Chapter 4 - Explain the accrual basis of accounting and the reasons for adjusting entries.

4.2 Prepaid expenses are costs that expire

with the passage of time (e.g., rent and insurance) or through use (e.g., supplies). companies postpone the recognition of such cost expirations until they prepare financial statements.

4.2 Contra asset account

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

4.1 Revenue recognition principle:

*companies recognize revenue in the accounting period in which the performance is satisfied.* When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. ex. Conrad Dry Cleaners cleans clothing on June 30, but customers do not claim and pay for their clothes until the first week of July. Conrad records revenue in June when it satisfies its performance obligation, which is when it performs the service, not in July when it receives the cash.

4.2 two types of deferrals

1. Prepaid expenses 2. Unearned revenues

4.4 Companies manage earnings this way:

1. the use of one-time items to prop up earnings numbers. 2. inflate revenue numbers in the short-run to the detriment of the long-run. 3. Companies also manage earnings through improper adjusting entries.

4.4 Prepare an adjusted trial balance and closing entries. Adjusted trial balance:

A list of accounts and their balances after all adjustments have been made. After a company has journalized and posted all adjusting entries, it prepares another trial balance from the ledger accounts. shows the balances of all accounts, including those adjusted, at the end of the accounting period. is to prove the equality the adjusted trial balance is the primary basis for the preparation of financial statements.

4.4 Preparing a Post-Closing Trial Balance Post-closing trial balance

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

4.4 Income Summary

A temporary account used in closing revenue and expense accounts. Companies close total revenues to Income Summary and total expenses to Income Summary. The balance in Income Summary in this case is net income of $2,860.

4.1 Cash-basis accounting

Accounting basis in which a company records revenue *only when it receives cash* and an expense only when it pays cash. For example, it fails to record revenue for a company that has performed services but has not yet received payment. As a result, the cash basis may not reflect revenue in the period that a performance obligation is satisfied. Business would show a loss which is not good. not in accordance with generally accepted accounting principles (GAAP). Revenue is reported on the income statement only when cash is received. Expenses are only recorded when cash is paid out. The cash method is mostly used by small businesses and for personal finances.

4.1 TIME-PERIOD ASSUMPTION

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.

4.1 TYPES OF ADJUSTING ENTRIES Accruals:

Accruals: has two subcategories. 1. Accrued revenues: Revenues for services performed but not yet received in cash or recorded. 2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.

4.1 TYPES OF ADJUSTING ENTRIES

Adjusting entries are classified as either *deferrals or accruals* each of these classes has two subcategories.

4.2 Contra Account

An account with a balance that is opposite, or "contra," to that of its related accounts. Equipment is a contra asset account. It is offset against Equipment on the balance sheet.

4.1 Fiscal year

An accounting period that is one year long.

4.1 Explain the accrual basis of accounting and the reasons for adjusting entries. Periodicity assumption

An assumption that the economic life of a business can be divided into artificial time periods. Accounting time periods are generally a month, a quarter, or a year.

4.4 Permanent accounts Permanent accounts are sometimes called real accounts.

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

4.4 PREPARING FINANCIAL STATEMENTS

Companies can prepare financial statements directly from an adjusted trial balance.

4.2 Prepaid Expenses: Insurance

Companies purchase insurance to protect themselves from losses due to fire, theft, and unforeseen events. is paid in advance, often for multiple months. 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.

4.3 Accrued Salaries

Company pays for employee salary and wages, *after* services are performed. Left over days in a month represent accrued expense and a liability to company. This accrual increases a liability, Salaries and Wages Payable. decreases stockholders' equity, by increasing expense account., Salaries and Wages Expense.

4.1 TYPES OF ADJUSTING ENTRIES: Deferrals

Deferrals: (a postponement of an action or event) has two subcategories. 1. Prepaid expenses: Expenses paid in cash before they are used or consumed. 2. Unearned revenues: Cash received before services are performed.

4.4 Preparing Closing Entries 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.

4.1 Adjusting entries

Entries made at the end of an accounting period to ensure that the revenue recognition and expense recognition principles are followed. the trial balance—the first pulling together of the transaction data—may not contain up-to-date and complete data. Adjusting entries are required every time a company prepares financial statements. Every adjusting entry will include one income statement account and one balance sheet account.

4.4 ACCRUED EXPENSES

Expenses incurred but not yet paid or recorded at the statement date. ex. Interest, taxes, utilities, and salaries 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.

4.2 one of two types of deferrals PREPAID EXPENSES

Expenses paid in cash before they are used or consumed. ex. Examples of common prepayments are insurance, supplies, advertising, and rent. Companies prepayments when they purchase buildings and equipment.

4.4 Quality of earnings

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

4.4 Temporary accounts Temporary accounts are sometimes called nominal accounts

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

4.3 Prepare to adjust entries for accruals ACCRUED REVENUES

Revenues for services performed but NOT yet received in cash or recorded. ex. interest revenue. the earning of interest does not involve daily transactions. may result from services that have been performed but not yet billed nor collected, commissions and fees. Prior to adjustment, both assets and revenues are understated adjusting entry for accrued revenues results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account.

4.2 Useful life

The length of service of a productive asset.

4.4 Earnings management

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

4.4 QUALITY OF EARNINGS Earnings management

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

4.1 Expense recognition principle (matching principle)

The principle that *matches expenses with revenues* in the period when the company makes efforts to generate those revenues. expense recognition is tied to revenue recognition. It dictates that efforts (expenses) be matched with results (revenues). Illustration 4.1 shows these relationships. The revenue recognition principle and the expense recognition principle help to ensure that companies report the correct amount of revenues and expenses in a given period.

4.2 Prepaid Expenses: 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. companies recognize supplies expense at the end of the accounting period.

4.2 Prepare adjusting entries for deferrals: Defer:

To defer means to postpone or delay. are costs or revenues that are recognized at a date later than the point when cash was originally exchanged. put aside for later

4.2 Prior to adjustment, assets ....

are overstated and expenses are understated. 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.

4.2 Prepaid Expenses: Depreciation

company typically owns a variety of assets that have long lives, such as buildings, equipment, and motor vehicles. they depreciate over time. The process of allocating the cost of an asset to expense over its useful life. 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.

4.2 All contra accounts

have increases, decreases, and normal balances opposite to the account to which they relate.

4.1 Accrual-basis accounting

https://www.investopedia.com/terms/a/accrualaccounting.asp reporting income when it is earned and expenses when they are incurred 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. accrual basis means that companies recognize revenues when they perform the services

4.2 Book value (carrying value)

the difference between the cost of a depreciable asset and its related accumulated depreciation. the purpose of depreciation is not valuation but a means of cost allocation.

4.2 Prepaid expenses are costs that expire either with

the passage of time (e.g., rent and insurance) or through use (e.g., supplies).

4.1 Proper reporting requires an understanding of the nature of the company's business. Two principles are used as guidelines:

the revenue recognition principle and the expense recognition principle.

4.4 Accrued Interest

three-month note payable in the amount of $5,000 on October 1. Interested to be paid 12% annual Value of Note: $5000 x Annual Interrest: 12% x Time in terms of one year 1/12 = Interrest: $50