ACCT 2113 1st Edition Lecture 3 Outline of Previous Lecture II The Accounting Information System A Roles III Measuring External Transactions A Classification B Six Steps in measuring C Ask three questions IV 10 Transaction Examples V Debits and Credits A Ask three questions VI Recording Transactions A Define general ledger posting and T account VII Prepare a Trial Balance A Define and preparation Outline of Current Lecture II Review A Debits and credits B Account Menus III Accrual Basis Accounting IV Revenue Recognition Principle A Examples V Matching Principle A Definition B Example VI Accrual vs Cash Basis Accounting A Definition B Examples VII The Measurement Process A Accounting Cycle B Adjusting Entries C Definitions VIII Prepaid Expenses A Examples These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute IX Unearned Revenues A Examples X Accrued Expenses A Examples XI Accrued Revenues A Examples XII The Reporting Process A Preparing the Financial Statements XIII The Closing Process A 4 steps B Closing Entries and Post Cost Trial Balance Current Lecture Chapter 3 the financial reporting process most on test Debits and Credits Account Menu Assets Accounts receivable Accumulated depreciation equipment contra Boxing equipment Cash Equipment Interest receivable Land Prepaid advertising Prepaid insurance Prepaid rent Supplies Account Menu Liabilities Accounts payable Interest payable Notes payable Salaries payable Income tax payable Unearned revenue Utilities payable Account Menu Owners Equity Common stock Retained earnings Stockholders equity composite of CS and RE Account Menu Revenues Interest revenue Membership revenue Service revenue Account Menu Expenses Advertising expense Depreciation expense Research and development expense Salaries expense Service expense Supplies expense Utilities expense Account Menu One offs Dividends Accrual Basis Accounting Net income is an essential aspect of good investment decisions Proper computation of net income requires considerable attention to be paid to the proper measurement of the two primary components of net income revenues and expenses Accounting information necessary for decision making To be useful in decision making accountants must report revenues and expenses in a way that reflects the ability of the company to create value for its owners Accrual basis accounting records revenues when earned the revenue recognition principle and expenses with related revenues the matching principle Revenue Recognition Principle Recognize revenue when it is EARNED EX Calvin books a cruise with Carnival Cruise Lines the world s largest cruise line He makes reservations and pays for the cruise in November 2012 but the cruise is not scheduled to sail until April 2013 When does Carnival report revenue from the ticket sale 1 In November 2012 No Because it has not substantially fulfilled its obligation to Calvin 2 In April 2013 Yes Because it is in April 2013 that the cruise occurs EX Suppose that anticipating the cruise Calvin buys a Jimmy Buffet CD from Best Buy Rather than paying cash Calvin uses his Best Buy card to buy the CD on account When does Best Buy recognize revenue Even though Best Buy doesn t receive cash immediately from Calvin it still records the revenue at the time it sells the CD Matching Principle There is a cause and effect relationship between revenue and expense recognition implicit in this principle In a given period we report revenue as it s earned according to the revenue recognition principle It s logical then that in the same period we should also record all expenses incurred to generate that revenue The result is a measure net income that matches current period accomplishments revenues and sacrifices expenses Expenses are reported with the revenues they help to generate The matching principle states that we recognize expenses in the same period as the revenues they help to generate Expenses include those directly and indirectly related to producing revenues Accrual Basis compared with Cash Basis accounting Under accrual basis accounting we record revenue and expense transactions at the time the earnings related activities occur Under cash basis accounting we record revenues at the time we receive cash and expenses at the time we pay cash The timing between the accrual basis and cash basis accounting in recognizing expenses The Measurement Process The accounting cycle starts with recording of external transactions We discussed external transactions in chapter 2 In this chapter we complete the accounting cycle by recording adjusting entries internal transactions preparing financial statements and recording closing entries Adjusting Entries Purpose of Adjusting Entries To record events that have occurred but which have not been recorded To record revenues in the period earned To record expenses in the period they are incurred in the generation of those revenues To correctly state assets and liabilities in the balance sheet Grouping Adjusting Entries Prepayments 1 Prepaid expenses we paid cash or had an obligation to pay cash for the purchase of an asset before we incurred the expense 2 Unearned revenues we received cash and recorded a liability before we earned the revenue Accruals 3 Accrued expenses we paid cash after we incurred the expense and recorded a liability 4 Accrued revenues we received cash after we earned the revenue and recorded an asset Prepaid Expenses Costs of assets acquired in one period that will be expensed in a future period Examples Purchase of equipment or supplies payment of rent in advance payment of insurance in advance Adjusting entry always includes debit expense account increase an expense Credit asset account decrease an asset EX Prepaid rent the balance in prepaid rent account on Jan 1 is 6 000 The rent expense for the month of January is 500 As such the balance in prepaid rent account is reduced to 5 500 on Jan 31 Adjusting entry The adjusting entry is recorded on Jan 31 debiting the rent expense account and crediting the prepaid rent account Notice that the adjusting entry includes a 500 expense E which reduces net income and stockholders equity SE At the same time the balance in the asset account prepaid rent decreases A by 500 and now has a balance of 5 500 6 000 500 Unearned Revenues Once a company has provided products or services they can record revenue earned and reduce the obligation to the