Test 2 Study Concepts Chapter 4 Accrual Accounting Concepts The revenue recognition principle The principle that companies recognize revenue in the accounting period in which the performance obligation is satisfied The expense recognition principle The principle that matches expenses with revenues in the period when the company makes effort to generate those revenues It is often referred to as the matching principle Expenses Delivery Advertisting Utilities Matching Revenues Let the expenses follow the revenues Accrual verses cash basis of accounting Accrual basis accounting means that transactions that change a company s financial statements are recorded in the period in which the events occur even if cash was not exchanged So companies recognize revenue when they perform the services even if the cash was not received Likewise companies recognize expenses when incurred even if cash was not paid Cash basis accounting is an alternative and under this method companies record revenue when they receive cash they record an expense when they pay out cash Appealing due to the simplicity but it leads to financial mistakes Not in accordance with GAAP The basics of adjusting entries Adjusting entries are made at the end of an accounting period to ensure that the revenue recognition and expense recognition principles are followed It is necessary to adjust the entries because the trial balance 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 ex Use of supplies or earning wages 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 ex Charges related to the use of buildings and equipment rent and insurance 3 some items may be unrecorded ex Utility service bill that will not be received until the next accounting period They are required every time a company prepares financial statements Every adjusting entry will include one income statement account and one balance sheet account Also cash is never included Types of adjusting entries Deferrals Test 2 Study Concepts 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 Companies also make adjusting entries for deferred revenues to record services performed during the period 1 Prepaid expenses Expenses paid in cash and recorded as assets before they are used or consumed Ex Insurance supplies advertising rent equipment and buildings Cost that expire either with the passage of time or through use Debit to an expense account and a credit to an asset account Companies typically own a variety of assets that have long lives like buildings equipment and motor vehicles The life cost of the asset is allocated of its useful life which is the idea of depreciation It is an allocation concept not a valuation concept It allocates an asset s cost to the periods in which it is used It does not attempt to report the actual change in the value of the asset So you could debit depreciation expense and credit the contra asset account accumulated depreciation equipment building land etc 2 Unearned revenues Cash received before service are performed Ex Rent airline tickets magazine subscription and customer deposits Adjusting entry to record the revenue that has been earned and to show the liability that remains Debit to a liability and credit to a revenue account Accruals Prior to an adjustment the revenue account and the related asset account or the expense account and the related liability account are understated So the accruals will increase both a balance sheet and an income statement account 1 Accrued revenues Revenues for services performed but not yet received in cash or recorded Ex Rent interest and services performed Accrued revenues may accumulate accrue with the passing of time and they are unrecorded because the earning does like interest does not involve daily transactions Debit to an asset account and credit to a revenue account An adjusting entry serves two purposes 1 shows the receivable that exists and 2 records the revenues for services performed 2 Accrued expenses Expenses incurred but not yet paid in cash or recorded Ex Rent interest taxes and salaries Debit to an expense account and credit to a liability account An adjusting entry serves two purposes 1 records the obligations and 2 recognizes the expenses Test 2 Study Concepts Closing the books At the end of the accounting period companies transfer the temporary account all revenue and expense accounts and dividends balances to the permanent all asset and liability accounts and s e stockholders equity account Retained Earnings In addition to updating Retained Earnings to its correct ending balance closing entries produce a zero balance in each temporary account The purpose of post closing trial balance is to prove the equality of the permanent account balances that the company carries forward into the next accounting period Chapter 5 Merchandising Operations and the Multiple Step Income Statement Flow of costs perpetual vs periodic Companies use either a perpetual inventory system or a periodic system to account for inventory Test 2 Study Concepts Perpetual system Maintained detailed records of the cost of each inventory purchase and sale records continuously show inventory that should be on hand for every item company determines cost of goods sold each time a sale occurs Advantages traditionally used for merchandise with high unit value shows the quantity and cost of the inventory that should be on hand at any time and provides better control over inventories than a periodic system Periodic system Do not keep detailed records of the goods on hand cost of goods sold determined by count at the end of the accounting period calculation of cost of goods sold Beginning inventory Purchases Goods available for sale Ending inventory Cost of goods sold Freight costs FOB FOB Stands for free on board FOB Shipping point means that the seller places the goods free on board the carrier and the buyer pays the freight costs FOB Destination means that the seller places the goods free on board to the buyer s place of business and the seller pays the freight costs Freight costs incurred by buyer Inventory is debited and cash is
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