ACC 221Exam # 2 Study Guide Lectures: 9 - 14Chapter 4 Accrual Accounting ConceptsTiming Issues:- Precocity Assumption: accounting divides the economic life of a business into artificial time periods-Revenue Recognition Principle: Requires that companies recognize revenue in the periodin which the performance obligation was satisfied-Expense Recognition Principle: Expenses matched with results- expense reported in the same period as revenue is recognizedAccrual Vs Cash Basis of Accounting- Accrual Basis of Accounting- transactions that change a company’s financial statements are recorded in the periods in which the events occuro Companies recognize revenues when they perform the service, even if cash is notreceivedo Do not match revenues with expenses- Cash Basis of Accounting- companies record revenue when they receive cash and record expenses when they give out cash. This is not in accordance with GAAP.Adjusting Entries- Ensure that:o Revenue recognition and expense recognition principles are followedo Accrual accounting takes place- Will always include one income statement account and one balance sheet account- Types:o Deferrals: costs or revenues recognized at a later date Prepaid expenses: expenses paid in cash before they are used or consumed Unearned revenues: cash received before services are performedo Accruals: Accrued Revenues: revenues for services performed but not yet received cash for or recorded Accrued Expenses: expenses incurred but not yet paid in cash or recordedAdjusting Entrees for Deferrals1. Prepaid expenses- expenses paid in cash before they are used or consumed (costs that expire with the passage of time or through use)- Companies don’t show cost until they prepare the financial statements- Prior to adjustment these assets are overstated and expenses are understated- And adjusting entry for a prepaid expense results in an increase (DR) to an expense account and a decrease (CR) to an asset account- Types of prepaid expenses:o Supplies- to recognize use of supplies at the end of accounting period (DR to asset account Supplies and CR to expense account Supplies Expense)o Insurance- for the cost of insurance that has expired during the period(Increase (DR) insurance expense and CR prepaid insurance)o Depreciation- the process of allocating cost if an asset to expense over its useful life (DR Depreciation expense CR asset or contra asset)Accounting for Prepaid ExpensesExamples Insurance, supplies, rent, advertising, depreciation Reason for Adjustment Prepaid expenses are recorded as an asset but have been usedAccounts before AdjustmentAssets are overstated, Expenses are understatedAdjusting Entry DR Expenses CR Assets or Contra Assets- Contra Asset Account: and account that is an offset against an asset account on the balance sheet (normal balance of credit)- Book Value: the difference between the cost of any depreciable asset and its related accumulated depreciation2. Unearned Revenues (opposite of Prepaids)- Adjusting entry is a decrease (DR) to a liability account and an increase (CR) to a revenueaccount- Without adjustment revenues would be understated and liabilities would be overstated and Stockholders Equity would be understatedAccounting for Unearned RevenuesExamples Rent, magazine subscriptions, customer deposits for future services Reason for Adjustment Unearned revenues recorded in liability accounts are now recognized as revenue for services performedAccounts before AdjustmentLiabilities are overstated, Revenues are understatedAdjusting Entry DR Expenses CR Assets or Contra AssetsAdjusting Entries for Accruals- Accruals adjustment will increase both a balance sheet and an income statement account- Accrued Revenues: revenues for services preformed but not yet recorded at the statement date1. Adjusting accrued revenues: results in and increase (DR) to an asset account and an increase(CR) to a revenue accountAccounting for Accrued RevenuesExamples Interest, rent, services Reason for Adjustment Services preformed, but not yet received in cash or recordedAccounts before AdjustmentAssets are understated, Revenues are understatedAdjusting Entry DR Assets CR Revenues2. Adjusting for Accrued Expenses: expenses incurred but not yet paid or recorded at the statement date. Increase (DR) to an expense account and an increase (CR) to a liability account3. Accrued Interest: Interest = face value x annual interest rate x time (in terms of one yr)- Without adjustment liabilities and interest expense is understated and net income and stockholder’s equity is overstated4. Accrued Salaries: Increases Salaries and Wages Payable (liability) and decreases stockholder’s equity by increasing the expense account Salaries and Wages ExpenseAccounting for Accrued ExpensesExamples Interest, rent, salaries Reason for Adjustment Expenses have been incurred but not yet paid in cash or recordedAccounts before AdjustmentExpenses understated, liabilities understatedAdjusting Entry DR Expenses CR LiabilitiesAdjusted Trial Balance and Financial StatementsAdjusted Trial Balance- Shows balances of all accounts, including those adjusted- Purpose: to prove the equality of the total debit balances and total credit balances after all adjustments- The primary basis for the preparation of financial statements- Illustration on page 183- Prepare financial statements directly from adjusted trial balanceClosing the Books- Temporary accounts- accounts that only relate to a given accounting period (revenues, expenses, dividends)- Permanent accounts- all balance sheet accounts- Preparing closing entries: o Transfer all temporary account balances into permanent Stockholder’s Equity account, which is part of Retained Earningso Produces a 0 balance in each temporary accounto Income Summary: a temporary account with the net income/ loss for the year. When it’s closed it is transferred to Retained EarningsPreparing a Post Closing Trial Balance- Post closing trial balance- a list of all permanent accounts and their balances after closing entries are journalized and postedLecture 9 (September 19)Accrual Accounting and Adjusting Journal:Timing Problems (illustration 4-1 p.165)Cash basis Accounting: revenues are recognized only when cash is receivedAccrual Basis Accounting: transactions are recorded in the periods in which the events occurWhy accounts may need adjusting:a. Prepaid Insurance- to recognize