Chapter 3 Adjusting the Accounts Pgs 100 112 Timing Issues Accountants divide the economic life of a business into artificial time periods This convenient assumption is referred to as the time period assumption This is done because most companies need immediate feedback about how well they are doing Fiscal and Calendar Years Accrual vs Cash Basis Accounting Accounting time periods are generally a month a quarter or a year Interim Periods Monthly and quarterly time periods Fiscal Year Accounting time period that is one year in length Some start with a random month and close out 12 months later However most companies use a calendar year which is Jan 1st to Dec 31st cash in which the events occur Under accrual basis accounting companies record transactions that change a company s financial statements in the periods This means that using the accrual basis to determine net income means that companies recognize revenues when they actually perform the services rather than when they receive cash Also means recognizing expenses when incurred rather than when paid Many medium and large companies use accrual basis accounting Under Cash Basis Accounting companies record revenue when they receive cash and record expenses when they pay out Fails to record revenue for a company that has provided services but for which it has not received the cash As a result it does not match expenses with earned revenues Is not in accordance with generally accepted accounting principles GAAP Often used for small business becauses they often have few receivables and payables Recognizing Revenues and Expenses It can be difficult to determine the amount of revenues and expenses to report in a given accounting period Two principles help in this task Revenue Recognition Principle When a company agrees to perform a service or sell a product to a customer it has a performance obligation When the company meets the obligation it recognizes revenue The Revenue Recognition Principle requires that companies recognize revenues in the accounting period in which the performance obligation is satisfied In other words you report revenue when you perform the service even if cash is paid later Expense Recognition Principle dictates that efforts expenses be matched with results revenues You match expenses with revenues in the period when the company makes efforts to generate those revenues Expense Recognition Principle In order to use the Revenue and Expense recognition principle companies make adjusting entries Adjusting Entries ensure that revenue recognition and expense recognition principles are followed They are required every time a company prepares financial statements The Basis of Adjusting Entries Required every time a company prepares financial statements Every adjusting entry will include one income statement account and one balance sheet account Types of Adjusting Entries Adjusting entries are classified as either deferrals or accruals Each of these classes has two subcategories Deferrals Accruals Prepaid Expenses Expenses paid in cash before they are used or consumed Unearned Expenses Cash received before services are performed Accrued revenues Revenues for services performed but not yet received in cash or recorded Accrued expenses Expenses incurred but not yet paid in cash or recorded Chapter 3 pg 1 Adjusting Entries for Deferrals To defer means to postpone or delay 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 deferrals to record the portion of the deferred item that was incurred as an expense or recognized as revenue during the current accounting period There are two types of deferrals 1 Prepaid expenses or prepayments are used when companies record payments of expenses that will benefit more than one accounting period Prepaid expenses are costs that expire either with the passage of time or through use At each statement date they make adjusting entries to record the expenses applicable to the current accounting period and to show the remaining amounts in the asset accounts 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 Examples of prepaid expenses Supplies Insurance Depreciation Purchase of supplies results in an increase debit to an asset account Companies recognize supplies expenses at the end of the accounting period They count the remaining supplies and the difference between the unadjusted balance in the supplies asset account and the actual cost of supplies on hand represents the supplies used an expense for that period This use of supplies decreases an asset Supplies and decreases stockholders equity by increasing an expense account Supplies Expense Cost of insurance premiums is paid in advance and is recorded as an increase debit Insurance Expense and decrease credit Prepaid Insurance for the cost of insurance that has expired during that period A company usually owns many assets that have long lives like buildings equipment and vehicles However after a period of time they become useless When they are useful this time period is referred to the useful life of an asset Recorded as an asset on the date that it was purchased Depreciation is the process of allocating the cost of an asset to expense over its useful life The acquisition of long lived assets is essentially a long term prepayment for the use of an asset Depreciation is an allocation concept not a valuation concept That is depreciation allocates an assets cost to the periods in which it is used Depreciation does not attempt to report the actual change in value of the asset Contra asset account is accumulated depreciation Normal balance is a credit This is preferred because it discloses both the original cost of the equipment and the total cost that has expired to date Statement Presentation Theoretical alternative to using a contra asset account would be to decrease credit the asset account by the amount of depreciation each period Book Value is the difference between the cost of any depreciable asset and its related accumulated depreciation 2 Unearned Revenues a type of liability that gets recorded when companies receive cash before services are performed Opposite of prepaid expenses When a company receives payment for services to be performed in a future accounting period it increases credits an unearned service revenue a liability account to