Chapter 4 Financial Accounting

EXPENSE RECOGNITION PRINCIPLE

In recognizing expenses, a simple rule is followed: "Let the expenses follow the revenues." Ex: this means that the salary expense Conrad incurred in performing the cleaning service on June 30 should be reported in the same period in which it recognizes the service revenue.

Revenue Recognition Principle

requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied Ex: Under the revenue recognition principle, Conrad records revenue in June when it performs the service, not in July when it receives the cash. At June 30, Conrad would report a receivable on its balance sheet and revenue in its income statement for the service performed.

ADJUSTING ENTRIES FOR ACCRUALS

Accrued Revenues: Revenues for services performed but not yet recorded at the statement date are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in the case of interest revenue. These are unrecorded because the earning of interest does not involve daily transactions. Companies do not record interest revenue on a daily basis because it is often impractical to do so. Accrued revenues also may result from services that have been performed but not yet billed nor collected, as in the case of commissions and fees. These may be unrecorded because only a portion of the total service has been performed and the clients won't be billed until the service has been completed. an adjusting entry for accrued revenues results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account Accrued Expenses: Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses. Interest, taxes, utilities, and salaries are common examples of accrued expenses. Companies make adjustments for accrued expenses to record the obligations that exist at the balance sheet date and to recognize the expenses that apply to the current accounting period. Prior to adjustment, both liabilities and expenses are understated. Therefore, an adjusting entry for accrued expenses results in an increase (a debit) to an expense account and an increase (a credit) to a liability account.

PREPARING A POST-CLOSING TRIAL BALANCE

After a company journalizes and posts all closing entries, it prepares another trial balance, called a post-closing trial balance, from the ledger. A post-closing trial balance is a list of all permanent accounts and their balances after closing entries are journalized and posted. The purpose of this trial balance is to prove the equality of the total debit balances and total credit balances of the permanent account balances that the company carries forward into the next accounting period. Since all temporary accounts will have zero balances, the post-closing trial balance will contain only permanent—balance sheet—accounts.

PREPARING CLOSING ENTRIES

At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders' equity account—Retained Earnings—through the preparation of closing entries. Closing entries transfer net income (or net loss) and dividends to Retained Earnings, so the balance in Retained Earnings agrees with the retained earnings statement. In addition to updating Retained Earnings to its correct ending balance, closing entries produce a zero balance in each temporary account. As a result, these accounts are ready to accumulate data about revenues, expenses, and dividends that occur in the next accounting period. Permanent accounts are not closed.

TYPES OF ADJUSTING ENTRIES

Deferrals: 1) Prepaid expenses: Expenses paid in cash before they are used or consumed 2) Unearned revenues: Cash received before services are preformed Accruals: 1) Accrued revenues: Revenues for services preformed but not yet received in cash or recorded 2) Accrued expenses: Expenses incurred but not yet paid in cash or recorded

QUALITY OF EARNINGS

Earnings Management: is the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. Quality of Earnings: The quality of earnings is greatly affected when a company manages earnings up or down to meet some targeted earnings number. A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements. A company with questionable quality of earnings may mislead investors and creditors, who believe they are relying on relevant and reliable information. As a result, investors and creditors lose confidence in financial reporting, and it becomes difficult for our capital markets to work efficiently.

ADJUSTING ENTRIES FOR DEFERRALS

Prepaid Expenses: are expenses paid in cash before they are used or consumed. When expenses are prepaid, an asset account is increased (debited) to show the service or benefit that the company will receive in the future. an adjusting entry for prepaid expenses results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account Supplies: The purchase of supplies, such as paper and envelopes, results in an increase (a debit) to an asset account. During the accounting period, the company uses supplies. Rather than record supplies expense as the supplies are used, companies recognize supplies expense at the end of the accounting period. At the end of the accounting period, the company counts the remaining supplies. The difference between the unadjusted balance in the Supplies (asset) account and the actual cost of supplies on hand represents the supplies used (an expense) for that period. Insurance: Companies purchase insurance to protect themselves from losses due to fire, theft, and unforeseen events. Insurance must be paid in advance, often for more than one year. The cost of insurance (premiums) paid in advance is recorded as an increase (debit) in the asset account Prepaid Insurance. At the financial statement date, companies increase (debit) Insurance Expense and decrease (credit) Prepaid Insurance for the cost of insurance that has expired during the period. Depreciation: A company typically owns a variety of assets that have long lives, such as buildings, equipment, and motor vehicles. The period of service is referred to as the useful life of the asset. Because a building is expected to provide service for many years, it is recorded as an asset, rather than an expense, on the date it is acquired. To follow the expense recognition principle, companies allocate a portion of this cost as an expense during each period of the asset's useful life. Depreciation is the process of allocating the cost of an asset to expense over its useful life. Unearned Revenues: Companies record cash received before services are performed by increasing (crediting) a liability account called unearned revenues. In other words, the company has a performance obligation to transfer a service to one of its customer. the adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.

CASH BASIS ACCOUNTING

companies record revenue when they receive cash. They record an expense when they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading financial statements. It fails to record revenue for a company that has performed services but has not yet received the cash. As a result, it does not match expenses with revenues. Ex: If Fresh Colors were to use cash-basis accounting, it would report $50,000 of expenses in 2013 and $80,000 of revenues during 2014. As shown in Illustration 4-2, it would report a loss of $50,000 in 2013 and would report net income of $80,000 in 2014. Clearly, the cash-basis measures are misleading because the financial performance of the company would be misstated for both 2013 and 2014

ACCRUAL BASIS ACCOUNTING

means that transactions that change a company's financial statements are recorded in the periods in which the events occur, even if cash was not exchanged. Ex: using the accrual basis means that companies recognize revenues when they perform the services (the revenue recognition principle), even if cash was not received. Likewise, under the accrual basis, companies recognize expenses when incurred (the expense recognition principle), even if cash was not paid.