Ch. 3 Financial Accounting Types of Adjusting Entries
Why don't adjusting entries involve cash?
- Cash receipts and cash payments are recorded when they occur at a specific point in time. - Adjusting entries are concerned with applying the revenue recognition and expense recognition principles to continuous activities. - Because revenue and expense recognition does not depend on cash receipt or cash payment, adjusting entries for continuous revenue and expense activities will not involve cash.
Expense recognition principle (matching principle)
Expense recognition is the process of identifying an expense with a particular time period. Under accrual accounting, expenses are recognized following the expense recognition principle, requires that expenses be recorded and reported in the same period as the revenue that it helped to generate.
Time-Period Assumption
Investors, creditors, and other financial statement users demand timely information from companies. For that reason, companies report their financial results for specific periods of time—a month, a quarter, or a year. - allows companies to artificially divide their operations into time periods so they can satisfy users' demands for information. - Companies frequently engage in activities that affect more than one time period. .
The Revenue Recognition Principle
- The revenue recognition principle determines when revenue is recorded and reported. - Under this principle, revenue is recognized, or recorded, in the period in which a company satisfies its performance obligation, or promise within a contract. - A seller satisfies a performance obligation by transferring control of a promised good or service to a customer.
Expenses for an accounting period should include
- only those costs used to earn revenue that was recognized in the accounting period.
Recording Accrued Expenses
1. Identify the accounts that require adjustment. This expense needs to be matched against December revenues (an application of the expense recognition principle) 2. Calculate the amount of the adjustment. 3. Record the adjusting journal entry.
Recording Accrued Revenues
1. Identify the accounts that require adjustment. Consistent with the revenue recognition principle, Rent Revenue 2. Calculate the amount of the adjustment. 3. Record the adjusting journal entry.
a point in time Example
assume that on August 30, a customer purchases a gas grill from Lowes. When the customer leaves the store with the grill, the risks and rewards of ownership have been transferred from the seller to the buyer. At this point, revenue is considered to be earned. -are recognized at the point in time when the customer obtains control of the merchandise, which is at the time of in-store purchase or delivery of the product to the customer.
Accrued Expenses
many companies incur expenses in the current accounting period but do not pay cash for these expenses until a later period. - previously unrecorded expenses that have been incurred, but not yet paid in cash. For accrued expenses, an adjustment is necessary to record the expense and the associated increase in a company's liabilities, usually a payable The accrual of the expense is necessary because the expense was incurred prior to the payment of cash.
the key to expense recognition is
matching the expense with revenue.
The distinction between business activities requiring adjustment and those that do not depends...
to some extent on our ability and willingness to keep track of activities. Some activities may occur so frequently or are so difficult to measure that no record of individual activities is maintained. In such cases, the sequence of individual activities becomes, for all intents and purposes, a continuous activity.
2. Accrual-Basis Accounting:
Accrual-Basis Accounting: Under accrual accounting, revenue is recognized when a company satisfies its performance obligation and expenses are matched with revenues. By following the revenue recognition and expense recognition principles, net income was properly recognized in the period that the business activity occurred. In short, the difference between cash-basis and accrual-basis accounting is a matter of timing.
Step 5: Adjusting the Accounts
Adjustments are often necessary because timing differences exist between when a revenue or expense is recognized and cash is received or paid.
Deferred (Unearned) Revenues
Companies may collect payment for goods or services that it sells before it delivers those goods or services. When the cash is collected, the revenue recognition is deferred, or delayed, until the service is performed. Transactions for which a company has received cash but not yet satisfied its performance obligations are called deferred (or unearned) revenues. Other examples of deferred revenues include rent received in advance, subscriptions received in advance, and tickets (e.g., for airlines, sporting events, concerts) sold in advance. In all of these situations, the receipt of cash creates a liability for the company to deliver goods or perform services in the future. The unearned revenue account delays, or defers, the recognition of revenue by recording the revenue as a liability until it is earned. Note that the deferral of revenue is necessary because the performance obligation was not satisfied at the time of cash receipt. The adjusting entry recognizes the amount of revenue that has been earned from the time of cash receipt until the end of the accounting period.
1. How should Computer Town account for cash and credit sales of equipment?
In both situations, the sale is complete at a single point in time (the delivery of the equipment) and no adjusting entry is needed.
Which Transactions Require Adjustment?
Many business activities continue for a period of time—for example, the use of rented facilities or interest incurred on borrowed money. Because entries in the accounting system are made at particular points in time rather than continuously, adjustments are needed at the end of an accounting period to record partially complete activities.
2. How should Computer Town account for repair services provided under service contracts?
Repair service contracts are continuous activities that require an adjustment at the end of the accounting period. Revenue is recognized over time as the service is provided and should be recorded in proportion to the period of time that has passed since the contract became effective. -The unexpired portion of the service contract should be recorded as a liability (unearned revenue) until the service is provided. -Any expenses associated with the repair services should be recognized in the same period that service revenue is recognized (the expense recognition principle).
1. Cash-Basis Accounting:
Under cash-basis accounting, revenue is recognized when cash is received and expense is recognized when cash is paid.
What is the relationship between the cash receipt or payment and the recognition of accruals or deferrals?
When the revenue is earned or the expense is incurred before the associated cash flow occurs, an accrual adjusting entry is necessary. When the revenue is earned or the expense is incurred after the associated cash flow occurs, a deferral adjusting entry is necessary.
Control can be transferred from the seller to the buyer either at...
a point in time or over time.
Why is accrual inferior to Cash Basis? (Advantages)
accrual accounting is a more complex system that records both cash and noncash transactions. - more complex
These timing differences give rise to two categories of adjusting entries—
accruals and deferrals.
continuous business activity (office supplies)
because it is too costly to maintain a record of each time supplies are used.
Why is accrual superior to cash-basis? (advantages)
because it links income measurement to selling, the principle activity of the company. - revenue is recognized as the company satisfies its performance obligations by delivering goods or providing services; expenses are recognized when they are incurred.
Repair service contracts
continuous activities that require an adjustment at the end of the accounting period.
Why are so many business activities recognized in the accounts through adjustments rather than through the normal journal entry process described in Chapter 2?
excluded activities that were still underway at the end of the accounting period.
Adjusting entries
journal entries that are made at the end of an accounting period to record the completed portion of partially completed transactions. Adjusting entries are necessary to apply the revenue recognition and expense recognition principles and ensure that a company's financial statements include the proper amount for revenues, expenses, assets, liabilities, and stockholders' equity.
The purpose of all adjustments is to
make sure revenues and expenses get recorded in the proper time period. As the revenue and expense balances are adjusted, asset and liability balances will be adjusted also. Therefore, all adjusting entries will affect at least one income statement account and one balance sheet account. Cash is never affected by adjustments.
accountants also make numerous adjustments at the end of accounting periods for business activities that occur over several accounting periods—activities like
performing services for customers, renting office space, and using equipment.
Accrued Revenues
previously unrecorded revenues that have been earned but for which no cash has yet been received. Another example of an accrued revenue is interest earned, but not yet received, on a loan. While interest is earned as time passes, the company only receives the cash related to interest periodically (e.g., monthly, semiannually, or annually). the accrual of revenue is necessary because the performance obligation was satisfied prior to the receipt of cash.
accrual accounting requires ...
requires that any incomplete activities be recognized in the financial statements. This often requires estimates and judgments about the timing of revenue and expense recognition. The result is that accountants must adjust the accounts to properly reflect these partially completed business activities.
revenue is recognized when______ not ________
the performance obligation is satisfied, regardless of when cash is received.
an accrual accounting system rests on three elements of the conceptual framework that were introduced in Chapter 2? Which ones?
the time-period assumption, the revenue recognition principle, the expense recognition principle.
Expenses for an accounting period should exclude
those costs used to earn revenue in an earlier period and those costs that will be used to earn revenue in a later period.
Determining Which Transactions Require Adjustment 1. How should Computer Town account for cash and credit sales of equipment? 2. How should Computer Town account for repair services provided under service contracts? 3. How should Computer Town account for the use of office supplies?
.........
Deferred (Prepaid) Expenses
Companies often acquire goods and services before they are used. These prepayments are recorded as assets called deferred (or prepaid) expenses. Common prepaid expenses include items such as supplies, prepaid rent, prepaid advertising, and prepaid insurance. The purchases of buildings and equipment also are considered prepayments. As the prepaid asset is used to generate revenue, an adjustment is necessary to reduce the previously recorded prepaid asset and recognize the related expense. The portion of the prepaid asset that has not been used represents the unexpired benefits and remains in the asset account until it is used. Note that the deferral of the expense is necessary because the initial cash payment did not result in an expense. Instead, an asset that provides future economic benefit was created.
Cash-basis accounting seems straightforward. Why complicate matters by introducing accrual accounting?
The objective of financial reporting is to provide information that is useful in making business and economic decisions. Most of these decisions involve predicting a company's future cash flows. The use of accrual accounting through the application of the revenue recognition and expense recognition principles links income recognition to the principal activity of the company, selling goods and services. Therefore, accrual accounting provides a better estimate of future cash flows than cash-basis accounting.
3. How should Computer Town account for the use of office supplies?
The use of supplies can be viewed as a sequence of individual activities. However, the preparation of documents required to keep track of each activity individually would be too costly. Instead, the use of supplies can be treated as a continuous transaction and recognized through an adjusting entry. Any supplies used will be reported as an expense, and the unused portion of supplies will be reported as an asset.
Example 3.1 Applying the Revenue Recognition and Expense Recognition Principles Calculate net income for November, December, and January using the following methods: (1) cash-basis accounting and (2) accrual-basis accounting.
When calculating net income in these for (1) make 3 tables and put down the Expenses and Revenue only in the month that something occurs (see picture) (2) When calculating their net income for accrual treat it the same you would in a regular and put it down when the service is provided even if they are not paid yet
Accrual accounting
a financial accounting method that allows a company to record revenue before receiving payment for goods or services sold and record expenses as they are incurred. In other words, the revenue earned and expenses incurred are entered into the company's journal regardless of when money exchanges hands. Accrual accounting is usually compared to cash basis of accounting, which records revenue when the goods and services are actually paid for. The method follows the matching principle, Time Period Assumption, Revenue Recognition Assumption uses the double-entry accounting method.
cash-basis accounting
a method of accounting in which revenue is recorded when cash is received, regardless of when it is actually earned. Similarly, an expense is recorded when cash is paid, regardless of when it is actually incurred. Cash-basis accounting does not tie recognition of revenues and expenses to the actual business activity but rather to the exchange of cash. by recording only the cash effect of transactions, cash-basis financial statements may not reflect all of the assets and liabilities of a company at a particular date. For this reason, most companies do not use cash-basis accounting.
Accrual-basis accounting
a method of accounting in which revenues are generally recorded when earned (rather than when cash is received) and expenses are matched to the periods in which they help produce revenues (rather than when cash is paid). an alternative to cash-basis accounting that is required by generally accepted accounting principles.
over time Example
assume that on March 29, FedEx picks up a computer from Apple's distribution center and receives a cash payment of $30 to ship the computer to a customer. FedEx delivers the computer on April 2. On March 31, FedEx determines that the shipment is 60% of the way to its destination. Because FedEx has satisfied 60% of its performance obligation to deliver the computer, it can recognize $18 (60% × $30) of revenue in March. The remaining $12 of revenue will be recognized when FedEx completes the delivery in April. REVENUE RECOGNITION. For transportation services, revenue is recognized over time as we perform the services in the contract because of the continuous transfer of control to the customer. Our customers receive the benefit of our services as the goods are transported from one location to another.
