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Business Insight

Sun, 28 Feb 2010 02:42:49 +0000

Suppose you are a filmmaker and spend $15 million to produce a film. Over what period should the $15 million be expenses? Yes, it should be expenses over the economic life of the film. But what is its economic life? The filmmaker must estimate how much revenue will be earned from box office sales, video sales, and television—a period that easily can stretch five years or more. If a filmmaker allocates the cost over five years, and the film produces revenue in the sixth year, proper matching has not occurred. Furthermore, in some cases, films flop, and yet the costs are spread out over five years in the hopes that the films will eventually succeed. For example, in the mid-I 980s Orion Pictures (now bankrupt) earned $7.3 million in one year, but lost $32 million the next year because it expenses 40 films that were not producing revenue. It was alleged that the company had overstated its income in earlier years because it did not expense these costs earlier. This case demonstrates the difficulty of properly matching expenses to revenues.
The critical issue in expense recognition is when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If the salary incurred on June 30 is not paid until July, the dry cleaner would report salaries payable on its June 30 balance sheet. The practice of expense recognition is referred to as the matching principle because it dictates that efforts (expenses) be matched with accomplishments (revenues).
Once the assumption is made that the economic life of a business can be divided into artificial time periods, it follows that the revenue recognition and matching principles can be applied. This one assumption and two principles thus provide guidelines as to when revenues and expenses should be reported.

Adjusting Entries for Prepayments

Mon, 15 Feb 2010 02:44:40 +0000

As indicated earlier, prepayments are either prepaid expenses or unearned revenues. Adjusting entries for prepayments are required at the statement date to record the portion of the prepayment that represents the expense incurred or the revenue earned in the current accounting period. Assuming an adjustment is needed for both types of prepayments, the asset and liability are overstated and the related expense and revenue are understated. For example, in the trial balance, the balance in the asset, Supplies, shows only supplies purchased. This balance is overstated; the related expense account, Supplies Expense, is understated because the cost of supplies used has not been recognized. Thus the adjusting entry for prepayments will decrease a balance sheet account and increase an income statement account.

Prepaid Expenses
As stated on page 91, expenses paid in cash and recorded as assets before they are used or consumed are identified as prepaid expenses. When a cost is incurred, an asset account is debited to show the service or benefit that will be received in the. future. Prepayments often occur in regard to insurance, supplies; advertising, and rent. In addition, prepayments are made when buildings and equipment are purchased.
Prepaid expenses expire either with the passage of time (e.g., rent and
insurance) or through use and consumption (e.g., supplies). The expiration of these costs does not require daily recurring entries, which would be unnecessary and impractical. Accordingly, it is customary to postpone the recognition of such cost expirations until financial statements are prepared. At each statement date, adjusting entries are made to record the expenses that apply to the current accounting period and to show the unexpired costs in the asset accounts.

The asset account Advertising Supplies

Tue, 02 Feb 2010 02:45:52 +0000

The asset account Advertising Supplies now shows a balance of $1,000, which is equal to the cost of supplies on hand at the statement date. In addition, Advertising Supplies Expense shows a balance of $1,500, which equals the cost of supplies used in October. If the adjusting entry is not made, October expenses will be understated and net income overstated by $1,500. Moreover, both assets and owner’s equity will be overstated by $1,500 on the October 31 balance sheet.
Insurance. Most companies have fire and theft insurance on merchandise and equipment, personal liability insurance for accidents suffered by customers, and automobile insurance on company cars and trucks. The cost of insurance protection is determined by the payment of insurance premiums. The term and coverage are specified in the insurance policy. The minimum term is usually one year, but three- to five-year terms are available and offer lower annual premiums. Insurance premiums normally are charged to the asset account Prepaid Insurance when paid. At the financial statement date it is necessary to debit Insurance Expense and credit Prepaid Insurance for the cost that has expired during the period.
On October 4, Pioneer Advertising Agency paid $600 for a one-year fire insurance policy. The effective date of coverage was October 1. The premium was charged to Prepaid Insurance when it was paid, and this account shows a balance of $600 in the October 31 trial balance. An analysis of the policy reveals that $50 ($600 ± 12) of insurance expires each month. Thus, the following adjusting entry