Chapter 4 Flashcards
(21 cards)
Timing Differences
- For most companies, revenue is not always
earned as cash is received, nor is an
expense necessarily incurred as cash is
disbursed. - Timing differences between cash flows and
the recognition of revenue and expenses
are referred to as accruals and deferrals
The Need for Adjusting Entries
- Certain transactions affect the revenue or
expenses of two or more accounting
periods. - Adjusting entries are needed at the end of
each accounting period to make certain that
appropriate amounts or revenue and
expense are reported in the company’s
income statement.
Categories of Adjusting Entries
Most adjusting entries fall into one of four general categories: 1. Converting assets to expenses. 2. Converting liabilities to revenue. 3. Accruing unpaid expenses. 4. Accruing uncollected revenue
Introduction: Converting Assets to Expenses
- A cash expenditure (or cost) that will benefit more than
one accounting period usually is recorded by debiting
an asset account (for example, Supplies, Unexpired
Insurance, and so on) and by crediting Cash. - The asset account created actually represents the
deferral (or the postponement) of an expense. - In each future period that benefits from the use of this
asset, an adjusting entry is made to allocate a portion of
the asset’s cost from the balance sheet to the income
statement as an expense. - This adjusting entry is recorded by debiting the
appropriate expense account (for example, Supplies
Expense or Insurance Expense) and crediting the
related asset account (for example, Supplies or
Unexpired Insurance).
Introduction: Converting Liabilities to Revenue
- A business may collect cash in advance for services to be rendered in future accounting periods.
- Transactions of this nature are usually recorded by
debiting Cash and by crediting a liability account (typically
called Unearned Revenue or Customer Deposits). Here,
the liability account created represents the deferral (or the
postponement) of a revenue. - In the period that services are actually rendered (or that
goods are sold), an adjusting entry is made to allocate a
portion of the liability from the balance sheet to the income statement to recognize the revenue earned during the period. - The adjusting entry is recorded by debiting the liability
(Unearned Revenue or Customer Deposits) and by
crediting Revenue Earned (or a similar account) for the
value of the services
Introduction: Accruing Unpaid Expenses
- An expense may be incurred in the current
accounting period even though no cash payment
will occur until a future period. - These accrued expenses are recorded by an
adjusting entry made at the end of each accounting
period. - The adjusting entry is recorded by debiting the
appropriate expense account (for example, Interest
Expense or Salary Expense) and by crediting the
related liability (for example, Interest Payable or
Salaries Payable).
Introduction: Accruing Uncollected Revenue
- Revenue may be earned (or accrued) during the
current period, even though the collection of cash
will not occur until a future period. - Unrecorded earned revenue, for which no cash has
been received, requires an adjusting entry at the
end of the accounting period. - The adjusting entry is recorded by debiting the
appropriate asset (for example, Accounts
Receivable or Interest Receivable) and by crediting
the appropriate revenue account (for example,
Service Revenue Earned or Interest Earned).
Adjusting Entries and Timing Differences
- In an accrual accounting system, there are
often timing differences between cash flows
and the recognition of expenses or
revenue. - A company can pay cash in advance of
incurring certain expenses or receive cash
before revenue has been earned. - Likewise, it can incur certain expenses
before paying any cash or it can earn
revenue before any cash is received. - These timing differences, and the adjusting entries
that result from them, are summarized as follows.
◦ Adjusting entries to convert assets to expenses
result from cash being paid prior to an expense
being incurred.
◦ Adjusting entries to convert liabilities to revenue
result from cash being received prior to revenue
being earned.
◦ Adjusting entries to accrue unpaid expenses result
from expenses being incurred before cash is paid.
◦ Adjusting entries to accrue uncollected revenue
result from revenue being earned before cash is
received.
Adjusting Entries
- Adjusting entries are needed whenever revenue or expenses affect more than one accounting period
- Every adjusting entry involves a change in either a
revenue or expense and an asset or liability
Converting Assets to Expenses
Prior Periods:
Transaction- Pay cash in advance of incurring expense
(creates an asset)
Adjusting Entry:
Recognises portion of asset consumed as expenses, and
Reduces balance of asset account
Example: Insurance policy
The Concept of Depreciation
Depreciation is the systematic allocation of the cost of a depreciable asset to expense On date when initial payment is made: Fixed asset (debit) Cash (credit) At the end of the period: Depreciation expense (debit) Accumulated depreciation (credit)
Depreciation expense (per period) formula
Depreciation expense (per period) = Cost of the asset / estimated useful life
Book value formula
Book value = Cost - Accumulated Depreciation
Converting Liabilities to Revenue
Prior periods:
Transaction-Collect cash in advance of earning revenue
(creates a liability)
Adjusting Entry
Recognises portion earned as revenue, and
Reduces balance of liability account
Example: Rental Revenue
Accruing Unpaid Expenses
End of current period: Adjusting entry Recognises expenses incurred, and Records liability for future payment Future periods: Transaction- Pay cash in settlement of liability. Example: Wages owed
Accruing Uncollected Revenue
End of current period: Adjusting entry Recognises revenue earned but not yet recorded, and Records receivable Future periods: Transaction- Collect cash in settlement of receivable Example: Service Revenue
Supporting the Matching Principle
The matching principle underlies such accounting practices as:
◦ Depreciating plant assets.
◦ Measuring the cost of supplies used.
◦ Amortising the cost of unexpired
insurance policies.
All end-of-the-period adjusting entries involving expense recognition are applications of the matching principle.
Matching Costs? (2)
Costs are matched with revenue in one of two ways.
1. Direct association of costs with specific revenue transactions. The ideal method of matching revenue with expenses is to determine the actual amount of expense associated with specific revenue transactions. However, this approach works only for those costs and expenses that can be directly associated with specific revenue
transactions. Commissions paid to salespeople are an example of costs that can be directly associated with the revenue of a specific accounting period.
2. Systematic allocation of costs over the useful life of the expenditure. Many expenditures contribute to the earning of revenue for a number of accounting periods but cannot be directly associated with specific revenue transactions.
Examples include the costs of insurance policies and depreciable assets. In these cases, accountants attempt to match revenue and expenses by systematically allocating the cost to expense over its useful life. Straight-line
depreciation is an example of a systematic technique used to match the cost of an asset with the related revenue that it helps to earn over its
useful life
Materiality Concept
- Materiality refers to the relative importance
of an item or an event.
An item is considered material if knowledge of the item might reasonably influence the decisions of users of financial statements.
Accountants must be sure that all material items are properly reported in financial statements. - Immaterial items are those of little or no consequence to decision makers.
◦ The financial reporting process should be cost-effective—that is, the value of the information should exceed the cost of its preparation.
◦ Immaterial items may be handled in the easiest and most convenient manner.
Materiality and Adjusting Entries
The concept of materiality enables accountants to shorten and simplify the process of making adjusting entries in several ways. For example:
1. Businesses purchase many assets that have a very low cost or that will be consumed quickly in business operations. Examples include: wastebaskets, lightbulbs, and janitorial supplies.
The materiality concept permits charging such purchases directly to expense accounts, rather than to asset accounts. This treatment conveniently eliminates the need to prepare adjusting entries to depreciate these items.
2. Some expenses, such as telephone bills and utility bills, may be charged to expenses as the bills are paid, rather than as the services are used. Technically this treatment violates the matching principle. However, accounting for utility bills on a cash basis is very convenient, as the
monthly cost of utility service is not even known until the utility bill is received. Under this cash basis approach, the amount of utility expense recorded each month is actually based on the prior month’s bill.
3. Adjusting entries to accrue unrecorded expenses or unrecorded revenue may actually be ignored if the dollar amounts are immaterial.
Materiality and Professional Judgment
Whether a specific item or event is material is a matter of professional judgment. In making these judgments, accountants consider several factors: 1. The size of the organisation. 2. The cumulative effect of numerous immaterial events. 3. Nature of the item. 4. Dollar amount of the item
