3 Chapter The Matching Concept and the Adjusting Process ______________________________________________
Chapter 3 introduces the adjusting process. The basic idea of the matching concept was presented in Chapter 1, where expenses incurred were matched against revenues. Now in Chapter 3, matching is introduced formally and as a stand-alone concept. Of all the accounting concepts and principles introduced in the early chapters of the text, matching is the most important. After studying the chapter, you should be able to: 1. 2. 3. 4. 5. Explain how the matching concept relates to the accrual basis of accounting. Explain why adjustments are necessary and list the characteristics of adjusting entries. Journalize entries for accounts requiring adjustment. Summarize the adjustment process and prepare an adjusted trial balance. Use vertical analysis to compare financial statement items with each other and with industry averages. Cash Basis Matching Concept Revenue Recognition Concept
KEY TERMS: Accounting Period Concept Accrual Basis Adjusting Process
Question: If rent for May is paid on June 1, in which month will it be reported as an expense under (a) the cash basis and (b) the accrual basis? Answer: (a) June, (b) May. Question: If a university received cash in August for football season tickets, when should this be reported as revenue under (a) the cash basis and (b) the accrual basis? Answer: (a) August, (b) throughout football season as games are played. The cash basis of accounting is used by most individuals for income tax purposes. Matching Concept: Similar to personal expenses, not all business expenses are paid monthly. If a business wants to know its true expenses for the month, it must consider all expenses incurred, not just the expenses paid that month. Likewise, payment for services provided to customers is not always received in the same month that the service is completed. If a business wants to know how much revenue it has earned, it must determine the value of services provided, not just the cash received in payment for services rendered. The accrual basis of accounting dictates that all revenues be recorded in the accounting records when they are earned, instead of when the cash payment is received from customers. All expenses are to be recorded in the accounting records when they are incurred, not when they are
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paid. Finally, if a business wants to determine whether the pricing of its services results in an adequate profit, it must compare the revenues earned from providing services to all the expenses incurred in providing those services. The matching concept in accounting states that all the expenses incurred in providing a service or selling a product must be recorded in the same period that the revenue from the service or sale is recorded. Expenses are matched against the revenue they generate. The matching concept and accrual basis of accounting go hand in hand. Because of these concepts, some accounts must be updated at the end of an accounting period to show the correct revenues and expenses. This process of updating the accounts is accomplished through adjusting entries. KEY TERMS: Accruals Accrued Expenses Accrued Revenues Adjusting Entries Deferrals Deferred Expenses Deferred Revenues Prepaid Expenses Unearned Expenses
Adjusting entries are necessary to update the accounting records to include all revenues earned and all expenses incurred. Making adjusting entries is a requirement of the accrual basis of accounting. Accruals and Deferrals: Deferrals adjust accounts that are already a part of a company's accounting records. Deferred expenses occur when an asset that will be used up or will expire is purchased. As this asset is used, its cost must be recorded as an expense. Therefore, you defer recording the cost of the asset as an expense until it is used. An example of a deferred expense is tuition paid at the beginning of each term. Business examples of deferred expenses include the following: 1. Supplies recorded as an asset when they are purchased. As the supplies are used, an adjusting entry is made to transfer the cost of the supplies to an expense account. This adjusting entry was demonstrated in Chapter 1. 2. Prepaid insurance when an insurance policy is paid in advance of the period covered, its cost is recorded as an asset. An adjusting entry must be made to transfer the cost of the insurance policy to an expense account as the policy expires. Revenues are deferred when cash is received from a customer before a business completes its service for the customer or delivers its product. When cash is received under these circumstances, it cannot be recorded as revenue, since it has not been earned. Instead, it is recorded as a liability, reflecting the company's obligation to provide its service or to deliver its product to the customer. Once this obligation has been fulfilled, the liability is removed and revenue is recognized. Therefore, you defer recording revenue until it is earned.
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Unearned revenues is the liability account used to record cash received from customers in advance. If any portion of the goods or services paid for has been delivered to the customer by the end of the accounting period, an adjusting entry must be made to transfer the revenue earned to a revenue account. Accruals record expenses that have been incurred or revenues that have been earned that have not been recorded in the accounting records. Some examples of accruals are as follow: 1. Accrued expenses salaries/wages owed to employees at the end of an accounting period that have not been paid; interest owed on loans that have not been paid. 2. Accrued revenues fees earned by an attorney or real estate agent that have not been received; interest on a savings account or other investment that has been earned but not received. KEY TERMS: Accumulated Depreciation Book Value of the Asset Contra Accounts Depreciation Depreciation Expense Fixed Assets
An example of an expense that is typically paid in advance is insurance. Insurance policies are paid at the beginning of a policy period. This outlay of cash is recorded in Prepaid Insurance an asset account. The portion of the insurance coverage that has expired by the end of the accounting period must be transferred to an expense account. Graphically, this can be illustrated as follows: New Data Asset: Prepaid Insurance Amount of Insurance Coverage Expired Expense: Insurance Expense
For example, on December 1, Atherton Plumbing purchased a 6-month insurance policy for $600. As of December 31, one month (or $100) of that coverage had expired. Original Entry: Adjusting Entry: Prepaid Insurance Cash. Insurance Expense... Prepaid Insurance 600 600 100 100
The T-accounts follow. Prepaid Insurance 12/1 Bal. 600 Adj. 100 500 Adj. 100 Insurance Expense
The T-accounts show that the $500 (or 5 months) of insurance coverage that has not expired is
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carried as the balance in the prepaid insurance account. Another asset that must be adjusted at the end of the accounting period is the supplies account. All supplies are recorded in the supplies account as they are purchased. By the end of the accounting period, some of the supplies will have been used. The supplies used must be taken out of the supplies account and transferred to an expense account. Graphically, this can be illustrated as follows: New Data Asset: Supplies Amount of Supplies that Have Been Used For example, on December 5, Atherton Plumbing purchased $250 in supplies. As of December 31, only $50 worth of those supplies were left. Original Entry: Supplies.. Cash 250 250 200 Expense: Supplies Expense
Adjusting Supplies Expense 200 Entry: Supplies.. (NOTE: $200 represents the supplies used) The T-accounts follow. Supplies 12/5 Bal. 250 50 Adj. 200
Supplies Expense Adj. 200
The T-accounts show that the balance of the supplies account is $50the amount of supplies left. Question: What is the easiest way to determine how many miles you have driven your car this month? Answer: record the beginning and ending odometer readings. This is easier than writing down the miles driven each time the car is used. Adjusting Entry for Unearned Revenue: If payment for goods or services is received before the goods are delivered or the service is performed, it cannot be recognized as revenue. Revenue can be recorded only after it is earned. Therefore, when payment is received in advance, it is recorded in an unearned revenue account. This is a liability account. By receiving payment, the company has obligated itself to deliver the goods or provide the services for which it was paid. This obligation is expressed in the accounting records as a liability. If a portion (or all) of the revenue has been earned by the end of the accounting period, some (or all) of the unearned revenue is transferred to a revenue account.
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Graphically, this can be illustrated as follows: New Data Liability: Unearned Revenue Amount of Revenue that Has Been Earned Revenue: Fees Earned (or other revenue earned account as appropriate)
For example, on November 2, Huber Rental Properties received 3 months' rent, totaling $2,400, in advance for one of its commercial properties. As of December 2 31, months' worth of this rent had been earned. Original Entry: Adjusting Entry: Cash. Unearned Rent. Unearned Rent. Rent Income. 2,400 2,400 1,600 1,600
The T-accounts follow. Unearned Rent Adj. 1,600 11/2 2,400 Bal. 800 Rent Income Adj. 1,600
The T-accounts show that the balance of the unearned rent is equal to the one month's rent that has not been earned$800. Please note that unearned rent is a liability on the balance sheet; earned rent is revenue on the income statement.
Adjusting Entry for Accrued Expenses: In order to get a true measure of profitability, any expenses that a business has incurred must be recorded before preparing financial statements. The act of recording expenses that have not been paid is called accruing expenses. One common example is wages paid to employees. Many organizations pay their employees on Friday. Wages expense is generally recorded only when wages are paid. Therefore, if the accounting period ends on a day other than payday, the employees will have earned wages that have not been recorded as an expense. These wages must be accrued. Graphically, this can be illustrated as follows: New Data
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Expense: Wages Expense Amount of Wages that Employees Have Earned Liability: Wages Payable
For example, assume that December 31 is a Wednesday. On that date, Huber Rental Properties owes $500 in wages to employees. These wages will be paid on Friday, the usual payday. Original Entry: Adjusting Entry: None Wages Expense. Wages Payable.. 500 500
The T-accounts follow. Wages Expense Adj. 500 Adjusting Entry for Accrued Revenues: Any revenue that a business has earned must be recorded before preparing financial statements in order to get a true measure of profitability. The act of recording revenues that have not been received is called accruing revenues. One example of accrued revenue is interest. Assume that a company charges its customers interest whenever they ask for more than 30 days to pay for a credit purchase. The interest is paid at the same time as the receivable. At the end of an accounting period, that company may have earned interest that it has not received, since the customer has not paid the account. That interest must be recorded in a revenue account (to show it has been earned) and a receivable account (to show it will be received in the future). Graphically, this can be illustrated: New Data Revenue: Interest Income Amount of Interest that Has Been Earned Asset: Interest Receivable Wages Payable Adj. 500
For example, Atherton Plumbing granted a customer additional time to pay an invoice; however, the customer must pay interest at a rate of 10% annually. At the end of the accounting period, the interest that has accumulated totals $80. Original Entry: Adjusting None Interest Receivable..
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80
Entry:
Interest Income
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The T-accounts follow. Interest Receivable Adj. 80 Interest Income Adj. 80
Other examples of accrued revenues would be commissions earned by a travel agent but not billed or fees earned by an attorney but not billed. Adjusting Entry for Depreciation: Assume that your car needs four new tires. One set of tires you are considering costs $200. The manufacturer estimates that these tires will last 20,000 miles. Since you drive about 10,000 miles per year, that equates to 2 years. Another set of tires costs $300. These tires should last 40,000 miles or 4 years. Assuming that you plan to keep your car at least another 4 years, which set of tires is the best deal? Why? The $200 set of tires will cost the driver $100 per year. The $300 set will cost only $75 per year. Therefore, the $300 set is a better value in the long run. It is common to break the cost of a long-term asset into a cost per year or a cost per month when evaluating whether or not to purchase the asset. Allocating the cost of an asset (such as the tires) to the years it is used makes it easier to determine the yearly expense of owning the asset. The cost of owning the $300 set of tires is $75 per year. The accrual basis of accounting requires business owners to allocate the cost of long-term assets to the years they are used. This process is called depreciation. Question: A florist purchases a delivery van for $12,000. The van will last 3 years. What is the florist's cost per year for this van? Answer: $4,000 When the florist purchases the van, he will record it in an asset account. Does that van remain an asset forever? No, after 3 years, the van's usefulness will be gone. Therefore, the van's cost must be transferred from the asset account to an expense account over the 3 years it is used. In other words, the van must be depreciated over the 3 years it is used. The florist's accountant is required to record depreciation on the delivery van for the following two reasons:
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1. Whenever an asset is used up in running a business, it must be recorded as an expense. Similar to supplies or prepaid insurance, the florist's van will not last forever. Its usefulness will eventually expire. Therefore, a portion of the van will be recorded as an expense in each year the van is used. 2. The matching principle dictates that all costs incurred in running a business must be matched against the revenues they generate. The van will allow the florist to sell flowers and make deliveries for 3 years. Therefore, a portion of the cost of the van must be matched against the revenue earned in each of those 3 years. Graphically, this can be illustrated as follows: New Data Asset: Delivery Van Portion of the Van's Usefulness that Has Expired Expense: Depreciation Expense
The journal entries to record the purchase of the van and the first year's depreciation are as follows: Original Entry: Adjusting Entry: Delivery Van Cash. Depreciation ExpenseDelivery Van Accumulated Depreciation Delivery Van.. 12,000 12,000 4,000 4,000
Note that the account credited by the adjusting entry is Accumulated DepreciationDelivery Van. This is a contra-asset accountan account that works "against" another asset account to reduce it. The accumulated depreciationdelivery van account works against the delivery van account. The T-accounts follow. Delivery Van 12,000 Bal. 12,000 Depreciation ExpenseDelivery Van Adj. 4,000 Bal. 4,000
Accumulated Depreciation Delivery Van Adj. 4,000 The asset and contra-asset accounts are
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reported on the balance sheet as follows: Bal. 4,000 Delivery van Less: Accum. deprec. Net book value of van $12,000 4,000 $ 8,000
Why use a contra-account to record the adjusting entry for depreciation? Why not just reduce the delivery van account directly? 1. Both the original cost and the amount of depreciation recorded on a fixed asset should be reported on the balance sheet. Therefore, the amounts are kept in separate accounts. 2. Any depreciation recorded on a fixed asset is just an estimate of the asset's usefulness that has expired. This estimate is maintained in a separate account. Please note the following: 1. 2. 3. 4. A fixed asset must be owned and used by the business. Depreciation expense is a noncash expense. Depreciation is not related to the value of the asset. The normal balance of the accumulated depreciation account is a credit.
Use of an Accumulated Depreciation Account: To understand the purpose of accumulated depreciation contra-accounts, consider the following example: Company 1 Company 2 Net book value of Equipment $10,000 $10,000 Without using a contra-account, both companies look identical. However, if accumulated depreciation is also shown, it provides useful information: Equipment Accumulated Depreciation Net book value of Equipment Company 1 $100,000 90,000 $ 10,000 Company 2 $11,000 1,000 $10,000
Question: What information does the contra-account provide? Answer: First, the equipment is 90% depreciated in Company 1 and only about 9% depreciated in Company 2. Second, Company 1 originally invested nearly 10 times as much into its equipment as Company 2. Therefore, Company 1 is probably a much larger operation. Since Company 2 has recorded a smaller percentage of depreciation, it may be a younger organization. Conclusion: Companies 1 and 2 are quite different, and reporting only book values does not reveal the differences. KEY TERM: Vertical Analysis Under vertical analysis, all financial statement items are shown as a percentage of a significant total on the statement. On an income statement, all items are shown as a percentage of revenues.
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On a balance sheet, all items are shown as a percentage of total assets. An income statement which shows percentages calculated using vertical analysis is also called a common-size income statement. Comparing percentages computed under vertical analysis with industry averages can provide valuable information in assessing a companys performance. One web site where you can find some data on industry averages without paying a subscription is http://www.MarketGuide.com. After reaching this web site, you will need to click on the Industries tab and select the industry they wish to view. Under the profitability section of the industry statistics, they will find the Net Profit Margin %. This number compares to the percentage computed for Net Income on a common-size income statement.
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