Chapter 3 Accounting

Classification as Deferral

-Deferrals are either prepaid expenses or unearned revenues. -Adjusting entries for deferrals are required to record the portion of the deferral that represents. 1) The expense incurred or the revenue earned in the current accounting period. Transaction classify: -Expenses paid in cash and recorded as assets before they are used or consumed. -Cash received and recorded as liabilities before revenue is earned.

Time period assumption

-The time period (or periodicity) assumption assumes that the economic life of a busniess can be divided into artificial time periods. -Accounting time periods are generally a month, a quarter, or a year. -The accounting time period of one year in length is referred to as a fiscal year.

Preparation of financial statements

-the income statement is prepared from the revenue and expense accounts. -the retained earnings statement is derived from the retained earnings account, dividends account, and net income. -The balance sheet is prepared from the asset, liability, and equity accounts. Retained earnings balance comes from retained earnings statement. -Financial statements are prepared from the adjusted trial balance -> income statement ->retained earning statement-> balance sheet. 1) prepare a trial balance 2) make adjusting entries 3) prepare an adjusted trial balance 4) prepare the income statement 5) prepare the retained earning statement 6) prepare the balance sheet

The Accounting cycle

1) Analyze business transactions 2) Journalize the transactions 3) Post to ledger accounts 4) prepare a trial balance 5) Journalize and post adjusting entries: Deferrals and Accruals 6) prepare an adjusted trial balance 7) Prepare financial statements: Income statements, retained earning statement, balance sheet 8) Journalize and post closing entries 9) Prepare a post-closing trial balance

Adjusted trial balance

A list of accounts and their balances after all adjustments have been made. -an adjusted trial balance is prepared after all adjusting entries have been journalized and posted. -Its purpose is to prove the equality og the total debit and credit balances in the ledger after all adjustments have been made. -Financial statements can be prepared directly from the adjusted trial balance.

Post-closing trial balance

A list of permanent accounts and their balances after a company has journalized and posted closing entries.

Worksheet

A multiple-column form that companies may use in the adjustment process and in preparing financial statements.

Income Summary

A temporary account used in closing revenue and expense accounts.

Cash-basis accounting

Accounting basis in which a company records revenue only when it receives cash, and an expense only when it pays cash. -Revenue is recognized when cash is received. -Expense are recognized only when cash is paid.

Accrual-basis accounting

Accounting basis in which companies record, in the periods in which the events occur, transactions that change a company's financial statements, even if cash was not exchanged. -Under accural basis accounting, transactions that change a company's financial statements are recorded in the periods in which the events occur. -The revenue recognition matching principle are used under the accrual basis. -Under cash basis accounting, revenue is recorded when cash is received, and expense are recorded when cash is paid. -Generally accepted accounting principles require accrual basis accounting.

Classification as Accrual

Accruals are the second category of adjusting entries -Adjusting entries for accruals are required to record revenues earned and expenses incurred in the current period. -The adjusting entry for accruals will increase both a balance sheet and an income statement account. Transaction classify: Revenues earned but not yet received in cash or recorded -Expense incurred but not yet paid cash or recorded.

Contra asset account

An account that is offset against an asset account on the balance sheet.

Fiscal year

An accounting period that is one year long.

Periodicity assumption

An assumption that the economic life of a business can be divided into artificial time periods.

Reversing entry

An entry made at the beginning of the next accounting period; the exact opposite of the adjusting entry made in the previous period.

Prepaid expenses (prepayments)

Assets that result from the payment of expenses that benefit more than one accounting period. -Expenses paid in cash and recorded as assets before they are used or consumed. -Expenses expire with the passage of time or through use and consumption -An asset-expense account relationship exists with prepaid expenses. -Prior to adjustment, assets are overstated and expenses are understated. -The adjusting entry results in a debit to an expense account and a credit to an asset account. -Example of prepaid expense include supplies, insurance, and depreciation.

Permanent accounts

Balance sheet accounts whose balances are carried forward to the next accounting period.

Unearned revenues

Cash received before a company earns revenues and recorded as a liability until earned. -Cash received and recorded as liabilities before revenue is earned. -Unlearned revenues are revenues received and recorded as liabilities before they are earned. -Unlearned revenues are subsequently earned by rendering a service to a customer. -A liability-revenue account relationship exists with unearned revenues. -Prior to adjustment, liabilities are overstated and revenues are understood. -The adjusting entry results in a debit to a liability account and a credit to a revenue account. -Example of unearned revenues include rent, magazine subscriptions and customer deposits for future services. -Unlearned revenue is a prepayment that requires an adjusting entry when services are performed.

Types of Adjusting Entries

Deferrals- 1) Prepaid Expenses 2)Unlearned Revenues Accruals- 1) Accrued Revenue 2) Accrued Expense

Closing entries

Entries at the end of an accounting period to transfer the balances of temporary accounts to a permanent stockholders' equity account, Retained Earnings. -Closing entries transfer the temporary or nominal account balances to the permanent stockholders' equity account-retained earnings. Temporary- All revenues accounts, all expense accounts, Dividends Permanent- All assets accounts, all liability accounts, stockholders' equity accounts

Adjusting entries

Entries made at the end of an accounting period to ensure that the revenue recognition and expense recognition principles are followed. -Adjusting entries are needed to ensure that the revenue recognition and matching principle are followed: 1)Accrual basis accounting usually requires "adjusting entries" 2) Adjusting entries are entries for when there may or may not be "Source documents" such as invoices or sales receipts.

Accrued expenses

Expenses incurred but not yet paid in cash or recorded. -Expenses incurred but not yet paid in cash or recorded. -Accrued expense are expense incurred but not paid yet. -A liability expense account relationship exists -Prior to adjustment, liabilities and expenses are understated. -The adjusting entry results in a debit to an expense account and a credit to a liability account.

Quality of earnings

Indicates the level of full and transparent information that a company provides to users of its financial statements.

GAAP Relationships in Revenue and Expense Recognition

Look in chapter 4 powerpoint slide 5

Temporary accounts

Revenue, expense, and dividend accounts whose balances a company transfers to Retained Earnings at the end of an accounting period.

Accrued revenues

Revenues earned but not yet received in cash or recorded. -Revenues earned but not yet received in cash or recorded -Accrued revenues may accumulate with the passing of time or through services performed but not billed or collected. -An asset-revenue account relationship exists with accrued revenues. -Prior to adjustment, assets and revenues are understated. -The adjusting entry requires a debit to an asset account and a credit to a revenue account.

Book value

The difference between the cost of a depreciable asset and its related accumulated depreciation.

Useful life

The length of service of a productive asset.

Earnings management

The planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income.

Matching Principle

The practice of expense recognition is referred to as the matching principle. -the matching principle dictates that efforts (expenses) be matched with accomplishments (revenues). -Matching principle matches expenses with revenues

Revenue recognition principle

The principle that companies recognize revenue in the accounting period in which it is earned. -The revenue recognition principle dictates that revenue should be recognized in the accounting records when it is earned. The revenue recognition principle dictates that revenue be recognized in the accounting period in which it is earned. -In a service business, revenue is considered to be earned at the time the service is performed.

Expense recognition principle (matching principle)

The principle that dictates that companies match efforts (expenses) with results (revenues).

Depreciation

The process of allocating the cost of an asset to expense over its useful life. -Depreciation is allocated of the cost of an asset to expense over its useful life in a rational and systematic manner. -The purchase of equipment or a building is views as a long-term prepayment of service and therefore, is allocated in the same manner as other prepaid expenses. -Depreciation is an estimate rather than a factual measurement of the cost that expired. -In recording depreciation, depreciation expense is debited and a contra asset account, Accumulated Depreciation, is credited. -In the balance sheet, Accumulated Depreciation is offset against the asset account. -The difference between the cost of any depreciable asset and its related accumulated depreciation is referred to as the book value of the asset.