Long-terms assets are assets which a company plans to hold for more than one year. Typically, when we think of long-term assets, we think of buildings, land and equipment. Long-term assets also include intangible assets, like patents, trademarks and copyrights.
Assets are typically assigned to accounts based on the type of asset. Vehicles are separated from buildings. Land is separated both of these. It is important to note that buildings and land do not go in the same account, which means when a building is purchased on a piece of land, the costs of these items must be individually allocated into their separate accounts.
When a business acquires an asset, that asset must be recorded at cost. All costs associated with acquiring the asset and getting it ready to use should be considered as part of the cost of an asset. Remember that an asset is something the company owns or has the right to, which can be used to generate revenue. If the company purchases a piece of machinery but in order to use it, the company must have it delivered and installed, those costs should be included in the cost of the asset. Other costs that might be considered part of the asset include legal and closing costs, appraisal fees, transportation, upgrades and even repairs in cases where the machine isn’t working at the time of purchase.
To record assets, debit the asset account (Buildings, Land, Equipment, Vehicles, etc.) and credit the methods of payment, which are generally Cash, Notes Payable or a combination of the two. Note that these entries are regular journal entries and should be recorded at the time of purchase.
Allocating the Purchase Price Among Several Assets
When a business purchases a building, the company is not just acquiring a building. Many times we forget that the purchase includes land, improvements to the land (driveways, sidewalks, etc.), light fixtures and climate control systems inside the building. There might also be equipment or furniture included in the deal. Why is this important?
As assets are used up, they must be depreciated. This also allows the company to recover the cost of those assets. The matching principle states that expenses must be matched with the revenue they help generate. Companies use assets to generate revenue, therefore, a portion of the cost must be expensed.
Not all assets are used up at the same rate. The useful life of a building is much longer than the useful life of the carpets in the building. Land has an indefinite life, but land improvements have a definite life that is probably shorter than the building on that land. Because all these items have different lives and will be replaced at different times, the costs associated with those pieces of the purchase need to be split up and properly categorized.
On February 24, the business purchases a building and land for $450,000, paying $250,000 in cash and signing a note for the difference. An appraisal company hired by the business assesses the purchase for asset allocation purposes and comes up with the following appraisal:
You might be asking yourself how it is possible that the value is $510,000 when the purchase price was $450,000. One reason this happens is because the individual components are worth more than the bundle. There are also market forces, like a large number of similar buildings or few buyers, that can depress prices. Regardless of the reason, the company needs to find a way to allocate the cost.
The best way to allocate the purchase price is to use ratios. We can easily determine the ratios by using the assessed value of each component to the total assessed value. For example, the building is 49% of the total assessed value. Calculate that by dividing the assessed value of the building by the assessed value of the total purchase.
$250,000 / $510,000 = .49 or 49%
Repeat this for all of the components:
|Land Improvements||$ 90,000||18%|
|Building Fixtures||$ 40,000||8%|
Now that we know the ratio of each component to the total, we can use the ratios to allocate the purchase price of $450,000.
49% X $450,000 = $220,500
25% X $450,000 = $112,500
18% X $450,000 = $ 81,000
8% X $450,000 = $ 36,000
100% X $450,000 =$450,000
Using ratios allows us to allocate the assessment to the purchase price. Using the allocated amounts, we can now write a journal entry for the transaction.
Depreciation of Assets
We previously discussed the expensing or using up of assets. In accounting, the formal term for this is “depreciation”. You have probably heard the term deprecation used when referring to the decline in value of an asset, like a vehicle. In non-accounting terms, depreciation means fall in market value; however, in accounting, we very rarely use market value. In accounting, there is no connection between market value and depreciation.
Depreciation generates an expense, which we call Depreciation Expense (pretty complicated, huh?). If we were writing a journal entry to record depreciation, we would debit Depreciation Expense. What would the credit be? Remember that the cost principle states that assets must be recorded at cost. When we depreciate an asset, did the cost decrease? No. Therefore, we cannot decrease the asset account directly. Instead, we will pair an account with the asset to hold all the depreciation that has accumulated over the years. Do you know what we call that account? Ready for this one? It’s very complicated. We call the account Accumulated Depreciation. See, told you it was complicated. Since Accumulated Depreciation has a normal credit balance, the account is considered a contra-asset. Entries involving depreciation are considered adjusting entries.
Annual depreciation on the company’s equipment is $4,230.
Depreciation entries are one of the easiest types of entries because once you know the dollar value of the transaction, the entry is always the same. The accounts are Depreciation Expense and Accumulated Depreciation. Some companies have one Depreciation Expense and one Accumulated Depreciation account, while others have those accounts for each type of asset (buildings, equipment, computers, furniture and fixtures, etc). We will assume that the company has depreciation accounts for each type of asset.
Disposing of Assets
When a company gets rid of an asset, whether it is sold or just scrapped, the company must record a journal entry to remove the asset and the accumulated depreciation associated with it. The company must also determine if there is a gain or loss on the disposal.
In order to see if there is a gain or loss on an asset, the company must first determine the book value of the asset. Book value is the value of the asset on the company’s books or accounting records. Book value is asset cost less accumulated depreciation. If the company has a vehicle with a cost of $20,000 and accumulated depreciation of $17,000, the book value is $3,000. What if the company sold that vehicle for $5,000 cash on June 10? If the asset is worth $3,000 and is sold for $5,000, the company has a $2,000 gain.
To record the entry for the sale of the vehicle, we must remove $20,000 from Vehicles and $17,000 from Accumulated Depreciation – Vehicles. We must also record the $5,000 cash received for the vehicle and record the gain. A gain is like revenue and the normal balance in the account is a credit.
What if the asset was instead sold for $2,500? If the book value is $3,000, there is now a $500 loss on disposal. A loss behaves like an expense and the normal balance is a debit.
What if the company scraps the car, meaning the company just disposes of it? No cash is received. If the book value is $3,000 and the company receives nothing, there is now a $3,000 loss.
When disposing of assets, remember to remove the entire cost of the asset and all of the accumulated depreciation for that asset. Do not just remove the book value. Disposing of an asset means disposing of all traces of it!
What are adjusting journal entries?
The matching principle states expenses must be matched with the revenue generated during the period. The purpose of adjusting entries is to ensure that all revenue and expenses from the period are recorded. Many adjusting entries deal with balances from the balance sheet, typically assets and liabilities, that must be adjusted. In addition to ensuring that all revenue and expenses are recorded, we are also making sure that all asset and liability accounts have the proper balances. Adjusting entries are dated for the last day of the period.
When analyzing adjusting entry transactions involving assets and liabilities, remember that you are recording the change in the balance, not the new balance in the account. Ask yourself “what must I do to the account to get the adjusting balance?”
As a business goes through the normal day-to-day operations, many transactions are recorded. When work is done and the company is paid, revenue is recorded. Revenue is also recorded when invoices (accounts receivable) are created. Expenses are recorded when bills (accounts payable) are received. If the company has already recorded all those things, then what could possibly be left to do? You would be surprised!
NOTE: Cash should never appear in an adjusting entry. Most adjusting entries are done after year end and backdated to the end of the year. When cash is spent, the transactions are recorded immediately. With electronic banking, we can instantly check cash transactions. There is no reason why a business shouldn’t know about transactions affecting its cash accounts. Cash is never an account in an adjusting entry.
If a business has done work for a client but has not yet created an invoice, there is unrecorded revenue that must be recorded. Maybe the business just hasn’t gotten around to completing the invoice yet, or maybe the work is partially done but not completely finished. This entry looks exactly like an entry to record work that has been completed but have not yet been paid for.
On December 31, KLI Video Production had completed $3,000 worth of work for clients which has not yet been billed.
Another type of unrecorded revenue deals with work the business was paid for before the work was completed (unearned revenue) which was completed by the end of the period. Transactions of this type can be written two different ways. We could be told how much revenue has been earned or we could be told the remaining balance in unearned revenue. Let’s look at how these transactions could be written so you can see the differences and identify which method to use.
Unearned revenue has an unadjusted balance of $4,000. An analysis of the account shows that $2,500 of the balance has been earned.
When looking at transactions like this one, we need to determine what we are being given. You want to ask yourself if the transaction is giving you the amount of the adjustment (revenue or expense to be recorded) or the adjusted (correct) balance in the asset or liability account. T-accounts are really helpful when doing adjusting entries because you can visualize what is happening. Here is the T-Account for unearned revenue.
We are told the account has an unadjusted balance of $4,000. Unearned revenue is a liability account and therefore the normal balance is a credit. We are told that $2,500 has been earned. Is that the new balance in the account? No, the $2,500 is the amount we need to remove from the account because it is no longer unearned. So if $2,500 is not the balance, then what is the balance? If the business has earned $2,500 of the $4,000, then the new balance is $1,500.
Now we can see the beginning balance and the ending balance in the T-account. Now, we have to determine how to get there. If we have a $4,000 credit balance and then have a $1,500 credit balance, the balance decreased by $2,500. How do we decrease an account with a credit balance? We debit the account. The $2,500 was given in the transaction, but now we know what to do with it. If you can predict what the balance should be in the account, you can do a T-account to make sure your entry will actually do what you predicted.
The credit in the entry is fees earned (revenue) because we were told that $2,500 had been earned. When you see earned, you should always think revenue unless the transaction states the money has not yet been earned. That statement should make you think of unearned revenue because it has not been earned.
The company had an unadjusted balance in unearned revenue of $4,000. An analysis of the account shows $1,500 is still unearned.
This transaction is worded a bit differently than the last. This transaction tells you what the ending balance in the account should be. Using a T-account in this scenario is a smart idea.
Notice, this example is exactly the same as Example #2. In order to get the balance from $4,000 credit to $1,500 credit, we need to debit unearned revenue $2,500.
Make sure to watch the wording in all adjusting entry transactions to ensure you understand what information you have.
Typically, when we are looking for unrecorded expenses, we look to the balance sheet. There are two types of unrecorded expenses: those that are related to assets that have been used up or need to be adjusted and those related to unrecorded liabilities.
Assets and Expenses
The definition of an asset is something the company owns or has the right to which it can use to generate revenue. When we were recorded journal entries, we recorded transactions to various asset accounts that when used up, will generate an expense. Some of those accounts were supplies, prepaid expenses and long-term asset accounts, like equipment and buildings.
Supplies are initially recorded as an asset, but they get used up over time. Rather than record an entry every time a ream of paper or a bag of mulch is removed from storage, we do an adjusting entry at the end of the period to record the amount of supplies that have been used up. Recording an entry every time something is removed from the stockroom or garage would violate the cost-benefit constraint. At the end of the period, the company counts up what is left for supplies. The difference between the balance in the account (unadjusted) and the amount that is left (adjusted) is the value used in the journal entry.
The balance in the supplies account at the end of the year was $5,600. A count of supplies shows that $1,400 worth of supplies are still on hand.
What does this transaction tell us? The unadjusted supplies balance is $5,600 but the adjusted balance should be $1,400. The transaction does not tell us the amount of the adjustment. That is something we will need to figure out. You may want to draw up a quick T-account to visualize the transaction.
To decrease the account balance, which is a debit balance, we need to credit the account. How much will we need to credit the account? What amount will bring the balance from $5,600 to $1,400? The difference is $4,200. So we need to credit the supplies account $4,200.
Where did the supplies go? They were used it. We call this supplies expense. Now we can write the journal entry.
Use the same methodology when doing entries involving prepaid expenses. Draw a T-account to help visualize what is happening.
Long-term assets and Expenses
When a company purchases a long-term asset, such as a vehicle to use in its business, we record the entire value of the purchase as an asset. That vehicle is used to generate revenue so shouldn’t that vehicle somehow be expensed? Yes, it should be. We call the expensing of a long-term asset depreciation. Do not confuse depreciation in accounting with how the term is used outside of accounting. Typically, we think of depreciation as a decline in market value. For example, I have heard it said many time that when you purchase a new car, it depreciates or loses 20% of its value when you drive off the lot. Depreciation in accounting has nothing to do with market value. Depreciation represents the using up of an asset to generate revenue.
The cost principle states that we must record assets at cost. In order to maintain that principle, when we record depreciation expense (which is a debit in the journal entry), we do not credit the asset directly. Instead we will use a contra account. A contra account is an account linked to another account but which has a normal balance opposite to the account it is linked to. A contra asset account would be linked to a specific asset account but would have a credit balance. For the vehicle described above, we would have a contra asset account called accumulated depreciation. This account would be linked to the vehicles account and would have a credit balance.
Some companies have one accumulated depreciation account used for all long-term assets and others have a separate accumulated depreciation account for each long-term asset account. In the next example, we will assume there is one accumulated depreciation account.
The company calculates that the current year depreciation is $12,000.
As with all adjusting entries, we need to determine if we are being given an account balance (asset or liability) or the amount of the expense. In this case, as with all depreciation entries, we are given the amount of the expense. Therefore, there is nothing to calculate here. No T-account is needed.
For more information about long-term assets and depreciation, see the posts on long-term assets and calculating depreciation.
Adjusting Entries Involving Liabilities
Some adjusting entries involve expenses that have not yet been paid for nor has the obligation been recorded. However, in these cases an expense has been generated. Examples include unrecorded bills and unpaid wages, interest, and taxes. This is not an exhaustive list but it does cover most of the transactions you will see. These entries require the recording of an expense and a liability.
The company received a bill for December’s utilities on January 5. The bill was for $235.
Although the bill was received in January, the utilities were used in December to generate revenue in December. The matching principle tells us that we must record the utilities expense in December.
The company pays its employees every two weeks. On December 31, the employees had worked four days for which they had not been paid. The amount due to the employees was $4,300.
Are you thinking matching principle here? Our employees help us generate revenue. The wages that we pay them must be matched to the revenue they are creating. Therefore, the $4,300 must be recorded in December. The wages have not been paid so we must show a liability. The liability used in this case will be wages payable.
Note: Accounts payable should only be used for routine bills (utilities, supply and inventory purchases). Other short-term payables should be named based on the expense they are related to. That is why wages payable was used in this case.
The company has a long-term note payable with Ginormic National Bank. As of December 31, $670 of interest had accrued on the loan but had not yet been paid.
Why do we have to record this? First, the interest is an expense for December even though it has not yet been paid. Second, to be accurate in our financial statements, the balance owed to the bank on December 31 includes not only the balance on the loan but also the unpaid interest. If we contact Ginormic National Bank to payoff the loan on December 31, we would need to pay the principal owed plus the $670 of interest. The interest is considered a separate payable and should not be added to the note payable.
The company estimates its profit to be $42,000 for the year and is in a 35% tax bracket.
When reading this transaction, it doesn’t even sound like something we would need to record. It just sounds like a statement, but the matching principle should set off an alarm. Why are we paying income taxes? The company had a profit for the year of $42,000. Income taxes are an expense of doing business. Should the expense fall in the year that is completed or the year we are currently in? The expense is related to the year that is completed and, therefore, must be recorded as an adjusting entry.
To figure out how much to record for taxes, we need to calculate 35% of the profit, which would be $14,700 ($42,000 x 0.35). Now we can record the entry.
Things to Remember
Treat adjusting entries just like you would treat normal entries. Use these steps when completing adjusting journal entries.
- Read the transaction to determine what is going on. Is an entry required?
- Identify the accounts you will use in your entry. Remember, cash is never used in adjusting entries!
- Determine the amount. Did the transaction give you the amount to use or do you need to calculate it? T-accounts are helpful here.
- Determine which account(s) to debit and which account(s) to credit.