Chapter 4: Accrual Accounting Concepts

Steps in the accounting process that may occur daily

1. Analyze business transactions 2. Journalize the transactions 3. Post to ledger accounts

4.11: Which of the following are common time periods that businesses use as their accounting period? Select all that apply. A quarterly B daily C monthly D annually

A quarterly C monthly D annually

Prepare adjusting entries for deferrals

Deferrals are either prepaid expenses or unearned revenues. Companies make adjusting entries for deferrals at the statement date to record the portion of the deferred item that represents the expense incurred or the revenue for services performed in the current accounting period.

accrued revenues adjusting entry

Dr. Assets Cr. Revenues Dr. Accounts Receivable Cr. Service Revenue

How often does management usually want reports

Monthly

Order of closing entries

Revenue to income summary expenses to income summary income summary to retained earnings dividends to retained earnings

Companies can prepare financial statements directly from an adjusted trial balance. (T/F)

True

depreciation

is the process of allocating the cost of an asset to expense over its useful life

At December 31, 2013, before any year-end adjustments, Macarty Company's Prepaid Insurance account had a balance of $2,700. It was determined that $1,500 of the Prepaid Insurance had expired. The adjusting entry for Insurance Expense for the year would be $2,700 $1,200 $1,900 $1,500

$1,500

end that beginning of a period, temporary accounts balance is

0

Steps in a basic worksheet

1) Prepare a trial balance 2) Enter adjustment data 3) Enter adjusted balances 4) Extend adjusted balance to appropriate statement columns 5) Total the statement columns, compute net income or loss, and complete worksheet

Adjusting entries are necessary because the trial balance—the first pulling together of the transaction data—may not contain up-to-date and complete data. This is true for several reasons:

1. Some events are not recorded daily because it is not efficient to do so. Examples are the use of supplies and the earning of wages by employees. 2. Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions. Examples are charges related to the use of buildings and equipment, rent, and insurance. 3. Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period.

Accounting Cycle Steps

1. Analyze business transactions 2. Journalize the transactions 3. Post to ledger accounts 4. Prepare a trial balance 5. Journalize and post adjusting entries 6. Prepare an adjusted trial balance 7. Prepare financial statements 8. Journalize and post closing entries 9. Prepare a post-closing trial balance

Steps in the accounting process that are performed on a periodic basis

4. Prepare a trial balance 5. Journalize and post adjusting entries 6. Prepare an adjusted trial balance 7. Prepare financial statements

Steps of the accounting process performed annually

8. Journalize and post closing entries 9. Prepare a post-closing trial balance

Worksheet

A multiple-column form that companies may use in the adjustment process and in preparing financial statements. the worksheet is a working tool for the accountant. A worksheet is not a permanent accounting record;

Suppose that Robert Jones purchases a $100 gift card at Best Buy on December 24, 2013, and gives it to his wife, Mary Jones, on December 25, 2013. On January 3, 2014, Mary uses the card to purchase $100 worth of CDs. When do you think Best Buy should recognize revenue and why?

According to the revenue recognition principle, companies should recognize revenue when the performance obligation is satisfied. In this case, revenue results when Best Buy provides the goods. Thus, when Best Buy receives cash in exchange for the gift card on December 24, 2013, it should recognize a liability, Unearned Sales Revenue, for $100. On January 3, 2014, when Mary Jones exchanges the card for merchandise, Best Buy should recognize revenue and eliminate $100 from the balance in the Unearned Sales Revenue account.

Prepare adjusting entries for accruals.

Accruals are either accrued revenues or accrued expenses. Adjusting entries for accruals record revenues for services performed and expenses incurred in the current accounting period that have not been recognized through daily entries.

permanent accounts (real accounts)

All asset accounts All liability accounts Stockholders' equity accounts balance sheet accounts whose balances are carried forward to the next accounting period

Describe the nature and purpose of the adjusted trial balance.

An adjusted trial balance is a trial balance that shows the balances of all accounts, including those that have been adjusted, at the end of the accounting period. The purpose of an adjusted trial balance is to show the effects of all financial events that have occurred during the accounting period.

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.

Explain why adjusting entries are needed, and identify the major types of adjusting entries.

Companies make adjusting entries at the end of an accounting period. These entries ensure that companies record revenues in the period in which the performance obligation is satisfied and that companies recognize expenses in the period in which they are incurred. The major types of adjusting entries are prepaid expenses, unearned revenues, accrued revenues, and accrued expenses.

Q 4.3: If an expense has been used or consumed but a bill has not been received at the end of the accounting period, which of the following is needed? A : an expense should be recorded when the bill is received B : an expense should be recorded when the cash is paid out C : it is optional whether to record the expense before the bill is received D : an adjusting entry should be made recognizing the expense

D : an adjusting entry should be made recognizing the expense

Companies must make adjusting entries A : when the company's profits are below the budget B : when revenues are recorded in the period in which they are earned C : when expenses are recorded in the period in which they are incurred Companies must make adjusting entries A : when the company's profits are below the budget B : when revenues are recorded in the period in which they are earned C : when expenses are recorded in the period in which they are incurred D : because some costs expire with the passage of time and have not yet been journalized

D : because some costs expire with the passage of time and have not yet been journalized

Which of the following is not a typical example of an accrued expense? Wages Interest Taxes Depreciation

Depreciation

adjusting entry for accrued expenses

Dr. Expenses Cr. Liabilities dr. interest expense dr. interest payable

unearned revenue adjusting entry

Dr. Unearned Revenue Cr. Revenue

Matching Principle

Expense Recognition Principle It dictates that efforts (expenses) be matched with results (revenues)

Saira works for a sports franchise which pays wages and salaries earned on a monthly basis. A new accountant was hired by the sports franchise in late May. Due to inexperience, the new accountant failed to accrue Saira's salary for May. What is the impact on the May 31 financial statements of the sports franchise? Revenues are overstated; income is understated. Expenses are understated; income is overstated. Liabilities are understated; assets are overstated. Liabilities are overstated; retained earnings is overstated.

Expenses are understated; income is overstated.

The revenue recognition principle dictates that revenue is recognized in the period in which the cash is received. False True

False

Depreciation represents the value of an assets (T/F)

False depreciation allocates an asset's cost to the periods in which it is used. Depreciation does not attempt to report the actual change in the value of the asset.

Interest formula

I=prt Interest = principle * Rate * Time = face value of note * annual interest rate * time of terms in years = $5,000 * 12% * /12

quality of earnings

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

Expense Recognition Principle

It dictates that efforts (expenses) be matched with results (revenues)

Which is the correct order of steps in the accounting cycle? Prepare financial statements, prepare adjusting entries, prepare closing entries, prepare a post-closing trial balance. Post transactions, journalize transactions, prepare a trial balance, prepare financial statements. Journalize and post transactions, journalize and post adjusting entries, journalize and post closing entries. Journalize and post transactions, journalize and post closing entries, journalize and post adjusting entries.

Journalize and post transactions, journalize and post adjusting entries, journalize and post closing entries.

Understand the causes of differences between net income and net cash provided by operating activities

Net income is based on accrual accounting, which relies on the adjustment process. Net cash provided by operating activities is determined by adding cash received from operating the business and subtracting cash expended during operations.

Explain the purpose of closing entries

One purpose of closing entries is to transfer net income or net loss for the period to Retained Earnings. A second purpose is to "zero-out" all temporary accounts (revenue accounts, expense accounts, and Dividends) so that they start each new period with a zero balance. To accomplish this, companies "close" all temporary accounts at the end of an accounting period. They make separate entries to close revenues and expenses to Income Summary, Income Summary to Retained Earnings, and Dividends to Retained Earnings. Only temporary accounts are closed.

Q 4.9: From an accounting standpoint, the acquisition of a long-lived asset such as a building can be thought of as a long-term A : accrual of revenue B : accrual of expense Q 4.9: From an accounting standpoint, the acquisition of a long-lived asset such as a building can be thought of as a long-term A : accrual of revenue B : accrual of expense C : prepayment for the use of the asset D : accrual of unearned revenue D : accrual of unearned revenue

Q 4.9: From an accounting standpoint, the acquisition of a long-lived asset such as a building can be thought of as a long-term A : accrual of revenue B : accrual of expense C : prepayment for the use of the asset D : accrual of unearned revenue

temporary accounts (nominal accounts)

Revenue, expense, and dividend accounts whose balances a company transfers to Retained Earnings at the end of an accounting period. accounts used to accumulate information until it is transferred to the owner's capital account

What motivates sales executives and finance and accounting executives to participate in activities that result in inaccurate reporting of revenues?

Sales executives typically receive bonuses based on their ability to meet quarterly sales targets. In addition, they often face the possibility of losing their jobs if they miss those targets. Executives in accounting and finance are very aware of the earnings targets of Wall Street analysts and investors. If they fail to meet these targets, the company's stock price will fall. As a result of these pressures, executives sometimes knowingly engage in unethical efforts to misstate revenues. As a result of the Sarbanes-Oxley Act, the penalties for such behavior are now much more severe.

adjusting entry for supplies

Supplies Expense.......... debit ..........Supplies...................... credit

Income Summary account

Temporary account used only in the closing process to which the balances of revenue and expense accounts (including any gains or losses) are transferred; its balance is transferred to the capital account (or retained earnings for a corporation).

What does the time period assumption state?

The economic life of a business can be divided into artificial time periods.

Describe the required steps in the accounting cycle.

The required steps in the accounting cycle are (A) analyze business transactions, (B) journalize the transactions, (C) post to ledger accounts, (D) prepare the trial balance, (E) journalize and post adjusting entries, (F) prepare an adjusted trial balance, (G) prepare financial statements, (H) journalize and post closing entries, and (I) prepare a post-closing trial balance.

Explain the revenue recognition principle and the expense recognition principle.

The revenue recognition principle dictates that companies recognize revenue when a performance obligation has been satisfied. The expense recognition principle dictates that companies recognize expenses in the period when the company makes efforts to generate those revenues.

Which statement is correct? As long as a company consistently uses the cash-basis of accounting, generally accepted accounting principles allow its use. As long as management is ethical, there are no problems with using the cash basis of accounting. The use of the cash basis of accounting violates both the revenue recognition and expense recognition principles. The cash basis of accounting is objective because no one can be certain of the amount of revenue until the cash is received.

The use of the cash basis of accounting violates both the revenue recognition and expense recognition principles.

Describe the purpose and the basic form of a worksheet.

The worksheet is a device to make it easier to prepare adjusting entries and the financial statements. Companies often prepare a worksheet using a computer spreadsheet. The sets of columns of the worksheet are, from left to right, the unadjusted trial balance, adjustments, adjusted trial balance, income statement, and balance sheet.

A worksheet is not a permanent accounting record (T/F)

True it is neither a journal nor a part of the general ledger. The worksheet is merely a supplemental device used to make it easier to prepare adjusting entries and the financial statements.

Differentiate between the cash basis and the accrual basis of accounting.

Under the cash basis, companies record events only in the periods in which the company receives or pays cash. Accrual-based accounting means that companies record, in the periods in which the events occur, events that change a company's financial statements even if cash has not been exchanged.

adjusted trial balance

a list of accounts and their balances after all adjustments have been made

post-closing trial balance

a trial balance prepared after the closing entries are posted

accrued expenses (Deferral/ Accrual)?

accrual expenses incurred but no yet paid in cash or recorded Deferrals are costs or revenues that are recognized at a date later than the point when cash was originally exchanged. Companies make adjusting entries for deferred expenses to record the portion that was incurred during the period

accrued revenues (Deferral/ Accrual)?

accrual revenues for services performed but not yet received in cash

adjusting entry for Dr. Expenses Cr. Liabilities

accrued expense

Interest, taxes, utilities, and salaries are examples of

accrued expenses

adjusting entry for Dr. Assets Cr. Revenues

accrued revenue

rent, interest, services performed are examples of

accrued revenues

The primary basis for the preparation of financial statements is the

adjusted trial balance the accounts contain all data needed for financial statements

Depreciation is used for allocation or valuation

allocation depreciation allocates an asset's cost to the periods in which it is used. Depreciation does not attempt to report the actual change in the value of the asset.

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

book value

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

book value

carrying value

book value cost of asset - depreciation

improper adjusting entries

booking too much revenue upfront on multi-year contract sales recognizing rebates from its vendors too early and therefore overstating revenue adjusting entries to increase net income by reclassifying liabilities as revenue and reclassifying expenses as assets.

deferral occurs when

cash is received or paid out before the item is recorded or services are performed

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. Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).

Adjustments for unearned revenues: increase assets and increase revenues. decrease revenues and decrease assets. decrease liabilities and increase revenues. increase liabilities and increase revenues.

decrease liabilities and increase revenues.

unearned revenues (Deferral/ Accrual)?

deferral cash received before services are performed

Prepaid expenses (Deferral/ Accrual)?

deferral expenses paid in cash before they are used or consumed

adjusting entry for accrued interest

dr. interest expense cr. interest payable

If an adjusting entry for depreciation is NOT made, __________________ will be understated.

expenses

accrued expenses

expenses incurred but not yet paid in cash or recorded

income statement accounts are closed to

income summary

Adjusting entry of accruals will always

increase both a balance sheet and an income statment account

adjusting entry for prepaid expenses

insurance expense.......... debit ..........prepaid insurance...................... credit

Examples of prepaid expenses

insurance, supplies, advertising, rent, depreciation

examples of accrued expenses

interest, taxes, utilities, salaries

Adjusting entries

journal entries recorded to update general ledger accounts at the end of a fiscal period ensure that the revenue recognition and expense recognition principles are followed

closing entries

journal entries used to prepare temporary accounts for a new fiscal period transfers net income / net loss and dividends to retained earnings

Expense Recognition Principle is also known as the

matching principle

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

Adjusting entries always include accounts from

one income statement account one balance sheet account

A post-closing trial balance will show

only permanent account balances

Q 4.6: If an adjustment is needed for unearned revenues, the liability is overstated and the related revenue is _________________ before adjustment.

overstated

useful life

period of service is referred to as the useful life of the asset

Real accounts are also called

permanent accounts

What is prepared after closing

post-closing trial balance

4.5: Which of the following exemplify an asset-expense relationship? A : liability accounts B : accrued expense adjusting entries C : revenue accounts D : prepaid expense adjusting entries

prepaid expense adjusting entries

insurance, supplies, advertising, rent, depreciation are examples of

prepaid expenses

Why are prepaid expenses adjusted at the end of an accounting period?

prepaid expenses recorded in asset accounts have been used assets are overstated and expenses are understated

The purpose of an adjusted trial balance is to

prove the equality of debit and credits in the ledger after adjustments

High quality of earnings

provides full and transparent information that will not confuse or mislead financial statement users earnings are high quality only if they are backed by cash. Ex. the associate might reinvest some of its earnings rather than distribute as dividends. The investor records its proportion of the associate's earnings as profit, but the cash isn't actually there; it remains with the associate company.

Examples of accrued revenues

rent, interest, services performed

Examples of Unearned Revenues

rent, magazine subscriptions, and customer deposits for future services

revenue recognition principle

requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied Recognizing revenue too early overstates current period revenue; recognizing it too late understates current period revenue.

dividends are closed to

retained earnings

the income summary is closed to the

retained earnings

accrual occurs when

revenue or expenses occur but havent been recorded.

The generally accepted accounting principle which dictates that revenue be recognized in the accounting period in which the performance obligation is satisfied is the

revenue recognition principle

accrued revenues

revenues for services performed but not yet received in cash or recorded

Accrued revenues are adjusted because

services performed but not yet received in cash or recorded assets understated revenues understated

Equation Analysis

summarizes the effects of transactions on the three elements of the accounting equation, as well as the effect on cash flows.

Nominal accounts are also called

temporary accounts

Book value

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

the income summary represents

the net income or net loss for the year

net cash provided by operating activities

the net result of the cash inflows and outflows arising from day-to-day operations reported on the statement of cash flows

earnings management

the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income The quality of earnings is greatly affected when a company manages earnings up or down to meet some targeted earnings number.

the purpose of depreciation is not valuation but a means of cost allocation. (true/false)

true

4.16: Suppose that a company did not make an adjusting entry to record revenue earned but not yet billed to customers. The result of this error would be to A : understate assets, net income, and stockholders' equity B : overstate assets and net income C : overstate liabilities and understate stockholders' equity D : overstate net income and understate assets

understate assets, net income, and stockholders' equity

adjusting entry for Dr. Unearned Revenue Cr. Revenue

unearned revenue

rent, magazine subscriptions, and customer deposits for future services are examples of

unearned revenue

Companies manage earnings by

use of one-time items to prop up earnings numbers inflate revenue numbers in the short-run to the detriment of the long-run improper adjusting entries