In this video, we're going to continue to talk about
the income statement but now we're going to focus on the role of adjusting entries.
Adjusting entries are important because there
are many events that occur during the period
that don't result in
a specific transaction and don't necessarily result in cash changing hands.
Nevertheless, because they're important events we have to record them.
Now, in principle, we could be recording these at any point during the period but
it's commonly waited until the very end of the period to record these.
Adjusting entries are tricky,
because they don't involve a specific transaction and there's no cash to point to.
These are the ones that require the most subjectivity and the most expertise.
So, in some sense they're the most manipulable.
In addition, because they're often done at the end of the period,
when you basically already have a pretty good idea for what your income needs to be,
adjusting entries are a tempting way to try to move income up a little bit if you need
it to be higher or move it down a little bit if incomes are plenty high already.
So, an example of an adjusting entry would be depreciation.
When we buy an asset,
we typically don't charge
the entire cost of property plant and equipment to the period in which we buy it,
if it's going to last for a long time.
So instead we're going to stretch the purchase cost out over the benefit period,
which we refer to as the assets useful life.
Depreciation is the term that we use to
describe that charging off of the original purchase price.
Now, you'll often hear the term depreciation used in other ways as well,
and that's not exactly the same way that we use it here.
So, you may have heard the expression "as soon as you buy a car,
the second it rolls off the lot,
it depreciates by one third".
That's basically saying that the resale value of the asset goes down by a third.
That's not exactly the same sense in which we use depreciation.
Instead depreciation here is usually
a more arbitrary and more even allocation of the purchase price over time.
We're not intending to resell it now,
so we're going to spread the cost out more evenly.
Straight-line depreciation is a common method of depreciation.
Straight-line depreciation takes the purchase price of
the asset and spreads it out evenly over the useful life.
It does recognize, however,
that even at the end of the useful life,
the asset might still have some value.
So, what it really does is it depreciates the difference between the value when you
buy it and the value that you expect it to have at the end of the useful life,
when you might sell it for example,
and divide that evenly over the useful life.
Note that to calculate depreciation,
you need an estimate of what the salvage value or residual value of the asset is,
as well as how long the asset is going to live.
Nobody knows those numbers for sure.
And so, you've got some wiggle room in deciding what they're going to
be that can make your depreciation expense either higher or lower,
and therefore move your income up or down.
The accounting convention for recording depreciation is
actually not to deduct that from the asset value directly.
We keep track of the assets original cost in a separate account,
and then we record the depreciation that we're accumulating in a separate account.
The net of those two is what we actually show on the balance sheet,
that's referred to as the net book value as opposed to the original cost,
which is the gross book value.
There is a lot of other kinds of adjusting entries that have to go on as well,
and together all of these provide more opportunities to move income up or down.
For example, when we make a credit sale,
we're not sure we're going to collect all that.
So we need to adjust the receivable and
our income down to reflect the fact that we might not collect at all.
How much we're going to collect?
Nobody knows for sure,
so it's an estimate that we can potentially manipulate upwards or downwards.
Similarly, returns.
Not everything we sell is going to stay with the customers,
some are going to get returned.
We need an allowance for that to adjust for the fact that some of those returns are going
to be high and our ultimate income is going to be lower than what we've recorded so far.
Income tax is another one.
If we've reported pre-tax income to shareholders,
we have to allocate some income tax expense to
that even if we don't actually owe the taxes yet.
So we need to estimate what the taxes are going to be.
Some assets we actually mark to market.
So, for those kinds of assets you have to decide what would
the asset be worth now at the end of the period even though I haven't sold it.
For many assets, there's not market prices you can readily look up,
and so there's a lot of subjectivity in deciding what the assets are worth, as well.
On the flip side, some assets go down in value.
Recognizing the downturn in asset value or
an impairment charge often is a very subjective thing, too.
Nevertheless, this has to be done to properly calculate income.
If you borrowed money or if somebody has borrowed money from you,
you also have to record interest income or interest expense as the case
may be even if the interest payments aren't actually due at this point in time.
So there's many economic events that occur over
the course of a period that need to be accounted for,
for which there is no specific transaction that
occurred and no cash that's changing hands this period.
This is the role of adjusting entries.
Again, because many of these are done at the end of
the period they're the most subjective and are the ones that you
need to watch out for the most in assessing whether or
not income really reflects the real performance of the company.
Richard LambertProfessor of Accounting
Christopher D. IttnerEY Professor of Accounting
