Please Note: This is article seven in a series of nine articles titled Accounting and Bookkeeping Principles for Contractors
Written by James R. Leichter
Adjusting Entries in Accounting
The receipt or payment of cash requires a straightforward entry into one or more journals. Journal entries for transactions governed by the accrual principle (see The Accrual Principle article), however, may require automatic or recurring journal entries.
Prepaid expenses, such as the gasoline example shown in The Accrual Principle article, require the establishment of a procedure for tracking and recording the transactions necessary to accurately credit the Gasoline asset account and debit the Gasoline expense account for the gas used on a monthly basis. Good accounting programs, such as Aptora’s Total Office Manager, provides a place to automatically track and enter the effect of these accrual situations. These entries, called adjusting entries, adjust expense and revenue accounts so that the Balance Sheet accurately reflects the current financial condition of a business.
Cost of Sales
Cost of sales, also called Cost of Goods Sold or Direct Expenses, are the expenses that can be readily traced to and directly attributable to sales. In accordance with the matching principle (see The Accrual Principle article), a contractor that sells labor and MESO (material, equipment, sub-contractors, and other) must match the expenses incurred to provide the labor and MESO with the revenue earned from the sale. Matching is vital as it ensures the accurate reporting of a company’s income and gross margin, the difference between sales revenue and direct expenses.
Matching is easy if the cost of individual items is known: Merely record the cost of the sale at the same time as the sales revenue. When a sale requires lots of labor and small items, and if the cost of the items is not tracked by inventory, then determining the cost of the sale can be difficult. Taking inventory at the beginning of each month and then determining the cost of sales through deduction at the end of the month is one solution. Another solution is called the retail method.
The retail method uses a business’ known markup, or percentage added to the cost of merchandise to determine the retail-selling price, and known markdown, or discount from the retail-selling price, to generate an approximate cost of sales. If the overall cost of sales for the business is normally 60 percent of the retail price, then the approximate cost of sales is 60 percent of sales revenue adjusted for markdowns in the months in which the sales occur.
Long-lived assets, often called fixed assets, have a limited useful life, called its service life. Since most assets are expected to become obsolete before they physically wear out, the service life is usually shorter than the asset’s actual life. A portion of a fixed asset’s cost is debited as a depreciation expense in each accounting period of its service life (except for land, which is use indefinitely). Depreciation expenses act like prepaid expenses (see The Accrual Principle article): If a long-lived asset has a service life of 120 months or 10 years, a portion of its cost is debited as a depreciation expense in each of those months. The expected resale value, or residual value, of the asset is subtracted from its original cost before calculating the depreciation.
Depreciation for fixed assets is credited to a special contra account called Accumulated Depreciation. A contra account does not follow the debit and credit rules discussed previously because 1) it records an amount belonging to another account and 2) acts contrary to the behavior of that account. If a credit to an asset account is a decrease, for example, then a credit to a contra account for that asset is an increase. Instead of decreasing the asset account for the fixed asset directly, any calculated depreciation for the fixed asset is added to the Accumulated Depreciation account. Therefore, the Balance Sheet reports both the original cost of the asset and the accumulated depreciation to date. The difference between the two accounts is called the fixed asset’s net book value.
The depreciation expense for an asset is the same each month, but the Accumulated Depreciation for the asset increases each month of its service life. For example: The depreciation expense for the 90th month of an asset with an initial cost of $12,000 and a service life of 120 months is $100, but it’s Accumulated Depreciation is $9,000 (90 months x $100). When Accumulated Depreciation equals the original cost of the asset, the depreciation expense is no longer recorded even if the asset is still being used.
Accumulated Depreciation is not an amount of cash that is available to buy new assets, even if cash was paid or a liability was created when the asset was acquired.
Gains and Losses
The service life and residual value of a fixed asset are estimates. When a fixed asset is sold or disposed of it will likely yield a different amount than its net book value. A gain refers to an amount that is more than the net book value and a loss refers to an amount that is less.
A gain or loss entry removes both the asset’s cost and its accumulated depreciation. For example: A machine was sold for $4,000 cash at the end of its 90th month. Since its original cost was $12,000 and its accumulated depreciation was $9,000, its net book value is $3,000: a cash receipt gain of $1000:
Dr. Cash 4,000
Accumulated Depreciation 9,000
Cr. Machine 12,000
Gain on Sale of Asset 1,000
A gain or loss on the sale of a fixed asset is treated like revenue (if a gain) or an expense (if a loss) on the Income Statement for the period in which the asset is sold or discarded.
Some costs that the business incurs during a period may be debited to more than one expense or asset account. In a company with multiple departments, for example, some general and administrative costs will have to be broken up and charged to departments according to their individual usage. This process is called cost allocation.
The basis of cost allocation is that each purpose should bear its fair share of the total cost. In practice, however, the process can require tedious and time-consuming calculations. Many businesses choose to only charge each department with the expenses that can be directly traced to that department while recording all other expenses as general non-allocated expenses called overhead. Consult a book on cost accounting for more information.
Revenue accounts represent additions to equity and expense accounts represent decreases to equity, so transactions in these accounts could have been made directly to equity. Items in these accounts are collected separately, however, because the individual revenue and expense items contain important business information that warrants the temporary subdivision of equity.
At the end of the year, all revenue and expense accounts are “closed” to equity and re-opened with a balance of zero. For example: A sales revenue credit for the year is closed by making an entry to the Profit/Loss account:
Dr. Sales revenue 90,000
Cr. Profit/Loss 90,000
The debit to Sales Revenue of $90,000 equals the credit balance of $90,000, so the balance in the account becomes zero.
Profit/Loss is a temporary account. After closing the revenue and expense accounts for the year, the Profit/Loss account is closed to Retained Earnings. If the profit for the year is $20,000, the entry is as follows:
Dr. Profit/Loss 20,000
Cr. Retained earnings 20,000
Accounting warrants the costs and efforts of collecting it. It provides vital financial information that is used internally to assess operating performance and to generate business strategies. Most companies access financial information on a daily basis: They want to know how much they have, how much they owe, how much they are owed, and more. Accounting also provides the tax, income, and employee information required by governments, organizations, shareholders, and lenders. One of the most important results of accounting is income tax information.
Please read Using Accounting Results next.