Lesson 7 of 9
The entries nobody invoices
Three entries at 31 December that no document prompts: rent used up, a machine worn down, interest owed but unpaid. Each contains an estimate.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Every other entry in this course was triggered by a document. These three are triggered by the calendar, and nothing arrives to prompt them.
- Each one moves an amount between a balance sheet account and the income statement, so each one changes reported profit.
- All three contain an estimate chosen by the business, which is where accounting stops being arithmetic.
An invoice, a receipt or a bank statement prompted every entry so far. At 31 December, three things are wrong in Fen Street Bindery's books and no document will ever point them out.
Rent is still shown as an asset although most of it has been used. The machine is still shown at full cost although it has run for a year. And interest has been recorded only to the extent it was paid.
What the three adjustments do to reported profit
- Profit before adjustments$77,200
- Rent used, nine months of twelve−$9,000
- Depreciation on the machine−$6,000
- Interest accrued but unpaid−$600
- Profit for the year= $61,600
The starting figure is revenue of $150,000 less cost of sales of $26,000, wages of $45,000 and the $1,800 of interest actually paid. The three adjustments take $15,600 off it, and $61,600 is the profit every later lesson uses.
The three entries
What each one is really saying
The rent entry says that occupancy from April to December was consumed and is gone. The $3,000 left in prepaid rent is next year's occupancy, which the business still owns.
The depreciation entry says the machine gave up one eighth of its usefulness. The credit goes to accumulated depreciation rather than to the equipment account, so the balance sheet can still show the original $48,000 alongside the $6,000 written off. A reader can then see both the cost and the wear, which a single net figure of $42,000 would hide.
The interest entry says the bank is owed money whether or not it has been paid. Six percent of $40,000 is $2,400 for a full year, $1,800 of it was paid in cash, and the remaining $600 is a liability at 31 December.
The estimates inside them
This is the part worth carrying into every later course.
The eight-year life of the machine is a choice. At six years, depreciation would be $8,000 and profit would be $2,000 lower. At ten years it would be $4,800 and profit $1,200 higher. Nothing about the machine changes; the reported profit changes by a quarter of the depreciation charge either way.
The nine-month rent split is a fact, because the lease dates are known. The interest accrual is a fact too, because the rate and the balance are in the loan agreement. The depreciation is not a fact and it is the largest of the three.
That asymmetry is general. Accruals divide into the ones a document settles and the ones management decides, and a reader who wants to know how much of a profit figure was chosen rather than earned has to find the second kind.
Why they are made at a date rather than continuously
A business could in principle record the consumption of rent daily. Nobody does, because the only moment the answer has to be right is the moment the accounts are drawn up.
That is also why a company's year end matters. Every estimate in a set of accounts is an estimate as at one day, and a business with a seasonal cycle looks materially different depending on where in that cycle the line is drawn.
Check yourself
Why is accumulated depreciation credited instead of the equipment account?
- Because equipment accounts cannot be reduced
- So the balance sheet can show the original cost and the amount written off separately
- Because depreciation is a liability
Show the answer
Answer: B.
A contra account keeps both facts visible. Netting them into a single $42,000 figure would lose the original cost, which a reader needs to judge the age of the asset base.The machine's useful life is changed from eight years to six. What happens to reported profit?
- Nothing, since the machine cost the same
- Depreciation rises to $8,000 and profit falls by $2,000
- Profit rises, because the asset is written off faster
Show the answer
Answer: B.
A shorter life spreads the same cost over fewer years, so each year's charge is larger and each year's profit is smaller. The cash paid for the machine never changes.Which of the three adjustments is an estimate rather than a fact settled by a document?
- The rent split, because the lease dates could be disputed
- The depreciation, because the eight-year life is a judgement
- The interest accrual, because the payment date is uncertain
Show the answer
Answer: B.
The lease dates and the loan rate are both written down somewhere. The useful life of the machine is chosen by the business and is the only one of the three that another business could reasonably set differently.Sources
- This lesson is taught from first principles. No external source is cited, because no claim here depends on one.
What this leaves out
- Fen Street Bindery and every figure are invented, chosen so each adjustment can be checked by hand.
- Three adjustments are the minimum a simple business needs. A real year end also brings bad debt allowances, inventory write-downs, accrued payroll, warranty provisions and tax, each with its own estimate.
- Straight-line depreciation is assumed here for legibility. Accelerated methods are permitted and used, and they change the timing of the charge.
- Nothing here is advice about any security.