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3.6: Adjustments for deferred items

  • Page ID
    19994
  • This section discusses the two types of adjustments for deferred items: asset/expense adjustments and liability/revenue adjustments. In the asset/expense group, you learn how to prepare adjusting entries for prepaid expenses and depreciation. In the liability/revenue group, you learn how to prepare adjusting entries for unearned revenues.

    MicroTrain Company must make several asset/expense adjustments for prepaid expenses. A prepaid expense is an asset awaiting assignment to expense, such as prepaid insurance, prepaid rent, and supplies on hand. Note that the nature of these three adjustments is the same.

    Prepaid insurance When a company pays an insurance policy premium in advance, the purchase creates the asset, prepaid insurance. This advance payment is an asset because the company will receive insurance coverage in the future. With the passage of time, however, the asset gradually expires. The portion that has expired becomes an expense. To illustrate this point, recall that in Chapter 2, MicroTrain Company purchased for cash an insurance policy on its trucks for the period 2010 December 1, to 2011 November 30. The journal entry made on 2010 December 1, to record the purchase of the policy was:

    2010

     

     

     

     

    Dec.

    1

    Prepaid Insurance

    2,400

     

     

     

     

     

     

    Cash

     

     

    2400

     

     

     

     

    Purchased truck insurance to cover a one-year period.

     

     

     

     

     

    The two accounts relating to insurance are Prepaid Insurance (an asset) and Insurance Expense (an expense). After posting this entry, the Prepaid Insurance account has a USD 2,400 debit balance on 2010 December 1. The Insurance Expense account has a zero balance on 2010 December 1, because no time has elapsed to use any of the policy’s benefits.

    (Dr.)

    Prepaid Insurance

    (Cr)

    (Dr.)

    Insurance Expense

    (Cr)

    2010

     

     

     

    2010

     

     

     

    Dec. 1

     

     

     

    Dec. 1

     

     

     

    Bal.

    2,400

     

     

    Bal.

    -0-

     

     

    By 2010 December 31, one month of the year covered by the policy has expired. Therefore, part of the service potential (or benefit obtained from the asset) has expired. The asset now provides less future services or benefits than when the company acquired it. We recognize this reduction by treating the cost of the services received from the asset as an expense. For the MicroTrain Company example, the service received was one month of insurance coverage. Since the policy provides the same services for every month of its one-year life, we assign an equal amount (USD 200) of cost to each month. Thus, MicroTrain charges 1/12 of the annual premium to Insurance Expense on 2010 December 31. The adjusting journal entry is:

    2010

     

     

     

     

     

    Dec.

    31

    Insurance Expense

    200

     

     

     

    Adjustment

     

     

     

     

    Prepaid Insurance

     

     

    200

     

     

    1—Insurance

     

     

    To record insurance expense for December.

     

     

     

     

     

     

    After posting these two journal entries, the accounts in T-account format appear as follows:

     

    (Dr.)               Prepaid Insurance                    (Cr)     

                        

     

    2010

    Dec. 1 Purchased

    on account 2,400

    2010

    Dec. 31 Adjustment 1      200

     

     

     

    Decreased by $200

     

    Bal. After adjustment                           2,200

     

     

     

     

    (Dr.)                Insurance Expense                (Cr.)

     

    Increased by $200

    2010

    31     Adjustment 1    200

     

     

     

     

    In practice, accountants do not use T-accounts. Instead, they use three-column ledger accounts that have the advantage of showing a balance after each transaction. After posting the preceding two entries, the three-column ledger accounts appear as follows:

    Prepaid Insurance    

    Date

     

    Explanation

    Post Ref.

    Debit

    Credit

    Balance

    Dec. 2010

    1

    Purchased on Account

    G1

    2400

     

    2400 Dr.

     

    31

    Adjustment

    G3*

     

    200

    2200 Dr.

    Insurance Expense

    Date

     

    Explanation

    Post Ref.

    Debit

    Credit

    Balance

    Dec. 2010

    31

    Adjustment

    G3*

    200

     

    200 Dr.

     

    Before this adjusting entry was made, the entire USD 2,400 insurance payment made on 2010 December 1, was a prepaid expense for 12 months of protection. So on 2010 December 31, one month of protection had passed, and an adjusting entry transferred USD 200 of the USD 2,400 (USD 2,400/12 = USD 200) to Insurance Expense. On the income statement for the year ended 2010 December 31, MicroTrain reports one month of insurance expense, USD 200, as one of the expenses it incurred in generating that year’s revenues. It reports the remaining amount of the prepaid expense, USD 2,200, as an asset on the balance sheet. The USD 2,200 prepaid expense represents 11 months of insurance protection that remains as a future benefit.

    Prepaid rent Prepaid rent is another example of the gradual consumption of a previously recorded asset. Assume a company pays rent in advance to cover more than one accounting period. On the date it pays the rent, the company debits the prepayment to the Prepaid Rent account (an asset account). The company has not yet received benefits resulting from this expenditure. Thus, the expenditure creates an asset.

    We measure rent expense similarly to insurance expense. Generally, the rental contract specifies the amount of rent per unit of time. If the prepayment covers a three-month rental, we charge one-third of this rental to each month. Notice that the amount charged is the same each month even though some months have more days than other months.

    For example, MicroTrain Company paid USD 1,200 rent in advance on 2010 December 28, to cover a three-month period beginning on that date. The journal entry would be:

    2010

     

     

     

     

    Dec.

    1

    Prepaid Rent

    1,200

     

     

     

    Cash

     

    1,200

     

     

    Paid three months' rent on a building.

     

     

     

    The two accounts relating to rent are Prepaid Rent (an asset) and Rent Expense. After this entry is posted, the Prepaid Rent account has a USD 1,200 balance and the Rent Expense account has a zero balance because no part of the rent period has yet elapsed.

    (Dr.)

    Prepaid Rent

    (Cr)

    (Dr.)

    Rent Expense

    (Cr)

    2010

     

     

     

    2010

     

     

     

    Dec. 1

     

     

     

    Dec. 1

     

     

     

    Bal. Cash Paid

    1,200

     

     

    Bal.

    -0-

     

     

    On 2010 December 31, MicroTrain must prepare an adjusting entry. Since one third of the period covered by the prepaid rent has elapsed, it charges one-third of the USD 1,200 of prepaid rent to expense. The required adjusting entry is:

     

     

    2010 Dec.

     

     

     

     

    Adjustment

     

     

     

    31

    Rent Expense

    400

     

    2—Rent

     

     

     

    Prepaid Rent To record rent expense for December

     

    400

     

     

     

     

     

     

     

    After posting this adjusting entry, the T-accounts appear as follows:

     

    (Dr.)

    Prepaid Rent                                            (Cr)

     

     

    2010

    Dec. 1  Cash Paid

    1,200

    2010 Dec. 31

    Adjustment 2      400

    Decreased

     

    Bal. after adjustment

    800

     

    by $400

     

    (Dr.)

    Rent Expense                                   (Cr)

     

    Increased by $400

    2010

    Dec.

    31     Adjustment 2

    400

     

     

     

    The USD 400 rent expense appears in the income statement for the year ended 2010 December 31. MicroTrain reports the remaining USD 800 of prepaid rent as an asset in the balance sheet on 2010 December 31. Thus, the adjusting entries have accomplished their purpose of maintaining the accuracy of the financial statements.

    Supplies on hand Almost every business uses supplies in its operations. It may classify supplies simply as supplies (to include all types of supplies), or more specifically as office supplies (paper, stationery, floppy diskettes, pencils), selling supplies (gummed tape, string, paper bags, cartons, wrapping paper), or training supplies (transparencies, training manuals). Frequently, companies buy supplies in bulk. These supplies are an asset until the company uses them. This asset may be called supplies on hand or supplies inventory. Even though these terms indicate a prepaid expense, the firm does not use prepaid in the asset’s title.

    On 2010 December 4, MicroTrain Company purchased supplies for USD 1,400 and recorded the transaction as follows:

    2010

     

     

     

     

    Dec.

    4

    Supplies on Hand

    1,400

     

     

     

      Cash

     

    1,400

     

     

     To record the purchase of supplies for future use.

     

     

    MicroTrain’s two accounts relating to supplies are Supplies on Hand (an asset) and Supplies Expense. After this entry is posted, the Supplies on Hand account shows a debit balance of USD 1,400 and the Supplies Expense account has a zero balance as shown in the following T-accounts:

    (Dr.)

    Supplies

    On Hand

    (Cr.)

     

    (Dr.)

    Supplies

    Expense

    (Cr.)

    2010

     

     

     

     

    2010

     

     

     

    Dec. 4

     

     

     

     

    Dec. 4

     

     

     

    Bal. Cash Paid

    1,400

     

     

     

    Bal.

    -0-

     

     

    An actual physical inventory (a count of the supplies on hand) at the end of the month showed only USD 900 of supplies on hand. Thus, the company must have used USD 500 of supplies in December. An adjusting journal entry brings the two accounts pertaining to supplies to their proper balances. The adjusting entry recognizes the reduction in the asset (Supplies on Hand) and the recording of an expense (Supplies Expense) by transferring USD 500 from the asset to the expense. According to the physical inventory, the asset balance should be USD 900 and the expense balance, USD 500. So MicroTrain makes the following adjusting entry:

    2010

     

     

     

     

     

    Dec.

    31

    Supplies Expense

    500

     

     

    Adjustment

     

     

    Supplies on Hand

    To record supplies used during December.

     

    500

    3—Supplies

     

    After posting this adjusting entry, the T-accounts appear as follows:

     

    (Dr.)               Supplies on Hand                   (Cr)

     

     

    2010

    Dec. 4 Cash Paid 1,400

    2010

    Dec. 31 Adjustment 3      500

    Decreased by $500

     

    Bal. after               900 adjustment

     

     

     

     

    (Dr.)               Supplies Expense               (Cr.)

     

    Increased by $500

    2010

    Dec 31  Adjustment 3

    500

     

     

    The entry to record the use of supplies could be made when the supplies are issued from the storeroom. However, such careful accounting for small items each time they are issued is usually too costly a procedure.

    Accountants make adjusting entries for supplies on hand, like for any other prepaid expense, before preparing financial statements. Supplies expense appears in the income statement. Supplies on hand is an asset in the balance sheet.

    Sometimes companies buy assets relating to insurance, rent, and supplies knowing that they will use them up before the end of the current accounting period (usually one month or one year). If so, an expense account is usually debited at the time of purchase rather than debiting an asset account. This procedure avoids having to make an adjusting entry at the end of the accounting period. Sometimes, too, a company debits an expense even though the asset will benefit more than the current period. Then, at the end of the accounting period, the firm’s adjusting entry transfers some of the cost from the expense to the asset. For instance, assume that on January 1, a company paid USD 1,200 rent to cover a three-year period and debited the USD 1,200 to Rent Expense. At the end of the year, it transfers USD 800 from Rent Expense to Prepaid Rent. To simplify our approach, we will consistently debit the asset when the asset will benefit more than the current accounting period.

    Depreciation Just as prepaid insurance and prepaid rent indicate a gradual using up of a previously recorded asset, so does depreciation. However, the overall time involved in using up a depreciable asset (such as a building) is much longer and less definite than for prepaid expenses. Also, a prepaid expense generally involves a fairly small amount of money. Depreciable assets, however, usually involve larger sums of money.

    depreciable asset is a manufactured asset such as a building, machine, vehicle, or piece of equipment that provides service to a business. In time, these assets lose their utility because of (1) wear and tear from use or (2) obsolescence due to technological change. Since companies gradually use up these assets over time, they record depreciation expense on them. Depreciation expense is the amount of asset cost assigned as an expense to a particular period. The process of recording depreciation expense is called depreciation accounting. The three factors involved in computing depreciation expense are:

    • Asset cost. The asset cost is the amount that a company paid to purchase the depreciable asset.

    • Estimated residual value. The estimated residual value (scrap value) is the amount that the company can probably sell the asset for at the end of its estimated useful life.

    • Estimated useful life. The estimated useful life of an asset is the estimated time that a company can use the asset. Useful life is an estimate, not an exact measurement, that a company must make in advance. However, sometimes the useful life is determined by company policy (e.g. keep a fleet of automobiles for three years).

    Accountants use different methods for recording depreciation. The method illustrated here is the straight-line method. We discuss other depreciation methods in Chapter 10. Straight-line depreciation assigns the same amount of depreciation expense to each accounting period over the life of the asset. The depreciation formula (straight-line) to compute straight-line depreciation for a one-year period is:

    \begin{equation}
    \text { Annualdeprecation }=\frac{\text { Assetcost- Estimatedresidualvalue }}{\text { Estimatedyearsofusefullife }}
    \end{equation}

    To illustrate the use of this formula, recall that on December 1, MicroTrain Company purchased four small trucks at a cost of USD 40,000. The journal entry was:

    2010

     

     

     

     

    Dec.

    1

    Trucks

    40,000

     

     

     

    Cash

     

    40,000

     

     

    To record the purchase of four trucks.

     

     

    The estimated residual value for each truck was USD 1,000, so MicroTrain estimated the total residual value for all four trucks at USD 4,000. The company estimated the useful life of each truck to be four years. Using the straight-line depreciation formula, MicroTrain calculated the annual depreciation on the trucks as follows:

    \begin{equation}
    \text { Annual deprecation }=\frac{\mathrm{USD} 40,000-\mathrm{USD} 4,000}{4 \mathrm{years}}=\mathrm{USD} 9,000
    \end{equation}

    The amount of depreciation expense for one month would be 1/12 of the annual amount. Thus, depreciation expense for December is USD 9,000 ÷ 12 = USD 750.

    The difference between an asset’s cost and its estimated residual value is an asset’s depreciable amount. To satisfy the matching principle, the firm must allocate the depreciable amount as an expense to the various periods in the asset’s useful life. It does this by debiting the amount of depreciation for a period to a depreciation expense account and crediting the amount to an accumulated depreciation account. MicroTrain’s depreciation on its delivery trucks for December is USD 750. The company records the depreciation as follows:

    2010

     

     

     

     

     

    Dec.

    31

    Depreciation Expense – Trucks

    750

     

     

     

     

        Accumulated Depreciation - Trucks

     

    750

    Adjusted 4-Depreciation

     

     

      To record depreciation expense for December.

     

     

     

     

     

    After posting the adjusting entry, the T-accounts appear as follows:

    (Dr.)        Depreciation Expense—Trucks           (Cr)

     

    Increased by $750

    2010

    Dec 31   Adjustment 4    750

     

     

     

     

     

     

     

     

     

     

     

    (Dr.)            Accumulated Depreciation—Trucks (Cr.)

    Increased by $750 (book value of asset decreased)

     

     

     

    2010

    Dec. 31 Adjustment 4  750       

     

     

     

    MicroTrain reports depreciation expense in its income statement. And it reports accumulated depreciation in the balance sheet as a deduction from the related asset.

    The accumulated depreciation account is a contra asset account that shows the total of all depreciation recorded on the asset from the date of acquisition up through the balance sheet date. A contra asset account is a deduction from the asset to which it relates in the balance sheet. The purpose of a contra asset account is to reduce the original cost of the asset down to its remaining undepreciated cost or book value. The accumulated depreciation account does not represent cash that is being set aside to replace the worn out asset. The undepreciated cost of the asset is the debit balance in the asset account (original cost) minus the credit balance in the accumulated depreciation contra account. Accountants also refer to an asset’s cost less accumulated depreciation as the book value(or net book value) of the asset. Thus, book value is the cost not yet allocated to an expense. In the previous example, the book value of the equipment after the first month is:

    Cost

    USD 40,000

      Less: Accumulated depreciation

    750

     Book value (or cost not yet allocated to as an expense)

    39,250

    MicroTrain credits the depreciation amount to an accumulated depreciation account, which is a contra asset, rather than directly to the asset account. Companies use contra accounts when they want to show statement readers the original amount of the account to which the contra account relates. For instance, for the asset Trucks, it is useful to know both the original cost of the asset and the total accumulated depreciation amount recorded on the asset. Therefore, the asset account shows the original cost. The contra account, Accumulated Depreciation—Trucks, shows the total amount of recorded depreciation from the date of acquisition. By having both original cost and the accumulated depreciation amounts, a user can estimate the approximate percentage of the benefits embodied in the asset that the company has consumed. For instance, assume the accumulated depreciation amount is about three-fourths the cost of the asset. Then, the benefits would be approximately three-fourths consumed, and the company may have to replace the asset soon.

    Thus, to provide more complete balance sheet information to users of financial statements, companies show both the original acquisition cost and accumulated depreciation. In the preceding example for adjustment 4, the balance sheet at 2010 December 31, would show the asset and contra asset as follows:

    Assets

     

    Trucks

    USD 40,000

      Less: Accumulated deprecation

    750

     

    USD 39,250

     

    As you may expect, the accumulated depreciation account balance increases each period by the amount of depreciation expense recorded until the remaining book value of the asset equals the estimated residual value.

    A liability/revenue adjustment involving unearned revenues covers situations in which a customer has transferred assets, usually cash, to the selling company before the receipt of merchandise or services. Receiving assets before they are earned creates a liability called unearned revenue. The firm debits such receipts to the asset account Cash and credits a liability account. The liability account credited may be Unearned Fees, Revenue Received in Advance, Advances by Customers, or some similar title. The seller must either provide the services or return the customer’s money. By performing the services, the company earns revenue and cancels the liability.

    Companies receive advance payments for many items, such as training services, delivery services, tickets, and magazine or newspaper subscriptions. Although we illustrate and discuss only advanced receipt of training fees, firms treat the other items similarly.

    Unearned service fees On December 7, MicroTrain Company received USD 4,500 from a customer in payment for future training services. The firm recorded the following journal entry:

    2010

     

     

     

     

    Dec.

    7

    Cash

    Unearned Service Fees

    To record the receipt of cash from a customer in payment for future training services.

    4,500

     

    4,500

    The two T-accounts relating to training fees are Unearned Service Fees (a liability) and Service Revenue. These accounts appear as follows on 2010 December 31 (before adjustment):

    (Dr.)                Unearned Service Fees                    (Cr.)

     

     

     

    (Dr.)                     

    2010

    Dec. 7   Cash received

    in advance             4,500

     

    Service Revenue                         (Cr.)

     

    *The $10,700 balance came

    2010

    Bal. before adjustment          10,700*

     from transactions discussed in Chapter 2.

    The balance in the Unearned Service Fees liability account established when MicroTrain received the cash will be converted into revenue as the company performs the training services. Before MicroTrain prepares its financial statements, it must make an adjusting entry to transfer the amount of the services performed by the company from a liability account to a revenue account. If we assume that MicroTrain earned one-third of the USD 4,500 in the Unearned Service Fees account by December 31, then the company transfers USD 1,500 to the Service Revenue account as follows:

     

    2010 Dec.

     

     

     

     

    Adjustment 5—Revenue earned

     

     

     

    31

    Unearned Service Fees

    Service Revenue

    To transfer a portion of training fees from the liability account to the revenue account.

    1,500

     

    1,500

     

     

     

     

     

     

     

                 

    After posting the adjusting entry, the T-accounts would appear as follows:

    Decreased by $1,500

    (Dr.)

    Unearned Service Fees

    (Cr.)

     

     

     

    2010

     

    2010

     

     

     

     

    2010 Dec. 31

    Adjustment 5   1,500

    Dec. 7  Cash received

     

     

     

     

     

    in advance

    4,500

     

     

     

     

    Bal. after adjustment

    3,000

     

     

    (Dr.)

    Service Revenue

    (Cr.)

     

     

     

     

    2010

    Bal. before adjustment Dec. 31 Adjustment 5

    10,700

    1,500   

    Increased —   by $1,500

     

     

     

    Bal. after adjustment

    12,200

     

    MicroTrain reports the service revenue in its income statement for 2010. The company reports the USD 3,000 balance in the Unearned Service Fees account as a liability in the balance sheet. In 2011, the company will likely earn the USD 3,000 and transfer it to a revenue account.

    If MicroTrain does not perform the training services, the company would have to refund the money to the training service customers. For instance, assume that MicroTrain could not perform the remaining USD 3,000 of training services and would have to refund the money. Then, the company would make the following entry:

    Unearned Service Fees

    3,000

     

    Cash

     

    3,000

    To record the refund of unearned training fees.

     

     

    Thus, the company must either perform the training services or refund the fees. This fact should strengthen your understanding that unearned service fees and similar items are liabilities.

    Accountants make the adjusting entries for deferred items for data already recorded in a company’s asset and liability accounts. They also make adjusting entries for accrued items, which we discuss in the next section, for business data not yet recorded in the accounting records.

    An accounting perspective:

    Business insight

    According to the National Association of Colleges and Employers, the average offer to an accounting major in 2009 was USD 48,334 and tends to increase each year. According to recent surveys, the market for accounting graduates remains brisk. Often, one of the chief problems for graduates is how to handle multiple job offers. As a result of the low unemployment rate, employers—especially small accounting firms with limited recruiting budgets—are doing whatever they can to grab qualified candidates.