3 Adjusting and Closing Entries Business, Accounting, and You It’s December 31st and closing time at Disney. Everyone has worked hard. The year Learning Objectives has come to a close. Millions of transactions have occurred and been recorded by the accountants. It’s time to wrap up the year and tabulate the score for Disney. 1 Understand the revenue recognition and matching How does Disney conclude a year’s activities and prepare for a new year? There has principles to be an end for a new beginning. Think of a sporting event. There must be an end to the game. At the end of 2 Understand the four types the game, the scorekeeper must make sure the score accurately reflects what of adjustments, and prepare happened. Accountants are the scorekeepers of the business. They have activities to adjusting entries complete at the end of each accounting period. They may need to go back and make sure they have recognized, measured, and reported all the business’s transactions. 3 Prepare financial statements Given the rules of Generally Accepted Accounting Principles (GAAP), they may need from an adjusted trial balance to adjust the scorecard to better reflect what happened. They then need to summa- 4 Prepare closing entries and a rize the transactions and prepare the final reports. post-closing trial balance 1 2 Chapter 3 Whether you are an accountant or a manager who uses accounting information, you need to understand the process used by accountants to adjust and c onclude (close) a business’s financial records. Why? Because they affect the reports used to manage the business. They affect the final score used to judge a business’s success. In Chapter 2, we learned about journalizing and posting transactions for a busi- ness, as well as how to prepare a trial balance and financial statements. These were steps one, two, three, and six of the accounting cycle. Once again the accounting cycle looks like this: Step One Recognize, measure and Step Eight journalize Step Two transactions Post Prepare a transactions post-closing to the general trial balance ledger Step Seven Step Three Journalize and Prepare an post closing unadjusted entries trial balance Step Six Step Four Prepare Journalize and financial post adjusting statements Step Five entries Prepare an adjusted trial balance Here in Chapter 3, we will learn how to prepare steps four, five, seven, and eight. The accounting cycle is repeated for every accounting period. The accounting period can be defined as a month, a quarter, or a year. The annual accounting period for most large companies runs the calendar year from January 1 through December 31, although some companies use a fiscal year that does not coincide with the calendar year. Fiscal year Any consecutive, A fiscal year is any consecutive 12-month period that a business chooses. It may be- 12-month period that a business gin on any day of the year and end 12 months later. Usually, the fiscal year-end date is adopts as its accounting year. the low point in business activity for the year. Although we will focus primarily on an an- nual time period, usually financial statements are prepared monthly, quarterly, or semi- annually so that businesses have an idea of how they are doing before the year ends. Real Business Video In the Real Business Video, meet the Chief Financial Officer (CFO) of Rosa Mexicana Restaurants, who oversees the purchase and financing of business initiatives of the res- taurants from the purchase of assets to the opening of a new restaurant. She reviews Adjusting and Closing Entries 3 the types of expenses and revenues and financial statements prepared and other calcu- lations needed to account for a dynamic and successful restaurant chain’s operations. How Does a Company Accurately Report Its Income? Revenue Recognition and Matching Principles 1 Understand the revenue In Chapter 1, we learned that financial statements are prepared in order to provide useful recognition and matching information to various users. However, for financial statements to be useful, they must principles be accurate and up to date. To ensure that financial statements are up to date, GAAP re- quires the use of accrual accounting. To practice accrual accounting, a business must Accrual accounting Accounting follow the next two accounting principles: method that records revenues when earned and expenses when incurred • The revenue recognition principle states that revenues should be recognized, or without regard to when cash is recorded, when they are earned regardless of when cash is received. exchanged. • The matching principle states that expenses should be matched with the revenues Revenue recognition they helped generate. In other words, expenses should be recorded when they are principle Recording revenues incurred regardless of when they are paid for. when they are earned by providing goods or services to customers. Accruals and Deferrals Matching principle Recording It is possible for a business to record revenues only when cash is received and record expenses in the time period they were expenses only when cash is paid. As discussed in Chapter 1, this is referred to as incurred to produce revenues, thus cash-basis accounting. In many instances, when a company uses cash-basis account- matching them against the revenues ing, its financial statements do not present an accurate picture of how the company is earned during that same period. performing. This is because a business may provide goods and services to customers “on Cash-basis accounting account.” In this case, the business has earned revenue prior to receiving cash from the Accounting method that records customer. A business may also purchase goods and services from suppliers on account. revenues when cash is received and In this case, expenses are incurred before cash is paid. When revenues are earned before expenses when cash is paid. cash is received or expenses are incurred before cash is paid, it is called an accrual. Accruals Revenues earned or We have already seen accruals in Chapters 1 and 2 when we recorded transactions in expenses incurred before cash has Accounts Receivable and Accounts Payable. been exchanged. Businesses may also receive cash from customers prior to the delivery of goods or services to the customer. In this case, cash is received before revenue is earned. In addi- tion, businesses may pay for goods or services prior to receiving those goods or services from the supplier. In this case, cash is paid before an expense is incurred. When cash is received for goods or services prior to the recognition of a revenue or cash is paid for Deferrals Cash received or paid goods or services prior to the recognition of the expense, it is called a deferral. We have before revenues have been earned or also seen deferrals in Chapters 1 and 2 when we purchased supplies and equipment. expenses have been incurred. Accruals and deferrals can be summarized as follows: Now Later Accrued Revenue Revenue is recognized Cash is received Accrued Expense Expense is recognized Cash is paid Deferred Revenue Cash is received Revenue is recognized Deferred Expense Cash is paid Expense is recognized Adjusting entries Journal en- tries made at the end of the account- As we saw in Chapter 2, a business records transactions throughout the accounting ing period to measure the period’s in- period as the transactions occur. At the end of the period, the accountant prepares a come accurately and bring the related trial balance and uses it to prepare financial statements. However, before most businesses asset and liability accounts to correct balances before the financial state- can prepare accurate, up-to-date financial statements, the accountant will have to pre- ments are prepared. pare adjusting entries. 4 Chapter 3 Stop and Think… If cash is so important to the well-being of a business, why does US GAAP require the use of accrual accounting instead of cash-basis accounting? Answer The goal of US GAAP is for financial statements to reflect accurate information re- garding the performance of a business. The fact that a business has received cash from customers does not necessarily mean that the business is performing well. For example, let’s assume that during the year a business received $20,000 from customers for services that it had provided during the same year. The business also received another $10,000 from customers for services that will not be provided until the following year. Under cash-basis accounting, the business would report $30,000 of revenues in the first year. Now, suppose during the second year the customers asked for (and received) a refund of the $10,000 before the services were provided. The $30,000 in revenues that were originally reported under cash-basis accounting during the first year now seems to be inaccurate because the business only ended up with revenues of $20,000. Under accrual accounting, the business would have only reported $20,000 of revenues in the first year, which would have reflected a more accurate picture of the business’s performance. This is because, under accrual accounting, revenues are recorded when they are earned i nstead of when cash is received. What Is the Role of Adjusting Entries, and When Are They Prepared? 2 Understand the four Adjusting entries are journal entries used to ensure that the revenue recognition prin- types of adjustments, and ciple and the matching principle are followed. Adjustments may be needed for accru- prepare adjusting entries als when revenues have been earned, or expenses have been incurred, before cash is exchanged. Because cash has not been exchanged, it is possible that the revenue or expense has not been recorded, so an adjusting entry is needed to record the revenue or expense. • Two types of adjustments are made for accruals: 1. Accrue, or record, unrecorded revenues. Revenues are recorded in the current period by debiting a receivable and crediting revenue. 2. Accrue, or record, unrecorded expenses. Record the expenses in the current period by debiting an expense and crediting a liability. A deferral is created when cash is exchanged before the related revenue or expense is recognized. Examples include receiving cash from customers prior to providing services or purchasing supplies that are not used immediately. • Two types of adjustments are made for deferrals: Unearned revenue A liability 1. Divide unearned revenues between periods. When payment is received in created when a business collects advance from a customer for goods or services, cash is debited. The liability cash from customers in advance of account, Unearned Revenue, is credited because the customer is owed providing goods or services; also the goods or services. Once the customer receives the goods or services, called deferred revenue. an adjusting entry is prepared in which the Unearned Revenue account is debited to reduce it and a Revenue account is credited. Adjusting and Closing Entries 5 Prepaid expenses Amounts that 2. Divide prepaid expenses, supplies, buildings, equipment, and other assets are assets of a business because they between periods. These items are recorded as assets when they are purchased represent items that have been paid because the item that was paid for has not yet been used up. Therefore, an for but will be used later; also called asset account is debited and cash is credited to record the purchase. Once deferred expenses. part, or all, of the item is used up, an adjusting entry is prepared in which an expense account is debited and the related asset is credited to reduce it. At the end of the accounting period, the accountant prepares a trial balance from the account information contained in the general ledger. This trial balance lists most of the revenues and expenses of the business, but these amounts are incomplete because the adjusting entries have not yet been prepared. Therefore, this trial balance is called an Unadjusted trial balance A unadjusted trial balance (step three in the accounting cycle). Remember Osborne trial balance that is prepared at the Consulting, Inc., from Chapter 2? Exhibit 3-1 shows the unadjusted trial balance for end of the accounting period prior to Osborne Consulting, Inc., at the end of its first quarter of operations, at March 31, the adjusting entries being made. 2014. Now, we need to prepare adjusting entries at March 31, 2014. Osborne Consulting, Inc. (Unadjusted) Trial Balance March 31, 2014 BALANCE ACCOUNT TITLE DEBIT CREDIT Cash $26,300 Accounts Receivable 3,100 Supplies 900 Prepaid Rent 3,000 Equipment 12,600 Accounts Payable $13,100 Unearned Service Revenue 450 Common Stock 20,000 Retained Earnings 9,500 Dividends 3,200 Service Revenue 7,000 Salaries Expense 550 Utilities Expense 400 Total $50,050 $50,050 Exhibit 3-1 Remember from Chapter 2 that transactions are recorded in the journal and posted to accounts in the general ledger. This process is still used when adjusting the accounts. In this chapter, we will show how to record adjusting entries and how to post them to accounts. However, instead of using the real ledger account form, we will post adjust- ments to T-accounts. We use this method because it is easier to see how these entries affect the specific accounts as well as the accounting equation. Accruing Revenues Accounts Receivable Businesses sometimes earn revenue by providing goods or ser- vices before they receive cash. Assume that a local car dealership hires Osborne Consulting, Inc., on March 15 as a computer consultant. Osborne Consulting agrees to a monthly fee of $500, which the car dealership pays on the 15th of each month, beginning on April 15. During March, Osborne earns half a month’s fee, $250 ($500 × 1/2 month), for consulting work performed March 15 through March 31. On March 31, Osborne makes the following 6 Chapter 3 adjusting entry to reflect the accrual of the revenue earned during March (the beginning balance of each account is found on the unadjusted trial balance presented in Exhibit 3-1): GENERAL JOURNAL Date Account Debit Credit Mar 31 Accounts Receivable 250 Service Revenue 25500 GENERAL LEDGER Balance Sheet Income Statement Stockholders’ Equity Assets Liabilities Common Stock REaertnaiinngesd DDiivviiddeennddss Revenues Expenses Accounts Service Receivable Revenue Bal 3,100 Bal 7,000 250 250 Bal 3,350 Bal 7,250 Without the adjustment, Osborne Consulting’s financial statements are inaccurate because they would understate both Accounts Receivable and Service Revenue. Accruing Expenses Salaries Payable Suppose Osborne Consulting pays the office assistant a monthly salary of $550. Osborne pays the assistant on the 15th of each month for the past month’s work. On March 31, the following adjustment must be made to record the sala- ries expense for the month of March: GENERAL JOURNAL Date Account Debit Credit Mar 31 Salaries Expense 550 Salaries Payable 55500 GENERAL LEDGER Balance Sheet Income Statement Stockholders’ Equity Assets Liabilities Common Stock REaertnaiinngesd DDiivviiddeennddss Revenuueess Expenses Accounts Salaries Payable Service Salaries Receivable 550 Revenue Expense Bal 3,100 Bal 7,000000 Bal 550 250 255000 550 Bal 3,350 Bal 7,255000 Bal 1,100 Accrued expenses Expenses This is referred to as accruing the expense. Accrued expenses, such as the accrual that have been incurred prior to being for salaries expense, are expenses that the business has incurred but not paid. The adjust- paid for. ing entry to accrue the expense always creates a liability, such as Salaries Payable, Taxes Payable, or Interest Payable. Adjusting Deferred Revenues Unearned Revenues It is possible for a business to collect cash from customers prior to providing goods or services. Receiving cash from a customer before earning it creates Deferred revenue A liability a liability called unearned revenue, or deferred revenue. It is classified as a liability created when a business collects because the company owes a product or service to the customer. Even though the cash from customers in advance of providing goods or services; also account has the word revenue in its title, it is not a revenue account because the amount called unearned revenue. in the account represents what has not yet been earned. Adjusting and Closing Entries 7 Suppose a local real estate agency hires Osborne Consulting to provide consulting ser - vices, agreeing to pay $450 monthly, beginning immediately. Osborne Consulting collects the first amount from the real estate agency on March 21. Osborne Consulting records the cash receipt and a liability as follows: GENERAL JOURNAL Date Account Debit Credit Mar 31 Accounts Receivable 250 Service Revenue 25500 GENERAL LEDGER DATE ACCOUNTS POST REF. DR. CR. Balance Sheet Income Statement Mar 21 Cash 450 Stockholders’ Equity Unearned Service Revenue 450 Assets Liabilities Common Stock REaertnaiinngesd DDiivviiddeennddss Revenues Expenses Collected revenue in advance. Accounts Service The liability account Unearned Service Revenue now shows that Osborne Consulting Receivable Revenue Bal 3,100 Bal 7,000 owes $450 of services because of its obligation to provide consulting services to the real 250 250 Bal 3,350 Bal 7,250 estate agency. During the last ten days of March, Osborne Consulting earned one-third of the $450, or $150 ($450 × 1/3). Therefore, Osborne Consulting makes the following adjust- ment to record earning $150 of the revenue: GENERAL JOURNAL Date Account Debit Credit Mar 31 Unearned Service Revenue 150 Service Revenue 15500 GENERAL LEDGER Balance Sheet Income Statement Stockholders’ Equity Assets Liabilities Common Stock REaertaniinnegds DDiivviiddeennddss Revenuueess Expenses GENERAL JOURNAL Accounts Salaries Payable Service Salaries Date Account Debit Credit Receivable 550 Revenue Expense Mar 31 Salaries Expense 550 Bal 3,100 Bal 7,000000 Bal 550 Salaries Payable 55500 GENERAL LEDGER 250 Unearned 255000 550 Bal 3,350 Bal 7,255000 Bal 1,100 Service Revenue Balance Sheet Income Statement 15500 150 Bal 450 Bal 7,40000 Stockholders’ Equity Bal 300 Assets Liabilities Common Stock REaertnaiinngesd DDiivviiddeennddss Revenuueess Expenses Service Revenue increases by $150, and Unearned Service Revenue decreases by Accounts Salaries Payable Service Salaries $150. Now both accounts are up to date at March 31. Receivable 550 Revenue Expense Bal 3,100 Bal 7,000000 Bal 550 250 255000 550 Bal 3,350 Bal 7,255000 Bal 1,100 Adjusting Deferred Expenses Prepaid Rent Prepaid rent and prepaid insurance are examples of prepaid expenses, Deferred expenses Amounts also called deferred expenses. Prepaid expenses represent items that are paid for that are assets of a business because before they are used. Often, renters are required to pay rent in advance. This prepayment they represent items which have been creates an asset for the renter. Suppose Osborne Consulting, Inc., moves to a new office paid for but will be used later. Also and prepays three months’ office rent on March 1, 2014. If the lease specifies a monthly called prepaid expenses. rental of $1,000, the amount of cash paid is $3,000 ($1,000 × 3 months). The entry to record the payment is as follows: DATE ACCOUNTS POST REF. DR. CR. Mar 1 Prepaid Rent 3,000 Cash 3,000 Paid three months’ rent in advance. 8 Chapter 3 After posting, Prepaid Rent has a $3,000 debit balance. During March, Osborne Consulting uses the rented space for one month; therefore, the balance in Prepaid Rent is reduced by $1,000 (one month’s rent). The required adjusting entry is as follows: GENERAL JOURNAL Date Account Debit Credit Mar 31 Rent Expense 1,000 Prepaid Rent 1,00000 GENERAL LEDGER Balance Sheet Income Statement Stockholders’ Equity Assets Liabilities Common Stock REaertaniinnegds DDiivviiddeennddss Revenuueess Expenses Accounts Salaries Payable Service Salaries Receivable 550 Revenue Expense Bal 3,100 Bal 7,000000 Bal 550 250 Unearned 255000 550 Bal 3,350 Bal 7,255000 Bal 1,100 Service Revenue 155000 Prepaid Rent 150 Bal 450 Bal 7,400000 Rent Expense Bal 300 Bal 3,000 1,00000 1,000 Bal 2,000 The Rent Expense account is increased with a debit, which reduces Retained Earnings and, therefore, Stockholders’ Equity. The asset account Prepaid Rent is decreased with a credit for the same amount. After posting, Prepaid Rent and Rent Expense show the correct ending balances. If Osborne Consulting, Inc., had prepaid insurance, the same analysis would also apply to this asset account. The difference in the adjusting entry would be in the account titles, which would be Prepaid Insurance instead of Prepaid Rent and Insurance Expense instead of Rent Expense. The amount of the entry would also be different. Accounting in Your World In order to better understand the difference between a prepaid expense and an unearned revenue, con- sider this example: At the start of this quarter or semester in school, you paid your school the tuition that was due for the upcoming term. Your tuition will ulti- mately be an expense to you. However, before the term began, the amount you paid was not yet an expense to you because the school had not yet provided any classes. In other words, you had not yet received anything for your pay- ment. Instead, the amount you paid represented an asset known as a prepaid expense. It was an asset because the school owes you either the classes or a refund. Once classes started, you began to incur an expense. Technically, the amount of your asset, prepaid expense, would have decreased and the amount of your expense would have increased every day. By the end of the quarter or semester, none of the tuition you paid would be considered to be a prepaid expense. Instead, it becomes an expense. Now, let’s look at the same example from the perspective of your school. When your school received the tuition payment from you, it did not have the right to record it as a revenue because it had not provided you with any classes. Instead, the school Adjusting and Closing Entries 9 would record your tuition as a liability called unearned revenue. Unearned revenue rep- resents a liability to the school because the school owes you either the classes or your money back. Once classes started, your school began to earn revenue. The amount of its unearned revenue would have decreased and the amount of its revenue would have increased GENERAL JOURNAL every day. By the end of the quarter or semester, the entire amount of tuition you Date Account Debit Credit Mar 31 Rent Expense 1,000 paid would be considered to be revenue to your school. As you can see, one entity’s Prepaid Rent 1,00000 GENERAL LEDGER prepaid expense is another entity’s unearned revenue and vice versa. Balance Sheet Income Statement Stockholders’ Equity Assets Liabilities Common Stock REaertaniinnegds DDiivviiddeennddss Revenuueess Expenses Supplies Supplies receive the same treatment as prepaid expenses. On March 5, Osborne Consulting pays $900 for office supplies. The asset accounts, Supplies and Cash, are both affected. Supplies increased by $900, while Cash decreased by $900, as Accounts Salaries Payable Service Salaries Receivable 550 Revenue Expense shown here: Bal 3,100 Bal 7,000000 Bal 550 250 Unearned 255000 550 Bal 3,350 Bal 7,255000 Bal 1,100 Service Revenue 155000 Prepaid Rent 150 BBaall 435000 Bal 7,400000 Rent Expense DATE ACCOUNTS POST REF. DR. CR. Bal 3,000 1,00000 1,000 Bal 2,000 Mar 5 Supplies 900 Cash 900 Purchased office supplies. The March 31 trial balance, as shown in Exhibit 3-1 on page 5, shows Supplies with a $900 debit balance. During March, Osborne Consulting uses some of these supplies to conduct business. Therefore, Osborne Consulting’s March 31 Balance Sheet should not report supplies of $900. To figure out the amount of supplies used, Osborne Consulting counts the supplies on hand at the end of March. The supplies on hand are still an asset to the business. Assume that Osborne Consulting has supplies costing $600 at March 31. The supplies purchased ($900) minus the supplies on hand at the end of March ($600) equals the value of the supplies used during the month ($300). The amount of supplies used during the month will become supplies expense. The March 31 adjusting entry updates the Supplies account and records Supplies Expense for the month: GENERAL JOURNAL Date Account Debit Credit Mar 31 Supplies Expense 300 Supplies 30000 GENERAL LEDGER Balance Sheet Income Statement Stockholders’ Equity AAsssseettss Liabilities Common Stock REaertaniinnegds DDiivviiddeennddss Revenuueess Expenses Accounts Salaries Payable Service Salaries Receivable 550 Revenue Expense Bal 3,100 Bal 7,000000 Bal 550 250 Unearned 255000 550 Bal 3,350 Bal 7,255000 Bal 1,100 Service Revenue 155000 Prepaid Rent 150 Bal 450 Bal 7,400000 Rent Expense Bal 300 Bal 3,000 1,000000 1,000 Bal 2,000 Supplies Supplies Expense Bal 900 300 300 Bal 600