Accounting principles 10e by kieso chapter 03

Revenue Recognition Principle Recognizing Revenues and Expenses SO 2 Explain the accrual basis of accounting.. Expense Recognition Principle Recognizing Revenues and Expenses SO 2 Explai

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3-1

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CHAPTER 3

Adjusting the Accounts

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3-3

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 Generally a month , a quarter , or a year

 Also known as the “Periodicity Assumption”

Timing Issues

Accountants divide the economic life of a business into

artificial time periods ( Time Period Assumption ).

SO 1 Explain the time period assumption.

.

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 Monthly and quarterly time periods are called interim

periods

 Public companies must prepare both quarterly and

annual financial statements

 Fiscal Year = Accounting time period that is one year

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The time period assumption states that:

a revenue should be recognized in the accounting

period in which it is earned

b expenses should be matched with revenues

c the economic life of a business can be divided into

artificial time periods

d the fiscal year should correspond with the calendar

year

Review

SO 1 Explain the time period assumption.

Timing Issues

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Accrual-Basis Accounting

 Transactions recorded in the periods in which the

events occur

 Revenues are recognized when earned, rather than

when cash is received

 Expenses are recognized when incurred, rather

than when paid

Accrual- vs Cash-Basis Accounting

SO 2 Explain the accrual basis of accounting.

Timing Issues

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Cash-Basis Accounting

 Revenues recognized when cash is received

 Expenses recognized when cash is paid

 Cash-basis accounting is not in accordance with

generally accepted accounting principles (GAAP)

Accrual- vs Cash-Basis Accounting

Timing Issues

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Revenue Recognition Principle

Recognizing Revenues and Expenses

Recognize revenue in the

accounting period in which it

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Expense Recognition Principle

Recognizing Revenues and Expenses

Match expenses with

revenues in the period

when the company makes

efforts to generate those

revenues

“Let the expenses follow

the revenues.”

Timing Issues

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3-11 SO 2 Explain the accrual basis of accounting.

Timing Issues

Illustration 3-1 GAAP relationships in revenue and expense recognition

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3-12 SO 2 Explain the accrual basis of accounting.

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One of the following statements about the accrual basis of

accounting is false That statement is:

a Events that change a company’s financial statements

are recorded in the periods in which the events occur

b Revenue is recognized in the period in which it is

earned

c The accrual basis of accounting is in accord with

generally accepted accounting principles

d Revenue is recorded only when cash is received, and

expenses are recorded only when cash is paid

Review

Timing Issues

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 Adjusting entries are necessary because the trial

balance may not contain up-to-date and complete data

 Ensure that the revenue recognition and expense

recognition principles are followed

 Required every time a company prepares financial

statements

 Will include one income statement account and

one balance sheet account

SO 3 Explain the reasons for adjusting entries.

The Basics of Adjusting Entries

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Adjusting entries are made to ensure that:

a expenses are recognized in the period in which

they are incurred

b revenues are recorded in the period in which they

are earned

c balance sheet and income statement accounts

have correct balances at the end of an accounting period

d all of the above

SO 3 Explain the reasons for adjusting entries.

Review

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1. Prepaid Expenses.

Expenses paid in cash and

recorded as assets before

they are used or consumed.

Cash received and recorded

as liabilities before revenue

is earned.

Accruals

Illustration 3-2 Categories of adjusting entries

SO 4 Identify the major types of adjusting entries.Types of Adjusting Entries

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SO 4 Identify the major types of adjusting entries.Types of Adjusting Entries

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Payment of cash, that is recorded as an asset because

service or benefit will be received in the future

Prepayments often occur in regard to:

SO 5 Prepare adjusting entries for deferrals.

Prepaid Expenses

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 Expire either with the passage of time or through use

 Adjusting entry:

► Increase (debit) to an expense account and

► Decrease (credit) to an asset account

Illustration 3-4

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Illustration: Pioneer Advertising Agency

purchased supplies costing $2,500 on

October 5 Pioneer recorded the payment

by increasing (debiting) the asset

Supplies This account shows a balance

of $2,500 in the October 31 trial balance

An inventory count at the close of

business on October 31 reveals that

$1,000 of supplies are still on hand.

Supplies expense 1,500 Oct 31

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SO 5

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Illustration: On October 4, Pioneer

Advertising Agency paid $600 for a

one-year fire insurance policy Coverage

began on October 1 Pioneer recorded

the payment by increasing (debiting)

Prepaid Insurance This account shows a

balance of $600 in the October 31 trial

balance Insurance of $50 ($600 / 12)

expires each month.

Insurance expense 50 Oct 31

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SO 5

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Depreciation

 Buildings, equipment, and vehicles (assets with long

lives) are recorded as assets, rather than an expense,

in the year acquired

 Companies report a portion of the cost of the asset as

an expense (depreciation expense) during each period

of the asset’s useful life

 Depreciation does not attempt to report the actual

change in the value of the asset

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40

Illustration: For Pioneer Advertising,

assume that depreciation on the

equipment is $480 a year, or $40 per

month.

Accumulated depreciation 40 Depreciation expense

Oct 31

Accumulated Depreciation is called a contra asset

account.

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SO 5

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Statement Presentation

 Accumulated Depreciation is a contra asset account

 Appears just after the account it offsets (Equipment)

on the balance sheet

 Normal balance of a contra asset account is a credit

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Receipt of cash that is recorded as a liability because the

revenue has not been earned

 Rent

 Airline tickets

Cash ReceiptCash Receipt BEFORE Revenue Recorded

 Magazine subscriptions

 Customer deposits

Unearned revenues often occur in regard to:

Unearned Revenues

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 Adjusting entry is made to record the revenue that

has been earned and to show the liability that remains

 Results in a decrease (debit) to a liability account

and an increase (credit) to a revenue account

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Illustration: Pioneer Advertising Agency received $1,200 on

October 2 from R Knox for advertising services expected to be

completed by December 31 Unearned Service Revenue shows a balance of $1,200 in the October 31 trial balance Analysis reveals that the company earned $400 of those fees in October.

Unearned service revenue 400 Oct 31

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SO 5

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3-35

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Accruals are made to record

 Revenues earned

OR

 Expenses incurred

in the current accounting period that have not been

recognized through daily entries.

Adjusting Entries for Accruals

SO 6 Prepare adjusting entries for accruals.

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Accrued revenues often occur in regard to:

Accrued Revenues

BEFORE Cash Receipt Revenue Recorded

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 Adjusting entry shows the receivable that exists and

records the revenues earned

► Increases (debits) an asset account and

► Increases (credits) a revenue account

SO 6

Accrued Revenues

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Illustration: In October Pioneer Advertising

Agency earned $200 for advertising services

that had not been recorded.

Accounts receivable 200

Nov 10

200 Service revenue 200 Accounts receivable

Oct 31

On November 10, Pioneer receives cash of

$200 for the services performed.

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SO 6

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Accrued expenses often occur in regard to:

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 Adjusting entry records the obligation and recognizes

the expense

► Increase (debit) an expense account and

► Increase (credit) a liability account

SO 6

Accrued Expenses

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Illustration: Pioneer Advertising Agency signed a three-month

note payable in the amount of $5,000 on October 1 The note

requires Pioneer to pay interest at an annual rate of 12%.

Interest expense 50 Oct 31

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SO 6

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3-46

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Illustration: Pioneer Advertising Agency last paid salaries on

October 26; the next payment of salaries will not occur until

November 9 The employees receive total salaries of $2,000 for a five-day work week, or $400 per day Thus, accrued salaries at

October 31 are $1,200 ($400 x 3 days).

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SO 6

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SO 6 Prepare adjusting entries for accruals.Summary of Basic Relationships

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Adjusted Trial Balance

 Prepared after all adjusting entries are journalized

and posted

 Purpose is to prove the equality of debit balances

and credit balances in the ledger

 Is the primary basis for the preparation of financial

statements

SO 7 Describe the nature and purpose of the adjusted trial balance.

The Adjusted Trial Balance

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Which of the following statements is incorrect concerning the

adjusted trial balance?

a An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made.

b The adjusted trial balance provides the primary basis for the preparation of financial statements

c The adjusted trial balance lists the account balances segregated by assets and liabilities

d The adjusted trial balance is prepared after the adjusting entries have been journalized and posted.

Review

The Adjusted Trial Balance

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Financial Statements are prepared directly from the

Balance Sheet

Income Statement

Owner’s Equity Statement

The Financial Statements

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3-55 SO 7

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SO 7

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 When a company prepays an expense, it debits that

amount to an expense account

 When a company receives payment for future

services, it credits the amount to a revenue account

Alternative Treatment of Prepaid Expenses

and Unearned Revenues

SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

APPENDIX3A

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3-58 SO 8 Prepare adjusting entries for the alternative treatment of deferrals.

Illustration 3A-2

APPENDIX3A

Company may choose to debit (increase) an expense

account rather than an asset account This alternative

treatment is simply more convenient

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APPENDIX3A

Company may credit (increase) a revenue account when

they receive cash for future services

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Summary of Additional Adjustment

Relationships

APPENDIX3A

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Key Points

ensure that they record transactions that change a company’s financial statements in the period in which events occur.

IFRS.

time periods Under both GAAP and IFRS, this is referred to as the time period assumption.

statements, including comparative information annually.

IFRS A Look at IFRS

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Key Points

Many of these rules are industry specific In contrast, revenue recognition under IFRS is determined primarily by a single standard Despite this large disparity in the amount of detailed guidance devoted to revenue recognition, the general revenue recognition principles required by GAAP that are used in this textbook are similar to those under IFRS.

major issue in U.S financial reporting The same situation occurs

in other countries, as evidenced by revenue recognition breakdowns at Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch grocer AHold NV.

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Key Points

18) In general, the standard is based on the probability that the economic benefits associated with the transaction will flow to the company selling the goods, providing the service, or receiving investment income In addition, the revenues and costs must be capable of being measured reliably GAAP uses concepts such as realized, realizable (that is, it is received, or expected to be

received), and earned as a basis for revenue recognition

permitted IFRS allows depreciation based on revaluation of assets, which is not permitted under GAAP.

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Key Points

losses, differs somewhat between IFRS and GAAP For example, income is defined as:

Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from shareholders

Expenses are defined as:

Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity other than those r elating to distributions to shareholders.

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Looking into the Future

The IASB and FASB are now involved in a joint project on

revenue recognition The purpose of this project is to develop comprehensive guidance on when to recognize revenue

Presently, the Boards are considering an approach that focuses

on changes in assets and liabilities (rather than on earned and realized) as the basis for revenue recognition.

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