ACCT 201 Chapter 4 Summary: Accrual Accounting Concepts
ACCT 201 Chapter 4 Summary: Accrual Accounting Concepts ACCT 201
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This 7 page Study Guide was uploaded by Amend on Tuesday August 23, 2016. The Study Guide belongs to ACCT 201 at Towson University taught by Raymond Kitson Walters in Fall 2016. Since its upload, it has received 10 views. For similar materials see Principles of Financial Accounting in Accounting (ACCT) at Towson University.
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ACCT 201 Chapter 4 Summary: Accrual Accounting Concepts The Revenue Recognition and Expense Recognition Principles Determining the amount of revenues and expenses to report in a given accounting period can be difficult. Accounting divides the economic life of a business into artificial time periods. This is the periodicity assumption. Many transactions affect more than one of these periods. Determining the amount of revenues and expenses to report in a given accounting period can be difficult. Proper reporting requires an understanding of the nature of the company’s business. Two principles are used as guidelines: o Revenue recognition principle o Expense recognition principle The revenue recognition principle requires that revenue be recognized in the accounting period in which the performance obligation is satisfied. When a company agrees to perform a service or sell a product to a customer, it has created a performance obligation. A service company recognizes (records) revenue when the services are performed. The expense recognition principle requires that efforts (expenses) be matched with accomplishments (revenues). The critical issue is determining when the expense makes its contribution to revenue. Expenses need to be matched with the revenue in the period when the company makes efforts to generate those revenues. The Cash Basis and the Accrual Basis of Accounting Accrualbasis accounting means that transactions that change a firm’s financial statements are recorded in the periods in which the events occur, even if cash was not exchanged. 1 ACCT 201 Chapter 4 Summary: Accrual Accounting Concepts With cash basis accounting, revenue is recognized (recorded) when cash is received. Expenses are recognized (recorded) only when cash is paid. Accrual basis accounting requires accountants to adhere to the revenue recognition principle and the expense recognition principle. Cash basis accounting does not satisfy the requirements of Generally Accepted Accounting Principles (GAAP), whereas accrual basis accounting does. Accrual basis accounting provides an objective measurement of net income. The Role of Adjusting Entries Adjusting entries are needed to ensure that the revenue recognition and expense recognition principles are followed. The trial balance may not contain uptodate and complete data for several reasons: Some events are not recorded daily because it is not efficient to do so. 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. Some items may be unrecorded. Adjusting entries are required every time a company prepares financial statements. Every adjusting entry will include one income statement account and one balance sheet account. Adjusting entries can be classified as either deferrals or accruals. Each of these classes has two subcategories. Deferrals can be prepaid expenses or unearned revenues. Accruals are either accrued revenues or accrued expenses. 2 ACCT 201 Chapter 4 Summary: Accrual Accounting Concepts Adjusting Entries for Deferrals Deferrals fall into two categories—prepaid expenses and unearned revenues. Prepaid expenses expenses paid in cash and recorded as assets until they are used or consumed. Prepaid expenses are costs that expire with the passage of time (i. e. rent and insurance) or through use (i. e. supplies). Unearned revenues – cash received and recorded as liabilities before the services are performed. An adjusting entry for prepaid expenses will result in an increase (a debit) to an expense account and a decrease (a credit) to an asset account. An adjusting entry for unearned revenues will result in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account. An adjusting entry for deferrals (prepaid expenses or unearned revenues) will decrease a balance sheet account and increase an income statement account. Adjusting Entries for Accruals Accruals fall into two categories—accrued revenues and accrued expenses. Accrued revenues revenues for services performed but not yet received in cash or recorded at the statement date. an adjusting entry for accrued revenues will result in an increase (a debit) in an asset account and an increase (a credit) to a revenue account. Accrued expenses expenses incurred but not yet paid in cash or recorded at the statement date. an adjusting entry for accrued expenses results in an increase (a debit) to an expense account and an increase (a credit) to a liability account. an adjusting entry for accruals (accrued revenues or accrued expenses) increases both a balance sheet and an income statement account. 3 ACCT 201 Chapter 4 Summary: Accrual Accounting Concepts Summary of basic relationships: Type of Adjustment Accounts Before Adjusting Adjustment Entry Prepaid expenses Assets overstated Dr. Expenses Expenses understated Cr. Assets Unearned revenues Liabilities overstated Dr. Liabilities Revenues understated Cr. Revenues Accrued revenues Assets understated Dr. Assets Revenues understated Cr. Revenues Accrued expenses Expenses understated Dr. Expenses Liabilities understated Cr. Liabilities The Nature and Purpose of the Adjusted Trial Balance The adjusted trial balance is prepared after all adjusting entries have been journalized and posted. The adjusted trial balance shows the balances of all accounts, including those that have been adjusted, at the end of the accounting period. The purpose of the adjusted trial balance is to prove the equality of the total debit balances and total credit balances in the ledger after all adjustments. Financial statements are prepared from the adjusted trial balance. The Purpose of Closing Entries Closing entries transfer net income (or net loss) and dividends to Retained Earnings. This causes the ending balance of Retained Earnings (amount shown on the Balance Sheet) to agree with the balance shown on the Retained Earnings Statement. Close the revenue accounts to the Income Summary account. 4 ACCT 201 Chapter 4 Summary: Accrual Accounting Concepts Close the expense accounts to the Income Summary account. Close the Income Summary account to Retained Earnings. Close Dividends to Retained Earnings. Closing entries produce a zero balance in each temporary account (revenues, expenses, and dividends) These accounts are then ready to accumulate data for the next accounting period. Permanent accounts (assets, liabilities, common stock and retained earnings) are not closed. After the closing entries have been journalized and posted, a postclosing trial balance is prepared. The postclosing trial balance shows the balances of all of the permanent accounts. The permanent account balances are carried forward to the next accounting period. All of the temporary accounts have a zero balance. The Required Steps in the Accounting Cycle Analyze business transactions. Journalize the transactions. Post to ledger accounts. Prepare a trial balance. Journalize and post adjusting entries—deferrals and accruals. Prepare an adjusted trial balance. Prepare financial statements: 5 ACCT 201 Chapter 4 Summary: Accrual Accounting Concepts Income statement Retained earnings statement Balance sheet Journalize and post closing entries. Prepare a postclosing trial balance. Quality of Earnings Earnings management is 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. A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements. A company with questionable quality of earnings may mislead investors and creditors, who believe they are relying on relevant and reliable information. Companies manage earnings in a variety of ways: Use of onetime items to prop up earnings numbers (i.e. nonrecurring gains). Inflate revenue numbers in the shortrun (to the detriment of the longrun). Improper adjusting entries As the result of investor pressure and the SarbanesOxley Act, many companies are trying to improve the quality of their financial reporting. The Causes of Differences between Net Income and Cash Provided by Operating Activities 6 ACCT 201 Chapter 4 Summary: Accrual Accounting Concepts Net income is based on accrual basis accounting and is accomplished through the adjusting entry process. Cash provided by operating activities is determined by comparing cash received from operating activities to cash expenditures from operating activities. Cash provided by operating activities is essentially net income determined under the cashbasis of accounting. The Purpose and the Basic Form of a Worksheet The worksheet is a multiplecolumn form that may be used in the adjustment process and in preparing financial statements. Today most accountants use computer spreadsheets. A worksheet is not a permanent accounting record. 7
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