Principles Accounting I
Principles Accounting I BUS 201
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This 4 page Class Notes was uploaded by Bennett Murphy on Monday October 12, 2015. The Class Notes belongs to BUS 201 at Indiana State University taught by Joseph Sanders in Fall. Since its upload, it has received 50 views. For similar materials see /class/222223/bus-201-indiana-state-university in Business at Indiana State University.
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Date Created: 10/12/15
BUS 201 CHAPTER 4 NOTES KWK 3E Accrual Accounting Concepts Study Objectives 1 Explain the revenue recognition principle and the matching principle 2 Differentiate between the cash basis and the accrual basis of accounting 3 Explain why adjusting entries are needed and identify the major types of adjusting entries 4 Prepare adjusting entries for deferrals 5 Prepare adjusting entries for accruals 6 Describe the nature and purpose of the adjusted trial balance 7 Explain the purpose of closing entries 8 Describe the required steps in the accounting cycle Understand the causes of differences between net income and cash provided by operating activities 10 Describe the purpose of the basic form of a worksheet Chapter Outline Study Objective 1 Explain the Revenue Recognition Principle and the Matching Principle 9 Determining the amount of revenues and expenses to report in a given accounting period can be difficult 0 Proper reporting requires an understanding of the nature of the company s business Two principles are used as guidelines revenue recognition principle 2 matching principle 9 The revenue recognition principle requires that revenue be recognized in the accounting period in which it is earned A service company recognizes records revenue when the services are performed 9 The matching principle requires that efforts expenses be matched with accomplishments revenues o The critical issue is determining when the expense makes its contribution to revenue Study Objective 2 Differentiate Between the Cash Basis and the Accrual Basis of Accounting 9 With cash basis accounting revenue is recognized recorded when cash is received Expenses are recognized recorded only when cash is paid 4 1 o Accrual basis accounting requires accountants to adhere to the revenue recognition principle and the matching principle 9 Cash basis accounting does not satisfy the requirements of Generally Accepted Accounting Principles GAAP whereas accrual basis accounting does 0 Accrual basis accounting provides an objective measurement of net income Study Objective 3 Explain why Adjusting Entries are Needed and Identify the Major Types of Adjusting Entries 0 Adjusting entries are needed to ensure that the revenue recognition and matching principles are followed 0 The trial balance may not contain uptodate and complete data for several reasons 0 Some events are not recorded daily because it is not efficient to do so 0 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 0 Some items may be unrecorded o Adjusting entries are required every time a company prepares financial statements 0 Every adjusting entry will include one income statement account and one balance sheet account 0 Adjusting entries can be classified as either deferrals or accruals Each of these classes has two subcategories Study Objective 4 Prepare Adjusting Entries for Deferrals Deferrals fall into two categoriesprepaid 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 orthrough use i e supplies 2 Unearned revenues cash received and recorded as liabilities before the revenue is earned 9 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 9 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 9 Study Objective 5 Prepare Adjusting Entries for Accruals o Accruals fall into two categoriesaccrued revenues and accrued expenses Accrued revenues revenues earned but not yet received in cash or recorded at the statement date 0 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 0 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 4 2 0 an adjusting entry for accruals accrued revenues or accrued expenses increases both a balance sheet and an income statement account expenses revenues expenses Study Objective 6 Describe the Nature and Purpose of the Adjusted Trial Balance 9 The adjusted trial balance is prepared after all adjusting entries have been journalized and posted 9 The adjusted trial balance shows the balances of all accounts including those that have been adjusted at the end of the accounting period 9 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 9 Financial statements are prepared from the adjusted trial balance Study Objective 7 Explain the Purpose of Closing Entries 9 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 0 Close the revenue accounts to the Income Summary account 0 Close the expense accounts to the Income Summary account 0 Close the Income Summary account to Retained Earnings 0 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 9 0 After the closing entries have been journalized and posted a postclosing trial balance is prepared 0 The postclosing trial balance shows the balances of all of the permanent accounts 0 The permanent account balances are carried forward to the next accounting period Study Objective 8 Describe 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 entriesdeferrals and accruals Prepare an adjusted trial balance Prepare financial statements Income statement Retained earnings statement Balance sheet Journalize and post closing entries Prepare postclosing trial balance 9999999 99 9 Quality of Earnings 0 Earnings management is the planned timing of revenues expenses gains and losses to smooth out bumps in net income 0 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 9 Companies manage earnings in a variety of ways 0 Use of onetime items to prop up earnings ie nonrecurring gains 0 Inflate revenue numbers in the shortrun to the detriment of the longrun o Improper adjusting entries 9 As the result of investor pressure and the SarbanesOxley Act many companies are trying to improve the quality of their financial reporting Study Objective 9 Understand the Causes of Differences Between Net Income and Cash Provided by Operating Activities 0 Net income is based on accrual basis accounting and is accomplished through the adjusting entry process 0 Cash provided by operating activities is determined by comparing cash received from operating activities to cash expenditures from operating activities 0 Cash provided by operating activities is essentially net income determined under the cashbasis of accounting Study Objective 10 Describe the Purpose and the Basic Form of a Worksheet 0 The worksheet is a device to make preparing adjusting entries and financial statements easier 0 A worksheet is not a permanent accounting record