Rabu, 13 Juni 2012

The Adjustment Process Illustrated

The Adjustment Process Illustrated

Accountants prepare a trial balance both before and after making adjusting entries. Reexamine the Greener Landscape Group's unadjusted trial balance for April 30, 20X2.

Account
Debit
Credit
100
Cash
$ 6,355
110
Accounts Receivable
150
140
Supplies
50
145
Prepaid Insurance
1,200
150
Equipment
3,000
155
Vehicles
15,000
200
Accounts Payable
$ 50
250
Unearned Revenue
270
280
Notes Payable
10,000
300
J. Green, Capital
15,000
350
J. Green, Drawing
50
400
Lawn Cutting Revenue
750
500
Wages Expense
200
510
Gas Expense
30
520
Advertising Expense
35
$26,070
$26,070
Consider eight adjusting entries recorded in Mr. Green's general journal and posted to his general ledger accounts. Then, see the adjusted trial balance, which shows the balance of all accounts after the adjusting entries are journalized and posted to the general ledger accounts.
Adjustment A: During the afternoon of April 30, Mr. Green cuts one lawn, and he agrees to mail the customer a bill for $50, which he does on May 2. In accordance with the revenue recognition principle, Mr. Green makes an adjusting entry in April to increase (debit) accounts receivable for $50 and to increase (credit) lawn cutting revenue for $50.



Adjustment B: Mr. Green's $10,000 note payable, which he signed on April 2, carries a 10.2% interest rate. Interest calculations usually exclude the day that loans occur and include the day that loans are paid off. Therefore, Mr. Green uses the formula below to calculate how much interest expense accrued during the final twenty-eight days of April.





Since the matching principle requires that expenses be reported in the accounting period to which they apply, Mr. Green makes an adjusting entry to increase (debit) interest expense for $79 and to increase (credit) interest payable for $79.



Adjustment C: Mr. Green's part-time employee earns $80 during the last four days of April but will not be paid until May 10. This requires an adjusting entry that increases (debits) wages expense for $80 and that increases (credits) wages payable for $80.



Adjustment D: On April 20 Mr. Green received a $270 prepayment for six future visits. Assuming Mr. Green completed one of these visits in April, he must make a $45 adjusting entry to decrease (debit) unearned revenue and to increase (credit) lawn cutting revenue.



Adjustment E: Mr. Green discovers that he used $25 worth of office supplies during April. He therefore makes a $25 adjusting entry to increase (debit) supplies expense and to decrease (credit) supplies.



Adjustment F: Mr. Green must record the expiration of one twelfth of his company's insurance policy. Since the annual premium is $1,200, he makes a $100 adjusting entry to increase (debit) insurance expense and to decrease (credit) prepaid insurance.



Adjustment G: If depreciation expense on Mr. Green's $15,000 truck is $200 each month, he makes a $200 adjusting entry to increase (debit) an expense account (depreciation expense–vehicles) and to increase (credit) a contra-asset account (accumulated depreciation–vehicles).



The truck's net book value is now $14,800, which is calculated by subtracting the $200 credit balance in the accumulated depreciation–vehicles account from the $15,000 debit balance in the vehicles account. Many accountants calculate the depreciation of long-lived assets to the nearest month. Had Mr. Green purchased the truck on April 16 or later, he might not make this adjusting entry until the end of May.
Adjustment H: If depreciation expense on Mr. Green's equipment is $35 each month, he makes a $35 adjusting entry to increase (debit) depreciation expense–equipment and to increase (credit) accumulated depreciation–equipment.



After journalizing and posting all of the adjusting entries, Mr. Green prepares an adjusted trial balance. The Greener Landscape Group's adjusted trial balance for April 30,20X2 appears below.

The Greener Landscape Group Adjusted Trial Balance April 30,20X2
Account
Debit
Credit
100
Cash
$ 6,355
110
Accounts Receivable
200
140
Supplies
25
145
Prepaid Insurance
1,100
150
Equipment
3,000
151
Accumulated Depreciation–Equipment
$ 35
155
Vehicles
15,000
156
Accumulated Depreciation–Vehicles
200
200
Accounts Payable
50
210
Wages Payable
80
220
Interest Payable
79
250
Unearned Revenue
225
280
Notes Payable
10,000
300
J. Green, Capital
15,000
350
J. Green, Drawing
50
400
Lawn Cutting Revenue
845
500
Wages Expense
280
510
Gas Expense
30
520
Advertising Expense
35
530
Interest Expense
79
540
Supplies Expense
25
545
Insurance Expense
100
551
Depreciation Expense–Equipment
35
556
Depreciation Expense–Vehicles
200
$26,514
$26,514

Depreciation

Depreciation

Depreciation is the process of allocating the depreciable cost of a long-lived asset, except for land which is never depreciated, to expense over the asset's estimated service life. Depreciable cost includes all costs necessary to acquire an asset and make it ready for use minus the asset's expected salvage value, which is the asset's worth at the end of its service life, usually the amount of time the asset is expected to be used in the business. For example, if a truck costs $30,000, has an expected salvage value of $6,000, and has an estimated service life of sixty months, then $24,000 is allocated to expense at a rate of $400 each month ($24,000 ÷ 60 = $400). This method of calculating depreciation expense, called straight-line depreciation, is the simplest and most widely used method for financial reporting purposes.
Some accountants treat depreciation as a special type of prepaid expense because the adjusting entries have the same effect on the accounts. Accounting records that do not include adjusting entries for depreciation expense overstate assets and net income and understate expenses. Nevertheless, most accountants consider depreciation to be a distinct type of adjustment because of the special account structure used to report depreciation expense on the balance sheet.
Since the original cost of a long-lived asset should always be readily identifiable, a different type of balance-sheet account, called a contra-asset account, is used to record depreciation expense. Increases and normal balances appear on the credit side of a contraasset account. The net book value of long-lived assets is found by subtracting the contra-asset account's credit balance from the corresponding asset account's debit balance. Do not confuse book value with market value. Book value is the portion of the asset's cost that has not been written off to expense. Market value is the price some-one would pay for the asset. These two values are usually different.
Suppose an accountant calculates that a $125,000 piece of equipment depreciates by $1,000 each month. After one month, he makes an adjusting entry to increase (debit) an expense account (depreciation expense–equipment) by $1,000 and to increase (credit) a contra-asset account (accumulated depreciation–equipment) by $1,000.



On a balance sheet, the accumulated depreciation account's balance is subtracted from the equipment account's balance to show the equipment's net book value.

ACME Manufacturing Partial Balance Sheet December 31, 20X7
Property, Plant, and Equipment
    Equipment
125,000
    Less: Accumulated Depreciation
(1,000)
124,000

Unearned Revenues and Prepaid Expenses

Unearned Revenues

Unearned revenues are payments for future services to be performed or goods to be delivered. Advance customer payments for newspaper subscriptions or extended warranties are unearned revenues at the time of sale. At the end of each accounting period, adjusting entries must be made to recognize the portion of unearned revenues that have been earned during the period.
Suppose a customer pays $1,800 for an insurance policy to protect her delivery vehicles for six months. Initially, the insurance company records this transaction by increasing an asset account (cash) with a debit and by increasing a liability account (unearned revenue) with a credit. After one month, the insurance company makes an adjusting entry to decrease (debit) unearned revenue and to increase (credit) revenue by an amount equal to one sixth of the initial payment.



Accounting records that do not include adjusting entries to show the earning of previously unearned revenues overstate total liabilities and understate total


Prepaid Expenses

Prepaid expenses are assets that become expenses as they expire or get used up. For example, office supplies are considered an asset until they are used in the course of doing business, at which time they become an expense. At the end of each accounting period, adjusting entries are necessary to recognize the portion of prepaid expenses that have become actual expenses through use or the passage of time.
Consider the previous example from the point of view of the customer who pays $1,800 for six months of insurance coverage. Initially, she records the transaction by increasing one asset account (prepaid insurance) with a debit and by decreasing another asset account (cash) with a credit. After one month, she makes an adjusting entry to increase (debit) insurance expense for $300 and to decrease (credit) prepaid insurance for $300.



Prepaid expenses in one company's accounting records are often—but not always—unearned revenues in another company's accounting records. Office supplies provide an example of a prepaid expense that does not appear on another company's books as unearned revenue.
Accounting records that do not include adjusting entries to show the expiration or consumption of prepaid expenses overstate assets and net income and understate expenses.

Accrued Expenses

Accrued Expenses

An adjusting entry to accrue expenses is necessary when there are unrecorded expenses and liabilities that apply to a given accounting period. These expenses may include wages for work performed in the current accounting period but not paid until the following accounting period and also the accumulation of interest on notes payable and other debts.
Suppose a company owes its employees $2,000 in unpaid wages at the end of an accounting period. The company makes an adjusting entry to accrue the expense by increasing (debiting) wages expense for $2,000 and by increasing (crediting) wages payable for $2,000.



If a long-term note payable of $10,000 carries an annual interest rate of 12%, then $1,200 in interest expense accrues each year. At the close of each month, therefore, the company makes an adjusting entry to increase (debit) interest expense for $100 and to increase (credit) interest payable for $100.



Accounting records that do not include adjusting entries for accrued expenses understate total liabilities and total expenses and overstate net income.

Adjusting Entries & Accrued Revenues

 

Adjusting Entries
Before financial statements are prepared, additional journal entries, called adjusting entries, are made to ensure that the company's financial records adhere to the revenue recognition and matching principles. Adjusting entries are necessary because a single transaction may affect revenues or expenses in more than one accounting period and also because all transactions have not necessarily been documented during the period.
Each adjusting entry usually affects one income statement account (a revenue or expense account) and one balance sheet account (an asset or liability account). For example, suppose a company has a $1,000 debit balance in its supplies account at the end of a month, but a count of supplies on hand finds only $300 of them remaining. Since supplies worth $700 have been used up, the supplies account requires a $700 adjustment so assets are not overstated, and the supplies expense account requires a $700 adjustment so expenses are not understated.
Adjustments fall into one of five categories: accrued revenues, accrued expenses, unearned revenues, prepaid expenses, and depreciation.

 

 

Accrued Revenues

An adjusting entry to accrue revenues is necessary when revenues have been earned but not yet recorded. Examples of unrecorded revenues may involve interest revenue and completed services or delivered goods that, for any number of reasons, have not been billed to customers. Suppose a customer owes 6% interest on a three-year, $10,000 note receivable but has not yet made any payments. At the end of each accounting period, the company recognizes the interest revenue that has accrued on this long-term receivable.
Unless otherwise specified, interest is calculated with the following formula: principal x annual interest rate x time period in years.





Most textbooks use a 360-day year for interest calculations, which is done here. In practice, however, most lenders make more precise calculations by using a 365-day year.
Since the company accrues $50 in interest revenue during the month, an adjusting entry is made to increase (debit) an asset account (interest receivable) by $50 and to increase (credit) a revenue account (interest revenue) by $50.



If a plumber does $90 worth of work for a customer on the last day of April but doesn't send a bill until May 4, the revenue should be recognized in April's accounting records. Therefore, the plumber makes an adjusting entry to increase (debit) accounts receivable for $90 and to increase (credit) service revenue for $90.



Accounting records that do not include adjusting entries for accrued revenues understate total assets, total revenues, and net income.

Senin, 11 Juni 2012

Internal Control

Internal Control

Internal control is the process designed to ensure reliable financial reporting, effective and efficient operations, and compliance with applicable laws and regulations. Safeguarding assets against theft and unauthorized use, acquisition, or disposal is also part of internal control.
Control environment. The management style and the expectations of upper-level managers, particularly their control policies, determine the control environment. An effective control environment helps ensure that established policies and procedures are followed. The control environment includes independent oversight provided by a board of directors and, in publicly held companies, by an audit committee; management's integrity, ethical values, and philosophy; a defined organizational structure with competent and trustworthy employees; and the assignment of authority and responsibility.
Control activities. Control activities are the specific policies and procedures management uses to achieve its objectives. The most important control activities involve segregation of duties, proper authorization of transactions and activities, adequate documents and records, physical control over assets and records, and independent checks on performance. A short description of each of these control activities appears below.

  • Segregation of duties requires that different individuals be assigned responsibility for different elements of related activities, particularly those involving authorization, custody, or recordkeeping. For example, the same person who is responsible for an asset's recordkeeping should not be respon sible for physical control of that asset Having different indi viduals perform these functions creates a system of checks and balances.
  • Proper authorization of transactions and activities helps ensure that all company activities adhere to established guide lines unless responsible managers authorize another course of action. For example, a fixed price list may serve as an official authorization of price for a large sales staff. In addition, there may be a control to allow a sales manager to authorize reason able deviations from the price list.
  • Adequate documents and records provide evidence that financial statements are accurate. Controls designed to ensure adequate recordkeeping include the creation of invoices and other documents that are easy to use and sufficiently informa tive; the use of prenumbered, consecutive documents; and the timely preparation of documents.
  • Physical control over assets and records helps protect the company's assets. These control activities may include elec tronic or mechanical controls (such as a safe, employee ID cards, fences, cash registers, fireproof files, and locks) or computer-related controls dealing with access privileges or established backup and recovery procedures.
  • Independent checks on performance, which are carried out by employees who did not do the work being checked, help ensure the reliability of accounting information and the efficiency of operations. For example, a supervisor verifies the accuracy of a retail clerk's cash drawer at the end of the day. Internal auditors may also verity that the supervisor performed the check of the cash drawer.
In order to identify and establish effective controls, management must continually assess the risk, monitor control implementation, and modify controls as needed. Top managers of publicly held companies must sign a statement of responsibility for internal controls and include this statement in their annual report to stockholders.

Generally Accepted Accounting Principles

Generally Accepted Accounting Principles

Accountants use generally accepted accounting principles (GAAP) to guide them in recording and reporting financial information. GAAP comprises a broad set of principles that have been developed by the accounting profession and the Securities and Exchange Commission (SEC). Two laws, the Securities Act of 1933 and the Securities Exchange Act of 1934, give the SEC authority to establish reporting and disclosure requirements. However, the SEC usually operates in an oversight capacity, allowing the FASB and the Governmental Accounting Standards Board (GASB) to establish these requirements. The GASB develops accounting standards for state and local governments.
The current set of principles that accountants use rests upon some underlying assumptions. The basic assumptions and principles presented on the next several pages are considered GAAP and apply to most financial statements. In addition to these concepts, there are other, more technical standards accountants must follow when preparing financial statements. Some of these are discussed later in this book, but other are left for more advanced study.
Economic entity assumption. Financial records must be separately maintained for each economic entity. Economic entities include businesses, governments, school districts, churches, and other social organizations. Although accounting information from many different entities may be combined for financial reporting purposes, every economic event must be associated with and recorded by a specific entity. In addition, business records must not include the personal assets or liabilities of the owners.
Monetary unit assumption. An economic entity's accounting records include only quantifiable transactions. Certain economic events that affect a company, such as hiring a new chief executive officer or introducing a new product, cannot be easily quantified in monetary units and, therefore, do not appear in the company's accounting records. Furthermore, accounting records must be recorded using a stable currency. Businesses in the United States usually use U.S. dollars for this purpose.
Full disclosure principle. Financial statements normally provide information about a company's past performance. However, pending lawsuits, incomplete transactions, or other conditions may have imminent and significant effects on the company's financial status. The full disclosure principle requires that financial statements include disclosure of such information. Footnotes supplement financial statements to convey this information and to describe the policies the company uses to record and report business transactions.
Time period assumption. Most businesses exist for long periods of time, so artificial time periods must be used to report the results of business activity. Depending on the type of report, the time period may be a day, a month, a year, or another arbitrary period. Using artificial time periods leads to questions about when certain transactions should be recorded. For example, how should an accountant report the cost of equipment expected to last five years? Reporting the entire expense during the year of purchase might make the company seem unprofitable that year and unreasonably profitable in subsequent years. Once the time period has been established, accountants use GAAP to record and report that accounting period's transactions.
Accrual basis accounting. In most cases, GAAP requires the use of accrual basis accounting rather than cash basis accounting. Accrual basis accounting, which adheres to the revenue recognition, matching, and cost principles discussed below, captures the financial aspects of each economic event in the accounting period in which it occurs, regardless of when the cash changes hands. Under cash basis accounting, revenues are recognized only when the company receives cash or its equivalent, and expenses are recognized only when the company pays with cash or its equivalent.
Revenue recognition principle. Revenue is earned and recognized upon product delivery or service completion, without regard to the timing of cash flow. Suppose a store orders five hundred compact discs from a wholesaler in March, receives them in April, and pays for them in May. The wholesaler recognizes the sales revenue in April when delivery occurs, not in March when the deal is struck or in May when the cash is received. Similarly, if an attorney receives a $100 retainer from a client, the attorney doesn't recognize the money as revenue until he or she actually performs $100 in services for the client.
Matching principle. The costs of doing business are recorded in the same period as the revenue they help to generate. Examples of such costs include the cost of goods sold, salaries and commissions earned, insurance premiums, supplies used, and estimates for potential warranty work on the merchandise sold. Consider the wholesaler who delivered five hundred CDs to a store in April. These CDs change from an asset (inventory) to an expense (cost of goods sold) when the revenue is recognized so that the profit from the sale can be determined.
Cost principle. Assets are recorded at cost, which equals the value exchanged at the time of their acquisition. In the United States, even if assets such as land or buildings appreciate in value over time, they are not revalued for financial reporting purposes.
Going concern principle. Unless otherwise noted, financial statements are prepared under the assumption that the company will remain in business indefinitely. Therefore, assets do not need to be sold at fire-sale values, and debt does not need to be paid off before maturity. This principle results in the classification of assets and liabilities as short-term (current) and long-term. Long-term assets are expected to be held for more than one year. Long-term liabilities are not due for more than one year.
Relevance, reliability, and consistency. To be useful, financial information must be relevant, reliable, and prepared in a consistent manner. Relevant information helps a decision maker understand a company's past performance, present condition, and future outlook so that informed decisions can be made in a timely manner. Of course, the information needs of individual users may differ, requiring that the information be presented in different formats. Internal users often need more detailed information than external users, who may need to know only the company's value or its ability to repay loans. Reliable information is verifiable and objective. Consistent information is prepared using the same methods each accounting period, which allows meaningful comparisons to be made between different accounting periods and between the financial statements of different companies that use the same methods.
Principle of conservatism. Accountants must use their judgment to record transactions that require estimation. The number of years that equipment will remain productive and the portion of accounts receivable that will never be paid are examples of items that require estimation. In reporting financial data, accountants follow the principle of conservatism, which requires that the less optimistic estimate be chosen when two estimates are judged to be equally likely. For example, suppose a manufacturing company's Warranty Repair Department has documented a three-percent return rate for product X during the past two years, but the company's Engineering Department insists this return rate is just a statistical anomaly and less than one percent of product X will require service during the coming year. Unless the Engineering Department provides compelling evidence to support its estimate, the company's accountant must follow the principle of conservatism and plan for a three-percent return rate. Losses and costs—such as warranty repairs—are recorded when they are probable and reasonably estimated. Gains are recorded when realized.
Materiality principle. Accountants follow the materiality principle, which states that the requirements of any accounting principle may be ignored when there is no effect on the users of financial information. Certainly, tracking individual paper clips or pieces of paper is immaterial and excessively burdensome to any company's accounting department. Although there is no definitive measure of materiality, the accountant's judgment on such matters must be sound. Several thousand dollars may not be material to an entity such as General Motors, but that same figure is quite material to a small, family-owned business.