Adjustment: Allocating Recorded Costs (Deferred Expenses)

Type 1 Adjustment: Allocating Recorded Costs (Deferred Expenses)

Companies often make expenditures that benefit more than one period. These costs are debited to an asset account. At the end of an accounting period, the amount of the asset that has been used is transferred from the asset account to an expense account. Two important adjustments of this type are for prepaid expenses and the depreciation of plant and equipment.

CHAPTER 3 Measuring Business Income FIGURE 3-3

Adjustment for Prepaid (Deferred) Expenses

BALANCE SHEET Asset

1. Allocating recorded costs between two or more accounting periods.

IN

Asset Account

Expense Account

M Expense

Entry

Entry

E Credit

Debit

Amount equals cost

2. Recognizing

of goods or services

unrecorded

A used up or expired.

3. Allocating recorded,

unrecorded,

unearned revenues

Revenue

earned revenues.

between two or more accounting periods.

If adjusting entries for prepaid expenses are not made at the end of an account- ing period, both the balance sheet and the income statement will present incor- rect information. The company’s assets will be overstated, and its expenses will be understated. Thus, stockholders’ equity on the balance sheet and net income on the income statement will be overstated.

To illustrate this type of adjusting entry and the others discussed below, we refer again to the transactions of Miller Design Studio, Inc.

At the beginning of July, Miller Design Studio, Inc. paid two months’ rent in advance. The advance payment resulted in an asset consisting of the right to occupy the office for two months. As each day in the month passed, part of the asset’s cost expired and became an expense. By July 31, one-half of the asset’s cost had expired and had to be treated as an expense. The adjustment is as follows:

Adjustment for Prepaid Rent

July 31: Expiration of one month’s rent, $1,600. Analysis: Expiration of prepaid rent decreases the asset account Prepaid Rent with

a credit and increases the expense account Rent Expense with a debit.

Application of Double Entry:

Assets ⫽ Liabilities ⫹ Stockholders’ Equity

P REPAID R ENT R ENT E XPENSE

July 3 3,200 July 31 1,600

July 31 1,600

Bal. 1,600

The Adjustment Process

Comment: The Prepaid Rent account now has a balance of $1,600, which rep- resents one month’s rent that will be expensed during August. The logic in this analysis applies to all prepaid expenses.

Miller Design Studio, Inc. purchased $5,200 of office supplies in early July.

A careful inventory of the supplies is made at the end of the month. It records the number and cost of supplies that have not yet been consumed and are thus still assets of the company. Suppose the inventory shows that office supplies cost- ing $3,660 are still on hand. This means that of the $5,200 of supplies originally purchased, $1,540 worth were used (became an expense) in July. The adjustment is as follows:

Adjustment for Supplies

July 31: Consumption of supplies, $1,540 Analysis: Consumption of office supplies decreases the asset account Office Supplies

with a credit and increases the expense account Office Supplies Expense with a debit.

Application of Double Entry:

Assets

⫽ Liabilities ⫹

Stockholders’ Equity

O FFICE S UPPLIES O FFICE S UPPLIES E XPENSE

Dr. Cr.

Dr. Cr.

July 5 5,200 July 31 1,540

July 31 1,540

Bal. 3,660

Entry in Journal Form :

Dr. Cr. July 31 Office Supplies Expense

Office Supplies

Comment: The asset account Office Supplies now reflects the correct balance of $3,660 of supplies yet to be consumed. The logic in this example applies to all kinds of supplies.

D Depreciation of Plant and Equipment When a company buys a long-term

Study Note

a asset—such as a building, truck, computer, or store fixture—it is, in effect, prepay-

In accounting, depreciation

i ing for the usefulness of that asset for as long as it benefits the company. Because

refers only to the allocation

a a long-term asset is a deferral of an expense, the accountant must allocate the

of an asset’s cost, not to any

cost of the asset over its estimated useful life. The amount allocated to any one c

decline in the asset’s value.

accounting period is called depreciation, or depreciation expense. Depreciation, a like other expenses, is incurred during an accounting period to produce revenue. l

It is often impossible to tell exactly how long an asset will last or how much of the asset has been used in any one period. For this reason, depreciation must o

Study Note

b be estimated. Accountants have developed a number of methods for estimating

The difficulty in estimating

depreciation and for dealing with the related complex problems. (In the discussion d

an asset’s useful life is further

that follows, we assume that the amount of depreciation has been established.) t

evidence that the net income

To maintain historical cost in specific long-term asset accounts, separate

CHAPTER 3 Measuring Business Income carrying value, or book value, of the asset. As the months pass, the amount of

the accumulated depreciation grows, and the carrying value shown as an asset declines.

Adjustment for Plant and Equipment:

July 31: Depreciation of office equipment, $300 Analysis: Depreciation decreases the asset account Office Equipment by increas-

ing the contra account Accumulated Depreciation–Office Equipment with a credit and increasing the expense account Depreciation Expense–Office Equipment with

a debit, as shown below.

Application of Double Entry:

Assets

⫽ Liabilities ⫹

Stockholders’ Equity

O FFICE E QUIPMENT D EPRECIATION E XPENSE –

Dr.

Cr.

O FFICE E QUIPMENT

July 6 16,320 Dr. Cr.

July 31

A CCUMULATED D EPRECIATION – O FFICE E QUIPMENT

Entry in Journal Form :

Dr. Cr. July 31 Depreciation Expense–Office

Equipment

Accumulated Depreciation–

Office Equipment

Comment: The carrying value of Office Equipment is $16,020 ($16,320 ⫺ $300)

and is presented on the balance sheet as follows:

P ROPERTY ,P LANT , AND E QUIPMENT

Office equipment

Less accumulated depreciation

Application to Netflix, Inc. Netflix has prepaid expenses and property and equipment similar to those in the examples we have presented. Among Netflix’s

prepaid expenses are payments made in advance to movie companies for rights to DVDs. By paying in advance, Netflix is able to negotiate lower prices. These fixed payments are debited to Prepaid Expense. When the movies produce revenue, the prepaid amounts are transferred to expense through adjusting entries. 7