Bookkeeping Fundamental-2The end of its fiscal year is a very important time for a business. Accountants prepare the business’s income statement and statement of cash flows for the year as well as its balance sheet. The board of directors critically reviews these financial statements to assess the business’s financial performance and position and to plan the future course of the business. The financial statements are sent to lenders and shareowners who make their lending and investment decisions based on these accounting reports. In short, the annual financial statements of a business are extraordinarily important. Accordingly, the financial statements require extraordinarily good accounting; financial statements are no better than the quality of accounting behind them. As I often say, good accounting demands a well-designed and reliable recordkeeping system, one that records the business’s transactions during the period completely and accurately.

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This post moves on to the additional bookkeeping fundamental [accounting procedures] done at the end of the period. An accountant can’t use a business’s various accounts to prepare financial statements until these end-of-period accounting steps are completed. In short, bookkeeping fundamentals-2 discuss the following: (1) Understanding the need for year-end adjusting entries (2) Recording various adjusting entries (3) Closing the books at year-end. Follow on…

 

 
Adjusting Entries

During an accounting period, certain expenses either aren’t recorded or aren’t fully recorded. The accountant waits until the end of the period and records adjusting entries for these expenses. In addition to expenses, revenue and income accounts may also need adjusting entries at the end of the period. Adjusting entries complete the profit accounting process for the period.

The termadjusting” DOES NOT mean “fiddling with”. Adjusting entries aren’t made to manipulate profit, such as to move profit closer to the forecast target for the period. Rather, an accountant makes adjusting entries to make profit for the period as accurate as possible.

In other words, adjusting entries make revenue and expenses correct for the period, and without them, the bottom-line net income for the period would be wrong. Keep in mind that the managers, directors, lenders, and shareowners of a business rely on the profit number more than any other figure in the business’s financial statements.

 

As you may know, businesses prepare quarterly (three-month) financial statements. In this post, I focus on the annual (twelve-month) accounting period. In the business world (and for economic analysis in general), one year is the standard time unit. One year includes the complete cycle of seasonal variations that many businesses experience. The annual income statement draws the most attention in business financial reporting, and everyone holds the annual income statement to high standards of accounting.

In broad overview, year-end adjusting entries are needed for two reasons:

  • To correct errors that may have crept into the recordkeeping process
  • To make final entries for the year in revenue, income, expense, and loss accounts so that the profit or loss for the year is accurate (or as accurate as possible given the inherent accounting problems of measuring profit and loss)

 

An accounting system involves an enormous amount of data and detail, so safeguards and procedures should be put in place to prevent bookkeeping errors. A business is well-advised to conduct a thorough search at the end of the year for bookkeeping errors that have gone undetected. In the section “Instituting Internal Controls” later in the post, I discuss internal accounting controls that should be put into place to minimize bookkeeping errors. Despite their best efforts, most businesses find that errors sneak into their bookkeeping systems.

 

Case Example

At year-end, the business searches for bookkeeping errors that may have gone undetected. Based on its year-end review, the business discovers that some office and computer supplies were thrown away and no entry was made (The supplies were thrown out because they were no longer of any use, but the bookkeeping department wasn’t informed that the supplies had been put in the Dumpster). In general, at the time of purchase, the costs of office and computer supplies are entered (debited) in an asset account called “prepaid expenses”. As these supplies are used, the appropriate amount of cost is removed from the asset account and recorded to expense. The cost of the discarded supplies was $4,800.

What adjusting entry should be made to correct this error?

The entry to correct the error of not recording the cost of supplies thrown away is:

[Debit]. Office and Computer Supplies Expense =  $4,800
[Credit]. Prepaid Expenses = $4,800

 

You could argue that throwing away office and computer supplies causes a special type of loss that should be recorded in a separate loss account, but I think that most accountants would put the cost of discarded office and computer supplies in the regular expense account.

 

Year-end Adjusting Entries

The chief accountant of a business must know which end-of-year adjusting entries should be made and should follow through to make sure that these critical entries are recorded correctly. In most businesses, the Controller takes a hands-on approach in recording adjusting entries at the end of the year.

Recording year-end adjusting entries marks a dividing line between bookkeeping and accounting. Bookkeeping consists of following established rules for accounting and recordkeeping, and the chief accountant makes and enforces the rules and takes charge of the year-end adjusting entries.

 

Recording Depreciation Expense

The theory of depreciation isn’t complicated. Businesses invest in long-term operating assets such as land, buildings, machines, equipment, delivery trucks and cars, forklifts, office furniture, computers, and so on. These are called “fixed assets” because they’re fixed in place, or stationary (well, trucks and cars move around of course). The term “fixed” also implies that the assets aren’t held for sale (that is, not until they reach the end of their useful lives to the business). In a balance sheet, these assets typically are reported in a category called property, plant, and equipment (although reporting practices vary on this point).

Charging the entire cost of fixed assets to expense at the time they’re bought or constructed wouldn’t be very smart. The obvious thing to do is to allocate the cost of a fixed asset over the years of its useful life; this practice is called “depreciation”.

But, can you predict the future useful life of a fixed asset?

A building may stand 40 or 50 years — or more. Some machines don’t really wear out; with proper maintenance and repair, they could last indefinitely. Another complicating factor is that businesses replace many fixed assets before the end of their useful lives — not because they wear out physically, but because they become obsolete and inefficient.

Congress charges the Internal Revenue Service (IRS), everyone’s favorite government agency, with the responsibility of implementing income tax legislation. The income tax law and IRS rulings deal with depreciation in a practical, if not entirely correct theoretical, manner. Useful life guidelines have been established for several categories of fixed assets. Generally speaking, these estimates are shorter than the actual useful lives of fixed assets.

For example, a business building is depreciated over 39 years, even though many buildings are used longer, and trucks are depreciated over five years, even though they may be driven for more years. As a practical matter, many businesses (probably the majority) simply adopt the depreciation useful life estimates permitted under the federal income tax law, although the estimates conflict with economic reality to a certain extent.

Depreciation also raises the question of whether each year of using a fixed asset should be charged with the same amount of depreciation. Or should some years be hit with more depreciation expense than others?

 

Generally the answer to this question boils down to a choice between the straight-line depreciation method (an equal amount is charged to expense each year) and an accelerated depreciation method (earlier years are hit with more expense than later years). My purpose here is simply to illustrate the year-end adjusting entry for depreciation.

 

Case Example

A business bought new computer software for $57,750 at the start of the year. It decides to follow IRS rules for depreciation of computer software and thus will depreciate the software cost over three years. The straight-line method (equal amounts per year) is used. The business has not recorded any depreciation on this software during the year.

What year-end adjusting entry is recorded for depreciation of the computer software?

Computer software isn’t your typical depreciable fixed asset. Because it’s hard to see or touch computer software, you may consider it to be an intangible asset. However, computer software is part and parcel of using computer hardware, and computer hardware isn’t good for anything without software to tell it what to do.

The entry to record the annual depreciation on the computer software is:

[Debit]. Depreciation Expense Computer Software =  $19,250
[Credit]. Accumulated Depreciation Computer Software =  $19,250

 
Note: In the above entry, I debit a specific depreciation expense account, but this doesn’t mean that this depreciation account is disclosed separately in the business’s income statement. Probably it’s grouped with other depreciation expense accounts, and only one total depreciation expense is reported in the income statement.

A full-year depreciation amount is recorded because the business has used the asset the entire year.

The calculation is $57,750 / 3 years = $19,250 per year.

Instead of crediting (decreasing) the fixed asset account, the standard accounting practice is to credit accumulated depreciation, which is the contra account to the fixed asset account. In essence, the contra account is the credit side of the fixed asset account. It’s maintained so that both the original cost of fixed assets and the cumulative depreciation amount on the fixed assets are available for reporting in the balance sheet.

 

 
Recording Amortization Expense

In addition to tangible fixed assets, a business may invest in intangible assets, which can’t be seen or touched. The value of an intangible asset is rooted in law. For example: a patent gives the owner the exclusive legal right to use the patent in the pursuit of profit. No one else can legally use the patent without being held liable for infringement. There are all sorts of intangible assets. For instance, a business may purchase a list consisting of thousands of names of potential customers or acquire the right to use an established trade name and logo.

The acquisition of an intangible asset is recorded as a debit (increase) in an asset account. The cost of an intangible asset usually is allocated over its predicted useful life to the business, much like depreciation (see the preceding section). Allocating the cost of an intangible asset to expense over the years of its useful life is called amortization.

 

Case Example

A business invests in a franchise, which gives it the right to operate under a well- known trade name and logo. The franchise contract is for ten years, and the business pays $250,000 to the franchisor.

What adjusting entry should be made at the end of the first year concerning the cost of the franchise?

At the end of the first year, the business has used up one year of the ten-year franchise investment. Therefore, the following year-end adjusting entry is made:

[Debit]. Franchise Amortization Expense = $25,000
[Credit]. Franchise = $25,000

 

Generally, the straight-line amortization method is used, which means that an equal amount is charged to expense each year. The asset account is credited (decreased) in recording amortization expense. A contra account is not used to accumulate amortization.

 

 
Recording Other Adjusting Entries

Depending on the business, year-end adjusting entries are made for:

  • Investment income that has been earned but not recorded
  • Bad debts expense (caused by uncollectible accounts receivable)
  • Inventory losses due to shrinkage and write-downs required by the lower of cost or market (LCM) accounting rule
  • Losses due to asset impairments
  • Buildup of liabilities for operating expenses that haven’t been recorded
  • Income tax liability based on the final determination of income tax for the year
  • Liability for product warranty and guarantee costs
  • Increases in liability for unfunded employees’ retirement benefits and for post-retirement medical and healthcare benefits

 

Note: I don’t list all possible adjusting entries made by businesses! This list should give you some idea of the burden on the chief accountant of a business to make sure that all its revenue and expenses are correctly recorded for the year.

 

Case Example

A business makes mostly credit sales. At the end of the year, its accountant does an aging analysis of its accounts receivables, analyzing the receivables according to how old they are. Generally, the older a receivable is, the greater the risk of not collecting it or not collecting the entire amount owed by the customer. At the end of the year, the business has $4,538,600 total accounts receivable. This ending balance doesn’t include specific accounts receivable that were written off during the period. Based on its aging analysis, the business estimates that sooner or later about $95,000 of the ending balance of its accounts receivable will not be paid by customers.

What year-end adjusting entry is made?

 

There are two methods of accounting for bad debts expense:

[1]. In the direct write-off method, no expense is recorded until specific accounts receivable are actually written off. Under this method, no adjusting entry is made at year-end because the business hasn’t identified specific customers’ accounts from its accounts receivable at year-end that should be written off. During the year, the business did write off specific receivables, and bad debts expense was debited (increased) in these entries. Only these write-offs are recorded in the bad debts expense account.

[2]. In the allowance method, based on the estimated amount of accounts receivable that will have to be written off in the future, the following entry is made:

[Debit]. Bad Debts Expense = $95,000
[Credit]. Allowance for Doubtful Accounts = $95,000

Allowance for doubtful accounts is the contra account to the accounts receivable asset account.

 

Note: I don’t discuss several bookkeeping procedures connected with the allowance method for recording bad debts expense in this post [I do lots of these in other posts of mine] because my goal in this post simply is to illustrate that bad debt expense can be recorded before specific accounts receivable are actually identified and written off as uncollectible.

 

The compelling theory of the allowance method is that the expense is recorded in the same period as the credit sales that generated the bad debts. On the other hand, estimating the amount of future write offs of accounts receivable is very tricky and is open to manipulation. As a matter of fact, the IRS doesn’t permit businesses other than financial institutions to use the allowance method.

The following questions offer examples of common year-end adjusting entries made by businesses, but a particular business doesn’t necessarily make every one of the following adjusting entries. For instance, consider a business that makes only cash sales and no credit sales. This business doesn’t have bad debts expense from uncollectible accounts receivable, but it does have expenses from taking counterfeit currency, accepting bad checks, making mistakes in giving change to customers, and thefts from cash registers.

 

 

Closing the Books on the Year

The annual income statement of a business is prepared from its revenue, other income, expense, and loss accounts for the year.

Indeed, where else could information for preparing the income statement come from?

 

Accountants use these accounts to determine the amount of profit or loss for the year. I needn’t remind you how important the annual profit number is to the managers and directors of the business as well as its lenders and shareowners.

Even a modest-size business may have 100 or so revenue accounts and 1,000 or so expense accounts. Managers need a lot of detailed information to run their businesses, so they depend on their accountants to generate regular reports that provide the detailed account information they need for decision-making and management control. In sharp contrast, relatively few lines of information are included in the external income statement distributed to a business’s lenders and shareowners. In its external income statement, the business co presses its many revenue accounts into only one or two sales revenue lines and its many expense accounts into relatively few expense lines.

After the business has prepared its annual financial statements, the revenue and expense accounts have served their dual purpose — to provide information for preparing the income statement and to aid in determining profit or loss for the year.

 What happens to these revenue and expense accounts after the year is concluded?

 

The traditional bookkeeping procedure is to make closing entries in the accounts. These special entries close, or shut down, the revenue and expense accounts for the year just ended. Also, the amount of profit or loss for the year is recorded in the retained earnings account.

In just one post I have here to illustrate closing entries, I can’t show you a hundred revenue accounts and a thousand expense accounts. So in the following example, I use just one sales revenue account and only four expense accounts. This scenario isn’t realistic, but it gets the point across. Read on…

 
Case Example

At the end of the year, after all year-end adjusting entries have been made and posted, the balances in the revenue and expense accounts of the business are as follows:

Sales Revenue = $4,526,500 [a credit balance]
Cost of Goods Sold Expense = $2,725,000 [a debit balance]
Selling & Administrative Expenses = $1,228,500 [a debit balance]
Interest Expense = $175,000 [a debit balance]
Income Tax Expense = $138,000 [a debit balance]

What entry is made to close the nominal accounts and enter the profit or loss for the year?

 

The journal entry to close the books is as follows:

[Debit]. Sales Revenue = $4,526,500

[Credit]. Cost of Goods Sold Expense = $2,725,000
[Credit]. Selling & Administrative Expenses = $1,228,500
[Credit]. Interest Expense = $175,000
[Credit]. Income Tax Expense = $138,000
[Credit]. Owners’ Equity — Retained Earnings = $260,000

 

Note: The debit to sales revenue and the credits to expenses close out these accounts. The $260,000 profit for the year (sales revenue less all expenses) is recorded in the retained earnings account, where it belongs.

Are the books still in balance? In other words, is the accounting equation still in balance after making this entry?

 

Sure. The total credit in this closing entry equals the total debit. So this entry doesn’t throw the accounting equation out of balance.