May 16, 2022 May 16, 2022/ Steven Bragg
When a business incurs an expense, this reduces the amount of profit reported on the income statement. However, the incurrence of an expense also impacts the balance sheet, which is where the ending balances of all classes of assets, liabilities, and equity are reported. The impact of expenses on the balance sheet varies, depending upon the nature of the original expense transaction. The possible variations are:
Accounts payable. Most expenses are recorded through the accounts payable function, when invoices are received from suppliers. In this case, the accounts payable account is increased, while the amount of the expense reduces the retained earnings account. Thus, the liability portion of the balance sheet increases, while the equity portion declines.
Accrued expense. When expenses are accrued, this means that an accrued liabilities account is increased, while the amount of the expense reduces the retained earnings account. Thus, the liability portion of the balance sheet increases, while the equity portion declines.
Cash payment. When an expense is recorded at the same time it is paid for with cash, the cash (asset) account declines, while the amount of the expense reduces the retained earnings account. Thus, there are offsetting declines in the asset and equity sections of the balance sheet.
Reserve change. The accounting department may elect to increase the size of a reserve, such as the allowance for doubtful accounts or accumulated depreciation. If so, this increases a contra asset account (which is an increase in a credit balance) while reducing the amount of retained earnings (which is a debit transaction). Effectively, the result is an increase in a liability and a reduction of equity.
Transfer from prepaid expenses. A supplier may have previously been paid in advance for services not yet performed, so the payment was originally recorded in the prepaid expenses (asset) account. When the services are eventually consumed, the amount is charged to expense. The result is a decline in the prepaid expenses (asset) account, and a corresponding decline in the retained earnings account.
May 16, 2022/ Steven Bragg/
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Deferrals are prepaid expense and revenue accounts that have delayed recognition until they have been used or earned. This recognition may not occur until the end of a period or future periods. When deferred expenses and revenues have yet to be recognized, their information is stored on the balance sheet. As soon as the expense is incurred and the revenue is earned, the information is transferred from the balance sheet to the income statement. Two main types of deferrals are prepaid expenses and unearned revenues.
Recall from Analyzing and Recording Transactions that prepaid expenses (prepayments) are assets for which advanced payment has occurred, before the company can benefit from use. As soon as the asset has provided benefit to the company, the value of the asset used is transferred from the balance sheet to the income statement as an expense. Some common examples of prepaid expenses are supplies, depreciation, insurance, and rent.
When a company purchases supplies, it may not use all supplies immediately, but chances are the company has used some of the supplies by the end of the period. It is not worth it to record every time someone uses a pencil or piece of paper during the period, so at the end of the period, this account needs to be updated for the value of what has been used.
Let’s say a company paid for supplies with cash in the amount of $400. At the end of the month, the company took an inventory of supplies used and determined the value of those supplies used during the period to be $150. The following entry occurs for the initial payment.
Supplies increases (debit) for $400, and Cash decreases (credit) for $400. When the company recognizes the supplies usage, the following adjusting entry occurs.
Supplies Expense is an expense account, increasing (debit) for $150, and Supplies is an asset account, decreasing (credit) for $150. This means $150 is transferred from the balance sheet (asset) to the income statement (expense). Notice that not all of the supplies are used. There is still a balance of $250 (400 – 150) in the Supplies account. This amount will carry over to future periods until used. The balances in the Supplies and Supplies Expense accounts show as follows.
Depreciation may also require an adjustment at the end of the period. Recall that depreciation is the systematic method to record the allocation of cost over a given period of certain assets. This allocation of cost is recorded over the useful life of the asset, or the time period over which an asset cost is allocated. The allocated cost up to that point is recorded in Accumulated Depreciation, a contra asset account. A contra account is an account paired with another account type, has an opposite normal balance to the paired account, and reduces the balance in the paired account at the end of a period.
Accumulated Depreciation is contrary to an asset account, such as Equipment. This means that the normal balance for Accumulated Depreciation is on the credit side. It houses all depreciation expensed in current and prior periods. Accumulated Depreciation will reduce the asset account for depreciation incurred up to that point. The difference between the asset’s value (cost) and accumulated depreciation is called the book value of the asset. When depreciation is recorded in an adjusting entry, Accumulated Depreciation is credited and Depreciation Expense is debited.
For example, let’s say a company pays $2,000 for equipment that is supposed to last four years. The company wants to depreciate the asset over those four years equally. This means the asset will lose $500 in value each year ($2,000/four years). In the first year, the company would record the following adjusting entry to show depreciation of the equipment.
Depreciation Expense increases (debit) and Accumulated Depreciation, Equipment, increases (credit). If the company wanted to compute the book value, it would take the original cost of the equipment and subtract accumulated depreciation.
Book value of equipment=$2,000–$500=$1,500Book value of equipment=$2,000–$500=$1,500
This means that the current book value of the equipment is $1,500, and depreciation will be subtracted from this figure the next year. The following account balances after adjustment are as follows:
You will learn more about depreciation and its computation in Long-Term Assets. However, one important fact that we need to address now is that the book value of an asset is not necessarily the price at which the asset would sell. For example, you might have a building for which you paid $1,000,000 that currently has been depreciated to a book value of $800,000. However, today it could sell for more than, less than, or the same as its book value. The same is true about just about any asset you can name, except, perhaps, cash itself.
Insurance policies can require advanced payment of fees for several months at a time, six months, for example. The company does not use all six months of insurance immediately but over the course of the six months. At the end of each month, the company needs to record the amount of insurance expired during that month.
For example, a company pays $4,500 for an insurance policy covering six months. It is the end of the first month and the company needs to record an adjusting entry to recognize the insurance used during the month. The following entries show the initial payment for the policy and the subsequent adjusting entry for one month of insurance usage.
In the first entry, Cash decreases (credit) and Prepaid Insurance increases (debit) for $4,500. In the second entry, Prepaid Insurance decreases (credit) and Insurance Expense increases (debit) for one month’s insurance usage found by taking the total $4,500 and dividing by six months (4,500/6 = 750). The account balances after adjustment are as follows:
Similar to prepaid insurance, rent also requires advanced payment. Usually to rent a space, a company will need to pay rent at the beginning of the month. The company may also enter into a lease agreement that requires several months, or years, of rent in advance. Each month that passes, the company needs to record rent used for the month.
Let’s say a company pays $8,000 in advance for four months of rent. After the first month, the company records an adjusting entry for the rent used. The following entries show initial payment for four months of rent and the adjusting entry for one month’s usage.
In the first entry, Cash decreases (credit) and Prepaid Rent increases (debit) for $8,000. In the second entry, Prepaid Rent decreases (credit) and Rent Expense increases (debit) for one month’s rent usage found by taking the total $8,000 and dividing by four months (8,000/4 = 2,000). The account balances after adjustment are as follows:
Another type of deferral requiring adjustment is unearned revenue.
Recall that unearned revenue represents a customer’s advanced payment for a product or service that has yet to be provided by the company. Since the company has not yet provided the product or service, it cannot recognize the customer’s payment as revenue. At the end of a period, the company will review the account to see if any of the unearned revenue has been earned. If so, this amount will be recorded as revenue in the current period.
For example, let’s say the company is a law firm. During the year, it collected retainer fees totaling $48,000 from clients. Retainer fees are money lawyers collect in advance of starting work on a case. When the company collects this money from its clients, it will debit cash and credit unearned fees. Even though not all of the $48,000 was probably collected on the same day, we record it as if it was for simplicity’s sake.
In this case, Unearned Fee Revenue increases (credit) and Cash increases (debit) for $48,000.
At the end of the year after analyzing the unearned fees account, 40% of the unearned fees have been earned. This 40% can now be recorded as revenue. Total revenue recorded is $19,200 ($48,000 × 40%).
For this entry, Unearned Fee Revenue decreases (debit) and Fee Revenue increases (credit) for $19,200, which is the 40% earned during the year. The company will have the following balances in the two accounts:
Besides deferrals, other types of adjusting entries include accruals.
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Willow knew from a young age that she had a future in food. She has just transformed her passion into a thriving business venture as the owner of a small restaurant called Summer Eatery.
To grow her business, Willow has decided to provide both restaurant dining and catering services. When Summer Eatery accepts catering orders, it requires a client deposit equal to 50% of the total order. Since Summer Eatery has not yet provided the catering services at the time of deposit, the deposit amount is recognized as unearned revenue. Once the catering services have been provided, this liability to the client is reclassified as revenue for the restaurant.
The catering service is a success, and Summer Eatery’s income increases twofold. The increase in business has allowed Willow to form a strong relationship with her vendors (suppliers). Because of this relationship, some suppliers will deliver the food and equipment she needs and allow the restaurant to defer payment until a later date. This helps Summer Eatery because it does not yet have enough cash on hand to pay for the food and equipment. Rather than incur more debt, or have to delay ordering, this arrangement allows Willow to grow and still meet her current obligations.
It takes more than an idea to make a business grow, and Willow will continue to experience the ebb and flow of running a restaurant and catering service. Her management of short-term obligations will be one of the keys to Summer Eatery’s future success.