2/1/2015

IEBWireframe

AdjustingEntries
Thereismoretothemeasurementofbusinessincomethanmerelyrecordingsimplerevenueandexpense
transactionsthataffectonlyasingleaccountingperiod.Certaintransactionsaffecttherevenueor
expensesoftwoormoreaccountingperiods.Thepurposeofadjustingentriesistoassigntoeach
accountingperiodappropriateamountsofrevenueandexpense.Forexample,OvernightAutoService
purchasedshopsuppliesthatwillbeusedforseveralmonths.Thus,anadjustingentryisrequiredto
recordtheexpenseassociatedwiththeshopsuppliesthatOvernightuseseachmonth.
LO41
LO41
LEARNINGOBJECTIVE
Explainthepurposeofadjustingentries.
THENEEDFORADJUSTINGENTRIES
Forpurposesofmeasuringincomeandpreparingfinancialstatements,thelifeofabusinessisdivided
intoaseriesofaccountingperiods.Thispracticeenablesdecisionmakerstocomparethefinancial
statementsofsuccessiveperiodsandtoidentifysignificanttrends.
Butmeasuringnetincomeforarelativelyshortaccountingperiodsuchasamonthorevenayear
posesaproblembecause,asmentionedabove,somebusinessactivitiesaffecttherevenueandexpenses
ofmultipleaccountingperiods.Therefore,adjustingentriesareneededattheendofeachaccounting
periodtomakecertainthatappropriateamountsofrevenueandexpensearereportedinthecompany's
incomestatement.
Forexample,magazinepublishersoftenselltwoorthreeyearsubscriptionstotheirpublications.Atthe
endofeachaccountingperiod,thesepublishersmakeadjustingentriesrecognizingtheportionoftheir
advancereceiptsthathavebeenearnedduringthecurrentperiod.Mostcompaniesalsopurchase
insurancepoliciesthatbenefitmorethanoneperiod.Therefore,anadjustingentryisneededtomake
certainthatanappropriateportionofeachpolicy'stotalcostisreportedintheincomestatementas
insuranceexpensefortheperiod.Inshort,adjustingentriesareneededwhenevertransactionsaffectthe
revenueorexpensesofmorethanoneaccountingperiod.Theseentriesassignrevenuestotheperiodin
whichtheyareearned,andexpensestotheperiodsinwhichrelatedgoodsorservicesareused.
Intheory,abusinesscouldmakeadjustingentriesonadailybasis.Butasapracticalmatter,theseentries
aremadeonlyattheendofeachaccountingperiod.Formostcompanies,adjustingentriesaremadeona
monthlybasis.
TYPESOFADJUSTINGENTRIES
LO42
LO42
LEARNINGOBJECTIVE
Describeandpreparethefourbasictypesofadjustingentries.
Thenumberofadjustmentsneededattheendofeachaccountingperioddependsentirelyuponthenature
ofthecompany'sbusinessactivities.However,mostadjustingentriesfallintooneoffourgeneral
categories:1
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

1/25

2/1/2015

IEBWireframe

1. Convertingassetstoexpenses.Acashexpenditure(orcost)thatwillbenefitmorethanone
accountingperiodusuallyisrecordedbydebitinganassetaccount(forexample,Supplies,
UnexpiredInsurance,andsoon)andbycreditingCash.Theassetaccountcreatedactually
representsthedeferral(orthepostponement)ofanexpense.Ineachfutureperiodthatbenefits
fromtheuseofthisasset,anadjustingentryismadetoallocateaportionoftheasset'scostfrom
thebalancesheettotheincomestatementasanexpense.Thisadjustingentryisrecordedby
debitingtheappropriateexpenseaccount(forexample,SuppliesExpenseorInsuranceExpense)
andcreditingtherelatedassetaccount(forexample,SuppliesorUnexpiredInsurance).
Page143
2. Convertingliabilitiestorevenue.Abusinessmaycollectcashinadvanceforservicestobe
renderedinfutureaccountingperiods.Transactionsofthisnatureareusuallyrecordedbydebiting
Cashandbycreditingaliabilityaccount(typicallycalledUnearnedRevenueorCustomer
Deposits).Here,theliabilityaccountcreatedrepresentsthedeferral(orthepostponement)ofa
revenue.Intheperiodthatservicesareactuallyrendered(orthatgoodsaresold),anadjusting
entryismadetoallocateaportionoftheliabilityfromthebalancesheettotheincomestatementto
recognizetherevenueearnedduringtheperiod.Theadjustingentryisrecordedbydebitingthe
liability(UnearnedRevenueorCustomerDeposits)andbycreditingRevenueEarned(orasimilar
account)forthevalueoftheservices.
3. Accruingunpaidexpenses.Anexpensemaybeincurredinthecurrentaccountingperiodeven
thoughnocashpaymentwilloccuruntilafutureperiod.Theseaccruedexpensesarerecordedby
anadjustingentrymadeattheendofeachaccountingperiod.Theadjustingentryisrecordedby
debitingtheappropriateexpenseaccount(forexample,InterestExpenseorSalaryExpense)andby
creditingtherelatedliability(forexample,InterestPayableorSalariesPayable).
4. Accruinguncollectedrevenue.Revenuemaybeearned(oraccrued)duringthecurrentperiod,
eventhoughthecollectionofcashwillnotoccuruntilafutureperiod.Unrecordedearnedrevenue,
forwhichnocashhasbeenreceived,requiresanadjustingentryattheendoftheaccounting
period.Theadjustingentryisrecordedbydebitingtheappropriateasset(forexample,Accounts
ReceivableorInterestReceivable)andbycreditingtheappropriaterevenueaccount(forexample,
ServiceRevenueEarnedorInterestEarned).
ADJUSTINGENTRIESANDTIMINGDIFFERENCES
Inanaccrualaccountingsystem,thereareoftentimingdifferencesbetweencashflowsandthe
recognitionofexpensesorrevenue.Acompanycanpaycashinadvanceofincurringcertainexpensesor
receivecashbeforerevenuehasbeenearned.Likewise,itcanincurcertainexpensesbeforepayingany
cashoritcanearnrevenuebeforeanycashisreceived.Thesetimingdifferences,andtheadjusting
entriesthatresultfromthem,aresummarizedbelow.
Adjustingentriestoconvertassetstoexpensesresultfromcashbeingpaidpriortoanexpense
beingincurred.
Adjustingentriestoconvertliabilitiestorevenueresultfromcashbeingreceivedpriortorevenue
beingearned.
Adjustingentriestoaccrueunpaidexpensesresultfromexpensesbeingincurredbeforecashis
paid.
Adjustingentriestoaccrueuncollectedrevenueresultfromrevenuebeingearnedbeforecashis
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

2/25

2/1/2015

IEBWireframe

received.
AsillustratedinExhibit41,adjustingentriesprovideimportantlinkagesbetweenaccountingperiods
relatedtothesetimingdifferences.Specifically,theylink:(1)priorperiodcashoutflowstocurrent
periodexpenses,(2)priorperiodcashinflowstocurrentperiodrevenue,(3)currentperiodexpensesto
futurecashoutflows,and(4)currentperiodrevenuetofutureperiodcashinflows.

EXHIBIT41
AdjustingEntriesProvideLinksBetweenAccountingPeriods

EXHIBIT41
AdjustingEntriesProvideLinksBetweenAccountingPeriods
CHARACTERISTICSOFADJUSTINGENTRIES
Keepinmindtwoimportantcharacteristicsofalladjustingentries:First,everyadjustingentryinvolves
therecognitionofeitherrevenueorexpenses.Revenueandexpensesrepresentchangesinowners'
equity.However,owners'equitycannotchangebyitselftherealsomustbeacorrespondingchangein
eitherassetsorliabilities.Thuseveryadjustingentryaffectsbothanincomestatementaccount(revenue
orexpense)andabalancesheetaccount(assetorliability).Rarelydoadjustingentriesincludeanentryto
Cash.Itisimportanttorecognizethatnoneoftheadjustmentsdiscussedinthischapterrequireadebitor
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

3/25

2/1/2015

IEBWireframe

acredittoCash.
Page144
Second,adjustingentriesarebasedontheconceptsofaccrualaccounting,notuponmonthlybillsor
monthendtransactions.NoonesendsOvernightAutoServiceabillsaying,ShopSupplyExpensefor
themonthis$500.YetOvernightmustbeawareoftheneedtorecordtheestimatedcostofshop
suppliesconsumedifitistomeasureincomeproperlyfortheperiod.Makingadjustingentriesrequiresa
greaterunderstandingofaccrualaccountingconceptsthandoestherecordingofroutinebusiness
transactions.Inmanybusinesses,theadjustingprocessisperformedbythecontrollerorbyaprofessional
accountant,ratherthanbytheregularaccountingstaff.
Page145
YEARENDATOVERNIGHTAUTOSERVICE
Toillustratethevarioustypesofadjustingentries,wewillagainuseourexampleinvolvingOvernight
AutoService.Chapter3concludedwithOvernight'strialbalancedatedFebruary28,2015(theendofthe
company'ssecondmonthofoperations).WewillnowskipaheadtoDecember31,2015theendof
Overnight'sfirstyearofoperations.Thiswillenableustoillustratethepreparationofannualfinancial
statements,ratherthanstatementsthatcoveronlyasinglemonth.
Mostcompaniesmakeadjustingentrieseverymonth.WewillassumethatOvernighthasbeenfollowing
thisapproachthroughout2015.Thecompany'sunadjustedtrialbalancedatedDecember31,2015,
appearsinExhibit42.ItisreferredtoasanunadjustedtrialbalancebecauseOvernightlastmade
adjustingentriesonNovember30therefore,itisstillnecessarytomakeadjustingentriesforthemonth
ofDecember.
EXHIBIT42
UnadjustedTrialBalance

http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

4/25

2/1/2015

IEBWireframe

d
OVERNIGHTAUTOSERVICE
TRIALBALANCE
DECEMBER31,2015
Cash............................................ $18,592
Accountsreceivable................................

6,500

Shopsupplies.....................................

1,800

Unexpiredinsurance................................

4,500

Toolsandequipment................................

12,000

Accumulateddepreciation:toolsandequipment..........
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

2,000
5/25

2/1/2015

IEBWireframe

Building..........................................

36,000

Accumulateddepreciation:building....................
Land.............................................

$1,500
52,000

Notespayable.....................................

4,000

Accountspayable..................................

2,690

Incometaxespayable...............................

1,560

Unearnedrentrevenue..............................

9,000

Capitalstock......................................

80,000

Retainedearnings..................................

Dividends.........................................

14,000

Repairservicerevenue..............................

171,250

Advertisingexpense................................

3,900

Wagesexpense....................................

56,800

Suppliesexpense..................................

6,900

Depreciationexpense:building........................

1,500

Depreciationexpense:toolsandequipment..............

2,000

Utilitiesexpense...................................

19,400

Insuranceexpense.................................

13,500

http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

6/25

2/1/2015

IEBWireframe

Incometaxesexpense.............................. 22,608

$272,000 $272,000
EXHIBIT42
UnadjustedTrialBalance
Inthenextfewpagesweillustrateseveraltransactions,aswellastherelatedadjustingentries.Bothare
shownintheformatofgeneraljournalentries.Tohelpdistinguishbetweentransactionsandadjusting
entries,transactionsareprintedinblueandadjustingentriesinred.
CONVERTINGASSETSTOEXPENSES
LO43
LO43
LEARNINGOBJECTIVE
Prepareadjustingentriestoconvertassetstoexpenses.
Whenabusinessmakesanexpenditurethatwillbenefitmorethanoneaccountingperiod,theamount
usuallyisdebitedtoanassetaccount.Attheendofeachperiodbenefitingfromthisexpenditure,an
adjustingentryismadetotransferanappropriateportionofthecostfromtheassetaccounttoanexpense
account.Thisadjustingentryreflectsthefactthatpartoftheassethasbeenuseduporbecomean
expenseduringthecurrentaccountingperiod.
Page146
Anadjustingentrytoconvertanassettoanexpenseconsistsofadebittoanexpenseaccountandacredit
toanassetaccount(orcontraassetaccount).Examplesoftheseadjustmentsincludetheentriesto
apportionthecostsofprepaidexpensesandentriestorecorddepreciationexpense.
PrepaidExpenses
PrepaidExpensesPaymentsinadvanceoftenaremadeforsuchitemsasinsurance,rent,andoffice
supplies.Iftheadvancepayment(orprepayment)willbenefitmorethanjustthecurrentaccounting
period,thecostrepresentsanassetratherthananexpense.Thecostofthisassetwillbeallocatedto
expenseintheaccountingperiodsinwhichtheservicesorthesuppliesareused.Insummary,prepaid
expensesareassetstheybecomeexpensesonlyasthegoodsorservicesareusedup.
ShopSupplies
ShopSuppliesToillustrate,considerOvernight'saccountingpoliciesforshopsupplies.Assuppliesare
purchased,theircostisdebitedtotheassetaccountShopSupplies.Itisnotpracticaltomakejournal
entrieseveryfewminutesassuppliesareused.Instead,anestimateismadeofthesuppliesremainingon
handattheendofeachmonththesuppliesthataremissingareassumedtohavebeenused.
PriortomakingadjustingentriesatDecember31,thebalanceinOvernight'sShopSuppliesaccountis
$1,800.ThebalanceofthisassetaccountrepresentsshopsuppliesonhandonNovember30.The
SuppliesExpenseaccountshowsabalanceof$6,900,whichrepresentsthecostofsuppliesusedthrough
November30.Assumethatapproximately$1,200ofshopsuppliesremainonhandatDecember31.This
suggeststhatsuppliescostingabout$600havebeenusedinDecemberthus,thefollowingadjusting
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

7/25

2/1/2015

IEBWireframe

entryismade:
Theadjustingentryrequiredtoconvertthecostofsuppliesusedfromanassetaccounttoan
expense

d
Dec.31SuppliesExpense..................................... 600
ShopSupplies....................................

600

DecemberShopSuppliesadjustingentry.
Thisadjustingentryservestwopurposes:(1)Itchargestoexpensethecostofsuppliesusedin
December,and(2)itreducesthebalanceoftheShopSuppliesaccountto$1,200theamountof
suppliesestimatedtobeonhandatDecember31.
InsurancePolicies
InsurancePoliciesInsurancepoliciesalsoareaprepaidexpense.Thesepoliciesprovideabenefit,
insuranceprotection,overaspecificperiodoftime.Asthetimepasses,theinsurancepolicyexpires
thatis,itisusedupinbusinessoperations.
Toillustrate,assumethatonMarch1,Overnightpurchasedfor$18,000aoneyearinsurancepolicy
providingcomprehensiveliabilityinsuranceandinsuranceagainstfireanddamagetocustomers'vehicles
whileinOvernight'sfacilities.Thisexpenditure(atransaction)wasdebitedtoanassetaccount,as
follows(again,thisisatransaction,notanadjustingentry):
Purchase12monthsofinsurancecoverage

d
Mar.1UnexpiredInsurance.................................

http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

18,000

8/25

2/1/2015

IEBWireframe

Cash..........................................

18,000

Purchasedaninsurancepolicyprovidingcoverageforthenext12months.
This$18,000expenditureprovidesinsurancecoverageforaperiodofonefullyear.Therefore,1/12of
thiscost,or$1,500,isrecognizedasinsuranceexpenseeverymonth.The$13,500insuranceexpense
reportedinOvernight'strialbalancerepresentstheportionoftheinsurancepolicythathasexpired
betweenMarch1andNovember30($1,500/mo.9months).The$4,500amountofunexpiredinsurance
showninthetrialbalanceistheremainingcostofthe12monthpolicystillineffectasofNovember30
($1,500/mo.3months).ByDecember31,anotherfullmonthofthepolicyhasexpired.Thus,the
insuranceexpenseforDecemberisrecordedbythefollowingadjustingentryatmonthend:
Page147
TheadjustingentryrequiredtorecordthecostofinsurancecoverageexpiringinDecember

d
Dec.31InsuranceExpense.................................... 1,500
UnexpiredInsurance...............................

1,500

DecemberInsuranceExpenseadjustingentry.
Noticethesimilaritiesbetweentheeffectsofthisadjustingentryandtheonethatwemadepreviouslyfor
shopsupplies.Inbothcases,theentriestransfertoexpensethatportionofanassetusedupduringthe
period.ThisflowofcostsfromthebalancesheettotheincomestatementisillustratedinExhibit43.
EXHIBIT43
AnExpiredAssetBecomesAnExpense

http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

9/25

2/1/2015

IEBWireframe

EXHIBIT43
AnExpiredAssetBecomesAnExpense
YOURTURNYouasaCarOwner
Carownerstypicallypayinsurancepremiumssixmonthsinadvance.Assumethatyourecentlypaidyour
sixmonthpremiumof$600onFebruary1(forcoveragethroughJuly31).OnMarch31,youdecideto
switchinsurancecompanies.Youcallyourexistingagentandaskthatyourpolicybecanceled.Areyou
entitledtoarefund?Ifso,why,andhowmuchwillitbe?
(SeeourcommentsontheOnlineLearningCenterwebsite.)
RecordingPrepaymentsDirectlyintheExpenseAccounts
RecordingPrepaymentsDirectlyintheExpenseAccountsInourillustration,paymentsforshop
suppliesandforinsurancecoveringmorethanoneperiodweredebitedtoassetaccounts.However,some
companiesfollowanalternativepolicyofdebitingsuchprepaymentsdirectlytoanexpenseaccount,such
asSuppliesExpense.Attheendoftheperiod,theadjustingentrythenwouldbetodebitShopSupplies
andcreditSuppliesExpenseforthecostofsuppliesthathadnotbeenused.
ThisalternativemethodleadstothesameresultsasdoestheprocedureusedbyOvernight.Undereither
approach,thecostofsuppliesusedduringthecurrentperiodistreatedasanexpense,andthecostof
suppliesstillonhandiscarriedforwardinthebalancesheetasanasset.
Page148
Inthistext,wewillfollowOvernight'spracticeofrecordingprepaymentsinassetaccountsandthen
makingadjustmentstotransferthesecoststoexpenseaccountsastheassetsexpire.Thisapproach
correctlydescribestheconceptualflowofcoststhroughtheelementsoffinancialstatements.Thatis,a
prepaymentisanassetthatlaterbecomesanexpense.Thealternativeapproachisusedwidelyinpractice
onlybecauseitisanefficientshortcut,whichstandardizestherecordingoftransactionsandmay
reducethenumberofadjustingentriesneededattheendoftheperiod.Remember,ourgoalinthiscourse
istodevelopyourabilitytounderstandanduseaccountinginformation,nottotrainyouinalternative
bookkeepingprocedures.
Theideaofshopsuppliesandinsurancepoliciesbeingusedupoverseveralmonthsiseasyto
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

10/25

2/1/2015

IEBWireframe

understand.Butthesameconceptalsoappliestoassetssuchasbuildingsandequipment.Theseassetsare
convertedtoexpensesthroughtheprocessofdepreciation.
THECONCEPTOFDEPRECIATION
Depreciableassetsarephysicalobjectsthatretaintheirsizeandshapebutthateventuallywearoutor
becomeobsolete.Theyarenotphysicallyconsumed,asareassetssuchassupplies,butnonethelesstheir
economicusefulnessdiminishesovertime.Examplesofdepreciableassetsincludebuildingsandall
typesofequipment,fixtures,furnishingsandevenrailroadtracks.Land,however,isnotviewedasa
depreciableasset,asithasanunlimitedusefullife.
Eachperiod,aportionofadepreciableasset'susefulnessexpires.Therefore,acorrespondingportionof
itscostisrecognizedasdepreciationexpense.
WhatIsDepreciation?
WhatIsDepreciation?Inaccounting,thetermdepreciationmeansthesystematicallocationofthecost
ofadepreciableassettoexpenseovertheasset'susefullife.ThisprocessisillustratedinExhibit44.
NoticethesimilaritiesbetweenExhibit44andExhibit43.
EXHIBIT44
TheDepreciationProcess

EXHIBIT44
TheDepreciationProcess
Depreciationisnotanattempttorecordchangesintheasset'smarketvalue.Intheshortrun,themarket
valueofsomedepreciableassetsmayevenincrease,buttheprocessofdepreciationcontinuesanyway.
Therationalefordepreciationliesinthematchingprinciple.Ourgoalistooffsetareasonableportionof
theasset'scostagainstrevenueineachperiodoftheasset'susefullife.
Depreciationexpenseoccurscontinuouslyoverthelifeoftheasset,buttherearenodailydepreciation
transactions.Ineffect,depreciationexpenseispaidinadvancewhentheassetisoriginallypurchased.
Therefore,adjustingentriesareneededattheendofeachaccountingperiodtotransferanappropriate
amountoftheasset'scosttodepreciationexpense.
DepreciationIsOnlyanEstimate
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

11/25

2/1/2015

IEBWireframe

DepreciationIsOnlyanEstimateTheappropriateamountofdepreciationexpenseisonlyanestimate.
Afterall,wecannotlookatabuildingorapieceofequipmentanddeterminepreciselyhowmuchofits
economicusefulnesshasexpiredduringthecurrentperiod.
Page149
Themostwidelyusedmeansofestimatingperiodicdepreciationexpenseisthestraightlinemethodof
depreciation.Underthestraightlineapproach,anequalportionoftheasset'scostisallocatedto
depreciationexpenseineveryperiodoftheasset'sestimatedusefullife.Theformulaforcomputing
depreciationexpensebythestraightlinemethodis:2

Theuseofanestimatedusefullifeisthemajorreasonthatdepreciationexpenseisonlyanestimate.In
mostcases,managementdoesnotknowinadvanceexactlyhowlongtheassetwillremaininuse.
CASEINPOINT

DigitalVision/Alamy
DigitalVision/Alamy
Howlongdoesabuildinglast?Forpurposesofcomputingdepreciationexpense,mostcompanies
estimateabout30or40years.YettheEmpireStateBuildingwasbuiltin1931,andit'snotlikelytobe
torndownanytimesoon.Asyoumightguess,itoftenisdifficulttoestimateinadvancejusthowlong
depreciableassetsmayremaininuse.
DepreciationofOvernight'sBuilding
DepreciationofOvernight'sBuildingOvernightpurchaseditsbuildingfor$36,000onJanuary22.
Becausethebuildingwasold,itsestimatedremainingusefullifeisonly20years.Therefore,the
building'smonthlydepreciationexpenseis$150($36,000cost240months).Wewillassumethat
OvernightdidnotrecordanydepreciationexpenseinJanuarybecauseitoperatedforonlyasmallpartof
themonth.Thus,thebuilding's$1,500depreciationexpensereportedinOvernight'strialbalance
illustratedinExhibit42onpage145represents10fullmonthsofdepreciationrecordedin2015,from
February1throughNovember30($150/mo.10months).Anadditional$150ofdepreciationexpenseis
stillneededonthebuildingforDecember(bringingthetotaltobereportedintheincomestatementfor
theyearto$1,650).
TheadjustingentrytorecorddepreciationexpenseonOvernight'sbuildingforthemonthofDecember
is:

http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

12/25

2/1/2015

IEBWireframe

d
Dec.31DepreciationExpense:Building............................. 150
AccumulatedDepreciation:Building......................

150

Decemberbuildingdepreciationadjustingentry($36,000240mo.).

Theadjustingentryrequiredtorecordmonthlydepreciationonthebuilding
TheDepreciationExpense:BuildingaccountwillappearinOvernight'sincomestatementalongwith
otherexpensesfortheyearendedDecember31,2015.ThebalanceintheAccumulatedDepreciation:
BuildingaccountwillbereportedintheDecember31balancesheetasadeductionfromtheBuilding
Account,asshownbelow.

Building.................................................. $36,000
Less:AccumulatedDepreciation:Building....................... (1,650)
BookValue............................................... $34,350
Page150
Howaccumulateddepreciationappearsinthebalancesheet
AccumulatedDepreciation:Buildingisanexampleofacontraassetaccountbecause(1)ithasacredit
balance,and(2)itisoffsetagainstanassetaccount(Building)toproducethebookvaluefortheasset.
Accountantsoftenusethetermbookvalue(orcarryingvalue)todescribethenetvaluationofanassetin
acompany'saccountingrecords.Fordepreciableassets,suchasbuildingsandequipment,bookvalueis
equaltothecostoftheasset,lesstherelatedamountofaccumulateddepreciation.Theendresultof
creditingtheAccumulatedDepreciation:Buildingaccountismuchthesameasifthecredithadbeen
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

13/25

2/1/2015

IEBWireframe

madedirectlytotheBuildingaccountthatis,thebookvaluereportedinthebalancesheetforthe
buildingisreducedfrom$36,000to$34,350.
Bookvalueisofsignificanceprimarilyforaccountingpurposes.Itrepresentscoststhatwillbeoffset
againsttherevenueoffutureperiods.Italsogivesusersoffinancialstatementsanindicationoftheageof
acompany'sdepreciableassets(olderassetstendtohavelargeramountsofaccumulateddepreciation
associatedwiththemthannewerassets).Itisimportanttorealizethatthecomputationofbookvalueis
baseduponanasset'shistoricalcost.Thus,bookvalueisnotintendedtorepresentanasset'scurrent
marketvalue.
DepreciationofToolsandEquipment
DepreciationofToolsandEquipmentOvernightdepreciatesitstoolsandequipmentoveraperiodof
fiveyears(60months)usingthestraightlinemethod.TheDecember31trialbalanceshowsthatthe
companyownstoolsandequipmentthatcost$12,000.Therefore,theadjustingentrytorecord
December'sdepreciationexpenseis:
Theadjustingentryrequiredtorecordthemonthlydepreciationontoolsandequipment

d
Dec.31DepreciationExpense:ToolsandEquipment................
AccumulatedDepreciation:ToolsandEquipment.........

200
200

Decembertoolsandequipmentadjustingentry($12,00060months=$200/mo.).
Again,weassumethatOvernightdidnotrecorddepreciationexpensefortoolsandequipmentinJanuary
becauseitoperatedforonlyasmallpartofthemonth.Thus,therelated$2,000depreciationexpense
reportedinOvernight'strialbalanceinExhibit42onpage145represents10fullmonthsofdepreciation,
fromFebruary1throughNovember30($200/mo.10months).Thetoolsandequipmentstillrequirean
additional$200ofdepreciationforDecember(bringingthetotaltobereportedintheincomestatement
fortheyearto$2,200).
WhatisthebookvalueofOvernight'stoolsandequipmentatDecember31,2015?Ifyousaid$9,800,
you'reright.3
DepreciationANoncashExpense
DepreciationANoncashExpenseDepreciationisanoncashexpense.Wehavemadethepointthatnet
incomedoesnotrepresentaninflowofcashoranyotherasset.Rather,itisacomputationoftheoverall
effectofcertainbusinesstransactionsonowners'equity.Therecognitionofdepreciationexpense
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

14/25

2/1/2015

IEBWireframe

illustratesthispoint.Asdepreciableassetsexpire,depreciationexpenseisrecorded,netincomeis
reduced,andowners'equitydeclines,butthereisnocorrespondingcashoutlayinthecurrentperiod.For
thisreason,depreciationiscalledanoncashexpense.Oftenitrepresentsthelargestdifferencebetween
netincomeandthecashflowfrombusinessoperations.
Page151
CONVERTINGLIABILITIESTOREVENUE
LO44
LO44
LEARNINGOBJECTIVE
Prepareadjustingentriestoconvertliabilitiestorevenue.
Insomeinstances,customersmaypayinadvanceforservicestoberenderedinlateraccountingperiods.
Forexample,afootballteamcollectsmuchofitsrevenueinadvancethroughthesaleofseasontickets.
Healthclubscollectinadvancebysellinglongtermmembershipcontracts.Airlinessellmanyoftheir
ticketswellinadvanceofscheduledflights.
Foraccountingpurposes,amountscollectedinadvancedonotrepresentrevenue,becausetheseamounts
havenotyetbeenearned.Amountscollectedfromcustomersinadvancearerecordedbydebitingthe
Cashaccountandcreditinganunearnedrevenueaccount.Unearnedrevenuesometimesisreferredtoas
deferredrevenue.
Whenacompanycollectsmoneyinadvancefromitscustomers,ithasanobligationtorenderservicesin
thefuture.Therefore,thebalanceofanunearnedrevenueaccountisconsideredtobealiabilityit
appearsintheliabilitysectionofthebalancesheet,notintheincomestatement.Unearnedrevenue
differsfromotherliabilitiesbecauseitusuallywillbesettledbyrenderingservices,ratherthanby
makingpaymentincash.Inshort,itwillbeworkedoffratherthanpaidoff.Ofcourse,ifthebusinessis
unabletorendertheservice,itmustdischargethisliabilitybyrefundingmoneytoitscustomers.
Whenacompanyrenderstheservicesforwhichcustomershavepaidinadvance,itisworkingoffits
liabilitytothesecustomersandisearningtherevenue.Attheendoftheaccountingperiod,anadjusting
entryismadetotransferanappropriateamountfromtheunearnedrevenueaccounttoarevenueaccount.
Thisadjustingentryconsistsofadebittoaliabilityaccount(unearnedrevenue)andacredittoarevenue
account.Forinstance,TheNewYorkTimesCompanyreportsa$67millioncurrentliabilityinits
balancesheetcalledUnexpiredSubscriptions.Thisaccountrepresentsunearnedrevenuefromselling
subscriptionsforfuturenewspaperdeliveries.TheliabilityisconvertedtoCirculationRevenueand
reportedinthecompany'sincomestatementastheactualdeliveriesoccur.
Toillustratetheseconcepts,assumethatonDecember1,HarborCabCo.agreedtorentspacein
Overnight'sbuildingtoprovideindoorstorageforsomeofitscabs.Theagreeduponrentis$3,000per
month,andHarborCabpaidforthefirstthreemonthsinadvance.Thejournalentrytorecordthis
transactiononDecember1was(again,thisisatransaction,notanadjustingentry):

d
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

15/25

2/1/2015

IEBWireframe

Dec.1Cash............................................

9,000

UnearnedRentRevenue.........................

9,000

CollectedinadvancefromHarborCabforrentalofstoragespaceforthreemonths.

Anadvanceit'snotrevenueit'saliability
RememberthatUnearnedRentRevenueisaliabilityaccount,notarevenueaccount.Overnightwillearn
rentalrevenuegraduallyoverathreemonthperiodasitprovidesstoragefacilitiesforHarborCab.Atthe
endofeachofthesethreemonths,Overnightwillmakeanadjustingentry,transferring$3,000fromthe
UnearnedRentRevenueaccounttoanearnedrevenueaccount,RentRevenueEarned,whichwillappear
inOvernight'sincomestatement.ThefirstinthisseriesofmonthlytransferswillbemadeatDecember
31withthefollowingadjustingentry:

d
Dec. UnearnedRentRevenue.............................
31
RentRevenueEarned...........................

3,000

3,000

DecemberadjustingentrytoconvertUnearnedRentRevenuetoRentRevenueEarned
($9,0003mo.).

AnadjustingentryshowingthatsomeunearnedrevenuewasearnedinDecember
Afterthisadjustingentryhasbeenposted,theUnearnedRentRevenueaccountwillhavea$6,000credit
balance.ThisbalancerepresentsOvernight'sobligationtorender$6,000worthofserviceoverthenext
twomonthsandwillappearintheliabilitysectionofthecompany'sbalancesheet.TheRentRevenue
EarnedaccountwillappearinOvernight'sincomestatement.
TheconversionofunearnedrevenuetorecognizeearnedrevenueisillustratedinExhibit45.
Page152
EXHIBIT45
UnearnedRevenueBecomesEarnedRevenue
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

16/25

2/1/2015

IEBWireframe

EXHIBIT45
UnearnedRevenueBecomesEarnedRevenue
RecordingAdvanceCollectionsDirectlyintheRevenueAccounts
RecordingAdvanceCollectionsDirectlyintheRevenueAccountsWehavestressedthatamounts
collectedfromcustomersinadvancerepresentliabilities,notrevenue.However,somecompaniesfollow
anaccountingpolicyofcreditingtheseadvancecollectionsdirectlytorevenueaccounts.Theadjusting
entrythenshouldconsistofadebittotherevenueaccountandacredittotheunearnedrevenueaccount
fortheportionoftheadvancepaymentsnotyetearned.Thisalternativeaccountingpracticeleadstothe
sameresultsasdoesthemethodusedinourillustration.
Inthistext,wewillfollowtheoriginallydescribedpracticeofcreditingadvancepaymentsfrom
customerstoanunearnedrevenueaccount.
ACCRUINGUNPAIDEXPENSES
LO45
LO45
LEARNINGOBJECTIVE
Prepareadjustingentriestoaccrueunpaidexpenses.
Thistypeofadjustingentryrecognizesexpensesthatwillbepaidinfuturetransactionstherefore,no
costhasyetbeenrecordedintheaccountingrecords.Salariesofemployeesandinterestonborrowed
moneyarecommonexamplesofexpensesthataccumulatefromdaytodaybutthatusuallyarenot
recordeduntiltheyarepaid.Theseexpensesaresaidtoaccrueovertime,thatis,togroworto
accumulate.Attheendoftheaccountingperiod,anadjustingentryshouldbemadetorecordany
expensesthathaveaccruedbutthathavenotyetbeenrecorded.Sincetheseexpenseswillbepaidata
futuredate,theadjustingentryconsistsofadebittoanexpenseaccountandacredittoaliability
account.WeshallnowusetheexampleofOvernightAutoServicetoillustratethistypeofadjusting
entry.
AccrualofWages(orSalaries)Expense
AccrualofWages(orSalaries)ExpenseOvernight,likemanybusinesses,paysitsemployeesevery
otherFriday.Thismonth,however,endsonaTuesdaythreedaysbeforethenextscheduledpayday.
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

17/25

2/1/2015

IEBWireframe

ThusOvernight'semployeeshaveworkedformorethanaweekinDecemberforwhichtheyhavenotyet
beenpaid.
Timecardsindicatethatsincethelastpayrolldate,Overnight'semployeeshaveworkedatotalof130
hours.Includingpayrolltaxes,Overnight'swageexpenseaveragesabout$15perhour.Therefore,at
December31,thecompanyowesitsemployeesapproximately$1,950forworkperformedinDecember.4
Thefollowingadjustingentryshouldbemadetorecordthisamountbothaswagesexpenseofthecurrent
periodandasaliability:
Adjustingentryrequiredtoaccruewagesowedattheendofthemonth

d
Dec.31WagesExpense......................................
WagesPayable...................................

1,950
1,950

AdjustingentrytoaccruewagesowedbutunpaidasofDecember31.
Page153
ThisadjustingentryincreasesOvernight'swagesexpensefor2015andalsocreatesaliabilitywages
payablethatwillappearintheDecember31balancesheet.
OnFriday,January3,2016,Overnightwillpayitsregularbiweeklypayroll.Letusassumethatthis
payrollamountsto$2,397.Inthiscase,thetransactiontorecordpaymentisasfollows(again,thisisa
transaction,notanadjustingentry):5
Paymentofwagesearnedintwoaccountingperiods

http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

18/25

2/1/2015

IEBWireframe

2016
Jan.3WagesExpense(forJanuary)...........................

447

WagesPayable(accruedinDecember)...................

1,950

Cash...........................................

2,397

Biweeklypayroll,$1,950ofwhichhadbeenaccruedatDecember31,2015.
AccrualofInterestExpense
AccrualofInterestExpenseOnJanuary22,2015,Overnightpurchaseditsbuilding,anoldbusgarage,
fromtheMetropolitanTransitAuthorityfor$36,000.Overnightpaid$6,000cash,andissueda$30,000
90daynotepayableforthebalanceowed.Overnightpaidthe$30,000obligationinApril.Therewasno
interestexpensetoaccruebecausethisnotepayablewasnoninterestbearing.
OnNovember30,2015,Overnightborrowed$4,000fromAmericanNationalBankbyissuingan
interestbearingnotepayable.Thisloanistoberepaidinthreemonths(onFebruary28,2016),along
withinterestcomputedatanannualrateof9percent.TheentrymadeonNovember30torecordthis
borrowingtransactionis(again,thisisatransaction,notanadjustingentry):

d
Nov. Cash............................................
30
NotesPayable................................

4,000

4,000

BorrowedcashfromAmericanNationalBank,issuinga9%,$4,000notepayable,due
inthreemonths.
OnFebruary28,Overnightmustpaythebank$4,090.Thisrepresentsthe$4,000amountborrowed,plus
$90interest($4,000.093/12).The$90interestchargecoversaperiodofthreemonths.Althoughno
paymentismadeuntilFebruary28,2016,interestexpenseisincurred(oraccrued)atarateof$30per
month,asshowninExhibit46.
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

19/25

2/1/2015

IEBWireframe

EXHIBIT46
AccrualofInterest

EXHIBIT46
AccrualofInterest
ThefollowingadjustingentryismadeatDecember31toaccrueonemonth'sinterestexpenseandto
recordtheamountofunpaidinterestowedtothebankatDecember31,2015:
AdjustingentryrequiredtorecordinterestexpenseaccruedinDecember

d
Dec.31InterestExpense...........................................
InterestPayable.......................................

30
30

AdjustingentrytoaccrueDecemberInterestExpense($4,000.091/12).
Page154
The$30interestexpensethataccruedinDecemberwillappearinOvernight's2015incomestatement.
Boththe$30interestpayableandthe$4,000notepayabletoAmericanNationalBankwillappearas
liabilitiesintheDecember31,2015,balancesheet.
Overnightwillmakeasecondadjustingentryrecognizinganother$30ininterestexpenseonJanuary31,
2016.ThetransactiononFebruary28torecordtherepaymentofthisloan,including$90ininterest
charges,is(again,thisisatransaction,notanadjustingentry):
Paymentofinterestexpenseaccruedoverthreemonths
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

20/25

2/1/2015

IEBWireframe

d
2016
Feb.
28

NotesPayable.........................................

4,000

InterestPayable(fromDecemberandJanuary)...............

60

InterestExpense(Februaryonly)...........................

30

Cash.............................................

4,090

Repaid$4,000notepayabletoAmericanNationalBank,including$90ininterest
charges.
ACCRUINGUNCOLLECTEDREVENUE
LO46
LO46
LEARNINGOBJECTIVE
Prepareadjustingentriestoaccrueuncollectedrevenue.
Abusinessmayearnrevenueduringthecurrentaccountingperiodbutnotbillthecustomeruntilafuture
accountingperiod.Thissituationislikelytooccurifadditionalservicesarebeingperformedforthesame
customer,inwhichcasethebillmightnotbeprepareduntilallservicesarecompleted.Anyrevenuethat
hasbeenearnedbutnotrecordedduringthecurrentaccountingperiodshouldberecordedattheendof
theperiodbymeansofanadjustingentry.Thisadjustingentryconsistsofadebittoanaccount
receivableandacredittotheappropriaterevenueaccount.Thetermaccruedrevenueoftenisusedto
describerevenuethathasbeenearnedduringtheperiodbutthathasnotbeenrecordedpriortothe
closingdate.
Toillustratethistypeofadjustingentry,assumethatinDecember,Overnightenteredintoanagreement
toperformroutinemaintenanceonseveralvansownedbyAirportShuttleService.Overnightagreedto
maintainthesevansforaflatfeeof$1,500permonth,payableonthefifteenthofeachmonth.
Noentrywasmadetorecordthesigningofthisagreement,becausenoserviceshadyetbeenrendered.
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

21/25

2/1/2015

IEBWireframe

OvernightbeganrenderingservicesonDecember15,butthefirstmonthlypaymentwillnotbereceived
untilJanuary15.Therefore,OvernightshouldmakethefollowingadjustingentryatDecember31to
recordtherevenueearnedfromAirportShuttleduringthemonth:
Adjustingentryrequiredtoaccruerevenueearnedbutnotyetbilledorcollected

d
Dec.31AccountsReceivable...................................
RepairServiceRevenue.............................

750
750

AdjustingentrytorecordaccruedRepairServiceRevenueearnedinDecember.
ThecollectionofthefirstmonthlyfeefromAirportShuttlewilloccuronJanuary15,2016.Ofthis
$1,500cashreceipt,halfrepresentscollectionofthereceivablerecordedonDecember31theotherhalf
representsrevenueearnedinJanuary.Thus,thetransactiontorecordthereceiptof$1,500fromAirport
ShuttleonJanuary15willbe(again,thisisatransaction,notanadjustingentry):
Entrytorecordcollectionofaccruedrevenue

d
2016
Jan. Cash.............................................
15
AccountsReceivable.............................
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

1,500

750
22/25

2/1/2015

IEBWireframe

RepairServiceRevenue...........................

750

CashcollectedfromAirportShuttleforvanmaintenanceprovidedDecember15through
January15.
Page155
ThenetresultoftheDecember31adjustingentryhasbeentodividetherevenuefrommaintenanceof
AirportShuttle'svansbetweenDecemberandJanuaryinproportiontotheservicesrenderedduringeach
month.
ACCRUINGINCOMETAXESEXPENSE:THEFINALADJUSTINGENTRY
Asacorporationearnstaxableincome,itincursincometaxesexpense,andalsoaliabilityto
governmentaltaxauthorities.Thisliabilityispaidinfourinstallmentscalledestimatedquarterly
payments.ThefirstthreepaymentsnormallyaremadeonApril15,June15,andSeptember15.Thefinal
installmentactuallyisdueonDecember15butforpurposesofourillustrationandassignmentmaterials,
wewillassumethefinalpaymentisnotdueuntilJanuary15ofthefollowingyear.6
Initsunadjustedtrialbalance(Exhibit42onpage145),Overnightshowsincometaxesexpenseof
$22,608.ThisistheincometaxesexpenserecognizedfromJanuary20,2015,(thedateOvernightopened
forbusiness)throughNovember30,2015.IncometaxesaccruedthroughSeptember30havealready
beenpaid.Thus,the$1,560liabilityforincometaxespayablerepresentsonlytheincometaxesaccrued
inOctoberandNovember.
Theamountofincometaxesexpenseaccruedforanygivenmonthisonlyanestimate.Theactualamount
ofincometaxescannotbedetermineduntilthecompanypreparesitsannualincometaxreturn.Inour
illustrationsandassignmentmaterials,weestimateincometaxesexpenseat40percentoftaxable
income.Wealsoassumethattaxableincomeisequaltoincomebeforeincometaxes,asubtotaloften
showninanincomestatement.Thissubtotalistotalrevenuelessallexpensesotherthanincometaxes.

INTERNATIONALCASEINPOINT
Corporateincometaxratesvaryaroundtheworld.Arecentsurveyshowsthatratesrangefrom9percent
inMontenegroto55percentintheUnitedArabEmirates.Worldwide,theaveragetaxrateis24percent.
TheaveragerateintheUnitedStatesis40percent.*Inadditiontocorporateincometaxes,some
countriesalso(1)withholdtaxesondividends,interest,androyalties,(2)chargevalueaddedtaxesat
specifiedproductionanddistributionpoints,and(3)imposebordertaxessuchascustomsandimport
duties.Afewcountries,includingtheBahanashavenocorporatetaxes.
*KPMGCorporateTaxRateSurvey(2013).
In2015,Overnightearnedincomebeforeincometaxesof$66,570(seetheincomestatementinExhibit
52,page196,inChapter5).Therefore,incometaxesexpensefortheentireyearisestimatedat$26,628
($66,57040percent).GiventhatincometaxesexpenserecognizedthroughNovember30amountsto
$22,608(seetheunadjustedtrialbalanceinExhibit42),anadditional$4,020inincometaxesexpense
musthaveaccruedduringDecember($26,628$22,608).Theadjustingentrytorecordthisexpenseis:
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

23/25

2/1/2015

IEBWireframe

AdjustingentryrequiredtorecordincometaxesaccruedinDecember

d
Dec.31IncomeTaxesExpense............................... 4,020
IncomeTaxesPayable............................

4,020

AdjustingentrytorecordincometaxesaccruedinDecember.
Page156
ThisentryincreasesthebalanceintheIncomeTaxesExpenseaccounttothe$26,628amountrequired
fortheyearendedDecember31,2015.Italsoincreasestheliabilityforincometaxespayableto$5,580
($1,560+$4,020).ThetransactiontorecordthepaymentofthisliabilityonJanuary15,2016,willbe
(again,thisisatransaction,notanadjustingentry):

d
2016
Jan.15IncomeTaxesPayable...........................5,580
Cash.....................................

5,580

Paymentoftheremaining2015incometaxliability.
IncomeTaxesinUnprofitablePeriods
IncomeTaxesinUnprofitablePeriodsWhathappenstoincometaxesexpensewhenlossesareincurred?
Inthesesituations,thecompanyrecognizesanegativeamountofincometaxesexpense.Theadjusting
entrytorecordincometaxesattheendofanunprofitableaccountingperiodconsistsofadebittoIncome
TaxesPayableandacredittoIncomeTaxesExpense.
http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

24/25

2/1/2015

IEBWireframe

Negativeincometaxesexpensemeansthatthecompanymaybeabletorecoverfromthegovernment
someoftheincometaxesrecognizedasexpenseinpriorperiods.7IftheIncomeTaxesPayableaccount
hasadebitbalanceatyearend,itisreclassifiedasanasset,calledIncomeTaxRefundReceivable.A
creditbalanceintheIncomeTaxesExpenseaccountisoffsetagainsttheamountofthebeforetaxloss,as
showninExhibit47.
EXHIBIT47
PartialIncomeStatement

d
PartialIncomeStatementforanUnprofitablePeriod
Income(loss)beforeincometaxes.................................... $(20,000)
Incometaxbenefit(recoveryofpreviouslyrecordedtaxes)................. 8,000
Netloss......................................................... $(12,000)
EXHIBIT47
PartialIncomeStatement
Incometaxbenefitcanreduceapretaxloss
Wehavealreadyseenthatincometaxesexpensereducestheamountofbeforetaxprofits.Noticenow
thatincometaxbenefitsintheformoftaxrefundscanreducetheamountofapretaxloss.Thus,
incometaxesreducethesizeofbothprofitsandlosses.Thedetailedreportingofprofitsandlossesinthe
incomestatementisillustratedinChapter5.

http://textflow.mheducation.com/parser.php?secload=4.1&fake&print

25/25