Principles of financial accounting 12e by needles crosson chapter 03

Accrual Accounting Matching Rule Under accrual accounting often referred to as the matching rule net income is measured by assigning: – Revenues to the accounting period in which the

Powers

Principles of

Accounting

12e

Adjusting the Accounts

3

C H A P T E R

Net Income

 Net income is the net increase in owner’s

equity that results from a company’s

operations.

– In its simplest form, net income results when revenues exceed expenses.

Net Income = Revenues − Expenses – When expenses exceed revenues a net loss

occurs.

 Revenues are increases in owner’s equity that result from performing business activities.

 Expenses are decreases in owner’s equity

resulting from the cost of doing business.

 The majority of companies present annual

financial statements on the assumption that the business will continue to operate indefinitely— that is, that the company is a going concern

 The continuity assumption states that unless

there is evidence to the contrary, the

accountant assumes that the business is a

going concern and will continue to operate

indefinitely.

– The continuity assumption allows certain

expense and revenue transactions to be allocated over several accounting periods.

 The periodicity assumption states that

although the lifetime of a business is

uncertain, it is nonetheless useful to

estimate the business’s net income in

terms of accounting periods.

 A 12-month accounting period is called a

fiscal year

– The fiscal year may be the same as the

calendar year or some other 12-month period.

 Accounting periods of less than a year are called interim periods

Accrual Accounting (Matching Rule)

 Under accrual accounting (often

referred to as the matching rule) net

income is measured by assigning:

– Revenues to the accounting period in which the goods are sold or the services performed – Expenses to the accounting period in which

they are used to produce revenue.

 When there is no direct means of

connecting expenses and revenues, costs are allocated among the accounting

periods that benefit from the costs.

Concepts Underlying Accrual Accounting

 The cash basis of accounting is the

practice of accounting for revenues in the period in which cash is received and for

expenses in the period in which cash is

paid.

– With this method, taxable income is calculated

as the difference between cash receipts from revenues and cash payments for expenses.

 In accrual accounting, revenues and

expenses are recorded when they are

earned or incurred rather than when they

are received or paid.

Recognizing Revenues

 The process of determining when revenue should be recorded is called revenue

recognition

 The Securities and Exchange Commission requires that all the following conditions

be met before revenue is recognized:

– Persuasive evidence of an arrangement exists – A product or service has been delivered.

– The seller’s price to the buyer is fixed or

determinable.

– Collectibility is reasonably ensured.

Recognizing Expenses

 Expenses are recorded when all of the

following conditions are met:

– There is an agreement to purchase goods or

services.

– The goods have been delivered or the services rendered.

– A price has been determined or can be

determined.

– The goods or services have been used to

produce revenue.

 The recognition of the expense does not

depend on the payment of cash.

The Adjustment Process

– Adjustments are necessary because the accounting period, by definition, ends on a particular day Some transactions

invariably span the cutoff point, and therefore, some accounts need adjustment.

– When transactions span more than one accounting period, accrual accounting requires the use of adjusting entries These are either deferrals or accruals.

 A deferral is the postponement of the recognition of an expense already paid or of revenue received in advance The cash

payment or receipt is recorded before the adjusting entry is made.

 An accrual is the recognition of an expense or a revenue that has arisen but not been recorded during the accounting period The cash payment or receipt occurs in a future accounting period.

Type 1 Adjustment: Allocating Recorded

Costs (Deferred Expenses)

 Companies often make expenditures

that benefit more than one period.

– These costs are debited to an asset account – At the end of the accounting period, the

amount of the asset that has been used is transferred from the asset account to an expense account.

companies pay in advance, such as

rent, supplies, and insurance.

Depreciation of Plant and Equipment

 When a company buys a long-term asset, it is paying for the usefulness of that asset for as long as it

benefits the company

 The accountant must allocate the cost of the asset

over its estimated useful life The amount allocated to any one accounting period is called depreciation

– To maintain historical costs, Accumulated Depreciation

accounts are used to accumulate the depreciation on each long-term asset.

 These accounts are called contra accounts The balance of a contra account is shown on a financial statement as a deduction from its related account (for example, an asset account).

 The net amount is called the carrying value (or book value) of

the asset.

Type 2 Adjustment: Recognizing Unrecorded Expenses (Accrued Expenses)

 At the end of an accounting period, some expenses incurred during the period have not been recorded These expenses require adjusting entries Examples include:

– Interest on borrowed money

– Wages

– Utilities

 These expenses are called accrued

the corresponding liability accumulate,

they are said to accrue.

Type 3 Adjustment: Allocating Recorded,

Unearned Revenues (Deferred Revenues)

 When a company receives revenues in advance, it has an obligation to deliver goods or perform services These

unearned revenues are shown in a

liability account.

– As a company delivers part of the goods or performs part of the services, it earns a part

of the advance receipts.

– The earned portion must be transferred from the liability account to a revenue account.

Type 4 Adjustment: Recognizing Unrecorded, Earned Revenues (Accrued Revenues)

 Accrued revenues are revenues that

a company has earned by performing a service or delivering goods but for

which no entry has been made in the

accounting records.

– Any revenues earned but not recorded

during an accounting period require an adjusting entry that debits an asset account and credits a revenue account.

Using the Adjusted Trial Balance to Prepare

Financial Statements

 After adjusting entries have been recorded and posted, an adjusted trial balance is prepared

by listing all accounts and their balances.

– The revenue and expense accounts are used to prepare the income statement, and the asset and liability

accounts are used to prepare the balance sheet.

– Net income from the income statement is combined

with the Withdrawals account on the statement of owner’s equity to give the net change in the Capital account.

– The balance of the Capital account is used in preparing the balance sheet.

Net Income: Ethical Measurement and Cash

Flows

 Adjusting entries affect net income and the assets and liabilities on the balance sheet

that are used to assess the need for cash.

 Because judgment underlies the adjusting entries, there is potential for abuse.

 The manipulation of revenue and expenses

to achieve a specific outcome is called

earnings management

– When estimates move outside a reasonable

range, financial statements become misleading

Determination of Cash Flows from

Accrual-Based Information

received from any revenue or paid for any

expense is to determine the potential cash

payments or cash receipts and deduct the

amount not paid or not received The

application of the general rule by account

type is shown below: