Accounting Principles I – Adjustments and Financial Statements - Quick Guides

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Study GuideAccounting Principles I–Adjustments and FinancialStatements1. Accrued RevenuesSometimes a businessearns revenue before it records it. When this happens, the company mustmake anadjusting entryat the end of the accounting period. This type of adjusting entry is called anaccrual for revenues.What are accrued revenues?Accrued revenuesare revenues that have been:•earned(the work is done or the time has passed), but•not yet recorded, and often•not yet billedto the customer.This commonly happens with:•Interest revenue•Completed services or delivered goodsthat haven’t been billed yetExample 1: Accrued Interest RevenueA company has a$10,000 note receivablethat earns6%annual interestfor3 years. The customerhas not made any payments yet.Even though no cash has been received, the company stillearns interest as time passes. So, at theend of each accounting period, the company must record the interest revenue that has built up.About the number of daysMost textbooks use a360-day yearto simplify interest calculations (that’s what we use here).In real life, many lenders use a more accurate365-day year.

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Study GuideCalculating the interest for one monthFor April (30 days):So the company earns$50 interest revenueduring the month.Adjusting entry for accrued interestBecause interest has been earned but not recorded, the company must:•Increase (debit) Interest Receivable→ anasset(because the company will receive theinterest later)•Increase (credit) Interest Revenue→ arevenue accountAdjusting Entry:•DebitInterest Receivable$50•CreditInterest Revenue$50This makes sure revenue is recorded in the correct period, even if the cash comes later.

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Study GuideExample 2: Accrued Service Revenue (Unbilled Work)Imagine a plumber does$90 of work on April 30, but doesn’t send the bill untilMay 4.Even though the customer hasn’t been billed yet, the work wascompleted in April, so the revenuemust be recorded inApril’s records.Adjusting entry for unbilled service revenueThe plumber should:•Increase (debit) Accounts Receivable→ anasset(money owed by the customer)•Increase (credit) Service Revenue→ revenue earnedAdjusting Entry:•DebitAccounts Receivable$90•CreditService Revenue$90This keeps revenue in the period when it was earned.

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Study Guide2. Accrued ExpensesSometimes a businessuses something or receives a service, buthas not paid for it yet. Eventhough no cash has gone out, the expense still belongs to the current accounting period.That’s why we recordaccrued expensesat the end of the period using anadjusting entry.What are accrued expenses?Accrued expensesare expenses that have:•already happened(the business has received the benefit), but•have not been recorded yet, and•have not been paid yetSo, the company must record:1.theexpense, and2.theliability(money it still owes)Common examples of accrued expensesAccrued expenses often include:1) Unpaid WagesEmployees may work near the end of the period, but the company might pay them later (in the nextperiod).2) Interest on Notes PayableInterest builds up over time, even if the company hasn’t paid it yet.Example 1: Accrued Wages (Unpaid Salaries)Suppose at the end of the accounting period, a company owes employees$2,000 in wages, buthasn’t paid them yet.

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Study GuideEven though the cash hasn’t been paid, the employeesalready worked, so the expense must berecorded now.Adjusting entry for unpaid wagesTo record this properly, the company will:•Increase (debit) Wages Expense→ this shows the cost of labor for the period•Increase (credit) Wages Payable→ this shows a liability (money owed)Adjusting Entry:•DebitWages Expense$2,000•CreditWages Payable$2,000This way, the expense is matched to the correct accounting period.Example 2: Accrued Interest ExpenseNow imagine the company has a$10,000 long-term note payablewith12% annual interest.

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Study GuideAdjusting entry for accrued interestThe company will:•Increase (debit) Interest Expense$100•Increase (credit)Interest Payable$100Adjusting Entry:•DebitInterest Expense$100•CreditInterest Payable$1003.Unearned RevenuesSometimes a business receives moneybeforeit actually does the work or delivers the product. Whenthat happens, the money isnot revenue yet—because it hasn’t been earned.That type of payment is calledunearned revenue.What are unearned revenues?Unearned revenuesare payments receivedin advancefor:•services that will be performed later, or•goods that will be delivered later

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Study GuideIn other words, the customer has paid, but the companystill owes something.Simple examples•Newspaper subscription paid ahead of time•Extended warrantypurchased at the time of saleAt the time the customer pays, the company has a responsibility to provide future service. So itrecords the payment as aliability, not revenue.Why do we adjust unearned revenue?As time passes, the company begins toearnthe revenue by delivering the service (or product).So at the end of each accounting period, the company must record anadjusting entryto show:how much has been earned, andhow much is still unearned.Example: Unearned Insurance RevenueA customer pays$1,800for an insurance policy that covers her delivery vehicles for6 months.Adjusting entry after one monthTo record earned revenue, the insurance company must:

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Study Guide•Decrease (debit) Unearned Revenue$300•Increase (credit) Revenue$300This reduces the liability because the company now owes less service in the future.It also increases revenue because part of the service has been completed.4.Prepaid ExpensesSometimes a business pays for somethingbeforeit actually uses it. At first, that payment is not anexpense—it is anassetbecause the business will benefit from it in the future.These are calledprepaid expenses.What are prepaid expenses?Prepaid expensesareassetsthat eventually becomeexpensesas they:•expire over time, or•get used upEasy example: Office suppliesWhen a business buys office supplies, it records them as anassetat first.But once the supplies are used in daily business work, they turn into anexpense.Why do prepaid expenses need adjusting entries?Prepaid expenses change over time. Each accounting period, some part of the prepaid amount isused uporexpires.So at the end of the accounting period, the company must record anadjusting entryto:show the amount that has become an expense, and

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Study Guidereduce the asset balance to match what is left.This helps keep financial statements accurate.Example: Prepaid Insurance (Customer’s Point of View)Now let’s look at thesame insurance example, but this time from the customer’s side.The customer pays$1,800for6 monthsof insurance coverage.Adjusting entry after one monthShe records:•Debit Insurance Expense$300•Credit PrepaidInsurance$300Insurance Expense increases because the cost has been used this month.Prepaid Insurance decreases because there is less future coverage left.Important idea to remember

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Study GuideAprepaid expenseon one company’s books is often (but not always) anunearned revenueonanother company’s books.Example:•The customer recordsPrepaid Insurance (asset)•The insurance company recordsUnearned Insurance Revenue (liability)But this is not always true. For example,office suppliesare prepaid expenses for one business, butthey usually don’t appear as unearned revenue for another company.5. DepreciationDepreciation is how a businessspreads the cost of a long-term asset over time. Instead ofrecording the full cost as an expense right away, the business records part of that cost as an expenseeach period the asset is used.Important note:Land is never depreciated.What depreciation really meansDepreciation is the process ofallocating the depreciable costof a long-lived asset toexpenseoverthe asset’sestimated service life(how long the business expects to use it).This helps match:•the cost of using the assetwith•the revenue the asset helps earnDepreciable cost (the amount we actually depreciate)Before calculating depreciation, we need to find thedepreciable cost.Depreciable cost includes:•All costs needed to buy the asset and get it ready to useminus•the asset’ssalvage value

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