6) SuperDels must recognize the portion of revenue earned by the end of current accounting period. Services provided by SuperDels are assumed to be of a continuous nature, thus, it is not practical to record revenue every hour, day, etc. It is more reasonable and practical to adjust the accounting records for the earned revenue only once - at the end of the accounting period. In our example, SuperDels has a deferred revenue balance of $3,000. Dividing this amount by 12 months will give monthly revenue:

$3,000 / 12 months = $250 / month

Because 6 months of services were completed in 20X7, $1,500 ($250 x 6 months) must be recognized in a single year-end adjusting entry. An adjusting entry to move this amount ($1,500) from the Unearned Revenue account to the Revenue account accomplishes this task. This adjusting entry is a claims exchange transaction.

Claims exchange transactions increase one claim account and decrease another. Thus, only claim accounts are involved in such transactions. Total claims remain unchanged.

In this situation, the decrease in liabilities (unearned revenues) causes revenue recognition in the income statement. Recall that revenue is defined as either an increase in assets or decrease in liabilities (as in our situation) resulting from operating activities.

Illustration 7: Effect of earned revenue adjusting entry

7) SuperDels must also recognize expenses for the car cost used during 20X7. As the car is estimated to be in use for 5 years, it is logical to spread the full cost over 5 years. The car has a cost of $4,000, and the salvage value of $500.

Salvage value is portion of an asset cost that is expected to be recovered at the end of its useful life.

A salvage value can be recovered through a sale or exchange of the asset at the end of its useful life.

Useful life is a term of service during which an asset is expected to provide benefits to a company.

So, only $3,500 (i.e., $4,000 - $500) of the total cost represents a true cost for SuperDels because the $500 is expected to be recovered at the end of the fifth year. The $3,500 is the amount to be expensed over 5 years. Accordingly, the amount of expense to be recognized in the current accounting period (one year) is calculated as follows:

($4,000 - $500) / 5 years = $700 / year

Note that we assumed a full year of depreciation is charged to expenses during the first and last years of the car useful life, even though the car is not used for full 12 months during those two years. This is a simplified way of calculating straight-line depreciation (see below for the definitions). More advanced ways of calculating depreciation is provided in the chapter devoted to long-term assets.

The formula we employed to determine the depreciation expense to be recognized in connection with using a car is called a straight-line method. The generic formula for this method is shown below:

Cost Allocation = (Cost - Salvage Value) / Useful Life

The process of allocating the car cost over its useful life is also referred to as depreciation:

Depreciation is allocation of the cost of an asset to expenses over the asset's useful life in a rational and systematic manner (i.e., straight-line).

The use of assets results in expense recognition and this is an asset use transaction:

Illustration 8: Effect of depreciation expense recognition

It is important to note that the Car account was not directly affected by this transaction. Instead, a special contra asset Accumulated Depreciation account was used. Using the accumulated depreciation account allows keeping track of the original car cost recorded in the Car account.

Accumulated depreciation represents an estimated cost of an asset used in operations. Accumulated depreciation is a cumulative of all depreciation expenses recognized for a particular asset. Accumulated depreciation is an example of a contra asset account. This account is included in the balance sheet under related asset accounts.

Contra asset account is one that is offset against an asset account on the balance sheet. Contra asset accounts have credit balances and thus, reduce asset account balances.

Book value, also referred to as carrying value, is the result of asset and related contra asset accounts offset. In other words, book value is the difference between an asset account (i.e., cost) and corresponding contra asset account (i.e., accumulated depreciation).

In SuperDels' case, the book value of the car will be $3,300. The book value is calculated as the difference between the original cost of $4,000 and accumulated depreciation of $700.