000 Jun 30 1 000 Bal 2 000 Bal 1 000 Correct asset amount: → Total accounted for: ← Correct expense amount: $2 000 $3 000 $1 000 The Prepaid rent is an example of an asset that was overstated prior to posting the adjusting entry. Notice that the ending balance in Prepaid rent is now $2 000. Because Prepaid rent is an asset account for Smart Touch, it should contain only two more months of rent on 30 June (for July and August): $1000 rent per month×two months equals the $2000 Prepaid rent balance. The same analysis applies to the prepayment of three months of insurance. The only difference is in the account OT DISTR titles. ‘Prepaid insurance’ would be used instead of ‘Prepaid rent’, and ‘Insurance expense’ would be used instead O N of ‘Rent expense’. In a computerised system, the adjusting entry can be programmed to recur automatically each I accounting period. D B UT - Supplies © P E A RS O N E Supplies are also accounted for as prepaid expenses. Let’s look at an example. On 2 June, Smart Touch paid $500 for office supplies. On 15 June, it spent another $200 on office supplies. ENT.... The 30 June trial balance, therefore, still lists Supplies with a $700 debit balance, as shown in Exhibit 3-2. But Smart Touch’s 30 June balance sheet should not report supplies of $700. Why not? TUD During June, the e-learning agency used supplies to conduct business. The cost of the supplies used becomes supplies expense. To measure supplies expense, Smart Touch counts the supplies on hand at the end of June. This is the amount of the asset still owned by the business. Assume that supplies costing $600 remain on 30 June. Use S FO 7@ the Supplies T-account to determine the value of the supplies that were used: R HE 58 1 T PR 2 0 94 Assets IVAT Expenses E USE OF Supplies Supplies expense Jun 2 500 Supplies Jun 15 200 used ??? ??? Bal 600 Bal ??? So, we can solve for the supplies used as follows: Beginning supplie + Supplies purchased – Supplies used = Ending supplies s $0 + 500 + 200 – Supplies used = $600 Supplies used = $100 The 30 June adjusting entry updates Supplies and records Supplies expense for June as follows: (b) Jun 30 Supplies expense ($700 − $600) (E+) 100  Supplies (A–) 100 To record supplies used. After posting the adjusting entry, the 30 June balance of Supplies is correctly reflected as $600 and the Supplies expense is correctly reflected as $100. Assets Expenses Supplies Supplies expense Jun 2 500 Jun 15 200 Jun 30 100 Jun 30 100 Bal 600 Bal 100 The Supplies account then enters July with a $600 balance, and the adjustment process is repeated each month. Supplies is another example of an asset that was overstated at $700 on the trial balance prior to posting the adjusting entry. The adjusting entry then gave the correct balance of Supplies on 30 June of $600. N OT DISTR Exhibit 3-2 O I B Unadjusted trial balance D UT - © P E A RS O N SMART TOUCH LEARNING E ENT.... Unadjusted trial balance as at 30 June 2021 TUD $ $ Balance S FO 7@ Account Debit Credit R HE 58 Cash 4 800 41 T Accounts receivablePR IVAT 209 2 200 Supplies E USE OF 700 Prepaid rent 3 000 Furniture 18 000 Building 48 000 Accounts payable 18 200 Unearned service revenue 600 Loans payable 20 000 Sheena Bright, beginning capital 33 200 Sheena Bright, drawings 1 000 Service revenue 7 000 Salary expense 900 Electricity and gas expense 400 Total 79 000 79 000 Depreciation Property, plant and equipment assets are long-lived, non-current, tangible assets used in the operation of a business. Examples include land, buildings, equipment, furniture and vehicles. As a business uses non-current assets, their value and usefulness decline. The decline in usefulness of a non-current asset is an expense, and accountants systematically spread the asset’s cost over its useful life. A business might pay cash for a vehicle the day it is purchased but it’s something that may last for years, so the accountant averages or allocates the cost spent on the vehicle over the time the vehicle is expected to be used. The allocation of a non-current asset’s value to expense is called depreciation. Land is an exception. We record no depreciation for land, as its value typically doesn’t decline with use. Similarity to prepaid expenses The process of accounting for non-current assets is similar to that for prepaid expenses. The difference is the length of time it takes to transfer the cost or value from the asset account to the expense account. Prepaid expenses usually expire within a year, but non-current assets remain useful for several years. Let’s review an example for Smart Touch. On 3 June, Smart Touch purchased furniture for $18 000 and made the following journal entry: N OT DISTR Jun 3 Furniture (A+) O I B 18 000 Cash (A−) D 18 000 UT - Purchased furniture. © P E A RS O N After posting, the Furniture account has an $18 000 balance: E Assets ENT.... Furniture T UD Jun 3 18 000 S FO 7@ R Sheena Bright believes that the furniture will remain useful for five years and then will be worthless. One way H 58 41expected useful life (five years). So, T to calculate depreciation is to divide theEcost of the asset ($18 000) by its the depreciation for each month is then PRI 2 09 $ 300 ( $ 18 000 / 5 years = $ 3 600 / 12 VATmonths E USE= O $ F300 per month ). This method of calculating depreciation is called ‘straight-line’ depreciation (covered in detail in Chapter 10). Depreciation expense for June is recorded by the following adjusting entry: (c) Jun 30 Depreciation expense—furniture (E+) 300 Accumulated depreciation—furniture (CA+) 300 To record depreciation on furniture. The Accumulated depreciation account Notice that in the above adjusting entry for depreciation we credited Accumulated depreciation—furniture and NOT the asset account Furniture. Why? To aid decision making, we need to keep the original cost or value of the furniture separate from cumulative, subjective, past estimates of how long a non-current asset will remain useful and how much it may eventually be worth. For instance, this information may help decide how much to pay for new furniture. The accumulated depreciation account is the sum of all the depreciation recorded for the asset, and that total increases (accumulates) over time. Accumulated depreciation is a contra asset (CA), which means that it is an asset account with a normal credit balance. Contra means opposite. A contra account has two main characteristics: A contra account is paired with and follows its related account. A contra account’s normal balance (debit or credit) is the opposite of the balance of the related account. For example, Accumulated depreciation—furniture is the contra account that follows the Furniture account on the balance sheet. The Furniture account has a debit balance, so Accumulated depreciation, a contra asset, has a credit balance. A business may have a separate Accumulated depreciation account for each depreciable asset. If Smart Touch has both a Building and a Furniture account, it may have these two accounts: Accumulated depreciation— building, and Accumulated depreciation—furniture. After posting the depreciation, the accounts appear as follows: Assets Expenses Normal asset Contra asset N OT DISTR O I B Furniture D Accumulated Depreciation UT - depreciation—furniture expense—furniture © P E A RS O N Jun 3 18 000 Jun 30 E 300 Jun 30 300 Bal 18 000 Bal 300 ENT.... Bal 300 T UD Carrying value (book value) S FO 7@ The balance sheet reports both Furniture and Accumulated depreciation—furniture. As it is a contra account, R Accumulated depreciation—furnitureHis subtracted from Furniture. The resulting net amount (cost minus 58 41 or sometimes its book value. T E P asset is called its carrying 9amount, accumulated depreciation) of a non-current R IV is as follows: F 2 For Smart Touch’s furniture, the carrying amount 0 ATE USE O Carrying value of furniture assets: Furniture $18 000 Less: Accumulated depreciation—furniture 300 Carrying amount of the furniture $17 700 The carrying amount represents value invested in the asset that the business hasn’t yet expensed. Suppose that the e-learning agency also owns a building that cost $48 000, with monthly depreciation of $200. The following adjusting entry would record depreciation for June: (d) Jun 30 Depreciation expense—building (E+) 200 Accumulated depreciation—building (CA+) 200 To record depreciation on building. The 30 June balance sheet would report non-current assets as shown in Exhibit 3-3. Exhibit 3-3 Non-current assets on the balance sheet of Smart Touch Learning (30 June) Non-current assets Furniture $18 000 Less: Accumulated depreciation—furniture 300 $17 700 Building $48 000 Less: Accumulated depreciation—building 200 47 800 Non-current assets, net $65 500 N OT DISTR O I B D UT - © P E A RS O N E ENT.... ST UD FO 7@ R HE 58 1 T PR 2 094 IVAT E USE OF Accrued expenses Businesses often incur expenses before paying for them. The term accrued expense refers to an expense of this type. An accrued expense hasn’t been paid for yet. Consider an employee’s salary. The salary expense grows as the employee works, so the expense is said to accrue. Another accrued expense is interest expense on a loan payable. Interest accrues as time passes on the loan. An accrued expense always creates a liability. Companies don’t usually make weekly journal entries to accrue expenses. Instead, they wait until the end of the accounting period. They make an adjusting entry to bring each expense (and the related liability) up to date for the financial statements. Remember that prepaid expenses and accrued expenses are opposites. A prepaid expense is paid first and expensed later. An accrued expense is expensed first and paid later. N OT DISTR Accruing salary expense O I B D UT - Suppose that Smart Touch pays its employee a monthly salary of $1 800—half on the 17th and half on the first ©PEARSON day of the next month. Here is a calendar for June and July with the two pay days circled: E ENT.... STUD FO 7@ R HE 58 1 T PR 2 0 94 IVAT E USE OF During June, Sheena Bright paid the first half-month salary on Thursday 17 June, and made this entry: Jun 17 Salary expense (E+) 900 Cash (A–) 900  To pay salary. After posting, Salary expense shows the following balance: Expenses Salary expense Jun 17 900 1. The trial balance on 30 June (Exhibit 3-2) includes Salary expense, with a debit balance of $900. This is Smart Touch’s salary expense for the first half of June. The second payment of $900 will occur on 1 July; however, the expense was incurred in June, so the expense must be recorded in June. On 30 June, Smart Touch makes the following adjusting entry: (e) Jun 30 Salary expense (E+) N OT DISTR 900 O I B D Salary payable (L+) 900 UT - To accrue salary expense. ©PEARSON After posting, both Salary expense and Salary payable are up to date: E Expenses ENT.... Liabilities Salary expense Salary payable TUD Jun 17 900 Jun 30 900 S FO 7@ Jun 30 900 Bal R HE 58 41 T Bal 1 800 PR 0 9 IV T Salary expense shows a full month’s salary, and A EU Salary F 2 the liability owed at 30 June. This is an SE Oshows payable example of a liability that was understated before the adjusting entry was made. It is also an example of the matching principle—we are recording June’s salary expense in June so it will be reported in the same income statement period as June’s revenues. Accruing interest expense Borrowing money creates a liability for a Loan payable. If, on 1 June 2021, Smart Touch borrows $20 000 from the bank after signing a one-year loan payable, the entry to record the loan on 1 June 2021 is as follows: Jun 1 Cash (A+) 20 000 Loan payable (L+) 20 000 Borrowed money. Interest on this loan is payable one year later, on 1 June 2022. On 30 June 2021, the business must make an adjusting entry to record the interest expense that has accrued for the month of June. Assume that one month’s interest expense on this loan is $100. The 30 June adjusting entry to accrue interest expense is as follows: (f) Jun 30 Interest expense (E+) 100 Interest payable (L+) 100 To accrue interest expense. This is another example of a liability that was understated before the adjusting entry was made. After posting, Interest expense and Interest payable have the following balances: Expenses Liabilities Interest expense Interest payable Jun 30 100 Jun 30 100 OT DISTR Bal 100 Bal 100 O N IB Exhibit 3-2 D UT - ©PEARSON Unadjusted trial balance E SMART TOUCH LEARNING Unadjusted trial balance ENT.... TUD as at 30 June 2021 $ $ S FO 7@ Balance R HE 58 Account 1 Debit Credit T Cash PR 2 0 94 4 800 IVAT Accounts receivable E USE OF 2 200 Supplies 700 Prepaid rent 3 000 Furniture 18 000 Building 48 000 Accounts payable 18 200 Unearned service revenue 600 Loans payable 20 000 Sheena Bright, beginning capital 33 200 Sheena Bright, drawings 1 000 Service revenue 7 000 Salary expense 900 Electricity and gas expense 400 Total 79 000 79 000  N OT DISTR O I B D UT - ©PEARSON E ENT.... STUD FO 7@ R HE 58 1 T PR 2 0 94 IVAT E USE OF Accrued revenues As we have just seen, expenses can occur before a business makes a cash payment for them, which creates an accrued expense. Similarly, businesses can earn revenue before they receive the cash. This creates an accrued revenue, which is a revenue that has been earned but for which the cash hasn’t yet been collected. Assume that Smart Touch is hired on 16 June to perform e-learning services for the University of Western Australia. Under this agreement, Smart Touch will earn $800 monthly. During June, Smart Touch will earn half a month’s fee, $400, for work from 16 June to 30 June. On 30 June, Smart Touch makes the following adjusting entry to accrue the revenue earned from 16 June to 30 June: (g) Jun 30 Accounts receivable ($800 ×1/2) (A+) 400 Service revenue (R+) 400 To accrue service revenue. N OT DISTR The unadjusted trial balance in Exhibit 3-2 shows that Accounts receivable has an unadjusted balance of $2 200. The unadjusted balance for Service revenue is $7 000 from the day-to-day June transactions recorded as O I B journal entries. (Detailed entries for June transactions aren’t shown in the Accounts receivable or Service D revenue T-accounts. Only adjusting entries are shown.) The adjusting entry updates both accounts. UT - © P E ARS O N E Assets Revenues Accounts receivable Service revenue DENT.... 2 200 7 000 Jun 30 400 Jun 30 400 STU Bal 2 600 Bal 7 400 FO 7@ Without the adjustment, Smart Touch’s financial statements would understate both an asset, Accounts R H receivable, and a revenue, Service revenue. 58 41 T EP 9 RIV 0 Now we turn to the final category of adjusting ATE USE OF 2 entries. Exhibit 3-2 Unadjusted trial balance SMART TOUCH LEARNING Unadjusted trial balance as at 30 June 2021 $ $ Balance Account Debit Credit Cash 4 800 Accounts receivable 2 200 Supplies 700 Prepaid rent 3 000 Furniture 18 000 Building 48 000 Accounts payable 18 200 Unearned service revenue 600 Loans payable 20 000 Sheena Bright, beginning capital 33 200 Sheena Bright, drawings 1 000 Service revenue 7 000 Salary expense 900 Electricity and gas expense 400 Total 79 000 79 000 N OT DISTR O I B D UT - © P E ARS O N E DENT.... STU FO 7@ R HE 58 1 T PR 2 0 94 IVAT E USE OF Unearned revenues Some businesses collect cash from customers in advance of performing work. Receiving cash before earning it creates a liability to perform work in the future, called unearned revenue. The business owes a product or a service to the customer, or it owes the customer his or her money back. Only after completing the job will the business earn the revenue. Because of this delay, unearned revenue is also called deferred revenue. Unearned revenue occurs when the business is paid cash before it does all the work to earn it. Suppose, for example, that a legal firm engages Smart Touch to provide e-learning services, agreeing to pay $600 in advance monthly, beginning immediately. Sheena Bright collects the first amount on 21 June. Smart Touch records the cash receipt and a liability as follows: Jun 21 Cash (A+) 600 Unearned service revenue (L+) 600 Collected revenue in advance. Connect to: Ethics N OT DISTR O I B D Many unethical schemes enacted to artificially inflate earnings or change accounts on the balance sheet are UT - accomplished through adjusting journal entries. Remember that every journal entry will have some document ©PEARSON that substantiates why the entry is being made, such as an invoice that supports how many supplies were E purchased or a contract with a customer that supports what services are to be provided. ‘Supporting documents’ for unethical entries often don’t exist or are modified copies of real documents. ENT.... Now the liability account, Unearned service revenue, shows that Smart Touch owes $600 in services. TU D Liabilities S Unearned service revenue FO 7@ R HE 58 41 T Jun 21 600 PR 2 09 IVAT E USE OF Unearned service revenue is a liability because the business owes a service to a client in the future. The 30 June trial balance (Exhibit 3-2) lists Unearned service revenue with a $600 credit balance. During the last 10 days of the month—21 June to 30 June—Smart Touch will earn one-third (10 days divided by 30 days) of the $600, or $200. Therefore, Smart Touch makes the following adjusting entry to record earning $200 of revenue: (h) Jun 30 Unearned service revenue ($600 ×1 / 3) (L–) 200 Service revenue (R+) 200 To record service revenue that was collected in advance. This adjusting entry shifts $200 from liabilities to revenues. Service revenue is increased by $200, and Unearned service revenue is decreased by $200. Now both accounts are up to date at 30 June: Liabilities Revenues  Unearned service revenue Service revenue Jun 30 200 Jul 21 600 7 000 Bal 400 Jun 30 400 Jun 30 200 Bal 7 600 This is an example of a liability that was overstated prior to posting the adjusting journal entry. Remember this key point: An unearned revenue is a liability account, not a revenue account. An unearned revenue to one firm is a prepaid expense to the business that paid in advance. Consider the law firm in the preceding example. The law firm had prepaid e-learning expense—an asset. Smart Touch had unearned service revenue—a liability. Exhibit 3-4 summarises the timing of prepaid and accrual adjustments. Study the exhibit from left to right, and then move down. N OT DISTR O I B Exhibit 3-4 D UT - ©PEARSON Prepaid and accrual adjustments E ENT.... STU D FO 7@ R HE 58 41 T PR 2 09 IVAT E USE OF Source: The authors thank Darrel Davis and Alfonso Oddo for suggesting this exhibit. On the left of the ledger are original entries and on the right of the ledger are adjusting entries for various transactions. Under original entry are the postings for prepaids and accruals. PREPAIDS: Cash receipt or payment occurs first. Prepaid expenses: Prepaid rent A plus, XXX in the debit record of the ledger; Cash A minus, XXX in the credit record. Pay for rent in advance and record an asset first. Depreciation: Furniture A plus, XXX in the debit record of the ledger; Cash A minus, XXX in the credit record. Pay for furniture in advance and record an asset first. Unearned revenues: Cash A plus, XXX in the debit record of the ledger; Unearned service revenue L plus, XXX in the credit record. Receive cash in advance and record a liability first. ACCRUALS: Cash receipt or payment occurs later. Accrued expense: Salary expense E plus, XXX in the debit record of the ledger; Salary payable L plus, XXX in the credit record. Accrue for expense incurred first. N OT DISTR Accrued revenues: Accounts receivable A plus, XXX in the debit record of the ledger; Service revenue O I R plus, XXX in the credit record. Accrue for revenue earned first.B D Under adjusting entry are the following postings. UT - ©PEARSON E Prepaid expenses: Rent expense E plus, XXX in the debit record of the ledger; Prepaid rent A minus, XXX in the credit record. Adjust for rent used later. ENT.... Depreciation: Depreciation expense for furniture E plus, XXX in the debit record of the ledger; Accumulated depreciation for furniture CA plus, XXX in the credit record. Adjust for depreciation use of asset later. TU D Unearned revenues: Unearned service revenue L minus, XXX in the debit record of the ledger; Service revenue R plus, XXX in the credit record. Adjust for revenue earned later. S FO 7@ Accrued expense: Salary Payable L minus, XXX in the debit record of the ledger; Cash A minus, XXX R H 58 in the credit record. Pay cash later. 1 T EP 94 R 2 0 Accrued revenues: Cash A plus, XXX IinVthe ATdebit F the ledger; Accounts receivable A minus, recordOof XXX in the credit record. Receive cash later. E U S E Exhibit 3-5 summarises the adjusting entries of Smart Touch at 30 June. The adjustments are keyed by letter. Panel A gives the data for each adjustment. Panel B shows the adjusting entries. Panel C shows the account balances after posting. Exhibit 3-5 Journalising and posting the adjusting entries of Smart Touch Learning  N OT DISTR O I B D UT - ©PEARSON E ENT.... STU D FO 7@ R HE 58 41 T PR 2 09 IVAT E USE OF The screenshot has two panels A and B. Panel A shows information for adjustments made on 30th June 2021. Panel B shows the adjusting entries. The details of Panel A are as follows:  1. Prepaid rent expired, $1 000. 2. Supplies used, $100. 3. Depreciation on furniture, $300. 4. Depreciation on building, $200. 5. Accrued salary expense, $900. 6. Accrued interest on loan, $100. 7. Accrued service revenue, $400. 8. Service revenue that was collected in advance and now has been earned, $200. The postings in panel B are for all the adjustments listed in panel A and for 30th June 2021 and are as follows: Prepaid rent expense: Rent expense E plus, $1000 in the debit record of the ledger. Prepaid rent A minus $1000 in the credit record. To record rent expense. N OT DISTR Supplies: Supplies expense E plus, $100 in the debit record of the ledger. Supplies A minus $100 in the credit record. To record supplies used.O I B D Depreciation on furniture: Depreciation on furniture E plus, $300 in the debit record of the ledger. UT - ©PEARSON Accumulated depreciation of furniture CA plus $300 in the credit record. To record depreciation on E furniture. Depreciation on building: Depreciation on building E plus, $200 in the debit record of the ledger. ENT.... Accumulated depreciation of building CA plus $200 in the credit record. To record depreciation on building. Accrued salary expense: Salary expense E plus, $900 in the debit record of the ledger; Salary payable L TU D plus, $900 in the credit record. To accrue salary expense. S FO Accrued interest on loan: Interest expense E plus, $100 in the debit record of the ledger; Interest 7@ payable L plus, $100 in the credit record. To accrue interest expense. R HE 58 1 T Accrued service revenue: AccountsPreceivable 94 debit record of the ledger; Service RIV A plus, $400F in20the revenue R plus, $400 in the credit record.A ToTaccrue E O revenue. E service US Service revenue that was collected in advance and now has been earned: Unearned service revenue L minus, $200 in the debit record of the ledger; Service revenue R plus, $200 in the credit record. To record service revenue that was collected in advance. Exhibit 3-5 (Panel C)  N OT DISTR O I B D UT - ©PEARSON E ENT.... STU D FO 7@ R HE 58 41 T PR 2 09 IVAT E USE OF The details of the T-account for assets, liabilities, owners’ equity and expenses are as follows: Panel C: Ledger accounts in T-account form. Under assets are the following postings:  Cash: Opening balance of 4800 on the debit side. Accounts receivable: 2,200 and 400 from adjusted entry G of panel B on the debit side. Closing balance: 2,600. Supplies: 700 on the debit side. 100 from adjusted entry B of panel B on the credit side. Closing balance: 600. Prepaid rent: 3000 on the debit side. 1000 from adjusted entry A of panel B on the credit side. Closing balance: 2000. Furniture: Opening balance of 18,000. Building: Opening balance of 48,000. Accumulated depreciation on furniture: 300 on the credit side. Closing balance: 300. Accumulated depreciation on building: 200 on the credit side. Closing balance: 200. Under liabilities are the following postings: Accounts payable: Opening balance of 18,000. N OT DISTR O I B D Salary payable: 900 from adjusted entry E of panel B on the credit side. Closing balance: 900. UT - Interest payable: 100 from adjusted entry F of panel B on the credit side. Closing balance: 100. ©PEARSON E Unearned service revenue: 200 from adjusted entry H of panel B on the debit side. 600 on the credit side. Closing balance: 400. Loans payable: Opening balance of 20,000. ENT.... Under owners’ equity are the following postings: TU D Sheena Bright, Capital: Opening balance of 33,200. S FO 7@ Sheena Bright, Drawings: Opening balance of 1000. R H 58 41 T E Under revenue are the following postings: PR 9 IV T 2 0 Service revenue: 7000, 400 from adjustedA OFfrom adjusted entry H of panel B on the SE 200 E GUand entry credit side. Balance is 7600. Under expenses are the following postings: Rent expense: 1000 from adjusted entry A of panel B on the debit side. Balance is 1000. Salary expense: 900 and 900 from adjusted entry E of panel B on the debit side. Balance is 1800. Supplies expense: 100 from adjusted entry B of panel B on the debit side. Balance is 100. Depreciation expense on furniture: 300 from adjusted entry B of panel B on the debit side. Balance is 300. Depreciation expense on building: 200 from adjusted entry D of panel B on the debit side. Balance is 200. Interest expense: 100 from adjusted entry F of panel B on the debit side. Balance is 100. Electricity and gas expense: Opening balance of 400. Try it! 3.2 Look at the eight adjusting entries in Exhibit 3-5. Notice that only the last two adjusting entries, (g) and (h), increased revenues. Six of the eight adjusting entries increased expenses. So, when in doubt about an adjustment, it is more likely that it will be an adjusting entry that increases (debits) an expense account. You can refer to the examples in the text and in the exhibit to confirm your adjusting entry. An invoice is now received for the purchase of materials. Which accounts are affected? Will these accounts be debited or credited? Exhibit 3-2 Unadjusted trial balance SMART TOUCH LEARNING Unadjusted trial balance N T D as at 30 O I STR June 2021 O IB D $ Balance $ UT - ©PEARSON Account Debit Credit E Cash 4 800 Accounts receivable 2 200 Supplies ENT.... 700 Prepaid rent 3 000 Furniture 18 000 TU D Building 48 000 S Accounts payable 18 200 FO 7@ Unearned service revenue 600 R H 58 41 T Loans payable E P 9 20 000 R IVAcapital 2 0 Sheena Bright, beginning TE U S E OF 33 200 Sheena Bright, drawings 1 000 Service revenue 7 000 Salary expense 900 Electricity and gas expense 400 Total 79 000 79 000 3.4 The adjusted trial balance LO 3.4 Explain the purpose of and prepare an adjusted trial balance This chapter began with the unadjusted trial balance (Exhibit 3-2). After the adjustments, the accounts appear as shown in Exhibit 3-5 Panel C. A useful step in preparing the financial statements is to list the accounts, along with their adjusted balances, on an adjusted trial balance. Exhibit 3-6 shows how to prepare the adjusted trial balance. Exhibit 3-6 Preparation of adjusted trial balance N OT DISTR O I B D UT - ©PEARSON E ENT.... STU D FO 7@ R HE 58 41 T PR 2 09 IVAT E USE OF The balance sheet has three sections: Unadjusted trial balance, adjustments and adjusted trial balance. The details of the unadjusted trial balance are as follows: Cash: 4800 on the debit side. Accounts receivable: 2000 on the debit side. Supplies: 700 on the debit side. Prepaid rent: 3000 on the debit side. Furniture: 18 000 on the debit side. Building: 48 000 on the debit side. Accumulated depreciation for furniture: NA. Accumulated depreciation for building: NA. Accounts payable: 18,200 on the credit side. Salary payable: NA. N OT DISTR Interest payable: NA. O I B D Unearned service revenue: 600 on the credit side. UT - ©PEARSON Loans payable: 20,000 on the credit side. Sheena Bright, beginning capital: 33,200 on the credit side. E Sheena Bright, drawings: 1000 on the debit side. ENT.... Service revenue: 7000 on the credit side. TU D Rent expense: NA. S FO 7@ Salary Expense: 900 on the debit side. R HE NA. 58 41 T Depreciation expense for furniture: PR 2 09 I Depreciation expense for building: NA.VATE USE OF Interest expense: NA. Electricity and gas expense: 400 on the debit side. Total of unadjusted trial balance is 79,000 on both credit and debit sides. The details of the adjustments are as follows: Cash: NA. Accounts receivable: 400 from ledger posting G on the debit side. Supplies: 100 from ledger posting B on the credit side. Prepaid rent: 1000 from ledger posting A on the credit side. Furniture: NA. Building: NA.  Accumulated depreciation for furniture: 300 from ledger posting C on the credit side. Accumulated depreciation for building: 200 from ledger posting D on the credit side. Accounts payable: NA. Salary payable: 900 from ledger posting E on the credit side. Interest payable: 100 from ledger posting F on the credit side. Unearned service revenue: 200 from ledger posting F on the credit side. Loans payable: NA. Sheena Bright, beginning capital: NA. Sheena Bright, drawings: NA. Service revenue: 400 and 200 from ledger postings G and H on the credit side. Rent expense: 1000 from ledger posting A on the debit side. N OT DISTR O I Salary Expense: 900 from ledger posting E on the debit side. B D Supplies Expense: 100 from ledger posting B on the debit side. UT - ©PEARSON Depreciation expense for furniture: 300 from ledger posting C on the debit side. E Depreciation expense for building: 200 from ledger posting D on the debit side. Interest expense: 100 from ledger posting F on the debit side. ENT.... Electricity and gas expense: NA. TU D Total of adjustments balance is 3200 on both credit and debit sides. S FO 7@ The details of the adjusted trial balance are as follows: R HE 58 41 T Cash: 4800 on the debit side. PR 09 ATE USE OF 2 I side. Accounts receivable: 2000 on the debit V Supplies: 600 on the debit side. Prepaid rent: 2000 on the debit side. Furniture: 18 000 on the debit side. Building: 48 000 on the debit side. Accumulated depreciation for furniture: 300 on the credit side. Accumulated depreciation for building: 200 on the credit side. Accounts payable: 18,200 on the credit side. Salary payable: 900 on the credit side. Interest payable: 100 on the credit side. Unearned service revenue: 400 on the credit side.  Loans payable: 20,000 on the credit side. Sheena Bright, beginning capital: 33,200 on the credit side. Sheena Bright, drawings: 1000 on the debit side. Service revenue: 7600 on the credit side. Rent expense: 1000 on the debit side. Salary Expense: 1800 on the debit side. Depreciation expense for furniture: 300 on the debit side. Depreciation expense for building: 200 on the debit side. Interest expense: 100 on the debit side. Electricity and gas expense: 400 on the debit side. Total of adjusted trial balance is 80,900 on both credit and debit sides. N OT DISTR All values are in dollars. O I B D Exhibit 3-6 is also a partial worksheet. We will cover the complete worksheet in Chapter 4. For now, simply UT - note how clear this format is. The account titles and the unadjusted trial balance are copied directly from the ©PEARSON E trial balance in Exhibit 3-2. The two adjustments columns show the adjusting journal entries from Exhibit 3- 5. ENT.... The Adjusted trial balance columns give the adjusted account balances. Each amount in these columns is calculated by combining the trial balance amounts plus or minus the adjustments. For example, Accounts receivable starts with a debit balance of $2 200. Adding the $400 debit from adjustment (g) gives Accounts receivable an adjusted balance of $2 600. Supplies begins with a debit balance of $700. After the $100 credit TU D adjustment, Supplies has a $600 balance. More than one entry may affect a single account. For example, Service revenue has two adjustments, (g) and (h), and both increase the Service revenue balance. S FO 7@ Exhibit 3-2 R HE 58 41 T Unadjusted trial balance PR 2 09 IVAT E USE OF SMART TOUCH LEARNING Unadjusted trial balance as at 30 June 2021 $ $ Balance Account Debit Credit Cash 4 800 Accounts receivable 2 200 Supplies 700 Prepaid rent 3 000 Furniture 18 000 Building 48 000  Accounts payable 18 200 Unearned service revenue 600 Loans payable 20 000 Sheena Bright, beginning capital 33 200 Sheena Bright, drawings 1 000 Service revenue 7 000 Salary expense 900 Electricity and gas expense 400 Total 79 000 79 000 Exhibit 3-5 (Panel C) N OT DISTR O I B D UT - ©PEARSON E ENT.... TU D S FO 7@ R HE 58 41 T PR 2 09 IVAT E USE OF  N OT DISTR O I B D UT - ©PEARSON E ENT.... STU D FO 7@ R HE 58 41 T PR 2 09 IVAT E USE OF The details of the T-account for assets, liabilities, owners’ equity and expenses are as follows: Panel C: Ledger accounts in T-account form. Under assets are the following postings:  Cash: Opening balance of 4800 on the debit side. Accounts receivable: 2,200 and 400 from adjusted entry G of panel B on the debit side. Closing balance: 2,600. Supplies: 700 on the debit side. 100 from adjusted entry B of panel B on the credit side. Closing balance: 600. Prepaid rent: 3000 on the debit side. 1000 from adjusted entry A of panel B on the credit side. Closing balance: 2000. Furniture: Opening balance of 18,000. Building: Opening balance of 48,000. Accumulated depreciation on furniture: 300 on the credit side. Closing balance: 300. Accumulated depreciation on building: 200 on the credit side. Closing balance: 200. Under liabilities are the following postings: Accounts payable: Opening balance of 18,000. N OT DISTR O I B D Salary payable: 900 from adjusted entry E of panel B on the credit side. Closing balance: 900. UT - Interest payable: 100 from adjusted entry F of panel B on the credit side. Closing balance: 100. ©PEARSON E Unearned service revenue: 200 from adjusted entry H of panel B on the debit side. 600 on the credit side. Closing balance: 400. Loans payable: Opening balance of 20,000.